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Asset Valuation

Property, Plant and Equipment

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Introduction

• Property, plant and equipment are defined as fixed tangible assets which are held by a company for use in the production or supply of goods and services, for rental to others, or for administrative purpose

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The notion of cost

• Historical Cost

• Replacement Cost

• Fair value

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Historical cost

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Historical Cost

• Historical cost is the amount paid to acquire goods or services.

• It includes all expenditures which prepare the asset for intended use

• Apart from the invoice price of the asset, it also includes the freight charges, import duties and installation costs of the asset

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Replacement cost

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Replacement Cost

• Replacement cost is the current cost to replace or to purchase an item similar to the existing item

• It abandons the realization concept• Under replacement cost accounting, the net

profit obtained from the profit and loss account includes both the operating income and holding gain

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Fair value

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Fair value

• It is the amount for which as asset could be exchanged for in a fair transaction

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Example 1

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Example 1Chan started a business with a capital of 1000 units of stock at $1 per unit. On 1 October, he sold 700 units at $2 per unit. The price level indicates for the year are:

Replacement Cost1 Jan 2007 $1.01 October 2007 $1.331 December 2007 $1.5

Profit and loss account for the year ended 31 December 2007Historical cost Replacement cost

Sales (700*$2) 1400 1400Less: Cost of sales 700 910Gross profit 700 490Realized holding gain 210Unrealized holding gain 150Net profit 700 850

700*1.3

700*0.3

300*0.5

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Balance Sheet as at 31 December 2007Historical cost Replacement cost

Stock 300 450Cash 1400 1400

1700 1850Capital 1000 1000Add Profit – realized 700 700

- unrealized 1501700 1700

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Valuation of Property, plant and equipment• Property, plant and equipment are fixed tangible

assets that– Are held by an enterprise for use in the production or

supply of goods or services, for rental to others, or for administrative purpose; and

– Are expected to be used during more than one period

• Property, plant and equipment should be carried at its cost less any accumulated depreciation and any accumulated impairment losses

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Land and buildings

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Land and buildings

• Freehold land

• Leasehold land

• Buildings

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Freehold Land

• It has an unlimited useful life, and its value does not decline over time, so it should be treated as non-depreciable assets

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Leasehold land

• Leasehold land should be regarded as depreciable assets whether the lease is more than 50 years or not

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Buildings

• Buildings have limited useful lives. The cost should be allocated over their useful economic lives, so they should be regarded as depreciable assets

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Exception to the treatment of land and buildings• Land and buildings held for resale

• Investment properties

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Land and building held for resale• They should be treated as trading stock.

These assets are stated at the lower of cost and net realizable value

• No depreciation should be provide for

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Investment properties

• They are land and buildings held as investments, and not for the consumption in the operation of business

• They should not be subject to depreciation, except when the lease of a property is for less than 20 years

• They should be valued at open market value

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• An increase in value should be credited to the investment property revaluation reserve

• A decrease in value should be debited to the investment property revaluation reserve. If the reserve is insufficient, the decrease can also be debited to the profit and loss account

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Initial measurement of property, plant and equipment• Cost of property, plant and equipment

• Expenditures not included in the cost of property, plant and equipment

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Cost of property, plant and equipment• An item of property, plant and equipment

should be recognized as an asset and recorded at its cost

• Cost= Purchase Price + Other acquisition costs – Trade discounts -

rebates

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Example 2

• Cost of property

$Construction cost 2000000Stamp duty 140000Legal cost 50000Land premium 5000000Cost of site preparation 400000Cost of dismantling the old property 100000

7690000

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Example 3

• Cost of equipment

$Purchase price 200000Less: Trade discounts 20000

180000Import duty 10000Delivery cost 4000Installation cost 3000

197000

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Expenditures not included in the cost of property, plant and equipment

• Assets are recorded at their cash prices. Interest expenses should not be included in the purchase price unless they are capitalized in accordance with the SSAP 19 ‘ Borrowing cost’

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• If the asset is produced by the firm itself, the following costs should not be included in the cost of property, plant and equipment:– Administrative cost– General overhead cost– Start-up and similar pre-production costs– Internal manufacturing profit– Abnormal amounts of wasted material, labour, or

other resources incurred in the production of a self-constructed asset

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Subsequent expenditure

• Improvement on property, plant and equipment can be recognized as assets only when the expenditure can improve the condition of assets beyond their originally assessed standard of performance

• Examples of improvements, can be capitalized, include:– Modifying an asset to extend its useful life and to

increase its productive capacity;– Upgrading an asset to achieve a substantial

improvement in the quality of output

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– Adopting new production processes to assure a substantial reduction in previously assessed operating costs

• It the subsequent expenditure only restores or maintains the future economic benefits to the originally assessed standard, it should be written off as an expense when it is incurred. Examples include repairing and maintenance

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Revaluation

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Revaluation

• Two different bases for the determination of the carrying amount (NBV) of property, plant and equipment

• As asset may be stated either:– At cost less accumulated depreciation and any

accumulated impairment losses– At a revaluated amount, being the fair value

(fair market value), less any subsequent accumulated depreciation

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• Owning to the substantial difference between the cost and market value of land and buildings, revaluation of land and buildings is a common practice in Hong Kong

• The fair value is determined by appraisal normally undertaken by professional qualified valuers

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• Although revaluation of plant and equipment is permitted by the SSAP, enterprises seldom recognize the market value of plant and equipment in their balance sheets

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Several points should be noted upon revaluation of asset:• An increase in the value of property, plant and

equipment should be credited directly to equity under the heading of “ revaluation reserve”

• Accumulated depreciation prior to the revaluation should be credited to the revaluation reserve

• After revaluation, depreciation should be charged against the revalued amount

• When the revalued asset is disposed of, the revaluation reserve should be transferred directly to the retained profits but not to the profit and loss account

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Example 4

• The purchase price of land and buildings was $100 million at 1 January 2000. 10% depreciation on cost was charged

Revalued on 1 January 2002 $120m

Sold on 1 January 2003 $140m

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The JournalDr. Cr.$m $m

2002Jan 1 Land and Buildings 20

Provision for deprecation($100*10%*2) 20Revaluation reserve 40

Being surplus on revaluation transferred to the revaluation reserve

Dec 31 Profit and loss (120/8) 15Provision for depreciation 15

Being provision for deprecation on the revalued amount over the remaining useful economic life

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The JournalDr. Cr.$m $m

2003Jan 1 Bank 140

Provision for deprecation 15Land and buildings 120Profit and loss – gain 35

Being disposal of land and buildings

Jan 1 Revaluation reserve 40Retained profit 40

Being transfer of the realized revaluationreserve to the retained profits

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Treatment of revaluation surplus and deficit• An increase in value should be credited

directly to equity under the heading of ‘revaluation reserve’

• A decrease should be charged directly against the revaluation reserve

• If the amount of the revaluation reserve is insufficient to write off the decrease in value, the decrease can be recognized as an expense in the profit and loss account

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• If the fair value rises again, the revaluation deficit recognized as expenses previously should be reversed and credited to the profit and loss account as income

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Example 5

• On 1 Jan 2000, A Ltd. purchased a freehold land at a cost of $100 million. No depreciation would be provided on the freehold land

• On 31 Dec 2002, owing to the property market boom, the freehold land was revalued to $140 million

• On 31 Dec 2003, the property market crashed. The freehold land was revalued to $90 million

• On 31 Dec 2004, the housing policy changed and the property market boomed again. The freehold land was revalued to $160 million.

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The JournalDr. Cr.$m $m

2000Jan 1 Freehold land 100

Bank 100Being purchase of Freehold land

2002Dec 31 Freehold land 40

Revaluation reserve 40Being surplus on revaluation transferredto the revaluation reserve

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The JournalDr. Cr.$m $m2003

Dec 31 Revaluation reserve 40Profit and loss 10

Freehold land 50The revaluation deficit should be directly charged against the revaluation reserve. The excess amount of revaluation deficit over the related revaluation reserve should be charged as an expense to the profit and loss account

2004Dec 31 Freehold land 70

Profit and loss 10Revaluation reserve 60

Being reversal of the write down of $10 million and revaluation of the asset to its fair value

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Impairment loss

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Impairment loss

• Property, plant and equipment should be stated at cost less accumulated depreciation and any accumulated impairment losses

• An asset is impaired when its carrying amount exceeds its recoverable amount

• If there is no indication of impairment loss, it is not required to make a formal estimate of recoverable amount

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Definition

• Carrying amount

• Recoverable amount

• Net realizable value

• Value in use

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Carrying amount

• Carrying amount is the net book value at which an asset is recognized in the balance sheetCarrying amount

= Historical cost – Accumulated depreciation –

Accumulated impairment losses

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Recoverable amount

• Recoverable amount is the higher of an asset’s net realizable value and value in use

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Net realizable value

• Net realizable value is the amount at which an asset could disposed of, less any direct selling costs

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Value in use

• Value in use is the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life

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• When an impairment loss occurs, the revised carrying amount shown in the balance sheet is calculated as follows:

Revised carrying amount

Lower of

Carrying amount Recoverable amountOR

Value in useNet realizable value

Higher of

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Indications of impairment

• The enterprise should estimate the recoverable amount of assets if the following indications of impairment appear:– External indicators– Internal indicators

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External indicators

• A significant decline in the market value of asset

• Material adverse changes in the technological, economic or regulatory environment

• Long-term increase in market interest rates which results in a material decrease in the asset’s recoverable amount

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Internal indicators

• Obsolescence or physical damage of an asset

• Discontinued operation or major reorganization

• Evidence indicating that the economic performance of an asset is worse than expected

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Treatment of impairment loss

• If the carrying amount (cost less accumulated depreciation) exceeds the recoverable amount (the higher of net realizable value and value in use), there will be impairment loss

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Accounting entriesDr. Profit and loss

Dr. Accumulated depreciation

Cr. Asset

Assets previously stated at cost

Dr. Revaluation reserve

Cr. Asset

Assets previously revalued and the revaluation reserve is greater than the impairment loss

Dr. Revaluation reserve (first)

Dr. Profit and loss

Cr. Asset

Assets previously revalued and the revaluation reserve is less than the impairment loss

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Example 6

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• On 1 January 1991, Fortune Ltd. bought a building at a cost of $2000000. The building had a useful life of 20 years and depreciation was charged on a straight line basis

• Owing to the changes in market condition, Fortune Ltd. considered that the building might be impaired. On 31 December 2002, the directors estimated that the net selling price was $480000 (estimated selling cost of $50000 less selling cost of $20000) and the value in use of the asset was $300000

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$Historical cost 2000000Accumulated depreciation as at December 2002 (2000000*5%*12) 120000

800000Less: Recoverable amount

(the higher pf the net selling price of $480000 and the value in use of $30000) 480000

Impairment loss 320000

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The JournalDr. Cr.$m $m

Profit and loss 320000Provision for depreciation 1200000

Buildings (2000000 – 480000) 1520000

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Example 7

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• On 1 January 1991, Fortune Ltd. bought a building at a cost of $2000000. The building had a useful life of 20 years and depreciation was charged on a straight line basis

• On 1 January 2001, caused by the property market boom, the building was revalued to $2500000 with a remaining useful life of 10 years

• Owing to the changes in market conditions, Fortune Ltd considered that the building might be impaired . On 31 December 2002, the directors estimated that the net selling price was $480000 (estimated selling cost of $500000 less selling cost of $20000) and the value in use of the asset was $300000

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$Revalued amount 2500000Accumulated depreciation as at December 2002 (2500000*2/10) 500000

2000000Less: Recoverable amount

(the higher pf the net selling price of $480000 and the value in use of $30000) 480000

Impairment loss 1520000

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The JournalDr. Cr.$ $

2001Jan 1 Building 500000

Provision for depreciation($2000000*5%*10) 1000000

Revaluation reserve 1500000Being surplus on revaluation transferredto the revaluation reserve

2001Dec 31 Profit and loss 250000

Provision for depreciation($2500000*10%) 250000

Being provision for depreciation on the revalued amount

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The JournalDr. Cr.$ $2002

Dec 31 Profit and loss 250000Provision for depreciation($2500000*10%) 250000

Being provision for depreciation on the revalued amount

2002Dec 31 Revaluation reserve (1st ) 1500000

Profit and loss (then) 20000Provision for depreciation 500000

Buildings(2500000-480000) 2020000

Being carrying amount written downto the recoverable amount

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Subsequent reversal of an impairment loss• After the recognition of an impairment loss, the

depreciation should be provided on the revised carrying amount, less any residual value, over its remaining useful life

• If the impairment loss recognized in previously years decreases or on longer exists, the carrying amount of the asset should be increased to its recoverable amount. That increase is a reversal of an impairment loss

• The reversal of impairment loss is restricted to the amount that will restore the carrying amount as if no impairment loss has been recognized

Recoverable amount

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Example 8

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• On 1 January 1991, Fortune Ltd. bought a building at a cost of $2000000. The building had a useful life of 20 years and depreciation was charged on a straight line basis

• Owing to the changes in market conditions, Fortune Ltd. considered that the building might be impaired. On 31 December 2002, the directors estimated that the recoverable amount was $480000.

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Ans.

• An impairment loss of $320000 was recognized (I.e. 2000000*8/20 - $480000)

• After recognition of impairment loss, the depreciation 60000 (I.e. 480000*1/8) should be provided on the revised carrying amount of $480000 over its remaining useful life of 8 years

• The carrying amount at 31 December 2003 was $420000(I.e. $480000*7/8)

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Ans

• After the recognition of impairment loss, the depreciation $60000 should be provided on the revised carrying amount of $480000 over its remaining useful life of 8 years

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• Owning to the change of the housing policy, the directors determined the recoverable amount at 31 December 2004 has increased to $1700000

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Ans

• The recovery of carrying amount is shown as follows:Carrying amount as at 31 Dec 2003 as if no impairment loss has been recognized ($800000*7/8) 700000Less: Carrying amount as at 31 Dec 2003

after recognizing the impairment loss 420000

Reversal of impairment loss 280000

$

200000*8/20

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Ans.The Journal

Dr. Cr.

Buildings 280000Profit and loss 280000*The carrying amount of buildings will be shown as $700000

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• If the enterprise wants to recognize the market value of the property (I.e. $1700000) in its balance sheet, the remainder of the uplift (I.e. $1000000) would be treated as a revaluation movement

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Ans.The Journal

Dr. Cr.

Buildings 1220000Provision for depreciation (480000*1/8) 60000Profit and loss (first) 280000

*The carrying amount of buildings will be shown as $700000

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Investments

• Both long-term investments and current investments should be valued at the lower of cost and market value

• Investment are recorded at their cost of acquisition, while permanent decreases in value may be written off against current profits. Increases in value are not recognized until realized

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Example

• Cost of quoted securities in 1995 $100,000

• Market value of investment in 1996 $95,000

• Market value of investment in 1997 $110,000

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1996 Dr. Profit and loss $5000 Cr. Provision for Diminution in

value of investment $5000

1997 Dr.Provision for Diminution in value of investment $5000

Cr. Profit and loss $5000

Balance Sheet as at 31 Dec (extract)

1996 Investments Quoted securities ,at market value (cost$100000) 95000

1997 Investments Quoted securities ,at cost (mkt. value$110000) 100000

$

Ans: