Chapter 5Revaluations and impairment testing of non-current assets

Learning objectivesUnderstand how and when to revalue an item of property, plant and equipment in accordance with AASB 116Understand how and when to revalue an intangible asset in accordance with AASB 138Understand the difference in accounting treatments for upward revaluations to fair value, as opposed to downward revaluations to recoverable amountUnderstand what an impairment loss is and know how to account for oneContinues/

Learning objectives (cont.)Understand how to account for revaluations that act to reverse previous revaluation increments and decrementsUnderstand how to account for accumulated depreciation when a non-current depreciable asset is revaluedUnderstand that, subsequent to revaluation, new depreciation charges will be based on the revalued amount of the non-current assetKnow how the profit is determined on disposal of a revalued non-current assetContinues/

Learning objectives (cont.)Understand how asset revaluations can affect an organisations profits owing to changes in depreciation expenses and in final profits or losses on the sale of the revalued assetBe able to explain possible motivations driving an organisation to elect to/not to revalue its non-current assets to fair valueKnow the disclosure requirements pertaining to asset revaluations

Status of newly converged accounting standardsPrior to 2005, accounting standard for revaluations was AASB 1041 Revaluation of Non-Current AssetsNow there are two standards:AASB 116 Property, Plant and Equipment Requirements for revaluations, depreciation and determining acquisition cost of property, plant and equipmentAASB 138 Intangible Assets Revaluation of intangible assets and other issues

Continues/

Status of newly converged accounting standards (cont.)Prior to 2005, accounting standard for recoverable amount write-downs was AASB 1010 Recoverable Amount for Non-Current AssetsNow the standard is AASB 136 Impairment of Assets

IntroductionHistorical cost has been criticised for bearing no relation to current asset valuesIn Australia, entities may revalue many non-current assetsAASB 138 specifically excludes the revaluation of some intangiblesAsset revaluationsRecognising a reassessment of the carrying amount of a non-current asset to fair value as at a particular dateExcludes recoverable amount write-downs (i.e. impairment losses)Continues/

Introduction (cont.)If a non-current assets carrying amount exceeds its recoverable amount it must be written down to its recoverable amount (AASB 136)The write-down is called an impairment lossCarrying amount: cost of asset (or revalued amount) less accumulated depreciation or impairment lossesRecoverable amount: higher of an assets net selling price and value in use

Continues/

Introduction (cont.)Net selling price: amount obtained from the sale of an asset in an arms length transaction between knowledgeable, willing parties less the costs of disposalValue in use: present value of the future cash flows expected from an asset

Measuring property, plant and equipment at cost or fair valueAASB 116 requires each class of property, plant and equipment to be measured at either cost or fair valueExamples of classes are land and buildings, machinery and motor vehiclesSome classes can be measured at cost and others at fair valueWith a mix of measurement methods, is the total balance of non-current assets meaningful?Entities may switch from fair value to cost for justifiable reasons and provided adequate disclosures are made (AASB 116)

Continues/

Measuring property, plant and equipment at cost or fair value (cont.)Where an entity changes from cost to fair value for a class of non-current assets and there was a previous impairment loss (AASB 116):any increase in an assets carrying amount is first recognised as income; andany excess above the amount if no impairment loss was recognised is transferred to a revaluation reserveIf a class of non-current assets is measured at cost, AASB 136 is to be appliedIf an assets carrying amount is greater than its recoverable amount, an impairment loss must be recognisedThis is not a revaluation

The use of fair valuesAny revaluation of non-current assets must be to fair value (AASB 116)Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arms length transactionFair value is determined on the assumption that the entity is a going concernMarket price is to be used where an active and liquid market exists for the assetContinues/

The use of fair values (cont.)The required disclosures regarding asset revaluations (AASB 116) are:effective date of revaluationwhether an independent valuer was involvedmethods and assumptions appliedextent to which fair values were determined, with reference to observable prices in active markets or recent market transactionsfor each revalued class, the carrying amount if the cost model was usedthe revaluation reserve, indicating change for the period and any restrictions on distribution of the balance to shareholdersContinues/

The use of fair values (cont.)Revaluations must be made with sufficient regularity so the carrying amount of each asset in the class does not differ materially from its fair value (AASB 116)If values change regularly and changes are material, revaluations might be necessary each reporting periodOtherwise every three to five years is sufficient

Revaluation incrementsGeneral procedure (AASB 116):

Debit Asset Credit Revaluation reserve

Revaluation reserve is part of shareholders funds (owners equity)Directors may approve cash distributions to shareholders from revaluation reserves but they must exercise extreme caution

Treatment of balances of accumulated depreciation upon revaluationIf a revalued asset is a depreciable asset, any balance of accumulated depreciation is credited to the asset account prior to revaluation (AASB 116)Journal entry (net-amount method):

Debit Accumulated depreciationCredit Asset

Refer to Worked Example 5.1Subsequent depreciation is to be based on the revalued amount of the asset

Continues/

Treatment of balances of accumulated depreciation upon revaluation (cont.)Alternative method (AASB 116)Accumulated depreciation may be restated proportionately with the change in gross carrying amount of the asset, so the carrying amount after revaluation equals the revalued amountThis is referred to as the gross methodJournal entry:Debit AssetCredit Accumulated depreciationCredit Revaluation reserveRefer to Worked Example 5.2

Revaluation decrementsIn line with the concept of conservatism, revaluation decrements are recognised as an expense in the profit and loss accountJournal entry (AASB 116):

Debit Loss on revaluation of assetCredit Asset

Refer to Worked Example 5.3

Reversal of revaluation decrements and incrementsFor an asset class, reversals of previous revaluations should be recorded by the reverse of the initial revaluation entriesIf a revaluation decrement reverses a previous increment for the same asset:

DebitRevaluation reserveDebit Loss on revaluation (any excess)CreditAsset

Refer to Worked Example 5.4

Continues/

Reversal of revaluation decrements and increments (cont.)If a revaluation increment reverses a previous decrement for the same asset:

DebitAssetCreditGain on revaluation CreditRevaluation reserve (any excess)

Accounting for profit on disposal of a revalued non-current assetGain or loss from derecognition of an item of property, plant and equipment is to be calculated as the difference between (AASB 116):net disposal proceeds (if any); and the assets carrying amountDerecognition:the point in time when an asset is removed from the balance sheetwhen an asset is sold; orwhen no future economic benefits are expected from an assets use or disposalContinues/

Accounting for profit on disposal of a revalued non-current asset (cont.)When an asset is sold, any resulting balance in the revaluation reserve (AASB 116):may be transferred directly to retained earningscannot be transferred to the profit and loss accountIf a non-current asset is revalued upwards, any gain on sale will be less than the gain if the asset was not revaluedRefer to Worked Examples 5.5, 5.6 and 5.7

Consideration of present valuesRecoverable amount is the higher of an assets net selling price and its value in use (AASB 136)Value in use (AASB 136):is the present value of the future cash flows expected from an assetEstimating value in use (AASB 136) involves:estimating future cash inflows and outflows from the continued use and subsequent disposal of the asset; and applying the appropriate discount rate to the future cash flowsDiscounting future cash flows will decrease the calculated recoverable amount

Offsetting revaluation increments and decrementsThe old AASB 1041 required increments and decrements to be offset against each other within a class of non-current assetsNow, increments and decrements may be offset only to the extent that they relate to a particular asset (AASB 116)

Economic consequences of asset revaluationsIf contracts in place are tied to reported profits (debt or management compensation), management might have an incentive not to revalueHowever, if assets are increased a revaluation might loosen constraints such as debt-to-assets restrictionsFirms subject to political scrutiny might be more likely to undertake upward revaluation resulting in a reduction in profitsAs the perceived competence of independent valuers increases, audit time might be reduced

Disclosure requirementsAASB 116 includes various disclosure requirements relating to the revaluation of non-current assetsThese were previously discussed under the heading The use of fair values

SummaryThe chapter considers the revaluation of non-current assets, with the emphasis on property, plant and equipmentIf the recoverable amount is below the carrying amount, an impairment loss should be recordedFor upwards revaluations:assets are to be revalued to fair valueany increase is to be transferred to a revaluation reserve, unless it is a reversalFor downwards revaluations:any decrease is to be treated as an expense, unless it is a reversalContinues/

Summary (cont.)When a revaluation is undertaken:any existing accumulated depreciation should be credited against the non-current asset; and the non-current asset should be increased by the amount of the revaluationWhere a revalued asset is sold, the gain or loss is the difference between the carrying amount and the net disposal proceeds of the assetThe chapter also discusses how revaluations can loosen certain accounting-based debt covenants

Summary of main changes to accounting standardsPreviously it was permitted to offset increments and decrements within a class of property, plant and equipment. Now this must be done on an asset-by-asset basisPreviously future cash flows could be discounted to present values, but they did not have to be. Now there is an explicit requirement for future cash flows to be discounted to present valuesContinues/

Summary of main changes to accounting standards (cont.)Previously when a revalued asset was sold it was permissible but not required to transfer any related revaluation increment to retained earnings. Now when a revalued asset is sold any related revaluation increment must be transferred to retained earnings

Previously the account was referred to as an asset revaluation reserve. Now it is to be referred to as a revaluation reserve