AASB 116 Property Plant and Equipment - Example

Report On AASB116 Property Plant and Equipment Name: Course: Professor: Institution: City and State: Date: Factors likely to influence an entity in its choice between the revaluation model and cost model for measuring and accounting for non-current assets Plant, property and equipment can be referred to as tangible assets that have specific uses within a business entity. These uses range from production, supply, rental and administration. The assets are noncurrent, and thus are expected to be used for more than one accounting period. Property, plant and equipment whose fair value can be easily measured are accounted for using the revaluation model (Puxty and Laughlin, 1983). This is a reflection of the fair value at the date of the revaluation less any subsequent accumulated depreciation and impairment losses. However, care should be taken to ensure that the carrying amount is almost equal to the fair value. On the other hand, under the cost model property, plant and equipment are carried at cost less accumulated depreciation and impairment losses (Ronnie, 2011). The entity need to compute depreciation on the asset using a suitable depreciation method such as the straight-line method or accelerated depreciation method. In addition, the entity needs to perform an impairment test and compute impairment losses on the asset. When using the revaluation model, an entity should make the revaluations with sufficient regularity. This is done to avoid any material differences between the carrying amount and the amount that would be determined using fair value at the end of the reporting period. The revaluation surplus is credited when an asset’s carrying amount increases due to revaluation hence showing an improvement in asset value. In the event that the carrying amount of an asset falls or decreases due to a revaluation, the decrease is recognized as a loss unless there is a credit balance in the revaluation surplus. A credit balance would result in the revaluation surplus being debited for the amount of decrease to the extent of that credit balance (AICPA, 1980). Another factor likely to influence the model to use is where the revalued amount may be transferred to retained earnings. The amount of transfer is the difference between the depreciation based on the revalued carrying amount of the asset and the depreciation based on the asset’s original cost. The asset must have first been recognized and recorded in the books as an asset for it to be accounted for using either the cost or the revaluation model. All in all, it is a fact that the cost model is less complicated and easy to use than the revaluation model. AASB 116’s rationale for offering entities a choice in measurement models, and the pros and cons of this choice in terms of its potential effects on the relevance and reliability of financial reports. It must be appreciated that the cost model does not produce meaningful performance measurements in times of rapid changes in prices and money values. This is because property, plant and equipment need to be replaced on an ongoing basis. The costs of using property, plant and equipment should reflect its current cost, rather than an allocation based on historic costs. Historic cost may not be useful in providing the most relevant information for decision makers (Ronnie, 2011). However, engineers would argue that what is most meaningful is the replacement cost, as this is what should be budgeted to replace assets. Replacement cost also acts as a gauge for measuring estimated expenditures for maintenance and renewals of assets against actual expenditures. A different perspective would be that, at acquisition, the cost of an asset equals its current cost and fair value. After acquisition, however, there are basically three measurement options for valuing tangible capital assets: 1. Historical cost; 2. replacement cost commonly known as current cost; and 3. fair value or the market value. Varying values are used to support different decisions. For example, fair value is used when selling an asset. Replacement value may be very useful for insurance purposes or in a budgeting exercise, to estimate required financing requirements. On the other hand, historical cost is used for accountability and costing. Since accounting is transaction based, the most important measurement for both assets and liabilities is the value at the time they were acquired, developed or constructed. Therefore, historical cost accounting is more objective and reliable because it is based on haggled transactions. It successfully eliminates the uncertainties of using another measurement basis. Replacement cost basis, measures the value of a tangible capital asset at the possible current cost of replacing the asset. These costs reflect alternative uses for assets and are the current economic costs of obtaining similar service potential. The major advantage associated with accounting on a replacement cost basis is that it provides a realistic and understandable value for reported assets (Abdel and Rashad, 1976). This is particularly true for durable and tangible capital assets. This is because the related charge to operations for amortization has a current value corresponding to the values of other items such as revenue in the operating statement. This could be viewed as particularly useful when setting funding aside for eventual replacement of the asset. Fair value is the value of an asset based on the price that would be agreed on in an open and unrestricted market between fully informed, knowledgeable and willing parties. The advantages of using fair values for assets are the same as using replacement value. However, there may not be an active market for certain tangible capital assets and this makes the application of fair value fairly difficult. Lack of an active market and surrogate methods to determine fair values increases the extent of judgment required in preparing financial statements. There may be merit in using some other basis for the purposes of funding the replacement of a tangible capital asset. However the continued use of historical cost accounting is of utmost appropriateness. Historical cost can be independently verified and is reasonably free from error or bias. It also provides a consistent and verifiable foundation for the management to make estimates of future replacement costs or market value. Therefore, historical cost has been generally accepted by standard setters around the world for use in preparation of financial report (Ronnie, 2011). In addition, its application is well understood and it is still the preferred method of accounting for tangible capital assets. Cost model represents current value based on historical cost. It is commonly used for financial accounting purposes and it uses historical records of procurement that is first cost plus any subsequent costs, depreciated to present worth. It provides direct comparisons in time series progressions and its data is generally available and relatively simple. However, it does not account for changes in prices and ends up neglecting usage, technology and service standard changes. Another con is that its results can be misleading for older assets such as bridges and land. Revaluation model represents current values based on replacement cost depreciated to current condition. It is commonly used for management accounting purposes. Current market prices to be used to rebuild/replace and current condition is used to establish the write down value. The pros of this method are that it reflects current prices and technology and is easily understandable. It can easily compare assets and hence forms the basis for budgeting. On the other hand, its cons are that it is conjectural on replacement costs which means that it is subject to external market forces and there is the question of how to handle an upgraded/improved replacement. Issues of contention concerning class by class or item by item measurement and accounting for revaluation increments and decrements Accounting is done on an item by item basis, and revaluation is done on a class-by-class basis. Any Increase is taken directly to equity, rather than to the income statement. Asset revaluation reserve allows assets within an asset class to be revalued progressively over a 5-year period. In the contrary, AASB 116 does not allow progressive revaluations. It instead, requires all assets in a class to be revalued whenever a single asset in that class is revalued (Abdel and Rashad, 1976). It categorically states that, a class of assets may be revalued on a rolling basis given that the revaluation of the class of assets is completed within a short period of time. This is also subject to revaluations being up to date. AASB 116, does not however, clearly state what constitutes a short period. This is of major impact on accounting practitioner such as agencies. Without progressive revaluations, agencies with a large number of assets in an asset class will be required to revalue all the assets in that class within a single financial year. Where infrastructure assets are involved, this will require lots of effort to achieve. Accounting principles in use, allows revaluation increments and decrements to be offset against a revaluation reserve for a class of similar assets. On the contrary, AASB 116, require revaluation increments and decrements for-profit entities to be offset only against the asset being revalued and not against a class of assets. Not-for-profit entities are however allowed to offset revaluation increases and decreases against a class of similar assets. A not-for-profit entity can be defined as an entity whose principal objective is not to generate profit. A not-for-profit entity can take the form of a single entity or a group of entities comprising the parent entity and each of the entities that it controls. Accounting practitioners such as agencies fall within the definition of not-for-profit and so there will be no material distraction to their current treatment regarding revaluations. This will be different in public sector entities that aim at making profits (Ronnie, 2011). It however have a big impact on the way in which revaluation increments and decrements are treated and consequently on the administration of the asset revaluation reserve. This change in treatment of revaluation will result in more revaluation decrements being expensed. This is because an individual asset revaluation movement can no longer be offset against other asset revaluation movements within the same class. Effect of class by class basis of evaluation on reliability and relevance of financial reports If not carefully handled, use of class by class basis of evaluation can be detrimental to the reliability and relevance of financial report. Reliability is based on the fact that, the information agrees to the actual transaction and events to which it relates. Measures must therefore be taken to ensure that information relating to assets continues to satisfy the criterion of relevance. It is therefore necessary that periodic revaluations be performed. Determining the frequency of valuations depends on striking a balance between having relevant and time bound information and the cost of obtaining such information. It is important in such a case to provide for periodic comprehensive revaluations combined with annual interim revaluations based on specific indices. Accounting practitioners are therefore required to perform comprehensive revaluations at least once in a period of five years. They should undertake more frequent and comprehensive revaluations on the assets with significant or volatile changes in fair value. To enhance reliability, if any such change exists, the asset and the entire class to which the asset belongs should be revalued. AASB 116 provides that a class of assets may be revalued on a rolling basis as long as revaluation of the class of assets is completed within a short period and the revaluations are kept up to date. For reliability purposes, comprehensive revaluations may be conducted progressively over more than one year, provided that the entire asset class is revalued within a five-year period. Those assets not comprehensively revalued in a given year should be the subject of an interim revaluation. Changes in AASB116 that have been made since Ernst and Young (2002) study: A number of changes have been made on the AASB 116. It is required that property, plant and equipment be initially measured at its cost (Istemi and Pamela, 2011). The property, plant and equipment can after initial measurement be measured at either cost or at fair value, whichever is found to be more appropriate. In situations where property, plant and equipment are acquired at no nominal cost by a not-for-profit entity, the cost shall be taken to be its fair value as at the date of acquisition (Lawrence and Martin, 2011). Further changes have been made on revaluations, whereby it is required to be performed at the same time for all property, plant and equipment in the same class. On the other hand, revaluation increments or decrements in relation to property, plant and equipment held by a not-for-profit entity can be offset against a revaluation reserve for a class of similar assets. Any revaluation increments or decrements relating to property, plant and equipment that is held by a for-profit entity, must be offset against the revaluation reserve for that asset itself, and not against a class of assets. The last change aims at addressing the issue of property, plant and equipment disposal. In a nutshell, property, plant and equipment, shall be derecognized on disposal or when no future economic benefits are expected from use of the asset or from its disposal. Changes that could be made to increase the level of adoption of the revaluation model For easier adoption of the revaluation model, there is need for extra disclosure for revalued assets. Where items of Property, Plant and Equipment are stated at revalued amounts, it is important to disclose the method and significant assumptions that were used in estimating the assets value (Ronnie, 2011). It is also important to disclose the extent to which the items’ fair values were determined, giving direct reference to observable prices in an active market. A change is proposed that, each agency will need to disclose comparative information for their reconciliation in the notes to their first and subsequent financial statements (Judith and Ajay, 1997). It will be possible for accounting practitioners to use the reconciliation from their earlier financial statements unless they have changed valuation methodology on transition. Concerning disclosure of cost for property, plant and equipment measured at fair value. The proposal requires an entity to measures each class of Property, Plant and Equipment at fair value and to also disclose the carrying amount of that class had it been held at cost. Such provisions did not exist in the past. There is also in place an exemption on disclosure requirement for not-for-profit entities (Peter, Stark, and Martin, 2010). For those accounting practitioners that are not-for-profit, there will be no change to their current disclosure requirements. However, for-profit agencies, there is need to determine the historical cost for items of Property, Plant and Equipment measured at fair value, in order that cost information can be accurately disclosed. References Abdel, K. and Rashad, D., 1976.  An analysis of the attitudes of a sample of the AAA members toward. The Accounting Review, 21 (3), pp. 604–616. Accounting Firm and Practitioners AICPA, New York. 1980. American Institute of CPA's. Istemi, D. and Pamela, S., 2011. Risks and the financing of PPP: Perspectives from the financiers. The British Accounting Review, 43 (4), pp. 294-310. Judith, A. and Ajay, A., 1997. Journal of International Accounting. Auditing and Taxation, 6 (2), pp. 171-190. Lawrence, A. and Martin, P. L., 2011. Corporate governance and accounting research. Journal of Accounting and Public Policy, 30 (6), p. 503. Puxty, A. and Laughlin, H., 1983. A rational reconstruction of the decision usefulness criterion. Journal of Business Finance and Accounting, 10 (4), pp. 543–560. Peter, F. P., Stark, A. and Martin, W., 2010. The changes to come. Journal of Business Finance and Accounting, 24 (1), pp. 72-74. Ronnie, S., 2011. Liquidity risk and accounting information. The Journal of Accounting and Economics, 52 (3), pp. 144-152. Read More