On December 2, 2009, I was a speaker at an IFRS conference in Toronto, Canada, organized by Acumen Information Services. There were 3 areas that I discussed, all of which seem to be attracting a lot of discussion on IFRS forums, on my web-site blogs, and when I’m talking to people;
• IAS 16 – Property, Plant & Equipment – Revaluation Model and Cost Model.
• IAS 36 – Impairment of Long-Lived Assets, which is tied to Property, Plant and Equipment.
• IAS 40 – Investment Property
The first two topics are relevant to almost every company. Investment Property may not apply to every company, but it does there is a fair value choice associated with it that is important to understand.
In this blog, I am summarizing the discussion on the Revaluation Model.
When I received the list of delegates attending this conference, apart from being very impressed with the quality of the attendees, what I also noticed was that most people are from companies which have large amounts of fixed assets. PP&E is usually the single largest asset group within a manufacturing company, oil & gas, mining and resource based companies. The TSX and Venture exchanges are heavily weighted with these types of companies.
So, where am I going with this? There are fairly big differences between Canadian GAAP and IFRS, as it pertains to these assets. And, since this is such a significant portion of assets for most publicly traded companies, I think it is important to understand these differences, and the options available.
A quick Canadian GAAP refresher – you do not re-measure PP&E at Fair Value. It is only measured at Fair Value if it is lower than the carrying cost of the asset as a result of an impairment loss, which causes the Fair Value to fall below cost.
First, please understand that there is a difference in IFRS between the Fair Value Model and Revaluation Model. The REVALUATION model pertains to Property Plant & Equipment under IAS 16, whereas the FAIR VALUE Model pertains to INVESTMENT PROPERTY, under IAS 40 and is discussed in a separate blog.
Under IFRS, there is a choice to be made in accounting policy – either at COST and depreciating, which is essentially the same as Canadian GAAP, or FAIR VALUE using REVALUATION Model and depreciating.
This choice is available on a class by class basis, and a company can choose whatever is most convenient and relevant for them to use.
However, once the choice is made, it should be followed on a consistent basis. Later in this blog I will also discuss the elections available under IFRS-1, which may be helpful during the initial transition to IFRS.
The key fair value measurement concepts of the Revaluation Model are:
• It should be Market based.
• Determined by professionally qualified valuators and
• The frequency of revaluation depends to the type of asset and its price volatility.
Here are a few extracts from the IAS standards to give you a sense of the detail involved….
31 An item of property, plant and equipment whose fair value can be measured reliably shall be carried at its fair value at the date of the revaluation, less any subsequent accumulated depreciation and impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.
32 The fair value of land and buildings is usually determined from market-based evidence by appraisal that is normally undertaken by professionally qualified valuators. The fair value of items of plant and equipment is usually their market value determined by appraisal.
36 If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued.
The key concept is that, for the most part, any revaluations will impact EQUITY, and not Operating income.
In the Revaluation model, any increase in Fair Value does not go through OPERATING INCOME.
Instead, it is recognized directly on the Balance Sheet.
On the asset side – the carrying amount of PP&E is increased.
On the liability side, the increase goes directly to Equity – Revaluation Surplus.
A decrease in Fair Value also affects the Balance Sheet only – in other words no impact to Operating income.
Only if there is a decrease in Fair Value, below any previous increases, does it go through Operating Income as an expense item.
So, in summary…
• Revaluations that increase FV are recognized directly in Equity.
• Revaluations that decrease FV but remain above original Carrying value are also recognized in Equity.
• Revaluations that go below the original Carrying value go to the Income Statement.
To help with the understanding, I thought it would be helpful to provide an example. Suppose that a company has Land and Building that is used for a corporate head office, and they decide to use the Revaluation Model, and to re-measure at Fair Value. IFRS rules require that all buildings used in the same manner in the entities operations, must be also be accounted for at Fair Value using the Revaluation Model.
Just to make sure everyone understands what I mean by an asset class…..a class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. The following are examples of separate classes:
(b) Land and buildings;
(f) Motor vehicles;
(g) Furniture and fixtures; and
(h) Office equipment.
These asset groups are similar to what we all are familiar with under Canadian GAAP.
In this example Land and Building have a Carrying Value of $100, and has a fair value of $120.
With the Revaluation model, the $20 increase in Fair Value is reported on the Balance Sheet as Equity – Revaluation Surplus.
At a later date, the Land and Building is revalued, and the Fair Value decreases to $110.
In this situation, the carrying value of the asset decreases by $10, and the change is reported as a decrease in Equity.
Finally, the Land and Building are revalued again, and the Fair Value decreases to $90.
In this situation, the carrying value of the asset decreases by $20.
Of this change, $10 is reported as a decrease in Equity.
A further $10 change is reported as an expense, and would flow through Operating Income.
Once again, the basic premise is that revaluations do not affect the Operating Income, but rather are recognized directly in Equity, unless the revaluation decreases an asset value below its original carrying value – in this situation it would affect Operating Income as an expense item.
Note – in the presentation, I included a column for Comprehensive Income which is not Operating Income. I assume everyone is familiar with the difference. If not – very simply it can be thought of as a way to reconcile items that impact Balance Sheet Equity, but that do not impact Operating Income. The concept has been used in Canada since 2006, and will continue to exist with IFRS.
Under the Revaluation model, any change to fair value, also has an impact to amortization – any revaluation that increases the asset value, also increases the amount of amortization that must be recognized in Operating Income. Conversely, any revaluation that decreases an asset also decreases the amount of amortization that is required.
So the important point to remember, is that any fair value changes described in the previous example that impact the Balance Sheet Equity accounts – even though those changes don’t impact the income statement, the changes in the carrying value of the asset, will require a change in amortization. And this is one of the main reasons that the Revaluation model can present problems for accountants.
There are a lot of disclosure requirements with IFRS in general, and IAS 16 is no exception. There is a fairly lengthy list of disclosure requirements, and I can’t list them all but I am highlighting some of the more notable ones as they pertain to the Revaluation Model under IAS 16….
(a) Effective date of the revaluation;
(b) Whether an independent valuator was involved;
(c) The methods and significant assumptions applied in estimating the items’ fair values;
d) the extent to which the items’ fair values were determined directly by reference to observable prices in an active market or recent market transactions on arm’s length terms or were estimated using other valuation techniques;
(e) For each revalued class of property, plant and equipment, the carrying amount that would have been recognized had the assets been carried under the cost model; and
(f) The revaluation surplus, indicating the change for the period and any restrictions on the distribution of the balance to shareholders.
The internal controls associated with PP&E typically include; separate fixed asset sub-ledgers, reconciliations between the sub-ledger and GL, and verification of the carrying values, which under Canadian GAAP is historical cost.
Additional controls will be required if a company elects to use the Revaluation model, because it will be important to have a process in place to ensure that Fair Values are based on a structured, consistent approach with readily available market data that can be verified. In other words, a key control would be to review and approve this calculation.
I think the internal controls will be very important because of the Bill 198 certifications for public companies. Bill 198 is not disappearing with IFRS.
IFRS-1 Exemptions and Exceptions
As I mentioned previously, IFRS-1 is available for companies as they transition to IFRS for the first time. There are many elections and exemptions available, but I will discuss one that is relevant here. It relates to the requirement to have comparable information for 2010 as entities transition to IFRS in 2011.
The general principle is that for a calendar year company that is presenting IFRS financial statements for 2011, and comparatives for 2010, the IFRS standards must be applied retroactively to the periods that are being presented.
That sounds terrible, but thankfully it is not as bad as it sounds. Reason for that is that in IFRS-1, the standard setters have provided a lot of relief from the general principle.
Companies that may have not sufficient information to recreate PP&E, perhaps due to componentization or impairments, can use the exemption under IFRS-1 to designate fair value as the “deemed cost” at the date of transition to IFRS.
Afterwards, you can elect to use Cost or Revaluation model and your work is done.
One of the benefits of this exemption is that you can do it on an asset by asset basis – so you could do it for every asset, or asset class, or just one – the choice is yours – you can use whatever is most convenient to your company.
I hope this helps. This is one of a series of blogs that is meant to convey information relating to Canada’s transition from Canadian GAAP to IFRS.
For further information, please refer to the ongoing series of IFRS blogs on the Edelkoort Smethurst Schein CPA’s LLP web-site and please remember to contact your accounting professional for further guidance.
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