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MAA716 Financial Accounting Suggested Solution Topic 3 Chapter 6 Revaluations and impairment testing of non-current assets Review questions 6.1

What effect will an asset revaluation have on subsequent periods’ profits? Explain your answer. LO 6.10

Solution: If an upward asset revaluation has been undertaken for a depreciable asset, then depreciation in subsequent periods will increase, as the depreciation will be based on the higher revalued amount (which becomes the new ‘carrying amount’). Profit on sale of the asset, before the completion of its useful life, will also be lower. For example, to show how a revaluation can reduce any profit recorded on the ultimate sale of an asset, assume that a reporting entity has land recorded at a cost of $100 000 and then elects to revalue it to $300 000. The difference of $200 000 will be transferred to the revaluation surplus account, and is not treated as part of the period’s profits (although the increase will be included as part of ‘other comprehensive income’). If in a subsequent period the entity sells the asset at a price of $350 000, then it will record a profit on sale of $50 000 which will be included in profit or loss. Had it not revalued the land it would have recorded a profit on sale of $250 000. While the related revaluation surplus balance of $200 000 will need to be transferred to retained earnings when the revalued asset is ultimately sold, this transfer will be directly to retained earnings and will not go via profit or loss. Hence the transfer will not impact reported profits in the year of transfer. In summing up, upward asset revaluations will have an effect of decreasing profits in subsequent periods, either through increased depreciation and/or through decreased gains on sale.

6.3

When should a revaluation increment be included as part of profit or loss? LO 6.6, 6.8

Solution: A revaluation increment will always go to the statement of profit or loss and other comprehensive income, but it might be included either as part of profit or loss, or as part of ‘other comprehensive income’. A revaluation increment should be credited to the statement of comprehensive income as part of profit or loss when it reverses a previous devaluation to a particular class of assets. (The initial revaluation decrement would have been treated as an expense.), otherwise the increment goes to a revaluation surplus (and the increase in the revaluation surplus would be shown as part of ‘other comprehensive income’ in the statement of comprehensive income). As paragraph 39 of AASB 116 states in relation to property, plant and equipment:

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If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss. 6.7

If an item of property, plant and equipment is measured at cost, but the recoverable amount of the asset is determined to be less than cost, what action must be taken? LO 6.2, 6.5, 6.6, 6.7

Solution: It should be understood that within AASB 116 reporting entities have a choice between the ‘cost model’ and the ‘revaluation model’. A similar choice is available for intangible assets pursuant to AASB 138 (although there is a prohibition on the revaluation of many intangible assets). If the revaluation model is adopted then AASB 116 requires that after recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated 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 reporting date. If the cost model is adopted then after recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. Determination of recoverable amount can often be based on a great deal of professional judgement. AASB 116 requires that where property, plant and equipment are valued at cost, the carrying amount of the asset is not to exceed the recoverable amount. If the recoverable amount (which is defined as the higher of an asset’s fair value less costs of disposal and its value in use) is less than the carrying amount then an impairment loss must be recognised. An impairment loss is defined in AASB 116 as the amount by which the carrying amount of an asset exceeds its recoverable amount.

6.8

If a reporting entity decides to revalue its property, plant and equipment, what basis of valuation must be adopted? LO 6.3

Solution: Where a revaluation of a non-current asset is undertaken, that revaluation must be to fair value. As paragraph 31 of AASB 116 states: After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not

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differ materially from that which would be determined using fair value at the end of the reporting period. Fair value is defined in AASB 116 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 6.11

How could a revaluation of a non-current asset minimise or loosen the effects of a restrictive debt covenant? LO 6.10, 6.12

Solution: It is common for a restriction to be imposed by lenders upon borrowers that restricts the level of debt that a borrowing company may attract. This limitation may be based on some proportion of total assets (see Whittred and Zimmer, 1986). Increasing the carrying amount of assets through a revaluation will decrease the debt to asset ratio, thereby potentially loosening the effects of a debt restriction. Whittred and Zimmer (1986), however, point out that it is quite common that the debt contracts will restrict the ability of the firm to undertake revaluations for the purposes of the debt covenant. For example, it is quite common that only revaluations that are based on valuations given by valuers approved by the debt holders, or their trustee, may be included in the debt-to-asset ratio calculation.

6.12

Ignoring reversals of previous revaluations, do you think that requiring revaluation decrements to be part of the period’s profit or loss but letting revaluation increments go to the revaluation surplus is consistent with the requirements of the conceptual framework? Explain your answer. LO 6.3, 6.6, 6.10

Solution: Such a requirement would appear to be inconsistent with the conceptual framework, particularly in relation to the expectation that financial statements be free from bias. Requiring that only decrements be part of the period’s profit or loss (as expenses) introduces a conservative bias into the financial statements. Such notions of conservatism are not embodied within the conceptual framework, or within the definition and recognition criteria for the elements of accounting as provided in the conceptual framework. If decrements are to go to the statement of comprehensive income as an expense (and remember, pursuant to the conceptual framework, expenses arise when there is a reduction in assets, other than those relating to distributions to owners, that results in a decrease in equity during the period), then consistent with the conceptual framework, the increments would also be transferred to the statement of profit or loss and other comprehensive income as income. (Income arises when there is an increase in assets, other than those relating to contributions by owners, that result in an increase in equity during the period.) Nevertheless, accounting standards take precedence over the conceptual framework, and AASB 116 (and AASB 138 with respect to intangible assets) requires that, in the absence of reversals of previous increments or decrements, revaluation increments go to a revaluation surplus (and not be treated as part of profit or loss, but would be treated as part of ‘other comprehensive income’ in the statement of profit or loss and other comprehensive income), while decrements go to profit or loss within the statement of profit or loss and other comprehensive income (and be treated as expenses).

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It can be noted that requiring revaluation increments to be excluded from profit or loss (except in the case of reversals of previous decrements), but requiring revaluation decrements to be included in profit or loss (except in the case of reversals of previous increments) is generally consistent with the concept of ‘prudence’, which for a number of years was a cornerstone of financial reporting (one aspect of prudence was that profits should never be overstated). In the Exposure Draft of a revised conceptual framework released in May 2015, the idea of ‘prudence’ was explicitly reintroduced. In the Exposure Draft it is stated: Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets and income or the overstatement of liabilities and expenses, because such misstatements can lead to the overstatement of income or the understatement of expenses in future periods. It would appear therefore that the most recent reference to ‘prudence’ also does not provide strong justification for the asymmetrical treatment of revaluation increments and decrements that currently exists within accounting standards.

6.13

An item of depreciable machinery is acquired on 1 July 2015 for $120 000. It is expected to have a useful life of 10 years and a zero residual value. On 1 July 2019, it is decided to revalue the asset to its fair value of $110 000.

REQUIRED: Provide journal entries to account for the revaluation. LO 6.1, 6.2, 6.3

Solution: The revaluation takes place four years after acquisition, therefore, assuming the straight-line method of depreciation is used, the accumulated depreciation at revaluation date would be equal to $120 000 x 10% x 4 = $48 000. The carrying amount before the revaluation would be $72 000. 1 July 2019 Dr Cr

Accumulated depreciation Machinery

48 000

Dr Cr

Machinery Revaluation surplus

38 000

48 000

38 000

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6.14

What does the ‘impairment of an asset’ mean? How should an impairment of an item of property, plant and equipment be accounted for? LO 6.7

Solution: AASB 136 Impairment of Assets requires that if the carrying amount of non-current assets is greater than their recoverable amount then they shall be written down to their recoverable amount. Specifically, paragraph 59 of AASB 136 states: If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss. Therefore impairment losses will be recognised when the carrying amount of an asset exceeds the recoverable amount of the asset. Pursuant to AASB 136, different approaches to accounting for an impairment loss of property, plant and equipment will be required depending upon whether the cost model or revaluation model has been adopted. As paragraph 60 of AASB 136 states: An impairment loss shall be recognised immediately in profit or loss, unless the asset is carried at revalued amount in accordance with another Standard (for example, in accordance with the revaluation model in AASB 116). Any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with that other Standard. Therefore, if an asset has previously been upwardly revalued, the impairment loss will be recognised by reducing (debiting) the balance of the revaluation surplus as it pertains to the previous revaluation, and crediting ‘accumulated impairment losses’. Otherwise, the impairment loss is recognised by recognising an expense directly. In this case, where the ‘cost model’ is used, we would recognise an impairment loss by debiting an account such as ‘impairment loss’ and crediting an account called ‘accumulated impairment losses’.

6.16

An asset having a cost of $100 000 and accumulated depreciation of $20 000 is revalued to $120 000 at the beginning of the year. Depreciation for the year is based on the revalued amount and the remaining useful life of eight years. Shareholders’ equity, before adjusting for the above revaluation and subsequent depreciation, is as follows:

Share capital

300 000

Revaluation surplus

45 000

Capital profits reserve

85 000

Retained earnings

70 000 500 000

REQUIRED:

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Prepare journal entries to reflect the revaluation of the asset and the subsequent depreciation of the revalued asset. Which of the equity accounts would be affected directly or indirectly by the revaluation? LO 6.3, 6.9, 6.10, 6.12

Solution:

The entry at the beginning of the year for the revaluation would be:

Dr Cr

Accumulated depreciation Asset X

20 000

Dr Cr

Asset X Revaluation surplus

40 000

20 000

40 000

The entry at the end of the year would be: Dr Cr

Depreciation expense Accumulated depreciation

15 000 15 000

Depreciation is based on the revalued amount of the asset and the remaining expected life of the asset from the date of revaluation: $15 000 = $120 000  8. In terms of which equity accounts would be impacted by the revaluation, the revaluation surplus would obviously be increased. In the longer run, the revaluation would impact profits and therefore retained earnings. Profits will be impacted because depreciation would be based on the higher revalued amount (thereby reducing profits) and any gain on sale in the next years would be reduced because of the revaluation.

6.17

Townend Ltd has the following assets in its statement of financial position as at 30 June 2018. Plant and equipment, at independent valuation less Accumulated depreciation

$2 000 000 400 000

Carrying amount

1 600 000

The plant and equipment originally cost Townend $600 000 in 2016, but due to market conditions the fair value of the plant and equipment has increased. The directors of Townend Ltd are concerned about the effects of the higher carrying value on profits— owing to the higher depreciation it is reducing profits. They ask you, the accountant, to reverse the previous revaluation. Being ethical in nature, what would you do? LO 6.3, 6.12

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Solution: The act of reversing the revaluation would result in a debit to the revaluation surplus, a debit to accumulated depreciation and a credit to the asset account. As the debit entry will be to the existing revaluation surplus, no expense will be recognised at the time of recognising the revaluation decrement. The effect of this entry would be to reduce future depreciation charges and, therefore, to record higher profits in subsequent periods.

As the motivation for reversing the previous revaluation entry is to increase reported profits, this is hardly an objective approach to accounting, and hence is not consistent with the ‘representational faithfulness’ recommendations embodied within the conceptual framework. It would be a case of ‘creative accounting’. Being ethical, the accountant should resist the pressure to perform the adjusting entry. Challenging questions 6.23 Many organisations elect not to measure their property, plant and equipment at fair value, but rather, prefer to use the ‘cost model’. This will provide lower total assets and lower measures, such as net asset backing per share. You are required to answer the following questions: (a)What might motivate directors not to revalue the property, plant and equipment? (b)What are some of the effects the decision not to revalue might have on the firm’s financial statements? (c)Would the decision not to revalue adversely affect the wealth of the shareholders? LO 6.12 Solution (a)

Working out the possible motivation for why a particular accounting method or approach is adopted by an organisation is not an easy exercise. Researchers often rely upon different theories to provide possible explanations. In terms of possible reasons or motivations for using the cost model, the directors might believe that, for accountability purposes, retaining historical cost valuations is more efficient. Nevertheless, such an approach does appear to be conservative. By electing not to take the revaluations, the assets will be understated relative to their current values. A result of this is that depreciation expenses will be lower (meaning higher reported profits) and any profit on sale will also be higher. Hence, a possible motivation (and we cannot really know whether this is the motivation of the management) may be that by electing not to undertake a revaluation, reported profits will be higher. Other performance indicators, such as return on assets, will be improved (as a result of the higher profits and the lower asset base). To the extent

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that management receives bonuses based on profits, an election not to undertake a revaluation could result in greater benefits for the managers. (b)

As noted above, if upward revaluations are not undertaken, then assets will be understated, but profits, through reduced depreciation charges, will be higher.

(c)

The answer to this question will, in part, be driven by how efficient we believe the capital market is. If we believe the market is not efficient then we may believe that the share prices will simply (or mechanistically) reflect the information provided in the financial statements. Lower assets, and consequently lower net asset backing per share, may be impounded in share prices. However, some of this reduction in share price may be offset by the higher reported profit (caused by the lower depreciation expenses). However, if we believe the capital market is efficient then it does not really matter whether the statement of financial position reflects the assets’ fair values, as long as there is some information that is publicly available about the current fair value of the firm’s assets. As this information might be available in the notes to the financial statements, those individuals who believe that the market is efficient would probably argue that the firm’s accounting treatment will have minimal or no implications for the share price.

6.24 On 1 July 2017, Ocean Grove Ltd acquired and installed an item of machinery for use in its manufacturing business. When acquired the machinery cost $1 200 000, had an estimated useful life of 10 years, and had an expected residual value of $200 000. Ocean Grove Ltd depreciates machinery on a straight-line basis over its useful life. At 30 June 2019 the machinery had a carrying amount of $1 000 000. At...