Applying the revaluation model

Valuations do not need to be performed every year or every reporting period, but they should be performed with sufficient regularity that the carrying amount does not differ materially from fair value at the end of the reporting period.

Property, plant, and equipment within a single class should all be valued at the same time, to avoid selective revaluation of assets. However, a class of assets can be revalued on a rolling basis, provided that the revaluation is completed within a short period and the revaluations are kept up to date.

Defining asset classes for the purposes of applying the revaluation model Entity A is a large manufacturing group. It owns a number of industrial buildings, such as factories and warehouses, and office buildings in several capital cities. The industrial buildings are located in industrial zones, whereas the office buildings are in central business districts of the cities. Entity A’s management wants to apply the IAS 16 revaluation model to the subsequent measurement of the office buildings, but to continue to apply the historical cost model to the industrial buildings. Is this acceptable under IAS 16? Entity A can apply the revaluation model to just the office buildings. The office buildings can be clearly distinguished from the industrial buildings in terms of their function, their nature and their general location. IAS 16 permits assets to be revalued on a class-by-class basis. The different characteristics of the buildings enable them to be classified as different classes of property, plant and equipment. The different measurement models can, therefore, be applied to these classes for subsequent measurement. All properties within the class of office buildings must, therefore, be carried at the revalued amount. Separate disclosure of the two classes must be given.

How does a business combination affect period revaluation of fixed assets? Entity A is acquiring entity B, which has fixed assets that are a similar class of fixed assets to those already owned by entity A. Generally, where fixed assets are revalued, all the assets of that class have to be revalued. Does this mean that, when the entity fair values the acquired subsidiary’s fixed assets, it is required to revalue its own fixed assets that are in the same class? The fair value, on acquisition, is the cost to the group of the fixed assets acquired, so no revaluation has taken place from a group perspective. Therefore, the existing tangible fixed assets of the same class held by the group do not need to be revalued.

Frequent valuations might be necessary where fair values are volatile, as might be the case with land and buildings or in hyperinflationary economies.

Where fair values are stable over a long period, as might be the case with plant and machinery, valuations might be required less frequently. The standard suggests that annual revaluations might be needed where there are significant and volatile movements in values. If movements in fair value are insignificant, revaluations every three or five years might be sufficient.

Fair value is the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. There is no requirement in IAS 16 to use a third-party valuation specialist.

Revaluation gains

A revaluation surplus is credited to other comprehensive income and accumulated in equity under the heading of revaluation surplus. An exception is a gain on revaluation that reverses a revaluation decrease (impairment) on the same asset previously recognized as an expense. Gains are first credited to the income statement to the extent that the gain reverses a loss previously recognized in the income statement.

The revaluation surplus included in equity can be transferred directly to retained earnings when the surplus is realized, usually when the asset is de-recognized. The transfer is made through reserves, not through the income statement. The revaluation surplus can also be transferred as the entity uses the asset.

The amount transferred is the difference between depreciation based on the asset’s revalued carrying amount and depreciation based on the asset’s original cost. This amount can be transferred from revaluation surplus to retained earnings each year, through a reserve transfer.

Voluntary disclosure of revalued amounts Entities that adopt the cost model of accounting for their property, plant and equipment may wish to disclose the fair value of their property, plant and equipment in a note to the financial statements, when this is materially different from the carrying amount. Such disclosures are encouraged by IAS 16. In disclosing such fair values, such entities are not strictly bound by IAS 16’s revaluation rules. However, when the amounts disclosed do not represent current fair values, they could mislead users of the financial statements. Therefore, the entity should either disclose the current fair values of the assets concerned, or not disclose revalued amounts at all. Similar considerations apply when an entity engages in ‘cherry-picking‘, by disclosing current values only for those assets whose fair values are significantly above carrying amounts and ignoring those assets whose fair values are significantly below their carrying amounts. Accordingly, when fair values are disclosed voluntarily under IAS 16, they should normally be disclosed for an entire class of assets.

Revaluation surplus – example Entity A purchased a parcel of land on 1 July 20X1 for CU125 million. At 31 December 20X1, the land was valued at CU150 million. The revaluation surplus of CU25 million is recognized in other comprehensive income and credited to a property revaluation reserve within equity.

Revaluation surplus reversing previous deficit – example Entity B purchased a parcel of land on 1 July 20X1 for CU140 million. At 31 December 20X1, the land was valued at CU125 million. At 31 December 20X2, the fair value of the land had increased to CU150 million. 20X1: Revaluation deficit of CU15 million is recognized in profit or loss. 20X2: Revaluation surplus is treated as follows: o   CU15 million is credited to profit or loss (i.e., reversal of the previous deficit); and o   CU10 million is recognized in other comprehensive income and credited to the property revaluation reserve within equity.

Revaluation deficit reversing previous surplus – example Entity C purchased a parcel of land on 1 July 20X1 for CU60 million. At 31 December 20X1, the land was valued at CU70 million. At 31 December 20X2, the fair value of the land had decreased to CU55 million. 20X1: Revaluation surplus of CU10 million is recognized in other comprehensive income and credited to the property revaluation reserve within equity. 20X2: Revaluation deficit is treated as follows: o   CU10 million is recognized in other comprehensive income and debited to the property revaluation reserve within equity (i.e., reversal of the previous surplus); and o   CU5 million is recognized in profit or loss (i.e., excess of deficit over available surplus attributable to the same parcel of land).

Revaluation surplus reversing previous deficit: effect of depreciation – example Entity D purchased a property with a useful life of 20 years for CU10 million. Depreciation each year is CU0.5 million. At the end of Year 5, the property has a carrying amount of CU7.5 million and a fair value of CU6 million. At that date, the directors move to the revaluation basis of accounting. The deficit on revaluation of CU1.5 million is recognized in profit or loss. At the end of Years 6 through 9, the directors determine that there is no material difference between the carrying amount of the property and its fair value and, therefore, no valuation adjustments are required. Depreciation of CU2 million (i.e., 5 × CU0.4 million) is recognized in the periods up to the end of Year 10, at which time the property has a carrying amount of CU4 million. During Year 10, however, the value of the property increases sharply to a closing fair value of CU7 million. Applying the basic principle as stated in IAS 16, the portion of the revaluation surplus that is to be credited to profit or loss at the end of Year 10 might appear to be CU1.5 million (i.e., the amount of the deficit previously recognized in profit or loss). In effect, however, part of this revaluation decrease has already been reversed through the recognition of a lower depreciation charge for Years 6 to 10. Accordingly, the amount of the revaluation surplus that is credited to profit or loss should be reduced by the cumulative reduction in depreciation in Years 6 to 10 as a result of recognizing the revaluation deficit (i.e. (CU0.5 million less CU0.4 million) × 5 years). Therefore, the amount of the revaluation surplus credited to profit or loss is CU1 million. The remaining CU2 million of the revaluation surpluses is recognized in other comprehensive income and credited to the revaluation reserve within equity. The end result is that the balance on the revaluation reserve (CU2 million) is the excess of the carrying amount (CU7 million) over what it would have been had the property never been revalued (CU5 million). This treatment is consistent with the treatment prescribed for the reversal of an impairment loss under IAS 36.

Revaluation losses

A revaluation decrease should be charged against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation surplus (that is, in reserves) in respect of that same asset. Any balance of the decrease should then be recognized as an expense in profit and loss. A negative revaluation reserve cannot be created.

Treatment of a revaluation decrease An item of property, plant and equipment cost C100 and is depreciated over 10 years on a straight-line basis, with nil residual value. At the end of year 1, the asset is revalued to C135. The revaluation gains of C45 (C135 – C90 (that is, C100 less C10 depreciation)) is recognized in other comprehensive income and accumulated in equity. At the end of year 2, the asset’s value has fallen to C50. After depreciation for the year of C15 (C135 / 9), there is a revaluation loss of C70 (C120 − C50). Under IAS 16, the revaluation loss of C70 is first matched against the previous surplus on the same asset contained in the revaluation surplus in reserves. This amount is C45, and so C45 of the revaluation loss is charged against the revaluation surplus in reserves, with the balance of C25 being charged to the income statement. C Carrying amount at beginning of year 2 135 Depreciation for year (15) Carrying amount at end of year 2, just before revaluation 120 Fall in value charged to revaluation surplus (45) Fall in value charged to income statement 75 Carrying amount (revalued amount) at end of year 2 (25) Carrying amount at beginning of year 2 50 The standard permits a transfer to be made from the revaluation surplus to retained earnings as the related asset is used and the surplus is realized. The surplus could be realized as the related asset is depreciated. In this example, C5 of the surplus would have been realized in year 2 (depreciation for the year of C15 less depreciation of C10 on the historical cost amount). If this amount had been transferred to retained earnings, the balance left on the revaluation surplus would be only C40. The amount of the revaluation loss of C70 that could be charged against the revaluation surplus would be only C40, and C30 would be charged to the income statement. Also, deferred tax that might have been charged to the revaluation surplus should be considered, to determine the balance of the revaluation surplus that is available for reduction.

Utilization of revaluation reserve

Under IAS 16, the revaluation reserve may be transferred directly to retained earnings when the asset is derecognized. The reserve may be transferred on the retirement or disposal of the asset. Part of the reserve may, however, be transferred over the period for which the asset is used by the entity.

In such circumstances, the amount of the reserve transferred is the difference between the depreciation charge based on the revalued carrying amount of the asset and the depreciation charge based on the asset’s original cost. The transfer from revaluation reserve to retained earnings, whether on disposal or a systematic basis over the life of the asset, is not made through profit or loss.

The reserve transfers referred to in IAS 16 are implied to be at the option of the reporting entity, rather than being mandated by the Standard. There would, therefore, appear to be another alternative – to make no reserve transfer. That option would, however, result in the permanent retention of the portion of the revaluation reserve relating to assets that have been fully depreciated or disposed of.

Any transfer between the revaluation reserve and retained earnings, which should be made on a net of tax basis, will reduce the amount that is available for offset against future revaluation deficits in respect of individual assets.

Transfer from revaluation reserve to retained earnings – example Entity E purchased a property with a useful life of 20 years for CU10 million. Depreciation each year is CU0.5 million. At the end of Year 5, the property has a carrying amount of CU7.5 million and a fair value of CU12 million. The surplus on revaluation of CU4.5 million is credited to the revaluation reserve and the property will be depreciated over its remaining 15-year useful life at the rate of CU0.8 million per annum. Assume that, for the remainder of its useful life, the depreciated carrying amount of the property is not materially different from its fair value. Therefore, no further revaluation adjustments are required. In Years 6 through 20, depreciation has been increased by CU0.3 million per annum as a result of the revaluation. Therefore, at the end of each of those years, it is acceptable to make a transfer from the revaluation reserve to retained earnings of an amount of CU0.3 million, to reflect the realization of the revaluation surplus. If such periodic transfers are made, then the revaluation reserve will have been reduced to zero at the point that the property is fully depreciated. Alternatively, if no annual transfers are made, the reserve may be transferred in its entirety on the retirement or disposal of the asset.

Revaluation and deferred tax

There could be significant deferred tax complexity arising from the application of the revaluation model.

Depreciation

The depreciable amount of an asset should be allocated on a systematic basis over its useful life. The method of depreciation that is used should reflect the pattern in which the asset’s future economic benefits are consumed by the entity.

Depreciation applies to all property, plant, and equipment, whether held at historical cost or revalued amount, with two exceptions: Investment properties measured at fair value under IAS 40 which are not depreciated. Any asset that has an unlimited useful life, such as land.

Depreciation of restoration obligation and cost of land A landfill site will need to be restored when it is no longer used. The costs of the obligation to restore the site should be depreciated over the period during which refuse is dumped in the site. The site itself has a limited useful life to the landfill site operator. Its residual value will be considerably less than its original cost. The cost of the land would also be depreciated over the life of the site to its residual value.

Expenditure (for example, repairs and maintenance) does not remove the need to charge depreciation.

Definition of depreciation

Depreciation is defined as:

“… the systematic allocation of the depreciable amount of an asset over its useful life”; and the depreciable amount is defined as “the cost of an asset or other amount substituted for cost, less its residual value”.

Depreciation is charged even if an asset that is held at costless depreciation has a fair value over that carrying amount, provided the asset’s residual value does not exceed its carrying amount. Repairs and maintenance do not remove the need to depreciate an asset.

Omission of depreciation for certain assets A challenging issue is whether it might be appropriate to omit annual charges for depreciation in respect of certain assets. The issue most frequently arises in the context of buildings. It might be appropriate not to record a depreciation charge where the residual value of the building is in excess of the carrying amount. A company buys a property costing C1m in 20X6. The property’s estimated total physical life is 50 years. However, the company considers it likely that it will sell the property after 20 years. The estimated residual value in 20 years’ time, based on 20X6 prices, is (a) C1m, or (b) C900000. A residual value that is the same as, or close to, the original cost is rare, because it assumes that, in 20 years’ time, potential purchasers would pay, for a 20-year-old property, an amount similar to what they would pay for a new property. In case (a), the company considers that the residual value, based on prices prevailing at the balance sheet date, will equal the cost. There is, therefore, no depreciable amount and depreciation is correctly zero. In case (b), the company considers that the residual value, based on prices prevailing at the balance sheet date, will be C900000; and the depreciable amount is, therefore, C100000. Annual depreciation (on a straight-line basis) will be C5000 (1,000,000 − 900,000 / 20).

Depreciation when replacement expenditures equal annual depreciation charge An entity operates several hotels. The total carrying amount of hotel equipment (such as bed linen and dishes) remains consistent from year to year. All equipment is replaced every few years, to ensure that high standards are maintained. Management has introduced a rolling replacement programmer, such that the cost of replacement assets remains at a consistent level from year to year. Management is keen to reduce administration and proposes that it no longer depreciates the hotel equipment, but expenses the cost of replacements each year. The entity should capitalize all assets with useful lives of more than one year and depreciate them over their useful lives. Management could, for efficiency purposes, capitalize groups of similar assets as a single asset and then calculate depreciation for those assets as if they were a single asset. The proposed policy of expensing all replacement assets purchased during the year, and not providing depreciation on the asset capitalized, is not appropriate.

Depreciation charged in a period is recognized in the income statement unless it is included in the carrying amount of another asset. Depreciation can be included in inventory or work-in-progress as part of an allocation of overheads, following IAS 2 or IFRS 15. Depreciation can also form part of the cost of another item of self-constructed property, plant, and equipment.

Capitalization of depreciation as part of the cost of an asset A mining company acquires earth-moving equipment for the purpose of excavating a new mine. The depreciation of the equipment is, therefore, a directly attributable cost of digging the mine. The equipment’s depreciation charge should be capitalized as part of the mine’s cost. Depreciation of equipment used for development activities can be included in the cost of an intangible asset under IAS 38.

Depreciation charge absorbed in the production of another asset Entity A manufactures car components for the automotive industry and uses some self-made tools in its production process. Entity A’s customers, the car manufacturers, continually introduce new models or redesign existing models. Entity A must, therefore, continually develop new tools for use in its production processes. The costs of the tools are capitalized and depreciated over three years, which is the expected useful life of the tools. Entity A has one factory in which all of its production takes place. 10% of this factory is used for the development and construction of the tools. The building is depreciated using the straight-line method. The entity should include 10% of the factory depreciation charge in the costs of the tools, which are capitalized and depreciated. The factory’s depreciation charge is part of the cost of producing the tools.

Depreciation of components

An asset might consist of several different significant components. Each component is treated separately for depreciation purposes and depreciated over its individual useful life. If the useful life and pattern of consumption are similar, the components can be grouped for depreciation purposes. When a significant component is replaced or restored, the old component is de-recognized and the new component is capitalized, if its cost is recoverable.

The costs of a replacement component are recognized as an asset if they meet the recognition criteria. The carrying amount of the part or parts replaced is de-recognized; the cost and accumulated depreciation of the replaced parts are eliminated. If the cost and depreciation of the replaced part or component cannot be identified, the cost of the replacement is a reasonable proxy for the cost of the replaced part.

Land and buildings are treated as separate assets for depreciation purposes. Land, with some exceptions such as quarries and landfill sites, normally has an unlimited useful life and is not depreciated. Buildings, however, have a limited useful life and are depreciable assets. An increase in the value of land does not affect the determination of the depreciable amount of a building nor removes the need for depreciation to be charged on the building.

Depreciable components of land The carrying value of a land asset might include the costs of site dismantling, removal and restoration. The restoration cost component is depreciated over the period during which the economic benefits are obtained from the land. The land itself might have a limited useful life in some situations, in which case it is depreciated over that useful life. An example might be a landfill site that has to be restored. The costs of the obligation to restore the site might be depreciated over the period during which refuse is dumped in the site. The site itself might have a limited useful life to the landfill site operator and its residual value might be considerably less than its original cost. The cost of the land would also be depreciated over the life of the site to its residual value.

Separate depreciation of ‘intangible’ components A common example of the allocation of the cost of an item of property, plant and equipment is that of an aircraft, as mentioned in IAS 162. The airframe, engines and cabin interior of a single plane are likely to have significantly different useful lives. Under IAS 16, these parts are separately identified at the time that the aircraft is acquired, and each is depreciated separately over an appropriate useful life. This approach of depreciating separate parts of a single item of property, plant and equipment is easily understood in relation to the physical components of a single item, as in the aircraft example discussed in the previous paragraph. There will, however, also be ‘parts’ that are less tangible. An entity may purchase an item of property, plant and equipment that is required to undergo major inspections or overhauls at regular intervals over its useful life. For example, an entity might acquire a ship that requires a major overhaul, say, once every five years. Part of the cost of the ship may be allocable to a separate component representing the service potential required to be restored by the periodic overhauls. That separate component is isolated when the asset is acquired, and depreciated over the period to the next overhaul. The identification of this inherent component at the time of acquisition may not be simple, because it will generally not have been separately invoiced. Therefore, an estimate of the cost will be required. This will generally be based on the current cost of the expected overhaul or inspection (i.e., the estimated cost of those activities if they were performed at the time of the purchase). As discussed, expenditure incurred subsequently on the major inspection or overhaul is capitalized provided that the recognition criteria set out in IAS 16 are met. To the extent that the separate component representing the estimated cost of the inspection or overhaul has not been fully depreciated by the time that the inspection/overhaul expenditure is incurred, it is derecognised and will therefore give rise to a loss.

Separate depreciation of cost of major overhaul that qualifies for separate recognition – example An entity purchases a ship for CU40 million. This ship will be required to undergo a dry dock overhaul every five years to restore its service potential. At the time of purchase, the service potential that will be required to be restored by the overhaul can be measured based on the cost of the dry docking if it had been performed at the time of the purchase of the ship, say CU4 million. The following shows the calculation of the depreciation of the ship for Years 1 to 5, using the straight-line method. Amount Useful life CU ‘000 (years) Purchase price of ship 40,000 Comprising:      – the ship, excluding projected overhaul cost 36,000 30      – projected overhaul cost 4,000 5 For Years 1 to 5, depreciation charges per annum are:      – ship (excluding the service potential component) 1,200      – service potential 800 By the end of Year 5, the service potential would be fully depreciated. When a dry docking is carried out in Year 6, the expenditure is capitalized to reflect the restoration of service potential, which is then depreciated over the period to the next overhaul in Years 6 to 10. The process in Years 6 to 10 repeats every five years from Year 11 onwards until Year 30, when both the ship and the cost of dry docking are fully depreciated and a new ship is acquired.

Separate depreciation of cost of a major overhaul – entity does not identify service potential as a separate component at acquisition Note that the entity is required to use its best efforts to identify separately components such as the service potential component, as described, when the asset is first acquired or constructed. That separate identification, and the subsequent separate depreciation of the service potential component, is not, however, a necessary condition for the capitalization of the subsequent expenditure on the overhaul as part of the cost of the asset. For example, if the entity described had failed to identify the service potential component at the date of acquisition, because it was not considered significant, and had not depreciated it separately during Years 1 to 5, the expenditure on the overhaul in Year 6 would still be capitalized as part of the cost of the asset, provided that the general recognition criteria were met. In this circumstance, the entity would be required to estimate the remaining carrying amount of the service potential component at the date of the first overhaul (which would be approximately CU3.33 million, i.e., CU4 million depreciated for five years out of 30), and to derecognize that carrying amount at the same time as the expenditure on the overhaul is capitalized.

Spare parts classified as property, plant and equipment In contrast to the depreciation of stand-by equipment, the useful life of spare parts classified as property, plant and equipment commences when they are put into use, rather than when they are acquired. For example, an entity buys five new machines for use in its production facility. Simultaneously, it purchases a spare motor to be used as a replacement if a motor on one of the five machines breaks. The motor will be used in the production of goods and, once brought into service, will be operated during more than one period. It is therefore classified as property, plant and equipment. The motor does not qualify as stand-by equipment because it will not be ready for use until it is installed. Therefore, the useful life of the motor commences when it is available for use within the machine rather than when it is acquired. It should be depreciated over the period starting when it is brought into service and continuing over the shorter of its useful life and the remaining expected useful life of the asset to which it relates. If the asset to which it relates will be replaced at the end of its useful life and the motor is expected to be used or usable for the replacement asset, a longer depreciation period may be appropriate. During the period before the motor is available for service, any reduction in value should be reflected as an impairment loss under IAS 36 at the time impairment is indicated.

Determining useful life

Useful life is defined as:

“… the period over which an asset is expected to be available for use by an entity; or the number of production or similar units expected to be obtained from the asset by an entity.”

An asset’s useful life starts from the date of acquisition when the asset is capable of operating in the manner intended by the entity. The definition of useful life includes the phrase ‘expected to be available for use’. Useful life is the period when the asset is used by the entity. The useful life of a tangible fixed asset might be less than the asset’s total physical life.

The entity might have a practice of replacing assets before they reach the end of their physical lives. The estimate of an asset’s useful life is a matter of judgment, based on experience with similar assets.

Depreciation charged from when an asset is ready for use Entity B constructs a machine for its own use. Construction is completed on 1 November 20X6, but the entity does not begin using the machine until 1 March 20X7. The entity should begin charging depreciation from the date when the machine is ready for use, which is 1 November 20X6. The fact that the machine was not used for a period after it was ready to be used is not relevant in considering when to begin charging depreciation.

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Depreciation when an asset is in use Entity C acquired plant for an original cost of C100m in June 20X1, with an estimated useful life of 20 years and a nil residual value. The plant, which had a net book value of C75m, was closed in June 20X6 due to the downturn in demand for its product. Entity C determined that the plant met the IFRS 5 criteria for classification as held for sale based on a plan put in place to it. An impairment charge of C50m was recognized in 20X6, to write the plant down to fair value less cost to sell of C25m and depreciation ceased. However, in December 20X6, demand unexpectedly increased and outstripped current productive capacity. Management decided to forego plans for its sale and recommission the plant. Forecast future cash flows will justify reversing all of the original C50m impairment. Recommissioning is expected to take six months ending in June 20X7. The entity would reverse the previous impairment of C50m less depreciation for the period that the asset remained idle between June 20X6 and June 20X7 (C5m). The plant’s net book value of C70m (C25m + C50m – C5m) would be depreciated over its remaining expected life of 14 years.

Useful life of stand-by equipment The useful life of stand-by equipment should be determined by the useful life of the equipment for which it serves as a back-up. In the example cited (entity has installed two turbines), one turbine produces energy for the plant, and the other is used as a back-up in case the first turbine fails or is otherwise rendered out of service. The stand-by equipment should be depreciated from the date it is made available for use (i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management) over the shorter of the life of the turbine and the life of the plant of which the turbine is part (assuming the turbine cannot be removed and used in another plant). Note that, if the residual value of the stand-by turbine is estimated to be significantly higher than the residual value of the primary turbine (because it is expected to be in better condition at the end of the asset’s useful life due to lower usage), this will affect the depreciation charged over that useful life.

Spare parts classified as property, plant and equipment In contrast to the depreciation of stand-by equipment, the useful life of spare parts classified as property, plant and equipment commences when they are put into use, rather than when they are acquired. For example, an entity buys five new machines for use in its production facility. Simultaneously, it purchases a spare motor to be used as a replacement if a motor on one of the five machines breaks. The motor will be used in the production of goods and, once brought into service, will be operated during more than one period. It is therefore classified as property, plant and equipment. The motor does not qualify as stand-by equipment because it will not be ready for use until it is installed. Therefore, the useful life of the motor commences when it is available for use within the machine rather than when it is acquired. It should be depreciated over the period starting when it is brought into service and continuing over the shorter of its useful life and the remaining expected useful life of the asset to which it relates. If the asset to which it relates will be replaced at the end of its useful life and the motor is expected to be used or usable for the replacement asset, a longer depreciation period may be appropriate. During the period before the motor is available for service, any reduction in value should be reflected as an impairment loss under IAS 36 at the time impairment is indicated.

Cessation of depreciation

Depreciation of an asset ceases at the earlier of:

• the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) under IFRS 5; and
• the date that the asset is derecognized.

IFRS 5 requires that a non-current asset (or disposal group) be classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. For this to be the case, the asset (or disposal group) must be available for immediate sale in its present condition, and its sale must be ‘highly probable‘.

IAS 16 sets out specific requirements concerning the derecognition of items of property, plant, and equipment.

Therefore, depreciation of an asset does not cease when an asset becomes idle or is retired from active use unless the asset is fully depreciated. If the depreciation is calculated by reference to the usage of the asset, however, the depreciation recognized may be zero while there is no production.

In any case, when an asset becomes idle, or is retired from active use, this may trigger the recognition of an impairment loss which will result in the reduction of the carrying amount of the asset to its estimated recoverable amount.

Depreciation of an asset retired from active use – example Company Q uses specialized machinery to manufacture its products and is the only entity in its market that operates this type of machinery. Company Q plans to increase its production capacity by introducing new specialized machinery with improved technology. As a result, Company Q will discontinue using the specialized machinery currently in use. However, in order to protect its competitive advantage and deny other market participants access to the technology, Company Q will not sell the machinery currently in use, even though it is still in good working condition; instead, the machinery will be retired from active use and ‘mothballed’ by Company Q for potential further use or sale at a later date. At the date of retirement, the fair value less costs of disposal of the specialized machinery exceeds its carrying amount. Company Q should continue to depreciate the machinery when it is retired. The depreciable amount should be depreciated on a systematic basis over the estimated useful life of the machinery, which is defined in terms of its expected utility to Company Q. This utility may be either the use of the asset by Company Q or, alternatively, the retention of a competitive advantage by denying others access to such machinery. However, the useful life of the machinery will be limited to its economic life. IAS 16 specifies that depreciation of an asset should cease only at the earlier of (1) the date the asset is classified as held for sale (or is included in a disposal group classified as held for sale) under IFRS 5, and (2) the date that the asset is derecognised. Neither of these conditions is met in the circumstances under consideration. IAS 16 also states explicitly that “depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated”. Note that the retirement of the asset from active use is likely to be an indicator of impairment under IAS 36. However, in the circumstances under consideration, because the fair value less costs of disposal of the machinery is greater than its carrying amount, no impairment loss will be recognized.

Period of depreciation Entity A is considering a policy of not providing for depreciation on property, plant and equipment capitalized in the year until the following year, but provides for a full year’s depreciation in the year of disposal of an asset. Is this acceptable? The depreciable amount of a tangible fixed asset should be allocated on a systematic basis over its useful life. The depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. ‘Useful life’ means the period over which the asset is expected to be available for use by the entity. Depreciation should commence as soon as the asset is acquired and is available for use. Entity A should depreciate assets over the period of use.

Useful life of leasehold improvements Entity A enters into a lease agreement for six years, with a right to extend the contract for another six years. At the commencement date, entity A is not reasonably certain to exercise the option to extend the agreement, and it therefore concludes the lease term to be six years. Entity A will make significant leasehold improvements to comply with its brand standards. The expected useful life of these leasehold improvements is 10 years. IAS 16 states that the legal or similar limits on the use of the asset, such as the expiry dates of related leases, should be considered in determining the useful life of the asset. Therefore, it would generally be expected that the useful life (that is, the depreciation period) of the leasehold improvements is the same as the lease term under IFRS 16. However, there might be situations where the useful life of a leasehold improvement exceeds the assessed lease term (for example, where management will dismantle and redeploy the leasehold improvement at the end of the lease term).

Depreciation ceases when an asset is de-recognized or classified as held for sale under IFRS 5. Depreciation does not necessarily cease when an asset is idle.

Treatment of accumulated depreciation under the revaluation model

There are two methods of adjusting the carrying amount of an asset upon revaluation: the ‘gross’ method; and the ‘net’ method. The gross method restates the gross value (before depreciation) of the asset and restates accumulated depreciation as well.

The ‘net’ approach eliminates accumulated depreciation against the carrying amount of the asset and then revalues the net carrying amount. The net amount under both approaches should be the same, but the difference is presentation.

Treatment of gross cost and accumulated depreciation in revaluation model Property, plant and equipment is revalued to C1,500, consisting of C2,500 gross cost and C1,000 depreciation, based on observable market data.    Details of the property, plant and equipment, before and after revaluation, are as follows:     COST/ REVALUED COST ACCUMULATED DEPRECIATION NET BOOK VALUE Property, plant and equipment before revaluation 1000 (400) 600 Fair value 1500 Revaluation gain 900 Gain allocated proportionately to cost and depreciation 1500 (600) 900 Property, plant and equipment after revaluation 2500 (1000) 1500 The increase on revaluation is C900 (namely, C1500 − C600).

Treatment of accumulated depreciation when asset is revalued Details of the property, plant and equipment, before and after revaluation, are as follows:     COST/ REVALUED COST ACCUMULATED DEPRECIATION NET BOOK VALUE Property, plant and equipment before revaluation 1000 (400) 600 Fair value 1500              – 1500 Revaluation gain 500 400 The increase on revaluation is C900 (namely, C500 + C400).

Determining residual value

The depreciable amount of an asset is determined after deducting its residual value. Residual value is the estimated amount realized from the current disposal of the asset, assuming that the asset is in the age and condition to be expected at the end of its useful life.

Residual values take account of price changes up to the balance sheet date but not future price changes. Residual value, in practice, is often insignificant and is therefore immaterial to the calculation of the depreciable amount.

The residual value of an asset could increase to an amount that is equal to or greater than the asset’s carrying amount. If it does, the depreciation charge on the asset is zero, unless the residual value of the asset subsequently falls below the carrying amount of the asset.

Methods of depreciation

The depreciation method adopted should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

The most common method of depreciation is on a straight-line basis over the useful life of the asset. This is a time-based approach but is a proxy for usage and obsolescence. However, for some assets, actual usage might be a more reliable measurement. Time-based depreciation is appropriate if the expected and actual patterns of usage are similar.

Depreciation methods The straight-line method is the most common method used in practice as it can be easier to assess useful life by reference to time periods. However, usage might be a more reliable form of measurement. Cost or revalued amount less the estimated residual value is allocated over the useful life, so as to charge each accounting period on a systematic basis over the asset’s useful life. There are a number of different methods for determining depreciation other than straight line. These might allocate the depreciable amount based on usage (as in a unit of production method), or they are designed to charge higher amounts of depreciation in the earlier years of an asset’s use. Common methods include diminishing balance, sum of the units, sum of the years, and sum of the digit’s methods. Methods of accelerated depreciation are appropriate where the economic benefits are consumed more rapidly in the earlier years of an asset’s life. An asset might become less reliable and more likely to break down, less capable of producing a high-quality product, or less technologically advanced. Falling prices for the output of an asset are one factor to be considered, but they do not alone require the adoption of an accelerated depreciation method. A number of these methods are discussed in this example. Diminishing balance method: This method is designed to charge higher amounts of depreciation in the earlier years of an asset’s use, as follows (the example assumes no residual value): C Cost 125 Depreciation charge (20%) 25 Carrying amount at end of year 1 100 Depreciation charge (20% of 100) 20 Carrying amount at end of year 2 80 Depreciation charge (20% of 80) 16 Carrying amount at end of year 3 64 Reverse declining balance method: The reverse declining balance method is not a commonly used method of depreciation. It results in a depreciation charge that increases over time. This method might be appropriate where an asset is consumed primarily by usage, and production begins at a low level but builds up over time. However, such cases are unusual and a units of production method of depreciation might be more appropriate, as it reflects the consumption of an asset’s economic benefits. Sum of the digit’s method: This method is similar in its effect to the reducing balance method although the mechanics are different. If an asset is expected to last, say, 12 periods (years, months, etc.), the digits 1 to 12 are added (total 78); the first period is charged with 12/78, the next period with 11/78 and so on. Sum of the units (or units of production) method: This method relates depreciation to the asset’s estimated use or output. The rate of depreciation per hour of usage or unit of production is given by dividing the depreciable amount by the asset’s estimated total service capability, measured in terms of hours or units. This method is sometimes employed, where the asset’s usage varies considerably from period to period, as a better measure of the consumption of economic benefits. Examples of the types of assets that are often depreciated in this way are: for hourly rates, airline engines; and, for unit of production, landfill sites and natural resources. Example – Depreciation charged based on the unit of production method A machine cost C100000 and its expected residual value is C10000. The total usage of the machine is expected to be 500,000 hours. The depreciation rate per hour’s usage is, therefore, C0.18 (C100000 – C10000 divided by 500000). Example – Depreciation charged based on estimated usage Costs amounting to C5 million are incurred in acquiring a landfill site. The landfill site comprises 2 million cubic meters of space. The rate of depreciation to be applied to the cost of the site is worked out as C2.5 per cubic meter of space used. In the first year, 200,000 cubic meters are used up and depreciation charged at C2.5 per cubic meter is C500000.

Depreciation methods adopted should be reviewed at least at each financial year end and, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the depreciation method should be changed to reflect the changed pattern of consumption of economic benefits. These changes are accounted for as a change in an accounting estimate by IAS 8.

There are a variety of acceptable depreciation methods identified in IAS 16. Management should select the method regarded as most appropriate, based on the expected pattern of consumption of future economic benefits, to allocate depreciation on a systematic basis over the asset’s useful life.

Economic benefits are consumed mainly through the use of an asset. However, other factors, such as technical obsolescence and wear and tear during idle periods, might reduce the economic benefits that could otherwise have been obtained from the asset. A fall in the demand for, or price of, the output of the asset might be an indicator of obsolescence.

The following factors should be considered when determining the pattern of economic consumption, and hence the depreciation method and useful life of an item of property, plant, and equipment:

• The asset’s expected use by the entity. This is the principal factor and is generally assessed by reference to the asset’s expected capacity or physical output.

• The asset’s expected physical deterioration through use or the passing of time (that is, ‘wear and tear’) when the asset is both in use and idle. This will depend on operational factors, such as the number of shifts for which the asset is to be used and how well the asset is maintained and repaired throughout its life.
• Technical or commercial obsolescence. The asset itself, or the product or service generated by the asset, might become commercially or technically obsolete by being superseded by new or more advanced products or production techniques. Similarly, changes in market demand (for example, changes in trends or competitor actions) might render an asset commercially obsolete.
• Legal or similar limits on the asset’s use, such as the expiry of a patent, license, or lease.

• The use of a revenue-based method of depreciation is not appropriate.

Determining appropriate depreciation method Entity B manufactures industrial chemicals and uses blending machines in the production process. The output of the blending machines is consistent from year to year, and the machines can be used for different products. However, maintenance costs increase from year to year, and a new generation of machines (with significant improvements over existing machines) is available every five years. Management should determine the depreciation method based on production output. The straight-line depreciation method might be a reasonable proxy for a usage-based method, because production output is consistent from year to year. Factors such as maintenance costs or technical obsolescence should be considered in determining the blending machines’ useful life.

Depreciation of revalued assets

Depreciation is charged on the carrying amount of revalued property, plant, and equipment, except investment properties accounted for at fair value under IAS 40. The depreciation charge on revalued assets is recognized as an expense in the income statement. An entity could, however, also transfer an amount equal to the excess depreciation from the revaluation reserve to retained earnings.

Basis of depreciation for revalued assets The standard does not specify what asset value should be used as the basis for calculating the year’s depreciation charge. The average value for the year might be the best measure but, in practice, either the opening or closing balance could be used, provided that it is used consistently in each period. The opening balance is most commonly used, together with the cost of subsequent additions, for determining the current year’s depreciation charge. This avoids the need to recalculate depreciation charged in the earlier part of the year that has been used, for example, in interim reports. An issue could arise, however, where there is a material change arising from the revaluation at the end of the year.

Change in the estimate of useful life

The useful lives of property, plant, and equipment should be reviewed at least at each year’s end and, if expectations are different from previous estimates, the change should be accounted for prospectively as a change in estimate by IAS 8.

Change in estimate of useful life Entity A purchased an asset on 1 January 20X0 for C100000, and the asset had an estimated useful life of 10 years and a residual value of nil. The entity has charged depreciation using the straight-line method at C10000 per annum. On 1 January 20X4, when the asset’s net book value is C60000, the directors review the estimated life and decide that the asset will probably be useful for a further four years, and so the total life is revised to eight years. The entity should amend the annual provision for depreciation to charge the unamortized cost (namely, C60000) over the revised remaining life of four years. Consequently, it should charge depreciation for the next four years at C15000 per annum. Alternatively, assuming that the life remains as 10 years, the entity might decide that, from 1 January 20X4, the sum of the digits method of calculation would give a fairer presentation than the straight-line method. If so, the depreciation charge for 20X4 would be C17143 (namely, C60000 × 6 / 6 + 5 + 4 + 3 + 2 + 1), because the asset still has a remaining useful life of six years.

Reduction in useful life of acquired fixed asset Entity A made an acquisition during the year. The acquired entity has a large computer system that the acquirer now intends to replace in a few years’ time. The fair value of the computer equipment was determined at the date of acquisition and the decision to replace it is a post-acquisition event. Management would like to charge additional depreciation immediately and show this as an exceptional item related to the acquisition. Is this appropriate? The decision to replace the computer system is a post-acquisition decision. It does not impact the fair value assigned in the purchase price allocation. There is no immediate impairment, even after the decision has been made, because future cash flows of the cash-generating unit support the carrying value of its assets. However, as the decision has been made to scrap the equipment in a few years, the carrying value should now be depreciated over the revised, shorter, useful life. Residual value and useful life must be reviewed at least at each financial year end. If either is revised, the change is accounted for prospectively as a change in an accounting estimate.

Change in estimate of residual value

Residual values should be reviewed at least at each year’s end. Reviews of residual value would take account, for example, of reasonably expected technological changes, and of price changes and inflation since the last balance sheet date.

If expectations differ from previous estimates, the changes should be accounted for in the same way as changes in useful lives – that is, prospectively as a change in accounting estimate by IAS 8.

Revising the residual value of an asset An asset is bought for C1000 with an estimated useful life of six years. Its estimated residual value at the date of acquisition was C70, and this estimate has not changed up to year 3, because there has been no significant inflationary or other price change. However, the rate of inflation is now expected to increase; and, at the end of year 4, the estimated residual value (based on prices at the end of year 4) is C100. If future inflation is taken into account, the estimated residual value at the end of the asset’s useful life is C400. The carrying amount at the end of year 3 is C535. However, in year 4 the residual value is revised to C100. The depreciable amount of the asset becomes C900. Deducting the depreciation charged to date of C465 leaves C435 to be depreciated over the remaining useful life of three years. Therefore, depreciation of C145 is charged in year 4. If, in year 5, the residual value is revised to C400, there will be no depreciation to be charged in years 5 and 6. The depreciable amount will be C600, and the depreciation charged in years 1 to 4 is, in aggregate, C610 (C465 for the first three years + C145 in year 4). The depreciation charged over the useful life to date might actually exceed the depreciable amount when residual values are updated for price changes. In such circumstances, the depreciation charge is adjusted to nil, and any excess is not reinstated.

Change in depreciation method

The depreciation method applied to an asset should be reviewed at least at each year’s end and, if there has been a significant change in the expected pattern of consumption of the asset’s future economic benefits, the method should be changed to reflect the changed pattern. Any such change in method should be accounted for prospectively as a change in accounting estimate by IAS 8.

Depreciation of historic buildings IAS 16 does not grant an exemption from the requirement to recognize depreciation in respect of historic buildings: the fact that they may have been built centuries earlier, and may be expected to last for centuries more, does not exempt them from depreciation. It is possible that the useful life of such a building may be very long. Also, when an entity intends to sell such a building in due course, rather than use it for the remainder of its physical life, it is possible that the residual value may be relatively high. Both of these factors may lead to the depreciation recognized being relatively small. Care should be taken to identify any components (e.g., roofs) that may require replacement at periodic intervals, which need to be depreciated over a shorter period.