Blind Freddy – More common errors when accounting for property, plant and equipment (IAS 16 – Part 2)

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

Even though IAS 16 Property, Plant and Equipment is an ‘easy’ standard to apply, last month, our Blind Freddy Accounting News article identified TEN common errors prepares could make when determining which types of property, plant and equipment (PPE) fall within scope of IAS 16, which are instead accounted for under other accounting standards, and when working out the ‘cost’ of an item of PPE.

This month we continue with IAS 16 and look at typical mistakes made when measuring PPE using either the ‘cost’ or ‘revaluation’ model for subsequent measurement.

Blind Freddy error 1 – ‘Cost’ or ‘revaluation’ models not applied consistently across classes of PPE

After initial recognition, IAS 16, paragraph 29 allows you to measure items of PPE using either the ‘cost’ or ‘revaluation’ model as your accounting policy. However, the caveat is that the particular policy chosen must be applied consistently to an entire class of PPE.

An entity shall choose either the cost model in paragraph 30 or the revaluation model in paragraph 31 as its accounting policy and shall apply that policy to an entire class of property, plant and equipment

IAS 16, paragraph 29

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: 

  • Land
  • Land and buildings
  • Machinery
  • Ships
  • Aircraft
  • Motor vehicles
  • Furniture and fixtures
  • Office equipment, and
  • Bearer plants.

IAS 16, paragraph 37

Paragraph 37 explains that a ‘class’ of PPE is a grouping of assets of a similar nature and use in the entity’s operations, and provides some examples of what is meant by a ‘class’ of PPE, however, it is not precise and judgement must be applied.

The ‘rule of thumb’ is that a class is generally the level at which separate disclosures are provided about the items in the financial statements.

Example:

Entity A has the following buildings:

  • Office premises
  • Manufacturing facility in New South Wales, and
  • Warehouse and distribution facilities in each state.

While these buildings may have a similar nature, they each have a different use in the business and therefore it could be argued that there are three classes of buildings. However, it is unlikely that the geographic dispersion of the warehouse and distribution facilities would result in each state facility being considered to be a separate class of building.

Identifying classes of PPE at too low a level could result in inconsistent accounting of similar items, with some being measured at cost and some at fair value.

Blind Freddy error 1

Identifying classes of PPE at too low a level, resulting in a mix of measurement models being used for items with a similar nature and use.

Blind Freddy error 2 – Not keeping revaluations up to date

Once the revaluation model has been chosen for a particular asset class, IAS 16 requires that revaluations are kept up to date so that at each reporting date, there is no material difference between carrying amount and fair value.

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 end of the reporting period.

IAS 16, paragraph 31

This does not necessarily mean that an external, independent valuation need be performed at each reporting date. However, directors and preparers need to satisfy themselves, based on current information available to market participants, that fair value has not moved by a material amount. A common Blind Freddy error occurs when directors and preparers assume that there are no revaluation movements to be recognised between the dates of external valuations.

Blind Freddy error 2

Applying a fixed schedule of independent revaluations (say every 3 to 5 years) without further consideration of movements in asset fair values.

Blind Freddy error 3 – Recognising revaluation increments in profit or loss

While not as common because it is spelt out so clearly in the standard, we have seen Blind Freddy errors where revaluation increments are recognised in profit or loss instead of other comprehensive income (asset revaluation surplus) when they are not reversing a previous revaluation decrement. This is a very obvious, biased error, and can significantly overstate profits of an entity.

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.

IAS 16, paragraph 39

Directors and preparers should perform a sanity check on revaluation movements recognised in profit or loss and reconcile all credits to profit or loss against previous decrements.

Blind Freddy error 3

Recognising revaluation increments (credits) in profit or loss when they do not reverse a previous revaluation decrement.

Blind Freddy error 4 – Offsetting revaluation increments and decrements across a class of assets

IAS 16, paragraphs 39 and 40 make it clear that increases and decreases in the fair value of an item of PPE measured using the ‘revaluation’ model can only be offset for the particular asset, and not within the class of assets being revalued.

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.

IAS 16, paragraph 39

If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall be recognised in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease recognised in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus.

IAS 16, paragraph 40

In Blind Freddy error 1 above we explained that a ‘class of assets’ is a grouping of assets with a similar nature and use to the entity.

Example

XYZ Entity acquired three properties (A, B and C) in 2017 and these fall into the class called ‘Land and buildings’.

For the year ended 30 June 2018, the fair values of property A and B increase but decrease for property C.

Property Purchase price ($) Fair value (Carrying amount) at 30 June 2018 ($) Balance in Asset Revaluation Surplus ($)
A 2,000,000 2,500,000 500,000
B 1,000,000 1,500,000 500,000
C 3,000,000 2,500,000 NIL
Total 6,000,000 6,500,000 1,000,000

A Blind Freddy error occurs if we assume that the excess fair value for the class of $500,000 ($6,500,000 - $6,000,000) is the balance in the asset revaluation surplus. IAS 16, paragraph 39 requires the increments in fair value for properties A and B to be recognised in other comprehensive income (asset revaluation surplus) and the decrement for property C to be recognised in profit or loss. Fixed asset registers therefore need to track, for each asset, movements into and out of the revaluation reserve.

Blind Freddy error 4

Offsetting revaluation increments and decrements across a class of assets rather than for each individual asset.

Note for not-for-profit entities:

Accounting for revaluation increments and decrements is different for not-for-profit entities. AASB 116 (Australian version of IAS 16) requires revaluation increments and decrements to be offset within a class of assets (paragraphs Aus 39.1 & Aus 40.1), but paragraph Aus 40.2  prohibits offsetting across different asset classes.

Blind Freddy error 5 – Recycling the balance on the ARR to profit or loss when the asset is sold

A common Blind Freddy error occurs where the balance in the asset revaluation reserve (ARR) is derecognised via profit or loss when the underlying asset is sold.

The revaluation surplus included in equity in respect of an item of property, plant and equipment may be transferred directly to retained earnings when the asset is derecognised. This may involve transferring the whole of the surplus when the asset is retired or disposed of. However, some of the surplus may be transferred as the asset is used by an entity. In such a case, the amount of the surplus transferred would be the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on the asset’s original cost. Transfers from revaluation surplus to retained earnings are not made through profit or loss.

IAS 16, paragraph 41

Although some standards require the balance of a reserve within equity to be recycled through profit or loss on disposal of the underlying asset (e.g. AFS investments by IAS 39 and foreign currency translation reserves by IAS 21), IAS 16 does not permit this. Paragraph 41 gives the choice to transfer the balance to retained earnings when the asset is derecognised, but this transfer cannot be made by recycling the balance through profit or loss. Assuming the balance in the asset revaluation reserve is $100,000 when the underlying is sold, the journal entry for such a transfer would be as follows:

    $ $
Dr Asset revaluation reserve 100,000  
Cr Retained earnings   100,000

Blind Freddy error 5

Recycling previous revaluation increments recognised in other comprehensive income as a gain on disposal in profit or loss

Blind Freddy error 6 – Excessive gains or losses on disposal of revalued assets 

As noted in Blind Freddy error 2 above, revaluations are to be performed regularly for assets measured using the ‘revaluation’ model so that there is no material difference between the carrying amount of the asset and its fair value at the reporting date.

Following on from this, and the concept in Blind Freddy error 5 that revaluation increments not be recycled through profit or loss when the asset is sold, we should not expect to see material amounts recognised in profit or loss as ‘gains on disposal of revalued PPE’. A Blind Freddy error often occurs where either:

  • There was an error in the valuation methodology used at the previous reporting date, or
  • Directors and preparers failed to consider whether the fair value had, in fact, changed at the previous reporting date (Blind Freddy error 2).

Unless there has been a significant change in circumstances relating to the asset since the previous revaluation, any large gain on disposal in profit is usually a red flag that there could have been an error in a previous revaluation, or that there was insufficient consideration at the previous reporting date whether the fair value had indeed changed by a material amount,

Blind Freddy error 6

Inadequate valuations resulting in excessive gains on disposal being recognised in profit or loss.

Blind Freddy error 7 – Changing accounting policy from ‘cost’ to ‘revaluation’ model and vice versa

Although not specifically addressed in IAS 16, once you have chosen a ‘cost’ model for a particular class of assets as discussed in Blind Freddy error 1, it is possible, depending on the facts and circumstances, to change policies and revalue the class of assets, provided the new policy is then applied across all assets in the class. However, the opposite is not usually the case.

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, paragraph 14 allows voluntary changes in accounting policies if they will result in more reliable and relevant information being provided in the financial statements.

An entity shall change an accounting policy only if the change:

  • Is required by an Australian Accounting Standard, or
  • Results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows.

IAS 8, paragraph 14

It is generally accepted that moving from a ‘cost’ to a revaluation model providers users with more reliable and relevant information, particularly where historical costs of assets are so outdated. However, the argument may not hold the other way around. It would be incorrect to assume that moving in both directions is always possible. Each case needs to be considered based on its specific facts and circumstances to ensure that both the ‘reliable’ and ‘relevance’ tests in paragraph 14(b) have been met.

Blind Freddy error 7

Changing from a revaluation to cost model where reliable fair valuations are available or determinable.

Blind Freddy error 8 – Restating comparatives when changing from a ‘cost’ to a ‘revaluation’ model

Another common Blind Freddy error occurs when an entity changes it measurement model (accounting policy) for a class of assets from a cost basis to a revaluation model. Many preparers automatically assume that the usual retrospective restatement rules for VOLUNTARY changes in accounting policies apply. This is not correct.

When changing accounting policies because a new accounting standard has been issued, or because the requirements of an existing accounting standard have changed, we would usually restate comparatives (adjust retrospectively) unless we are told otherwise. If the new or amending standard is silent on what to do on transition, it means we need to restate comparatives (refer IAS 8, paragraph 19(b)).

Paragraph 19(b) also tells us to restate comparatives when we change accounting policies VOLUNTARILY, i.e. we must apply the change retrospectively.

Subject to paragraph 23:

  • An entity shall account for a change in accounting policy resulting from the initial application of an Australian Accounting Standard in accordance with the specific transitional provisions, if any, in that Australian Accounting Standard, and
  • When an entity changes an accounting policy upon initial application of an Australian Accounting Standard that does not include specific transitional provisions applying to that change, or changes an accounting policy voluntarily, it shall apply the change retrospectively.

IAS 8, paragraph 19

However, you can imagine that trying to obtain valuations at the comparative reporting date, and the ‘opening balance sheet date’ for PPE items is likely to be a difficult exercise to perform, and likely to be biased so as to include the benefit of hindsight. As such, IAS 8 makes specific exemptions regarding retrospective restatement of comparatives where an entity decides to change its accounting policy from ‘cost’ to ‘revaluation’. It says that we deal with the initial adjustments as a revaluation under IAS 16 (see IAS 8, paragraph 17), and it also clarifies that the usual requirements for retrospective restatement and disclosures for voluntary changes in accounting policies in IAS 8, paragraph 19-31 do not apply.

The initial application of a policy to revalue assets in accordance with IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets is a change in an accounting policy to be dealt with as a revaluation in accordance with IAS 16 or IAS 38, rather than in accordance with this Standard. 

IAS 8, paragraph 17


Paragraphs 19–31 do not apply to the change in accounting policy described in paragraph 17.

IAS 8, paragraph 18

Blind Freddy error 8

Restating comparatives when changing from a ‘cost’ to a ‘revaluation’ model for a class of PPE.

Next month

Next month, our Blind Freddy series continues with common errors when depreciating PPE.