Global norms let firms decide asset value model

ACCOUNTANCY

If regulators concur to the decision of the Institute of Chartered Accountants of India (ICAI), listed companies will be required to use the International Financial Reporting Standards (IFRS) to prepare and present financial statements for fiscal years commencing on or after April 1, 2011. Some believe that the IFRS requires measurement of all assets and liabilities at fair value. This is not true. For example, the IFRS does not require measurement of property, plant and equipment (PPE) at fair value. However, it gives an option to entities to use "revaluation model", under which PPE are carried in the balance sheet at fair value.

Although the adoption of the IFRS will not change the accounting for PPE dramatically, there are some important differences between accounting principles stipulated in the IFRS and those stipulated in the Indian GAAP.

The IFRS (IAS-16) requires that, at initial recognition, an item of property, plant and equipment should be measured at its cost. Cost includes purchase price, any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management and the asset retirement obligation (ARO). ARO represents initial estimate of dismantling and removing the item and restoring the site on which it is located. Thus, there is no difference in the accounting principles stipulated in the Indian GAAP and those stipulated in the IFRS.

However, there is a significant difference. The Indian GAAP requires that the provision for ARO should be recognised at the nominal amount, while the IFRS requires that the provision should be recognised at the present value. For example, a firm estimates that the useful life of an asset is 20 years and at the end of 20 years it will incur Rs 10,00,000 for dismantling and removing the asset and restoring the site on which it is located. The Indian GAAP requires that the liability should be provided at Rs 10,00,000 and the same amount should be added to the cost of the asset. If we assume a discount rate of 10 per cent, a firm that is using the IFRS will provide for the obligation at Rs 1,49,000, which is the present value of Rs 10,00,000. It will add the same amount to the cost of the asset. In the next years' balance sheet, the provision will be measured at (1.10× Rs 1,49,000) or at Rs 1,63,900 due for the unwinding of the discount rate. Each year, the provision will increase because the firm is one year clo ser to the date when the expenditure is estimated to be incurred. The increase in the provision is charged to the profit and loss account. The difference in the accounting for ARO under the Indian GAAP and the IFRS will have an impact on the profit reported in the profit and loss account and the carrying amount of the asset in the balance sheet. Consequently, it will also change the estimation of the impairment loss.

The IFRS provides a choice to firms in deciding the accounting policy regarding measurement of PPE in the balance sheet subsequent to initial recognition. A firm may use either the cost model or the revaluation model. Under the cost model, an item of property, plant and equipment is measured at its cost less any accumulated depreciation and any accumulated impairment losses. Under the revaluation model, an item of property, plant and equipment is carried at the revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. The Indian GAAP also allows revaluation. But there is a major difference between the IFRS and the Indian GAAP. The IFRS allows a firm to choose the revaluation model as an accounting policy. Therefore, if a firm chooses the revaluation model for measurement of PPE after initial recognition, except in rare situations, it will not be allowed to change the policy voluntarily. IAS-16 specifically stipulates that a firm has to revalue items of PPE with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

The Indian GAAP is silent on the frequency of revaluation. Therefore, a firm that uses the Indian GAAP may even revalue a class of property, plant and equipment once in its life time, may be when it issues IPO. The difference is very significant. A firm has to estimate the cost of determining the fair value of PPE frequently before making the choice between the cost model and the revaluation model. Moreover, because depreciation is calculated based on the revalued amount, reported profit will be lower than that reported under the cost model, while the invested capital in the balance sheet will be higher than that under the cost model. Therefore, the choice of the policy has an impact on the accounting ratios that use profit or invested capital in the numerator or denominator. For example, return on invested capital (ROIC) will be lower for the firm using the revaluation model than that of a firm that uses the cost model.

The IFRS allows the use of different models for different classes of assets. Therefore, a firm may choose to use the revaluation model only for land, which is not a depreciable asset and whose fair value can be determined reliably without significant cost and efforts. This will provide valuable information to user of financial statements about the value, which can be unlocked through sale without any material loss.

Both the Indian GAAP and the IFRS require that any increase in the carrying amount as a result of revaluation should be credited directly to equity under the heading "revaluation reserve". They stipulate that the revaluation reserve should be transferred to retained profit (general reserve) when the asset is de-recognised. However, there is a difference between the IFRS and the Indian GAAP. Under the IFRS, the revaluation surplus may be transferred to the retained profit as the asset is used by the firm. The Indian GAAP does not allow such a transfer. Therefore, under the Indian GAAP until the asset is de-recognised, the revaluation surplus is not available for distribution to shareholders, while under the IFRS, every year a part is available for distribution to shareholders.

The US GAAP does not allow revaluation of PPE. It is appropriate. The most relevant measurement attributed for PPE is the historical cost because an enterprise acquires an item of PPE for use in production and administration. It generates cash flows by use of the asset. Therefore, it should not recognise any profit before the cash flow is generated and profit is earned. This is the reason why, the revaluation surplus is taken to the balance sheet directly and presented as a part of equity. Most analysts, for the purpose of analysis, deduct revaluation reserve from equity and invested capital. They consider "revaluation" as an accounting engineering.

The International Accounting Standards Board is taking part in research activities on revaluation of PPE. This research is intended to promote international convergence of standards. One of the most important issues is identifying the preferred measurement attributed for revaluation. This research could lead to amendment of IAs-16.