Property, Plant and Equipment (PP&E) constitute a significant portion of the value of assets that a manufacturing company holds. For service companies, often, property constitutes a significant portion of the value of assets. Therefore, accounting policy on the recognition and measurement of items of PP&E has significant impact on the net worth in the balance sheet of an entity.
Application of accounting principles and methods stipulated in Ind-AS-16 will bring some important changes in the accounting practices in India. Ind As-16 is fully convergent with IFRS (IAS- 16). There are two differences between accounting principles stipulated in Ind AS -16 and those stipulated in the IAS-16. Those differences have resulted from the differences between Ind ASs and corresponding IFRSs related to the accounting for government grants and measurement of investment property.
Ind AS - 16 permits fair value measurement of items of PP&E. as an alternative to the cost model. At present, there is no choice but to use the cost model. However, an entity is allowed to revalue items of PP&E at its discretion. Entities often use the discretion to increase the net worth in the balance sheet. Immediately before IPO or when they accumulate significant loss over years and decide financial restructuring. Ind AS- 16 requires an entity to exercise the choice between fair value model and cost model only once. It has to follow the accounting policy based on that choice consistently. An entity may choose the fair value model for some class of assets and the cost model for others.
Use of fair value to measure items of PP&E does not fit into the conventional wisdom that those assets should be measured at historical cost because an entity recovers their cost through use rather than by sale. But, that assumption may not be correct in every situation. We may take an example. A listed company has a manufacturing facility located somewhere close to South Mumbai. The company is a going concern. The conventional accounting wisdom would suggest that the land should be measured using the cost model because the company will not be able to unlock the value of the land separately. It will generate cash flow by manufacturing products using the land and other items of PP&E. But that might not be true. It might be possible for the company to relocate the manufacturing facility at a distant suburb of Mumbai without impairing its earning capacity. Thus, it can unlock the value of the land, while continuing its operations. In this situation it might be appropriate to measure the land at fair value. The fair value is determined taking into account the best use of the land. Use of the fair value model would reduce the information asymmetry between the management and investors. It will improve the transparency in corporate financial reporting. In most situations, it might not be appropriate to use fair value model to measure items of plant and machinery. This is so because, usually the cost of those items is recovered through use and not by sale, and estimation of fair value frequently is costly.
Any increase in the fair value during the reporting period is not recognised in profit or loss. It is a part of ‘other comprehensive income’ and is accumulated under ‘revaluation reserve’, which is presented separately in the balance sheet. However, a reduction in the fair value is recognised as a loss in the profit or loss for the reporting period, if there is no revaluation reserve. If, the balance in the revaluation reserve is inadequate, to the extent that the balance in the revaluation reserve does not cover the reduction in fair value, it is recognised as a loss in the profit or loss for the reporting period. For example, if, at the end of the reporting period, the fair value is lower by Rs 10,000 than the same at the beginning of the period, and the balance in the revaluation reserve is Rs 8,000, only Rs 2,000 is recognised as loss for the period. This accounting principle is an example of over emphasis on ‘prudence’. The loss is notional. A going concern will never incur this loss. Ind AS-16 provides the testimony that India has moved towards convergence of its accounting standards with IFRS in true spirit.
