An item of property, plant and equipment (PPE) is initially recognized at its cost, which includes all directly attributable expenditure incurred in acquiring and making that asset ready for its intended use. Subsequently, one of the following two models can be adopted for its accounting.
- Cost model
- Revaluation model
Let’s discuss both models for subsequent accounting of PPE.
Under the cost model, PPE is carried in the books of account at cost less accumulated depreciation and accumulated impairment losses, if any.
Carrying amount of PPE = Cost – accumulated depreciation – accumulated impairment losses
Depreciation is the systematic allocation of the cost of an item of PPE to income statement over its useful life. PPE is depreciated over its useful life and by doing so, the cost of PPE is transferred to income statement spreading over a number of years, as the economic benefits associated with PPE are also obtained over those years. Impairment loss is the difference between an asset’s carrying amount and its recoverable amount. Impairment loss is recorded when the asset’s carrying amount is greater than its recoverable amount.
Cost model is relatively simpler and easier to apply, as it is based on historical cost principle, disregarding any upward changes in the fair value of PPE. For example, an entity purchased a piece of land in 1995 for $25,000. We all know that land is not depreciated, however, after 35 years, its fair value has been increased to $200,000. The accountant has not accounted for this increase in fair value and has kept the carrying value of land at $25,000. Is he right? YES! Historical cost principle restricts the accountant to record any upward adjustment in the value of land and requires that land should be kept at its historical cost.
Under the revaluation model, PPE is carried in the books of account at cost or revalued amount less accumulated depreciation and accumulated impairment losses, if any.
Carrying amount of PPE = Cost or revalued amount – accumulated depreciation – accumulated impairment losses
Under the revaluation model, an entity is required to revalue PPE regularly so that their carrying amounts are not materially different from their fair values. Furthermore, when an item of PPE is revalued, the entire class of PPE to which that asset belongs must be revalued. For example, an entity has five buildings classified as PPE. If one building is revalued, revaluation of other four buildings must also be carried out.
As a result of revaluation, an asset’s carried amount is taken to its fair value resulting in revaluation gain or loss.
Let’s see how revaluation gains and revaluation losses are accounted for.
Revaluation gain is recorded as other comprehensive income and is shown in equity as a separate capital reserve with the name of “revaluation surplus”.
Revaluation loss is recorded as expense in the income statement. However, if there is some balance in the revaluation surplus reserve pertaining to any previous revaluation gains of the same asset, that revaluation surplus is adjusted first and to that extent, revaluation loss is recorded in the statement of other comprehensive income. Any excess revaluation loss is recorded in the income statement.