Valuation at the date of purchase
When an item of property, plant and equipment is purchased it will initially be recorded as a non-current asset at its cost.
The problem however, with leaving the item at its initial cost, is that the asset’s value will change over time. Most of these assets fall in value as they age and a business’ must take car to ensure that its assets are not over-valued.
In order to solve this problem, the accounting standard IAS 16 Property, Plant & Equipment requires businesses to record the asset at its cost when it is acquired but then they should be valued using either:
- The Cost Model; or
- The Revaluation Model (note that this method will only be covered in the very broadest terms in this course)
The Cost Model
Under the Cost Model, a business will gradually reduce the value at which the asset is recorded at over its useful life and will charge these reductions as an expense of the business (the expense is known as depreciation).
|Cost||The net amount paid for the asset|
|Residual value||The estimated value of the asset at the end of its useful life|
|Useful life||The period over which the business expects to use the asset|
|Depreciable amount||The asset’s cost less its residual value (i.e. the amount the asset’s value is expected to fall by over its useful life)|
|Depreciation||The fall in the recorded carrying value of the asset over an accounting period|
|Accumulated depreciation||The total depreciation charged against an asset up to the end of the accounting period|
|Carrying value||The cost of an asset less its accumulated depreciation (also know as the Net Book Value)|
Let’s say that a business buys a machine for £10,000. It expects to use the machine for three years at the end of which the machine will be sold for an estimated £1,000.
The asset’s cost is £10,000, its residual value is £1,000 and the depreciable amount is £9,000 (i.e. £10,000 less £1,000). The business will share this £9,000 over the three year useful life which would have the following two effects; first a depreciation expense would be recorded and second the asset’s value would be reduced by the amount of depreciation charged.
We will look at the different ways that depreciation can be calculated in the next session but for this example let’s say the depreciable amount is to be shared evenly over the useful life – so each year we will depreciate the machine by £3,000 and will reduce the asset’s carrying value by the same amount. By the end of the third year we will therefore have charged £9,000 in total and the asset’s carrying should have been reduced to its residual value of £1,000. A summary is shown below:
The Revaluation Model
It is not the aim of this course to go through this method of valuing property, plant or equipment in any detail but this method can be chosen by businesses to value selected classes of assets. Under this model an asset is initially recorded at its cost but should then be regularly revalued and recorded at its fair value (note that fair value is usually an asset’s market value).
The Revaluation Model is less commonly used than the Cost Model but some businesses do use it to record those assets such as land or buildings that tend to rise in value over time.