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Since the first years of the new millennium, the professional accounting environment has witnessed a series of efforts aimed at making the exchange of financial information more universally understandable. The availability of a common framework would allow all the subjects involved in dialogue, regardless of their origins. Hence, the convergence of several national accounting standard setters towards the International Accounting Standards Board (IAS) models (Hermann, Saudagaran & Thomas 2006, p. 44).
Among the IAS models, the IAS 16 Property, Plant, and Equipment deal with the accounting treatment for most property, plant, and equipment. IAS allows the use of both cost and evaluation models, while in many countries, including the USA, Spain, and Japan, the current status quo follows historical costs for all property, plant, and equipment (Hermann, Saudagaran & Thomas 2006, p. 43). Through a thorough analysis of the advantages and disadvantages of historical cost and fair value, this paper will offer an interpretation of the reasons why IAS 16 permits both methods.
Cost Model and Evaluation Model in the IAS 16
Originally issued in 1982, updated and amended several times, IAS 16 Property, Plant, and Equipment represent a considerable effort toward the internationalization of the accounting standards for property, plant, and equipment. According to IAS 16, property, plant, and equipment are “initially measured at its cost, subsequently measured either using a cost or revaluation model” (IAS 16 — Property, Plant and Equipment, para. 1).
The initial measurement of tangible non-current assets has to be recorded at costs, including all the expenses required to bring the asset to its operational standards. For the measures following the initial recognition, IAS 16 permits both the cost and the revaluation model. According to the cost model, property, plant, and equipment are carried at historical costs minus depreciation and possible impairment losses. Under the revaluation model, assets are carried at fair value at the of revaluation minus subsequent depreciation. Fair value is usually made by an appraisal, and it is crucial that revaluations are made regularly.
Analyzing cost and evaluation models through the lens of the qualitative characteristics that a financial reporting allows understanding the respective merits and disadvantages. The fundamental qualitative features are relevance, faithful representation, verifiability, comparability, timeliness, and understandability (Conceptual Framework for Financial Reporting, para. 7). Relevance indicates the ability of financial information to influence the process of decision-making and includes predictive value and confirmatory value. It is broadly recognized that fair values offer more reliable predictive value than historical cost (Hermann, Saudagaran & Thomas 2006, p. 49).
Faithful representation refers to the correspondence between a measurement and the phenomena it purports to represent. In the case of a transaction, fair value seems to provide better representation, while historical cost is more reliable when a historical analysis is required as the data are less manipulable than fair value, which on the contrary are based on subjective appraisals (Hermann, Saudagaran & Thomas 2006, p. 53). Historical cost and fair value do not exclude each other in the faithfulness of the information.
Comparability, timeliness, verifiability, and understandability are further characteristics that improve the relevance of the information. Fair value offers better outcomes with regards to comparability and timeliness and. For example, historical costs can prevent comparability in some cases, while a current appraisal is paramount in providing timely information to investors, creditors, and other interested users (Hermann, Saudagaran & Thomas 2006, p. 50; p. 54).
Historical cost is almost universally considered superior concerning verifiability of the valuation of property, plant, and equipment because of the reduced degree of subjectivity. However, fair value is preferred in some exceptions, including in assets subject to impairment, and donations.
The analysis of the advantages and disadvantages of historical cost and revaluation models seems to highlight greater reliability of fair value than historical cost. Why, then, IAS 16 includes both models in its framework? First, as highlighted in the introductory section, many countries privilege the historical cost model rather than the revaluation one. Hence, the IAS 16 provides a series of guidelines for users within these countries.
These subjects are likely to resort to the revaluation model only in the case of international transactions. Secondly, the historical cost model is preferred in certain situations, because it offers more transparency compared to revaluation. Fair values are based on subjective appraisals and can be manipulated or carrying some bias. Finally, considering the different characteristics of the two models, they might be used in a complementary way for improved outcomes.
Over the last two decades, national accounting standard setters have been producing efforts to converge and harmonize with the models suggested by IASB, also concerning property, plant, and equipment. The standard IAS 16 defines the guidelines for the accounting treatment for most types of property, plant, and equipment. After an initial recognition recorded at cost, the IAS 16 permits both historical cost and revaluation models for the following measurement, arousing a lively debate over the superiority of one or the other model.
The analysis shows that fair value is more versatile in complying with the qualitative characteristics suggested by the international standards for useful financial reporting. However, the historical cost model offers better outcomes in some specific cases and is the preferred model in many countries. These reasons suggest that IAS 16 has included the two models to cover the existing different national traditions and a possible complementarity of the two models.
Conceptual Framework for Financial Reporting. 2018. Web.
Hermann, D, Saudagaran S M & Thomas W B 2006, ‘The quality of fair value measures for property, plant, and equipment’, Accounting Forum, vol. 30, no.1, pp. 43-59.
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IAS 16 — Property, Plant and Equipment n.d. Web.