The accounting for property, plant, and equipment (PPE) varies worldwide. The two most popular methods to account for PPE are the cost model and the revaluation model.
United States Generally Accepted Accounting Principles (GAAP) requires companies to use the cost model. Meanwhile, International Financial Reporting Standards (IFRS) gives companies the option to choose between the cost model and the revaluation model.
IFRS is a widely adopted set of standards that is used by approximately 120 countries across the world. In recent years, there have been more efforts to converge US GAAP and IFRS. Look, for example, at the new revenue recognition standard, Revenue from Contracts with Customers. This was a joint effort that standardized the method of accounting for revenue recognition between the United States and international countries.
This sparks the question – why hasn’t US GAAP adopted the revaluation model? In the following sections, I give an overview of the accounting under the cost model and the revaluation model. I finish up with my take on whether US GAAP should adopt the revaluation model.
Table of Contents
Cost Model – US GAAP
Under the cost model, PPE is measured at its carrying value: historical cost less accumulated depreciation and impairment losses. Historical cost is the original cost that is expended to purchase or construct a long-term asset.
The cost model requires companies to adjust the carrying value of an asset to match its fair value if the asset is impaired. Fair value is the price that would be realized from selling the asset on the current date.1
An asset is impaired when its fair value is less than its carrying value.2 The cost model does not allow an adjustment in the opposite direction. That is – companies cannot adjust the carrying value of an asset upward to match the fair value. After recording an impairment, the adjusted carrying value of the asset serves as the new depreciation basis.3
In the following example, I give an overview of the accounting entries under the cost model.
Example 1:
Company A purchases a building on January 1, 2020 for $10,000,000. Company A will depreciate it straight-line over its 10-year useful life with no salvage value. Assume that the fair value of the building is $8,100,000 on December 31, 2020 and $15,000,000 on December 31, 2021. Company A sells the building for $12,000,000 on December 31, 2022
Year 1: January 1, 2020 – December 31, 2020
January 1, 2020
| Building | $10,000,000 | |
| Cash | $10,000,000 |
December 31, 2020
| Depreciation Expense | $1,000,000 | |
| Accumulated Depreciation | $1,000,000 |
| Impairment Loss | $900,000 | |
| Accumulated Depreciation | $1,000,000 | |
| Building | $1,900,000 |
Year 2: January 1, 2021 – December 31, 2021
December 31, 2021
| Depreciation Expense | $900,000 | |
| Accumulated Depreciation | $900,000 |
* An entry is not allowed to adjust the carrying value up to the fair value
Year 3: January 1, 2022 – December 31, 2022
December 31, 2022
| Depreciation Expense | $900,000 | |
| Accumulated Depreciation | $900,000 |
| Cash | $12,000,000 | |
| Accumulated Depreciation | $1,800,000 | |
| Building | $8,100,000 | |
| Gain on Sale | $5,700,000 |
Revaluation Model – IFRS
Under the revaluation model, the carrying value of a PPE asset is revalued to its fair value on the revaluation date. The carrying value of the asset can increase or decrease depending on its fair value. Note that this differs from the cost model which does not allow for upward adjustments of the asset’s carrying value.
An increase in the carrying value of the asset is recognized in other comprehensive income (OCI) unless the increase reverses a previously recognized impairment loss. Reversals in impairment losses are recognized in net income.4
A decrease in the carrying value of the asset is recognized in net income unless it reverses a previously recognized revaluation gain. Reversals of revaluation gains are recognized in OCI.5
The amounts recognized in OCI accumulate in the equity account called revaluation surplus.
OCI is found below net income on a company’s income statement. It includes certain non-core business activities that are not allowed to be included within net income. This division is meant to aid financial statement users by showing only core business activities within net income.
The following example gives an overview of the accounting entries under the revaluation model using the assumptions from Example 1.
Example 2:
Year 1: January 1, 2020 – December 31, 2020
January 1, 2020
| Building | $10,000,000 | |
| Cash | $10,000,000 |
December 31, 2020
| Depreciation Expense | $1,000,000 | |
| Accumulated Depreciation | $1,000,000 |
| Impairment Loss | $900,000 | |
| Accumulated Depreciation | $1,000,000 | |
| Building | $1,900,000 |
Year 2: January 1, 2021 – December 31, 2021
December 31, 2021
| Depreciation Expense | $900,000 | |
| Accumulated Depreciation | $900,000 |
| Building | $6,900,000 | |
| Accumulated Depreciation | $900,000 | |
| Revaluation Gain – Net Income | $900,000 | |
| Revaluation Gain – OCI | $6,900,000 |
Year 3: January 1, 2022 – December 31, 2022
December 31, 2022
| Depreciation Expense | $1,875,000 | |
| Accumulated Depreciation | $1,875,000 |
| Cash | $12,000,000 | |
| Accumulated Depreciation | $1,875,000 | |
| Loss on Sale – OCI | $1,125,000 | |
| Building | $15,000,000 |
| Revaluation Surplus | $5,775,000 | |
| Retained Earnings | $5,775,000 |
Carl’s Take
When comparing the two examples above, the differences in accounting occur on December 31, 2021. On this date, the revaluation model requires an upward adjustment of the carrying value of the building to its fair value. The cost model does not allow for this upward adjustment.
The revaluation model adds more variability to a company’s financial statements. Additionally, there is subjectivity involved with assessing the fair value of an asset. This gives managers some leeway in manipulating numbers reported within the financial statements.
For example, let’s say a company has a debt covenant that requires a certain asset to debt ratio. An enterprising manager using the revaluation model could apply a questionable measurement of fair value to meet the covenant.
The revaluation model is also expensive. It takes time and money to assess the fair value of PPE assets. Companies must hire external valuation specialists or employ specialized employees that understand PPE valuation. It is debatable whether the benefits of providing PPE fair value information to users outweigh the costs of obtaining that information.
In short, I do not think that US GAAP should adopt the revaluation model. Furthermore, I think IFRS should mandate companies to use either the cost model or the revaluation model. Presently, companies have the option to choose between both models.