Accounting for Residual Values – Part 1

In a few months companies will be pondering what journal entries to pass to reflect the change in the definition of residual values in property plant and equipment, among other changes. Unfortunately IAS16/AC123 is not very helpful in giving guidance onhow to account for the change over from the old to the new standard in this regard and I can anticipate many debates and arguments around the treatment of this change.

There are basically two issues to consider:

  1. Should the change be seen as a change in accounting policy and be made retrospectively or should it be dealt with as a change in estimate?
  2. How should entities account for the annual restatement of the residual value after the initial application of the standard?

The objective of the first part of the article is to deal with the treatment of the change from the old to the new standard. The second part of the article will deal with the accounting after the change.

The previous definition of residual value was “the net amount that the enterprise expects to obtain for an asset at the end of its useful life after deducting the expected costs of disposal.” The previous guidance on how to arrive at the residual value using the benchmark (historical cost) approach was: “When the residual value is likely to be significant, the residual value is estimated at the date of acquisition, and is not subsequently increased for changes in prices. The estimate is based on the residual value prevailing at the date of the estimate for similar assets that have reached the end of their useful lives, and have operated under conditions similar to those in which the asset will be used.” Because the residual value was fixed at the date of the acquisition under the previous statement, accounting for changes in residual values was not an issue.

The new definition of residual value is “the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life”. The new standard states that “the residual value shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with IAS8/AC103.” It goes on to state that “the residual value of an asset may increase to an amount equal to or greater than the asset’s carrying amount. If it does, the asset’s depreciation charge is zero unless and until it’s residual value subsequently decreases to an amount below the asset’s carrying amount.” So it is clear that the new standard requires that the residual value be reassessed every year (if material) and the change should be reflected as a change in estimate.

IAS8/AC103.19 states that an entity shall account for a change in accounting policy resulting from the initial application of a standard in accordance with the transitional provisions of the standard. If there are no transitional provisions, the change must be applied retrospectively unless it is not practicable to do so (see paragraphs 23 to 25 for how to handle this situation). IAS16/AC123 gives no guidance in the transitional provisions so the rule is “retrospective application”.

An accounting policy is defined as a principle, basis, convention, rule and practice applied in preparing and presenting financial statements. If such a rule, etc. is changed by a standard and, as a result assets or liabilities have to be restated, I see this as a change in accounting policy and not as a change in estimate. This issue often causes confusion and high emotion, especially when profits are affected. To understand the difference between the two treatments, a little background is in order.

The unwritten idea behind GAAP is that the balance sheet is the prime document and that the change in equity is effectively the profit or the loss achieved during the accounting period subject to changes in capital structure and distributions to equity holders. GAAP allows some items to by-pass the income statement, e.g. revaluations of property, plant and equipment, foreign currency translation gains or loss, etc. But the general rule is that changes in net assets are reflected in profit or loss.

When the original framework was written a decision had to be taken as to whether past income should be cast in stone or whether changes would be permitted for comparability purposes. The latter decision was taken and two situations were identified as to when prior period adjustments would be allowed:

  1. A fundamental error, which is now called a prior period error.
  2. The cumulative effect of changing an accounting policy.

AC141 now contains a third situation where one can restate the past.

Over the years there has been much debate as to what comprises a prior period adjustment and what comprises a change in estimate. Some historical examples are:

  1. When the statement on inventory was changed to require certain fixed overheads to be taken into account when valuing inventories, there was some debate as to whether the adjustment of the opening inventory was a prior year adjustment or a change in estimate. If it was accounted for as a change in estimate, the profit for the year of the changeover would have been grossly overstated. It was agreed that this was a prior period adjustment.
  2. When the LIFO method of accounting for inventory was banned, in the first year of the changeover there were large increases in inventories. Again there was some debate as to whether this increase should be accounted for in the current year or whether past profits were to be adjusted. The latter was eventually agreed to.
  3. When the statement on income taxes changed the rule for recognising debit deferred tax for an assessed loss, there was heated debate as to whether or not the initial recognition of the asset resulted in profit for the year or a prior year adjustment. Some companies actually increased their earnings by this prior period adjustment with the blessing of the auditors. I got the impression that the majority of accountants eventually accepted that the credit arising on initial compliance with the statement was a prior period adjustment.
  4. When IAS39 required entities to first start revaluing certain financial instruments the standard setters had the good sense to anticipate the arguments and required the initial take-on values to be treated as prior year adjustments.
  5. When IAS39 first required that companies not provide for future losses in debtors (this was a change in the rule as to how debtors were to be measured) there was much unhappiness when the profession agreed to require clients to take the reversal of the previous understatement of debtors to income. The companies who wanted to show fair profits for the year were required, under threat of qualification, to boost their profits by reversals of previous doubtful debt write-downs that had nothing to do with changing an estimate but had everything to do with changing the “principles, bases, conventions, rules and practices applied in preparing and presenting the financial statements.”
  6. The new standard on business combinations requires that amounts previously recognised as negative goodwill be written off. Fortunately the standard setters gave guidance that this write-off should go directly to equity and not through the income statement as it resulted from a change in accounting policy.

Unfortunately, the standard setters gave no guidance as to how to handle the changeover to the new basis for accounting for residual values so the whole argument is going to raise its head again.

Previously property, plant and equipment was measured, using the benchmark treatment, by taking the cost less depreciation based on historical residual values. Now, because of a change to the standard, the residual value has to be restated each year. In the case of a ship operating company, for example, this could result in material changes to the carrying values of the fleet of ships. Will the auditors force companies to take the revaluation of the ships due to reversing past depreciation based on the old standard to income or will this be seen as a change in accounting policy? To increase the current year’s profits by reversals of previous write-offs due to a change in an accounting standard must be wrong.

If a reporting entity changes the way it measures and/or recognises assets or liabilities, i.e. the principles, bases, conventions rules or practices used to measure or recognise, in my book this is a change in an accounting policy and results in a prior period adjustment. If the entity changes the measurement because of changing assumptions about the future, this is a change in estimate.

IFRS1.7 states that an “entity shall use the same accounting policies in its opening IFRS balance sheet and throughout all periods presented in its first IFRS financial statements. Those accounting policies shall comply with each IFRS effective at the reporting date for its first IFRS financial statements.” The exemptions to this principle do not cover property, plant and equipment. To state this simply: Fix the opening balance sheet. Do not account for changes in accounting policies as changes in estimates. This issue should be resolved ahead of the changeover to save unnecessary costs to the economy.

Charles Hattingh CA(SA), Chartered Financial Analyst and Honorary Professor at the University of the Free State invites you to visit his website at

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