QUESTION

You are the Chief Financial Officer of Metallica Ltd. The Chief Executive Officer (CEO) of Metallica has requested a meeting with you to discuss the measurement model that Metallica uses for its property plant and equipment. Currently the company accounts for its assets using the cost model. The CEO believes that the property plant and equipment are worth 20% more than the current book value. He is of the view that the company would be better served if it adopted the revaluation model instead of the cost model. He has asked you to prepare a report detailing the effect that adopting the revaluation model and bringing the assets up to his assessment of their value would have on the financial statements of Metallica Ltd., the implications of this change for the various stakeholders (with particular reference to shareholders, senior management and the company’s major lenders) and the ability of the company to raise further capital.

Further information is as follows:

As at the 30/6/11 the total assets of the company are $14,000,000. Property plant and equipment comprises $11,000,000 (written down value) and the remainder is current assets. Property plant and equipment is currently depreciated on a straight line basis over a ten year useful life and there is no residual value. They are currently half way through their useful life and it is not anticipated that either the useful life or the residual value of the assets would change. The company has long term liabilities of $7,000,000 and short term liabilities of $1,000,000. In the year ended 30/6/11 the interest expense was $360,000, the tax expense for the year was $100,000 and net profit was $800,000.

The current loan agreement that the company has with its major lenders stipulates that the debt ratio (calculated as Total Liabilities/Total Assets) must be less than .6 and that the times interest earned ratio (calculated as Profit before tax + interest expense/interest expense) should be greater than 3 and that should the times interest earned ration drop below 3 then Metallica cannot pay dividends to its shareholders.

Required:

Prepare the report to be presented to the Chief Executive Officer and make a recommendation to him as to whether or not the company should adopt the revaluation model for accounting for its property plant and equipment. (Ignore any tax implications of adopting the revaluation model)

Word Limit; 1,000 words (excluding the bibliography)

The assignment is marked out of 30 and comprises 20% of your overall marks for the semester. A detailed marking criteria sheet is attached and should be submitted with your assignment.

SOLUTION

Contents

Introduction to revaluation model 1

Introduction to Cost Model 1

Present Analysis. 1

Conclusions and recommendations. 2

References: 3

Introduction to revaluation model

Under the revaluation model the plant and machinery and the property of the company is revalued and this new value is considered for the purpose of accounting and the subsequent depreciation is claimed and is deducted. Thus under the revaluation model the carrying costs keeps on changing and is adjusted by the fair value of the plant machinery and the property. The losses accounted for the repair is also considered in estimating the carrying amount

This model is used when the estimating the fair value of the asset is possible and thus the carrying costs for the company can be estimated correctly.

A clear distinction is also to be made to the carrying costs and the values that will have to be considered in the reporting that is done for the financial year

Thus the revaluation model is greatly dependent on the correct estimation of the fair value but is one of the most practical approach to estimate the carrying costs of the company and thus make suitable adjustment.

Revaluation surplus is also introduced to make adjustments for the increase or decrease in the value of assets.

Introduction to Cost Model

Under the cost model the carrying amount of an asset is estimated by the actual value at the start of the project adjusted with the depreciation and the losses incurred because of the repairs. Thus it does not considers the fair value of the asset, which can be plant and machinery or any other property. Thus the adjustments that are made under the cost model are easy to implement and are simple as it doesn’t considers the fair value as the fair value of the asset is difficult to estimate which may be dependent on many constraints that are prevailing in the market.

Present Analysis

The total assets of the company are $14,000,000 of which Property plant and equipment comprises $11,000,000. Thus the major share in the asset is of the property and the plant and machinery. The fair value of the assets of the company has to be more than the actual value hat has been considered thus resulting in more advantage for the depreciation that has been taken and thus adding to the balance sheet of the company which will result in reducing the liabilities for the company

The company has long term liabilities of $7,000,000 and short term liabilities of $1,000,000. The interest expense was $360,000. With the above arrangements the increase in asset value of the company will be improved thereby having a direct impact on the debt equity ratio of the company.

The company might face issue with making the adjustments for the depreciation as earlier the company has been following the cost model and thus there will be cost and statutory compliance associated with it this change in accounting standard

The company will have to estimate the costs as this will be the major concern for the company. However such additional costs will be beneficial for the company in reducing the burden of maintaining the debt percentage.

This will also enable the company to make enough contribution to the dividends that have to paid. Thus shift in the accounting standard may not be easy implementation for the company but such stands have to be taken by the company in order to ensure they act in accordance to the necessary compliance.

Conclusions and recommendations

The decision for the company is to whether to go in with the revaluation model or the cost model. Both the models have been discussed above according to which the revaluation model considers the fair value and the cost model which considers the value that was considered at the start of the project. Both the models have different characteristics and thus result in a major accounting shift for the company to meet the accounting standards as well as the reporting system for the company. This is for two reasons with the change in the model the asset value wil be changing and the separate fund will be established and thus appropriate adjustments to the reporting will have to be made.

However with the revaluation model the company will be able to make necessary arrangements for meeting the target to establishing the debt requirement for the company and to able to give dividends to the shareholders of the company. Alo it will be able to increase the assets and thus make suitable adjustments to the interest payments.

The only issue with the implementation of the revaluation model is that the fair value estimation is not easy. Thus there is a lot of complexity associated with the revaluation which has made this model less popular however the IFRS has considered it an important aspect and thus will be globally accepted.

Thus it is recommended to the company to go in phased manner and maintain records as per both the models and then gradually shift to the revaluation model. Although the initial costs associated with this approach will be very high but it will help the accounting personnel as well as the company to get used to the accounting standard and thus make it simpler to maintain the reporting standards as per the compliance. A shift in the model is necessary but the costs should be considered not from the point of view of shift but from the point of the future costs associated with the revaluation model which will involve costs for getting the fair value for the model.

References:

Monday S E, (2009), IAS 16 and the Revaluation Approach: Reporting Property, Plant and Equipment at Fair Value

Herrmann, Don, Shahrokh Saudagagaran and Wayne B. Thomas. “The  Quality of  Fair Value Measurement for Property, Plant and Equipment”. 2005.

Thompson, Kevin. “Advantages and Disadvantages of  Historical cost Accoutning”.  Associated Content. 2007. 3 November 2008.  <http://www.associated content.com/articleI11 0085/advantages _ and_ disadvantages_ of_ historical.html?cat=3>

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