b) According to the IASB Conceptual Framework, the concept of capital maintenance is concerned with how an entity defines the capital it seeks to maintain. The concept of capital gives rise to financial capital maintenance and physical capital maintenance. The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements.
Required:
Distinguish between financial capital maintenance and physical capital maintenance. (6 marks)
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Financial capital maintenance: Under this concept, a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constraint purchasing power.
Physical capital maintenance: Under this concept, a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from owners during the period.
c) Once an entity has recognized an item of Property, Plant and Equipment as an asset in its books, the entity can choose between two models (or methods) to account for the asset in subsequent measurement periods, that is, the period(s) after the asset has been acquired and before its disposition. The two models are the cost model and the revaluation model. The entity shall apply the same model to the entire class of property, plant and equipment to which that asset is of similar nature and use in the entity’s operations.
Required:
Identify TWO differences between the cost and revaluation model for the measurement of Property, Plant and Equipment. (4 marks)
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- According to IAS 16 Property, Plant and Equipment all purchased items of property, plant and equipment are initially recognised at cost, after this an entity may choose to apply the cost model, where PPE is carried at cost less accumulated depreciation, or the revaluation model, where an item of PPE is carried at re-valued amount.
- If the revaluation model is used the entire class of PPE to which that asset belongs must be re-valued. The frequency of revaluation depends on the movements in the fair value of the items being re-valued, but where there are significant movements in fair value, annual revaluations may be required.
- The cost model is more objective as a cost is definite but is providing out of date information. The revaluation model could be considered more subjective as it relies on expert valuers to provide reliable measures of fair value. These measures will be more up to date but may lead to large revaluation gains and losses in the event of a booming property market followed by a crash, as is the case here. The cost model will be cheaper to apply as no expert opinions are required.
- Allowing two models leads to a lack of comparability across reporting entities, not just in the statement of financial position but also in the statement of profit or loss as the depreciation charges will be adjusted for revaluation. (Any 2)