By Yuriy Smirnov Ph.D.
The cost model is used as an accounting policy to report carrying an amount of property, plant, and equipment (fixed assets) in the balance sheet. It requires an asset to be carried at its initial cost (also referred to as historical cost) less any accumulated depreciation and impairment losses. The revaluation of assets is not allowed, but some accounting standards allow recovery of impairment losses recognized in the past.
Under IFRS, property, plant, and equipment accounting is treated in accordance with IAS 16. It allows use of the cost model or revaluation model as accounting policy, applying it to the entire class of Property, Plant, and Equipment.
The cost model assumes that a fixed asset is reported in the balance sheet at it initial cost less any accumulated depreciation and impairment losses. IFRS allows a reversal of impairment losses recognized in the past, but this amount is limited to the initial carrying amount of an asset adjusted to accumulated depreciation.
US GAAP requires entities to use the cost model as accounting policy for property, plant, and equipment. The revaluation model is prohibited!
Under US GAAP, fixed assets are reported in the balance sheet at their initial cost less any accumulated depreciation and impairment losses, but the reversal of impairment losses recognized in the past is prohibited!
Both US GAAP and IFRS require an item of property, plant, and equipment to be measured at its cost. It includes purchasing price, discounts, custom duties, transportation costs, installation and assembly costs, professional fees, and any other directly attributable costs.
Entry in the general journal debits the asset account (e.g., buildings, machinery, or office equipment) and credits Cash or Accounts Payable if an asset is acquired on credit.
Depreciation is entered in the general journal at the end of each accounting period by debiting Depreciation Expense and crediting Accumulated Depreciation.
If asset impairment is recognized, it must be recorded in the general journal. The debited account is Impairment Loss, and the credited account is Accumulated Impairment Losses.
Under the cost model, only IFRS allows reversal of impairment losses recognized in the past. The entry debits Accumulated Impairment Losses and credits Gain on Revaluation.
Depreciation expense depends on the following:
Under the cost model, the depreciation schedule remains unchanged until impairment or reversal of impairment is made.
Xander LTD has bought a plastic grinding machine for $30,000. The transportation cost amounted to $2,800, the import duty was $1,500, the customs brokerage fee was $500, and installation cost was $900. Management of Xander LTD estimates its useful life as 5 years, residual value as zero, and chooses the straight-line depreciation method.
The cost model requires the plastic grinding machine to be recognized at its total cost.
Cost = $30,000 + $2,800 + $1,500 + $500 + $900 = $35,000
If the straight-line depreciation method is used, the annual depreciation expense is $7,000.
Annual depreciation expense = $35,000 ÷ 5 = $7,000
Assuming that Xander LTD prepares financial statements annually, entry in the general journal at the end of each accounting period must be as follows:
Let’s assume that after two years an impairment test was made, and an impairment loss of $3,000 was recognized. It should be recorded in the general journal as follows:
Impairment loss affects the carrying value and depreciable amount. The accumulated depreciation after 2 years amounts to $14,000, so the carrying value before impairment is $21,000 ($35,000 - $14,000).
Since the grinding machine has no residual value, the depreciable amount after impairment equals a carrying value of $18,000 ($21,000 - $3,000). Thus, the annual depreciation expense must be adjusted as follows:
Annual depreciation expense = $18,000 ÷ 3 = $6,000
One year later the impairment test showed that the grinding machine had appreciated $4,000. Under the cost model, the impairment loss reversal is limited by the amount of accumulated impairment loss of $3,000. The entry in the general journal will be:
Reversal of impairment loss requires that the depreciation expense be adjusted. The depreciable amount at the end of the third year is $15,000 ($18,000 - $6,000 + $3,000). Since only 2 years remain before the grinding machine’s useful life expires, the adjusted depreciation expense will be $7,500.
Annual depreciation expense = $15,000 ÷ 2 = $7,500
All entries recording depreciation expense are as follows:
