In this class, we will discuss the recognition of assets in the balance sheet by looking both at the cost model and it's revaluation model. Let's see this example. A company purchases an equipment paying €5,000 for this equipment. It is purchased the 1st of January 2014 and the equipment is expected to be used for the next five years. What happens to the recognition in the balance sheet? Either the company is using a cost model or a revaluation model, the initial measurement is the same. So the initial measurement corresponds to €5,000 which is the purchasing price. Then we have a problem to recognition of the value of the equipment to the year subsequent to the initial one. Let's see what happens if a cost model is adopted. So this is the case with the cost model. The starting point is represented by the identification of the acquisition cost. The acquisition cost, as you see from the example, is €5,000 and the value is, of course, the same over the five years. So the acquisition costs wouldn't change and we have €5,000 for all of the five years. The company, if you remember, should calculate the depreciation, so the annual loss of value. The depreciation, if you remember the formula, is calculated as the ratio between the cost, which is €5,000, and the useful life that is represented by five years. So the annual depreciation is equal to €1,000. So we can identify the depreciation of €1,000 that enters. If you remember, the income statement and the value is the same for all of the five years. Then in order to calculate the value to recognize within the balance sheet, we need to identify the accumulated depreciation. The accumulated depreciation is simply the sum of the depreciations of each year. So we will have €1,000, which is the depreciation of the first year. Then the depreciation of 2015 will be €1,000 of 2014 plus the depreciation of 2015, so we will have €2,000. Then in 2016, we will have the accumulated depreciation plus the depreciation of the year, so we will have €3,000, and the same is going to be applied for the remaining years, arriving in 2018 with €5,000 of overall depreciation. At this moment, we can finally calculate the value of the equipment which is recognized in the balance sheet. So the equipment intended as value that is recognized within the balance sheet is calculated as the difference between the cost and the accumulated depreciation. So we will have €4,000, €3,000, €2,000, €1,000 and finally, we will have zero. Pay attention that the balance sheet in this case is provided at the end of each year. That's the reason why we have also the recognition of the depreciation in 2014. Now, let's see what happens if instead we decide to adopt the revaluation model. The revaluation model is different because the revaluation model looks at the fair value in the market. So we need some more data in order to apply this approach. Assuming, for example, that the fair value at the end of 2016 equals €3,900. So what happens to our balance sheet? What we need to do is to recognize, first of all, the value of the equipment that should be recognized in the balance sheet, where these value, if you remember, is exactly 3,900, which is the fair value. If we look at these by considering the overall balance sheet, this would be easier because we have, first of all, the value of the equipment. What's the value of the equipment? We need to start from the book value and at the beginning of 2016, the book value, if we look at here is €3,000. Now the difference between 3,900, which is the fair value, and the book value is equal to €900, which means that the revaluation of the equipment is equal to €900. This 900 is recognized within the revaluation reserve. The revaluation reserve represents a component of the shareholders equity and we will have a value of €900, which represents the difference between the fair value and the book value. Now remember, that still we need to calculate the depreciation. The depreciation, in this case is calculated as the ratio between the fair value, which is 3,900, and the remaining years of the useful life, we will have 2016, 2017 and 2018. So the remaining years is equal to three. So this value will be 1,300, which means that we need to deduct 1,300 from the value of the equipment. So we will have the value of the equipment at the end of 2016. So this is the balance sheet at the end of 2016 of 2,600. So that's very different because if you look, we have 2600 by using the revaluation approach. We have €2,000 by using the cost model, meaning that we have taken into account the fair value. We can have something more, assuming that we are moving to 2017. So at the end of 2017, the value of the equipment, the market value of the equipment is €1,100 and this value is unrecoverable. Meaning that, for example, a new technology has been launched in the market and the value of the equipment cannot be recovered anymore. So this will be 1,100 that cannot be recovered. In this case, the so called impairment test should be recognized in the balance sheet by the company. What should be done? First of all, we need to address within the balance sheet the new value. So we can calculate, again, the difference between the fair value, which is 1,100 with respect to the book value, which is 2,600. So the loss of value will be of 1,500. Again, as a difference between fair value and book value. In the moment in which we have this the loss of value, we need to recognize this loss of value also by looking at the revaluation reserve. We do not have €1,500 in the revaluation reserve, which means that we deduct only €900. So the revaluation reserve will have a value equal to zero. We are missing €600. This €600 that are missing will enter the income statement. That's the reason why I am writing them here because they do not enter exactly into this reports. So this €600 are an expense that is recognized in the income statement. Finally, what we need to do is, again, to calculate another time the depreciation. So the depreciation, in this case, will be the new value. So €1,100 divided by the useful life, which is 2017 and 2018. So divide it by the remaining two years. We will have a depreciation of 550. So minus 550, and we will have the final value of the equipment, in this case, in the year 2017 equals to 550. In this case, we have applied what is defined as impairment tests. The impairment test is apply both in the case of the revaluation model, but also if a cost model is adopted in the moment in which the loss of value is unrecoverable.
