Portable Power: An Application of IAS 16 Including Self-constructed Assets and the Revaluation Model CASE In the fall of 2015, Hans Grber initiated a crowdfunding campaign with help from the European Crowdfunding Network. His goal was to raise sufficient capital to launch Portable Power, a privately-held company that manufactures and sells portable energy chews for active people on the go. The company successfully raised 250,000 during the six-month campaign, funds sufficient to cover all costs related to the acquisition of machinery and materials needed to produce its single product, Dragon Energy. Dragon Energy is a portable energy chew favored by amateur and professional athletes. The product is extremely popular with bikers, runners and biathletes because of its energy kick and the essential vitamins and minerals delivered naturally through its unique ingredients. In contrast to generic energy gels and bars, Dragon Energy chews have a lower glycemic index and a slower, longer lasting, energy release. Distribution is limited to a few select Western European countries. The all-natural athletic fuel is produced using two components: maple syrup and a secret caffeine blend consisting of coffee, coconut oil and dragon fruit extract that the company promotes as the Dragon blend. The company grows its own dragon fruit; this process is complex and carefully managed. The plants produce fruit for five months each year, generally from May through September, in greenhouses situated in the beautiful, combustion engine car-free town of Zermatt, Switzerland. The location ensures pollution-free, organic, tasty fruit. As there are no producers of pure maple syrup in Europe, the pure maple syrup is imported from Vermont USA. The maple syrup and Dragon Blend are mixed together at the companys rented facility located in Valais, Switzerland. Following the blending process, the energy chews are packaged and sold exclusively online through the companys website. Portable Power began producing energy chews in 2017. Since then it has experienced consistent growth. The unique product and manufacturing process attracted the attention of several private investors. Their interest prompted now CEO Hans Grber to hire ABC International to audit its financial statements for the year ending December 31, 2018. The financial statements will be prepared in accordance with International Financial Reporting Standards (IFRS); the monetary unit is the Euro. Historically, the company has been using the cost model for valuing property, plant and equipment, consistent with International Accounting Standard (IAS) 16 (IASB 2014b). However, management now believes that the revaluation model for both land and machinery is more appropriate, under the presumption that fair value presents more relevant financial information to the potential investors. Portable Powers accountant prepared a draft of the financial statements; these are provided in Tables 1 and 2. The auditors informed Hans that they are concerned about how the company determined the fair value of its land and production equipment, as well as the companys accounting for the operating costs related to the greenhouse operations and the dragon fruit plants. Land for growing purposes At the end of 2015 Portable Power paid 80,000 for one acre of land on the outskirts of Zermatt. An active market exists for similar pieces of land in the region; Portable Power can access the markets at any time. Management is fairly certain that the land would not sell for less than 100,000, less selling costs of 5,000 and greenhouse removal costs of 2,000. As such, they propose that the land be reported at a fair value of 93,000, i.e., at their assessment of its fair value less costs of disposal. The auditors believe that the acre of land should be valued using the recent selling prices of land in the Zermatt area. Recent land sale prices in the Zermatt area are presented in Table 3. Management believes the fair value estimate for the land should be classified as Level 1 in the fair value hierarchy. Production equipment On January 1, 2017 the company acquired a one-of-a-kind, customized piece of production equipment for blending and packaging the energy chews. The equipment was purchased for 120,000, has a salvage value of 10,000, and an estimated useful life of 10 years. The initial batches of Dragon Energy were produced in August 2017; Portable Power elected to depreciate the machinery using the straight-line method and the half-year convention. As of December 31, 2018, management calculated the fair value of the equipment as 180,151 based on a discounted cash flow (DCF) model calculated using its estimated cost of capital, and its own assumptions about future cash flows. Management believes that neither the market nor the cost approach included in IFRS 13 (IASB 2014d) is relevant in this situation. Table 4 presents Portable Powers DCF model and the resulting calculations. The auditors cautioned Portable Powers management team that the use of the fair value revaluation model described in IAS 16, 31-42 is rarely seen in practice and that once management chooses the model it must be used for all assets within that class, and consistently used in future reports. Management replied that they believe the fair value is important to report under the companys current circumstances. The auditors agree that no active market with similar assets exists. However, they question the estimates and assumptions used by management, including the reliance on the income approach rather than the cost or market approach. Based upon their conversations with the machines manufacturer, the cost for a similar machine, roughly approximating the current condition of Portable Powers, ranges from 110,000 to 125,000. The auditors also had a long conversation with Portable Powers management about the content of the required financial statement disclosures. The draft financial statements currently omit specific disclosures as to the valuation techniques and inputs used to determine the fair value of the equipment as well as the effect of the fair value measurements on other comprehensive income for the year. The auditors are of the opinion that managements measurement does not faithfully represent fair value, and that operating assets are overstated. Greenhouses and dragon fruit plants During the first few months of 2016 management acquired and installed four greenhouses at a cost of 28,000 per greenhouse on the land acquired in 2015. Each greenhouse is a state-of-the-art, full-size, glass structure that includes electricity, heating and lighting. Management estimates a 25-year useful life for the greenhouses, as well as for the associated heating and ventilation equipment. Straight-line depreciation is used and there is no estimated salvage value. Portable Power next invested 3,000 per greenhouse establishing the dragon fruit plants preferred growing environment (30% sand, 30% compost, 40% local soil). The growing environment is critical to proper growth and production of the plants. The fixed costs to operate the greenhouses is $30,000 per year. Management expensed these annual amounts in 2016, 2017 and 2018. Following the installation of the greenhouses and the completion of the growing environment, the dragon fruit seeds were imported from Mexico at a cost of 2,000 (approximately 1.54 per germinated seed). During July 2016, the seeds were planted under the direction of a herbaceous plant specialist. The plants germinated and successfully grew in size during their first year. At the end of the first year, the greenhouses held 1,299 plants that were planted in clusters of three plants each, with each cluster supported by a trellis. The initial fruit crop appeared in 2017, this first crop was harvested in September. The plant expert estimates that the 2017 fruit output is about 50 percent the amount that will be produced in 2019 when the plants are fully mature. The crop produced in 2018 approximated 90 percent of the output anticipated for 2019 and the following years. Management estimates the dragon fruit plants will continue to produce fruit for 20 years with appropriate care. (Evans et al. 2010). IFRS makes some interesting and important distinctions about the accounting for agricultural assets. Prior to 1 January 2016, IAS 41 Agriculture (IASB 2014c) required that all biological assets related to agricultural activity be reported at fair value less costs to sell. The IASB explained that the presumption was fair value is the most appropriate measure to reflect the change in these assets over their lifetimes. However, the responses to the IASBs 2011 Agenda Consultation that focused on agriculture informed the IASB that they believed that mature bearer biological assets (specifically what are now referred to as bearer plants) are similar to assets used in manufacturing. These respondents suggested that the cost model be permitted for these assets because it is permitted for property, plant and equipment (IASB 2014e). It is important to realize that IAS 41 makes a distinction between bearer and consumable biological assets. The IASB distinguishes bearer biological assets as those that are held to produce product; the value of the plant itself is a by-product of the plants productive capacity. This (IASB 2014b, 1) notes that the principle attributes of property, plant and equipment are the recognition of the assets, the determination of their carrying amounts and the depreciation charges and impairment losses to be recognised in relation to them. IAS 16, paragraph 3(b) clearly states that the standard does not apply to biological assets related to agricultural activity other than bearer plants (see IAS 41 Agriculture). This Standard applies to bearer plants but it does not apply to the produce on bearer plants. Further, within the definitions provided in paragraph 6, a bearer plant is a living plant that: (a) is used in the production or supply of agricultural produce; (b) is expected to bear produce for more than one period; and (c) has a remote likelihood of being sold as agricultural produce, except for incidental scrap. In 2016, management capitalized the one-time seed costs and the cost of creating the growing environment. Portable Powers accountant determined this was the appropriate accounting treatment based on her reading ol, paragraph 16 (IASB 2014b): The cost of the item of property, plant and equipment comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. As shown in Table 2, as of December 31, 2018, 14,000 of seeds and growing environment are included under the asset capitalized greenhouse costs. The auditors scheduled a meeting for next Wednesday to discuss more appropriate valuations for the land, equipment, greenhouse costs, and the bearer plants. Assignment: 1. Why do you believe Portable Powers management decided to elect to use the revaluation model included in IAS 16? Explain the impact on both the balance sheet and income statement when shifting from a historic cost basis to a fair value basis. Use words, not actual numbers, in this explanation. 2. Assume that Portable Power elected to use the IAS 16 revaluation model for both its land and equipment. Carefully review IFRS 13 to determine: a. If Portable Powers estimate of the fair value of its land is appropriate. Be sure to consider the applicable guidance about using the market approach included in IFRS 13. b. Carefully review Portable Powers fair value estimate for the production equipment. What guidance does IFRS 13 provide about the cash flow estimates and discount rate when valuing a specific asset? Provide your best estimate of the fair value of the equipment. c. What journal entries are required to record the revaluation of the assets to their fair value? d. Clearly describe the impact of the revaluation option on both the ending balance sheet and income statement. Do you believe that the revaluation option more appropriately presents Portable Powers financial condition? Table 1: Statement of Comprehensive Income as Prepared by Management For the year ended Dec. 31 2017 2018 Sales revenue 200,000 360,000 Cost of sales: variable costs of production 150,000 270,000 Cost of sales: fixed costs of greenhouse operations 30,000 30,000 Cost of sales: fixed costs of manufacturing operations 30,000 30,000 Cost of sales: depreciation expense 9,980 15,480 Gross profit (19,980) 14,520 Administrative and operating expenses 100,000 100,000 Net loss (119,980) (85,480) Comprehensive income equipment revaluation Cost - AD = (120,000 - 16,500)=Book Value 103,500, FV=180,151 76,651 Comprehensive income - land revaluation (93,000 - 80,000) 13,000 Comprehensive income (loss) (119,980) 4,171 Table 2: Operating Assets as Drafted by Management 12/31/2017 12/31/2018 Land (2017 at cost, 2018 at fair value) 80,000 93,000 Production equipment (2017 at depreciated cost; 2018 at fair value) 120,000 180,151 Less accumulated depreciation 2017 (120,000 - 10,000 = 110,000/10 = 11,000 per year. 2017 = .5 year = 5,500) (5,500) - Greenhouses (28,000 * 4 = 112,000) 112,000 112,000 Less accumulated depreciation (112,000/25 years = $4,480 per year, 2017 1.5 years, 2018 2.5 years) (6,720) (11,200) Subtotal 299,780 373,951 Capitalized greenhouse costs: Growing environment (3,000*4) 12,000 12,000 Dragon fruit seeds 2,000 2,000 Total greenhouse costs 14,000 14,000 Total operating assets 313,780 387,951 Greenhouse operating costs of $7,500 were expensed each year. Table 3: Valais Land Market (Active) Each property is classified as agricultural land located in a valley or river basin. All represent recent selling prices. Market/Region Price/Acre Zermatt (Valais) 85,000 Cervinia (Italia) 60,000 Saas Fee (Valais) 70,000 Table 4: Managements Production Equipment Discounted Cash Flow (DCF) Assumptions and Model Actual Projected Assumptions 2017 2018 2019 2020 2021 2022 2023 Dragon Energy production in units, assuming 4% annual growth rate after 2019 10,000 18,000 20,000 20,800 21,632 22,497 23,400 Revenue per bar 20 Variable cost per bar 15 Annual fixed costs of production, 30,000 devoted to greenhouse operations 60,000 Purchase cost of equipment 20,000 Useful life (years) 10 Disposal value 10,000 Portable Power's estimated cost of capital 10% Discounted Flow Calculations 1 2 3 4 5 2017 2018 2019 2020 2021 2022 2023 Dragon Energy production in units 10,000 18,000 20,000 20,800 21,632 22,497 23,400 Revenue per bar 20 400,000 416,000 432,640 449,940 468,000 Variable cost per bar 15 (300,000) (312,000) (324,480) (337,455) (351,000) annual fixed costs of production 60,000 (60,000) (60,000) (60,000) (60,000) (60,000) Net cash flow 40,000 44,000 48,160 52,485 57,000 Discounted at 10% cost of capital 180,151 36,364 36,364 36,183 35,848 35,392 Book value production equipment Purchase price 120,000 120,000 Accumulated depreciations (.5 and 1.5 years) 5,500 16,500 Book value 14,500 103,500