The deemed cost, is a substitute cost used in recognition of property plant and equipment, or intangible assets, in the adoption of international financial reporting standards for the first time.
That is, when an entity has its accounting under the principles different from the international accounting standards, it may need to convert its financial statements to IFRS, because this is required by the regulation where the company operates, or basically because it needs to have financial statements that are comparable with the financial statements of other companies at an international level.
When this occurs, an entity must apply IFRS 1.
This standard, brings a series of exemptions that an entity can apply when using international financial reporting standards for the first time.
Among these, we find the deemed cost.
This concept, refers to the fact that an entity can recognize its property plant and equipment or its intangible assets, in applying the IFRS for the first time, at fair value, or as a revaluation according to the previous accounting principles.
Let’s see a series of practical examples, to understand this concept more easily.
Example of fair value as deemed cost
In the example below, we will see the financial statement impact for the first time of using fair value as deemed cost.
A company has its financial statements under the accounting principles in the entity’s jurisdiction.
At the end of year 5, this entity needs to convert its financial statements to IFRS.
Within the heading of property plant and equipment, there are a series of buildings with a historical cost of 2,000,000, and an accumulated depreciation of 300,000.
On the other hand, the fair value of the buildings increases to 7,000,000.
The entity’s management considers that recognizing these assets at carrying amount in the financial statements under IFRS for the first time, would be an error because it would not show the company’s economic reality.
For this reason, the entity uses the fair value as deemed cost, for the initial recognition of this property plant and equipment.
In this way, the recognition would be as follows:
So, as we can analyze, it was necessary to derecognize the property plant and equipment in its entirety, and recognize the new valuation of the buildings for 7,000,000.
It is essential to say, that the difference arising between the measurement at the fair value of property plant and equipment, based on international financial reporting principles, and the property plant and equipment, derecognize according to local accounting principles, must be recognized in equity under paragraph 11 of IFRS 1.
Example of a revaluation as deemed cost
Another option, allowed by international financial reporting standards, is to recognize property plant and equipment, using as a base the revaluation applied to these assets under previous accounting principles.
Let’s analyze the following example, where a company uses revaluation based on previous accounting principles.
An entity, in year 1 acquires land for 500,000.
In the jurisdiction where the entity operates, it is allowed to increase the value of assets, based on real estate market prices.
The local regulations applied by this entity, establish that a company must show these increases in the equity in an account called revaluation.
In year 5, the carrying amount of this asset, is equal to 1,200,000.
And the balance in the revaluation account, equals 700,000.
This year, the entity converts its financial statements, to international accounting standards and uses the revaluation as deemed cost.
In this way, when recognizing the land under IFRS, based on the previous accounting principles, the only accounting entry that the entity must make, is to reclassify the balance of the asset revaluation account, to retained earnings.
From our point of view, this revaluation, should not be recognized under international accounting principles, in the application of IFRS for the first time.
This is so because, according to IAS 16, an entity will only recognize an increase in the value of property plant and equipment in the equity when using the revaluation model, in the subsequent measurement of these assets.
Example of not applying deemed cost
And finally, it may happen that an entity does not avail itself of the deemed cost exemption, as we will see in the following example.
In year 1, an entity acquires a series of machines, which will be used in the company’s production process.
The cost of these assets is 300,000.
The regulations applied by this entity allow these assets to be depreciated using a maximum useful life of 10 years.
At the end of year 7, the entity converts its financial statements from local standards to IFRS.
The carrying amount of these assets at the end of the period amounts to 90,000.
In this case, the entity does not apply for the deemed cost exemption, because it considers that there is no active market for this type of machine, and therefore, it is not possible to set out its fair value.
The management of the entity, according to an evaluation carried out by a third party, considers that the useful life of these assets should be 25 years, counted from the date of acquisition.
The accounting recognition in the adoption for the first time of the IFRS, would be the following:
As we can see, in the accounting recognition under IFRS, the actual useful life of the machinery was taken into account.
Therefore, by analyzing these transactions, we can see that the opening balance of property plant and equipment, which should be reflected in the financial statements for the first time, equals 216,000.
This balance results from deducting the accumulated depreciation to asset cost by 84,000.
This depreciation, was calculated based on a useful life of 25 years.
In this way, it will be necessary to reverse the accumulated depreciation for 210,000, and adjust the asset for 84,000.
It is important to say, that from our point of view, asset must be recognized for a net value of 216,000 in the financial statements under IFRS for the first time.
This, taking into account that to show an accumulated depreciation, would indicate that these assets have been depreciating based on international accounting principles for several years.
As we can analyze, year 7 would be the opening balance under IFRS.
Therefore, it would not be coherent to show an accumulated depreciation in the first year of FRS application.
It is also important to say, that the depreciation expense for the following years must be calculated based on the asset’s remaining useful life, in other words, 18 years, taking into account that 7 have already passed.
In conclusion, the use of the deemed cost requires management’s judgment, because as we saw in the examples shown above, if an asset tends to present increases in values, as is the case with real estate, it will probably be necessary to use the fair value as deemed cost.
On the other hand, if an entity considers that the revaluation of a properly recognized using accounting principles before IFRS reflects the economic reality of an asset, it must use this value as deemed cost.
And finally, if an entity is sure that certain types of assets do not present valuations, and instead it will lose value over time, it does not make much sense to use fair value as deemed cost.
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