Revaluation of long-lived assets is an important technique in finance that is used to figure out the true value of the assets owned by the firm. Long-lived assets are divided into three categories viz. tangible assets like property, equipment, plant, etc; identifiable intangible assets like license, trademark or patent and non-identifiable intangible assets like goodwill of the company.
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Definition of Revaluation
Revaluation is a method to describe true value of assets owned by the company. The revaluation of long-lived assets is allowed only in IFRS and not in GAAP. It is done to report the fair market value of the long-lived assets. The revaluation is different from a planned depreciation which is linked to the age of the asset. Even if a firm is looking at reselling its asset, the asset is revalued for the negotiation.
Under U.S. GAAP, the historical cost model is used to report long-lived assets. Accumulated depreciation and an impairment loss are deducted from historical cost to figure out the value of the assets. Under IFRS, both historical cost model and revaluation model is used. Under the revaluation model, accumulated depreciation and impairment is deducted from the fair value to report the value of the assets.
Purpose for Revaluation
Any company going for the revaluation of its long-lived assets may have one of the following reasons:
- To determine the actual rate of return on capital.
- To determine the fair market value of long-lived assets after a huge appreciation since their initial purchase.
- To take a loan from a bank by mortgaging the asset. A correct revaluation may lead to the higher loan amount.
- To negotiate the proper price for the asset in case of any merger or acquisition by some other company.
A downward revaluation of an asset results in the decrease in the book value of an asset. This decrease or loss is reported in the income statement initially. Subsequently, if the carrying amount of the asset increases due to an increase in the fair market value, the increase is reported as profit in the income statement, but only to the extent of the amount of loss reported previously for the asset. The remaining amount of gain due to revaluation bypasses the income statement and is reported in shareholder’s equity as other comprehensive income.
An upward revaluation of an asset results in an increase in the carrying amount of the asset. Unlike the treatment in the downward revaluation, this initial profit is not recognized in the income statement and is reported in the shareholder’s equity under other comprehensive income as revaluation surplus. Thus, this upward revaluation results in an increase in shareholder’s equity and decrease in net income due to a higher depreciation. As a result, there is a decrease in ROE, ROA, and debt/capital ratio. Subsequently, if there is a decrease in the fair value of the asset and it results in the decrease in the book value of the asset, this loss due to revaluation will be first reported in other comprehensive income, but only to the extent of the amount of previous gain. The remaining loss is recognized in the income statement.
If an asset is disposed off or retired, the amount of surplus is recognized directly under retained earnings.
Effects of Asset Revaluation
The revaluation of long-lived assets has an effect on all the financial statements in the following ways:
- An increase in the book value of the asset results in an increase in total assets and equity and in turn reduces leverage.
- The decrease in the book value of the asset reduces net income.
- The decrease in the carrying amount results in a decline in ROA and ROE in the particular year.
- However, in the downward revaluation scenario, because of lower total assets and equity, the profitability appears to increase in future years.
- Similarly, any reversal of downward revaluation of assets also experiences an increase in earnings.
Conclusion: The revaluation of assets is an important accounting decision in the firm as it impacts various financial statements. Though it is not allowed under U.S. GAAP, the companies following IFRS should undergo the revaluation diligently.
References:February 17th, 2018