Revaluation of fixed assets

From Wikipedia, the free encyclopedia

In finance, a revaluation of fixed assets is a technique that may be required to accurately describe the true value of the capital goods a business owns.

Fixed assets are held by an enterprise for the purpose of producing goods or rendering services, as opposed to being held for resale in the normal course of business. For example, machines, buildings, patents or licences can be fixed assets of a business.

The purpose of a revaluation is to bring into the books the fair market value of fixed assets. This may be helpful in order to decide whether to invest in another business. If a company wants to sell one of its assets, it is revalued in preparation for sales negotiations.

1 Reasons for revaluation
2 Methods of revaluation of fixed assets

[edit] Reasons for revaluation

It is common to see companies revaluing their fixed assets. The purposes are varied:

a) To show the true rate of return on capital employed.
b) To conserve adequate funds in the business for replacement of fixed assets at the end of their useful lives. Provision for depreciation based on historic cost will show inflated profits and lead to payment of excessive dividends.
c) To show the fair market value of assets which have considerably appreciated since their purchase such as land and buildings.
d) To negotiate fair price for the assets of the company before merger with or acquisition by another company.
e) To enable proper internal reconstruction, and external reconstruction.
f) To issue shares to existing shareholders (rights issue) or for an external issue of shares (public issue of shares).
g) To get fair market value of assets, in case of sale and leaseback transaction.
h) When the company intends to take a loan from banks/financial institutions by mortgaging its fixed assets. Proper revaluation of assets would enable the company to get a higher amount of loan.
i) Sale of an individual asset or group of assets.
j) In financial firms revaluation reserves are required for regulatory reasons. They are included when calculating a firm's funds to give a fairer view of resources. Only a portion of the firm's total funds (usually about 20%) can be loaned or in the hands of any one counterparty at any one time(Large Exposure Regulations).

[edit] Methods of revaluation of fixed assets

The common methods used in revaluing assets are:

[edit] I.Indexation

[edit] II.Current market price (CMP)

Land values can be estimated by using recent prices for similar plots of land sold in the area. However, certain adjustments will have to be made for the plus and minus points of the land possessed by the company. This may be done with the assistance of brokers and agencies dealing in land, or by a licensed appraiser.
Buildings values can be estimated by a realtor (real estate dealer) or Chartered Surveyor (in the UK) in a similar manner to land.
Plant & Machinery): The CMP can be obtained from suppliers of the assets concerned. However, with efflux of time, many earlier brands are not available in the market due to closure of companies manufacturing them. Similarly, there is change in the models manufactured by a company from time to time. Comparison of assets to most similar types available for sale, new or used, can provide an estimate of value.

CMP of an asset ‘n’ years old = (CMP of new asset/useful life of asset)*(useful life of asset –n).

[edit] III.Appraisal Method

Under this method, technical experts are called in to carry out a detailed examination of the assets with a view to determining their fair market value. Proper appraisal is necessary when the company is taking out an insurance policy for protection of its fixed assets. It ensures that the fixed assets are neither over-insured nor under-insured. The factors which are considered in determining the value of an asset, are as follows-:

a) Date of purchase.
b) Extent of use i.e. single shift, double shift, triple shift.
c) Type of asset. Whether the asset is a general purpose or special purpose asset?
d) Repairs & Maintenance policy of the enterprise.
e) Availability of spares in the future, mainly in the case of imported machines.
f) Future demand for the product manufactured by an asset.
g) If the asset is part of a bigger fixed asset, the life of the latter is crucial.

[edit] Selective Revaluation and why it should be avoided

Selective revaluation can be defined as revaluation of specific assets within a class or all assets within a specific location.

A manufacturing company may have its manufacturing facilities spread over different locations. Suppose it decides to undertake a revaluation of its plant & machinery. Selective revaluation will mean revaluing specific assets (such as boiler, heater, central air-conditioning system) at all locations, or revaluing all items of Plant & Machinery at a particular location only. Such revaluation will lead to unrepresentative amounts being shown in the Fixed Assets Register (FAR). In case of revaluation of specific assets of a class, while some assets will be shown at a revalued amount others will be shown at historic cost. The same will happen in case of revaluation of all assets of plant & machinery at a particular location only.

It does not sound logical and correct to value fixed assets using different bases. Similarly, depreciation on such assets too will be faulty.

[edit] Points to be considered before revaluation is undertaken

Before revaluation is undertaken, it is necessary to take into confidence the Production Department (PD), Accounts Department (AD), and the Technical Department (TD) in the company. Similarly, liaison with external appraisers becomes necessary. Generally, a team comprising officials from the PD, AD, and the TD is formed to liaison with appraisers and undertake / supervise the task of revaluation of fixed assets.

1) Why is the revaluation necessary?
2) What is the most suitable method, taking into account the type of fixed assets, statutory requirements, availability of required information? Should the values arrived at by one method be crosschecked with the values derived from another method?
3) What assets are to be revalued?
4) What is the period within which the revaluation has to be completed?
5) Laying down guidelines for the revaluation.
6) What modifications will be required in the FAR to show revalued figures in place of historic figures? Similarly, depreciation will be computed twice. One taking into account the historic cost, and the other as per revalued figures.

[edit] US GAAP on Upward Revaluation of Fixed Assets

The FASB does not allow upward revaluation of fixed assets to reflect fair market values although it is compulsory to account for impairment in fixed assets (downward revaluation of fixed assets) as per FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

In other countries, upward revaluation is mainly done for fixed assets such as land, and real estate whose value keeps rising from year to year. It seems the concept of upward revaluation of fixed assets such as real estate has not been widely welcomed by a majority of companies in USA on account of fear of paying higher property taxes. Further, the provision against upward restatement ensures conservative valuation.

The United Kingdom, Australia, and India allow upward revaluation in the values of fixed assets to bring them in consonance with fair market values. However, the law requires disclosure of the basis of revaluation, amount of revaluation made to each class of assets (for a specified period after the financial year in which revaluation is made), and other information. Similarly, law prohibits payment of dividend out of any reserve created as a result of upward revaluation of fixed assets.

[edit] Important Points

1) The increase in value of fixed assets because of revaluation of fixed assets is credited to ‘Revaluation Reserve’, and is not available for distribution as dividend. Revaluation Reserve is treated as a Capital Reserve.
2) The increase in depreciation arising out of revaluation of fixed assets is debited to ‘Revaluation Reserve’.
3) Selection of the suitable method of revaluation is extremely important. The most used method is the appraisal method. Methods such as indexation, and reference to current market prices are also used. However, when these methods are used they are crosschecked with the values arrived at by using the appraisal method.
4) When any asset, which is revalued, is sold, the part of loss resulting due to revaluation is debited to the ‘Revaluation Reserve’.
5) When assets are revalued, every Balance Sheet shall show for a specified period of years, the amount of increase / decrease made in respect of each class of assets. Similarly, the increased / decreased value shall be shown in place of the original cost.
6) In case of assets such as land and buildings, revaluation is desirable as their value increases over time and is carried out every 3 to 5 years. In case of plant & machinery, revaluation is carried out only if there is a strong case for it. In case of assets such as vehicles, furniture & fittings, office equipments etc., revaluation is not carried out.
7) Revaluation should not result in the net book value of an asset exceeding its recoverable value.
8) Revaluation does not mean only an upward revision in the book values of the asset. It can also mean a downward revision (also called impairment) in the book values of the assets. However, any downward revision in the book values of the assets is immediately written off to the Profit & Loss account.
9) On upward revaluation of a fixed asset, which has been previously subject to downward revaluation, the amount of upward revaluation as is equal to the amount expensed previously is credited to the Profit & Loss a/c.

Example: Machinery ‘A’ is purchased on 01-04-1999 for $ 1,00,000/-. It is depreciated using Straight Line Method at the rate of 10%.

PARTICULARS	First Revaluation	Second Revaluation
Nature of Revaluation	Downward	Upward
Date of Revaluation	01-04-2001	01-04-2004
Gross Cost	1,00,000	93,750
Less: Depreciation	20,000	46,875
Net Book Value	80,000	46,875
Revalued - Appraisal Method	75,000	55,000
Increase / (Decrease) in Net Book Value	(5,000)	8,125
Debit to Profit & Loss a/c	5,000	0
Credit to Profit & Loss a/c	0	5,000
Credit to Revaluation Reserve	0	3,125