Revaluation

[A380]

If capital expenditure is a cost to be allocated in more than one period for the economic benefits drawn in those periods, then why revaluation is allowed and what is the exact purpose of allowing such treatments.

[kamranACA]

Dear,

I have a question for you in turn that can make it easier to understand this concept. When we incur a cost of say Rupees 1,000,000 on acquiring some shares in a listed company that is actual cash outflow from our business then why we are needed to classify such investment in either available for sale or held to maturity etc? And why we are needed to value such investment on fair values (if treated as available for sale) and why we enhance our reserves due to increase in fair values? Why this all is required by IAS 39?

First of all I clear that I know revalued amounts of fixed assets are not the exact fair values. However, In fact all the IFRSs are intended to present the components of financial statements (specially financial assets and financial liabilities)on fair value basis. Almost all new pronouncements are based upon this concept. You can just see the treatments of investment properties (IAS 40), agricultural produce/biological assets (IAS 41) Employees Benefits (IAS 19), Leases (IAS 17) etc where non-financial assets/liabilities are also mandated to be treated on fair value.

The historical cost convention of accounting has remained a popular convention over the decades and is still in existence for so many components of balance sheet like inventories, property, plant and equipment (if not stated under revlaution model), certain investments, liabilities and assets etc.

Yes off course the fixed assets are recorded on historical cost which has to be allocated on systematic basis over the useful lives of the related assets and this has so much to do with the concept of utility of such assets for the business. Net worth of a business is calcuated by deducting all liabilities form total assets. This way fixed assets have a great contribution in determination of the net worth of a business. At any point of time if you have to ascertain your net worth, the historical figures might not be a very good choice to make a basis for such determination.

You know that on balace sheet's asset side

-Fixed assets are normally shwon on historical cost less accumulated depreciation. (Impairment has to be deducted but impair ment in fixed assets occures rarely). Historical cost is not a gud meausre or actual worth due to time valuation of money factors, fluctuation in foreign currency rates, technological advancements/obsolesence and inflation etc.

-Investment properties are stated at fair value under IAS40.

-Advances etc are shown on amortized cost (normally on historical cost if bear almost fair rate of interest or if the amounts are not material)

-Investments in associates are shown on equity method thus reflecting the correct net worth value of the investee. (almost)

-Investments in others are shown on fair values (in case of held to maturity investments initially at fair value and then at amortized cost which is also fair value driven amortized cost), that is a good way to reflect current values/worth.

- Inventories are stated at cost or NRV whichever is lower thus reflecting the gud estimate of actual worth.

-Short term advances and receivables are shown on cost becoz these have to be paid on similar values and there is no need to determine fair values by the implication of price indices etc.

Whereas on Libailities side

- all long-term loans, finances and other obligations including employment benefits are almost stated at fair values (initially at fair values and then on amortised cost which is also fair value driven amortised cost) under IAS 39, IAS 17 and IAS 19 etc.

- all short term financing, trade and other payables and accrued liabilities etc are shown on cost/amortised cost which is also a best estimate of fair value in my view

By having a look on these components, we see that now almost all balance sheet components are stated on fair values (or almost fair values) except for the property, plant and equipment (fixed assets) that are normally shown on written down values, if not taken at revlaued figures.

This way, at any point of time, the thing which affects most to the net worth of a business is the historical written down cost of the fixed assets. For having a gud approximate to the actual net worth, the fixed assets are opted to be shown on revalued amounts. If some entity adopts this policy, it has to revlaue its fixed assets with a determined/settled frequency. This frequency could be three years or five years.

One should understand that the fair value (revaluation) of fixed assets is not based upon the current market value or simply the present value of future cash flows associated with it. It is normally based upon the depreciated present value and in some cases determined by estimating the current values keeping in view the current technological advancements to which the fixed assets already errected fall short of and the fluctuations in foregin currency prices etc and then working back on all the depreciation which might had been charged had the current values been capitalised as original costs. Normaly the revaluation is done as per this methodology.

When revaluation is done, assets are shown on almost fair value (depreciated present value) and this way the net worth comes to a logical figure. The revlaued portion is again charged to profit or loss on the basis of remaining useful lives of the related assets. Further, it is not necessary to revalue all fixed assets. If some assets are estimated to be on correct value, there is no need to value them. However, IAS 16 requires that when revaluation policy is adopted, it should be applied to entire class of assets. One cannot select assets from various classes for revaluation leaving other assets at written down cost. One whole class could be left and one whole class has to be revlaued.

Banks consider various ratios as a basis for allowing credit facilities to customers which have to be based upon the balance sheet figures such as Debt Euity ratio accepted by banks is 6040. For reaching such ratios, revaluation is done to improve the balance sheet structure. This is another reason for incorporating revlauation model. However, banks always require such revaluation and it is not compulsory to incorporate it in balance sheet. SBP prodential regulations stipulate that revluation must not be of more than 3 years age, if loans have to be based on it.

Hope this post will clarify some facets of your quesry. Let's c what other members suggest.

Best regards,

Kamran.