What Is Revaluation?
Revaluation is an accounting practice that adjusts the carrying amount of an asset on a company's balance sheet to reflect its current fair value rather than its original historical cost. This process falls under the broader category of Accounting and Financial Reporting and aims to present a more accurate and up-to-date picture of an entity's financial position, especially concerning its non-current assets like property, plant, and equipment. Revaluation can lead to either an increase (revaluation surplus) or a decrease (revaluation deficit) in the asset's value.
History and Origin
Historically, many accounting frameworks emphasized the historical cost principle, where assets were recorded at their acquisition cost and systematically depreciated over their useful life. However, this approach often failed to reflect significant changes in an asset's market value, particularly for long-lived assets such as land and buildings. The introduction of the revaluation model by International Financial Reporting Standards (IFRS), specifically under IAS 16 "Property, Plant and Equipment," allowed companies to choose between the cost model and the revaluation model for subsequent measurement of their fixed assets.9 This option gained traction globally as a way to provide more relevant financial information to stakeholders, especially in economies experiencing significant inflation or property market fluctuations. US Generally Accepted Accounting Principles (GAAP), however, generally do not permit the revaluation of most capital assets upwards.8
Key Takeaways
- Revaluation adjusts an asset's carrying amount on the balance sheet to its fair value.
- It can result in a revaluation surplus (increase) or a revaluation deficit (decrease).
- The revaluation model is permitted under IFRS, particularly for property, plant, and equipment, while US GAAP generally prohibits upward revaluations for most assets.
- Revaluation aims to provide a more current and relevant representation of asset values on the financial statements.
- A revaluation surplus is recognized in other comprehensive income and accumulated in a revaluation surplus reserve within equity.
Formula and Calculation
When an asset is revalued, its carrying amount is adjusted to its fair value. The accounting treatment depends on whether it's an initial revaluation or a subsequent one, and whether it's an increase or a decrease.
The revaluation amount is generally calculated as:
Where:
Fair Value at Revaluation Dateis the market-based valuation of the asset at the time of revaluation.Net Book Value (Carrying Amount)is the historical cost less accumulated depreciation and impairment losses up to the revaluation date.
If the revaluation results in an increase, the surplus is recognized in other comprehensive income. If it's a decrease, it's recognized in profit or loss, unless it reverses a previous revaluation surplus on the same asset.
Interpreting the Revaluation
Revaluation provides insight into the current economic value of a company's non-current assets. A revaluation surplus indicates that the market value of the assets has increased significantly since their last valuation or acquisition. This can enhance a company's perceived financial strength and borrowing capacity, as the balance sheet reflects a higher net book value of assets. Conversely, a revaluation deficit signals a decline in asset values, which can negatively impact a company's financial position and potentially trigger impairment tests. Users of financial statements must understand whether a company uses the revaluation model to properly interpret its asset values and equity.
Hypothetical Example
Consider a hypothetical company, "Diversified Holdings Inc.," that owns a commercial building.
- Original Cost: The building was purchased for $1,000,000 on January 1, 2020.
- Useful Life: 20 years.
- Annual Depreciation: $50,000 ($1,000,000 / 20 years).
By December 31, 2024 (after 5 years), the accumulated depreciation is $250,000 (5 years * $50,000).
The net book value (carrying amount) is $1,000,000 - $250,000 = $750,000.
Due to a boom in the local real estate market, Diversified Holdings Inc. decides to revalue the building at its fair value on December 31, 2024, which is appraised at $1,200,000.
The revaluation calculation is:
Revaluation Amount = Fair Value - Net Book Value
Revaluation Amount = $1,200,000 - $750,000 = $450,000 (Revaluation Surplus)
This $450,000 revaluation surplus would be recognized in other comprehensive income and held in a revaluation reserve in the equity section of the balance sheet. The building's carrying amount on the balance sheet would then be adjusted to $1,200,000. Subsequent depreciation would be based on this new revalued amount over the remaining economic life.
Practical Applications
Revaluation is primarily applied to fixed assets such as land, buildings, and machinery, and in some cases, intangible assets if an active market exists for them. Companies in capital-intensive industries, particularly those with significant real estate holdings, often utilize revaluation. For instance, real estate companies operating under IFRS might revalue their properties to reflect current market conditions, providing investors with a more accurate picture of asset values.7 Such revaluations can impact financial ratios, enhance perceived solvency, and affect subsequent depreciation charges.6 The practice is particularly common in jurisdictions that have adopted International Financial Reporting Standards.5
Limitations and Criticisms
Despite its benefits in providing relevant asset values, revaluation faces several criticisms. One primary concern is the potential for subjectivity, especially when an active market for the asset does not exist, requiring management to make significant judgments in determining fair value. This subjectivity can lead to volatility in financial statements and, in some cases, be exploited for earnings management or to present an overly optimistic financial picture.4 Critics argue that while fair value information can be more relevant, its reliability may be compromised by the inherent estimations involved, contrasting with the verifiable nature of historical cost accounting.3 Another limitation is the cost and administrative burden associated with frequent revaluations, which often require professional appraisals.2 Changes in asset values due to revaluation also do not necessarily reflect an increase in cash flow or operating performance.1
Revaluation vs. Depreciation
While both revaluation and depreciation affect the carrying amount of an asset on the balance sheet, they serve fundamentally different purposes. Depreciation is the systematic allocation of an asset's cost over its economic life to reflect its usage, wear and tear, or obsolescence. It is a predictable, recurring expense designed to match the asset's cost with the revenues it helps generate. In contrast, revaluation is an episodic adjustment of an asset's value to its current market price. It reflects changes in the asset's overall market worth, which can be due to inflation, market demand shifts, or unique improvements, rather than its consumption. Unlike depreciation, revaluation can increase an asset's value, and any resulting surplus typically bypasses the profit and loss statement directly impacting equity.
FAQs
What types of assets can be revalued?
Typically, tangible fixed assets such as land, buildings, machinery, and equipment can be revalued. Under some accounting standards, certain intangible assets may also be revalued if there is an active market providing reliable fair value information.
How often should revaluations occur?
Accounting standards typically require revaluations to be carried out with sufficient regularity to ensure that the carrying amount of an asset does not differ materially from its fair value at the end of the reporting period. For highly volatile asset values, this might be annually, while for more stable assets, it could be every three to five years.
Does revaluation affect a company's profit?
A revaluation increase generally does not affect a company's net profit in the period it occurs. Instead, it is recognized directly in other comprehensive income and accumulates in a revaluation surplus reserve within the equity section of the balance sheet. However, a revaluation decrease is usually recognized as an expense in the profit or loss statement, unless it reverses a previous revaluation surplus on the same asset.
What happens to depreciation after an asset is revalued?
After an asset is revalued upwards, the new revalued amount becomes its new depreciable base. Subsequent depreciation charges will be calculated based on this revalued amount over the asset's remaining economic life. This means higher depreciation expenses in future periods if the asset's value increased.