Revaluation of Assets

Introduction:

Many countries around the world are committed to adopt IFRSs directly or to get their national standards aligned with IFRSs. The change to IFRS will have major effects on the financial statements. This is because of the following reasons:

1. In view of IASB’s commitment, the body promulgating IFRSs, to move towards convergence with US GAAP; and

2. The IASB’s focus on assets and liabilities as the primary elements of financial statements in contrast to the traditional accounting practice based on historical cost focusing on accounting for transactions placing more emphasis on profit recognition and matching of costs and revenues.

IASB’s approach, which is consistent with its Conceptual Framework titled "Framework for the preparation and presentation of Financial Statements", is based on the principle that a reporting entity should recognize all items in its balance sheet that are considered to be assets and liabilities, and that income and expenses are determined by reference to increases and decreases in assets and liabilities.

The valuation approach that the IASB is advocating is "fair value" as the primary basis of asset / liability measurement on the basis of relevance. Fair value has been defined as, "Fair Value is the amount for which an asset / liability could be exchanged between knowledgeable, willing parties in an arm’s length transaction". This is the hot issue now for many standard setters. Revaluation of Assets is one of the ways of getting the assets fair valued. Opinions expressed herein are the views of the author.

Scope:

This article discusses accounting for Revaluation of Assets which is a process of restating the value of assets to its fair value in the context of the provisions of the following with illustrations:

1. Framework for the Preparation and Presentation of Financial Statements

2. Accounting Standard (AS) 10, "Accounting for Fixed Assets"

3. Relevant Provisions of the Companies Act, 1956

4. Accounting Standard (AS) 6, Depreciation Accounting"

5. Guidance note on Treatment of Reserve created on Revaluation of Fixed Assets

6. Exposure Draft on Accounting Standard (AS) 10 (Revised) "Tangible Fixed Assets"

7. International Accounting Standard (IAS) 16, "Property, Plant and Equipment"

8. Audit and Assurance Standard (AAS) 28, "Auditor’s Report on Financial Statements"

9. Audit and Assurance Standard (AAS) 25, "Comparatives"

10. International Accounting Standard (IAS) 1, "Presentation of Financial Statements"

11. Guidance Note on Availability of Revaluation Reserve for Issue of Bonus Shares

12. Sec.115JB of the Income Tax Act, 1961

13. Accounting Standard (AS) 26, "Intangible Assets"

14. International Accounting Standard (IAS) 38, "Intangible Assets"

15. Accounting Standard (AS) 22 "Accounting for Taxes on Income"

16. International Accounting Standard (IAS) 12, "Income Taxes"

Though the article explains the accounting technique of revaluation of assets, the author’s main focus is on the use of the revaluation reserve / surplus. Many of the issues have been analysed assuming that the provisions in Exposure Draft on AS (Revised) are retained in the text of AS 10 (Revised) "Tangible Fixed Assets"

Methods of Revaluation

Para 13 of AS 10 contains provisions for Revaluation of Fixed Assets. It states three methods of revaluation:

1. Appraisal by competent valuers (Standard refers this as a common technique)

2. Indexation (Standard requires this method to be cross checked periodically by appraisal method)

3. Current market prices (Standard requires this method to be cross checked periodically by appraisal method)

Fixed assets should not be revalued selectively. Revaluation should be done for an entire class of fixed assets such as entire class of Plant and Machinery or Buildings etc. The revalued amount should not be greater than the net recoverable amount which is the higher of the asset’s net selling price and its value in use. This situation will arise only if the costs of disposal of the asset are significant.

Exposure Draft on AS 10 (Revised) "Tangible Fixed Assets"

The Exposure Draft on AS 10 (Revised), "Tangible Fixed Assets" besides appraisal by competent valuers also suggests income approach (discounted cash flow projections) and depreciated replacement cost approach. It requires revaluations to be carried out with sufficient regularity.

Methods of Accounting for Revaluation

AS 10 allows two methods of accounting for revaluation:

1. By restating both the gross book value and accumulated depreciation to give net book value; and

2. By restating the net book value by adding therein the net increase on account of revaluation.

Initial Revaluation:

An increase in the net book value on revaluation should be credited directly to owners’ interests under the heading of revaluation reserve and the same is not available for distribution directly. AS 10 also envisages a situation where on initial revaluation there is a decrease in net book value. In such a case, the decrease is charged to Profit and Loss Account. This situation can arise where recoverable amount is based on value in use of the asset.

Subsequent revaluation:

· If previous increase and subsequent increase

o Credit Revaluation Reserve

· If previous increase and subsequent decrease

o Debit Revaluation Reserve and if still the carrying amount of the asset is higher than its revalued amount then charge to Profit and Loss Account.

· If previous decrease and subsequent decrease

o Charge to Profit and Loss Account

· If previous decrease and subsequent increase

o Credit Profit and Loss to the extent of previous decrease(s) and if still the carrying amount of the asset is lower than its revalued amount, credit the balance to revaluation surplus.

Illustration:

This illustrates the two methods of accounting for revaluation:

Rs.(in ‘000s)

Cost 1000

Accumulated Depreciation 250

Carrying Amount 750

Provisions of Schedule VI to the Companies Act, 1956

Part I of Schedule VI requires that if there is a revaluation or reduction in value of assets, the balance sheet should show the increased or reduced figures in place of the original cost for at least five years. Thus, in accordance with Schedule VI, method 2 cannot be followed.

Carrying amount is to be restated under both the methods at a revalued amount of:

a) Rs.(‘000s) 1100

b) Rs.(‘000s) 600

· Method 1: a):

Fixed Assets A/c. dr. Rs.(‘000s) 717

To Revaluation Reserve Rs.(‘000s) 717

Revaluation Reserve dr. Rs.(‘000s) 367

To Accumulated Depreciation Rs. (‘000s) 367

· Method 1: b):

Profit & Loss A/c. dr. Rs.(‘000s) 200

To Fixed Assets Rs.(‘000s) 200

Accumulated Depreciation dr. Rs.(‘000s) 50

To Profit & Loss Account Rs. (‘000s) 50

· Method 2: a):

Accumulated Depreciation dr. Rs.(‘000s) 250

To Fixed Assets Rs.(‘000s) 250

Fixed Assets dr. Rs.(‘000s) 350

To Revaluation Reserve Rs. (‘000s) 350

· Method 2: b):

Accumulated Depreciation dr. Rs.(‘000s) 250

To Fixed Assets Rs.(‘000s) 250

Profit and Loss A/c. dr. Rs.(‘000s) 150

To Fixed Assets Rs. (‘000s) 150

Disposal of Revalued Fixed Assets

If the asset has been sold at a loss, first the loss is charged to revaluation reserve and the balance to Profit & Loss Account. If revaluation reserve is not squared up, the balance is transferred to general reserve. If the asset has been sold at a profit, the profit is credited to Profit and Loss Account and the revaluation reserve balance is transferred to General Reserve Account.

Use of Revaluation Reserve:

· Whether additional depreciation can be charged against revaluation reserve?

Revaluation Reserve is not a free reserve. No dividend can be declared out of such reserve. However, revaluation reserve can be used to nullify the effect of additional depreciation arising out of revaluation of fixed assets. AS 6 in para 26 states that "where the depreciable assets are revalued, the provision for depreciation should be based on the revalued amount and on the estimate of the remaining useful lives of such assets". Thus, there is an additional depreciation charge on account of revaluation. The issue here is whether this additional depreciation can be charged against revaluation reserve?

AS 10 and AS 6 are silent on the treatment of such additional depreciation. However, the ICAI has issued a Guidance Note on Treatment of Reserve created on Revaluation of Fixed Assets. Para 12 of this Guidance Note suggests that "it will be prudent not to charge additional depreciation against revaluation reserve". However, in other paras, the Guidance Note allows utilizing revaluation reserve to nullify the effect of additional depreciation. It is further suggested that company will have to provide for full depreciation in the profit and loss account and thereafter it can take transfer from revaluation reserve to adjust additional depreciation. Mostly, companies do not opt for the more prudent policy of not adjusting additional depreciation.

Let us take the previous illustration of restating fixed asset to Rs. 1100000/-. Suppose, the entity provides depreciation @ 20% on Reducing Balance Method. Had no revaluation been done, the depreciation would have been Rs. 150,000/-. After revaluation, the depreciation would be Rs. 220,000/-. Thus, there is an extra depreciation of Rs. 70,000/- (220,000–150,000). As per the Guidance Note, this Rs. 70,000/- can be transferred by debiting Revaluation Reserve a/c. and crediting Profit and Loss Account.

· Whether such transfer can affect the profit attributable to equity shareholders?

The Guidance Note explains that the company should charge full depreciation to the Profit and Loss and thereafter it can take transfer from revaluation reserve to adjust additional depreciation. Thus, the Guidance Note vaguely explains that such transfer should not affect profit attributable to equity shareholders. However, companies use revaluation reserve to maintain bottom line by adjusting it directly in depreciation and thereby affecting net profit attributable to equity shareholders.

As explained in the illustration above, the extra depreciation of Rs. 70,000/- can be transferred from Revaluation Reserve to Profit and Loss Account. There are two methods for making such transfer:

Method 1:

Debit Revaluation Reserve and Credit Profit and Loss Account.

This does not affect profit attributable to equity shareholders for the period

Method 2 (as adopted by Reliance Industries Limited):

Debit Revaluation Reserve and Credit Depreciation Account.

This affects the Profit attributable to Equity Shareholders, Earnings per Share calculations, and Transfer of Profits to Reserves Rules.

Exposure Draft on AS 10 (Revised)

Para 43 of the Exposure Draft on AS 10 (Revised) states that "An enterprise transfers an amount equal to the difference between the depreciation based on the revalued carrying amount of a tangible fixed asset and the depreciation based on its original cost to the statement of profit and loss pertaining to the relevant period from the revaluation surplus". Thus, the Exposure Draft has endorsed Method 2, explained above, for transferring the Revaluation Reserve to Depreciation Account.

International Accounting Standard (IAS) 16 "Property, Plant & Equipment"

Indian Accounting Standards are based on IFRSs. IFRSs are a body of standards which include:

1. International Financial Reporting Standards (IFRSs);

2. International Accounting Standards (IASs)

3. Interpretations issued by International Financial Reporting Interpretations Committee (IFRIC) and the former Standing Interpretations Committee (SIC)

The Exposure Draft on AS 10 (Revised) is framed on the lines of IAS 16. However, there is a significant difference with regard to utilisation of Revaluation reserve.

Para 41 of IAS 16 states as follows:

"The revaluation surplus included in equity in respect of an item of property, plant and equipment may be transferred directly to retained earnings when the asset is derecognized. This may involve transferring the whole of the surplus when the asset is retired or disposed of. However, some of the surplus may be transferred as the asset is used by an entity. In such a case, the amount of the surplus transferred would be the difference between depreciation based on the asset’s original cost. Transfers from revaluation surplus to retained earnings are not made through profit or loss".

Thus, IAS 16 clearly states that the transfer from revaluation reserve for nullifying the effect of additional depreciation should not be made through profit or loss. Thus, IAS 16 categorically says that such transfers should not affect net profit attributable to equity shareholders. Thus, IAS 16 requires Method 1 to be followed.

· Whether a company can take stand against the provisions of AS 10 (Revised) "Tangible Fixed Assets" (Now in the form of Exposure Draft) saying that it is imprudent to use revaluation reserve to maintain bottom-line and EPS and such treatment would not give a true and fair view of the financial statements?

In this regard, we would have to analyse the provisions of Sec. 211 of the Companies Act, 1956.

Sec. 211(3A) states that every profit and loss account and balance sheet of the company shall comply with the accounting standards.

Sec. 211(3C) explains that the accounting standards referred in Sec. 211(3A) are those recommended by the Institute of Chartered Accountants of India and prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards.

Sec. 211(3B) states that where the profit and loss account and the balance sheet of the company do not comply with the accounting standards, such companies shall disclose in its profit and loss account and balance sheet, the following namely;

· the deviation from the accounting standards;

· the reasons for such deviation; and

· the financial effect, if any, arising out of such deviation.

Thus, a company can opt to follow the prudent policy of not adjusting depreciation but of transferring from revaluation reserve to the balance of Profit and Loss Account, the amount of additional depreciation on account of revaluation. However, the company will have to give the details required by Sec. 211(3B).

Here, it would be interesting to discuss the provisions of International Accounting Standard (IAS) 1, "Presentation of Financial Statements". Paras 17–21 of IAS 1 deal with this issue. Para 17 states that in extremely rare circumstances in which management concludes that compliance with a requirement in a Standard or an Interpretation would be so misleading that it would conflict with the objective of financial statements set out in the framework, the entity shall depart from that requirement, if the relevant regulatory framework requires or does not prohibit such a departure. However, the following are to be disclosed:

· that management has concluded that the financial statements present fairly the entity’s financial position, financial performance and cash flows;

· that it has complied with applicable Standards and Interpretations, except that it has departed from a particular requirement to achieve a fair presentation;

· the title of the Standard or Interpretation from which the entity has departed;

· the nature of the departure, including the treatment that the Standard or Interpretation would require;

· the reason why that treatment would be so misleading that it would conflict with the objective of financial statements set out in the Framework;

· the treatment adopted; and

· for each period presented, the financial impact of the departure on each item in the financial statements that would have been reported in complying with the requirement.

The above disclosures were to be given when the regulatory framework prohibits departure from the requirement in a Standard or Interpretation. If the regulatory framework does not prohibit departure, the following are to be disclosed:

· the title of the Standard or Interpretation from which the entity has departed;

· the nature of the requirement

· the reason why that treatment would be so misleading that it would conflict with the objective of financial statements set out in the Framework; and

· for each period presented, the financial impact of the departure on each item in the financial statements that would have been reported in complying with the requirement.

When an entity departs from a requirement of a Standards or an Interpretation in a prior period, and that departure affects the amounts recognized in the financial statements for the current period, it shall make the following disclosures:

· the title of the Standard or Interpretation from which the entity has departed;

· the nature of the departure, including the treatment that the Standard or Interpretation would require;

· the reason why that treatment would be so misleading that it would conflict with the objective of financial statements set out in the Framework;

· the treatment adopted; and

· for each period presented, the financial impact of the departure on each item in the financial statements that would have been reported in complying with the requirement.

Para 22 of IAS 1 states the points that management should consider when assessing whether complying with a specific requirement in a Standard or an Interpretation would be so misleading that it would conflict with the objective of financial statements. These are as under:

· why the objective of financial statements is not achieved in the particular circumstances; and

· how the entity’s circumstances differ from those of other entities that comply with the requirement.

If other entities in similar circumstances comply with the requirement, there is a rebuttable presumption that the entity’s compliance with the requirement would not be so misleading that it would conflict with the objective of financial statements set out in the framework.

· If the company discloses the information required by Sec. 211(3B), whether the auditor is required to qualify his report?

In this regard, we would have to analyse the provisions of Sec. 227 of the Companies Act, 1956 and Audit and Assurance Standard (AAS) 28 "Auditor’s Report on Financial Statements".

Sec. 227(3)(d) requires an auditor to state in his report whether, in his opinion, the profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of Section 211.

Thus, the auditor will have to give a qualified opinion. Para 41 of AAS 28 states that whenever an auditor issues an opinion that is other than unqualified, a clear description of all the substantive reasons should be included in the report, and unless impracticable, a quantification of the possible effect(s), individually and in aggregate, on the financial statements should be mentioned in the auditor’s report. The auditor may state his qualification as under:

"We invite your attention to Note X of Schedule X. The company has not transferred the additional depreciation amount on account of revaluation from revaluation reserve to the profit and loss account. This is not in accordance with Accounting Standard (AS) 10 (Revised), "Tangible Fixed Assets". Due to this, the depreciation for the year and the balance of revaluation reserve has been overstated by Rs. XXXX and the Net Profit attributable to equity holders has been understated by the same amount".

· If the company has transferred the additional depreciation amount from revaluation reserve to the balance of profit and loss account as required by IAS 16 instead of adjusting current year’s depreciation, how would the auditor qualify his report?

In the given case, the auditor may qualify his report as under:

"We invite your attention to Schedule X. The company has transferred the additional depreciation amount on account of revaluation from revaluation reserve to the balance of profit and loss account instead of adjusting current year’s depreciation. This is not in accordance with Accounting Standard (AS) 10 (Revised), "Tangible Fixed Assets". Due to this, the depreciation for the year has been overstated by Rs. XXXX and the Net Profit attributable to equity holders has been understated by the same amount".

· If the company adjusts current year depreciation but does not present separately as a deduction from the amount of depreciation on the face of the Profit and Loss Account, how should the qualification be in the auditor’s report?

In the given case, the auditor may qualify his report as under:

"We invite your attention to Profit and Loss Account. The company has not presented separately as a deduction from the amount of depreciation the amount of additional depreciation on account of revaluation on the face of the Profit and Loss Account. This is not in accordance with Accounting Standard (AS) 10 (Revised), "Tangible Fixed Assets". However, such presentation does not affect the figures stated in the financial statements"

· If the company continues its policy of not transferring additional depreciation in the second year, how should the auditor state his qualification?

Para 11 of Audit and Assurance Standard (AAS) 25, "Comparatives" states that when the auditor’s report on the prior period, as previously issued, included a qualified opinion, disclaimer of opinion or adverse opinion and the matter which gave rise to the modification in the audit report is:

· Unresolved, and results in modification of the auditor’s report regarding the current period figures, the auditor’s report should also be modified regarding the corresponding figures; and

· Unresolved, but does not result in a modification of the auditor’s report regarding the current period figures, the auditor’s report should be modified regarding the corresponding figures

Thus, the auditor may qualify his report as under:

"We invite your attention to Note X of Schedule X. The company has not transferred the additional depreciation amount on account of revaluation from revaluation reserve to the profit and loss account. This is not in accordance with Accounting Standard (AS) 10 (Revised), "Tangible Fixed Assets". Due to this, the depreciation for the year and the balance of revaluation reserve has been overstated by Rs. XXXX (Rs. XXXX for the previous year) and the Net Profit attributable to equity holders has been understated by the same amount (Rs. XXXX for the previous year)".

· If the company does not disclose the details required by Sec. 211(3B) of the Companies Act, 1956, whether the auditor’s qualification should state such non-disclosure?

The auditor’s qualification should state the non-disclosure of details of deviation required by Sec. 211(3B) of the Companies Act, 1956 apart from qualifying on the aspect of non-compliance with Accounting Standards.

· Whether bonus shares can be issued out of revaluation reserve?

SEBI guidelines for disclosure and investor protection do not allow issue of bonus shares out of revaluation reserve. This prohibition is applicable to listed companies. DCA vide its Circular No. 9/94 has also prohibited issue of bonus shares out of revaluation reserve by existing private / closely held and unlisted companies.

Guidance note on availability of revaluation reserve for issue of bonus share issued by ICAI states that the excess of the revalued amount over the net book value of fixed assets, which is credited to revaluation reserve, is created as a result of book adjustment only. The revaluation reserve does not result from an arm’s length transaction; it represents an expert’s perception of value. The revaluation reserve, thus, does not represent realized gain.

The Guidance Note also states that share capital represents money or money’s worth received from the owners and capitalization of earned profits or other gains arising out of arm’s length transaction. Only profits as are earned or the relevant capital receipts as are realized, can be capitalized.

However, the Guidance Note on Treatment of Reserve created on Revaluation of Fixed Assets discussed above or the Exposure Draft on AS 10 (Revised) allows transfer from revaluation reserve to the extent of additional depreciation to the Profit and Loss Account. To that extent profit is inflated every year and the revaluation reserve is converted into so called "earned profit". As the entire revaluation reserve is converted into "earned profit", a company can issue bonus shares.

Thus, the prohibition on use of revaluation reserve for issue of bonus shares has been nullified.

· Whether the transfer has any effect on book profits calculated u/s. 115JB of the Income Tax Act, 1961?

As per the Finance Act, 2006, for the purpose of calculating book profit, the amount of depreciation will be added first and then the amount of depreciation excluding the depreciation on account of revaluation of assets would be deducted. Deduction will also be made for the amount withdrawn from revaluation reserve and credited to profit and loss account to the extent it does not exceed the amount of depreciation on account of revaluation of assets. Thus, in substance, the entire depreciation will first be added and then deducted. By including this provision in Sec. 115JB of the Income Tax, 1961, the enterprises would be encouraged to transfer revaluation reserve and adjust depreciation thereby affecting net profit attributable to equity shareholders. This provision will also create more differences between Accounting Standards and the Income Tax Act, if the ICAI takes a decision to change the requirement of adjusting current year’s depreciation as stated in the Exposure Draft so as to be in line with International Accounting Standard (IAS) 16, "Property, Plant & Equipment".

· Whether Intangible assets can be revalued?

AS 26 requires that an intangible asset that qualifies for recognition should be initially measured at cost. Subsequent measurement must be at cost less accumulated amortization and accumulated impairment losses, if any. An intangible asset cannot be revalued.

However, IAS 38 permits revaluation as subsequent measurement. Para 72 of IAS 38 requires an entity to choose either the cost model or the revaluation model as its accounting policy. If an intangible asset is accounted for using the revaluation model, all the other assets in its class shall also be accounted for using the same model, unless there is no active market for those assets.

Thus, under IFRS, intangible assets can be revalued subject to the satisfaction of the following conditions:

1. All assets in one class of intangible assets should be revalued; and

2. There should be active market for those assets.

· Whether deferred tax arises on revaluation of assets?

AS 22 deals with deferred tax accounting. It says that deferred tax is the tax effect of timing differences. Timing Differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods. Taxable income is the amount of income for a period determined in accordance with the tax laws, based upon which income tax payable is determined. Accounting income is the net profit or loss for the period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.

Thus, AS 22 is based on income statement approach. It looks at the differences in the tax income statement and accounts income statement and analyses it into timing and permanent differences.

Due to revaluation the amount of depreciation in the statement of profit and loss increases as per prudent practices. However, for income tax purposes, the depreciation is calculated on the written down value of the asset. Amount of revaluation is not permitted to be added to the written down value. Thus, the amount of depreciation to the extent arising due to revaluation is a permanent difference and hence no deferred tax arises as per AS 22.

IAS 12, "Income Taxes", is based on balance sheet liability method. According to IAS 12, Deferred Tax is the tax effect of temporary differences. Temporary differences are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. Thus, on revaluation, the carrying amount of the asset increases but the tax base of the asset remains the same. This creates taxable temporary differences and hence deferred tax arises and should be accounted for. However, the deferred tax charge to the extent it relates to revaluation should be charged to revaluation reserve and not to profit and loss account.

Continuing with the illustration above, let us assume that the applicable tax rate is 33.66%. Therefore, there would be increase in deferred tax liability of Rs. 23562/- (Rs. 70,000/- * 33.66%). This deferred tax is charged to Revaluation Reserve by debiting Revaluation Reserve and crediting Deferred Tax Liability.

· What would be the effect on deferred tax when an entity transfers from revaluation reserve to profit and loss account to the extent of extra depreciation that has arisen on revaluation of assets?

As the revaluation of assets, does not have any effect on deferred tax as per AS 22, the transfer from revaluation reserve to profit and loss account would also not have any effect on deferred tax.

However, IAS 12 requires deferred tax charge to be calculated on revaluation of assets and the charge should be to the revaluation reserve. If the entity transfers an amount equal to the difference between the depreciation on a revalued asset and the depreciation based on the cost of that asset, the amount transferred is net of any related deferred tax.

Continuing with the illustration above, let us assume that the entity has a policy of transferring from revaluation reserve to profit and loss account the extra depreciation arising due to revaluation. In this case, the entity will transfer Rs. 46438/- (Rs. 70,000 – Rs. 23,562/-) by debiting Revaluation Reserve and crediting Retained Earnings.