Cite this item: S. Shafqat. (2021). The Problems With the Revaluation Method for Asset Reporting. Risk Concern. Accessible at: link.
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While the US GAAP only allows the cost model for the periodic valuation and reporting of long-lived assets, IFRS, on the other hand, allows the use of both the cost model and the revaluation model.
This report examines the problems with the revaluation method for the periodic valuation and reporting of long-lived assets and how this option may be used by unscrupulous management to manipulate, misrepresent, or smooth out financial statements, defrauding the users of the financial statements, especially those without substantial accounting and financial analysis experience.
While under the cost model, long-lived assets are reported at historical cost and subsequently depreciated, amortized, or depleted, under the revaluation method, when it is applied by the management, "the asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably. [IAS 16.31]."
When an asset is revalued, if the revaluation decreases an asset class's carrying amount, the asset's carrying amount decreases, and this decrease is recognized in profit or loss. Conversely, in subsequent revaluations, if the assets carrying amount increases due to a revaluation, the increase is recorded in the balance sheet, but the extent of the increase that can be recognized in the income statement is limited to the amount of the losses recorded in prior periods, and the rest goes to other comprehensive income.
For example, if a hypothetical $100 property's carrying amount is decreased by $10 by a revaluation, the income statement would recognize an expense of $10; in a later period, if the revaluation increases the carrying amount by $15, $10 would go through the income statement, as an income, and $5, the amount higher than the previously recognized expense, would be recognized as a revaluation surplus to equity, in other comprehensive income.
If the property revaluation initially increased the carrying amount of the property without a previous decrease, the increase would bypass the income statement and go directly to other comprehensive income, as revaluation surplus to equity; in later periods, if the revaluation decreases the carrying amount, first the revaluation surplus to equity would be reduced before an expense is recognized in the income statement.
For example, with an initial increase in the revaluation of $10 that went to the revaluation surplus to equity in other comprehensive income, a later revaluation decrease of $15 would first reduce the revaluation surplus, previously recorded $10, and record a $5 in the income statement as an expense.
The standard for investment properties, IAS 40, arguably, leaves more room for manipulation, as subsequent revaluations of investment properties go directly to the profit loss account; for example, for an investment property with a carrying amount of $100, a revaluation increase of $10 would go directly to the profit loss account, unlike the revaluation of operational assets, properties in operational use, and intangible assets, leaving more room for manipulation. Investment properties are carried at historical cost in US GAAP, of course.
So, what are the critical problems with the revaluation method? How can it be misused, and what problems it poses for the users of financial statements?
The flexibility that the revaluation model provides can be manipulated by management. The revaluation, especially, internally assessed revaluation, can be tactically used to manipulate financial statements, to present a picture that management wants to portray, instead of presenting the actual performance of the entity.
For example, if the management wants to lower the presented profitability, for lowering the tax liability; or, for profit smoothing, so the increase in profitability, over time, appears smoother than it actually is; or, for depressing profits in economic upturns so they can be reversed, as per the mechanism discussed above, so that, in an economic downturn, the firm's performance appears better than it actually is; or, to keep profits down in a period of high mergers and acquisition activity so the firm doesn't become a target for a takeover, etcetera.
Another area of financial analysis that this malpractice can impact is ratios and ratio analysis. For example, reducing or increasing profitability can impact several ratios; reducing or increasing the carrying amount of the assets can also impact financial ratios. For example, the asset turnover ratio (total revenue ÷ total assets) can be manipulated by the decrease of the asset(s) carrying amount through a revaluation; as total asset figure (denominator) is reduced while the numerator, total revenue, either increases or remains the same, the ratio would appear to have improved. Similarly, profitability ratios may also be manipulated in this manner to achieve the above-mentioned unscrupulous objectives.
Reading the notes to financial statements thoroughly and understanding the causes of the revaluation, with in-depth scrutiny of the assumptions used in the revaluation(s), is very important. For example, the present value method may have been used in the revaluation method; scrutinizing the assumptions used, such as the future inflows as assessed by management, the discount rate used, etcetera, are critical in gauging the validity of the revaluations.
In terms of the users of the financial statements, this problem is especially more relevant for smaller investors, retail traders, and those who have to make hasty buy and sell decisions based on a quick look at the financial statements or ratios provided by a terminal service, etcetera. This isn't a major issue for larger creditors or investment funds with dozens of analysts who can scrutinize the notes to financial statements to make adjustments to bypass any shenanigans, if present in the financial statements.
Principled management and finance leadership team, understanding these concerns, should avoid the use of the revaluation, wherever reasonably possible, to eliminate all concerns regarding this issue. Furthermore, if such shenanigans persist, as the US GAAP only allows the historical cost method, IASB is likely to eliminate the revaluation method in the future; this would also enable further convergence of the international accounting standards in this area.