Financial Accounting Essay On Cost And Revaluation Model.

Cost Model

Discuss about the Financial Accounting for Cost and Revaluation Model.

In our report we will limit ourselves to cost model and revaluation model.

Cost model and revaluation model are methods used in accounting to value property plant and equipment. Usually the methods take into account the lifetime and deprecation of anassets and estimates the current value, however the two methods do differ in various ways. For cost model the asset is carried at its cost less any accumulated depreciation or impairment loss. Asset continues to be recorded at original cost and in most times lacking a residual value at the end of its useful life.This model only allows downward adjustment.On the other hand revaluation model considers the fair value of the asset that is the revalued amount at the date of revaluation less subsequent depreciation and impairment, provided the fair value can be measured reliably (Iasplus.com, 2016).in this case salvage value is often realized. This model permits both upward and downward adjustment.

Companies currently applying the cost model whereby they are  limited to only on depreciation of assets till there is no salvage value, fail to recon that the written off asset after it useful life time  will still be disposed at a value and that amount will not reflect on the balance sheet, consequently this leads to decrease in assets value and also the value the company which in turn eats into the shareholders capital, since property plant and equipment in most companies comprises about 80% of the total assets. Creditors are also forced to hold back their supplies since once the company’s asset decrease in value, the debt ratio (calculated as Total Liabilities/Total Assets) increases which is not favorable for business in the long run (Greener, n.d.). As for the shareholders they may not be able to enjoy occasional increase in dividends as cost model is not flexible as depreciation will remain constant throughout the working years of an asset resulting to constant profits and hence constant dividends (all other factors constant) which is distributed once time interest earned (Profit before tax + interest expense/interest expense)rises above 3. However the senior management will enjoy the cost model since there is less work to be done due to the predetermined downward adjustment method that only involves calculation to determine the current value of an asset (Atrissi, n.d.). This saves the senior managers cash that eventually appears at the profit and loss account as profit, however in the long run it’s a loss to the company since the same management enjoys acquiring  the assets at a throw away price due to lack of a salvage value in the records.

Revaluation Model

As for the revaluation model companies are able to address a lot and save a lot in the process. The model takes into account various factors such as market price and employs methods like selective revaluation which avoid generalization of assets, appraisal method where external appraisers who have expertise in appraising are paid to revalue the assets. Revaluation is used in order to attain the following,

• To provide reserves that are spend in replacing the equipment after its useful life time, since provision for depreciation reflects inflated profits and may lead to payment of exaggerated dividends.
• To indicate the present value of an asset especially land and building that appreciate with time.
• It also puts a company at a better position in negotiations during mergers and acquisitions.
• When sourcing for loans from the financial institutions the company is able to leverage its asset and solicit for higher amount due to proper revaluation.
• In order to show the correct return on capital

During the application of this model various points are to be considered i.e.

• The revaluation of assets should be credited or debited to the revaluation reserve and the amount cannot be distributed as dividends.
• In case of a debit in the revaluation account the normal depreciation is reflected in the profit and loss account.
• The appraisal method is the most commonly applied in revaluation model however the other methods i.e. indexing and current market price are applied though whenever they are used they should crosschecked with the appraisal method in order to arrive at a reliable value,
• When an asset is disposed and it had been previously revalued, the revalued amount should appear in the revaluation reserve.
• Revaluation is most suitable to property such as land and buildings since there is only upward adjustment as they gain value over time, in case of assets such as furniture, fittings office equipments and vehicles, revaluation may be too unfair and hence reflect unreliable values, plant and machinery valuation can be applied though its after a given period of time like 3to5 years. The recoverable value of an asset should always exceed the net book value after revaluation (Wang, 2011).

In application of such a model, residual value of assets is realized and recorded, hence the value of assets increases both during disposal and at times during the working period of the asset. As for the shareholders there capital is ensured of growth since amount realized after disposal is ploughed back as capital as opposed to cost model where the asset is disposed at a value not known since the records indicate zero value after the useful lifetime of the asset, the management is the only gainer on the written off assets since it disposes the asset and pockets the amount or ploughs it to the profit and loss account hence exaggerating the profits and misleading the share holders that the company is performing where else is not the case, more over increase in dividends may be experienced from time to time depending on how the assets have been revalued e.g. a downward adjustment on  asset value will lead to decrease in depreciation and thus increase in profits before tax hence time interest earned ratio (Profit before tax + interest expense/interest expense) will be above 3 and counting the reverse is true (Hoggett, 2011). In case of an upward adjustment the value of asset increases thus increasing the total value of assets. Creditors at this point will feel safe to extend credit to a company since the increase in company assets value reduces the debt ratio (Total Liabilities/Total Assets) far below 0.6, not only will the creditors be secure but also the company is able to leverage for more assets on loan. With the application of this model the senior management will be tasked with the duty of conducting the revaluation at every end of financial year and also be forced to lias with external appraisers who require payment for their services. The model takes a lot of time during revaluation as each and every technique must be applied in order to arrive at a reliable value (King, 2011). The luxury of acquiring assets from the company at a throw away price will also be waived from the management since  residual value will be reflecting on the records at end of the asset’s useful life and incase of disposal one should meet the price to acquire asset.

Recommendation

We recommend that the chief executive officer (CEO) stick to the cost model that has less cost implications on the company as well as the stake holders. According to the calculations

Debt ratio (calculated as Total Liabilities/Total Assets) must be less than 0.6

Debt ratio = (($17,500,000 + $2,500,000) / $35,500,000)) =0.56338

The calculation above shows that the company is operating with in its limits and that creditors are engaged with a secure organization, though the company cannot carry any more debt since the value is almost equal to the stipulated 0.6 mark

Times interest earned ratio (calculated as Profit before tax + interest expense/interest expense)

Times interest earned ratio = (($2,000,000 + $250,000 + $900,000) / $900,000) = 3.5

According to the calculations above it shows clearly that the company is performing well and it can be able to issue out dividends as the times interest ratio has surpassed the stipulated ratio which 3 an above. However the methods can be applied together such that the property like land buildings plant and machinery will be adjusted using the revaluation model while cost model will be used to value furniture fittings office equipments and vehicles.

Conclusion

Companies that employ cost model are by far saving on operational cost as well as time needed to value the assets, not only do the companies provide uniformity through constant depreciation (downward adjustment) but also can be able to adjust the percentage at which an asset is depreciated the model also plays a beneficial role to senior managers such that they are able to gain on disposal of such assets , however the model fails to consider  property plant and equipment, includes land and buildings which there value continues to increase as time goes. On the other hand revaluation model may either increase or decrease the value of an asset during each end year revaluation. This model employs various techniques such as indexing, current market price and leasing with external appraisers leading to cost implications that vary from year to year hence digging deep into the profits.

References

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Atrissi, N. (n.d.). Capital Structure and Assets Revaluation. SSRN Electronic Journal.

Greener, M. (n.d.). Between the lines of the balance sheet.

Hoggett, J. (2008). Financial accounting. Milton, Qld.: John Wiley & Sons.

Hoggett, J. (2011). Financial accounting 1. Milton, Qld.: John Wiley & Sons Australia, Ltd.

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Iasplus.com. (2016). IAS 16 — Property, Plant and Equipment. [online] Available at: https://www.iasplus.com/en/standards/ias/ias16 [Accessed 28 Aug. 2016].

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Accountingtools.com. (2016). The revaluation model - Questions & Answers - AccountingTools. [online] Available at: https://www.accountingtools.com/questions-and-answers/the-revaluation-model.html [Accessed 28 Aug. 2016].

Wang, Z. (2011). Upward Revaluation of Fixed Assets. Journal of Business & Economics Research (JBER), 4(1).