Revaluation Model Structure and Sticky Costs

Question: Discuss about the Revaluation Model for Structure and Sticky Costs. Answer: Introduction: The report consists definition of revaluation model and the reason of its application. The present case of Sha Maru has been analysed and a conclusion has been derived regarding the application of revaluation model or not. The details regarding the method of application revaluation model and its impact on Sha Maru Ltd. has been also described. The benefits which will be available to the organisation after the application of revaluation model are also included in the report. Cost Model In this method, the cost of an asset is the total expenditure done for putting the asset in a usable form. The purchase cost, transportation and initial expenditure expended for making asset usable are included in cost of this method (Choi and Yoo, 2013). The model emphasis on the input of parameters according to which attributes of the project and physical requirements are being estimated. It does not an emphasis on the fair value of the asset hence an appropriate value of asset cant be ascertained with it. Revaluation Model An option of accounting fixed asset on revalued amount is availed by a business by application of revaluation model. The period of interval after which revaluation of the asset should be done depends on the nature of asset (DRURY, 2013). Some assets are volatile in nature hence, it is necessary to revalue them at least once a year. The general period acceptable by IFRS is three to five years for revaluation. After the application of revaluation model, the amount at which asset is carried in books of accounts is the fair value of asset deducted by accumulated depreciation and impairment losses. According to this approach, entity must revalue the assets on regular period so that the amount at which the asset is carried on is not different from the fair value of the asset. The same is in compliance with IFRS. The model is majorly dependent on estimation of fair value of asset but it is a practical approach to estimating the carrying cost of the asset and make an appropriate adjustment (Liang and Riedl, 2013). If an asset is revalued than accordingly the other assets of the group should also be revalued to prevent misleading in financial position due to a mix of historical cost and current values. Accounting treatment of depreciation in revaluation model In the case when an entity has adopted revaluation model it is having the option to adopt any of the one methods from the two methods with the depreciation that has accumulated since last revaluation (Percy and et.al., 2015). The amount of accumulated depreciation in the year in which revaluation model is being applied is deducted from the total carrying revalued amount of asset; The asset is carried with the revalued amount in the books of account and the amount of depreciation is proportionally restated. Analysis of the case The present case study is related to ShaMaru Ltd. whose total assets are $35,500,000. The assets include Property plant and equipment of $27,500,000 and the remaining is current assets. It can be analysed from the financial data of the company that a major portion of the asset is property, plant and equipment. Thus the carrying amount of asset should be more than the actual value as it is given it the data that the fair amount of asset is twenty-five percent more than its current value. It will result in the advantage of more depreciation and the increase in the value of the asset will reduce the liabilities of the company. The long-term liabilities of the company are $17,500,000 and short term liabilities is $2,500,000. The interest expense for the current period is 900,000, tax expense $250,000 and net profit was $2,000,000. The increase in carrying the amount of asset will have direct positive impact on the debt-equity ratio of the company. Since the company will have to make changes in the depreciation adjustments as previously the company was following of cost methodology and now revaluation method is being adopted by the company. The company will need to comply with cost and statutory changes according to change in accounting standard. The difference between the revalued amount and the carrying amount of asset should be presented properly while reporting in books of accounts (Zakaria and et.al, 2014). The application of revaluation model will be beneficial in a way for maintaining debt percentage and will also allow the company to make enough payments in form of dividend. Impact on books of accounts of revaluation model: The assistance of a qualified valuation can be taken for ascertaining the fair value of the asset. If the asset is of a specialized nature that market value method cannot be used than alternative method can be used to ascertain fair value of the asset. In case the revaluation of asset results in an increase in carrying the amount of asset, the increase is recognised as an increase in other comprehensive income and accounted as revaluation surplus in equity account (Revaluation of Fixed Assets, 2012). Thus if in future the value of the asset is decreased again the relevant profit will be recognised as revaluation gain and the loss of the extent balance is available in the revaluation account will be done by reducing the revaluation reserve. In case the revaluation concludes with a decrease in value of the asset, than in that case the decrease in amount will be accounted as a loss in profit loss account (Balakrishnan and Soderstrom, 2014). In case revaluation reserve exists in books of account than the amount of loss will be adjusted against revaluation reserve account to the balance available and the remaining part will be charged to profit and loss. Journal entries in revaluation model: Journal Entries in case if revaluation results in increase in value of asset In $ 000' Sr. No. Date Particular Dr. Amount Cr. Amount 1 30.06.2016 Non- Current Asset A/c 6875000 To Revaluation Surplus A/c 6875000 [Being the revaluation reserve created with the increased in carrying amount of asset.] Conditions for raising debt Debt ratio must be less than 0.6 The times interest earned ratio should be greater than 3 Cost model Revaluation model Debt ratio Total Liabilities/Total Assets Debt $ 20,000,000.00 Debt $ 20,000,000.00 Assets $ 35,500,000.00 Assets $ 42,375 ,000.00 * Ratio 0.563380282 Ratio 0.47197 Times interest earned ratio Profit before tax + interest expense/interest expense Profit before tax $ 450,000.00 Profit before tax 7325000 Interest exp. $ 900,000.00 Interest exp. $ 900,000.00 Ratio 1.5 Ratio 9.138888889 Amount of total assets Existing fixed assets $27,500,000 Upward revaluation (25%) $6,875,000 Current assets $8,000,000 Total assets $42,375 ,000 Conclusion: The discussions regarding both the models have been presented in the report. It can be concluded from the above analysis that cost model considers the price at which project was started and revaluation model considers fair value of the asset of the project. Both the models needs different calculations and presentation thus a shift in the method will need appropriate changes in accounting method for compliance with accounting standard (What is the difference between the cost model and the revaluation model of fixed assets? 2013). The issue regarding revalue model is that it is a typical job to ascertain the fair value of an asset. Hence complexity is associated with revaluation model but as IFRS has considered it as an important aspect it will be accepted by the entities. The advantages that will be received by the company after the application of revaluation model are: Presentation of the value of the asset at fair value rather than its cost which is more appropriate. Improving debt equity ratio. Increasing the share of contribution like dividends. The increase in the asset will allow the company to make suitable adjustments in interest payments. It is recommended to comply with revaluation model and changes in accounts should be made in compliance with the standard. The initial cost of the project may be expensive but with the assistance of accounting personnel the company can easily report in books of accounts in compliance with standard regarding the shift in policy. In accordance with the above analysis, it could be said that the compliance with revaluation model leads an entity to incur a high cost at beginning with some critical calculations for compliance with standard but it is an appropriate methodology as it considers fair value of asset rather than its cost. The application of this model let the entity to account assets at its fair value which leads to present books of accounts in a more fair and appropriate manner. References: Balakrishnan, R. and Soderstrom, N.S. (2014). Cost structure and sticky costs. Journal of Management Accounting Research. 26(2). Pp.91-116. Choi, T.H. and Yoo, C.Y. (2013). Demand for Fair Value Accounting: The Case of Asset Revaluations in Private Versus Public Firms. DRURY, C.M.(2013).Management and cost accounting. Springer. Liang, L. and Riedl, E.J. (2013). The effect of fair value versus historical cost reporting model on analyst forecast accuracy.The Accounting Review.89(3), Pp.1151-1177. Percy, M. and et.al. (2015). Journal of Contemporary Accounting Economics. Journal of Contemporary Accounting Economics. 11, Pp.31-45. Zakaria, A.and et.al. (2014). A Review of Property, Plant and Equipment Asset Revaluation Decision Making in Indonesia: Development of a Conceptual Model. Mindanao Journal of Science and Technology, 12(2014), pp.109-128. Revaluation of Fixed Assets. (2012). [Online]. Available through https://accountingexplained.com/financial/non-current-assets/revaluation-of-fixed-assets. [Accessed on Accessed on 27th August 2016]. What is the difference between the cost model and the revaluation model of fixed assets? (2013). [Online]. Available through https://www.bayt.com/en/specialties/q/213362/what-is-the-difference-between-the-cost-model-and-the-revaluation-model-of-fixed-assets/. [Accessed on 27th August 2016].