‘I think he revalued everything in his house according to the measure of response it drew from her well-loved eyes.’
F. Scott Fitzgerald (The Great Gatsby)
In a nutshell
The balance sheet typically records fixed assets at their purchase (historic) cost. A business is permitted, under accounting rules, to record fixed assets at their market value. The business can further choose which types (classes) of fixed asset to revalue (e.g. land and buildings, plant and machinery). However, once a company decides to revalue one or more classes of assets, valuations must be kept up to date.
The effect of revaluing is to increase (or decrease) fixed asset values from their original purchase cost. The higher (or lower) value is recorded within fixed assets and included as a gain (or loss) is recorded in a revaluation reserve.
Land and buildings is the class of fixed assts most likely to be revalued.
Need to know 
A company has the option to choose whether it wants to revalue its fixed assets and which class(es) of assets to revalue. It is an accounting policy choice (see Chapter 19 Accounting and financial reporting standards).
Where a business decides to revalue however it must do so regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. Valuations should be carried out by independent experts such as qualified surveyors.
Revalued assets are subject to depreciation in the same way as fixed assets held at historic cost (see Chapter 9 Tangible fixed assets and depreciation).
Example 1– Revaluation of building (assume no depreciation)
ABC Ltd originally purchased a building at a cost of £100,000. The company has adopted a policy to revalue buildings. At the end of the year, the building had a market value of £250,000.
The ‘gain’ in value is calculated as the difference between valuation and original cost, i.e. £150,000 (£250,000 − £100,000).
This would be reflected in the financial statements as follows:
| Fixed assets (building) | £250,000 (£100,000 + £150,000) |
| Revaluation reserve | £150,000 |
Note that the revaluation gain of £150,000 is recorded within a revaluation reserve, not in the profit and loss account. The revaluation reserve is a capital reserve and is therefore not distributable (see Chapter 15 Capital and reserves).
Why and when is this important? 
Companies may choose a policy of revaluation to improve their balance sheet net asset position. Asset values, particularly land and buildings, generally rise over time and this can present commercial benefits for the business:
- ■A business that is considering acquisition talks with another company would show a stronger balance sheet net asset position after revaluation. This may strengthen its negotiating position.
- ■Revaluations demonstrate the value of security available against which to borrow. What would otherwise be ‘hidden’ value is visible on the balance sheet, providing visible evidence of additional asset security available.
- ■For companies already laden with debt, revaluing assets may create headroom to meet existing covenant terms or secure further loans (see Chapter 30 Debt finance).
Companies may be inclined or feel obliged to adopt a revaluation policy where this is the norm across an industry, as it makes performance comparisons easier. However, revaluation is a policy choice and this choice can make comparing businesses more difficult. Financial statements are however required to include sufficient information to enable comparison of performance (see Chapter 19 Accounting and financial reporting standards). Specifically, companies that adopt a policy of revaluation must disclose equivalent historical cost information in their financial statements. This enables comparison on a like-for-like basis between companies that revalue and those that adopt a historic cost basis of accounting.
Gains versus profits
Gains are different to profits. Profits arise from trading or operating activities. Revaluations are gains that arise as a result of accounting measurement changes rather than trading activities. Increases (or decreases) in the value of fixed assets held are therefore recorded in a revaluation reserve, which is a capital i.e. non-distributable reserve (see Chapter 15 Capital and reserves).
To understand clearly the distinction between gain and profit, consider the property you live in. If the property has increased in value over the period since it was purchased, then this is a capital gain for the owner. However, this gain cannot be considered a profit as it is an unrealised gain or ‘paper’ gain. Unless or until the property is sold, the benefit (in the form of cash proceeds) cannot be accessed by the property owner (although the property owner could utilise the increase in value as security against further borrowings). (Unrealised) gains convert into profit only when a fixed asset is sold. At this point the gain becomes realised. In the case of the property owner, they are able to convert the (paper) gain into cash following sale. In the case of a business, when a revalued asset is sold, a profit is realised on sale and the surplus is available for distribution, i.e. can be paid out as dividends (see Chapter 15 Capital and reserves).
Downward revaluation (assume no depreciation)
Asset values can of course go down as well as up. Decreases in valuation will reverse any previous (upward) revaluations.
Example 2a
Using information from Example 1:
Three years later, a revaluation of the property results in a fall in value to £200,000.
The asset’s value has fallen by £50,000 since the previous valuation, i.e. from £250,000 to £200,000.
The latest valuation would be reflected as follows:
| Fixed assets (building) | £200,000 | (£50,000 lower than the previous valuation) |
| Revaluation reserve | £100,000 | (£150,000 − £50,000) |
Note that, despite the lower valuation, the asset is still valued above its original cost, i.e. there is still an (unrealised) gain of £100,000 relating to the asset (shown in the revaluation reserve).
Example 2b – losses
If a revaluation takes the valuation below the original purchase cost, the difference is a loss and must be ‘expensed’, i.e. charged as an expense in the profit and loss account.
Continuing Example 2a, a few years later the asset is revalued (downwards) to £60,000.
The latest valuation of £60,000 is now below the original cost (£100,000).
| Fixed asset (Building) | £60,000 (£140,000 lower than previous valuation) |
| Revaluation reserve | £0 (£100,000 − £100,000) |
| Accounting loss | £40,000 |
The asset has fallen in value by £140,000 since the previous valuation. The asset value is reduced by £140,000 to a new value of £60,000. The revaluation reserve is eliminated (£100,000 − £100,000) and the remaining difference of £40,000 (£140,000 − £100,000) is charged against the company’s profits in the year. The loss must be recognised even though the asset has not been sold to reflect ‘prudent’ accounting (see Chapter 6 Revenue recognition).
In practice 
Despite the potential benefits, relatively few companies choose to adopt a policy of revaluation. A company is likely to prefer historic cost accounting because a policy of revaluation can result in considerable cost to implement (e.g. professional fees of independent valuers) and require significant management effort to keep asset values up to date.
Revaluations also adversely impact key profitability ratios (see Chapter 23 Profitability performance measures) such as return on capital employed (ROCE) because upward revaluations result in higher asset values.
Example 3 (assume no depreciation)
Using the same information from Example 1 and assuming the company’s profit were £10,000.
ROCE would be calculated as follows:
Higher asset values also result in increased depreciation charges, reducing profit (see Example 4 in the Optional detail section below) and ROCE.
Nice to know 
Subjectivity and manipulation
A business choosing a policy of revaluation does not have to revalue all of its fixed assets under that policy.
Revaluations must be undertaken by ‘class of asset’ although the definition of ‘class’ may be open to interpretation. ‘Land and buildings’ are typically considered to be one class of asset, ‘plant and machinery’ another etc. A company could, however, argue that ‘office buildings’ and ‘manufacturing buildings’ represent different classes of asset, even though they are both examples of land and buildings.
Such subjectivity might enable a business to ‘cherry pick’ classes of assets most likely to benefit from rising values.
Valuation methods
Market values must be used wherever possible when carrying out revaluations. However, for certain assets, such as specialised machinery, a ‘market’ to determine value may not exist. Where no market exists, depreciated replacement cost is used as an alternative. Essentially this method attempts to estimate the current cost of replacing an identical asset, i.e. the current cost of an asset adjusted for its present age and condition.
Optional detail 
Depreciation
(See also Chapter 9 Tangible fixed assets and depreciation)
Revalued assets must be depreciated, applying the same methods as would be applied to historic cost fixed assets.
Depreciation would be applied to the revalued amount.
Example 4
Company A and company B each own an identical asset purchased 5 years earlier. Company A records assets at historic cost. Company B adopts a policy of revaluation.
The annual depreciation for each company is as follows:
Depreciation
| Company A | Company B | |
|---|---|---|
| Annual depreciation | £4,000 | £8,000 |
| charge | (£100,000 § 4%) | (£200,000 § 4%) |
The net book value at the latest balance sheet date (i.e. after 5 years) would be as follows:
Net book value
| Company A | Company B | |
|---|---|---|
| After 5 years | £80,000 (£100,000 − £20,000) | £160,000 (£200,000 − £40,000) |
| Basis of calculation | Purchase cost less 5 years’ depreciation | Valuation less 5 years’ depreciation |
Depreciation is higher in company B as it has revalued its assets. A higher annual depreciation charge will have the effect of reducing profit (and therefore distributable earnings) in company B.
Reported profits are lower in company B and this will further impact ROCE negatively (see earlier). However, one advantage of the reduction in profits caused by a higher depreciation charge is that it restricts the amount that can be paid out as dividends. This means a company retains more funds within the business for asset replacement. In contrast, depreciation based on historic cost may enable a company to pay higher (excessive) dividends leaving it with insufficient cash reserves to fund the purchase of a replacement asset at a higher price in the future.
Company directors adopting a policy of revaluation may need to maintain dividend payouts because of shareholder expectations to deliver a constant or progressive dividend policy (see Chapter 27 Investor ratios). Accounting rules permit an adjustment to reserves for companies that choose to revalue their assets so that the effects on profits of higher depreciation can be reversed. A transfer equal to the excess depreciation is permitted, from the revaluation reserve to distributable profits. In the above example, £4,000 per year may be transferred from the revaluation reserve to distributable reserves by company B. The effect of this adjustment is that company B would not be at any disadvantage to company A in the amount it is legally able to pay as dividends.
Reflect and embed your understanding 
- 1Explain the difference between a revaluation gain and profit. Why is the distinction important?
- 2Reflect on the reasons why only a minority of companies adopt a policy to revalue their fixed assets.
- 3Why might a company choose to revalue only certain classes of fixed assets?
- 4The balance sheet is a statement of net assets and not a valuation statement. Reflect on why this statement holds true, in particular in the context of a company that may have acquired significant land and property over many years.
For the authors’ reflections on these questions, please go to financebook.co.uk
Where to spot in company accounts 
The accounting policy note will include the basis of revaluation, if any, adopted.
There should be sufficient information included in the notes to the accounts to identify the financial effects of a revaluation. This will enable users to compare performance with businesses using historical cost accounting.
The balance sheet (or supporting notes) should include details of:
- ■Assets held at revaluation (included within fixed assets).
- ■Revaluation reserve (included within capital and reserves).
Changes in revaluation each year are explained in the ‘Statement of changes in equity’ (cross referenced from the balance sheet).
Greggs plc prepares accounts on an historical cost basis and therefore does not include information on revaluation of fixed assets.
Extract from Greggs plc 2020 financial statements Appendix p. 450
(b) Basis of preparation
The accounts are presented in pounds sterling, rounded to the nearest £0.1 million, and are prepared on the historical cost basis except the defined benefit pension asset/liability, which is recognised as the fair value of the plan assets less the present value of the defined benefit obligation.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 404.
Watch out for in practice 
- →The size of any revaluations to assess their likely impact on key financial ratios.
- →The definition of class of assets. Is this different to other companies in the same sector? This may affect ratio comparisons. Consider the classes of assets each business has chosen to revalue.
- →Evidence of selective assets (only) being revalued. A company can selectively revalue particular asset types, i.e. those most likely to rise in value. This may provide scope for distorting the financial performance and position of the business.
- →Direction of revaluations – are they all upwards? Have there been any downward revaluations?
- →When was the last time the company revalued its assets? If it has been a number of years, is there any reason why the assets have not changed in value?
- →A change of policy from cost to revaluation and the justification given, if any. This could signal impending corporate activity (a potential takeover or merger), or the need to show a higher capital base against which additional debt finance might be secured.
- →Significant risks of material misstatement existing in the financial statements due to revaluations. Read the audit report to identify whether critical areas reviewed by external auditors include revaluations.