A company can account for changes in the market value of its various fixed assets by conducting a revaluation of the fixed assets. Revaluation of a fixed asset is the accounting process of increasing or decreasing the carrying value of a company’s fixed asset or group of fixed assets to account for any major changes in their fair market value.
Initially, a fixed asset or group of fixed assets is recorded on a company’s balance sheet at the cost paid for the asset. Afterward, there are two methods used to account for changes in the value of the fixed asset or assets.
- Sometimes, a company’s fixed assets – such as property, plant, & equipment – will experience substantial changes in their market prices.
- When this occurs, the company must account for changes in value using either the cost method or revaluation techniques.
- Accounting rules allow for either methodology, so management discretion must be used to choose the most appropriate model.
The most straightforward accounting approach is the cost model. With the cost model, a company’s fixed assets are carried at their historical cost, minus the accumulated depreciation and accumulated impairment losses associated with those assets. The cost model does not allow for upward adjustments in the value of an asset based on the fair market value.
The primary reason companies might choose the cost approach to valuation is that the resulting number is much more of a straightforward calculation with far less subjectivity. However, this approach does not offer a way to arrive at an accurate value for non-current assets since the prices of assets are likely to change with time—and the price doesn’t always go down. Quite often, they go up. This is particularly true for assets such as property or real estate.
The second accounting approach is the revaluation model. With the revaluation model, a fixed asset is originally recorded at cost, but the carrying value of the fixed asset can then be increased or decreased depending on the fair market value of the fixed asset, normally once a year. If an asset reduces in value, it is said to be written down. Under International Financial Reporting Standards (IFRS)assets that are written down to their fair market value can be reversed, while under generally accepted accounting principles (GAAP)assets that are written down remain impaired and cannot be reversed.
The main advantage of this approach is that non-current assets are shown at their true market value in financial statements. Consequently, the revaluation model presents a more accurate financial picture of a company than the cost model. However, revaluation must be re-done at regular intervals, and management may sometimes be biased and assign a higher revalue than is reasonable for the market.
Revaluation vs. Cost: How Do You Choose?
The decision of choosing between the cost method or the revaluation method should be made at the discretion of management. Accounting standards accept both methods, so the deciding factor should be which method is the best fit for the unique needs of the business in question. If the business has a greater proportion of valuable non-current assets, revaluation might make the most sense. If not, then management may need to go deeper to reveal the factors needed to make the best decision.
Just remember that for a revaluation model to function properly, it must be possible to arrive at a reliable market value estimate. If reliable comparisons to similar assets (such as past real estate sales in a neighborhood) are possible, then the subjectivity of the revaluation is decreased, and the reliability of the revaluation increases.