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.
Key Takeaways
- Sometimes, a company’s fixed assets, such as property, plant, and 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.
Cost 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.
Note
Depreciation and amortization both involve spreading the cost of an asset over time. Depreciation primarily applies to tangible assets, like machines, while amortization applies to intangible assets, such as patents.
Revaluation Model
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.
What Is the Difference Between IFRS and GAAP?
Both International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP) are accounting standards used by companies. GAAP is primarily used in the U.S., while IFRS is used widely across the globe. The primary difference is that GAAP is a rules-based accounting framework whereby companies must adhere to strict rules. IFRS, on the other hand, is a principles-based accounting framework that allows for more flexibility via different interpretations of the accounting principles.
What Is the Cost Method of Asset Valuation?
The cost method of asset valuation is a simple way to measure the value of an asset. It solely assesses the original purchase price of the asset minus any depreciation. It’s a straightforward approach because it doesn’t take into account any market fluctuations or the value of future cash flows. While it is basic in approach, it is not the most accurate way to value an asset.
What Is Market Value?
Market value is the price an item would sell for at a given moment based on supply and demand. It is the price a seller is willing to sell a good or service for and a buyer is willing to buy when both have all the required information and are freely allowed to make a decision.
The Bottom Line
Choosing between the cost model and the revaluation model depends on what best suits a company’s financial strategy. The cost model is a simple approach but may not represent the true value of assets over time.
The revaluation model provides a more accurate picture of asset value but is more intensive as it requires ongoing adjustments and involves some subjectivity. Ultimately, management needs to decide which method best suits the company’s needs and balance the pros and cons.
