Question

Many organisations elect not to measure their property, plant and equipment at fair value, but rather, prefer to use the ‘cost model’. This will provide lower total assets and lower measures, such as net asset backing per share. Required You are required to answer the following questions:

(a)What might motivate directors not to revalue the property, plant and equipment?

(b)What are some of the effects the decision not to revalue might have on the firm’s financial statements?

(c)Would the decision not to revalue adversely affect the wealth of the shareholders?

Answer 1

(a) Directors are aware of the fact that the revaluation of assets may result either in an understatement or overstatements of assets. If the assets are undervalued, the loss is debited to profit and loss account and would be charged to wealth of shareholders; and when the assets are overstated the profit on revaluation is transferred to profit and loss account; and further would be transferred to shareholders fund. The directors are not motivated to revalue the assets as excess gain on revaluation will be distributed to shareholders. As they will derive any benefit in revaluation thus are not motivated. Moreover there is cost involved in revaluation which results to an increase in expenses which eventually leads to decline in net profits and reduced cash flow.

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(b) In case revaluation is not done then a true and fair picture of financial statements of the company will not be depicted. The accounting based on historical cost based considers assets to be recorded at the value at which it was acquired at any time in past, however with the passage of time the value of assets increases or decreases. Thus it becomes important that these assets must be compared with the market value and required adjustments are done to revalue the assets. In absence of revaluation of the assets the financial statements would become misleading and therefore investors may take inappropriate decision based on this. Consequently the financial statements of the firm is of no use when company goes for mergers and acquisitions as in such case current market price is taken to compute the purchase consideration

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(c) Yes, the decision not to revalue adversely affects the wealth of the shareholders because the remaining profits and losses after meeting external liabilities are transferred to shareholders fund. An upward revaluation will leads to a rise in the shareholders wealth and no revaluation will result in low shareholders wealth.