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Accounting for revaluations
On 1 January 2016, Good Ltd acquired a block of land for $100000 cash and on the same day better ltd purchased the adjacent block, which was virtually identical to the block purchased by Good ltd also for $100000 cash, Both companies intended to construct industries warehouse on these properties .For the next 2 years the property market went through a boom period and by co incidence , on June 2018 both companies obtained independent valuations of $180000for their blocks of land.
Good ltd has decided to adapt the revaluations model for land in the accounts on the last day of the year ended 30 June 2018, by following the requirements of IAS/AASB 116.Better ltd decided to use the cost model.
On 30 April 2019 each company sold its block of land for $200,000 cash.
Give reasons for the discrepancy in profit figures between the two companies. Does the existence of the discrepancy make sense? What message is being conveyed to users the performance of both companies? Discuss fully. How can the discrepancy be avoided?
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As per AASB 116 an asset is initially recognized at cost. After recognition in the books the asset can be measured either by the cost model or the revaluation model as it has been prescribed by the board. This can be measured as per the accounting policy of the company but the same has to be applied to the entire class of plant, property and equipment.
If an asset is measured at cost model it would be recognized at cost less accumulated depreciation less any impairment loss.
An asset can be measured by revaluation model if the fair value of the asset is reliably measurable. An asset that is subsequently measured using the revaluation model shall be measured at the revalued figure that is reliably available ad it would be reduced by any subsequent accumulated depreciation and subsequent impairment losses. The revaluations are made in such a manner that the value of the asset does not differ significantly from its fair value at the end of the reporting period. In the same manner, if this approach is followed the frequency of the revaluation depends upon the fair values of the asset. Frequent revaluations are unnecessary rather the assets should be revalued once in three or five years.
If the value of an asset has increased as a result of revaluation then the increase would be included in other comprehensive income and the shareholder’s equity will be credit with the increase under the head revaluation surplus. Only that amount of increase will be credited to profit or loss that has been previously provided as revaluation decrease for that same class of asset.
When such asset is sold the entire amount of revaluation surplus lying under equity is transferred to retained earnings.
In the given case, it can be observed that Good Ltd and Better Ltd. acquired a block of land each at $100000. Good Ltd. followed Revaluation Model and Better Ltd decided to adopt the cost model. Therefore, when the asset was revalued on June 30, 2018 at $180000 Better Ltd would have given no treatment for the same, while Good Ltd would have increased the Other Comprehensive Income by $80000 and the equity would be credited by Revaluation Surplus of $80000.
On 30 April 2019, when both sold their lands at $200000, Better Ltd would have recognized the entire gain of $100000 and the equity of the company would have increased by $100000. However, for Good Ltd. $80000 was previously recognized under Other Comprehensive Income therefore, currently the equity would increase by only $20000.
It can be assessed that discrepancy in profit is present for both the companies. The same is attributable to the fact that both have adopted different methods for the valuation of the asset. This discrepancy does not make sense because it has arisen as a result of difference in accounting policies not as a result of difference in sale value of the figure. The profit figure for this transaction would be higher for Better Ltd as compared to Good Ltd because of the different approaches of the valuation of the asset that has been followed by them. This discrepancy can be avoided only if both the companies employ same accounting policy for the recognition for each of the class of asset.
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