Tag: Advanced Accounting Notes

Indian companies act 1956, does not provide any scope for showing any information about human resources in financial statement. Due to the development of business and industries, some of the Indian companies, both public and private, value their human resources and report this information in their annual report. The companies, who are presently reporting human assets valuation, includes

• Steel Authority of India Ltd (SAIL).
• Bharat heavy Electrical Ltd (BHEL).
• Oil and Natural Gas Commissioning (ONGC).
• Project and Equipment corporation of India. (PEC).
• Oil India Ltd
• Engineers India limited
• Electrical India Ltd.
• Mineral and Metal trading Corporation of India. (MMTC).
• Hindustan Shipyard Ltd.
• Infosys Technologies Ltd.
• Cement corporation of India. (CCI).
• Tata Engineering and Locomotive Works
• Associated Cement Company Ltd ACC).
• Southern Petrochemicals Industries Corporation Ltd SPIC).
• National Thermal Power Corporation Ltd (NTPC).

Benefits

Calculate Return on Investment (ROI):

The return on investment can realistically be calculated only when the investment on human resources also is taken into account. The ROI is may be good because there is an investment on human beings.

Improving employee efficiency:

It helps in improving the efficiency of employees. The employees come to know of the cost incurred on them and the return given by them in the form of output, and so on, which will motivate them to increase their worth.

Proper investment:

It can be seen whether the business has made proper investment in human resources in terms of money or not. If the investment is in excess, efforts should be made to control it.

Cost of developing human resources:

HRA will give the cost of developing human resources in the business. This will enable the management to ascertain the cost of labor turnover also.

Planning and executing personal policies:

It will help the management in planning and executing personal policies. The management also makes use of its help in taking decisions regarding transfers, promotions, training, retirement and retrenchment of human resources.

Calculation of Reasonable Return

Control Reserve fall short of reasonable return, the appropriations to this reserve can be reduced by the amount of shortfall. The amount of such reserve is to be invested in the same electricity undertaking and is to be handed over to purchaser of the business in case the business is sold away.

The Electricity (Supply) Act, 1948, imposes restrictions on electricity undertakings on earning too high a profit, by means of the concept of reasonable return, which stipulates the following:

1. A yield at the standard rate which is the Bank Rate stipulated by the Reserve Bank of India from time to time, plus 2% on the Capital Base.
2. Income derived from investments excluding investments made against the Contingencies Reserve.
3. An amount equal to ½% on any loans advanced by the Board.
4. An amount equal to ½% on the amounts borrowed from organisations or institutions approved by the State Government.
5. An amount equal to ½% on the amounts realised by the issue of debentures.
6. An amount equal to ½% on the accumulations in the Development Reserve.
7. Any other amount as may be allowed by the Central Government, having regard to the prevailing tax structure in the country.

An electricity company must adjust the rates so that the clear profit in any year does not exceed the reasonable return by more than 20 per cent of the reasonable return. In case it exceeds, it should be credited to Customers Rebate (or Benefit) Reserve.

Moreover, even the surplus within 20 per cent of the reasonable return has to be disposed of as follows:

(i) 1/3 of the surplus not exceeding 5 per cent of the reasonable return will be at the disposal of the undertaking.

(ii) Of the balance, 1/2 will be transferred to the Tariffs and Dividend Control Reserve.

(iii) The balance left will be distributed among consumers by way of reduction of rates or by way of special rebate.

Calculation of Disposal of Surplus

Should the clear profit exceed the reasonable return, the surplus has to be disposed of as under:

(a) One-third of the surplus not exceeding 5% of the reasonable return will be at the disposal of the undertaking;

(b) Of the balance, one-half will be transferred to “Tariffs and Dividends Control Reserve”; and

(c) The balance will be distributed among consumers by way of reduction of rates or by way of special rebate.

An electricity undertaking must so adjust rates that the amount of clear profit in any year does not exceed the reasonable return by more than 20% of the reasonable return.

Replacement of an Asset

In an Electricity company an asset once appeared in a Capital account cannot be reduced even after its replacement or disposal. So, when no extension or improvement is involved the entire replacement cost is charged to revenue and if some extension is involved, the difference is to be capitalised. i.e. the difference between the actual amount spent and the amount that would have been spent had the old asset been constructed now. For this the following calculations and journal are necessary.

Three procedures for replacement of an asset.

(i) The original cost of the asset will remain intact.

(ii) The estimated cost of replacement of the old asset is ascertained. At the same time, the estimated cost is reduced by the sale proceeds of old materials, if any, or by the value of materials re-used in the new construction. The balance is charged to Revenue Account.

(iii) The difference between the total cost of the entire work and the estimated replacement cost of the old asset in original manner is charged to Capital Account, i.e., capitalized.

In addition to above, the additions and improvements are capitalized. Moreover, the auxiliary mains, subsidiary, subsidiary permanent ways, etc. are also to be capitalized. Improvement is the excess amount spent over the cost of replacement with asset of equal efficiency.

It may be mentioned, however, in this respect that current cost of the old assets may be determined either from the market or from the price index. That is, price index which is applicable to the type of asset with same efficiency after 20-30 years may be practically obsolete now.

It may be applied simply to get the estimated current cost. If the asset is in the nature of Construction Works, separate indices have to be applied to different elements of cost. But if the estimate differs (between engineering data and price indices) the lesser amount may be capitalized just on the basis of conservatism.

Revenue Account

This account is similar to the Profit and Loss Account of a trading or manufacturing concern. It is debited with various items of expenses and credited with various items of incomes. Depreciation on fixed assets is charged by debiting the Revenue Account and crediting the Depreciation Fund Account. Generally, expenses are shown under the following broad headings:

(A) Generation;

(B) Distribution;

(C) Public Lamps;

(D) Rent, Rates and Taxes;

(E) Management Expenses;

(F) Law Charges;

(G) Depreciation;

(H) Special Charges.

Similarly, incomes are grouped as:

(1) Sale of energy for lighting;

(2) Sale of energy for power;

(3) Sale of energy under special contracts;

(4) Public lightings;

(5) Rental of meters;

(6) Rent receivable; and

(7) Transfer fees, etc.Statutory Form of Revenue Account under Indian Electricity Act, 1910 is given below :

Revenue Account for the year ended ………………

Net Revenue Account

This is similar to the Profit and Loss Appropriation Account of a trading or manufacturing concern except the treatment of interest on debentures and loans.

In the Net Revenue Account, it is treated as appropriation of profits. However, In ordinary cases, such interest is treated as a charge against profits and shown in the Profit and Loss Account. The balance of the Net Revenue Account is shown in the General Balance Sheet.

The Statutory form of Net Revenue Account under the Indian Electricity Act,1910 is given below:

Net Revenue Account for the year ended ……………….

Capital Account (Receipts and Expenditure on Capital Account)

The main purpose of this account is to show total amount of capital raised and its application for acquisition of fixed assets for carrying on the business.As per the statutory forms (prescribed by the Indian Electricity Act, 1910) there are three columns on each side:

(i) one showing balance at the end of the previous year;

(ii) disclosing the amount received/spent during the year; and

(iii) balance at the end of the year. Statutory form of Capital Account under The Indian Electricity Act, 1910 is given below:

Receipts and Expenditure on Capital Account for the year ended………….

General Balance Sheet

In the General Balance Sheet, all the remaining assets and liabilities, like current assets, current liabilities, reserves, etc., are shown along with the total of receipts (on the liability side) and the total expenditure (on the asset side).

The Statutory Form of General Balance Sheet under Indian Electricity Act, 1910 is given below:

General Balance Sheet as on ………………………..

Treatment of Replacement of an Asset

Under the Single Account System when an asset is replaced, the Cash Account is debited and the Asset Account is credited, and the difference is transferred to the Profit and Loss Account (being profit or loss on sale of asset). The Asset Account is reduced by its written down value. Similarly, when an asset is purchased, the Asset Account is debited and the Cash or Bank Account is

credited and the Asset Account is increased by that amount. However, under the Double Account System when an asset is replaced, the original cost of the asset is not disturbed, instead it continues to appear in the Capital Account at the old figure. Under this system, the cost of replacement is treated in the books of accounts as under:

(i) When no Extension or Improvement is involved:

In this case, the entire amount of cost of replacement is treated as revenue expenditure and is debited to Revenue Account.

(ii) When Extension or Improvement is Involved:

In this case, an amount equal to the present cost of replacement of the old asset is treated as revenue expenditure and is charged to the Revenue Account. However, this chargeable amount is reduced by

(a) sale proceeds of scrap of the old asset

(b) value of materials of old asset used in rebuilding the new asset.

The total cost of replacement plus the value of materials of old asset used in rebuilding the new asset minus the present cost of replacement of the old asset is capitalised. Some Important Provisions

The students should note the following important matters which will affect the accounts of electricity companies as provided in the Sixth Schedule to The Electricity (Supply) Act. 1948.

These are as follows:

(a) Depreciation on fixed assets

(b) Fixed assets and their prescribed life

(c) Contingency reserve

(d) Development reserve

(e) General reserve

(f) Appropriation of profits

Depreciation on Fixed Assets

As per the provision of Sec. of The Electricity (Supply) Act, 1948, every fixed asset must be depreciation and for calculating depreciation, the life of each asset is to be taken as stated in the Seventh Schedule. Schedule VI provides for two methods of depreciation, viz:

(a) Compound Interest Method

(b) Strait Line Method.

Compound Interest Method

Under this method, such an amount should be set aside annually as depreciation throughout the prescribed life of the asset concerned, as would,with 4% p.a. compound interest, produced by the end of the prescribed period an amount equal to 90% of the original cost of the asset.

Straight Line Method

Under this method, the depreciation is calculated by dividing 90% of the original cost of the asset by the prescribed period in respect of such an asset.All sums credited to the Depreciation Reserve may be invested either in the  business or may be utilised for repayments of loans not guaranteed under Section or for repayment of sums paid by the State Government under Guarantee  Assets Written Down to 10% of Cost and No depreciation is allowed in respect of an asset which has been written-down to 10% (or less) of its original cost.

When a fixed asset is discarded or becomes obsolete it cannot be depreciated any more. In this case, the written-down value of such an asset is transferred to a special account. Any profit on sale of such assets is transferred to the Contingency Reserve Account.

Contingencies Reserve

Every electricity supply company is required to maintain a Contingencies Reserve. A sum equal to not less than 1/4% or not more than 1/2% of the original cost of fixed assets must be transferred from the Revenue Account to the Contingencies Reserve. The maximum amount in this account must not exceed 5% of the original cost of the fixed assets. The amount of Contingencies Reserve must be invested in trust securities. With the prior approval of the State Government, the Contingencies Reserve can be utilised for the following purposes :

( i ) For meeting expenses or loss of profit due to accident, strikes or circumstances beyond the control of the management;

(ii) For meeting expenses on replacement or removal of plant or works other than expenses required for normal maintenance or renewals;

(iii) For paying compensation under any law for the time being in force and for which no other provision has been made.

Development Reserve

An amount equal to income tax and super tax saved on account of Development Rebate allowed under Income Tax Act, 1961 has to be transferred to the Development Reserve Account. If, in any accounting year, the clear profit without considering special appropriations plus balance in the credit of Tariffs and Dividend Control Reserve is less than the required amount of Development Reserve, the shortfall may not be made good. In case of sale of the undertaking, this reserve should be handed over to the buyer.

General Reserve

Section of the Electricity Act, 1948 provides for the creation of the General Reserve by making appropriation from the Revenue Account after charging interest and depreciation. The amount of contribution shall be calculated @ 1/2% of the original cost of the fixed assets until the total of such reserve comes to 8% of the original cost of the fixed assets. Tariffs and Dividend Control Reserve

It is created out of the disposable surplus of the electricity company (explained below). This reserve can be utilised whenever the clear profit is less than reasonable return. At the time of sale of the undertaking, this reserve should be handed over to the buyer.

Appropriation of Profits

The Electricity (Supply) Act, 1948 provides that an electricity company cannot charge any rate as they like. They are entitled to charge such rates which give them a reasonable return. They must so adjust the rate that the amount of clear profit in any year does not exceed the reasonable return by more than 20%.

Disposal of Surplus

The excess of clear profit over reasonable return to the extent of 20% of reasonable return has to be disposed of as under: (Any excess over 20% of reasonable return must be refunded to customers).

(i) 1/3 of the surplus (not exceeding 5% of reasonable return) at the disposal of the undertaking.

(ii) Of the balance, 1/2 is to be transferred to the Tariffs and Dividend Control Reserve.

(iii) The balance is to be transferred to the Consumer’s Rebate Reserve for reduction of rates or for special rebate.

Calculation of Clear Profit

The Clear profit is the difference between the total income and total expenditure plus specific appropriations. The Clear profit is calculated as follows:

(A) Income from

(i) Gross receipts from sale of energy, less discount

(ii) Rental of meters and other apparatus hired to customers

(iii) Sale and repair of lamps and apparatus

(iv) Rent, less outgoings not otherwise provided for

(v) Transfer fees

(vi) Interest on investments, fixed and calls deposits and bank balances

(viii) Other taxable general receipts

Total Income

(B)Expenditure

(i) Cost of generation and purchases of energy

(ii) Cost of distribution and safe of energy

(iii) Rent, rates and taxes (other than taxes on income profits)

(iv) Interest on load advanced by Board

(v) Interest on loan taken from organization or institutions approved by the State Government

(vi) Interest on debentures issued by the licencee

(vii) Interest on security deposits

(viii) Legal charges

(ix) Bed debts

(x) Auditor’s fees

(xi) Management expenses

(xii) Depreciation (as per Schedule Seventh)

(xiii) Other admissible expenses

(xiv) Contribution to Provident Fund; gratuity, staff pension and apprentice and other training schemes

(xv) Bonus paid to the employees of the Undertaking. In case of dispute, in accordance with the decision of the tribunal.

In any other case, with the approval of the State Government Total Expenditure

Balance (A – B)

Less : Specific Appropriations

(i) Past losses (i.e., excess of expenditure over income)

(ii) All taxes on income and profits

(iii) Amount written-off in respect of fictitious and intangible assets

(iv) Contribution to Contingency Reserve

(v) Contribution towards arrears depreciation (if any)

(vi) Contribution to Development Reserve

(vii) Other appropriation (special) permitted by the State Government Clear Profit

Reasonable Return: It means the sum of the following items:

(i) An amount calculated at (bank rate + 2%) on Capital Base as defined below.

(ii) Income from investments (except income from Contingency Reserve Investment).

(iii) An amount equal to 1/2% on loans advanced by the State Electricity Board.

(iv) An amount equal to 1/2% on the amounts borrowed from organisations or institutions approved by the State Government.

(v) An amount equal to 1/2% on the amount raised through issue of debentures.

(vi) An amount equal to 1/2% on the balance of Development Reserve.

(vii) Any other amount as may be permitted by the Central Government.

Capital Base : Capital Base means :

(i) Original cost of fixed assets available for use Less : Contribution, if any, made by the customers for construction of service lines

(ii) the cost of intangible assets

(iii) the amount of investments made compulsorily on account of contingencies reserve

(iv) the original cost of work-in-progress

(v) working capital which is equal to the sum of:

(a) 1/2 of the sum of stores, materials and supplies including fuel on hand at the end of each month of the accounting year;

(b) 1/ 2 of the sum of cash and bank balance and call and short term deposit at the end of each month of accounting year but does not exceed in aggregate an amount equal to 1/4 of the expenditure (already listed in previous page).

(i) Deduct

Accumulated deprecation on tangible assets and amounts written-off tangible assets Loan advanced by Electricity Board

(ii) Security deposits of customers held in cash.

(iii) Debentures issued by the undertaking

(iv) Amount standing to the credit of Tariffs and dividend control revenue.

(v) Loan borrowed from organisations or institutions approved by the State Government.

(vi) Balance of Development reserve.

(vii) Amount carried forward for distribution to consumers.

Capital Base

This law prevents companies that hold public utilities from using their profits to pay for unregulated business activities. Side endeavors must be separated from the holding company. Although some utility companies argue that PUHCA restricts competition and no longer applies, repealing this law would result in the creation of several large utility companies and eliminate industry competition. Many believe that reform of this law should only take place as part of a thorough restructuring.

This law was originally passed to counteract the unfair business practices of large utility holding companies in the 1920s and 1930s. These businesses created complex pyramid structures that held shares in many subsidiaries. For example, at one point three holding companies controlled most of the industry with more than 130 subsidiaries. This resulted in inflated rates, hidden charges and fees, and a lack of accountability.

As per Section 2(46) “holding company”, in relation to one or more other companies, means a company of which such companies are subsidiary companies.

As per Section 2(87) “subsidiary company” or “subsidiary”, in relation to any other company (that is to say the holding company), means a company in which the holding company:

(i) controls the composition of the Board of Directors; or

(ii) exercises or controls more than one-half of the total share capital either at its own or together with one or more of its subsidiary companies:

Provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.

Explanation. For the purposes of this clause:

(a) A company shall be deemed to be a subsidiary company of the holding company even if the control referred to in sub-clause (i) or sub-clause (ii) is of another subsidiary company of the holding company;

(b) The composition of a company’s Board of Directors shall be deemed to be controlled by another company if that other company by exercise of some power exercisable by it at its discretion can appoint or remove all or a majority of the directors;

(c) The expression “company” includes anybody corporate;

(d) “Layer” in relation to a holding company means its subsidiary or subsidiaries;

Company Includes Body Corporate:

• As per Sec 2(87) Company include a ‘Body Corporate’.
• As per Sec 2(11) body corporate includes a ‘Company incorporate out of India’.

Thus, an Indian company in which more than 50% shares are held by a foreign body corporate will be a ‘Subsidiary Company’.

Structure of a Holding Company

A simple holding company owns all the stock shares of at least one subsidiary. The shares of the holding company are owned by trusts or individuals. The holding company and subsidiaries each act as independent entities, with separate finances and bank accounts. They must enter into agreements with one another for assets and real estate. Often, one subsidiary serves to manage the holding company’s operations.

The Internal Revenue Code defines a personal holding company under two classification systems, which must be fulfilled to constitute this entity. These include:

• Personal Holding Company Income Test: The entity must possess at 60 percent or more of the adjusted ordinary gross income of the corporation in question for the associated tax year.
• Stock Ownership Requirement: At least 50 percent of the outstanding stock of the corporation must be owned by fewer than six individuals at any point during the second half of the associated tax year.

Benefits of Holding Companies

The holding company can own and control several companies, thus spreading its risk across markets and industries.

Holding companies reduce risk for the companies whose stock they hold by stabilizing the investment, making it more valuable. This attracts more buyers.

Risk management is enhanced by dividing assets across two or more companies. This allows liability to be limited to a single subsidiary, if it gets sued for example.

A product line can be sold or transferred easily and confidentially, without revealing trade secrets.

Subsidiaries that are completely owned by a holding company can be treated as pass-through tax entities. This eliminates the need to file a corporate tax return while maintaining limited liability.

Intellectual property (IP) can be licensed to several subsidiaries for various purposes.

An inter-company transactions list provides information on all transactions that have occurred between your company and your group entities.

Intercompany transactions arises when the unit of a legal entity has a transaction with another unit within the same entity. Many international companies take advantage of intercompany transfer pricing and other related party transactions to influence IC-DISC, promote improved intercompany transaction taxes, and effectively enhance efficiency within the company. Intercompany transactions can be essential to maximizing the allocation of income and deductions

An inter-company transactions list contains details of the transactions within your corporate group including payment of dividends, purchase and sale of assets (e.g. inventory or machinery) and any borrowing and lending.

Information that is covered:

• Transaction Details: Nature and the type of a particular transaction entered
• Dates: Start and end dates of each transaction
• Parties Involved: Names of the group entities involved in each transaction
• Transaction Value: The amount and status involved in each transaction
• Documentation: Documents and agreements that provide the evidence of each transaction.

Examples of intercompany transactions:

• Two subsidiaries
• Two departments
• Parent company and subsidiary
• Two divisions

Importance

Intercompany transactions can help improve the flow of finances and assets greatly. Transfer pricing studies can help ensure intercompany transfer pricing falls within arm’s length pricing to help avoid unnecessary audits. Intercompany transactions accounting can help keep records for resolving tax disputes, especially in countries where the markets are new and there is little or no regulations governing related party transactions. Here are few areas affected by the use of intercompany transactions:

• Sales and transfer of assets
• Loan participation
• Dividends
• Transactions with member banks and affiliates
• Insurance policies
• Management and service fees

Pros of addressing Inter-Company Transactions

• Facilitate transparency and provide real-time information on your inter-company transactions.
• Create consolidated and accurate financial statements and avoid any misrepresentation of your company’s financial position.
• Implement uniform accounting and treatment policies and procedures for inter-company transactions.
• Comply with tax norms and regulations related to inter-company transactions across jurisdiction.
• Mitigate any potential for disputes between your company and its entities as each transaction is documented.

Any transaction between affiliates of a company group requires elimination, including:

• Unrealized gain in ending inventory due to intercompany sale of above-cost inventory not later sold to third parties prior to year-end.
• Elimination of equity in company acquisitions: When one company acquires another company, only the acquirer’s share of the shareholders’ equity of the acquired company is eliminated through consolidation in the equity section of the consolidated financial statements.
• Unrealized gain due to intercompany sales of fixed assets above net book value: Such sales are only internal transfers of assets and no gain or loss should be recognized.

Intercompany loans: When one group company makes a loan to another affiliated company, there are several items that have to be eliminated on both sides:

• Loans receivable and loans payable;
• Interest income and interest expense; and
• Interest payable and interest receivable.

Elimination of intercompany profits: Any intercompany profit or loss on assets remaining within the group must be eliminated and only profits and losses from third-party transactions should be included in the consolidated statements.

An interim dividend is a dividend payment made before a company’s annual general meeting (AGM) and the release of final financial statements. This declared dividend usually accompanies the company’s interim financial statements. The interim dividend is issued more frequently in the United Kingdom where dividends are often paid semi-annually. The interim dividend is typically the smaller of the two payments made to shareholders.

The holding company may receive interim dividend from the subsidiary company; if such an interim dividend is to be apportioned between pre-acquisition period and post-acquisition period, it should be assumed that the interim dividend has been earned evenly throughout the year.

Proposed Dividend:

On the liabilities side of the balance sheet of the subsidiary company, proposed dividend may appear. Unless the facts of the case point otherwise, it should be assumed that proposed dividend is out of post acquisition profits. Hence, holding company’s share of proposed dividend will be added to the holding company’s Profit and Loss Account whereas minority shareholders’ share will be added to minority interest.

Dividend received by the holding company from its subsidiary out of pre-acquisition profits is treated as capital receipt; the journal entry for its record being as follows:

Bank	Dr.
To Shares in Subsidiary Company

The following points will highlight the three steps for payment of interim dividend.

(a) First, total amount of interim dividend (i.e.,% of dividend on Subsidiary’s Co.’s Share Capital) should be added with the current profit;

(b) Deduct subsidiary’s share of interim dividend from Minority Interest.

(c) Deduct Holding Company s share of interim dividend from Profit and Loss Account of holding company in the liability side of the Consolidated Balance Sheet.

In the consolidated books, the following entry will be passed:

Finance Income……….Dr.

To, Retained Earnings

(Amount of dividend paid by the subsidiary company to its parent entity)

Current Tax……………..Dr.

To, Retained Earnings

A revaluation of fixed assets is an action that may be required to accurately describe the true value of the capital goods a business owns. This should be distinguished from planned depreciation, where the recorded decline in value of an asset is tied to its age.

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.

Fixed assets are held by an enterprise for the purpose of producing goods or rendering services, as opposed to being held for resale for the normal course of business. An example, machines, buildings, patents or licenses can be fixed assets of a business.

The purpose of a revaluation is to bring into the books the fair market value of fixed assets. This may be helpful in order to decide whether to invest in another business. If a company wants to sell one of its assets, it is revalued in preparation for sales negotiations.

Reasons for revaluation

It is common to see companies revaluing their fixed assets. It is important to make a distinction between a ‘private‘ revaluation and a ‘public‘ revaluation which is carried out in the financial reports. The purposes are varied:

• To show the true rate of return on capital employed.
• To conserve adequate funds in the business for replacement of fixed assets at the end of their useful lives. Provision for depreciation based on historic cost will show inflated profits and lead to payment of excessive dividends.
• To show the fair market value of assets which have considerably appreciated since their purchase such as land and buildings.
• To negotiate fair price for the assets of the company before merger with or acquisition by another company.
• To enable proper internal reconstruction, and external reconstruction.
• To issue shares to existing shareholders (rights issue or follow-on offering).
• To get fair market value of assets, in case of sale and leaseback transaction.
• When the company intends to take a loan from banks/financial institutions by mortgaging its fixed assets. Proper revaluation of assets would enable the company to get a higher amount of loan.
• Sale of an individual asset or group of assets.
• In financial firms revaluation reserves are required for regulatory reasons. They are included when calculating a firm’s funds to give a fairer view of resources. Only a portion of the firm’s total funds (usually about 20%) can be loaned or in the hands of any one counterparty at any one time (large exposures restrictions).
• To decrease the leverage ratio (the ratio of debt to equity).

Methods

Appraisal Method

In this method, the technical valuer does a detailed assessment of the assets to find out the market value. A complete assessment is required when the Co. is taking out an insurance policy for fixed assets. In this method, we should ensure that the fixed assets not over/undervalued.

• Date of purchase of fixed assets for calculating the age of fixed assets.
• Usage of Assets such as 8 hours, 16 hours, and 24 hours (Generally 1 Shift = 8 Hours).
• Type of assets such as Land & Building, Plant & Machinery.
• Repairs & Maintenance policy of the enterprise for fixed assets;
• Availability of Spare Parts in the future.

Current Market Price Method

As per the prevailing market price of assets.

Plant and Machinery: Forgetting the fair market value of plant and machinery, we can take the help of the supplier.

Revaluation of the Land & Building: For getting the fair market value of the building, we can take the help of real estate values/ property dealers available in the market.

Indexation Method

In this method, the index does apply to the cost of assets to know the current cost. Index list issued by the statistical department.

Advantages

• To negotiate a fair price for the assets of the entity before the merger with or takeover by another company.
• If assets revalued on the upward side, this will increase the cash profit (Net Profit plus Depreciation) of the Entity.
• The credit balance of revaluation reserve can be used for the replacement of fixed assets at the end of their useful lives.
• Tax Benefit: It results in an increase in the value of assets; hence the amount of depreciation will increase and thereby resulting in income tax deductions.
• To decrease the leverage ratio (Secured Loan to Capital).

Disadvantages

• The total depreciation charged on fixed assets revaluation does not show a regular pattern.
• The company could not revalue its fixed assets every year, or the cost of the fixed asset may not decline. In such a situation, depreciation could not be charged by the company.
• The company does spend much amount on revaluation of fixed assets as this work takes assistance from technical experts, and an increase in expenses results in less profit.