What is Revaluation Reserve?
A revaluation reserve is a non-cash reserve created to reflect the true value of the asset when the market value of a certain category of asset is more or less than the value of such asset at which it is recorded in the books of account. Any increase or decrease in the value will be adjusted through a revaluation reserve journal entry.
This reserve’s purpose is to reflect and account for, in the books, the real and fair value of an asset. It is expressly excluded from free reserves; hence, this reserve is not available to distribute dividends to shareholders. This reserve is generally created when the underlying asset’s value is experiencing fluctuations due to currency relationships.
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Revaluation Reserve Explained
A revaluation reserve is an account created by companies to account for the fluctuations of a long-term asset. The increase in value of the asset is credited to the reserve account. Inversely, a fall in the value of the asset results in a debit from the reserve account.
These revaluation reserve accounts are not very common among companies. However, they are used when the company finds that the value of the asset might fluctuate beyond the pre-determined schedules. It is usually based on the depreciation schedule of the asset. The increase and decrease in this account are based on the estimates of the asset’s fair value.
The essence of the revaluation reserve account, as it can be appreciated from the above discussion, is reflecting the right and fair value of the asset even in case of upward adjustments to its value. Since accounting for an upward adjustment in the value of an asset is not an average gain, the same cannot be recognized as income but is shown under the Revaluation Reserve account, and any subsequent downward adjustment will reduce this account accordingly.
Hence, this account ensures that the income statement is undisturbed by changes in the asset value during the asset’s lifetime. The loss on the asset’s sale will be recognized in the income statement only after adjusting it against the revaluation reserve; profit, if any, is recognized in the income statement.
Let us understand the formula to calculate the value of the asset before passing the revaluation reserve journal entry. This shall act as a basis for our understanding of all related concepts as well.
Revaluation Reserve = Asset’s Market Value – Asset’s Book Value
How To Calculate?
Let us understand how to calculate the value from a revaluation reserve account through the discussion below.
Revaluation reserve is created out of changes in the value of specific categories of assets. Any increase in the value of an asset from the value recorded in books will increase the reserve and vice versa. Depending on the accounting policy followed, there are different methods of valuing the asset on the revaluation date. IndexationIndexationIndexation is a method of adjusting the purchase price of an investment (bonds, debentures, or any other asset class) to account for the effect of inflation over the investment term, lowering the capital gain and reducing taxable income. and the Current Market Price method are the most commonly used methods.
The frequency of revaluation depends on the changes in the asset’s fair value. Suppose the fair value of the asset changes materially from the carried value. In that case, the revaluation of the asset is appropriate, and it is done using the proper method depending on the asset class.
The increase or decrease in an asset’s value needs to be accounted for diligently to avoid confusion or potential losses in reporting. Let us understand how to provide accounting treatment and pass revaluation reserve journal entries through the discussion below.
- A revaluation reserve account is credited when the asset’s market value exceeds its historical value in the books and vice versa.
- Revaluation of assets differs depending on the accounting policy followed, namely US GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting. and IFRS. The method of revaluation followed under these two policies differs in the following manner.
- US GAAP follows Cost Model for valuing fixed assets where it is generally carried at historical cost less accumulated depreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet.. Any downward adjustment due to impairment loss is only accounted for, and upward adjustments are ignored. There is no revaluation reserve account, and the downward adjustment, which impairment of assetImpairment Of AssetImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company's income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable., directly reduces the value of an asset. The loss is recognized in the income statement.
- IFRS follows the Revaluation model, where both upward and downward adjustments to the asset’s value are reflected under these accounts. In case of disposal of an asset being revalued, if sold at a profit, the amount standing in the asset’s revaluation reserve is transferred to the General ReserveGeneral ReserveGeneral reserve is the amount kept aside from the profit earned by the company during its normal course of the operation to meet future needs like contingencies, strengthening the company’s financial position, increasing working capital, paying dividends, offsetting specific future losses. account. Once the same is transferred to the General Reserve account, it is available to distribute dividends Dividends Dividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.to shareholders.
- If the asset is sold at a loss, any amount in reserve is reduced to the extent of the damage. Balance, if any, in the revaluation reserve is transferred to the General Reserve account
Revaluation Reserve Vs Capital Reserve
Let us understand the differences between maintaining a revaluation reserve account and a capital reserve account through the comparison below.
- The primary difference is that the revaluation reserve is created to account for an increase/decrease in the value of certain assets. The capital reserve is created to finance future projects for business expansion or meet unforeseen business exigencies. Capital reservesCapital ReservesCapital reserve is a reserve that is formed from the company's profits earned from its non-operating activities during a period of time and is retained for the purpose of financing the company's long-term projects or writing off its capital expenses in the future. are created out of non-operational activities like profit arising out of the sale of fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples., sale of investments, issue of shares at a premium, etc.
- Certain profits are required to be disclosed under capital reserve like share premiumShare PremiumShare premium is the difference between the issue price and the par value of the stock and is also known as securities premium. The shares are said to be issued at a premium when the issue price of the share is greater than its face value or par value. This premium is then credited to the share premium account of the company. (shares issued at a premium). In contrast, certain profits may transfer to the Capital reserve at the discretion of the management, like profit on the sale of fixed assets or investment. In contrast, revaluation reserve is created out of an increase in the value of the assets compared to their recorded value in the books.
- Capital reserves are carried in the Balance Sheet until future projects are financed or to finance the unforeseen business exigencies. In contrast, revaluation reserves are carried in the Balance Sheet until the asset is discarded.
- Understanding the similarities between the two will also lighten the characteristics of the two reserves. One of the similarities between the two reserves is that both the reserves are not created out of profits from normal business operationsNormal Business OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.. Hence, both these reserves cannot reflect the company’s operational efficiency.
Revaluation Reserve Vs Revaluation Surplus
Although both these reserves are often confused with one another due to similarities in their names, there are differences in their fundamentals and implications. Let us understand them through the comparison below.
- Revaluation surplus is the amount remaining after adjusting for loss or discarding the revalued asset. The revaluation surplus is transferred to the General Reserve account, which is then available for distribution to shareholders as a dividend. Hence, the revaluation surplus arises only after the discarding of an asset
- Revaluation reserve is the upward and downward adjustment of an asset’s value, depending on the material changes in the asset’s value. This reserve is not available for the distribution of dividends to shareholders.
This article has been a guide to what is Revaluation Reserve. Here we explain its account treatment, how to calculate, and compared it with reserve surplus. You may learn more about financing from the following articles –