When any business enterprises purchases the building to conduct its business it deducts the depreciation ie cost 10 lacs and depreciation 1 lacs ie written off in 10 years
But @ the end of 10th year if we go in market to sell the building we may get 1 crore for that building
So how cum its possible that anything that looses its value over a span of time can be sold @ higher price ??
Land is also a component in this transaction. Land never depreciates. It may lose value due to real estate trends but its not considered to be a depreciating asset.
- Basic accounting principle is record assets and liabilities at historical cost. This means when you buy a Car capitalise the invoice amount of all that needs capitalisation.
- Any subsequent addition to fixed asset is treated as operating expenses (can be repairs and maintenance say) unless it’s going to increase the useful life of asset then it’s added to original cost of asset or capitalised.
- if there is no addition and deletion balance carried forward in balance sheet at cost price only. Management has discretion to revalue asset if they feel what is stated in balance sheet is under or over valued. But note it’s voluntary not compulsory.
- Depreciation is charged is for normal wear and tear, this is a reserve fund to meet the expenses once useful life is over. This means when car becomes non functional or too old one needs to keep aside some money on regular basis to meet the capital expenditure for new car.
The difference between market value of balance sheet and recorded value always differ in every company.
a. hence while valuing a company I use reproduction value of balance sheet (meaning the price a competitor has to pay for getting similar asset).
b. management generally doesn’t revalue asset upwards even in most of tangible assets are undervalued. The reason being : i) higher depreciation charges due to amended upward asset cost, this will increase profit and taxes too. ii) drags down asset ratios like ROA as proportionate increase in asset will be much higher than revised depreciation.
This is a challenging area to find underneath value of tangible asset. Intangible asset another black hole for another day.
Thnx for the detailed answer but can u xplain point 2 i.e. drags down asset ratio like roa…
Say Asset value-1000
Profit before depreciation: 300
Depreciation: 100 (10% on 1000)
Profit after depreciation- 200 (300-100)
Return on Assets- 200/100 or 20%
Now assume I revalue asset value to 2000
Profit before depreciation: 300
Depreciation becomes 200 (10% on 2000)
Profit after depreciation: 100 (300-200)
Return on assets will be 10% (100/1000)
There are other issues as well like revaluation value is kept as revaluation reserve which is not a free reserve. This means you cant use the reserve for purpose like capital allocation (say bonus can’t be issued against revaluation reserve).
Revaluation takes place if you need to bolster balance sheet (say you want loan).
A reading of GAAP will help further.
Ok thanks once again for ur detailed answer but my question is for building and ur 1st answer is based on car
What i m trying to say is that for car it is much known that a 10 lacs car will not earn more than 50 k or 70 k after 10 years
But the same building will earn 1 crore after 10 years how’s that possible
Building can be both over valued or under valued depending on specific case.
If you have bought a building in 1970 for 1000 in Bandra the valuation now could have manifolded. Real estates revaluation is largely due to location of land in which building is situated.
But there can be other inference. If you are looking for a specific company you have to spell out the details of revaluation.
In point 1, I think you meant to say, net profit will decrease as the depreciation will increase due to revaluation.