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Q11-14IFRS

Expert-verified
Intermediate Accounting (Kieso)
Found in: Page 609

Short Answer

Companies following international accounting standards can revalue fixed assets above the assets’ historical costs. Such revaluations are allowed under various countries’ standards and the standards issued by the IASB. Liberty International, a real estate company headquartered in the United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty’s stockholders’ equity.

Liberty International

Completed Investment Properties

Completed investment properties are professionally valued on a market value basis by external valuers at the balance sheet date. Surpluses and deficits arising during the year are reflected in the revalution reserve.

Liberty reported the following additional data. Amounts for Kimco Realty (which follows GAAP) in the same year are provided for comparison.

Liberty

(pounds sterling, in thousands)

Kimco

(dollars, in millions)

Total revenues

£ 741

$ 517

Average total assets

5,577

4,696

Net income

125

297

Instructions

  1. Compute the following ratios for Liberty and Kimco.
    1. Return on assets.
    2. Profit margin on sales.
    3. Asset turnover.

How do these companies compare on these performance measures?

  1. Liberty reports a revaluation surplus of £1,952. Assume that £1,550 of this amount arose from an increase in the net replacement value of investment properties during the year. Prepare the journal entry to record this increase.
  2. Under U.K. (and IASB) standards, are Liberty’s assets and equity overstated? If so, why? When comparing Liberty to U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above?

Answer

Based on return on assets (ROA), Kimco is performing better than Liberty. Relative to GAAP, an argument can be made those assets and equity are overstated. ROA of Liberty increases to 3.45%.

See the step by step solution

Step by Step Solution

Step 1: Meaning of Ratio Analysis

Ratio analysis is a basic approach to assessing a company's health by examining the relationships between key financial indicators. According to many analysts, ratio analysis is the most important aspect of the analytical process.

Step 2: (a1) Computing Return on Assets

Calculating return on asset for Liberty

Calculating return on asset for Kimc

Step 3: (a2) Computing Profit margin on sales

Calculating profit margin on sales for Liberty

Calculating profit margin on sales for Kimco

Step 4: (a3) Computing Asset turnover

Calculating Asset turnover for Liberty

Calculating Asset turnover for Kimco

Kimco is outperforming Liberty in terms of return on assets (ROA). The fundamental reason for this disparity is a profit margin that is more than three times that of Liberty. While Liberty has a larger asset turnover (.13 vs.11), the smaller profit margin leads to only a 2.2 percent return on investment (ROI).

Step 5: (b) Preparing journal entry

Date

Particular

Debit (£ )

Credit (£ )

Investment Properties

1,550

Unrealized Gain on Revaluation

1,550

Step 6: (c) Explaining the adjustment

It is possible to argue that assets and equity are inflated in comparison to GAAP. The revaluation adjustment raises Liberty's asset values and equity in the item in (b) above. To make Liberty's reported figures comparable to those of a U.S. corporation like Kimco, you'd have to subtract the revaluation excess from Liberty's assets and equity.

For example, after adjusting Liberty’s assets downward by the amount of the revaluation reserve, Liberty’s ROA increases to:

This is still lower than Kimco’s ROA, but the gap is narrower after adjusting for differences in revaluation.

Note: Adjusting Kimco's assets to fair value is another technique to make Liberty and Kimco comparable. This method might be used to talk about the trade-off between relevance and accuracy in representation.

Most popular questions for Business-studies Textbooks

Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial reporting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2016.

Original cost $36million

Accumulated depreciation $10 million

Estimated remaining useful life 4 years

Estimated expected future

annual cash flows (not discounted) $4.0 million per year

Appropriate discount rate 5 percent

Accounting

  1. Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2016 and the book value at which Electroboy should report the five stores on its fiscal year-end 2016 balance sheet. Assume that the cash flows occur at the end of each year.
  2. Repeat part (a), but instead assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are $2,720,000 per year, and (3) the appropriate discount rate is 6 percent.

Analysis

Assume that you are a financial analyst and you participate in a conference call with Electroboy management in early 2017 (before Electroboy closes the books on fiscal 2016). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2017. Briefly discuss what implications this would have for Electroboy’s 2016 financial statements. Assume the same facts as in part (b) above.

Principles

Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting.

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