As private companies in Canada get closer to presenting their first financial statements under the Accounting Standards for Private Enterprises ("ASPE"), there are a number of policy changes companies need to consider.
Section 1500 of Part II of the CICA Handbook on Accounting Standards for Private Enterprises deals with first-time adoption of ASPE. This section provides a very unique opportunity for private enterprises to measure any item included in property, plant and equipment at its fair value, as opposed to its historical cost which was the standard under the former CICA Handbook. This article examines the election companies can make to record their capital assets at fair value, looking at the actual application of making this election, as well as the pros and cons of doing so.
When a company adopts ASPE for the first time it is required to prepare comparative financial statements for the previous year. The accounting policies must be consistent for both periods, which means the date of revaluing is the beginning of the previous year. For example if a company is applying ASPE for the first time on their financial statements for the year ended December 31, 2011, then January 1, 2010 would be the date when the capital assets are to be revalued (the date of transition).
This obviously makes revaluing assets a little trickier as the company must ascertain what the fair value was at the date of transition as opposed to the current fair value. Section 1500 allows the company to make these estimates provided they are based on the conditions that existed at that date.
Once fair value for the asset has been determined, this figure becomes the deemed cost of the asset. An election made by a company under this section indicates that the fair value is greater than the carrying cost, so an entry must be made to increase the value to the asset. The offsetting credit is made to retain earnings. The gain in asset value is not reflected anywhere on the income statement.
If a company does decide to revalue certain assets, then additional disclosures are required. Specifically a company must disclose which assets have been revalued as well as the resulting change made to retained earnings. Additionally the company must prepare a reconciliation of the prior year net income reported under the former standards as compared with the net income reported under the current standards.
The adjusted cost base and capital cost allowance will not change as a result of making this election. The only potential tax effect is that retained earnings will have increased, which means the company will have higher taxable capital. Some small business deductions use taxable capital as the eligibility factor, so it is important to assess this before making the election.
Here's a look at the pros and cons of making this election:
- More accurate financial statements
One of the major drawbacks to recording capital assets at their historical value has always been accuracy. This is especially true for real property which has a tendency to increase in value over time. This increase is not captured in the financial statements if using the historical cost method of valuing assets. Furthermore, if the property is depreciable (i.e. buildings) then the assets will actually decrease in value as a result of the amortization taken each year. By assessing the fair value of the property a company has the opportunity to present a more accurate picture.
- Access to increased financing
When companies borrow funds from financial institutions, the loans are generally secured by assets, whether specifically pledged as collateral or under a general security agreement. By increasing the value of certain assets, a company may be able to secure additional financing from lenders. It should be noted however that if a lender has properly assessed the company, then chances are they have already considered the actual value of assets as opposed to the recorded amount. If this is the case then changing the value on the balance sheet will have no effect.
- Improved balance sheet
By increasing the value of existing assets, a company is presenting a healthier balance sheet simply through a change in accounting policy. This may help a company when looking for additional investment, or bidding on contracts. Companies should exercise caution if this is the sole reason for electing to revalue however. If someone investing in a company or awarding contracts has properly assessed your company, then this change is not likely to alter their decision-making process.
- Increase in depreciation expense
While increasing the value of assets will strengthen the balance sheet, it will have a negative effect on future earnings. By raising the value of depreciable assets, the amortization taken on an annual basis will also have to be increased.
- Cost of valuing assets
Every decision a company makes requires some form of cost-benefit analysis. Assessing the fair value of capital assets can be quite difficult in some cases and the company may have to hire an outside consultant to ascertain the value of a particular asset. The fact that the value has to be determined as of the transition date as opposed to the current date only increases the complexity of this task.
- Potential for a future write-down if circumstances change
Capital assets are required to be written-down if circumstances change and their fair value drops below their carrying value. While this rule still applies to companies that do not elect to revalue, increasing the value of assets will always increase the risk of a future write-down as well. If the assets fair value fluctuates regularly, than it might be a better option to leave it at its historical value.
While the opportunity to increase an asset's value initially seems like an obvious choice, there is no guarantee that doing so will provide any additional benefit in future operations, it is quite possible that the only change ends up being increased amortization and another consulting expense. It is recommended that companies considering this election consult not only their accountant but also the individual users of the financial statements. If the reason for making the election is to increase the credit limit, then meeting with the lender and finding out what the effect would be is the most relevant information in making the decision.