Question

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?

Short answer

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%.

Step-by-step solution

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.

(a1) Computing Return on Assets

Calculating return on asset for Liberty

$\begin{array}{c}\text{Return\hspace{0.17em}on\hspace{0.17em}asset}=\frac{\text{Net\hspace{0.17em}income}}{\text{Average\hspace{0.17em}total\hspace{0.17em}assets}}\\ =\frac{\pounds 125}{\pounds 5,557}\\ =2.2\%\end{array}$

Calculating return on asset for Kimc$\begin{array}{c}\text{Return\hspace{0.17em}on\hspace{0.17em}asset}=\frac{\text{Net\hspace{0.17em}income}}{\text{Average\hspace{0.17em}total\hspace{0.17em}assets}}\\ =\frac{\$297}{\$4,696}\\ =6.32\%\end{array}$

(a2) Computing Profit margin on sales

Calculating profit margin on sales for Liberty

$\begin{array}{c}\text{Profit\hspace{0.17em}margin\hspace{0.17em}on\hspace{0.17em}sales}=\frac{\text{Net\hspace{0.17em}income}}{\text{Total\hspace{0.17em}revenues}}\\ =\frac{\pounds 125}{\pounds 741}\\ =16.9\%\end{array}$

Calculating profit margin on sales for Kimco

$\begin{array}{c}\text{Profit\hspace{0.17em}margin\hspace{0.17em}on\hspace{0.17em}sales}=\frac{\text{Net\hspace{0.17em}income}}{\text{Total\hspace{0.17em}revenues}}\\ =\frac{\$297}{\$517}\\ =57.4\%\end{array}$

(a3) Computing Asset turnover

Calculating Asset turnover for Liberty

$\begin{array}{c}\text{Asset\hspace{0.17em}turnover}=\frac{\text{Total\hspace{0.17em}revenues}}{\text{Average\hspace{0.17em}total\hspace{0.17em}assets}}\\ =\frac{\pounds 741}{\pounds 5,577}\\ =1.3\end{array}$

Calculating Asset turnover for Kimco

$\begin{array}{c}\text{Asset\hspace{0.17em}turnover}=\frac{\text{Total\hspace{0.17em}revenues}}{\text{Average\hspace{0.17em}total\hspace{0.17em}assets}}\\ =\frac{\$517}{\$4,696}\\ =1.1\end{array}$

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).

(b) Preparing journal entry

Date	Particular	Debit (£)	Credit (£)
	Investment Properties	1,550
	Unrealized Gain on Revaluation		1,550

(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:

$\begin{array}{rcl}ROA& =& \frac{NetIncome}{Averagetotalassets-RevaluationSurplus}\\ & =& \frac{125}{5,577-1,952}\\ & =& 3.45\%\end{array}$

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.