Positive Acct Theory

The Debt / Assets hypothesis

The effect of adopting the revaluation model is to increase the entity’s assets and equities. Hence, entities which need to report higher amounts in these areas would consider adoption of the revaluation model.

For example, entities which have debt covenants generally have constraints relating to their debt-asset ratio e.g. the debt-asset ratio must not exceed 50%. Hence, for an entity with increasing debt, adoption of the revaluation model for a class of assets which is increasing in value will ease pressure on the debt-asset ratio by increasing the asset base of the entity, providing, of course, that the debt covenant allows revaluations to be taken into account in measuring assets.

The political cost hypothesis

The incentives for entities to adopt fair value measures, then, tend to be entity-specific because of pressures placed on the entities relating to external circumstances.

For example: an entity’s reported profit figure may be under scrutiny from a specific source, such as a trade union seeking reasons to support claims for higher pay, or regulators looking at monopoly control within an industry.

Conclusion

Where there are pressures to report lower profits, adoption of the revaluation model provides scope of higher depreciation charges with increases in the value of non-current assts not affecting the income statement. With lower reported profit and a higher asset/equity base, any judgment made by reviewing ratio such as rate of return on assets or equity will result in the entity being seen in a less favorable light. (Company Accounting – Ken Leo, John Hoggett – Page 189 and 190)