Revalue of Extraordinary Value

This time last year the Antwerp diamond sector was all abuzz about the proposed ‘amnesty’ (sorry, I must not call it that) whereby diamond companies and sole traders would be allowed to revalue up their inventories.  In order to avoid reporting profits over the years, diamond companies were devaluing their inventories each year to the extent that in some companies the book value was less than 50% of the real value.

Experts were brought in to lecture on the benefits of the revaluation such as more equity for the banks and stronger balance sheets for the sightholders.

The main conditions of the revaluation were a 4.5% one time tax on the revalued amount to be paid in December 2006 and the revaluation amount put in a reserve that cannot be distributed for 10 years.  Many companies took advantage of this and the more astute overvalued their inventory to avoid paying taxes in future years.

Now with hindsight, the banks are still not sure how to treat the revaluation reserves for Basel 2 and a revaluation reserve that does not go through the profit and loss account is of less use to the sightholders.  In fact, the 4.5% tax charge shows up as an expense, while the revaluation does not go through the profit and loss account so performance deteriorates.  And the 4.5% was from retained profits, so it actually was more like 6.5%.

Those Belgian diamond companies with good tax structures are able to bring in profits from overseas subsidiaries at much lower tax rates than 4.5% and, unlike the revaluation reserve, benefit from distributions and subsequent notional interest.

But what about the accounting treatment?  If for example ABC Ltd revalued its $30m inventory up by $20m, it would have paid tax of $900k. If ABC had sales of $200m, gross profit of $15m and expenses of $5m and $0.1m tax, its P & L would look like this.

The revaluation would have been disclosed in the financial statements with the note to the accounts that this treatment was not compliant with IFRS which does not allow revaluations upward and has also moved away from extraordinary and exceptional items.

Even though the DTC has claimed that it will not use the financials other than for verifying that sales were more than $30m, some sightholders brought the revaluation surplus into the P&L  in an even more non-IFRS manner: 

As its name implies, an extraordinary item is ignored when analysing financial statements, and the DTC’s reporting template no longer has a separate line for it.  Technically speaking, it is more of an exceptional item than an estraordinary item, but in either case the treatment is incorrect. And, if you are going to pump up your profit from $9m to $29m you may as well invite Kroll Associates to investigate you before the DTC sends them in!

Now, if you are going to deviate from IFRS and haved a good accountant and an agreeable auditor you could justifiably claim that the revaluation was a correction to the cost of goods and that it should be written off to the P & L over the duration of the 10 year freezing of the revaluation reserve.  And on the same basis you could spread the tax charge over the same period and put the timing difference in the balance sheet.  Now ABC has a much better P & L: 

$11.8m looks a lot better than $9m and the gross profit ratio has improved from 7.5% to 8.5%, but you need a good accountant to do this……………

socrates@diamondfinance.info