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ACCA Applied Knowledge · Financial Accounting · Importance and purpose of analysis of financial statements

An analyst compares the return on capital employed of two retail companies, Alpha and Beta, and concludes that Alpha is better managed. Alpha revalued its freehold properties last year, while Beta carries its properties at historical cost. Which statement best describes a limitation affecting this comparison?

Different accounting policies limit comparability. Alpha's revalued properties increase its asset base and capital employed, and depreciation rises, so its ROCE tends to be lower than Beta's historical-cost figure. The comparison therefore may understate Alpha's performance. The revaluation surplus is in other comprehensive income, not profit.

  1. AAlpha's higher carrying amounts for assets will tend to lower its ROCE, so the comparison may understate Alpha's performance relative to BetaCorrect
  2. BRatios can only be calculated for companies that use the same reporting date, so no comparison is possible
  3. CRevaluation has no effect on ratios because property values are excluded from capital employed
  4. DAlpha's revaluation will raise its ROCE because profit is increased by the revaluation surplus

Explanation

Different accounting policies (revaluation versus historical cost) reduce comparability. Revaluation increases asset values and therefore capital employed, which tends to reduce ROCE, and it also raises depreciation, reducing profit. So Alpha's ROCE is likely understated relative to Beta. The option claiming a revaluation surplus increases profit is wrong, because the surplus goes to other comprehensive income, not profit or loss.

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