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ACCA Applied Skills · Financial Reporting · Limitations of interpretation techniques

Entity P measures its property at cost less depreciation. Entity Q, in the same sector, uses the revaluation model for property and has recently recognised a large revaluation surplus in other comprehensive income. Which comparison of the two entities' ratios is most likely to be distorted?

Gearing is the ratio most distorted. Entity Q's revaluation surplus raises its equity, lowering its debt-to-equity ratio, while P's cost-based property keeps equity lower. P therefore appears more highly geared even if the financing structures are identical.

  1. ACurrent ratio, because revalued property is a non-current asset
  2. BGross profit margin, because revaluation surplus is included in cost of sales
  3. CGearing calculated as debt/equity, because Q's revaluation surplus increases its equity and its asset base, which makes P's gearing appear relatively higherCorrect
  4. DInterest cover, because revaluation surplus is added to profit before interest

Explanation

A revaluation surplus is credited to equity, so Q's equity is higher than it would be under the cost model. Debt/equity is therefore lower for Q, making P look more highly geared for reasons of policy rather than financing. The surplus is in OCI, not in cost of sales or profit before interest, and the current ratio uses current items only.

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