Revaluation reserves (or, more precisely, revaluation surplus reserves) arise when the value of an asset becomes greater than the value at which it was previously carried on the balance sheet, increasing shareholders funds . Not every increase in value is added to the revaluation reserve, and the exact treatment depends on the history of the asset: in particular whether it has been impaired.
Fair value accounting requires that revaluations are carried out whenever there is a material difference between the current market value of an asset and the value at which it carried on the balance sheet. This principle is should be applied strictly to assets such as land and investments in which a market exists, or for which a fair value can be calculated. For practical reasons, and to keep the accrual principle effective, IFRS permit plant and equipment to be simply carried at the depreciated value.
The gain from a revaluation is called a surplus. It is not usually a profit because it is not taken through the profit and loss account and recognised as a profit. This is not prevent profits being distorted by one-off gains, obscuring trends in the business itself. A reduction in the value of an asset on revaluation (a deficit) is usually a loss.
The surplus on a revaluation is not always added to the revaluation reserve. Where it reverses a previous impairment, the impairment is reversed, but any surplus in excess of the amount of the impairment is added to the revaluation reserve. Where an impairment is reversed, this is a profit, as it is necessary to reverse the loss from the impairment.
Similarly, a deficit on revaluation is first used to reverse any previous surplus (reducing the revaluation reserve), with the excess over that treated as any other impairment and taken through the P & L as a loss.
Revaluation reserves are not distributable, but may be used for scrip issues and may change their nature in re-organisations of capital.