Financial Asset Valuation Methods

The field of accounting has several areas where differing principles have to be applied in order to achieve an accurate assessment of both the performance as well as financial position of the organization in question. One such area regards the valuation methods adopted for the different assets owned by the organization. The major valuation methods available for use in accounting include the historical cost method, the fair value method, the current cost method, current purchasing power method and the net present value method (Accounting concept and conventions, 2010, par3). All these methods have their merits and demerits but even more importantly, they are certain circumstances which demand their application. This paper looks at the historic cost accounting, fair value accounting and current cost accounting. It performs a critical analysis of the methods’ suitability in application and also assesses the extent to which the different methods are utilized in normal financial reporting practice.

Historical accounting of assets basically entails the use of the specific amount of the cost incurred in acquiring an asset. Here, the records of acquisition constantly guide the valuation of the cost in the balance sheet of the company. The amount paid for during purchase of the asset is not adjusted for inflation. Consequently, this method does not portray any changes which may occur overtime to affect the valuation of the asset (Krumwiede, 2008, par4). Under the Generally Applied Accounting Principles applicable in most developed nations, there is the requirement that financial statements should be prepared in accordance with the values which the company pays for rather than the fair market value of the asset (Business Definition for: historical cost accounting, 2010, par6).

In applying this method practically, the cost of an asset can is only adjusted for elements such as depletion, amortization, impairment and depreciation. Consequently, if a company bought equipment in the year 1990 at a value of £1 million, then the entry in the balance sheet remains the same £1 million over the years but adjusted by depreciation meaning that, the net figure may reduce over time due to depreciation element but not revaluation. However, is should be noted that these adjustments are guided by an elaborate set of rules and regulations. Indeed in the current accounting practice across the world almost all tangible assets as well as stocks are valued using the historical cost method. Intangible assets such as goodwill are exempt from this requirement mainly due to the fact that goodwill is purely based on the current status. However, there is an emerging trend introduced by the adoption of the International Accounting Standards which encourage the use of fair values in countries such as the US.

The two most visible advantages of the historical costing method are that it is simple and certain. The method is simple in the sense that no major valuation processes are required in determining the value of an asset. Only the records documenting the purchase price are required to authenticate the value of the assets. Adjustments for depreciation and amortization are performed in accordance to established procedures making the method simple (Williamson, 2003, par6). Again, the element of certainty also emerges from the fact that figures used in this method are highly objective and beyond manipulation. This is in recognition of the fact that companies do not have the ability engage in malpractices with the intention of boosting its asset portfolio fraudulently in order to boost share valuations by duping investors. The method significantly reduces the ability of companies engaging in creative accounting.

Evidently, the valuation method has visible flaws and limitations. They mainly emerge from the fact that the valuation method disregards changes which may have occurred both within and without the company. Elements such as inflation are not adjusted meaning that if the company operates in an economic environment characterized by high inflation, then there are possibilities of significant overvaluation of the company’s assets which may reverse the gains made in preventing creative accounting.

Fair valuation of assets on the other hand entails rational estimations of the potential worth of the assets in full consideration of the current relevant factors. These factors could be objective or subjective. Some objective factors include the cost of substitutes or the cost of replacing the asset and the current forces of demand and supply likely to influence pricing. Subjective factors on the other hand entail the returns expected from utilizing the asset, elements of risk associated with the asset and the prevailing perceptions of the assets utility (Securities Industry Association, 2002, par5). More generally, the fair value represents the current worth of an asset. It represents how much an asset is likely to be sold or bought by willing parties currently except in cases of liquidation. Clearly, this method requires the inclusion of experts who are trained and able to quantify the relevant factors and come up with an accurate figure of how much the asset is worth. It is also commonly called the ‘mark-to-market’ accounting. This valuation method is ideally applied in cases of take over and mergers (Chasan, 2008, par4). The intention is to ensure that the new investor gets good value for their money. They are able to compare the true worth of their investments and the resources they are willing to employ in acquiring the assets (Ryan, 2010, par3).

In the case involving a company’s equipment described above, it is clear that the historical cost is recorded throughout in the balance sheet. However, if the company intends to sell the equipment, a fair value would have to be arrived at taking to consideration, the usefulness of the equipment, the availability of market for the equipment and the returns likely to be obtained from the use of the equipment in addition to other factors. In a case where the item is highly useful and on high demand, the value is likely to surpass the adjusted historical cost significantly.

The main advantage of the fair value is the fact that it takes to consideration the market conditions hence investors are able to make more accurate decisions based on up to date data as reflected by the fair values. It is indeed a more accurate representation of the current financial position and offers better comparability than the historical methods (PriceWaterHouseCopers, 2010, par3).

On the other hand, the subjective nature of the valuation method is prone to manipulation by companies key on fraudulently raising the company’s stock valuations by misinforming investors. Due to its complex nature, the method presents loop holes for creative accounting. In fact the valuation method has been linked to historical collapse of companies such as Enron which were perceived as strong as per the asset valuations.

Again, at different times different information is used to determine the asset values. This introduces inherent inconsistencies likely to hinder comparability of financial reports produced by the company. Consequently, the application of this valuation method is mostly applied for use by investors whose interest is on the current valuations rather than historical costs. Sections of the US and the UK are slowly adapting to the method though the aftermath of the financial crisis has exposed the inability to arrive at a true fair value of asset as conditions could change drastically.

Current cost accounting can be said to be at the middle of historical costing and fair value costing. It involves valuing assets at their current market prices. This valuation method unlike the fair value method applies to assets with an identifiable market. It is also called replacement cost accounting due to the fact that it utilizes the cost which would be incurred if the said asset was to be replaced. Elements of inflation are fully taken care of in this model of accounting. This is in addition to other adjustments such as inflation and amortization (Schempf, 2010, par6).

. The concept was introduced in the 1980s through the standard (SSAP 16, 1980) in the UK. However, consistent non-compliance by companies saw the rule become voluntary and was withdrawn by 1988. The main reasons for non-compliance arose due to the fact that the UK has historically low inflation rates meaning that the differences arising from the valuation method were minimal in addition to an unfavorable change in government policy concerning the use of the method in accounting. In an economy experiencing a high inflation rate, the use of the historical cost is likely to be grossly misleading due to the resultant undervaluation. This necessitates the adoption of a formula to constantly update the cost in line with inflationary pressures. If equipment cost £1 million in 1990 and the inflation rate was 15%, then the recorded figures in 1991 should be:

  • 115%*1000000=1115000

This figure should continue rising in the consecutive years and should be adjusted for depreciation. However, regulated utility companies in the UK such as regional electricity companies and British Gas continue to use this valuation method despite the lack of popularity.

According to experts, the use of the current cost accounting method is well applicable in the regulation of state owned businesses. The argument is that the current cost is the cost likely to be faced by any new entrant in the industry of concern. This being the case, operating profits obtained through the current cost method would be more useful in determining the real rate of return for the government enterprise. The real rate of return on the other hand if compared with the real interest rate in the economy would help determine whether the state enterprise makes inadequate, reasonable or excessive returns (Kirkman, 1976, par4).

Also, in countries experiencing hyperinflation (inflation rates of above 100%) then the current cost measures are the only reasonable measures likely to represent the true financial standing. Such cases do not mean a departure from the historical method but rather an attempt to ensure accuracy in representation in the face of extreme conditions (Whittington, 1994, par2-5).

As mentioned above, the main problem with the valuation method is the fact that, in economies of low inflation rates, it is not economically viable to conduct the current cost valuations since the resultant differences may be very marginal and not worth the effort. Consequently, its current application is limited to utility companies in the UK (Current cost accounting. 2010, par4).

In conclusion, the valuation methods discussed above are useful in different circumstances. The Historical method is the traditional method of asset valuation and remains the most widely applied method. It is simple and highly certain hence the most preferred as it presents fewer problems to authorities as well as investors due to its simplicity and certainty aspects. It informs the book value recorded in the book of accounts and the balance sheet especially for long-term tangible assets. The fair value on the other hand values assets taking to full consideration all the factors which could affect the value. It is not only a realistic approach to accounting but also presents a more accurate, factual and reliable presentation of the financial position of a company. However despite these great advantages, the method is not utilized widely mainly due to its subjective nature which presents opportunities for crafty accountants to untruthfully boost the values of assets way beyond the actual values in a bid to present better performance to authorities and investors despite the fact that these valuations are rarely sustainable. The current cost or inflation accounting is the least applicable asset valuation method. It simply values assets at their replacement values as informed by the market prices. In current accounting practice, the relevance of this valuation method is mainly limited to public utility companies in the UK. Clearly, each valuation method has its usefulness in the accounting practice as it addresses the elements which are not addressed by the other method by employing a different approach.

Reference List

Accounting concept and conventions, 2010. Tutor2u. Web.

Business Definition for: historical cost accounting, 2010. Web.

Chasan, E. 2008. Is fair value accounting really fair? Web.

Current cost accounting. 2010. Money terms. Web.

Kirkman, P. 1976. Current Cost Accounting. Managerial Finance. Vol. 2(1).

Krumwiede, T. 2008. Why historical cost accounting makes sense. Web.

PriceWaterHouseCopers, 2010. Point of view: Fair value accounting.Web.

Ryan, S.2010. Fair Value Accounting: Understanding the Issues Raised By The Credit Crunch.Web.

Schempf, N. 2010. Full Cost Accounting. Web.

Securities Industry Association. 2002. Explanation and Benefits of Fair Value Accounting. Web.

Whittington, G. 1994. Current Cost Accounting: It’s Role in Regulated Utilities. Fiscal Studies vol. 15(4), pp. 88-101. Web.

Williamson, D. 2003. Brief Notes on Historical Cost Accounting. Web.

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