The following points highlight the top four valuation concepts of assets. The concepts are: 1. Historical Cost 2. Current Entry Price (Replacement Cost) 3. Current Exit Price (Net Realisable Value) 4. Present Value of Expected Cash Flows.
Valuation Concept # 1. Historical Cost:
Cost has been the most common valuation concept in the traditional accounting structure. Assets are generally recorded initially on the basis of the exchange prices at which the acquisition transactions take place. They are then presented in financial statements at this acquisition cost or some unamortized portion of it.
Therefore, cost is the exchange price of goods and services at the time they are acquired. When the consideration given in the exchange consists of non-monetary assets, the exchange price is determined by the current fair value of assets given up in the exchange. Cost is thus the economic sacrifice expressed in monetary terms required to obtain a specific asset or a group of assets.
Very often cost is not represented by a single exchange price, but it includes many sacrifices of economic resources necessary to obtain the asset in the form, location, and time in which it can be useful to the operations of the firm.
Thus, all of these sacrifices should be included in the concept of cost valuation. But it should be recognized that the term cost is used in many senses and for various purposes. In many cases, it includes only a part of the total sacrifices and in other cases, it includes too much.
One of the main disadvantages of historical cost valuation is that the value of the assets to the firm may change over time; after long periods of time it may have no significance whatever as a measure of the quantity of resources available to the enterprise. Historical cost valuation is also disadvantageous because it fails to permit the recognition of gains and losses in the periods in which they may actually occur.
Also, because of changes over time, costs of assets acquired in different time periods cannot be added together in the balance sheet to provide interpretable sums. The historical cost valuation concept has the added practical disadvantage of blocking out other possibly more useful valuation concepts.
“Relevance to decisions is considered to be the primary requirement of accounting information, and hence irrelevance to decisions appears to be the most fatal weakness of historical cost. Clearly, the focus of attention in the accounting theory of valuation has shifted to replacement cost, net realisable value, discounted future cash flows, and some synthesis of these, in the attempt to make accounting data more relevant to economic decision.”
Valuation Concept # 2. Current Entry Price (Replacement Cost):
Current entry price, i.e., current replacement costs and historical costs are the same only on the date of acquisition of an asset. After that date the same asset or its equivalent may be obtainable for a larger or smaller exchange price. Thus current costs represent the exchange price that would be required today to obtain the same asset or its equivalent.
If a good market exists in which similar assets are bought and sold, an exchange price can be obtained and associated with the asset owned; this price represents the maximum value to the firm (unless net realizable value is greater), except for very short periods until a replacement can be obtained.
It should be noted, however, that this current exchange price is cost price only if it is obtained from quotations in a market in which the firm would acquire its assets or services; it cannot be obtained from quotations in the market in which the firm usually sells its assets or services in the normal course of its operations, unless the two markets are coincident.
Current cost has become an important valuation basis in accounting, particularly as a means of presenting information regarding the effect of inflation on an enterprise.
In a number of other situations, current cost is an appropriate measure of fair value, either in establishing an initial acquisition price (as in certain exchanges of non-monetary assets) or in establishing a maximum value (as in determining the present value of a capital lease for the lessee). Because of the potential increase in relevance of current costs as compared with historical costs, its use is likely to increase in the future.
Valuation Concept # 3. Current Exit Price (Net Realisable Value):
It represents the amount of cash or generalized purchasing power that could be obtained by selling each asset under conditions of orderly liquidation, which may be measured by quoted market prices for goods of a similar kind and condition. This current cash equivalent is assumed to be relevant because it represents the position of the firm in relation to its adaptive behaviour to the environment.
That is, it is assumed to be the contemporary property of all assets, which is relevant for all actions in markets and thus uniformly relevant at a point in time. Past prices are irrelevant to future actions, and future prices are nothing more than speculation. Therefore, the current cash equivalent concept avoids the necessity to aggregate past, present, and future prices.
One of the major difficulties with the current cash equivalent concept is that it provides justification for excluding from the position statement all items that do not have a contemporary market price. For example, non-vendible specialized equipment, as well as most intangible assets, would be written off at the time of acquisition because of an inability to obtain a current market price.
However, it is suggested to modify the procedures somewhat to provide approximations of the current cash equivalents by the use of specific price indexes and by making subjective depreciation computations.
The main deficiency in using the current cash equivalent concept for all assets is that it does not take into consideration the relevancy of the information to the prediction and decision needs of the users of financial statements, although it does provide the investor with contemporary information regarding the financial position of the firm and some alternatives available to it.
The concept has been criticized because it has a non-additive property, the summation of the current cash equivalents of the individual assets is not equal to the cash equivalent of the assets of a group; and the sale of assets in combination or the sale of the firm as a whole may be just as relevant or more relevant than the sale of individual assets in the adaptive behaviour of the firm.
These criticisms, however, do not deny the current cash equivalent concept as having semantic interpretation as an accounting measurement.
Valuation Concept # 4. Present Value of Expected Cash Flows:
Present value refers to the present value of net cash flows expected to be received from the use of asset or the net outflows expected to be disbursed to redeem the liability. This valuation concept requires the knowledge or estimation of three basic factors—the amount or amounts to be received, the discount factor and the time periods involved.
When expected cash receipts require a waiting period, the present value of these receipts is less than the actual amount expected to be received. And the longer the waiting period, the smaller is the present value.
Conceptually, the present value is determined by the process of discounting. But discounting involves not only an estimate of the opportunity cost of the money, but also an estimate of the probability of receiving the expected amount.
The longer the waiting period, the greater is the uncertainty that the amount will be received. Furthermore, a single amount may be received after a time period or different amounts are to be received at different time periods. In later case, each amount must be discounted at the appropriate discount rate for the specific waiting period.
Economists use this valuation model to measure income. Using the Hicks definition of income, economists express income as the net present value of expected future cash flows, discounted at a reasonable rate of discount.
Income is, thus, determined in terms of capitalized money value of an enterprise’s prospective cash flows or receipts. Income will be found only when there is an increase in the capitalized value over the period. Also, income in this approach depends upon assets valuation and assets valuation is prerequisite to income measurement.
Present value model, although considered theoretically best model, has been found largely as impractical. It has many limitations such as the following:
(i) The expected cash receipts generally depend upon subjective probability distributions that are not verifiable by their nature.
(ii) Even though opportunity discount rates might be obtainable, the adjustment for risk preference must be evaluated by management or accountants, and it might be difficult to convey the meaning of the resultant valuation to the readers of financial statements.
(iii) When two or more factors, including human resources as well as physical assets, contribute to the product or service of the firm and the subsequent cash flow, a logical allocation to the separate service factors is generally impossible. It has been suggested that the marginal net receipts associated with the asset can be used, but the sum of the individual marginal net receipts is not likely to add to the total net receipts from the product or services.
(iv) The discounted value of the differential cash flows of all of the separate assets of the firm cannot be added together to obtain the value of the firm. This is partly due to the joint-ness of the contributions of the separate assets, but it is also due to the fact that some assets, such as intangibles, cannot be separately identified.
In spite of the above difficulties, the discounted cash flow concept has some merit as a valuation concept for single ventures where there are no joint factors requiring separate accounting or where the aggregation of assets can be carried far enough to include all of the joint factors. But it is also relevant for monetary assets where waiting is the primary factor determining the net benefit to be received in cash by the firm.
For example, if bill receivable is fairly certain of being collected and if the timing of the payment is specified by contract, the discounted value of the bill represents the amount of cash that the firm would be indifferent to holding as compared to holding bill. The minimum amount, however, would be the amount of cash that could be obtained by discounting or selling the bill to a bank or other financial institution.
The longer the waiting period, however, the greater the uncertainties will usually be, making the discounted cash receipts concept less applicable. On the other hand, when the waiting period is short, the discounting process can usually be ignored for monetary assets because the amount of the discount is usually not material.
Evaluation of Valuation Concepts of Assets:
In the valuation of assets, there is no single concept or procedure that is ideal in the presentation of the statement of financial position, in the determination of income, or in the presentation of other information relevant to decisions of investors, creditors, and other users of financial statements.
From a structural point of view, historical cost valuation is frequently assumed to be the ideal in so far as it is based on double entry book-keeping, which requires the recording of all resources changes and permits their subsequent identification. However, formal structures can also be devised for other valuation concepts.
An objective of asset valuation from an interpretational point of view is to provide a relative measurement of the resources available to the firm in the generation of future cash flows. Historical cost valuation lacks interpretation and current replacement costs permits greater interpretation if the measurements are taken from used-asset markets rather than restating historical costs by the use of specific price indexes.
Net realisable and current cash equivalents permit interpretations if the valuations are taken from prices existing in markets. Realisable value may be useful in a situation where its amount and recoverability are known almost with certainty and the main bottleneck in the cycle of activities is in purchasing.
Replacement cost is useful when the true goal of an entity is to reproduce the existing resource mix on a larger scale. That target is not attained until assets are replaced at their proper levels. Realisable value may be justified when the entity’s aim is to return the maximum amount of money to the owners.
Replacement cost and realisable value are suitable when resources are disposed of or replaced at frequent intervals. However, a business enterprise controls many resources which it does not intend to dispose of or replace. A decision to shut-down or replace a plant may occur only once every ten years for any given plant.
During this ten year period, management does not consider disposal or replacement plans, not because they are unaware of this alternative, but because during most of the plant’s economic life such an alternative is not likely to be more profitable than continuing the existing operation.
There is no doubt that replacement cost and realisable value provide useful information if they are tailor-made for a specific decision and reported at the appropriate time. The question raised here is whether the continuous recording and reporting of such data, and especially whether performance measurement based on such data, are likely to be of any use.
In addition, valuation by replacement cost or realisable value has a particular weakness since the evaluation of assets by these methods is based on actions that the entity is not likely to take. Other methods, such as appreciation or realised value, are based on estimates of actions that the entity will most likely take.
Therefore, when we use appreciation or realised value we may later verify the estimates that were made. Verifying the accuracy of data on replacement cost or realisable value is not possible because the data cannot be compared with actual results.
Littleton states this problem pointedly:
“Accounting has no facility for reporting what might have been…. It might be interpretively interesting later to think of what might have been or of how the event would look if just now completed. It might even be wise to ‘re-think’ some important transactions. But present prices cannot change the amounts of recorded transactions already completed.”
About different valuation concepts, Ijiri concludes:
“Though each of these (alternative asset valuation) methods can be rationalised and justified under some conditions, there is no convincing argument that one is better than the others in every situation.”
Using normative investment models, it may be assumed that an objective of asset valuation is to provide information that will permit the prediction of future cash outflows necessary to acquire similar resources in the future in the continuation of business operations and to permit the prediction of future cash receipts. Current replacement costs obtained from existing markets may reflect the cash outflows required to duplicate the existing facilities.
Thus, as a prediction of future cash outflows, current input costs, and expected future input prices are more significant than past input valuations. In the prediction of future cash receipts, output concepts are generally superior to input valuation concepts.
Thus, net realisable values and current cash equivalents may be relevant for many predictions. But when the expected future benefits are highly uncertain, the use of input valuations may offer a reasonable substitute in some situations.