Valuation of Assets and Equities
Financial statements generally value assets based on their historical or acquisition cost. Price-Level Adjusted Historical Cost. Net Realizable Value. Future Profits, Replacement Cost. Valuation of liabilities. Valuation of stockholders equity.
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Valuation of Assets and Equities
One would not expect there to be much controversy over the valuation of balance sheet items. Wouldn't they simply be recorded at what they're worth? Unfortunately, it isn't as easy as that. Consider having bought a car three years ago for $20,000. Today it might cost you $24,000 to buy a similar car. Is your car worth $20,000 or $24,000?
Wait, it's more complicated than that. Your old car is no longer new and so its value has gone down with age. Because the old car is three years old, and generally cars are expected to have a five-year useful life, your car has lost 60 percent of its value, so it's only worth $8,000. However, due to inflation, you could sell the car for $14,000 and you 'd have to pay $16,000 to buy it on a used car lot.
What is the value of your car? Is it $20,000 or $24,000, or $8,000, $14,000, or $16,000? Obviously valuation is a complex issue. This chapter looks at how accountants value assets, liabilities, and stockholders ' equity for inclusion in financial statements. In addition, several other useful valuation methods that are not allowed for financial statement reporting will be discussed.
Historical Cost or Acquisition Cost
Financial statements generally value assets based on their historical or acquisition cost. This is done in order to achieve a valuation based on the GAAP of objective evidence. If the firm values all of its assets based on what was paid for them at the time it acquired them, there can be no question as to the objectivity of the valuation.
For example, let's suppose that some number of years ago a railroad company bought land at a cost of $10 an acre. Suppose that 1,000 acres of that land runs through the downtown of a major city. Today, many years after the acquisition, the firm has to determine the value at which it wishes to show that land on its current financial statements. The historical cost of the land is $10,000 ($10 per acre multiplied by 1,000 acres).By historical cost, we mean the historical cost to the firm as an entity. The firm may have bought the land from previous owners who paid $1 per acre. Their historical cost was $1 per acre, but to our entity the historical or acquisition cost is $10 per acre.
Accountants are comfortable with their objective evidence. If the land cost $10,000 and the firm says it cost $10,000, then everyone gets a fair picture of what the land cost. However, one might well get the impression from the balance sheet that the property is currently worth only $10,000.
In fact, today that land might be worth $10,000,000 (or even $100,000,000).The strength of using the historical cost approach is that the information is objective and verifiable. However, the historical cost method also has the weakness of providing outdated information. It doesn't give a clear impression of what assets are currently worth. Despite this serious weakness, historical or acquisition cost is the method that generally must be used on audited financial statements.
For assets that wear out, such as buildings and equipment, the historical cost is adjusted each year to recognize the fact that the asset is being used up. Each year the asset value is reduced by an amount that is referred to as depreciation expense. Depreciation is discussed in Chapter 15.
Price-Level Adjusted Historical Cost
Accountants are ready to admit that the ravages of inflation have played a pretty important part in causing the value of assets to change substantially from their historical cost. The longer the time between the purchase of the asset and the current time, the more likely it is that a distortion exists between the current value of an item and its historical cost. One proposed solution to the problem is price-level adjusted historical cost or PLAHC (pronounced plack). This method is frequently referred to as constant dollar valuation .
The idea behind constant dollar valuation is that most of the change in the value of assets over time has been induced by price-level inflation. Thus, if we use a price index such as the Consumer Price Index (CPI)to adjust the value of all assets based on the general rate of inflation, we would report each asset at about its current worth. While this approach may sound good, it has some serious flaws.
Unfortunately, not everything increases at the same rate of inflation. The land in the railroad example may have increased in value much faster than the general inflation rate. There is no way to easily adjust each asset for the specific impact that inflation had on that particular asset, using price indexes such as the CPI.
Where does that leave us? Well, PLAHC gives an objective measurement of assets. However it might allow an asset worth $10,000,000 to be shown on the balance sheet at only $110,000. Perhaps it is better to leave the item at its cost and inform everyone that it is the cost and is not adjusted for inflation, rather than to say that it has been adjusted for inflation when the adjustment may be a poor one.
Net Realizable Value
A third alternative for the valuation of assets is to measure them at what you could get if you were to sell them. This concept of valuation makes a fair amount of sense. If you were a potential creditor, be it banker or supplier, you might well wonder, "If this firm were to sell off all of its assets, would it be able to raise enough cash to pay off all of its creditors?"
The term net is used in front of realizable value to indicate that we wish to find out how much we could realize net of any additional costs that would have to be incurred to sell the asset. Thus, commissions, packing costs, and the like would be reductions in the amount we could expect to obtain.
This method doesn't seek to find the potential profit. We aren't interested in the comparison of what it cost to what we 're selling it for. We simply want to know what we could get for it. In the case of the railroad land, its net realizable value is $10,000,000 less any legal fees and commissions the railroad would have to pay to sell it.
Is this a useful method? Certainly. Does it give a current value for our assets? Definitely. Then why not use it on financial statements instead of historical cost? The big handicap of the net realizable value method is that it is based on someone 's subjective estimate of what the asset could be sold for. There is no way to determine the actual value of each of the firm's assets unless they are sold. This always poses a problem from an accountant's point of view. Another problem occurs if an asset that is quite useful to the firm does not have a ready buyer. In that case, the future profits method that follows provides a more reasonable valuation.
The main reason a firm acquires most of its assets is to use them to produce the firm's goods and services. Therefore, a useful measure of their worth is the profits they will contribute to the firm in the future. This is especially important in the case where the assets are so specialized that there is no ready buyer. If the firm owns the patent on a particular process, the specialized machinery for that process may have no realizable value other than for scrap.
Does that mean that the specialized machinery is worthless? Perhaps yes, from the standpoint of a creditor who wonders how much cash the firm could generate if needed to meet its obligations. From the standpoint of evaluating the firm as a going concern, a creditor may well be more interested in the ability the firm has to generate profits. Will the firm be more profitable because it has the machine than it would be without it?
Under this relatively sensible approach, an asset's value is set by the future profits the firm can expect to generate because it has the asset. However, once again the problem of dealing with subjective estimates arises. Here we are even worse off than with the previous valuation approach. At least we can get outside independent appraisers to evaluate the realizable value of buildings and equipment. However, under this method, estimates of future profit streams require the expertise of the firm's own management. Even with that expertise, the estimates often turn out to be off by quite a bit.
The replacement cost approach is essentially the reverse of the net realizable value method. Rather than considering how much we could get for an asset were we to sell it, we consider how much it would cost us to replace that asset. While this might seem to be a difference that splits hairs, it really is not.
Suppose that last year you could buy a unit of merchandise for $5 and resell it for $7. This year you can buy the unit for $6 and sell it for $8. You have one unit remaining that you bought last year. Today, its historical cost is $5, the amount you paid for it; its net realizable value is $8, the amount you can sell it for; and its replacement cost is $6, the amount you would have to pay to replace it in your inventory. Three different methods result in three different valuations.
Replacement cost (often referred to as current cost) is another example of a subjective valuation approach. Unless you actually go out and attempt to replace an asset, you cannot be absolutely sure what it would cost to do so.
Which Valuation Is Right?
Unfortunately, none of these methods (see Exhibit 6-1) is totally satisfactory for all information needs. Different problems require different valuations. The idea that there is a different appropriate valuation depending on the question being asked may not seem to be quite right. Why not simply say what it's worth and be consistent?
From the standpoint of financial statements, we have little choice. GAAP requires the financial statements. You might say, "Okay, the financial statements must follow a certain set of rules, but just among us managers, what is the asset's real value?" Still we respond:"Why do you want to know?" We really are not avoiding the question... Let's consider a variety of possible examples.
First, assume that one of your duties is to make sure the firm has adequate fire insurance coverage. The policy is currently up for renewal and you have obtained a copy of your firm's annual report. According to the balance sheet, your firm has $40,000,000 of plant and equipment. You don't want to be caught in the cold, so you decide to insure it for the full $40 million. Nevertheless, you may well have inadequate insurance. The $40 million merely measures the historical cost of your plant and equipment.
Which valuation method is the most appropriate? In this case, the answer is replacement cost. If one of the buildings were to burn down, then our desire would be to have enough money to replace it. Other measures, such as net realizable value, are not relevant to this decision.
Suppose we are considering the acquisition of a new machine. What measure of valuation is the most appropriate? We could value the machine at its historical cost -- that is, the price we are about to pay for it.
Useful, but subjective
NET REALIZABLE VALUE
Useful, but subjective
Objective, but limited relevance; basis for financial statements
Useful, but subjective
Objective but limited relevance
This method cannot possibly help us to decide if we should buy the asset.
Looking at an asset's value from the point of view of its cost would lead us to believe that every possible asset should be bought, because by definition it would be worth the price we pay for it.
How about using the net realizable value? What would the net realizable value of the machine be the day after we purchase it? Probably less than the price we paid because it is now used equipment. In that case, we wouldn't ever buy the machine. How about using replacement cost? On the day we buy a machine, the replacement cost will simply be the same as its historical cost.
Logically, why do we wish to buy the machine? Because we want to use it to make profits. The key factor in the decision to buy the machine is whether or not the future profits from the machine will be enough to more than cover its cost. So the appropriate valuation for the acquisition of an asset is the future profits it will generate.
Finally, consider the divestiture of a wholly owned subsidiary that has been sustaining losses and is projected to sustain losses into the foreseeable future. What is the least amount that we would accept in exchange for the subsidiary? Historical cost information is hopelessly outdated and cannot possibly provide an adequate answer to that question. Replacement cost information can't help us. The last thing in the world we want to do is go out and duplicate all of the assets of a losing venture. If we base our decision on future profits, we may wind up paying someone to take the division because we anticipate future losses, not profits.
The appropriate valuation in this case would be net realizable value. Certainly we don't want to sell the entire subsidiary for less than we could get by auctioning off each individual asset.
As you can see, it is essential that you be flexible in the valuation of assets. As a manager, you must do more than simply refer to the financial statements. In order to determine the value of assets, you must first assess why the information is needed. Based on that assessment, you can determine which of the five methods discussed here provides the most useful information for the specific decision to be made.
Valuation of liabilities
Valuation of liabilities does not cause nearly as many problems as valuation of assets. With liabilities, if you owe Charlie fifty bucks, it's not all that hard to determine exactly what your liability is; it's fifty bucks. In general, our liability is simply the amount we expect to pay in the future.
Suppose we purchase raw materials for our production process at a price of $580 on open account with the net payment due in thirty days. We have to pay $580 when the account is due. Therefore, our liability is $580. The crucial aspects are that our obligation is to be paid in cash and it is to be paid within one year. Problems arise if either of these aspects does not hold.
For instance, suppose we borrow $7,000 from a bank today and have an obligation to pay $10,000 to the bank three years from today. Is our liability $10,000? No, it isn't. Banks charge interest for the use of their money. The interest accumulates as time passes. If we are to pay $10,000 in three years that implies that $3,000 of interest will be accumulating over that three-year period. We don't owe the interest today, because we haven' yet had the use of the bank's money for the three years. As time passes, each day we will owe the bank a little more of the $3,000 of interest. Today, however, we owe only $7,000, from both a legal and an accounting point of view.
You might argue that legally we owe the bank $10,000. That really isn't so, although the bank might like you to believe that it is. Let's suppose that you borrowed the money in the morning. That very same day, unfortunately, your rich aunt passes away. The state you live in happens to have rather fast processing of estates and around one о'clock in the afternoon you receive a large inheritance in cash. You run down to the bank and say that you don't need the money after all. Do you have to pay the bank $10,000?
If you did, your interest for one day would be $3,000 on a loan of $7,000. That is a rate of about 43 percent per day, or over 15,000 percent per year. Perhaps there would be an is to be paid in cash and it is to be paid within one year. Problems arise if either of these would be an early payment penalty, but it would be much less than $3,000. Generally, accountants ignore possible prepayment penalties and record the liability at $7,000.
Another problem occurs if the liability is not going to be paid in cash. For example, perhaps we have received an advance payment for an order of widgets that we intend to fill over the coming year. What we owe is widgets, but we have to make some attempt to value that liability. Take the example one step further. We have received $18,000 for the widgets, but they will only cost us $9,000 to make. Is our liability $18,000 or $9,000?
In cases in which the obligation is nonmonetary in nature, we record the obligation as the amount received, not the cost of providing the nonmonetary item. What if for some reason we cannot provide the widgets? Will the customer be satisfied to receive a refund of $9,000 because that's all it would have cost us to make the widgets? No, the customer needs to get the full $ 18,000 back, so we must show that amount as the liability. If, over time, we make partial shipments, we can reduce the liability in a pro rata fashion.
Valuation of stockholders equity
The valuation of stockholders ' equity is relatively easy. Recall that assets are equal to liabilities plus stockholders' equity. Once the value of assets and liabilities has been determined, the stockholders ' equity is whatever it must take to make the equation balance. Remember that the stockholders ' equity is, by definition, a residual of whatever is left after enough assets are set aside to cover liabilities. Thus, given the rigid financial statement valuation requirements for assets and liabilities, there is little room left for interpreting the value of stockholders' equity...
On the other hand, might there not be another way to determine the value of the firm to its owners? For a publicly held firm the answer is clearly yes. The market value of the firm's stock is a measure of what the stock market and the owners of the firm think its worth. If we aggregate the market value of the firm's stock, we have a measure of the total value of the owners equity.
Is the market value of the firm likely to equal the value assigned by the financial statements? Probably not. The financial statements tend to substantially undervalue a wide variety of assets. Intangible assets that may be quite valuable are not always included in financial statements. Further, historical cost asset valuation causes the tangible assets to be understated in many cases. Thus, the assets of the firm may be worth substantially more than the financial statements indicate. If the public can determine that to be the case (usually with the aid of the large number of financial analysts in the country), the market value of the stock will probably exceed the value of stockholders ' equity indicated on the financial statements. Furthermore, stock prices are often dictated by the firm's ability to earn profits. In some cases companies with few assets can still be quite profitable, and therefore have a market value well in excess of the stockholders ' equity shown on the balance sheet.
This discussion of valuation of assets and equities has left us in a position to better interpret the numbers that appear in financial statements. Financial statements are the end product of the collection of information regarding a large number of financial transactions. Each transaction is recorded individually into the financial history of the firm using the valuation principles of this chapter. Chapter 7 discusses the process of recording the individual transactions --how and why it's done. Chapter 8 demonstrates how all of the transactions, perhaps millions or even billions during the year, can be consolidated into three one-page financial statements.
Asset valuation --there are a variety of asset valuation methods. The appropriate value for an asset depends on the intended use of the asset valuation information.
a. Historical cost --the amount an entity paid to acquire an asset. This amount is the value used as a basis for tax returns and financial statements.
b. Price-level adjusted historical cost --a valuation method that adjusts the asset's historical cost, based on the general rate of inflation.
c. Net realizable value --valuation of an asset based on the amount we would receive if we sold it, net of any costs related to the sale.
d. Future profits --this valuation method requires each asset to be valued on the basis of the amount of additional profits that can be generated because we have the asset.
e. Replacement cost --under this method each asset is valued at the amount it would cost to replace that asset.
Liability valuation --the value of liabilities depends on whether they are short-term or long-term and whether or not they are to be paid in cash.
a. Short-term cash obligations --Amounts to be paid in cash within a year are valued at the amount of the cash to be paid.
b. Long-term cash obligations --Amounts to be paid in cash more than a year in the future are valued at the amount to be paid, less the implicit interest included in that amount.
с Nonmonetary obligations --an obligation to provide goods or services rather than cash, where the liability is generally valued at the amount received, rather than the cost of providing that item. Stockholders 'equity valuation -- given a value for each of the assets and liabilities, stockholders ' equity is the residual amount that makes the fundamental equation of accounting balance.
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