Measurement of assets, liabilities and equities in accounting
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Across time, various accounting theories have been developed by a number of well-respected academics. However, the accounting profession is normally failed to embrace these theories. This paper has analyzed the different valuation models that are currently used and especially focus on historical cost accounting and exit value accounting. It first examines Edward's statement and then explained exit value accounting. After the introduction of several substitute accounting models and comparison between historical cost accounting and exit value accounting, the conclusion is generated at the end.
Measurement of assets, liabilities and equities historically has been one of the major issues in financial accounting. There are various accounting standards requiring different classes of assets and liabilities to be measured in different valuation approaches in financial statements. Therefore, there are mixed approaches applied to measure financial performance and companies have certain level of discretion to choose more suitable measurements model to prepare their individual financial statements. The attribute of historical cost has long been accepted as a fundamental measurement principle for assets, liabilities and equities. However, this attribute recently has been challenged for its lack of relevancy which is the main characteristics of useful information
In this paper, we first examine the statement of Edwards in his journal of "The state of current value accounting" and then explain exit value accounting. In the following part, seven alternative measurement models are enumerated and the models would be analyzed in detailed. After all the description and analysis, we focus on the comparison between historical cost accounting and exit value accounting and conclude that different entities should find the appropriate accounting model according to their different characteristics.
1. PART A
Edward states that for the valuation of assets of which relatively permanent (he shows with the sentence "that the firm has taken definite decision not to replace or even the function it performs") are better using either entry value or exit value method. We should choose the lesser between those two. However, if we use exit value method, he disagrees with the method of just copy (adopt) the exit price in the buyer market for assets valuation. That method can only appropriate for unusual values in unusual situations. Say, for example if company A that is in healthy and going concern condition decides to use the exit-price method for its assets valuation. If company A take the value in buyer market in which usually company B as the buyer, it will lead to misleading information if company B under liquidation situation. Therefore, for the assets and liabilities of the going concern that the company normally sells should not be valued at current prices. It would be better to use the higher between replacement cost and net-realizable-value. However, there will be an exception for the company that is temporarily selling at loss (Edwards, 1975).
2. Explain what you understand by 'exit value' accounting
Exit price accounting is "a form of current cost accounting which is based on valuing assets at their net selling prices (exit prices) at the balance sheet date and on the basis of orderly sales" (Deegan, 2006). This normative accounting theory was developed by Raymond Chambers and labeled as Continuously Contemporary Accounting (CoCoA). The theory relies on assessments of the exit or selling price of an entity's liabilities and assets.
According to Edwards and Bell (1961; 75) an exit value is the maximum price a currently held asset could be sold for in the market less the transactions costs of the sale (the net realizable value for the asset).
The theory was developed under the following key assumptions. Firstly, firms exist to increase the owners' wealth. Secondly, the organization's ability to adapt to changing circumstances is the basis of successful operations and Finally, the capacity to adapt will be best reflected by the monetary value of the organization's assets, liabilities and equities at balance date, where the monetary value is based on the current exit or selling prices of the organization's resources (Deegan, 2007).
All assets in the exit-price accounting should be recorded at their current cash equivalents which represented by the amounts expected to be generated by selling the assets and an orderly sale determine the net-sales or exit-prices. Depreciation costs would not be realized within exit-price accounting as the model is based on the current cash equivalents.
Liabilities would be similarly valued at the amounts it would take to pay them off as of the statement date. The income statement for the period would be equal to the change in the net realizable value of the firm's net assets occurring during the period, excluding the effect of capital transactions. Expenses for such elements as depreciation represent the decline in net-realizable value of fixed assets during the period.
This model is based on immediate sale, which seems under the control of the entity although some estimation of the future may be included (IASB Research Agenda Project, 2009). As a result, the asset does not contribute to an entity's capacity to adapt to changing circumstances if it is not ready to sell (as it does not have a sales price). In addition, the profit for a certain time should also be related the alteration of the current exit-prices of the assets and hence, profit should reflect changes in an organization's capacity to adapt.
The benefit of this system is the relevance of the information it provides. With this approach, the balance sheet becomes a huge statement of the net liquidity available to the enterprise in the ordinary course of operations. It thus portrays the firm's adaptability, or the ability to shift its presently existing resources into new opportunities.
3. Explain briefly the alternative measurement models
3.1 Historical cost valuations;
Historical-cost basis of accounting refers to the amount of cash or cash-equivalent paid to acquire an asset, thus assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values.
This method assumes that there is no inflation in the economy and it can be considered to be a tradeoff between relevance and reliability. The problem is that historical-cost accounting implicitly assumes that monetary values at the end of an accounting period are comparable to monetary values at the beginning of the accounting period. The advantages claimed for historical-cost information are it is objective and reproducible, and conservative. Both of these advantages are subject to criticism. However, the most important problem is that historical-cost end of period values will be completely meaningless in a high inflation environment; they will not reflect current opportunity costs or market values.
The other weakness of historical-cost accounting is the "accuracy" of the information. The strength and weaknesses of this method will be explained more detail in part 4.
3.2 Current purchasing power accounting (CPPA)
Current purchasing power accounting (CPPA) can be also called general price level accounting, constant dollar accounting or general purchasing power accounting. CPPA was developed on the basis of the view that, "in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs the result could be a reduction in the real value of an entity-that is, in real terms the entity could risk distributing part of its capital." (Deegan, 2006)
However, it is not necessary to consider the every price change of specific goods or services, so the price indices are suggested to be used. CPPA tends to favor price-level-adjusted accounts which is through using indices and therefore, is considered to be easier and less costly to apply.
All adjustments are done at the end of the period when using CPPA. Monetary assets are fixed in terms of the monetary value while non-monetary assets, such as equipment and plant, would change their value over time as a result of inflation. On the other hand, the purchasing power of non-monetary assets is proposed to be stable. The weakness is the value for the asset will not equal its end of period market value (unless the general inflation rate is equal to the asset specific inflation rate). However, its strength is that it will adjust for the effects of general inflation.
3.3 Current cost accounting (CCA)
Current cost accounting (CCA) focuses on actual valuations and aims at separating trading profits from gains that come from holding an asset. Inventory cost flow assumptions including LIFO, FIFO or weighted average are not necessary which is quite different from historical-cost accounting. Although CCA provide a good opportunity to compare the performances between different entities, the difficulty in determines replacement costs becomes the potential limitation of CCA and also the reliance on replacement values is criticized. Both replacement cost and exit values are included in CCA.
3.3.1 Exit-value accounting;
This model has been introduced in part 2 and will be explained more in part 4.
3.3.2 Replacement (or reproduction) costs or Entry Value;
Replacement cost (entry-value) refers to the amount of cash or cash-equivalent that would be paid to acquire an equivalent or the same asset currently.
As the name implies, this system uses current-replacement cost valuations in financial statements. Replacement cost will usually be higher than the exit-price value and ideally measured where market values are available for similar assets. In the absence of firm market prices, either appraisal or specific index adjustment can estimate replacement cost.
However, there are some weaknesses of this method; replacement costs are not generally reproducible and not generally additive (if a group of assets is replaced, the aggregate replacement cost may be less than the sum of the individual replacement costs). We can impose additivity by seeking replacement costs for assets according to how they were originally purchased. However, the lack of reproducibility is a serious limitation of this method
3.4 Economic-Value Accounting (Discounted cash flows);
In this system, valuation of assets is a function of discounted cash flows and income is measured by the change in the present value of cash flows arising from operations during the period. Discounted cash flow models measure enterprise value as the discounted present value of all expected future cash flows available to the firm's stockholders and creditors. Thus, both asset valuation and income measurement are anchored to future expectations. The internal rate of return of the asset is found by discounting the future cash flows at the rate that will make them just equal the cost of the asset.
However it suffers from two flaws: future discounted net returns are generally not known with any degree of certainty and hence the resulting estimates will not be reliable (Canning, 1929) and even if we did know future revenue flows with certainty, revenue flows are produced by the joint efforts of all assets and it is generally impossible to allocate the resulting joint net revenue flows to individual assets (Daines, 1929).
In a real situation, the method would be virtually impossible to apply because many assets contribute jointly to the production of cash flows, so individual asset valuation could not be determined.
3.5 Specific Price Level Adjusted Historical Cost; and
This method for constructing an end of period estimated asset value is very similar to the CPPA; the only difference is that now a presumably more relevant specific price index is used for revaluation purposes rather than an index of general inflation.
The SPLA asset value should also be closer to its end of period market value (net realizable value) since presumably, the index numbers reflect a sample of market transaction prices for new units of the asset (or similar assets) during a time period that includes the end of period. Thus SPLA values will tend to be reproducible and relevant.
3.6 Valuations based on intertemporal cost allocation methods.
The nature of a capital asset used in production is that a production unit makes expenditure in the current period but the benefits of this asset expenditure are not confined to the current period. Thus the accounting problems in the present section have a different character than in the previous sections, where a straightforward opportunity cost approach was used. In the present section, the approach taken is one of matching current costs with future expected revenues.
The problem of intertemporally allocating intangible investment expenditures to future periods when the benefits might be realized is similar to other intertemporal cost allocation problems that are associated with prepaid expenses and transactions costs.
3.7 Fair Value Accounting
Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (Trott and Eastman, 2008). Transaction cost does not affect the value but transportation cost must be considered sometimes as for the location of an asset. This measurement model is rather market-based than entity-specific and as a market-based measurement model. There are many benefits such as providing comparability in financial reporting, having observable market while lacking of such market in entity-specific models and reflecting the efficiency of a reporting entity (Trott and Eastman, 2008). However, fair value is considered to be less reliable due to its subjective nature.
The differences between a fair-value model and a historical-cost model is that the initially recorded measurement can be changed at the later reporting dates under the fair-value model, while the measurement once recorded, under the historical, it would not changed. However, at its subsequent reporting date, the amount would be changed to its fair value. In addition, the fair value accounting model faces the issue of how to account for the change in the reporting measurement while historical-cost would not.
4. In light of the present financial crisis and the statement above by Edwards offer a solution to the conundrum that historical cost account information is verifiable but useless for decision making whilst exit value accounting information is decision useful but not particularly useful.
In financial crisis condition, the inflation rate tends to be high and therefore it will influence the price level stability and fluctuation of currencies' exchange rates. Under this condition, historical-cost accounting information cannot be relied, as it does not measure the loss of value of monetary as the result of inflation. The most important problem is that historical-cost end of period values will be meaningless in a high inflation condition because constant purchasing power is the fundamental assumption of this method, thus they cannot reflect current opportunity costs or market values. This historical-cost information is based on the values when they are first acquired and they are not then generally restated for changes in values. Hence, historical-cost accounting values might be objective but at the same time, they are irrelevant as they cannot provide the current value of the assets and the command of goods (COG) is not measured. A measure of COG reflects changes in both the specific and general price level and represents the ability to buy the amount of goods necessary for capital maintenance (Chambers, 1975). As historical-cost accounting ignores the change of the price, it usually overstates profits in times of rising prices and may take the risk of distributing operating capacity to shareholders. Therefore, under this condition, historical-cost information cannot be relied for decision-making. The other reason is that historical-cost information contains timing errors as it recognizes operating income and holding gains and losses that occurred in the previous period in the current period or recognizes operating income and holding gains and losses that occurred in the current period in the future period. However, despite all the above weaknesses, the historical-cost information is still verifiable (Krumwiede, 2008) and interpretable. This information is verifiable not only because it does not need the reference to the market value and produced straightforward, but also more important, it does not record valuation gains until it realized. Historical-cost information is based on the concept of money maintenance and the attribute being expressed is the number of dollars (NOD). The balance sheet information reports the stocks in NOD and the income statement reports the change of NOD during the year.
Further, some accountants suggest the use of exit-value accounting to replace the historical-cost. They believe that it will provide better information for decision-making than historical-cost. This method refers to the amount of cash or cash-equivalent that would be obtained by selling the asset currently. It is true that this method will provide more reliable information for decision-making as it does not contains any timing errors. It reports all operating profit and holding gains and losses in the same period in which they occur and excludes all operating and holding gains and losses that occurred in previous periods. Besides that, it provides the relevant information of the current value and portrays the firm's adaptability, the ability to shift its presently existing resources into new opportunities. As well as historical-cost, this method also interpretable as the information is based on the concept of productive-capacity maintenance. The attribute being measured is expressed in NOD on the income statement and in COG on the balance sheet. Asset figures are expressed as measures of COG in the output market rather than in the input market (Chambers, 1975).
However, this method has weaknesses that make it not particularly useful for decision-making. This method does not particularly concern to the operations of the firm but instead, concerns price changes of assets and liabilities. Therefore, it will be difficult to evaluate the firm's performance and operating efficiency as it concentrates on financial liquidity and short-term decision-making. Besides that, the financial position of the organization might deem to have no value if assets cannot be sold separately. Other weaknesses are the exit-value accounting information contains measuring-unit errors as it disregards the changes in general and specific price-level, it relies on net-realizable value as the attribute of the information. Furthermore, this view appears to ignore the 'value in use' of assets. If an asset is retained instead of selling, its value in use would more likely be greater than its current exit-price and some intangible assets, such as goodwill would be assessed as having no net selling-price and therefore would be attributed zero value; thus as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility. In addition, exit value markets are often thin and inefficient (Jensen, 2007). Finally, the sales, the basis of determining the exit-prices, might not show values at balance date and might happen at different times. So such financial statements might not be useful in monitoring the organization's management.
CONCLUSION & RECOMMENDATION
Assets valuation is undertaken for some purposes such as to provide the information for internal control, meet requirements for external financial reporting, insurance and risk, etc. The choice of an appropriate valuation method depends on the purpose of the valuation and on the nature of the asset involved. The initial valuation is applied at the time of acquisition, and commonly interrelated to the cost of acquisition. Subsequent revaluations are undertaken at periodic intervals with a frequency chosen to reflect the nature of the class of assets concerned.
Then we should distinguish the assets type such as physical and non-physical or core and non-core to determine valuations.
Therefore, there is no single one method is the best for all situation. For deciding which methods is the best depends on many factors such as timing, interpretability and relevance. Take pension-assets as an example, better using Fair-Value or Market-Value accounting (American Actuarial Standard Boards). For most closely represents a preferred-income position, the best method is general price-level-adjusted, net-realizable-value accounting, base on the assessment of timing errors, measuring-unit errors, interpretability and the relevance as measures of COG (Belkaoui, 2004).