Valuation of Assets Js 69

8/2/2019 Valuation of Assets Js 69

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VALUATION OF ASSETS

Basis of ValaationThe concept of value in economics is based onfuture expectations. Under this concept the valueof an asset in equal to the present worth of future netreceipts that the asset is expected to produce duringits life. This concept is theoretically sound. Butas the future cannot be known with certainty, practi.cal difficulties arise in the application of expectationas the basis of valuation. Even economists do notapply this method of valuation in the calculationof national incomes. Nev, rth .. less in a rl:al situation,assets are acqui. cd and dLp,)sed l ,f with som._ approximation to thi.s sort of subj_ctiv.: valuation. Thatis, o n ~ pays th : price of an asstt when one l X p ~ c t s that th ' tvtal b 'n fit::; th.u wi:i b driv. d from itWill not b . I S5 than th p.ic,. Th cost of an assdmay, th r,fur" b. clgard d as th,- 'b.st ~ i n g l " "vid:nc... ' of its value. Cost is also d\.finite and readilydet...rminable. In accounting, cost is th..:r"fore considered as v a l u ~ in an objl:lctiw sense. Little objdctioncan raised against such values at the time ofacquLition. If prices remained constant, existingmethods of valuation by matching historical costwith revenues would not also create any major problem in accounting bdCause, in such a situation, costs(less depr.eciation where applicabk) would be meaningful approximations of values. (Diminution in valueof assets arising through abnormally high u s a g ~ orthrough normal obsolescence is usually c o v l : l r ~ d byincreased charges against revenues). But prices aresubject to changes and, therefore, with the passageof time the values of assets in use in current termsmay diffl:lr widely from historical costs. In a concern,assets may be bought at different times and at diffl:lrentprices and they are therefore not stated in like termsin a conventional Balance Sheet. If they are valuedin current terms such values may differ in varyingdegrees from their historical costs. During inflation,the conventional Balance Sheet therefore loses muchof its significance and it can hardly be termed a statement of financial position. This happens in spiteof the fact that, in a going concern, most of the assetsare replaced and their values are restored to currentcosts at different time intervals depending on thenature of the assets.In traditional accounting, assets are valued on anhistorical cost basis for practical rather than theoreti

Jaly-September,I969

M . A. MONDAL,M. Com. (Dacca)M. Phil. (Southampton)

cal reasons. (The existing method is actually concernedwith amortisation of costs instead of valuation ofassets. Nevertheless, the monetary amount placedagainst an asset is generally known as value). Thegoing concern assumption in accounting has to agreat e:xtent obviated the need for re-appraisal ofhistorical costs. On the other hand, departure fromhistorical costs raises the question of proper valuationof assets. If it is supposed that assets can be revaluedwith reasonable accuracy, accountants will stillhesitate to measure periodic profits on the basis ofannual appraisal of assets btcause of the realisationprincipk. Incluskn of unn alitcd capital gains (orlosses) will not only raise the problt m of taxation(who will pay tax. s on unCI alised profit 1) but willmak ffi' aningCui anaiy b of th nature and Cl mposition 0; p.1. fit mon difficult. Mort OVl:f, l vt:n assuming thlt valuation can bl: t:ffLct(d with reasonableaccuracy, it must, in most cases, be a matter ofopinion,and thlflfor-.; periodical profits will be directly influenc, d by such opinion."valaatioD of Assets

Although annual appraisal of values has not beenregard..d as an ace. ptable alternative to the historicalcost basis, assets are nevertheless revalued in manycases and gains on revaluation are treated as capitalreserves instead of periodical profits. Generally,only fix


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Firstly, revised values are subject to personal opinionand therefore depreciation charges based on suchvalues are directly affected by such opinion. Secondly,matching of costs through revaluation alone isinadequate to deal with the problem of maintenanceof capital (real capital) during continuing inflation.Finally, the historical cost basis is lost in the processof revaluation and financial statements fail to disclosethe extent to which the revised value is affected bypersonal opinion.Revaluation will create little problem if thematching aim of the same is changed. (This is notnecessary in cases where revaluation enters into thenormal accounting process, such as, in the case ofacquisition of a business). Matching of currentcosts of assets may better be left for costing purposes.In financial accounting, revaluation should be intendedto determine only realisable value gains (positiveor negative) and not for the matching of current costs,and realisable gains should be insolated from costsof assets so that the historical matching is not disturbedand the extent of value revision which is subject toopinion is clearly disclosed in accounts. Recording

of realisable gains in this manner will have the following advantages: First, the traditional historicalcost basis of account keeping will remain undisturbed.Secondly, assets will be shown at their meaningfulvalues, disclosing at the same time how much ofsuch values is affected by personal opinion. Thelast bu t the most important advantage is that it willhelp measure real profits and maintain real value ofequity capital in accounting. For this, the loss (orgain) of capital value may be calculated by mUltiplyingthe opening balance of equity capital with the changeof price index during the period. The loss should betreated as capital Reserve (forming part of capital)and be adjusted against net accounting profits notentirely at a time but only to the extent to which thesame is not covered by unrealised profits.Suggested Methods of Valuation

For accounting purposes assets should be revaluedindividually or in groups instead ofvaluing the concernas a whole. However, the aggregate values of individual assets may no t be the same as the value of thewhole concern because of its goodwill value.Obviously goodwill is the excess of the value of theconcern over the piecemeal values of its individualassets. I f assets are valued individually as has beensuggested here, the figure attributable to goodwilltends to be a matter of the opinion of those who willuse accounting data. The users of accounting information, particularly those who will be interestedto know the amount of goodwill, will not necessarilyaccept the accounting measurement of goodwitl ;rather they will draw their own conclusion on thebasis of present position and futute prospects of theconcern. Of course, if information on goodwill is8

considered desirable it may be given in the AnnualReport.It has been mentioned earlier that the price (i.e.cost) of an asset is the only objective evidence of itsvalue and, at the time of acquisition, the cost of anasset can reasonably be regarded as its value. Forthe same reason, i.e., to preserve objectivity, revaluation should also be based on current prices of similarassets. But in the case of revaluation, current pricesmay refer to both buying and selling prices. Thevalue of an asset based on the buying price may becalled replacement value (cost). Such value may bedifferent from the exchange or realisable value basedon the selling price. For accounting purposes,revaluation of assets should mean the determinationof their worth to the concern. When the asset isheld for disposal, such as stock-in-trade, its worthto the concern may be equal to the net realisa:blevalue. But in other cases, value should mean replacement cost, i.e., the current cost ofacquising the servicesof an asset if the concern did not possess the same.The cost of an asset's potential services is, in fact,a measure of minimum worth of that asset to theconcern. Therefore, except when the asset is awaitingdisposal, revaluation in accounting should mean thedetermination of the cost of replacing the equivalenservices.Apart from the fact that current value may implyeither the replacement or realisable value, the revaluation of existing assets of a concern may raise thefollowing problems. Firstly, an objective evidenceof value may not be readily available. Secondlydifficulty may be experienced in the determinationof depreciation of the store of services of a fixedasset and, thirdly, determination of the effect of technological changes on the current value of the existing

asset may be subject to complications. Some reasonable methods should be followed consistently to taclethese 'problems of revaluation. The first problem,i.e., the. problem of objective evidence of value isaccentuated by price changes. The current marketpr ice of similar assets should be taken as the basisof revaluation. For this reason, the specific priceindex may be used so far as such an index is available.Price indices of different classes of assets, such asplant al)d machinery, equipment, construction costLand etc., may be developed for accounting use.In many cases, such as inventories, current marketprice may be obtained without difficulty. Arrangements can also be made for current quotations at theend of each period direct from the market or thesources of supply of the assets. The second problem,i.e., the problem of determination of depreciationarises from the fact that the value of usable servicesin an existing asset is to be determined after deductingthe value of services already used from its total value.I t is true that ideally depreciation of an asset is areduction of its present value over a given time. In

Tbe Pakistan Aceowrtan


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d,k' C W t ; ~ . / other words,it is the difference between the capitalizedvalues at the beginning and at the end of the period.But the capitalized value approach is not suitable foraccounting purposes because of the subjective natureof calculation. On the contrary, the accountingmethods of depreciation may be regarded as theobjective approach to determination of value ofservices used in so far as the methods applied isrealistic under the circumstances. For example,if an asset provides equal services in ten years withuniform expenditure on repairs and maintenance, itsoriginal service value (i.e. original cost) may be objectively reduced by one-tenth each year under thestraight-line method. In such a case the capitalizedvalue method will, of course, result in less depreciation in the early years of the asset's life as comparedwith the later years!. For this reason, the value ofan asset at any time will be higher under the capitalizedmethod than the value under a realistic accountingmethod. This fact rather goes in favour of orthodoxaccounting methods because of the preference forconservatism in valuation for accounting purposes.Therefore. a realistic accounting method under whichdepreciation will approximately represent the reduction of service value ofan asset under the circumstancesprevailing at the time of revaluation can be used toascertain the current value of the remaining servicesof the assets. The third problem of valuation relatesto technological changes. Where technology ischanged, the value .ofan asset in use can be determinedafter making due allowance for the effect of the changeupon the existing asset. The technological changesmay be relevant in the revaluation of such assets asplant, machines and equipment. Arrangement canbe made to obtain information on technologicaldevelopment from the suppliers of and dealers in theassets at closing dates. Such information can betaken as the basis of valuation.

As a matter of fact, determination of values ofexisting assets of a concern with absolute accuracyis neither possible nor essential. In the revaluationprocess, the problems are mainly related to the determination of the replacement value (of fixed assets)in which the continued existence of the concern whichis using the assets in implied. In a going concern,inaccuracies in the valuation of fixed assets can beadjusted subsequently as and when detected. Moreover, as periodical profits will not be directly affectedby such valuation (as suggested earlier), the ex:istenceof unavoidabJe inaccuracies will not create muchproblem. As such, the expensive method ofdetermining exchange values (of fixed assets) can be avoidedin accounting except when the assets are to be disposedof separately or collectively.

Some suggestions have been given below as tomethods that should be followed in the valuationlReference: A. J. Merrett Be. Allen, Sykes "The Finance andAnalysis ofCapitai Projects" (Longmans, 1962) pp. 486-88.

July-September, 1969

of different classes of assets. ~ ~ ' t i ~ ~ ~ ~ ~ ? e ~ 1 should, of course, prescribe detailed methods ofvaluation of various assets with a view to maintaininguniformity and consistency.(a) Inventories.

Inventories are acquired usually for the purposeof sale with or without processing. Replacementcost should be the basis of valuation of raw-materialsand other inventory stocks that have not passedthrough further processing. Such valuation willobviously indicate the cost that would have beenincurred if the inventory stocks were acquired on thedate of valuation. In case of stocks of partly processed goods, valuation should be made on the basisof reproduction cost. Finished stock-s of a manufacturing concern should be valued either on the basisof net realisable value or at reproduction cost. Themethod applied should of course, be followed consistently.(b) Fixed Assets.

Unlike inventories, fixed assets of a concern aremeant for use rather than for sale. Therefore, itshould normally be presumed at the time of valuationthat the concern will exist to use the services of fixedassets. Of course, there may be some abnormalsituation such as bankraptcy, under which fixedassets are disposed of. But such abnormal situation,unless known beforehand, need not be assumed inaccounting. If accounts reveal the normal situation,one can make ones own assessment about the unknownabnormal situation. Moreover, uncertainties as tothe future are usually provided for in accounts bymaking provision. I f desired, similar provision maybe made against unexpected disposal of assets.

It has been metioned that the current cost of anew asset should be taken as the basis for determiningthe value or worth of an e;x:isting similar asset to theconcern. For example, if the net services (i.e. theservice value net of repairs and maintenance cost)of a machine costing Rs. 10,000/00 are equal over itsten years'life and at the end of the first five years thecurrent cost of installing a similar new machine hasincreased by 60 percent, the existing machine (withno scrap value at the end of life) should be valued atRs. 8,000/000 (the cost of replacing half of the totalservices of the machine) as shown below:

Cost of the machine in use Rs. 10,000/00Less Depreciation (SjlOth) S,OOO/OO

Rs. 5,000/00Add 60% increase in value (cost) 3,000/00Current value of the machine in use Rs. 8,000/00

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Depreciation for the purpose of revaluation neednot necessarily be similar to book depreciation. Themethod of depreciation should be reviewed at thetime of revaluation.In many cases, the chllnge of price of an assetmay be partly or wholly the result of improved technology. Because of better technology, the newasset may have one or more advantages in respect of

productive capacity, per unit cost, type or quality ofproducts. Thus, in cases where the asset in use isnot exactly similar to the new one, at the time ofrevaluation, due allowance for the expired life andfor the possible effects of technological changes onthe future use of the existing asset should be made.The technological effect may be quantified on thebasis of available information. Allowance for technological changes may then be made from the originalcost (less depreciation) in the ratio of cost disadvantages to current depreciation. Thus, if the priceof the above mentioned machine has increased by60 percent due only to the two-fold rise in productivecapacity of the new machine, the periodic depreciation(under straight line method) for the new machinewith double capacity will be Rs. 1,600 and, therefore,for the equivalent of existing production (i.e. one-half)will be Rs. 800 (as against Rs. 1,000). That is, 20percent cost disadvantage to the existing machinedue to depreciation. The current value may, thus,be calculated as follows:

Cost of tne machine in use Rs. 10,000Less depreciation (SJIOth) 5,000

Rs. 5,000Less Allowance for cost 20disadvantage (Rs. 5,000 X- - 1,000100Current value of the machine in use 4,000This method may be useful in cases where a numberof factors influence the value. of the asset in use, suchas cost advantages of the new asset, cost disadvantagesof the existing asset (due to fall in the quality of services) and rise or fall of price of existing products. Insuch cases, the original cost (less depreciation) shouldbe adjusted in the ratio of net disadvantage (or ad

vantage) to current depreciation.Due to technological changes, the existing assetmay also suffer from obsolescence. That is, theasset may be required to be replaced earlier than theend of its expected life or/and its service value mayreduce due to change of demand for the products.[n such cases, the current value of the asset in useshould be reduced in proportfon to obsolescence.For instance. if the review of the life of the existing10

machine (as stated above) in the fifth year revealsthat because of the technological improvements itshould also be replaced after another three yearsinstead of five years, its current value should be asfollows:Current value of the machine in(as shown above)Less allowance for obsolesce(2!Sths.)

useRs.nce

4,0001,600

Current value of the machine in use Rs. 2,400If during the remaining life, the demand for theproducts is expected to fall, the current value shouldbe reduced in proportion to the expected fall of production. I f such estimates are not possible for thewhole of the remaining life, the current value may beadjusted at the end of each year on the basis of yearlyreduction of production.Valuation of fixed assets made by experts or forthe purpose of insurance may also be accepted foraccounting use if the same appears to have been madeon the basis of replacement cost instead of realisablevalue. In some cases, such as loose tools, valuationis made on the basis of their realisable values. Suchpractice need not be changed as it is applied only in afew special cases.

(c) Other AssetsValuation of other assets, such as intangibleassets, securities, book-debts and receivables wouldbe easier than those of fixed assets. Therefore, problems connected with these assets are not dealt with

in this article.Periodic AdjustmentFor the purpose. of end of period adjustments,the difference between the current value of an assetand its net book value at any closing date should betreated as realisable gains (positive or negative) onthat date. Realisable gains should be shown in theBalance Sheet as addition or deduction, as the casemay be, to the book value of the respective asset.At the time of first revaluation, the total realisablegains, and thereafter only the increase or decrease ofclosing realisable gains over the opening balance of

such gains-should be adjusted in accounts. Adjustment for the difference between the total realisablegains and the unreal profit should also be made againstaccounting profit to determine real profit of a period.Developing Economy

In a developing economy like Pakistan, the procedure of revaluation of assets should. in general be(Contd. on page 14)

The Pakistan Accountant


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TENTH INTERNATIONAL CONGRESS OF ACCOUNTANTS

The Tenth International Congress of Accountantswill be held in Sydney, Australia, from Monday the16th October to Friday the 20th October, 1972. Themembers of the Australian Society of Accountantsand the Institute ofChartered Accountants in Australiawill play host. The Sydney Opera House will be usedas the Congress Centre and the plenary sessions willbe held there.The technical programme which has been developedwill enable major problems of the profession to bediscussed in depth. The theme selected for thesesessions is FINANCIAL MEASUREMENT ANDCOMMUNICATION. The following summary of thetopics for discussion will be of interest:

Measurement

Communication

1. The ascertainment of PeriodicFinancial Results2. Bases of Accounting other thanHistorical Cost3. Principles and Problems in Consolidation1. The Audit Report2. Information for Proprietors andothers3. Information for Management

An attractive social programme is being arranged.This will include the traditional functions ofan openingreception, a Congress dinner, a symphony concert withalternate entertainment and a closing dinner dance.

*July-September, ." 9

An interesting programme for ladies is also beingarranged.About June, 1970 copies of an advanced programme'to all participating bodies will be circulated andbulletins rtporting the progress of arrangements willbe sent at six-months intervals.The President of the Congress while extending aninvitation to the President and the members of thisInstitute has expressed the following:"At the heart of all our organisation is a desire toensure that the Tenth Congress will consolidaterelationships between accountants from all partsof the world, enable them to meet here in Australiato discuss matters of mutual interest and provide apleasant opportunity to enjoy the hospitality ofthe profession in Australia which feels deeplyindebt( d to those who have entertained our mem-bers at former congresses.I do look forward to seeing you and many of yourmembers in Sydney in October, 1972 and willappreciate your c o - o ~ r a t i o n in making the Congress an outstanding ~ u c c e s s . " "This information is being published in the Journalas a preliminary notice giving the dates, venue andtheme so that interested members may start makingplans to visit Australia in October, 1972.(The Council hopes to consider the matter at thenext meeting in December. 1969 and a circular tomembers will follow thereafter).

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*AUDITING THE AUDITOR Like Caesar's wife, the auditor must be ahove

suspicion. And so he was until recently. But inthe past two years he has heen the target for an out-burst of criticism in Britain, the United States andAustralia. Is he really as independent as he needsto be when he is, in effect, appointed by the verypeople be is reporting on and who provide his in-come? And what about those accounting prin-ciples: do they really produce results that are trueand fair?This sudden questioning has come about as lifeoffices have moved into equities, as people haveswitched their savings into unit trusts, as occupa-

tional pensions have spread: in short, as the pro-blem of judging company accounts has come to affecteverybody. directly or indirectly. Shareholders donot have the right or the means to check the ae-L'Ul'acy of publisbed accounts; they rely on the au-ditor. To many people be is a watchdog, if not abloodhound, whose main function is to detect fraud.But this is not so. His most important job is toauthenticate the accounts presented by companymanagements to the investing public at large. Whathappens in practice is Ihis: the management pre-sents draft accounts to the auditor; he and his staffthen investigate the underlying records to verify theaccuracy of the accounts (to see that the assets exist,have heen fairly valued, and so on); and then theaditor approves the way these facts and circum-stances are reflected in the cold ligures in tbe com-pany's published balance sheet and profit and lossaccount. On the rare occasions when he and themanagement cannot agree, the management's ver-sion is published and the auditor qualifies his report.

It is this question of presentation that has causedsome of the recent criticism. There are no absolutemeasures of profits or assets. The auditor merelyapplies the guidelines laid down by the professionalaccounting bodies; lhese are drawn up in generalterms and not for individual industries, let alonefor individual companies, whose circumstances canvary hugely. And even companies in the same in-dustry may be using quite different bases withouttheir various firms of auditors, let alone their share-holders, knowing what differences exist. Indeed,one authority calculates that the rules for valuing

-Reproduced from uTbe EconomistU , London. August 9,1969.Jul),-Septemher, 1969

assets on a company's balance sheet can be com-bined together in at least a million different ways,to produce over a million alternative "true and fair"views of the same set of facts. Thus, the solicitorgeneral of the State of Victoria, in his report on thecollapse of the large Australian Reid Murray group,commented that common sense compelled him toreject a numher of the group's accounting p r a c t i c e ~that were apparently acceptable to the profession.

Two immediate reforms are needed. One isto make the auditor disclose fully how acceptedaccounting conventions have been applied to thecompany accounts he is attesting, a disclosure thatmight cover such tricky questions as depreciationpolicy, how work in progress is valued, how deve-lopment expanditure is written off, what is doneabout the cost of advertising and promoting a newproduct and so on-all decisions that are now madeunder a cloak of secrecy. The other is to make theauditor give the maximum and minimum figares fortotal asset value and profits if accepted accountingprinciples were stretched in both directions.

These reforms would have two useful effects.Shareholders would immediately become better in-formed about their companies. And there would growup, over time, a body of published information Onhow accounting prinCIples are being applied. So, forthe first time. auditors would gain an insight intothe way accounting principles were actually beingapplied to the acccunts of companies other thanthose audited by themselves.There remains the problem of the auditor's inde-pendence. In practice, managements can usuallyfind a pretext for getting rid of him if he is being tooawkward, or at least make his life miserable or im-possible. I f he does other work for the firm, forexample as tax consultant, management consultant,adviser on computer installation, or on wage or

honus incentive schemes, his vulnerability is evengreater. To be fair, there is not a straw of evidenceto suggest that the integrity of the auditor is beingeroded in Britain, the United States or Australia, bysuch financial pressures. What is at issue is whetherhe can, as a human being, preserve his independenceof mind when he works so cl()5ely with companymanagements on a growing range of problems overmost of the year, and then suddenly has to change in-to an outside watchdog for four weeks In February.

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This isslle'would virtually disappear if the follow'irig reforms wete carried out. Auditing Iii InS wouldcontinue to act as they do today, looking at the factsof the particular situation and considering the aeeounting treatment proposed by the company management.Where clear-cut precedents were known to exist, theauditor could point to the evidence and his positionin checking this accounting treatment would beimmeasurably stronger. But where there was anydoubt about the aeeounting treatment proposed bythe management, what then? The system wouldbe greatly strengthened if there were a board of judges,selected from the accountancy profession, to whomit would be the auditor's duty to refer the case. Theirjob would be to hear evidence on contentious issuesof accounting prinCiple, and to give a judgment onthe best method, in the circumstances, of showinga true and fair view. They would be paid by the stateand so would be entirely independent of the companiesconcerned. All the hearings and judgments wouldbe reported like law cases and could then be used

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as guides in future cases. And any suspicion that theauditor was accusing the company of malpractice orincompetence would be removed, by using the COn-tinental inquisitional system of hearings, rather thanhaving the auditor stating the case, so to speak, forthe prosecution.I t would be misleading to give the impression

that the British aeeounting profession is in a messor that the system is breaking down, so that fromnow on all public companies should be checked Overannually by an official watchdog. Professional ex-pertise and integrity is stilt the auditor's hallmark.But it is quite wrong that often he should bave tomake arbitrary judgments involving people of wbombe is not totally independent. And a body of auditing Case law is badly needed to standardise the wayaccounting principles are applied to similar sets offacts. It cannot be built overnight. but a start canand sbould be made.

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(Contd. from page 10)the same as has already been stated. Yet, the circumstances may be different to some extent in a developing country. Usually machines, equipment,finished products and some raw materials are im-ported by developing countries from different sources.If such goods are regularly marketed within thecountry, the current values of assets in use may bedetermined on the basis of current market price.In tbe case of goods not available in regular markets,the current price may be obtained from the agentsor suppliers, but in such cases a price index method(tbe general or specific price indelt whichever is suitable) may be more appropriate because of the uncertainty as to the source of supply for replacement.I t has already been mentioned that in the process ofrevaluation difficulty arises mainly in respect of medassets, the value of which is influenced by technological cbanges. In a developing e

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Valuation of Assets Js 69