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Business Accounting: Asset Valuation methods
Free essay example:
Business Accounting Essay
Asset Valuation Methods
Determining the valuation of a business is an expensive, complex and time-consuming task, yet more and more people are valuing there businesses each year. A leading cause of this growth in volume is the fact that a valuation is frequently used in setting a price for a business that is being bought or sold. Also professional valuations are being used to determine the amount of credit that should be extended to a company, by courts in determining litigation settlement amounts and by investors in evaluating performance of company management. Lastly, a valuation is often required under a variety of accounting and tax regulations. (http://www.ventureline.com/bizval.asp)
I will begin firstly by giving you a brief introduction about the company that I chose that is British Airways. British Airways is in the top FTSE 100 and is the UK’s largest international scheduled airline, flying to over 550 destinations at convenient times. Providing a service of the highest standard and looking after its customers is top priority to British Airways. This is defined on there company website “Whether customers are in the air or on the ground, British Airways takes pride in providing a full service experience”. Under IFRS net assets for the year ended March 31 2005 were £1.4billion (British Airways financial information under IFRS). The airlines turnover for the year ended March 31, 2006 was at £8,515m, this is an increase of £743,000 from the previous financial year, as the turnover on March 31 2005 was £7,772m. British airways net income was £451m for the year ended March 31 2006, the airlines total assets was valued at £12,174m. (http://briefings.ft.com/company/profile.html?extelID=00000148)
The British airways group consists of British Airways plc and a number of other subsidiary companies including in particular British Airways holidays and BA connect ltd. (http://www.britishairways.com/travel/aboutba/public/en_gb).
For this essay I will be examining the valuation methods used by British Airways for both their property plant and equipment and intangible assets. Also, I will need to obtain reliable measurements for their assets; the appropriateness of each method used will be evaluated. I will also be focusing on how the adoption of the IFRS results has an impact on there financial information. British Airways currently consolidates their financial statements under UK Generally Accepted Accounting Policies (GAAP). In 2002 all EU listed companies are required to prepare consolidated financial statements in accordance with the International Financial Reporting Standards (British Airways financial information under IFRS).
To examine BA valuation methods I will require there financial statements, this is vital as this will provide information about there financial position and performance, they use this information to make economic decisions. Financial statements provide information about the company’s Assets, Liabilities, Equity, Income and expenses, and other changes in equity. This is documented through a company’s Balance sheet, income statement and cash flow.
BA need to meet IFRS requirements and must comply with IFRS regulations. “IAS 1 requires that an entity whose financial statements comply with IFRSs make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRSs unless they comply with all the requirements of IFRSs”. [IAS 1.14]
To begin with there are a number of ways to value a company. The most widely used and accepted type of valuation that I will be using is asset value. “Asset value considers the business to be a collection of assets that have a marketable value to a third party in an asset scale” .Asset valuations are used for businesses that are ceasing operation and for specific types of businesses such as holding companies and investment companies. Asset valuation methods include the book value method, the adjusted book value method, the economic balance sheet method, and the liquidation method. In reference to Alexander and Nobes “ In most parts of the world the measurement of tangible and intangible assets continues to be based on cost, after taking account of wearing out (depreciation) and loss of value (impairment).
Historical cost is based on Generally Accepted Accounting Principles (GAAP) Financial statements often assess the value of assets on the basis of their historical cost.
The basic premise of the historical cost approach in valuing its assets is that the “value of any economic entity can be estimated by a balance-sheet analysis of its assets and its liabilities”. An evaluation of a company would suggest that the purchaser should not pay substantially more than the owner's equity - that is, the difference between total assets and total liabilities. It is argued that historic cost fairly represents a company’s tangible value.
Under IFRS strict guidelines, BA must make certain that all costs are included in its financial statement that includes any repairs or work carried out on its aircrafts to bring it to its working condition “Cost includes all costs necessary to bring the asset to working condition for its intended use. This would include not only its original purchase price but also costs of site preparation, delivery and handling, installation, related professional fees for architects and engineers, and the estimated cost of dismantling and removing the asset and restoring the site (see IAS 37, Provisions, Contingent Liabilities and Contingent Assets). [IAS 16.16-17].
From looking at BA financial statement, any fleet that is owned or held on finance, lease or hire purchase arrangements are held at cost, which is then taken from the depreciation cost, the residual value of the fleet (the remaining life of the fleet) is then valued over a straight line basis. Cabin interior modifications, including those required for brand changes and re – launches, are depreciated over the lower of five years, this is depreciated using the straight line method. Aircraft and engine spares are depreciated in line with the fleet they relate to.Any overhaul expenditure, including replacement spares and labour costs is amortised over the major expected life of the overhaul. BA need to ensure that they depreciate any overhaul expenditure separately if it is greater than the total cost, this is in compliance with the IFRS “Note, however, that if the cost model is used each part of an item of property, plant, and equipment with a cost that is significant in relation to the total cost of the item must be depreciated separately”. - [IAS 16.43]. Freehold properties and certain leasehold properties are valued at cost; depreciation on freehold properties is based upon the expected useful life of the property.
IAS 16 states that “depreciation is the systematic allocation of the depreciable amount of an asset over its useful life”. The straight line depreciation method calculates the depreciation of an asset by assuming the asset will lose an equal amount of value each year. The annual depreciation is calculated by taking away the estimated value of the asset from the purchase price, and then dividing this number by the estimated residual value of the asset. (Dyson 2004)
The IASB refers to Intangible assets as “an identifiable non monetary asset without physical substance held for use in the production or supply of goods and services”. According to IFRS the three critical attributes of intangible assets are the following:
- Identifiability (capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or as part of a package) or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
- Control (power to obtain benefits from the assets)
- Future economic benefits such as revenues or reduced future costs
“After initial recognition the benchmark treatment is that intangible assets should be carried at cost less any amortisation and impairment losses” (IAS 38.74). British Airways regards goodwill, landing rights and software as there intangible assets. Goodwill is defined as the “difference between the purchase price and the fair market value of an acquired company's assets. Goodwill is an leftover amount that cannot be identified, after a thorough investigation, as any other tangible or intangible asset” (http://home.att.net/~s-prasad/GW.htm). Goodwill is considered imperative to a company’s financial statement, but many professionals find it hard to measure, from an accountant’s perspective “goodwill appears in accounts of a company only when the company has purchased some intangible and valuable economic source”.
In the BA financial statement, it states that “Where the cost of acquisition exceeds the fair value attributable to the net assets acquired, the resulting goodwill is capitalized”. Goodwill is held at cost and is valued when the purchase cost exceeds the company’s net assets; the difference is assumed to be an asset ‘goodwill’. Goodwill is tested for impairment annually and is amortised over a period not exceeding 20 years. This is amortised using a straight line basis. This is in compliance with IAS 38.97, (please see page 5)
Under IFRS guidelines goodwill must be charged to an expense when occurred, this is supported by Rosen 2004 who stated that “It used to be that companies regularly amortized their goodwill, drawing down the amount every year and recognizing an expense on the income statement. It made sense that since the goodwill was helping to produce revenue, it should be matched up as an expense as it slowly deteriorated. And yes, most goodwill eventually deteriorates to nothing.”. Alexander and Nobes stated that “some intangible assets are purchased separately and have a clear cost”, this applies to BA as there landing rights are obtained from other airlines and are capitalized at cost and amortised over a period not exceeding 20 years. The carrying value is reviewed for impairment if events or changes in circumstances indicate the carrying value may not be recoverable.
According to IFRS 3, intangible assets must be identified separately, valued and held on the balance sheet. BA has acted in accordance with IFRS guidelines as the cost of purchase or development of computer software that is separable from an item of related hardware is capitalized separately and amortised over a period not exceeding 4 years on a straight line basis.
In accordance to IAS 38.97 “intangible assets are classified under indefinite life or finite life”, indefinite life is when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. And finite life is when there is a limited period of benefit to the entity. BA intangible assets have a limited period of useful life, so there intangible assets are classified under finite life. In compliance with IAS 38.7 “The cost less residual value of an intangible asset with a finite useful life should be amortised over that life”. BA has met these terms as they have amortised there intangible assets by straight line method and they have tested their intangible assets impairment annually.
Focusing on BA’s financial statement, they mainly employ historic cost as an asset valuation method. Because cost is widely used for most companies, it is therefore a more convenient way of valuing its assets. As mentioned before, historic cost fairly represents a company’s tangible value, this is because historic costs recognizes the effect of accumulated depreciation, because most businesses are unlikely to maintain large amount of inventories (stock) the depreciated value of assets fairly represents a company’s tangible value.
Although this method provides significant information from the financial statements, the appropriateness of historical cost as valuation method is questionable, particularly for assets that are either newly bought or fully depreciated, where the difference between book value and market value will be greatest. For example a new car that you bought five years ago for £5000, would have depreciated over a rate of 10% a year, over 5 years it would have depreciated 50%, the book value of the car over this period would be £2500, even though the book value is £2500, the buyer would look at the condition of the car i.e. damages, mileages, owners, etc, and offer you a fair market value of the car, which could be £2000 or less depending on the condition, this is the market value of the car. “The fair market value is the price at which the asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts”. http://en.wikipedia.org/wiki/Fair_market_value
Moreover, the historical approach focuses mainly on companies tangible assets and largely overlooks its intangible assets. The tangible assets of BA, such as fleet, cabin modifications and overhaul expenditure are relatively easy to calculate financially. On the other hand, the value of intangible assets, such as goodwill, landing rights, software cannot be adequately reflected on a balance sheet. This is argued by Alexander & Nobes (2004) “intangible assets that are created by the company itself, such as brand names or customer lists. These cannot be capitalized unless they have been bought from somebody else, because otherwise a cost or value is difficult to determined.”. However British Airways capitalized its landing rights as they obtained it from other airlines. The landing rights are valued separately and have a clear cost.
A further problem in the historical cost method is that historical records may not represent a company’s actual value because expenses may have been inflated for tax purposes. As a result, this approach often substantially undervalues businesses.
BA has also used the straight line depreciation method to value its assets. Straight line depreciation is very common way to value tangible and intangible assets (fixed assets). This approach works best for BA, as they own a numerous number of fleet. They will not need to replace or change these aircraft in the short term, so therefore the straight line approach will spread out the cost equally over the lifetime of the asset. Using this approach for long-term assets will be more appropriate because shareholders will not see accelerated depreciation on a long-term asset. However, this method can not be used for all types of assets.
“Today's markets are dynamic and volatile. Whether it is for buying or selling, what people want to know is what an asset is worth today” (H:\Business accounting\Fair Value.htm). Basically this statement emphasises the point I made earlier with the car example, the asset is only worth the amount you can get on the market, today’s price, never mind projected forecasts.
The simplest and most relevant form of valuing an asset is fair value, according to GAAP “Fair Value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in liquidation”. This method is very similar to that of Net realizable value. The FASB is also a strong supporter of this method “The FASB, after extensive discussions, has concluded that Fair Value is the most relevant measure for financial instruments. In its deliberations of Statement 133, the FASB revisited that issue and again renewed its commitment to eventually measuring all financial instruments at Fair Value”. (H:\Business accounting\Fair Value.htm)
Fair Value accounting provides more simplicity than historical cost based measurements, as it does not recognise company’s assets that are either newly bought or fully depreciated, historic cost largely focuses on NBV, whereas fair value looks at the market value of the asset. According to a website, using the fair value approach could help investors and shareholders to make better decisions “Maybe, if all companies measured all fixed assets at Fair Value, regulators and investors could have achieved greater regulatory and market discipline and avoided some of the losses that investors and taxpayers have had to pay during previous downturns in the economy”. (H:\Business accounting\Fair Value.htm)
In BA financial statement, intangible assets are capitalized at cost and amortised using the straight line basis, this is in guidance with (IAS 37.74). But if there intangible assets were capitalized using fair value then they would use the revaluation model. According to IAS 38.75 a revaluation model is “where Intangible assets may be carried at a revalued amount (based on fair value) less any subsequent amortisation and impairment losses only if fair value can be determined by reference to an active market.” [IAS 38.75]. If BA’s landing rights were valued at the fair value approach, they would still be amortised using the straight line basis but the landing rights would be capitalized through a reassessment of the net book value (carrying amount). This excludes measures to value its recoverable amount and impairment losses.
My opinion is that BA can use this approach in valuing its fixed assets, making estimates in fair value is made through a quoted market price for example in BA perspective fleet can be valued in a quoted market price. However like other methods, fair value has its downfalls, in many circumstances, quoted market prices are unavailable, as a result, making estimates on fair value is difficult.
Source available at: (H:\Business accounting\Fair Value.htm)
Other method that BA could use instead of cost is net realizable value. Alexander and Nobes define net realizable value as “expected sales receipts less any costs to finish and to sell” The net realizable value approach assesses the value of assets based on what they could be sold for in the current market. For example BA’s net assets is worth £1.4billion - the amount one could get for the companies tangible assets, remember intangible assets also can be accounted for using this approach. If, for example, the landing right could be sold to another airline like Virgin for £75million, the net realizable value of the company would be £2 billion.
Although this method provides an accurate valuation of assets, this method assumes how much an actual buyer would be willing to purchase the company at an estimated price.
An even greater problem with this method is that little is gained from knowing the value of these assets, and such a valuation may, in fact, result in an undervaluation of the company. Rather, the valuation should focus on determining the value of the company as a whole.
An additional method that BA could use is the Discounted Cash Flow (DCF) “Discounted Cash Flow was first formally articulated in 1938 in a text by John Burr Williams: 'The Theory of Investment Value'. This was after the market crash of 1929 and before auditing and public accounting was mandated by the SEC”. This is the “amount someone is willing to pay today, in order to receive the anticipated cash flow of future years.” (http:\Business accounting\Discounted Cash Flow)
An important component of the DCF method is the translation of future profits into a present-day value. This is accomplished by discounting future profits by applying a discount rate to those profits. The discount rate is the annual percentage rate applied to convert future profits to a present-day value.For example, at a 10 percent discount rate, a £100 profit next year would be valued at £90 today. Discounting of future cash flows is accumulated over years, and thus £100 made several years into the future would have even less value.
The two main factors of discounting future profitability is the time value of money, or the fact that money made today has more value than that made in the future. The second factor captured in a discount rate is business risk - the chance that the business fails and the projected future profits are never realized.
No approach to valuating a company like British airways is without limitations. To conclude, my outlook is that British airways should combine some of there methods of valuation, for example historic costs valuation should be used to value its tangible assets like they have and for intangible assets it should consist of the fair value approach. However the majority of companies now tend to use similar valuation methods. Methods used by British Airways in their financial report are methods that are in compliance with IFRS guidelines. British Airways employs financial regulators to ensure that the right methods are being used to value the company’s assets, my objective was to give a detailed analysis and evaluate their methods and also to recommend some methods of my own, in doing so I can see that the methods employed by British Airways have work well for them, but these methods may not work well for another company. Appropriateness of each methods used depend on current situations and types of assets.
- http:\Business accounting\IAS Plus International Accounting Standards IAS 38, Intangible Assets.htm (Deloitte)
- (http:\Business accounting\Fair Value.htm)
- (http:\Business accounting\Discounted Cash Flow)
- http:\Business accounting\IAS Plus International Accounting Standards IAS 16, Property, Plant and Equipment.htm (Deloitte)
- http:\Business accounting\Net Present Value (NPV).htm
- British Airways financial information under IFRS (www.ba.com)
- Rosen, A (2006) Canadian Business [Online] Toronto. Available from: http://proquest.umi.com/pqdweb?did=1104501611&Fmt=3&clientId=23490&RQT=309&VName=PQD
- Alexander,D and Nobes, C (2004) Financial Accounting An International Introduction Second Edition, England, Pearson Education Limited.
- Dyson, J (2004) Accounting for non-accounting students Sixth Edition, England, Pearson Education Limited.
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