Though the historical cost system of fixed assets valuation is more reliable, reproducible and less subjective, there are some challenges in ensuring that the financial information on fixed assets using this type of reporting provides the best information to the users of a company’s balance sheet. This is very important, because depending on the organization’s method of financial reporting, using this system can potentially negatively affect the relevancy of its financial reports for end users. Companies must be aware of these factors to ensure their fixed assets valuations and reporting systems provide useful information to users of its financial reports. One of the problems associated with this valuation method is the potential for inaccuracies in the balance sheet due to the lack of consideration and adjustments made for the fixed assets valuation based on evolving market value change, which according to Elmaleh can negatively affect the “usefulness of the balance sheet” (2007). This is important because balance sheets are prepared to provide readers with insight into the financial status of a company by outlining the “values of the firm’s assets, liabilities and equity at the end of the accounting period”, (Diewert, 2007) as such, readers may want a balance sheet to demonstrate the most up to date value of the firms fixed assets. Diewert goes further, contending that “the historical cost valuation may bear no resemblance at all to a current market valuation for the asset” thus “inflationary situation, historical cost depreciation allowances will be understated, income will be overstated and income taxes may become capital taxes” (2007). This could result in a “balance sheet [that] provides a less than accurate portrayal of economic condition” (Elmaleh, 2007).
It is therefore critical that companies value their fixed assets accurately so that the information provided to public and internal users of its financial reports is accurate and relevant. While using this method, it may be beneficial for limited companies to incorporate supplementary information for the end user that identifies the current market value of the fixed assets especially property. This is to ensure that the company’s balance sheet includes information on the current values of the asset and not just historical cost, especially during long-term and drastic inflation (AFMM, 70). Additionally, according to Steve Lawrence in his book International Accounting, when a company includes “an asset as a valuation, the historical cost must be identified and the revaluation surplus transferred to a reserved fund” (Lawrence, 1999:165). This according to Lawrence allows for transparency and appropriate disclosure by the company so financial statement readers are best informed by the information they are reviewing (Lawrence, 1999:165).
Market Value System
Another method of valuation of fixed assets is the market value system, where limited companies can record their fixed assets values through two diverse valuation methods in this system – the replacement cost valuation system and the net realizable value system. According to McMenamin, “market value is the value or price for which an asset currently trades in the marketplace, usually determined by the interaction of supply and demand for the asset” (1999:243). I will now examine these two distinct systems within market value.
Replacement cost valuation system
In the replacement cost valuation system, a company’s fixed assets are listed at the amount required to purchase an identical replacement for that asset and is “carried at its replacement cost” (Hoskin, Fizzell and Davidson, 2000:432-433). This system is over 80 years old, gaining popularity in 1920s as a means for fixed assets valuation due to the severe inflation of the period. In valuing fixed assets using this system, limited companies record the historical cost of the asset at initial time of purchase as the future replacement cost of that particular asset. With on-going use of the asset during business operations, the “carrying value” is modified – increased or decreased – to demonstrate the change in the replacement cost of the asset, with gains and losses listed in the financial statements and the amortization adjusted. The gains and losses amounts for the asset (recognized when the asset is sold) that is listed in the financial reports is the difference between the sales amount and amortized replacement cost. The benefit of this valuation system for users of financial statements is that it enables companies operating in countries with high rates of inflation to record their fixed assets at the replacement value to provide users of their financial reports with a clearer picture of their financial results for the reporting period (Hoskin, Fizzell and Davidson, 2000:433). For companies using this type of asset valuation method, it provides accountants with “the basis for computing depreciation on a current cost basis” (Diewert 2007). Certain organizations such as the Accounting Standards Board in Canada, have implemented recommendations for limited companies using this method, allowing them to provide “supplementary information on the replacement cost at the time of sale of their property, plant, and equipment” (Hoskin, Fizzell and Davidson, 2000:432-433). With this reporting process and supplementary information, limited companies can ensure that the users of the financial reports from those companies would have the most accurate information to use for their decision-making. Further, a United Nations statistical report asserts that fixed assets recorded in the balance sheet at written-down value, “a valuation frequently referred to as "written-down replacement cost", can allow a company’s balance sheet reporting to be consistent with “the measures of consumption of fixed capital elsewhere in the system” (Anonymous, 2007).
Net Realizable Value
Another form of market value fixed asset valuation method is the net realizable value, sometimes referred to as exit values where “assets are recorded as the amount that could be received by converting the asset to cash in the normal course of business… [In essence by] selling it” (Hoskin, Fizzell and Davidson, 2000:433). Through this method, a company can provide the users of its financial statements with details of its fixed assets value with related gains and losses shown as net realizable value including the yearly adjustments for the changes that occurs with this value (Hoskin, Fizzell and Davidson, 2000:433). Through this method limited companies can demonstrate according to W. Erwin Diewert “the net realizable values that the assets would bring in the market at the moment in time” (2007). A limited company can use net realized value method to value its fixed assets to best inform users of its financial reports in circumstances where there is arbitrary estimation of the costs of goods. That is “valuation on a historical cost basis breaks down either because of the infeasibility of determining meaningful cost estimates or because historical cost overstates expected market value. Further net realizable value is a method that can be used to value fixed assets when there exists an immediate, viable market for those goods” (Cadenhead 1970: 138-140).
To ensure that this method is reliable for use in determining the net value of fixed assets for reporting purposes, limited companies must ensure that they “determine what is the appropriate set of potential buyers and how their price bids could be elicited” (Diewert 2007). Further, to ensure the reports are current and accurate, the company can utilize the appraisal reports provided by insurance companies to value its fixed assets. This ensures impartiality, accuracy and eliminates the need for arbitrary judgments from company management in their valuation of a business's fixed assets (Diewert 2007).
In review of two components of the market value system for valuing fixed assets of a limited company, the primary challenge is ensuring the integrity in financial reports so that end users are best informed. Writing in his 2005 “The Measurement of Business Capital, Income and Performance” tutorial at University Autonoma of Barcelona, Professor W. Erwin Diewert from the University of British Columbia in Canada, stated, “the basic problem with the use of current [market] values is that it is difficult to determine exactly what is the “correct” concept” (2007). Accounting research has shown that historically many companies revalued their fixed assets to meet their business needs, creating financial reports with fixed assets values that supported their objectives, not necessarily reflecting accurate data. As such the reports that were produced, did not “best inform” the users. Subsequently, over the last 35 years the accounting profession has introduced and adopted “the historical cost accounting methodology for valuing assets…...[and] has stuck to this position… since that time, except when an economy experienced very rapid inflation” (Diewert:2007).
In the preparation of fixed assets valuations using the market value method, a limited company must ensure that it does not use specialty trading markets to value its assets, but rather “that the replacement market and the selling market are the markets in which the company normally trades” (Hoskin, Fizzell and Davidson, 2000:432-433). Further, many limited companies may utilize specialty equipment for which “may be very few objective measures, or even none, of current market value available” (McMenamic, 1999:249). This would make it difficult for a company to generate an accurate market value of its fixed assets in a specialty market as the values in those markets can differ from the normal market within which the company operates (McMenamic, 1999:249, Hoskin, Fizzell and Davidson, 2000:433). As such it is critically important that there are no abuses in the use of the replacement cost method in valuing fixed assets to ensure that the users of a company’s financial reports receives accurate information in the data they receive. Since according to McMenamin, there are challenges to finding the current market value of an asset, companies (1999:243) must ensure that “both the replacement market and the selling market are the markets in which the company normally trades (Hoskin, Fizzell and Davidson, 2000:433). Additional, many accounting boards in various countries, such as the Accounting Standards Board in Canada, provides recommendations and guidelines to companies using the replacement cost method to value assets. Specifically, the board had advised companies to include “supplementary information on the replacement cost of their property, plant and equipment” (Hoskin, Fizzell and Davidson, 2000:433).
Conclusion:
In conclusion, my research and subsequent readings have demonstrated that the diverse fixed assets valuation methods available to limited companies have both positive and negative attributes and can provide contradictory financial results to the users of the company’s financial reports. It is clear that each fixed assets valuation system - excluding the historical cost principle - will not generally create the same financial results when used by two different accounting professionals. Therefore, it is imperative that limited companies choose the fixed assets valuation methods that would enable them to provide the most comprehensive and accurate information that would best inform the users of its financial reports of the business operations, successes and challenges. Further, limited companies are obligated to ensure that valuation of their fixed assets not only informs users of its results but that it also adheres to the accounting standards and legal reporting requirements of the jurisdiction within which they operate their business. I would recommend that limited companies choose the historical cost principle for valuing its fixed assets as it is the most reliable, highly accurate, verifiable, and provides consistent information to allow end users of financial reports data to make prudent decisions.
REFERENCES
Accounting for Managers (2007), The School of Management, University of
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Cadenhead, Gary M., Journal of Accounting Research, Vol. 8, No. 1., 1970
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Diewert, W. Erwin.,
Elmaleh, Michael., Synopsis of Financial Accounting: A Mercifully Brief Introduction, , 2007
Hoskin, R., Fizzell, M.R, and Davidson, R. A., Financial Accounting, A User Perspective, John Wiley & Sons Canada, Ltd, Toronto, Ontario, Canada, (2000)
Lawrence, S., International Accounting, International Thomson Business Press, 1996, page 165
McMenamin, J., Financial Management: An Introduction, London, New York Routledge, 1999
Anonymous (2007),
Guide to Accounting for and reporting tangible capital assets, the Public Sector Accounting Group of the Canadian Institute of Chartered Accountants,
http://www.psab-ccsp.ca/index.cfm/ci_id/37536/la_id/1.htm
