Fixed Asset Valuation - Term Paper Example

Table of Contents Introduction………………………………………………………….………….………..2 2. Kinds of Financial ments…………………………………………………..…….….2 3. Valuation of FixedAssets………………………………………………….…….……….3 3.1. Distinguishing between capital expenditure and revenue expenditure…….….…..5 3.2 Approaches for Valuation of Fixed Assets in a Limited Company……….….…....6 3.21. Principles of Asset Valuations…………………………..…………………....6 3.22. Cost Approach……………………………….…………………….….……....8 3.23. Income Approach……………………………….……………….….………...9 3.24. Market Based Approach………………………………...…………....……...11 4. Conclusion…………………………………………………………………….…………12 5. References………………………………………………………………….……………12 1.0. Introduction Users of financial reports are interested in knowing how an entity is operating i.e. how it spends funds entrusted to it, how it generates profits and the way it uses generated profits. Companies have to prepare financial statements so as to provide essential information about the entity. Financial reports have been considered to provide stewardship information. Preparation of these reports has changed substantially. At first, accountants could only present a list of money spent by the company. The introduction of double entry accounting system has led to construction of both static financial statements which reflect financial position of a company and the dynamic financial records which reflect movements and changes in the financial position of the same company. Investors, shareholders, suppliers, customers, management, labor, creditors and government regulatory agencies are some of the users of the financial reports of an entity. They are interested in knowing the financial position of the company at a specified time. According to Stuart (2007, p. 140), financial reports are a source of information which reflects all the financial measurable aspects of the company and these are very vital to the users for they assist in making decisions. Investors use the financial reports to understand the possibility of continuity of the company hence they may choose to put their money for future benefits. Both unlimited and limited companies, due to complexity of business operations and concomitant complexity of the financial reports, have to ensure that relevant up-to-date financial information is presented in the financial reports. The reports should be accurate and easy to interpret so that financial users can acquire the best information which will help them to make financial decisions. 2.0. Kinds of Financial Statements Financial statements may be prepared for non-profit organizations, private individuals, retailers, manufacturers, service industries and wholesalers. The data and the information available in the financial reports are affected by the nature of the organizations or the enterprise involved. Balance sheet is a financial statement which an enterprise has to prepare. This provides the user with information about resources available to the enterprise as well as the claims to these resources. The second financial statement is the income statement which reveals the profitability nature of the enterprise. It details sources of revenue and the expenses incurred in generating this revenue. Statement of changes of the financial position is another very crucial financial statement which provides users with data about sources and uses of the enterprise’s financial resources. It also demonstrates changes in the capital structure of the enterprise. Last but not least is the statement of retained earnings which reconciles owners’ equity in the successive balance sheet. It details what is happening to the revenue generated by the enterprise (Stuart, 2007). 3.0. Valuation of fixed assets Valuation of these assets should be done following the laid down accounting standards. After identification of these assets, it is imperative to ascertain the component costs associated with them. According to accounting standards, the cost of fixed assets comprises of the purchase price, levied taxes and other directly attributable costs that bring the asset into existence for the intended purpose. The purchase price of the asset is arrived at by subtracting trade discounts and rebates. Some of the costs attributable to this include handling and initial delivery costs, costs of installation, professional fees and site preparation costs in case of plant and equipment. It is important to note that the cost of an asset may undergo subsequent changes due to exchange fluctuations, price adjustments and other similar factors. When valuing fixed assets, a limited company should exclude administration and overhead expenses from their cost since they are not associated with particular assets. Expenses are always incurred when testing and experimenting the effectiveness and efficiency nature of the assets. Start-up and commissioning of the asset requires resources. These should be capitalized as an indirect cost of construction of the asset. Accountants or other responsible persons should consider the condition of the fixed asset to be valued because of the fact that some of them, for example infrastructure, have a life cycle. The value of the fixed assets is very important especially when making decisions during sale or disposal of the assets, when the company intends to merge with another company, when the company intends to reinvest and when partnerships are to be launched. Quinn (2001, p. 39) noted that valuation of fixed assets by a limited company can be done using different valuation methodologies which are affected by objectives of the company. Recording of properties and their economic and physical characteristics for the purpose of record keeping is done following normative criteria as established by accounting standards. They should be recorded according to their normal book values, cadastral information and their numbers. Depreciation due to technical obsolescence and wearing out should be considered when recording replacement values of the fixed assets. Values of the assets should be updated to recent cost estimates. Real estate property should be recorded according to their comparative market values. In addition, fixed assets can be recorded according to their expected values. This applies to assets which have alternative economic use and are subject to sales or negotiation for concessions or joint ventures. The level of profit reported in the financial statement depends on the amount at which fixed assets are valued before listing in the balance sheet. Great care should be taken so that no errors are made when valuing fixed assets since it has far reaching effects on the profit level that will be reported in the balance sheet. This reduces the usefulness of the financial reports as a basis for assessing performance by the users. Appraisers of fixed assets in a limited company are obliged to identify costs and the depreciation charged on a particular fixed asset before reporting them in the financial statements. 3.1. Distinguishing capital expenditure from revenue expenditure This is the initial stage when appraising the value of an asset of a company. Any expenses incurred by a business has to be accounted for as either capital or revenue expenditure. It is important that appraisers of assets of a limited company identify the differences between the two types of expenditure. The appraisers should record the capital expenditure on fixed assets in the balance sheet at cost which is then charged against the revenue reported over the period in which the asset was used. On the other hand, revenue expenditure on fixed assets is recorded in profit and loss account against revenue generated over the period in which the asset was put into use (Antill 2005, p. 130). Assets reduce in value as they are being used by the company. Appraisers of fixed assets should calculate the value at which the assets have depreciated before presenting them in the books of accounts or the financial reports. This is charged in the accounts to show that the asset has declined in value as result of extensive use by the company. The benefits that the company derives from use of assets vary depending on the nature of the assets itself. Inability of the company’s management to ascertain which expense is regarded as capital or revenue expenditure on assets has led to accounting fraud. It is the responsibility of the management to classify expenses according to their nature and how they were used in maintaining the assets. Revenue expenditure should be taken up into the income statement and the capital expenditure be taken up in the balance sheet. The classification process of these expenditures differs from companies in one industry to another. For instance, most companies purchase land for resale hence this is considered revenue expenditure whereas others purchase it as part of their permanent assets hence they should be classified as capital expenditure. 3.2. Approaches for Valuation of Fixed Assets in a Limited Company Traditional business valuations are based on assets, income, historical or cost approaches. Valuation processes are faced with significant challenges because of changes that are occurring in the global economy. In order to best inform the users of financial reports, evaluators or appraisers of the company’s fixed assets should integrate information drawn from various sources before arriving at the value of an asset. Traditional business valuation approaches have had limitations in the sense that the end result of the valuation process is just but an estimate of value or range in which the value is suspected to fall. Evaluators’ skills, experience and judgment affect the valuation process a great deal. 3.21. Principles of Asset Valuations In order to give true and accurate financial information to financial users, evaluators have to follow valuation principles which act as guidelines in arriving at the real value of the assets at specified time. Every valuation technique or method must comply with the following principles in order to give final results which are significant to the users. Principle 1- What a rational buyer will pay a realistic seller “Reasonable” here is used in the economic sense. The seller and the buyer are believed to be rational enough that each has to make comparisons between alternative investments. The principle also implies that the seller and the buyer can make a deal upon realizing that the economic incentive to purchase the asset is equal to economic purchase to sell the asset. Principle 2- Business entities should be regarded as organized methods of producing revenue over a specified period of time. The evaluator should be able to divide business into two components mainly the asset value and the business value - goodwill value of the business. The asset value represents the value of the machinery, buildings, land, usable stock and legal rights. On the other hand, the goodwill value of the business encompasses the premium value that a buyer is willing to pay the seller for the company and the respective historical recorded cash flows. The evaluator should understand that there is no economic incentive to capital investment in any business which is not capable of producing net income in the excess of return on investment as noticed when comparing alternative investments. Principle 3- Accuracy is affected by the Standard use of terms, methods and the degree of information disclosure. It is the duty of the evaluator to ensure that the report given on the financial matters of the company is very accurate and up-to-date. The report should be as good as the data that the valuation is based upon and that it should allow the company to make adjustments for minor mistakes that were made during interpretation of the accounting records. The financial reports should include documents and source notes wherever possible. These materials affect transfer liability from evaluator’s opinion to fact. The documents are very important as they add credibility to the report given. In addition, the documents ensure accuracy and reliability of the report. Principle 4- Any estimated value made by the evaluator should be limited by time. It is important to recognize the fact that sales price of items are subject to change due to rapid changes in the market conditions. The valuator should note that the price of an asset is valid for a short time relative to the size of the company in the specific industry. Limited companies can value their fixed assets using three common approaches which include cost approach, market data approach and the income data approach 3.22. Cost Approach Ralph (2008, p. 35) claimed that cost approach has been widely used by many business entities in the global economy. It is based on the principle of substitution where the vale of a particular asset is estimated on the basis of the cost of putting up or installing similar assets at the current prices. The valuator has to consider that the cost of an asset does not necessarily determine its selling price. This is a traditional concept which has led to inaccurate financial reporting. The valuator has to make assumptions regarding the cost of purchasing the asset. The assumption underlying this approach is that the cost of purchasing new property at the current price is commensurate with the economic value of the products or services that the particular asset is going to offer during its life time. The cost of the inputs incurred in making the fixed asset should be equivalent to the value of the services derived from the same property. In valuing fixed assets of a limited company, all practitioners should agree that the book value of a specific fixed asset is not necessarily adequate proxy in which the company can represent the net value of the fixed asset of the company for valuation purposes. It is imperative to take into account the fact that book value of fixed asset is only a figure that is available for all the business entities and different business organizations arrived at this value using different rules which vary with the Generally Accepted Accounting Principles (GAAP). The valuator should refer to the company’s records in order to identify in detail each asset number which is the component of the book value as revealed in the financial statements. Most valuators use book value of a particular asset as starting point for the valuation process of the company’s fixed assets. In aid to giving true financial information, valuators of fixed assets should consider the concept that the value of the operating asset in the company should include consideration for the unique relationship of the specific fixed assets to a particular business operation as the subject. The value of the asset which is already in place and ready for use should represent the retail price plus any other applicable costs such as taxes incurred, freight costs and installation charges. The valuator should then sum up all these costs, deduct any depreciation and obsolescence costs so as to arrive at the true value of the fixed asset as at that time or end of a specific period. Under this approach assets are valued using historical cost or replacement and reproduction cost. In order to give the true information about value of the assets, it is imperative to consider their historical costs. This has been the orthodoxy in publishing financial statements of most companies around the world despite its limitations. The approach considers the cost incurred during installation of the asset. The method is more objective as compared to other valuation systems. Its valuation processes are more objectively determinable and can be better understood by many users in the company. It is due to its familiarity that the method has been used by most companies in the modern industries (Ralph 2008, p. 32). 3.23. Income Approach This approach is only used if the company uses fixed assets to produce income. The approach takes root from the market data approach since it involves analysis of what the current market is paying. This is arrived at by determining comparable returns which the valuator should capitalize into comparable purchase price of the asset. Under this approach, the values of the fixed assets are estimated considering the expected income attributable to the asset during the remaining economic life. The valuator should express the fair value of the fixed asset as the present value of the future stream of the economic benefits that the company will derive from the ownership of the asset. The fundamental factors considered in the approach in representing value of the asset include the economic benefit, capitalization or the discount rate and the economic life of the fixed asset. The company management or valuators are obliged to measure the future stream of economic income from the property by the amount of the net cash flow that the very company will derive from employment of the fixed asset (Stuart, 2007). Ralph (2008, p. 32) also argued that in order to arrive at the true and accurate value of a fixed asset, valuator should be able to identify income and costs that are associated with the fixed asset over its economic life. The second valuation step is to compute Present Value (PV) of future stream of cash flows of the asset. This should be done using appropriate discount rate which reflects risk of investment in the market. The following formula is then used to calculate the PV of the fixed asset;      Present Value of future cash flows derived from the fixed asset =                                          C1        +        C2      ……………………………………………...       +       Cn                                       (1+ r)    (1+ r)2                                                     (1+ r) n   Where r represents the discount rate in the market, C represents cash flows and n represents the number of years that the property is expected to last in the company while generating income. The valuator should compute the PV by deducting Present Value of Cash Outflows from the Present Value of the Cash Inflows as shown by the formula below Present Value of the Fixed Asset = Present Value of Cash Inflows - Present Value of Cash Outflows Weetman (2006, p. 234) argued that this approach is used for valuing assets of a business as a continuity entity. It is based on the ability of the company to generate income and the degree of risks that the owners of the company are ready to assume. The appraiser has to determine an appropriate capitalization rate which will be used to compute the market value of a company based on the income. In order to get the true market value, the appraiser has to consider the period in which the company has been in existence, known risk factors, profitability that it has achieved since its inception, growth history and potentialities of the company, uniqueness of technology adopted by the company, entry barriers of potential entrants among others. If the appraiser considers all these factors, it implies that the real market value of the company will be arrived at which in turn leads to true financial information that will be made available to the users. Limitations of the Approach Despite its extensive usage by most companies in the world, the method has its limitations. The major drawbacks are that it is very difficult to calculate income associated with fixed assets. Appraisers have been faced with challenges in calculating the actual income that the asset is expected to generate during its economic life. It is also quite difficult to calculate the economic life of the asset in question. Furthermore, appraisers have faced numerous problems in ascertaining the discount rate or the cost of capital (Stuart, 2007). 3.24. Market Based Approach According to Antill (2005, p.136), the appraiser can determine the value of the fixed asset by considering the market prices paid for similar fixed assets in the third party transactions. The value of the fixed asset is estimated basing this on the market prices of similar fixed assets which have been either bought or sold in the market between independent parties. The most common method used under this approach is; Market capitalization- If the company is listed in the stock exchange or market, this method can be used. The appraiser verifies the book value of all fixed assets in the balance sheet which are then subtracted from the total liabilities. Net Fixed Assets are calculated as: Net Fixed Assets (N) = Total Fixed Assets – Total Liabilities 4.0. Conclusion Fixed assets are very important in the presentation of financial reports of a limited company because of the fact that they represent a significant portion of the total assets. Valuation of fixed assets is regarded as a vital consideration and challenge hence should it be done by qualified personnel with extensive experience and strong personal qualities. Users of financial reports require accurate information on the state, financial value and the physical features of particular assets. Organizations should be able to provide sophisticated analyses of the factors affecting the value of these fixed assets so as to report quality information which best inform the users.   References Antill, N 2005, Valuation under IFRS: Interpreting and forecasting accounts using international financial reporting standards, USA, Harriman House Publishers, pp. 120-145. Quinn, P 2001, Law firm accounting and financial management, USA, Routledge Cavendish, pp. 34-78. Ralph, D 2008, the accountant, USA, Lafferty Publishers, pp. 13-42. Stuart, M 2007, Audit process: principles, practice and cases, New York, Cengage Publishers, pp. 190-243. Weetman, P 2006, Financial accounting: An introduction, Journal of accounting management, 2(1), pp. 231-267. Read More