valuation models in accounting

CONTENT  The valuation objective in accounting  The accounting system base on historical cost  The accounting system base on current cost  The accounting system base on the general p

VALUATION MODELS IN

ACCOUNTING

TANG TRI HUNG, PhD.

CONTENT

 The valuation objective in accounting

 The accounting system base on historical cost

 The accounting system base on current cost

 The accounting system base on the general price level

OBJECTIVES OF VALUATION

 what is valuation for?

– to determine profits

– to determine financial status

 Who use valuation?

– Valuation under the eyes of investors

– Valuation under the eyes of creditors

– Valuation under the eyes of managers

Income vs Financial position

INCOME STATEMENT

Income Costs Profit

BALANCE SHEET

Assets Liabilities Owner’s capital

Balance sheet approach

Income statement approach

Income vs Financial position

 Balance Sheet Approach

 Profits is the result of an

increase in net assets

 Evaluating of assets and

liabilities by using the current value / net

realizable value / historical cost…

 Income Statement Approach

 Profits is the result of revenue minus expenses determined in accordance with the matching principle

 Assets are the rest of expenses that have not been allocated

 Evaluate by using methods satisfying this condition, for example LIFO, revaluation of fixed assets

Investor vs Creditor

Investor

 Interest mostly in the

ability to predict: : Profits, cash flows, risks

 Current Price /

Appropriate realizable value

Creditor

 Interest in the solvency The choice of evaluation methods in favor of

Conservatism

HISTORICAL COST ACCOUNTING

 Historical cost accounting is based on the purchase price in the past to record the transactions and

financial statements This is the traditional pricing system developing many years since the technique of double entry bookkeeping Pacioli was born

 During the basic sciences, the theoretical basis of this system was formed So far, this system still plays a major role in accounting practices and accounting standards

 To find out whether the person representing him/her has

complete responsibility for managing or not.

 Historical cost accounting records the actual transaction

occurring Therefore, it provides evidence to evaluate whether managers have completed effectively their responsibilities or not



HISTORICAL COST ACCOUNTING

Reasons for valuating under historical cost

accounting :

 (1) Historical cost may affect valuation and decision

of managers The managements‟ decision must be based on the quality of work in the past and prediction

of the future Historical cost providing information forms the basis for those decisions

HISTORICAL COST ACCOUNTING

Reasons for valuating under historical cost

accounting :

 (2) Historical cost is input to determine “notion of satisfaction” Many managers make decisions to achieve the results they find satisfying rather than optimal results At this point, historical cost provides useful information

HISTORICAL COST ACCOUNTING

Reasons for valuating under historical cost

accounting :

 (3) Historical cost is used because it is imposed by the environment of decision makers For example, cost is the basis for tax calculation or pricing in form of the contract that payment is based on cost plus a fixed profit rate

HISTORICAL COST ACCOUNTING

Some basic assumptions are given as axioms to provide a basis for historical cost :

 (1) Going concern says that if there is no evidence to

the contrary, enterprise is assumed to continue to operate in the foreseeable future

HISTORICAL COST ACCOUNTING

Some basic assumptions are given as axioms to provide a basis for historical cost

 (2) Time period says that economic activity of

enterprises takes place in a certain period, so that the financial statements must present activities that are clearly distinguished between the periods This

assumption is the source of matching principles of historical cost accounting

HISTORICAL COST ACCOUNTING

Some basic assumptions are given as axioms to provide a basis for historical cost

 (3)monetary unit says that financial statements are

prepared on basis of a stable monetary unit When increase or decrease of prices is not significant, historical cost provides useful information for the evaluation of financial status as well as operating results of the company

HISTORICAL COST ACCOUNTING

Profits

 Profit for the historical cost accounting is the

difference between revenue and expense; in which revenue is considered accomplishments and expense

is considered efforts The difference between revenue and expense is basis of evaluating efficiency and

management capabilities

HISTORICAL COST ACCOUNTING

 The historical cost system uses the revenue recognition

principle and matching principle between revenues and expense to determine profit in the period.

 Revenue recognition principle requirements that revenue is

recognized when it is actually completed despite earning money or not.

 Matching principle requires expense to be recorded

respectively in the period in which it can generate revenue.

 These principles ensure that profit under historical cost

accounting provides useful information for evaluating results of operation of the business.

HISTORICAL COST ACCOUNTING

The argument protecting historical cost

 Objectivity

Historical cost is said to be less affected by subjectivity and difficult to adjust by the skills than other costs as current cost

(The use of other prices question their truthfulness as well as the accountant 's ability under pressure to

adjust the data requested by manager) .

HISTORICAL COST ACCOUNTING

 There are no empirical basis to replace historical

 Mautz commented : “ If management and investment

decisions makers had not found financial statements prepared

at historical cost useful over the years, changes in accounting would have happened a long time ago”

HISTORICAL COST ACCOUNTING

The critical point of historical cost

The purpose of accounting

 It is not necessary to reflect the transactions based on the past (at historical cost) In contrast, reflecting at current cost would provide more useful information

 Net assets (assets - liabilities) calculated at historical cost will not reflect the value of the investment at the present time

HISTORICAL COST ACCOUNTING

The critical point of historical cost

The purpose of accounting

 Historical cost accounting reflects the growth of net assets

under nominal monetary value but does not reflect this growth

in purchasing power or operational capacities

 During the period of increasing price due to inflation, profit calculated at historical cost will be higher than profit at current cost.

(This results in the fact that managers may decide to split the organization beyond the "net profit" and "gradually eating into capital”).

HISTORICAL COST ACCOUNTING

Profits

 Accounting profit stated at historical cost was

criticized for its economic significance, especially for manufacturing enterprises

 According to economists, the cost used to calculate the profit is opportunity cost Meanwhile, the current price will match the price more than the original

HISTORICAL COST ACCOUNTING

The basic assumption of historical cost

 The basic assumption underlying original cost was criticized as unrealistic Monetary unit assumptions are challenged because

of inflation, assumption of going concern is also suspected.

concern”.

 First, determining the appropriate relationship between revenue and expenses in many cases is not possible.

HISTORICAL COST ACCOUNTING

Matching principle

 Second, the allocation of costs is arbitrary since there

is no basis for choosing among the methods of distribution as well as there is no empirical evidence for this method

– historical cost model has to use adjustment, for example net realizable value in the case of provision for impairment.

– Sterling also believed that the essence of historical cost is Conservatism : “ Historical cost is not the basic principle of accounting; It is arising

of Conservatism in evaluating”.

GENERAL PRICE LEVEL

ACCOUNTING

The formation and development

 General price-level accounting) formed quite early when accountants wanted to eliminate the effects of inflation on accounting The model using the general price index to adjust financial statements was

launched by Sweeney in 1936

GENERAL PRICE LEVEL

ACCOUNTING

 Since the 1950s and 1960s, the professional

organizations were interested in adjusting financial statements in accordance with the general price level

as Accounting Research No 6 : Report on the

financial impact of changing prices issued by the AICPA in 1963 in the United States.

 And a number of drafts about this issue in Britain after World War 2

 However, these studies did not led to specific

provisions in accounting practices

transferred to the provisions of current cost in 1980s.

 Particularly in South American countries, general

price level accounting formed in the 1950s in Brazil and is still applied in many countries in Latin America region characterized by very high inflation

 General purchasing power reflects the ability of the monetary unit in purchasing goods and services; This ability is inversely proportional to the increase in prices of goods and services.

 Historical cost accounting does not record the changes

of the general purchasing power so that the balance sheet will reflect assets acquired at different times and different rates

 General price level accounting overcome this problem

by adjusting the balance sheet to reflect the impact of changes in the general price level

GENERAL PRICE LEVEL

ACCOUNTING

 Basis to adjust is price index (price index)

 The index commonly used is the consumer price index (CPI – is short for Consumer Price Index)

 GDP deflator (IPD – is short for GDP Implicit Price Deflator )

 IPD is considered better because it reflects the price changing of the whole product, service of society instead of only counting on the "basket of goods" with fixity as CPI

GENERAL PRICE LEVEL

ACCOUNTING

Concepts of capital maintenance

 Capital maintenance bases on the theoretical approach

of the owner, in which people are interested in maximizing the equity after a business cycle

 Accounting equation is written in this theory :

Equity = Assets - Liabilities

GENERAL PRICE LEVEL

ACCOUNTING

 Equity is the value of the net assets

 Equity must be maintained

(This means that profit after a business cycle is only achieved when the net asset value at maturity increases in comparison with beginning of the period after eliminating the effect of the additional capital contribution or distribution of profits).

GENERAL PRICE LEVEL

ACCOUNTING

 For historical cost accounting, net asset value is

calculated in nominal monetary units (nominal monetary units)

(Profit calculated in the period includes the effect of changing the purchasing power of monetary This would be acceptable when the purchasing power of currency does not change or alter negligibly If the purchasing power of the currency changes dramatically due to inflation, profit calculated will be higher than ability to generate net business profits because of

including the fluctuations of prices.

GENERAL PRICE LEVEL

ACCOUNTING

 General price level accounting requires that

calculation of net asset values bases on units of constant purchasing power (units of constant purchasing power)

 Portion of increase net asset value at maturity

compared to the beginning period on the same units of constant purchasing power (after eliminating the

effect of the contribution of capital or distribution of profits) will be business profits

 Because purchasing power changes,

Net asset value at beginning of the period adjusted according to general price will be

300 x 1,2 = 360.

At this point, the real profit from operations in the period is

400 – 360 = 40

 Long-term assets purchased on 1.1.20x0

 Long-term loans to purchase workshop on1.1.20x0

 Revenue, purchases, expenses and taxes steadily during the year Goods purchased in the period was 64.000.

 Enterprise applied first in first out method.

 Inventories 31.12.20x0 purchased at price index quarter 4.20x0.

 Dividends were announced 31.12.20x0.

Workshop 30.000 160/150 32.000 Machine 15.000 160/150 16.000

Equity

Long-term borrowings 22.000 160/150 23.466 Share capital 90.000 160/150 96.000

Asset Balance Coefficient Balance was adjusted

GENERAL PRICE LEVEL

ACCOUNTING

 Note: the monetary items such as cash, accounts

receivable, accounts payable and long-term loans are monetary items that do not adjusted

 Inventories, long-term assets and dividends are

adjusted according to price index last year compared

to the price index arising

 Particularly undistributed profits is not adjusted

according to price index, which is calculated as the rest of the equity after all other items are adjusted

 Net Assets at the end of period : 103.730

 Net assets at the beginning of year : (96.000)

 Capital contribution : 0

 Distribution of profits : 11.250

 Profits : 18.980

GENERAL PRICE LEVEL

ACCOUNTING

Step 3

Adjust the income statement according to price index

Unadjusted Coefficient Adjusted

Revenue 100.000 160/155 103.226 Cost of goods sold 60.000 63.48

Depreciation expense 2.250 160/150 2.400 Other expense 10.000 160/155 10.323 Earnings before tax 27.750 27.085 Income taxes 8.000 160/155 8.258 Earnings after tax 19.750 18.827

Unadjusted Coefficient Adjusted

GENERAL PRICE LEVEL

ACCOUNTING

Step 4

 Determine profit / loss caused by monetary items

Unadjusted Coefficient Adjusted

Net monetary assets at beginning

 Net business profits : 18.827

 Gains arising from monetary items : 153

 Profit: 18.980

 Gains arising from monetary items can be explained from the enterprise net monetary liabilities (monetary liabilities are bigger than monetary assets) increasing in comparison with beginning of the year.

 In inflationary economy, this brings business profit because liabilities under nominal monetary units will decrease when purchasing power reduces.

 In contrast, if enterprises hold more net monetary assets, the result will be incurring losses due to reduced purchasing power.

GENERAL PRICE LEVEL

ACCOUNTING

The debate on the general price level accounting

organizations as a practical approach to solve problems that affect the price to the financial statements :

on the financial statements of the same monetary unit of purchasing power at the same time to consider.

 (This increases the comparability between the financial statements of the businesses with each other )

 The techniques applied to the financial statements

under the general price level is generally quite easy to apply and does not create differences with accounting principles that generally accepted

 determined objectively and easily to verify

GENERAL PRICE LEVEL

ACCOUNTING

 General price level accounting provides useful

information for evaluating the management of businesses :

– (i) losses caused by monetary items reflect how managers cope with inflation;

– (ii) Non-monetary items adjusted according to general price level shows that “purchasing power" need to regenerate

them and

– (iii) profits eliminated influence of price movements will help to evaluate the possibility of making business profit more relevantly.