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3.1.3. Valuation

The default criterion that concerns the assets values, as you read them on the face of the balance sheet, is that the values should represent prudent valuations of the future economic benefits that are expected to emanate from the assets to the entity, under the assumption of 'going concern', i.e. the assumption that the entity will keep operating in the foreseeable future.11 To this respect, three important considerations must be made: firstly, the assumption is made that, as a starting point, the original cost of the assets when they were purchased, or indeed produced in-house, is a conservative and objective, hence appropriate, valuation of the assets (historical cost valuation); secondly, exceptions must be made in the case of current assets, and more specifically inventories, when their expected realizable value12 is lower than their cost of purchase or production; and thirdly, a different method, called 'fair value accounting', is required (or allowed) under certain circumstances for certain assets.

The historical cost valuation has the following implications for you, when you read the balance sheet of an entity. Assets reported using this method (and these are the vast majority of the non-current assets) are reported at a value that is calculated as their cost of purchase or production:

o less the sum of the deductions regularly and methodically made every year to represent the amount of their economic benefits that has emanated to the entity - these deductions are called depreciation for tangible assets and amortization for intangible assets

o less any further loss in value that is not represented by the regular deduction above explained, which result from exceptional, unexpected, permanent and unfavorable changes in the amount of future economic benefits still left to emanate to the entity, for example because of damages, or unexpected technological obsolescence, or shorter than originally accounted for useful life - these deductions are called impairments

o plus any increase in value that results from exceptional, unexpected, permanent, favorable and allowed to be reported changes in the amount of future economic benefits still left to emanate to the entity, for example because of permanent changes of the marketability of those assets, such as is the case of increases in value of properties (not in the context of a financial crisis) - these increases in values are called revaluations.

All the values and their changes as explained in the bullet point above can be easily traced in the notes to the accounts of your chosen entity. Look at its balance sheet, find the non-current (or fixed) assets, identify the notes to the accounts that refer to them; in those notes you will find a table with an explanation of the changes in the historical costs of those assets, due to acquisitions and disposal, split in categories, which vary according to the industry and to the entity, typical examples being machinery, fixture and fittings, properties, vehicles, equipment, etc. Also, based on the same categories, you will find the changes in value of the sum of the depreciation and amortization, the impairments and the revaluations.

Whilst the notes to the accounts refer to the facts of the entity's past years, you will find explanations about the policies adopted by the entity in the accounting policies, where the depreciation and amortization policies are explained, together with the impairment and revaluation criteria. These policies are normally shown in a section of the annual report that just precedes or just follows the financial statements or are included in the notes to the accounts as the first note.

Fair value accounting is applied to financial instruments and can be applied to other non-current assets. The underlying rationale of fair value accounting is that, where it is possible to refer to a market value for certain assets, that one is the most appropriate value for reporting purposes. Where no market value is available, then reference should be made to recent transactions involving similar items. In absence of these transactions, other techniques should be used, which are aimed at calculating the actual amount of economic benefit that will emanate from these assets.

Whilst the intention of this method of accounting is to provide the reader of the accounts with more realistic figures, which are updated at each period end (in the annual report or in the interim reports), the effect has also been to bring the volatility of market values and the uncertainty of valuation techniques to the balance sheet (and to an extent to the income statement, as we will address later on). The implications of fair value accounting, for you when you read the accounts of your chosen entity, are that the values of any investment or other financial instruments present in the balance sheet are likely to refer to their respective market quotations as known when the accounts you are reading were prepared. On this matter, though, you must be aware of recent developments due to the international financial crisis and on-going recession; a temporarily provision has been hastily taken by the International Accounting Standard Board, to 'relax' the fair value accounting rules. The rationale behind this provision is that, in a context of widespread financial crisis and recession, reporting corporate investments at their market values negatively affects the value of corporate equity and, as this equity is likely to represent investments of other entities, also these other entities' equities are negatively affected, triggering a destructive domino effect that contributes to spread panic among investors and deepens the crisis even further. It is not obvious, at the moment, how long the fair value accounting rules will stay 'relaxed' or whether they will ever be restored in their original form. Given the controversy that has accompanied these rules all along since they have been issued, it is very likely that those who have never been convinced by this approach will leverage on the current situation to radically modify it.

For what concerns the current assets, again the default criterion of valuation at cost applies, where possible i.e., as mentioned above, inventories are valued at their cost unless their net realizable value is expected to be lower. Cash, debtors and pre-payments are valued at their nominal value, less any prudent forecast of losses from those values, e.g. expected percentage of debts that will not be honored by the pool of debtors or the value of debts owed by debtors who are expected to default. Other investments are valued either at their cost or at their fair value.

 
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