The Bases of Asset Valuation
Within accounting, it is common knowledge that different methods of arriving at a result or outcome exist. Asset valuation, which is critical in financial accounting, is not always straightforward. Asset values change yearly, due to depreciation and appreciation, and the nature of assets (current versus non-current) make asset valuation methods significant.
Four basic methods of valuation of assets in financial statement include:
i) Historical cost
ii) Replacement cost
iii) Net realisable value
iv) Economic value
Historical cost is the most common valuation of assets in financial statements. This is because historical cost is provable and known. As its name suggests, historical cost recorded cost of an asset when the cost was incurred. In other words, the amount that an entity pays for an asset represents the historical cost. If, for example, you purchased an item for $10,000.00, then it would be valued at its cost. Although financial accountants find “costs” a more objective index than asset values, asset valuations are important for fairly presenting the position of a business.
The use of historical cost can be problematic in periods of high inflation. It can lead to the position of the business not being fairly presented if the asset has a lower valuation than its current cost. This is because historical cost does not recognize unrealised holding gains of a non-current asset (like property). The historical cost convention is generally used, except where it conflicts with other fundamental accounting concepts, such as prudence.
The replacement cost of an asset values the asset at the amount needed to replace it with an identical asset. For example, if you bought a mobile phone for $400.00 two years ago, but the current cost of replacement is $200.00, a replacement cost values the mobile phone at $200.00, whereas the historical cost convention would use the $400.00 valuation. If an entity is valuing an asset for insurance purposes, it might have to choose between replacement cost and actual cash value. The actual cash value refers to the fair market value of the asset in its current condition.
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