Valuation in accounting is important to know the figure at which transactions to be recorded. It helps in ascertainment of the price while selling off or discarding the asset at the later time.
There are generally 4 accepted measurement basis or valuation principles. These are as follows
- Historical Cost Method
- Current Cost Method
- Realisable Value Method
- Present Value Method
Now we shall discuss each method in detail-
Historical Cost Method of Valuation
Historical price means acquisition price or the past cost. For example, An aster is purchased for $ 50000 and paid $ 1000 for its installation. Here the acquisition cost shall be $50000 only although it will be recorded in the book of account at $51000.
According to this method, assets are recorded at an amount of cash and cash equivalent paid or the fair value of the asset at the time of purchase of an asset. Liabilities are recorded at an amount of consideration of the obligation or the expected amount to be payable in the future. For example. Mr. John takes $500000 as a loan from bank @10% interest p.a.it is to be recorded at a number of proceeds received in exchange for obligation. Here the obligation to repay is principal of $500000 plus interest @10% p.a. both items will be shown on the balance sheet and not only principal (if interest has been due).
Current Cost Method:
Current cost gives an alternative measurement base. Assets are carried out at the amount of cash or cash equivalent that would have to be paid if the same asset was purchased currently. Liabilities are recorded at the amount of cash that would have been payable if liabilities were to be settled immediately.
Suppose Mr. X purchased a machine on 1st January 2010 at $ 200000. As per historical cost method, it will be recorded at $200000 in the books of accounts i.e. at acquisition price. Now as on 1.1.2011, he found that it would cost $500000 to purchase the similar machine at present. As per current cost, approach asset will be recorded at $500000.
As per realisable value approach, assets are carried out at the amount of cash or cash equivalent that could currently be obtained by the selling the asset at the current time. Liabilities are carried out the amount that would be needed to settle the liability immediately. Suppose Mr. X found that he can get $450000 is he sell the asset purchased on 1st January 2010. Also, let there is a loan of $ 100000 and the lender is ready to waive off $2000 if the loan is repaid immediately.
Here machine should be recorded at $450000 and loan amount to be carried out at $98000. However, this valuation approach is not followed until the entity is going concern i.e. this approach is generally followed at the time of liquidation of companies when the entity ceases to be going concern.
As per the present value (PV) approach, the assets are carried out at the discounted present value or the net future cash inflows that the item is expected of generating in the normal course of business. Liabilities are recorded at present discounted value of future net outflows that they are expected to be settled in the normal course of business. The concept of compounding and discounting is used to value the asset and liabilities.