What Are Valuation Principles in Accounting?
Valuation principles are the rules that accountants use to determine the value of assets, liabilities, and equity instruments.
These principles help to ensure that financial statements are accurate and consistent. There are generally four standard 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-
The Historical Cost Method of Valuation
The historical cost principle is the most basic of the valuation principles. It states that assets and liabilities should be recorded at their historical cost, the price paid to acquire the asset or create the liability. This principle is easy to apply in most cases, but it can become more difficult when the historical cost is not easily determined, such as when an asset is acquired in a transaction that is not at arm’s length.
“Historical price” means acquisition price or past cost. For example, an aster was purchased for $50,000 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 several proceeds received in exchange for the 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 the 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.
For example, Mr X purchased a machine on 1st January 2010 at $ 200000. As per the historical cost method, it will be recorded at $200000 in the books of accounts, i.e. at the acquisition price. Now as of 1.1.2011, he found that it would cost $500000 to purchase a similar machine at present. As per current cost, the approach asset will be recorded at $500000.
As per the realisable value approach, assets are carried out at the amount of cash or cash equivalent that could currently be obtained by 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 sold 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 the 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 the present discounted value of future net outflows that 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.
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