What Are Valuation Principles in Accounting?

Valuation refers to determining the fair value of an entity’s assets or liabilities, which is crucial in assessing its overall worth.

Valuation principles are critical to the accounting profession, as they provide a foundation for measuring and reporting the financial health of businesses.

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

1. Historical Cost Method
2. Current Cost Method
3. Realisable Value Method
4. Present Value Method
5. Market Value and Book Value

In this article, we will explore the key valuation principles in accounting and their importance in financial reporting. We will delve into topics such as market value versus book value, historical cost accounting, fair value measurements, impairment testing, and more.

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 the 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 a 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 1^st 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.

Realisable Value

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 by 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 1^st 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 a going concern.

Present Value

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.

Market and Book Value

Market and book value are two important financial metrics that investors use to assess the worth of a company. Market value refers to the current price of a company’s stock, while book value is the total value of its assets minus its liabilities as listed on its balance sheet. The market value represents what investors are willing to pay for a share in the company, while the book value is an estimate of what shareholders would receive if the company were liquidated.

Investors often use the market-to-book ratio (M/B ratio) to compare a company’s market value with its book value. A low M/B ratio suggests that a company may be undervalued by investors relative to its assets, while a high M/B ratio indicates that it may be overvalued.