Background
Non-current assets such as real estate properties receive an ample degree of error in value estimation due to several factors ( 2002). Each real estate is situated in different environments with various levels of urbanization and development. Second, the relationship of the owner, agent and buyers are individually unique which cannot be duplicated by simply the same classification of assets. At the time of selling, there is also digression caused by liquidity preferences of those actors observed in bargaining especially when middlemen are not present.
To complete the difficulties in real estate valuation, illustration from commercial properties can be used. Valuation through comparison is an uncanny way in this situation since the property only requires minimal variation in physical design and location to obtain a non-replication status. The income flows that can emerge using this property are also applied with different approach depending on the lease contracts. These contracts are contextualize from the heterogeneous decisions of owners/ tenants which makes valuation through comparison further complex in both effectiveness and process.
There are several processes in which real estate valuation can be carried; namely, direct comparison, summation, capitalization, hypothetical development, depreciated replacement cost and discounted cash flow analysis (1991;2003;1994). They are distinguished by activities being done (e.g. compare similar properties, inclusion of rental or development values or future cash flows and waiving of depreciated costs), unique features (e.g. computation of yield, use of analytical reasoning, estimation of added value, need for scenario planning and application of net present value technique) and where are they practically useful (e.g. residential properties, vacant land, purposes of taxation, commercial establishments, specialized assets and subdivisions being developed).
However, as much as discussion is worthy to be given to these valuation processes, they are limited to real estate properties which are mere part of non-current assets in the balance sheet of companies. They do not measure the value of intangible assets, long-term receivables and other investments. As the paper is focus on the ability of corporate valuation methods to make their balance sheets free from “true and fair” value distortions of specific non-current asset elements, the paper is more concerned on general costing/ valuation approaches that are used to determine non-current asset values. This includes four major approaches; namely, historical cost, fair value, current cost and realization value (2007; 2007).
Historical Costs
This method assumes that the firm will continue to operate in the foreseeable future without regard to liquidation particularly on non-current assets such as fixed assets (2001). This concept is acceptable on a certain extent because a firm is created and its operations are being supported by capital assets that are largely non-current assets. With these assets, the firm is basically a going concern entity and can exist for infinite period. Historical cost approach argued that non-current assets are very different to current assets as the latter is bound to sell within its life time in which it makes it appropriate to value current assets also at current prices. This approach supports the idea behind the responsibility of accountants not to valuate rather allocate historical costs to present and future periods. Non-current assets are assumed to be idle for sometime until they are allocated as the period is reached. In effect, balance sheets will be adjusted based on residual value that are left unallocated.
Since historical cost approach requires costing of non-current assets at their acquisition price, non-objective and Excessive speculation from a volatile market environment with regards to valuation is reduced. Although reliable because the approach gives the valuation an explicit basis, it is weakened by the fact that the approach disabled the propensity of the assets to increase in value when appropriate (e.g. development is applied or interest rates are decreased). Used mostly in valuing corporate plant and equipments, historical cost approach does not only emphasize the amount of money being paid to acquire the asset but also amortization and depreciation that must be allocated periodically (2007). In this manner, this approach is not necessarily irrelevant with regards to adjusting for market changes at least natural changes such as change in time. This is not peculiar since due to its name which is focused on time horizons.
Another underlying concept that this approach embodies is enclosed to the belief that setting the value of the asset at its acquisition cost at the time of purchase is consistent to the impression that the firm is betting on this asset for an equal amount it can receive in the future. The firm is motivated to buy the asset simply because there is a potential economic return (1998). This argument is especially true when one is thinking of a rational behaving firm who is profit-oriented and whose actions are defined by monetary terms. On the other side, not all economic decisions even they are rational harvest expected returns due to risk factors that are beyond the control of the firm. The earlier recognition of the inability of historical cost approach to consider market forces rather isolated corporate actions is echoed in this bottleneck.
Fair Value
This approach fill-in the shortcoming of historical cost as fair value approach seeks to obtain substantial market information to estimate the price of non-current assets. According to (2005), this approach determines the price by which two parties can exchange the asset and ending-up both better off. Such price is said to provide the seller and buyer of the asset advantageous pricing position. Like historical cost, fair value follows the assumption that the entities are operating under going concern stance to prevent the obstacles to the supposedly optimal transaction for each party such as adversary terms on the contract. However, this approach goes beyond historical cost features because the former further assumes that seeking this optimal transaction is not easy and substantial marketing campaign should be initiated by either party.
Fair value is synonymous to highest value of an asset because the best use of the asset is presumed while legal and financial provisions with regards to the transaction are solved (2004). Although this sounds very promising, computation for fair value basically requires more complex criteria than historical cost. Liquid trading markets in which the asset is traded should be available. In its absence, market evidence can be reflected by a specific exchange between willing and able parties. However, the alternative is rather hard to find or hard to believe for a firm to valuate its non-current assets. The former is more consistent to the definition of the fair value but once the non-current asset is not explicitly quoted users of this approach may find it useless. The sophistication seen in market forces is basically the source of both strength and weaknesses of this approach. In the advent of absence of both market evidence and isolated transactions, fair value would tap to depreciated replacement cost or income approach and accept the market buying price of an asset as best price.
Fair value accounting is more transparent than historical cost accounting. This is the basis why the Financial Accounting Standards Board (FASB) is confident to the ability of fair value approach to impose a greater level of regulatory oversight towards companies and also economic crisis ( 2007). In contrast, an individual firm may not applause this advantage of fair value approach. With regards to non-current assets, a firm can benefit from the ability of the approach to meet the demands of an interested buyer or trader. If the firm wanted to appraise, collateralize or sell its non-current assets, this approach can be the best metric in order for the sale to be lucrative in the market.
Current Cost
Also referred as replacement cost, this approach is the valuation of non-current assets through establishment of expected or actual market value at the period when the operations/ production begins (2005). At part, it is similar to the fair value with differences in time horizon in which the market prices is claimed into the asset. There is a requirement that the operations must start initially before the appropriate value for the assets will be determined. In effect, when the non-current asset is idle or generally not in function, its value is zero as there is no back-up pricing assumption that current cost approach is using. The main strength of this approach is derived from the definition of FASB for assets that emphasize the probability of future gains from their use (1990). The gains will not be obtained without the future being obtained.
In this regard, historical cost approach is blemished because all it accounts is the reduction of the value of non-current assets through depreciation and allocation. However, in the case of land and properties including patents, their value will necessarily increase once they prove to be an income-generating asset. The current value approach assumes that the asset is in income-producing form where the fair value approach is mere accepted as supporting information (1990). Future benefit of non-current assets are not considered in historical cost while fair value focuses much on market factors (e.g. meeting of the minds of opposite parties) rather than the asset itself.
In the real estate industry, the importance of the future benefit concept is vivid due to sensitive fluctuation of real estate prices. Further, the industry particularly the value of buildings is largely influenced by their ability to incur revenues to their owners/ tenants rather than the bulk of properties these building owners/ tenants have. Historical values become irrelevant in the advent of capitalizing the cash flows that emerge in the course of business executed in those properties. The significance of current cost approach is shown when users demand accurate financial statements. Historical cost approach disregard appreciation and impairment of assets through time which can lead to misguided decision-making as the acquisition value does not reflect any financial difficulties of the firm triggered by the underlying assets.
Net Realizable Value
This is a valuation approach to non-current assets wherein the entity intends to sell such property. This can be computed by decreasing the value of the property by the cost associated with the disposal which largely relates to transaction costs (2007). This is a very different context compared to the earlier approaches except partially to fair value. But fair value does not intend to explicitly sell non-current assets but to relate the quotations for buying and selling assets to pricing the assets in question. This approach, thus, is useful when the non-current asset is bound to be sold and yet is currently recorded in the books of the company. It discloses to users important information about the standing of the company when the asset is already dispatched and future benefits are halted. In effect, the weaknesses of this approach also arise from this one-sided boundary (e.g. not going concern).
Sample Organization: Waters v Welsh Development Agency
This case highlighted the inability of Development Method of Valuation (HDMV) to aid in deriving sound judgment for the purpose of determining the value of land alone. Although the use of HDMV concerns with valuing improvements which is the distress arising from the natural reserve qualities of the subject land, the case shows the far more important aspect of initially identifying if the improvements intended in the subject land is conclusive in its valuation ( 2006). However, HDMV would have helped when the natural reserve qualities of the subject land is included in the valuation attributable to the claimants. The valuation method would have provided the total sum of compensation the claimants should receive from the respondents. In the contrary, the process is not been tapped as it was initially admitted that the value of the subject land was exclusive with the improvements the acquirer can provide after the purchase and after the development ( 2006).
The preceding statement can be partially answered by Residual Method of Analysis (RMA) because of its ability to measure the socio-economic qualities of the subject land. Impliedly, it may have been used when the possible increase in value of the claimant’s land after acquisition by the respondents is terminated in arriving at the compulsory acquisition compensation ( 2006). RMA has the capacity to strip back the value of the land without the pre-supposed improvements. The Court admonished that the increase in compensation primarily due to the improvements of the land from the acquirer’s developmental efforts is invalid ( 2006). RMA is a more active tool than HDMV because the value of the subject land is required less with the value of improvements. Another, RMA is an analytical technique where the bounds of HDMV are very limited. However, RMA socio-economic indicator is undermined because the acquisition features of the subject land of providing habitation for national birds from the primary work of constructing a barrage is not injected in the computation ( 2006).
The case noted several learning on determining property value. First, the seller should expect that a buyer would realize an enhanced value for the subject land as it would appear to be non-saleable if positive characteristics are not eminent. This is in conjunction with the “value to the owner” principle in which the claimant should establish his own share to increase the value of the subject land (2006). In effect, no other value attributable to the subject land should arise if the need and purpose of the acquirer is already triggered. In the latter case, the supposedly increased in value would be passed on to the buyer. This provision convinced that HDMV is useful for the buyer alone to establish the level of development in the acquired land. On the other hand, RMA can be useful in the perspective of the Court to explain fully the reduction in the value complaint of the claimants. The claimants can use HDMV to compare the probable increase in the purchase price to the cost of litigation to assess their risks, that is, there should be a positive net gain between them.
Secondly, the “special and pressing want” of the acquirer-authority should be disregarded in imposing the fair compensation value for the claimants and the subject land ( 2006). There is no reason that the increase in motivation and interest of the buyer can amplify the land’s value. The Court implied that the seller cannot use such to push his self-vested concentration that ultimately bends the real value of the property. This is learning for HDMV and RMA to exclude potentiality assessment beyond ones that can be realized in the strict open market. Here, the buyer are seen as homogenous and should be approached in determining the value of the subject land accordingly. Third and last, when assessing property value, the Pointe Gourde or “no scheme” principle applies (2006). This means that there should be no increase in the value of land due to the implementation of a certain project. This is helpful in rationalizing the improvement-based limitation of HDMV. Its unique feature to evaluate the benefits of land or property development takes away its ability to evaluate the land or property instead. In the contrary, RMA mitigates this shortcoming by readily reducing the land value with developments to arrive with the value without the development.
Conclusion
As discussed, there are at least four approaches on how a firm can valuate its non-current assets that will be posted on its balance sheets for the purpose of giving “true and fair” view to users. These approaches are distinguished by their different strengths and weaknesses and therefore should serve as a note to companies that valuation methods are relative in each different asset, corporate case, economic conditions, market forces, and the like. Perhaps, national and international accounting standards can lay the ground in which companies can assure the validity of their balance sheets. But since these approaches are accepted traditionally by firms due to serving of vested- and profit-interest, lack of rigid regulation may motivate companies to use them on their own terms. The case further shows that the processes regarding non-current asset valuation also have their advantages and disadvantages. This is the same consequence as the approaches. In effect, balance sheet presentations will obtain their “fair and true” views if companies and users are aware of these approaches and processes and also regulation is strict to their implementation/ restriction.
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