Valuation Rules

1. Historical Cost or Cost

Historical cost, also known simply as cost, is a fundamental valuation rule in accounting that states that assets, liabilities, and equity should be initially recorded at the transaction value at the time they are acquired.

For assets, this cost includes not only the purchase price but also any other cost directly attributable to preparing the asset for its intended use, such as transportation, installation, and start-up costs. A key feature of historical cost is that, once established, it is generally not adjusted to reflect subsequent changes in the asset's market value or the effects of inflation.

Historical cost provides an objective and easily verifiable basis for the valuation of items in the financial statements, as it is based on actual transactions that have occurred. However, a significant limitation is that historical cost may not reflect the current economic value of an asset, especially if a long time has passed since its acquisition or if the market in which that type of asset is traded has undergone significant changes.

1.1 Examples of Assets, Valued at Historical Cost

A wide range of assets are valued using the historical cost principle. Property, plant, and equipment (PP&E), which includes items such as land, buildings, machinery, and equipment, is a primary example of assets that are initially recorded at their historical cost. Inventory, which represents goods held for sale in the ordinary course of business, is also generally valued at its historical cost, although it may be subject to subsequent adjustments if its net realizable value falls below cost.

These examples illustrate how historical cost is mainly applied to tangible assets that a company uses in its operations to generate income over time.

The reason for using historical cost for these assets is that it provides a reliable and verifiable initial measure of their value. However, it is important to remember that, over time, the actual economic value of these assets may differ significantly from their historical cost due to factors such as use, wear and tear, obsolescence, and changing market conditions.

1.2 Examples of Liabilities, Valued at Historical Cost

Liabilities are also initially valued using the historical cost principle. Loans received by a company and accounts payable to its suppliers are common examples of liabilities that are initially recorded at the amount of the obligation at the time it is incurred. In the case of a loan, the historical cost would be the principal amount received, while for accounts payable it would be the amount owed for the goods or services received.

As with assets, the historical cost of liabilities provides an objective initial measure of a company's financial obligation. However, it is important to note that the current value of these liabilities may also change over time due to factors such as fluctuations in interest rates or changes in the company's creditworthiness.

1.3 Advantages of Historical Cost

The historical cost principle offers several advantages. It is simple to understand and apply, provides an objective measure of value based on an actual transaction, and is relatively easy to verify through documentation of the original transaction. Additionally, it is generally more cost-effective to implement in accounting systems compared to other valuation methods that require continuous updates of market value.

1.4 Disadvantages of Historical Cost

The main disadvantage is that it does not reflect the current market value of assets or liabilities, which can be particularly problematic in periods of significant inflation or deflation or when the market value of an asset has changed drastically over time. This can lead to financial statements presenting an outdated picture of the actual value of a company's assets, which can be misleading for investors seeking to assess the true net worth of the entity.

2. Fair Value

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This concept seeks to reflect current market conditions and the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. It is important to note that fair value may differ from market value in situations where there are specific factors related to the transaction or the entity that influence the agreed price.

Fair value provides a more current valuation of assets and liabilities compared to historical cost, which can be particularly relevant for investors in dynamic markets where values can fluctuate significantly in short periods of time.

2.1 Fair Value Hierarchy

To increase consistency and comparability in fair value measurements, accounting standards establish a hierarchy that classifies the inputs used in valuation techniques into three levels.

Level 1: This level provides the highest reliability, as it is based on quoted prices (unadjusted) in active markets for identical assets or liabilities that are being valued. An example would be the price of a share listed on an active stock exchange.

Level 2: This level includes observable inputs other than Level 1 quoted prices, either directly or indirectly. This could include quoted prices for similar assets or liabilities in active or inactive markets, interest rates, yield curves, credit spreads, and implied volatilities. An example would be the valuation of a bond using market interest rates for similar bonds.

Level 3: This level has the lowest priority and is used when no observable inputs are available. It is based on unobservable inputs, such as the company's own cash flow projections or internal data, which require the use of valuation techniques and significant assumptions.

The fair value hierarchy prioritizes the use of observable market data, which helps reduce subjectivity in the valuation process. Assets and liabilities classified in Level 3 are the most difficult to value and may require a greater degree of judgment by management and auditors.

2.2 Examples of Assets and Liabilities Valued at Fair Value

Fair value is increasingly used in accounting to value a variety of assets and liabilities:

• Investments in stocks and bonds, derivatives, and debt instruments are often valued at their fair value to reflect their current market value.
• Real estate investments can also be valued using fair value, especially if the intention is to sell them in the near future.
• Intangible assets acquired in a business combination, such as patents and trademarks, are initially recorded at their fair value.

3. Net Realizable Value

Net realizable value (NRV) is defined as the estimated selling price of an asset in the ordinary course of business, less the estimated costs of completion and disposal.1 This valuation rule is commonly used for the valuation of inventories and accounts receivable, with the aim of avoiding overestimation of the value of these assets in the financial statements. NRV provides a conservative measure of the value that a company expects to obtain from the sale of its assets, taking into account the costs associated with that sale.

3.1 NRV in Finished Goods

In the case of finished goods, net realizable value is calculated as the estimated selling price of the goods less the direct costs associated with their disposal, such as marketing, advertising, transportation costs, and any other costs necessary to complete the sale. This valuation method is particularly relevant for inventory that is damaged, obsolete, or whose demand has decreased, as it ensures that the value of inventory reported on the balance sheet does not exceed the amount that is reasonably expected to be received from its sale under current market conditions.

3.2 NRV in Work-in-Progress

For goods that are still in the process of production (work-in-progress), the net realizable value is determined similarly to that of finished goods, but with an additional consideration: the estimated selling price is reduced not only by the costs of disposal but also by the estimated cost necessary to complete the production of the goods. This recognizes that additional costs, such as labor and materials, must be incurred before the work-in-progress can be completed and sold.

3.3 Difference between Cost and Net Realizable Value

A fundamental rule in accounting is that inventory is generally valued at the lower of its historical cost and its net realizable value (NRV). This rule is based on the principle of prudence or conservatism, which seeks to avoid the overstatement of assets on the balance sheet. If the cost of an inventory item is higher than its net realizable value (for example, due to damage, obsolescence, or a decrease in market prices), the company must reduce the value of the inventory in its books to the NRV, recognizing an impairment loss. This reduction is known as an "adjustment to net realizable value".

4. Present Value

Present value (PV) is a fundamental financial concept that represents the value today of a sum of money or a cash flow to be received or paid in the future. It is determined by discounting the future value of that money or cash flow using an estimated rate of return, which reflects the return that the money could earn if invested over the corresponding period of time. The concept of present value is based on the principle of the time value of money, which states that an amount of money today is worth more than the same amount in the future due to its potential to earn interest or returns through investment. The discount rate used in the present value calculation reflects the opportunity cost of not having the money today and may also incorporate a risk premium associated with the uncertainty of future cash flows.

Present value is a fundamental tool for the valuation of long-term investments, capital budgeting decisions, and the evaluation of business projects. It allows investors and companies to compare the value of cash flows expected to be received at different times in the future in terms of their equivalent value in the present.

The basic formula for calculating the present value (PV) of a sum of money to be received in the future (FV) is as follows:

PV=(1+r)nFV​

Where: PV = Present Value / FV = Future Value / r = Discount Rate per period / n = Number of Periods

Understanding this formula is essential for anyone involved in investment and finance, as it allows for the quantification of the value of money over time. The discount rate (r) is a critical factor in this calculation, as it reflects the expected return on investments with similar risk and the time period until the future value is received. A higher discount rate will result in a lower present value, indicating that future money is less valuable in today's terms.

4.1 Applications in Accounting and Finance

The concept of present value has numerous applications in both accounting and finance. In the area of capital budgeting, it is used to evaluate the profitability and feasibility of long-term investment projects, allowing companies to determine whether the expected future benefits of a project justify the initial investment made in present value terms. In bond valuation, the present value of future coupon payments and the face value to be received at maturity are discounted at the required rate of return to determine the fair price or intrinsic value of the bond.

Lease versus buy analysis is also based on present value to help companies decide whether it is more economical to lease or buy an asset, by comparing the present value of lease payments with the present value of the costs associated with purchasing.

4.2 Examples of Valuation Using Present Value

To illustrate the application of present value, let's consider some examples. If a single payment of $10,000 is expected to be received in 5 years, and the discount rate is 6% per year, the present value of that payment can be calculated using the formula mentioned above. In this case, PV=(1+0.06)5$10,000​≈$7,473. This means that receiving $7,473 today is equivalent to receiving $10,000 in 5 years, given a 6% rate of return.

Another example is the valuation of an annuity, which is a series of equal payments occurring at fixed intervals over a specific period. If annual payments of $5,000 are expected to be received for 4 years, and the discount rate is 5% per year, a slightly different formula can be used to calculate the present value of this series of cash flows. The result would be the total amount someone would be willing to pay today to receive those future payments.

Finally, present value can also be used to value unequal cash flows that occur at different times. For example, if an investment generates $5,000 in Year 1, $7,000 in Year 2, and $4,000 in Year 3, and the discount rate is 8%, the present value of each of these cash flows is calculated separately and then summed to obtain the total present value of the investment.

5. Value in Use

Value in use is a valuation rule that represents the present value of the future cash flows expected to be derived from an asset or cash-generating unit during its normal use in the business and, where applicable, its ultimate disposal. Unlike fair value, which is based on the price that would be received in a market transaction, value in use reflects the specific value to the entity that is using the asset, taking into account its plans and expectations for the use of that asset. Value in use is primarily used in impairment testing of assets, to determine whether the carrying amount of an asset is greater than its recoverable amount. The recoverable amount is the higher of fair value less costs to sell and value in use.2

Value in use considers the future economic benefits that a company expects to obtain from the continued use of an asset, which may differ significantly from its market value if, for example, the company has a unique or particularly profitable way of using the asset.

6. Cost of Sales

Cost of sales, also known as cost of goods sold (COGS), represents the total accumulated cost of all costs directly related to the production of the goods or the provision of the services that a company has sold during a specific period. This cost includes direct labor costs, direct material costs, and any other indirect manufacturing costs that are directly associated with the production of the goods sold.

This information is crucial for evaluating the company's operational efficiency and its ability to generate profits from its sales. A lower cost of sales relative to sales revenue translates into a higher gross profit and, therefore, greater profitability for the company.

6.1 Calculation of Cost of Sales for Companies Selling Goods

Cost of Sales = Beginning Inventory + Purchases - Ending Inventory

This formula takes into account the value of the inventory that a company had at the beginning of the period, the cost of any additional inventory that it purchased or produced during the period, and the value of the inventory that remained at the end of the period. The difference represents the cost of the goods that were sold during that period.

6.2 Calculation of Cost of Sales for Service Companies

For companies that do not sell tangible products, the calculation of the cost of sales is different; it includes the direct cost of providing the services, such as the salaries of personnel providing the services and the costs of any materials or supplies directly used in the provision of those services.

Cost of Sales = Value of Time Spent on All Projects - Value of Time Spent on Incomplete Projects

Analyzing the trend of the cost of sales in relation to revenue over time can provide valuable insights into a company's ability to control its costs and maintain or improve its gross profitability. Investors often compare a company's cost of sales with that of its competitors within the same industry to gain perspective on its relative efficiency in producing and selling goods or services.

7. Amortized Cost

Amortized cost is a valuation method used for certain financial assets and liabilities, such as loans and bonds, that are held with the intention of collecting contractual cash flows until maturity. It is defined as the amount at which a financial asset or financial liability is measured at initial recognition minus principal repayments,3 plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity4 amount. In essence, amortized cost represents the original cost of an asset or liability adjusted over time by factors such as interest rates and payments made.

8. Transaction Costs

Transaction costs are the incremental costs that are directly attributable to the acquisition, issue, or disposal of a financial asset or financial5 liability. These costs include a variety of expenses incurred during the transaction process, such as commissions paid to intermediaries (e.g., stockbrokers), legal and advisory fees, taxes and duties, and any other costs that would not have been incurred if the transaction had not taken place.

Transaction costs are an essential part of the total cost of undertaking a financial transaction, and their accounting treatment can have a significant impact on a company's financial statements. Understanding how these costs are defined and accounted for is important for investors when evaluating the true cost of investments and the net returns they can expect from them.

8.1 Accounting Treatment of Transaction Costs

The accounting treatment of transaction costs depends on how the financial asset or financial liability is classified and measured in the financial statements. For financial assets and financial liabilities not measured at fair value through profit or loss, transaction costs that are directly attributable to their acquisition6 or issue are included in the initial cost of the asset or liability. For example, if a company incurs legal fees when issuing bonds, these fees will be deducted from the proceeds received from the bond issuance and will affect the amortized cost of the debt over time.

On the other hand, for financial assets and financial liabilities that are measured at fair value through profit or loss (such as assets held for trading), transaction costs are recognized as an expense in the profit or loss for the period in which they are incurred. The reason for this difference in treatment is that changes in the fair value of these instruments are already recognized in profit or loss, so including transaction costs in the initial cost would not provide additional useful information.

8.2 Examples of Transaction Costs

There are numerous examples of expenses that can be classified as transaction costs in the context of financial accounting. These include commissions paid to stockbrokers or agents for the purchase or sale of shares, bonds, or other securities. Legal and advisory fees incurred in the negotiation and structuring of financial agreements, such as the issuance of debt or the acquisition of another company, are also considered transaction costs. Taxes and duties paid in connection with the transfer of financial assets or the issuance of liabilities also fall into this category. In addition, transportation costs or costs directly related to putting a financial asset into operation can also be considered transaction costs.

9. Carrying Amount or Book Value

Carrying amount, also known as book value or net book value, represents the net amount at which an asset or a liability is recorded in a company's balance sheet.

For assets, the carrying amount is generally calculated as the original cost of the asset less any accumulated depreciation or amortization that has been recognized over its useful life, and less any accumulated impairment losses that have been recorded.

For liabilities, the carrying amount represents the amount of the obligation as it appears on the balance sheet. In the case of a company as a whole, the carrying amount often refers to the total value of its tangible assets less its total liabilities, and can also be equivalent to the company's net worth or equity, which represents the residual interest in the assets after deducting liabilities.

The carrying amount provides an indication of the value of a company's net assets that would be available to shareholders in the event of liquidation, assuming the assets were sold at their carrying amount.

9.1 Calculation of Carrying Amount

The calculation of carrying amount varies depending on whether it refers to an individual asset or a company as a whole.

9.1.1 Book Value of an Asset

For an individual asset, the general formula is: Book Value = Original Cost - Accumulated Depreciation/Amortization - Impairment. The original cost is the initial purchase price of the asset, the accumulated depreciation or amortization represents the portion of the asset's cost that has been recognized as an expense over its useful life, and impairment is a reduction in the asset's book value if its recoverable amount falls below it.

9.1.2 Book Value of the Company

To calculate the book value of a company, the formula is: Book Value of the Company = Total Assets - Total Liabilities. Total assets include all the resources the company owns, while total liabilities represent all its obligations to third parties. The difference is the net equity, which is the book value of the company available to its shareholders.

9.2 Book Value vs. Market Value

It is important to distinguish between the book value of a company or an asset and its market value. Book value is based on the historical cost of assets, adjusted for depreciation or amortization, and represents the value according to the company's accounting records. In contrast, market value reflects the current price at which a share or an asset is traded in the market.

The market value of a company often exceeds its book value. This is because market value takes into account a series of factors that are not necessarily reflected in book value, such as intangible assets (e.g., patents, trademarks, goodwill), expectations of future growth, brand reputation, and general market conditions.

Book value is generally considered a more conservative measure of a company's value, as it is based on historical costs and does not reflect potential unrealized gains or losses in the value of assets. Investors often compare book value to market value to try to identify companies that may be undervalued by the market (when market value is lower than book value) or overvalued (when market value is significantly higher than book value).

10 Residual Value

10.1 Useful Life

The useful life of an asset is the period over which an asset is expected to be available for use by an entity, or the number of production or1 similar units expected to be obtained from the asset. The2 estimation of useful life is a key factor in calculating the depreciation or amortization of an asset.

10.2 Economic Life

The economic life of an asset is the period over which an asset is expected to be economically usable by one or more users, or the number of production or similar units expected to be obtained from3 the asset by one or more users.4 Economic life can be different from useful life, as it can be affected by factors such as technological obsolescence or changes in market demand.

For example: a large printer in a printing company may have a useful life of 5 years, so depreciation will be recorded for those 5 years. When the 5 years are over, the printer is at its residual value (it has completed its life cycle), but nevertheless, its economic life can extend to 7, 8, 9 years... Generating profits for the company, until finally, due to obsolescence, deterioration, or lack of demand, it is sold for its residual value.

10.3 Depreciable Amount

The depreciable amount is the cost of an asset, or other amount substituted for cost in the financial statements (such as its revalued amount), less its residual value. This is the basis on which the depreciation or amortization of an asset is calculated over its useful life.

10.4 Residual Value

The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the5 asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. The residual value represents the amount expected to be recovered at the end of the asset's useful life, either from its sale as scrap or from its exchange for a new asset. When calculating depreciation, the residual value is subtracted from the cost of the asset to determine the amount that will be depreciated over its useful life.