deprival value lecture notes

7/27/2019 Deprival Value Lecture Notes

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The University of Birmingham

College of Social Sciences

Birmingham Business School

Department of Accounting and Finance

Accounting Theory

(07 !7"#

Deprival $alue Accounting

The previous lectures on this module have each looked separately at a particular

valuation basis economic value, replacement cost and net realisable value (the

CPPA system is an exception because cannot be considered as a system which values

balance sheet assets). ach o! these current value alternatives corresponds to a

particular course o! action that the !irm has in relation to any particular asset at any

point in time the !irm can use the asset (and realise its economic value the present

value o! the net cash !lows realised !rom the asset"s operations)# the !irm can replace

the existin$ asset (and hence its replacement cost is relevant)# the !irm can sell the

asset (and hence realise its net realisable value). ach o! these valuation bases has

associated with it particular advanta$es and disadvanta$es as detailed in the previous

lectures. This !act, to$ether with the lar$e variety o! uses which !inancial statements

purport to serve, provoke the %uestion o! whether any sin$le valuation method should

dominate and i! so which one& The %uestion is well put by 'hittin$ton (*+ +-)

/0t is not surprisin$ that a valuation basis which produces a

balance sheet which $ives a use!ul description o! the present

!inancial resources and liabilities o! a !irm will not necessarily

be e%ually e!!ective in producin$ a pro!it and loss statement

which $ives a use!ul description o! the !irm"s production andtradin$ operations over a period o! time. %ually, the type o!


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asset valuation which we would use in appraisin$ a !irm"s

suitability !or an 1asset2strippin$" take2over bid would not

necessarily serve e%ually well in appraisin$ the pro!itability o!

current operations with a view to makin$ a syner$ic take2over

bid.

'hittin$ton states elo%uently the !undamental problem concernin$ a !ully articulated

(i.e. where 1pro!it" in the pro!it and loss account is the 1balancin$ !i$ure" in the

balance sheet) accountin$ system based on current values. /! the balance sheet and the

pro!it and loss account serve di!!erent purposes they may lo$ically re%uire di!!erent

valuation approaches and one cannot assume that one valuation approach will serve

all purposes e%ually well. The most use!ul valuation basis may depend upon your own

point o! view as a user in that an 1asset2stripper" will be concerned with 345s and a

1mer$er bidder" more likely to be interested in replacement costs and economic values

because the latter has no intention to sell but to operate a continuin$ business.

These considerations have led to the development o! a valuation system that uses

more than one current value. The system is known variously as deprival value

accountin$ (65A) or 1value to the owner" or 1value to the !irm". This valuation basis

was the system pre!erred in the current cost accountin$ (CCA) rules introduced in the

78 in the *9s. The 65A system assumes that a company"s assets are normally

held either !or use in the business or !or sale. The valuation o! the assets there!ore

should re!lect which o! these two courses o! action the company intends to pursue

continued use or immediate sale. /t is !urther ar$ued that the upper value !or an asset

is its replacement cost because that is the maximum amount that the company would

lose i! it were deprived o! the asset and had to replace it.

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Continued use o! the asset is represented by its economic value (5) while its

immediate sale is represented by its net realisable value (345) while replacement

cost (4C) is used as an upper bound to the asset"s value in certain circumstances. /n

particular, it is the relationship amon$ these three values that determines the deprival

value o! a particular asset. ;ix possible combinations are possible as detailed in the

table below.

Com%ination

& 5 < 4C < 345

5 < 345 < 4C

' 345 < 4C < 5

345 < 5 < 4C

) 4C < 345 < 5

! 4C < 5 < 345

'hen usin$ the 65A system, the !irst %uestion which needs to be asked with respect

to a particular asset is use or sell& ;hould the asset be used in the business on a

continuin$ basis (and hence realise 5) or should it be sold immediately (in order to

realise 345)& This decision is determined by the relative values o! 5 and 345. /n

the !irst two cases it is clear that the asset should be used rather than sold because this

brin$s in the hi$hest value to the !irm (i.e. 5 is $reater than 345). /n the next two

combinations it is the other way around and in both cases the asset should be sold

immediately because 345 exceeds 5 in each case. The asset in case = should be

sold while that in case > should be used.

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The next %uestion to ask is what would the !irm do i! it were deprived o! the asset&

'hat would be the !irm"s rational course o! action i! the services o! the asset were,

!or whatever reason, taken away !rom it& /n the !irst two cases, because the value o!

5 exceeds the value o! 4C, the !irm"s most rational course o! action is to replace the

asset because by spendin$ 4C the !irm restores 5. ?ence the deprival value o! the

asset is 4C because this is the cash out!low that would be tri$$ered by the loss o! the

asset. A similar ar$ument is used in cases + and @ where 345 exceeds 4C i!

deprived o! the asset then spendin$ 4C would restore 345 and hence the deprival

value in each case is 4C because that is the cash !low tri$$ered by the loss o! the

asset. /n case = the asset"s deprival value is 345 because the asset would not be

replaced i! lost (as 4C exceeds 345) and in case > the asset"s deprival value is 5

!or the same reason a rational !irm would not replace an asset whose replacement

cost is hi$her than the pro!its that could be earned !rom operatin$ it. ;o that, in !our o!

the six possible cases, deprival value is 4C except in the two cases where 4C exceeds

both 5 and 345 where the deprival value is the hi$her o! 345 or 5. ee (*=

9-) sums up the rule neatly

This $ives rise to the 1value to the business" valuation rule

which is part o! 78 current cost accountin$ practice the

value o! an asset is the lower o! its replacement cost and the

hi$her o! its economic value and net realisable value. /naddition, it results in measures o! periodic income which are

derived a!ter allowin$ !or the consumption o! assets at their

value to the business.

The 65A system may appear a rather abstract and theoretical way to value the assets

o! a !irm but a simple example will serve to show that, contrary to initial impressions,

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it is in !act $rounded in a very practical business like valuation approach to the assets

owned by the !irm as the example below will illustrate.

6eprival value example

A !irm has the !ollowin$ !our assets with associated costs and values as shown below

$alue %asis Asset A

*

Asset B

*

Asset C

*

Asset D

*

4eplacement cost :99,999 *9,999 *,999 >+,999

3et realisable value 99,999 =,999 +9,999 >,999

conomic value :=9,999 >9,999 =99 ,999

+e,uired-

Calculate the deprival value (1value to the !irm") o! each asset.

Detail

Asset A Asset B Asset C Asset D

5alue data 5


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6espite bein$ an intuitively appealin$ valuation system, 65A is not without its

critics. Bne o! the criticisms o! this system relates to the 5 measure which, because

o! the need to estimate uncertain !uture cash !lows and interest rates, is criticised !or

bein$ too subective. /t is no answer to this criticism to point out that under the 65A

system, 5 only rarely turns out to be the valuation basis because an accurate

estimate o! this !i$ure is essential in determinin$ the answer to the !irst %uestion

relatin$ to the use or sell decision.

6eprival value is a hybrid measure which is made up o! a number o! di!!erent

valuation bases and it is sometimes %uestioned whether such mixed current values are

additive. The balance sheet !i$ure !or asset values represents neither economic values,

nor net realisable values nor replacement costs but is in !act a mixture o! all three in a

system that is not easily explained. /t is also doubt!ul whether an obvious answer to

the %uestion o! what the balance sheet values represent, i.e. that it is a type o!

insurance valuation interpreted loosely as what the !irm would $et back i!

everythin$ was lost in a !ire is relevant in a !inancial reportin$ !ramework. ;uch an

insurance valuation may not be an aid to stewardship, the investment distribution

decision or as a tax base !or $overnment.

A more serious criticism o! the 65A system is the problem o! a$$re$ate valuation in

situations in which assets are used ointly with others. /n these situations, it is di!!icult

to establish 5, 345 or 4C !or an individual asset used in conunction with other

assets other than by a$$re$atin$ to$ether cash !lows which cannot be meanin$!ully

allocated amon$ the several assets $eneratin$ them. ;uch assets may need to be

valued in total at a very hi$h level o! a$$re$ation the whole o! a production line or a

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complete !actory. This necessary procedure exacerbates the inherent uncertainty o!

the procedure and increases the subectivity o! the valuations.

?owever, the 65A system also has practical advanta$es. The valuation system has

intuitive appeal and bears some relation to the theory o! opportunity costs which is a

!amiliar concept. The 65A system avoids anomalous valuations which are the

inevitable product o! sin$le value systems. Additionally, the system has had practical

application with a system o! current cost accountin$.

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deprival value lecture notes

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