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

: 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.

+ 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 5 ' ( ) ! 345 345 4C 4C < < < < < < 4C 345 4C 5 345 5 < < < < < < 345 4C 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.

@ 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. Aee (()*=, (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$her o! its economic value and net realisable value. /n addition, it results in measures o! periodic income which are derived a!ter allowin$ !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,

= 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 4eplacement cost 3et realisable value conomic value

Asset A * :99,999 (99,999 :=9,999

Asset B * (*9,999 (=,999 >9,999

Asset C * (*,999 +9,999 =99

Asset D * >+,999 >,999 (,999

+e,uiredCalculate the deprival value (1value to the !irm") o! each asset.

Asset A Detail 5alue data 7se or sell& 4eplace& 6eprival value Asset type 5<4C<345

Asset B 4C< 5<345

Asset C 345<4C< 5

Asset D 4C<345< 5

> 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 subCective. /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$$re$ate valuation in situations in which assets are used Cointly with others. /n these situations, it is di!!icult to establish 5, 345 or 4C !or an individual asset used in conCunction with other assets other than by a$$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

complete !actory. This necessary procedure exacerbates the inherent uncertainty o! the procedure and increases the subCectivity 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$.