It’s Crucial to Value Assets by its Replacement Value in India

By Vipin Agnihotri

In an inflationary period, the book values of assets, typically reflecting historical cost less accumulated depreciation, do not reflect their true values. Hence, in my opinion it is worthwhile to consider revaluation of assets periodically so that the asset values shown in the balance sheet reflect economic reality more accurately.

Revaluation of assets is undertaken with one or more of the following objectives in mind:

• To attract investors by indicating to them the current value of assets

• To make depreciation provision which will enable the firm to meet replacement needs adequately

• To provide a more reasonable and accurate perspective regarding the true worth of assets in the event of a possible takeover or merger.

• To help management in assessing the true profitability of different divisions and formulating a more sensible dividend policy

• To enhance the borrowing capacity of the firm

It may be noted that irrespective of the objective sought by a firm from the revaluation study, an important advantage of such an exercise is that the capital asset records of the company are streamlined.

For purposes of valuing assets, the following concept, championed eloquently by JC Bronbright is widely followed:

“The value of a property (or asset) to its owner should be identical to the loss, direct and indirect, the owner might expect to suffer if he is deprived of the property (or asset)”.

This concept appears to be the obverse of the economic concept of opportunity cost according to which the cost of an action is “the gain foregone by sacrificing the best possible alternative course of action in order to adopt the proposed course of action.”

While the opportunity cost reflects the cost of a proposed course of action, the value concept, as suggested by Bronbright, reflects the value of something, which has been acquired in the past.

The question now arises: How should the value of an asset, as represented by loss on deprivation be measured? Three broad categories of measures you can use:

Replacement cost: This is the cost that will be incurred to replace the asset. It may be measured in terms of gross current replacement cost or net current replacement cost.

Realisable value: This represents the value that can be realised on the disposal of the asset. It may be measured as the current open market sales value of the asset or the forced sale value of the asset, that is the amount likely to be obtained for the asset if the same is sold under condition adverse to the seller.

Economic value: This denotes the value derivable from the economic use of the asset. It may be calculated as the value related to the earning potentials of the asset.

What it means for you

For investors, as the realisation value exceeds the economic value, it is advantageous to dispose of the asset rather than use it. However, the maximum loss suffered by the firm, using the ‘deprivation principle’ in these cases is the replacement cost, not the realisation value, because by buying another asset of the same type, the firm can restore the deprivation suffered by it. Hence, it is of paramount importance that the value of the asset should be measured by the replacement cost.