Value To The Business Measurement – FAQ | IFRS

Value to the business measurement

For any given asset, the value to the business basis of measurement tries to answer the question:

How much worse off would the business be if it were deprived of it?

The answer, as a rule, is given by the asset’s replacement cost. For a liability, value to the business measures how much better off the business would be if it were relieved of it.

Because there are markets for only a proportion of the assets held by companies in the age and condition in which they exist at the balance sheet date, there is often no price available for a comparable replacement asset. For this reason, it is usual in practice to calculate replacement cost by taking the price of a new replacement asset and, in the case of fixed assets, making an appropriate charge for depreciation and an adjustment for differences in service potential between the original asset and its replacement.

The measurement of liabilities on a value to the business basis is full of difficulties. The key problem is that replacement cost, the central concept in value to the business accounting for assets, is of doubtful applicability for liabilities. Beyond noting that the experts are perplexed on this issue, it is not proposed to discuss it here.

Value to the business implies recognition of gains as they arise rather than as they are realised, but it excludes from operating profit gains that arise purely from holding assets (i.e, gains from changes in purchase prices between an item’s acquisition and its sale or consumption, subject to the recoverable amount test).

Value to the business also implies the recognition of assets and liabilities that are unrecognised under historical cost. For example, the historical cost of an intangible asset might be written off as it is incurred because it is uncertain at the time whether an asset is being created. Once the asset definitely exists, its value to the business should be recognised and measured in the same way as for any other asset. An alternative interpretation, however, would restrict the assets (and liabilities) recognised under value to the business to those recognised under historical cost.

Value to the business has been advocated as a way of measuring a business’s profit so as to maintain its operating capability (or service potential). The argument is that if a business is to maintain its operating capability, it needs to charge against profit the current replacement cost of the assets it consumes in its operations – which, at a time of rising prices, will be higher than their historical cost. Otherwise, it risks paying out as dividends amounts that are needed to finance its continuing operations.

For any given asset, value to the business tries to answer the question: how much worse off would the business be if it were deprived of it? There are various ways of answering this question.

  • If the asset is held for resale, then the business may be worse off by the amount, net of costs, for which it could have sold it (net realisable value).

  • If the asset is held to be used in the business to generate income, then the business may be worse off by the net amount that the asset’s use could have generated (value in use). As this amount is a stream of (net) future income, it would be usual to discount the expected future cash flows to a present value.

  • If the asset can be replaced, the business may be worse off by the amount that it would cost to replace it (replacement cost).

  • Which way of answering the question is most appropriate for any given asset depends on the relationship between the values calculated for net realisable value, value in use and replacement cost.

Whether it is more sensible for a business to sell an asset or to keep it and use it depends on which figure is higher: net realisable value or value in use.

If net realisable value is higher, then it makes sense to sell the asset; and the loss to the business if it is deprived of the asset is then shown by its net realisable value.

If value in use is higher, then it makes sense to use the asset; and the loss to the business if it is deprived of it is then shown by its value in use.

The higher of net realisable value and value in use is the asset’s recoverable amount. If an asset cannot be replaced, its recoverable amount shows its value to the business.

If an asset can be replaced, the question is then: is it worth replacing? If the asset’s replacement cost is less than its recoverable amount, then it is worth replacing.

If the asset’s replacement cost is more than its recoverable amount, it is not worth replacing. Where an asset is worth replacing, the replacement cost measures the loss the business would suffer if deprived of the asset. Where an asset is not worth replacing, the recoverable amount measures the loss.

The resulting value to the business tree is shown in the figure below.

How far the measurement of profit after maintaining operating capability should reflect the extent to which operating assets are financed by creditors (or by gearing), rather than by shareholders, is also a controversial issue. To the extent that they are financed by creditors, it is debatable whether the additional operating costs recognised on the value to the business basis should be charged against the profit attributable to shareholders.

Why we like value to the business measurement? Value to the business measurement

Some value to the business measurements, where assets are in fact being replaced by other assets with the same service potential, will be objective as they will reflect the prices the business is currently paying, without the need for further adjustment.

Why we object value to the business measurement? Value to the business measurement

Where assets are not being replaced, or are being replaced by different assets, or by assets with a different service potential, value to the business measurements are likely to be subjective. Such situations are common as markets and technologies change. Value to the business also shares the subjectivities inherent in historical cost’s reliance on predictions and allocations (in calculating depreciation, allocating costs for self-made assets, and predicting useful lives).

Why is value to the business measurement relevant? Value to the business measurement

Information prepared on a value to the business basis might be more relevant for some purposes than information prepared on other bases. For example, the value to the business basis typically leads to measurements at replacement cost, which might be of interest to the following types of user:

  • Potential competitors could use replacement cost information to assess the costs of entering a particular market. Existing investors could use the information in a similar way to assess how vulnerable the business is to competition from new entrants.
  • Competition authorities might also be interested in replacement costs to assess how easy it would be for new entrants to join a market, and to help form a judgment on whether rates of return in the industry appear to be excessive.
  • Investors may want to assess whether the business is maintaining its operating capability.

Value to the business is also sometimes argued to have the advantage of providing a compound basis of measurement, with the basis for each individual asset and liability being the most relevant for each item (As in the recoverable historical cost tree, above). However, that tree shows, recoverable historical cost provides a compound basis of measurement in a similar way.

What do we hold against value to the business measurement?

Critics of value to the business argue that what is relevant to a business’s owners is profit after maintaining financial capital, rather than profit after maintaining operating capability. A business can increase its owners’ wealth while reducing its operating capability or increase its operating capability while reducing its owners’ wealth. So why should investors focus on operating capital maintenance? Value to the business measurement

It may also be argued that information measured from the perspective of a potential market entrant does not provide the most relevant information on financial position or performance for users generally. Moreover, it may be felt that the concept of replacement which lies at the heart of value to the business has become less relevant in a modern economy, where there is usually significant change in markets and technologies. Value to the business measurement

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