THE VALUE PROBLEM
The problems of value that accountants wrestle with have also historically plagued philosophers, economists, tax assessors, and the judiciary.
Moral philosophers over the centuries grappled with the notion of a “fair” price for merchants to charge. Early economists attempted to derive a product’s intrinsic value by calculating the units of labor embodied in it. Several distinct approaches have evolved for assessing real prop erty. These include capitalization of rentals, inferring a value based on sales of comparable properties, and estimating the value a prop erty would have if put to its “highest and best” use. Similar theories are involved when the courts seek to value the assets of bankrupt companies, although vigorous negotiations among the different classes of creditors play an essential role in the final determination.With commendable clarity of vision, the accounting profession has cut through the thicket of valuation theories by establishing historical cost as the basis of its system. The cost of acquiring or constructing an asset has the great advantage of being an objective and verifiable figure. As a benchmark for value, it is, therefore, compatible with accountants’ traditional principle of conservatism.
Whatever its strengths, however, the historical cost system also has disadvantages that are apparent even to the beginning student of accounting. As noted, basing valuation on transactions means that no asset can be reflected on the balance sheet unless it has been involved in a transaction. The most familiar difficulty that results from this convention involves goodwill. Company A has value above and beyond its tangible assets, in the form of well-regarded brand names and close relationships with merchants built up over many years. None of this intangible value appears on Company A’s balance sheet, however, for it has never figured in a transaction.
When Company B acquires Company A at a premium to book value, though, the intangibles are suddenly recognized. To the benefit of users of financial statements, Company A’s assets are now more fully reflected. On the negative side, Company A’s balance sheet now says it is more valuable than Company C, which has equivalent tangible and intangible assets but has never been acquired.Liabilities, too, can become distorted under historical cost accounting. Long-term debt obligations floated at rates of 5% or lower during the 1950s and 1960s remained outstanding during the late 1970s and early 1980s, when rates on new corporate bonds soared to 15% and higher. The economic value of the low-coupon bonds, as evidenced by market quotations, plunged to as little as 40 cents on the dollar. At that point, corporations that had had the foresight (or simply the luck) to lock in low rates for 30 years or more enjoyed a significant cost advantage over their competitors. A company in this position could argue with some validity that its lowcost debt constituted an asset rather than a liability. On its books, however, the company continued to show a $1,000 liability for each $1,000 face amount of bonds. Consequently, its balance sheet did not reflect the value that an acquirer, for example, might capture by locking in a cheap cost of capital for an extended period.