List arguments for and arguments against the use of historical cost, general price-level adjustment, exit value (net realizable value), and replacement cost (entry value). Explain why the discounted cash flow method is virtually impossible to apply in a real situation.

Question

What will be an ideal response?

Answer 1

ANSWER:
Historical cost
For: Historical cost is more objectively determinable and better understood than are other valuation systems. Historical costs have also been defended as more suitable as a means of distributing income among capital providers, officers and employees, and taxation agencies because it is not based on hypothetical opportunity cost figures.

Against: Opportunity cost valuations are more indicative of economic valuation than are historical costs. In a period of rising prices, attributes measured by historical costing methods generally have limited relevance to economic reality. There is also a serious additivity problem under historical costing because dollars of different purchasing power are added to or subtracted from each other.

General price-level adjustment
For: Price-level adjustments restore the additivity of amounts on the financial statements.

Against: Every item on the financial statements, except for monetary assets and liabilities, must be adjusted for price levels and restated in terms of the general purchasing power of the dollar during the current year.

Exit value (net realizable value)
For: The balance sheet reflects the net liquidity available to the enterprise in the ordinary course of operations, thus portraying the firm’s ability to shift its presently existing resource into new opportunities. Also, all the measurements are additive since valuations are at the same time point and measure the same attribute. Exit valuation can be combined with general price-level adjustment to provide a more complete analysis of inflationary effects upon the firm.

Against: The relevance of net realizable value measurements for fixed assets is questionable when the firm intends to keep and utilize the great bulk of them for revenue production purposes in the foreseeable future. Also, exit value measurements are often unavailable for unique fixed assets such as land, buildings, and custom-made equipment.

Replacement cost (entry value)
For: If the great majority of the firm’s assets were not already owned, it would be economically justifiable to acquire them. Replacement cost can also be combined with general price-level adjustment to provide a more complete analysis of inflationary effects upon the firm.

Against: Market values are often unavailable for such unique fixed assets as land, buildings, and heavy equipment specially designed for a particular firm. Discounted cash flows would be virtually impossible to apply because many assets contribute jointly to the production of cash flows, so individual asset valuation could not be determined. Also, the future orientation of asset valuation and income determination leads to very formidable estimation problems, which would reduce objectivity in terms of the degree of consensus among measurers.