Valuation and its importance in accounting

Małgorzata SKÓRA
Junior Accountant at RSM Poland

Determining the value of assets and liabilities affects items presented in the balance sheet (statement of financial position of the entity). What is more, it defines the financial result of the company. Given the fact that one of the tasks of accounting is to provide the information about the economic value of the entity, fair value began to be popular both for the initial valuation and for the balance sheet valuation. This valuation parameter, corresponding to the arm’s length value by definition, has become a source of great controversy, mainly due to accounting abuse.

The importance of valuation in accounting

At present, the term ”accounting” has a dual meaning. Accounting can be perceived as a scientific discipline that, through research, helps to improve communication between the creators of financial and non-financial information and its users. This term also denotes some practical activity, which involves a series of specific actions performed by qualified staff in economic units.¹

Accounting can also be regarded with a view to what it is being used for, i.e. broken down into financial accounting, used for external purposes, and managerial accounting, used for in-house purposes.

Diagram 1 Basic relationships between managerial accounting and financial accounting

Source: My work based on R. Patterson: Compendium of accounting terms in Polish and English, CFRR, Warsaw 2015 p. 377-378.

Valuation has a special place in accounting, as it is aimed at reflecting the reality by way of transferring actual processes into the financial dimension.² In other words, valuation is about using units of value to express phenomena, utility and qualities of objects, goods, entities, assets and services.³

In the dictionary of the Polish language, the term “valuation” is explained as “determining the material value of something”. According to this definition, the process of valuation should be treated as assigning material value to things and phenomena, and before starting the valuation you should determine the type of value you are looking for.

Types of valuation

Valuation is a process of estimating the value, which consists in recognising both the characteristics of the object and intentions of the subject and is aimed at assigning monetary value to events or objects in the company. What should be noted is that for any valuation to be possible, you need an object and a subject.⁴

In accounting, the following types of valuation are present:

• business valuation and asset valuation,
• initial valuation and balance sheet valuation.

The overriding business goal of the process of valuation in any company is to boost the company’s market value, which brings higher income to its owners.

The valuation of a business as a whole is made in the event of its lease, sale insurance, transfer in the form of lease and contribution in kind to another entity. It should be noted that this valuation is usually a one-off event. The valuation process is then based on a value measurement of the entity and its assets in order to provide reliable information to assess the effects of past actions and help take the best decisions in the future.⁵

The process of valuation of individual assets has been prescribed in legal regulations and accounting standards. This use of alternative solutions presented in the company’s accounting policy is also acceptable.

Diagram 1.2 presents the relationship between business valuation and its asset valuation.

Source: My work on the basis of: S. Hońko: The concept of prudent valuation.. quote, p. 18.

Valuation models

An initial valuation is carried out once when a new asset is being entered in the accounts. A balance sweet valuation, on the other hand, is performed periodically, on the balance sheet date.

The overriding principle in accounting is the concept of a faithful (true) and reliable picture of actual processes.

However, the approach to valuation in accounting systems in different countries is based on two divergent methods, i.e. fair value and transaction.

Fair value measurement, also known as the balance sheet approach, is mainly applied in English-speaking countries, and its assumptions are as follows:

• measurement of assets and liabilities is based on fair values,
• entity generates income when its assets increase or its liabilities decrease (excluding equity transactions); in this model, the profit includes the realised and unrealised part (resulting from revaluations),
• the balance sheet is the main element of financial statements.

The second model, i.e. historical cost accounting, is applied in the countries of continental Europe, and its assumptions are as follows:⁶

• assets and liabilities are measured at historical cost,
• revenue can be recognised only at the time of sale,
• residual account is presented in the balance sheet.

The main objective of the historical cost approach is to present the information about past events in the entity, and the most important element of financial statements is the income statement.

Summary

Wrapping up, a proper valuation of assets and liabilities has a great impact on the accuracy of financial statements, as well as the entity’s financial result. We encourage you to contact us if you need support in the process of valuation for the purposes of your company’s accounting.