Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the historical cost of the asset is updated, a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19 percent to this cost, representing the change in the wholesale price index over the seven years. This new, higher cost figure is depreciated using the straight-line method over the same 12-year assumed life (no salvage value).
a.) Calculate depreciation expense and book value of the metal press under both the historical cost and the price-level-adjusted historical cost.
b.) In general, what is the effect on ROA of changing the valuation bases from historical costs to current values?
c.) The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the manager's incentives to replace the metal press change if the firm shifts from historical cost valuation to the proposed price-level-adjusted historical cost valuation?
We examine whether and why companies prefer fair value to historical cost when they
can choose between the two valuation methods. With the exception of investment property
owned by real estate companies, historical cost by far dominates fair value in practice. Indeed,
fair value accounting is not used for plant, equipment, and intangible assets. We find that
companies using fair value accounting rely more on debt financing than companies that use
historical cost. This evidence is consistent with companies using fair value to signal asset
liquidation values to their creditors, and is not consistent with equity investors demanding fair
value accounting for non-financial assets. Our evidence broadly speaks to the importance of
accounting for contracting.
Keywords: Fair value accounting, IFRS, international accounting.
JEL Classification: M4, M42, M48
First
a.) To calculate the depreciation expense and book value under both the historical cost and the price-level-adjusted historical cost, we need to apply the depreciation method and the relevant factors.
1. Historical Cost:
The metal press was bought seven years ago for $522,000, and it has a 12-year assumed life with no salvage value. Therefore, the annual depreciation expense using the straight-line method can be calculated as follows:
Depreciation Expense = (Historical Cost - Salvage Value) / Useful Life
Depreciation Expense = ($522,000 - $0) / 12
Depreciation Expense = $43,500 per year
To calculate the book value at the end of year seven, we subtract the total depreciation expense for the seven years from the historical cost:
Book Value = Historical Cost - (Depreciation Expense per Year * Number of Years)
Book Value = $522,000 - ($43,500 * 7)
Book Value = $522,000 - $304,500
Book Value = $217,500
2. Price-Level-Adjusted Historical Cost:
To calculate the depreciation expense for the adjusted historical cost, we first need to determine the new cost figure after adjusting for the change in the wholesale price index. The calculation is as follows:
New Cost = Historical Cost + (Historical Cost * Price Index)
New Cost = $522,000 + ($522,000 * 0.19)
New Cost = $522,000 + $99,180
New Cost = $621,180
Using the same 12-year assumed life with no salvage value, we can now calculate the depreciation expense for the adjusted historical cost:
Depreciation Expense = (New Cost - Salvage Value) / Useful Life
Depreciation Expense = ($621,180 - $0) / 12
Depreciation Expense = $51,765 per year
To calculate the book value at the end of year seven using the adjusted historical cost, we subtract the total depreciation expense for the seven years from the adjusted cost:
Book Value = New Cost - (Depreciation Expense per Year * Number of Years)
Book Value = $621,180 - ($51,765 * 7)
Book Value = $621,180 - $362,355
Book Value = $258,825
b.) The effect on ROA of changing the valuation bases from historical costs to current values typically increases as the valuation increases. In this case, switching from historical cost to price-level-adjusted historical cost will result in higher values for both the depreciation expense and the book value. As a result, the asset base will be higher when calculating the return on assets, which may lead to a lower ROA. This is because the higher asset base will decrease the profitability ratio, as it would require higher earnings to achieve the same return on the larger asset base.
c.) The manager's incentives to replace the metal press may change if the firm shifts from historical cost valuation to the proposed price-level-adjusted historical cost valuation. Under historical cost valuation, the book value of the asset will be lower compared to the adjusted historical cost. As a result, the manager might perceive the asset as having a higher degree of obsolescence, making the replacement decision more attractive. However, under the proposed price-level-adjusted historical cost valuation, the book value will be higher, which might reduce the perceived obsolescence and potentially discourage the manager from replacing the metal press. Ultimately, the manager's incentives to replace the asset will depend on various factors, including the impact of the adjusted valuation on their performance metrics and the potential benefits of replacing the asset in terms of improved efficiency or capabilities.