Options for Balance Sheet Valuation - dummies

Options for Balance Sheet Valuation

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

If you need to value assets in the balance sheet, you may consider using historical cost, a value below cost, or a balance sheet value above cost:

  • Historical cost: Most of the assets in a typical balance sheet are valued at historical cost (original cost). That value should be your starting point.

  • Impairment: Accountants are required to write down impaired assets. The value of an impaired asset is typically below cost.

  • Increase in market value of asset: In some cases, the value of the asset is above cost. Short-term investments in marketable securities held for sale may have an adjusted value above cost. The recorded values of nearly all other assets aren’t written up (increased) to recognize appreciation in the replacement value or market value of the asset.

  • One reason is because assets you use in your business (buildings, equipment) aren’t held for sale. Also, these assets are likely to be used for many years. It’s not your intention to sell assets you use in your business.

Looking at balance sheet valuation entries

The dollar amounts reported for assets in a balance sheet are the amounts that were recorded in the original journal entries made when recording the asset transactions. These journal entries could have been recorded last week, last month, last year, or 20 years ago for some assets. Here are some examples:

  • The balance of the asset accounts receivable is from amounts entered in the asset account when credit sales were recorded. These sales are recent, probably within the few weeks before the end of the year.

  • The balance in the inventory asset account is from the costs of manufacturing or purchasing products. These costs could be from the last two or three months.

  • The costs of fixed assets reported in the property, plant, and equipment asset account in the balance sheet may go back five, ten, or more years — these economic resources are used for a long time.

Connecting balance sheet values and expenses

Most balance sheet assets are valued at historical cost. The amount of cost used to value the asset depends partly on how expenses are treated.

Merchandisers (retailers) purchase inventory and sell those goods to the public. Inventory is an asset. Accounting rules dictate that the cost of inventory should be the price paid for the asset plus any other costs incurred to prepare the goods for sale. Those other costs may include shipping, storage, and even costs to build display racks.

The additional costs to prepare the good for sale are not immediately expensed. Instead, the costs are posted to inventory. Those costs become expenses when the inventory item is sold. At that point, all the costs are posted to cost of sales (or cost of goods sold).

If you buy jeans for your retail shop, for example, the shipping costs you pay to get the jeans to your shop are considered part of inventory. If you need to build displays racks by the front window, those costs are part of inventory, too.

Another example to connect expenses with balance sheet values is the area of leasehold improvements — changes made to a leased space to meet a tenant’s needs. Instead of immediately expensing this amount, accountants capitalize the cost as an asset. The asset is usually depreciated over the remaining life of the lease.

Assume you lease a factory building to a manufacturer. To accommodate truck shipments for the manufacturer/tenant, you need to widen the road approaching the factory. The spending on the road isn’t immediately expensed. Instead, the cost is posted to an asset account called leasehold improvements.