Alternative Asset Measurements

To design accounting-based performance measures, we must consider different ways to measure the assets included in the investment calculations. Should the assets be measured at historical cost or current cost? Should gross book value (that is, original cost) or net book value (original cost minus accumulated depreciation) be used for depreciable assets?

Current Cost

Current cost is the cost of purchasing an asset today identical to the one currently held or the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased. Of course, measuring assets at current costs will result in different ROIs than the ROIs calculated on the basis of historical costs.

We illustrate the current-cost ROI calculations using the data for Hospitality Inns (Exhibit 24-1) and then compare current-cost-based ROIs and historical-cost-based ROIs. Consider the following additional information about the long-term assets of each hotel:

A table shows information about the long-term assets of three hotels

The table depicts age of facility in years, gross book value, accumulated depreciation, net book value, and depreciation for 2020 for hotels in San Francisco, Chicago, and New Orleans. The details of the table are as follows:

1. Age of facility in years, at end of 2020

2. Gross book value, original cost

3. Accumulated depreciation

4. Net book value at end of 2020

5. Depreciation for 2020

Hospitality Inns assumes its facilities have a 14-year estimated useful life and zero terminal disposal value and uses straight-line depreciation.

An index of construction costs indicating how the cost of construction has changed over the 8-year period Hospitality Inns has been operating (2012 year-end=100) is as follows:

Year20132014201520162017201820192020
Construction cost index110122136144152160174180

Earlier in this chapter, we computed an ROI of 24% for San Francisco, 15% for Chicago, and 17% for New Orleans (see section Return on Investment). One possible explanation for the high ROI for the San Francisco hotel is that its long-term assets are expressed in 2012 construction-price levels—prices that prevailed 8 years ago—and the long-term assets for the Chicago and New Orleans hotels are expressed in terms of higher, more recent construction-price levels, which depress ROIs for these two hotels.

Exhibit 24-2 illustrates a step-by-step approach for incorporating current-cost estimates of long-term assets and depreciation expense into the ROI calculation. We make these calculations to approximate what it would cost today to obtain assets that would produce the same expected operating income the subunits currently earn. (For RI and EVA calculations, similar adjustments to represent the current costs of capital and depreciation expense can be made.) The current-cost adjustment reduces the ROI of the San Francisco hotel by more than half.

Exhibit 24-2

ROI for Hospitality Inns: Computed Using Current-Cost Estimates as of the End of 2020 for Depreciation Expense and Long-Term Assets

Spreadsheet screenshot shows financial data for hotels for 2020 for three different cities.

Details as follows:

Step 1: Restate long-term assets from gross book value at historical cost to gross book value at current cost as of the end of 2020.

San Francisco

  1. Gross book value of long-term assets at historical cost: $1,400,000

  2. Construction cost index in 2020: 180

  3. Construction cost index in year of construction: 100

  4. Gross book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $2,520,000

Chicago

  1. Gross book value of long-term assets at historical cost: $2,100,000

  2. Construction cost index in 2020: 180

  3. Construction cost index in year of construction: 144

  4. Gross book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $2,625,000

New Orleans

  1. Gross book value of long-term assets at historical cost: $2,730,000

  2. Construction cost index in 2020: 180

  3. Construction cost index in year of construction: 160

  4. Gross book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $3,071,250

Step 2: Derive net book value of long-term assets at current cost as of the end of 2020. (Assume estimated useful life of each hotel is 14 years.)

San Francisco

  1. Gross book value of long-term assets at current cost at end of 2020: $2,520,000

  2. Estimated remaining useful life: 6

  3. Estimated total useful life: 14

  4. Net book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $1,080,000

Chicago

  1. Gross book value of long-term assets at current cost at end of 2020: $2,625,000

  2. Estimated remaining useful life: 10

  3. Estimated total useful life: 14

  4. Net book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $1,875,000

New Orleans

  1. Gross book value of long-term assets at current cost at end of 2020: $3,071,250

  2. Estimated remaining useful life: 12

  3. Estimated total useful life: 14

  4. Net book value of long-term assets at current cost at end of 2020 (above 1 multiplied with (above 2 divided by above 3)): $2,632,500

Step 3: Compute current cost of total assets in 2020. (Assume current assets of each hotel are expressed in 2020 dollars.)

San Francisco

  1. Current assets at end of 2020 (from Exhibit 24-1): $400,000

  2. Long-term assets from Step 2: $1,080,000

  3. Current cost of total assets at end of 2020 (Sum of above and above 2): $1,480,000

Chicago

  1. Current assets at end of 2020 (from Exhibit 24-1): $500,000

  2. Long-term assets from Step 2: $1,875,000

  3. Current cost of total assets at end of 2020 (Sum of above and above 2): $2,375,000

New Orleans

  1. Current assets at end of 2020 (from Exhibit 24-1): $660,000

  2. Long-term assets from Step 2: $2,632,500

  3. Current cost of total assets at end of 2020 (Sum of above and above 2): 3,292,500

Step 4: Compute current-cost depreciation expense in 2020 dollars.

San Francisco

  1. Gross book value of long-term assets at current cost at end of 2020 (from Step 1): $2,520,000

  2. Estimated total useful life: 14

  3. Current-cost depreciation expense in 2020 dollars (value of above 1 divided by above 2): $180,000

Chicago

  1. Gross book value of long-term assets at current cost at end of 2020 (from Step 1): $2,625,000

  2. Estimated total useful life: 14

  3. Current-cost depreciation expense in 2020 dollars (value of above 1 divided by above 2): $187,500

New Orleans

  1. Gross book value of long-term assets at current cost at end of 2020 (from Step 1): $3,071,250

  2. Estimated total useful life: 14

  3. Current-cost depreciation expense in 2020 dollars (value of above 1 divided by above 2): $219,375

Step 5: Compute 2020 operating income using 2020 current-cost depreciation expense.

San Francisco

  1. Historical-cost operating income: $240,000

  2. Current-cost depreciation expense in 2020 dollars (from Step 4): $180,000

  3. Historical-cost depreciation expense: $100,000

  4. Operating income for 2020 using current cost depreciation expense in 2020 dollars (above 1 minus (difference between above 2 and above 3): $160,000

Chicago

  1. Historical-cost operating income: $300,000

  2. Current-cost depreciation expense in 2020 dollars (from Step 4): $187,500

  3. Historical-cost depreciation expense: $150,000

  4. Operating income for 2020 using current cost depreciation expense in 2020 dollars (above 1 minus (difference between above 2 and above 3): $262,500

New Orleans

  1. Historical-cost operating income: $510,000

  2. Current-cost depreciation expense in 2020 dollars (from Step 4): $219,375

  3. Historical-cost depreciation expense: $195,000

  4. Operating income for 2020 using current cost depreciation expense in 2020 dollars (above 1 minus (difference between above 2 and above 3): $485,625

Step 6: Compute ROI using current-cost estimates for long-term assets and depreciation expense.

San Francisco

  1. Operating income for 2020 using current cost depreciation expense in 2020 dollars (from Step 5): $160,000

  2. Current cost of total assets at end of 2020 (from Step 3): $1,480,000

  3. ROI using current-cost estimate (above 1 divided by 2): $10.8%

Chicago

  1. Operating income for 2020 using current cost depreciation expense in 2020 dollars (from Step 5): $262,500

  2. Current cost of total assets at end of 2020 (from Step 3): $2,375,000

  3. ROI using current-cost estimate (above 1 divided by 2): $11.1%

New Orleans

  1. Operating income for 2020 using current cost depreciation expense in 2020 dollars (from Step 5): $485,625

  2. Current cost of total assets at end of 2020 (from Step 3): $3,292,500

  3. ROI using current-cost estimate (above 1 divided by 2): $14.7%.

Historical-Cost ROICurrent-Cost ROI
San Francisco24%10.8%
Chicago15%11.1%
New Orleans17%14.7%

Adjusting assets to recognize current costs negates differences in the investment base caused solely by differences in construction-price levels. The current-cost ROI better measures the current economic returns from the investment than the historical-cost ROI does. If Hospitality Inns were to invest in a new hotel today, investing in one like the New Orleans hotel offers the best ROI.

Current-cost estimates can be difficult to obtain for some assets. Why? Because the estimate requires a company to consider, in addition to increases in price levels, technological advances and process improvements that could reduce the current cost of assets needed to earn today’s operating income.

Long-Term Assets: Gross or Net Book Value?

The historical cost of assets is often used to calculate ROI. There has been much discussion about whether managers should use gross book value or net book value of assets. Using the data in Exhibit 24-1, we calculate ROI using net and gross book values of plant and equipment:

Operating Income (from Exhibit 24-1) (1)Net Book Value of Total Assets (from Exhibit 24-1) (2)Accumulated Depreciation (from page 933) (3)Gross Book Value of Total Assets ( 4 ) = ( 2 ) + ( 3 ) 2020 ROI Using Net Book Value of Total Assets Calculated Earlier ( 5 ) = ( 1 ) ÷ ( 2 ) 2020 ROI Using Gross Book Value of Total Assets ( 6 ) = ( 1 ) ÷ ( 4 )
San Francisco$240,000$1,000,000$800,000$1,800,00024%13.3%
Chicago$300,000$2,000,000$600,000$2,600,00015%11.5%
New Orleans$510,000$3,000,000$390,000$3,390,00017%15.0%

Using gross book value, the 13.3% ROI of the older San Francisco hotel is lower than the 15.0% ROI of the newer New Orleans hotel. Those who favor using gross book value claim it enables a firm to compare ROI across its subunits more accurately. For example, when using gross-book-value calculations, the return on the original plant-and-equipment investment is higher for the newer New Orleans hotel than for the older San Francisco hotel. This difference probably reflects the decline in earning power of the San Francisco hotel. Using the net book value masks this decline in earning power because the constantly decreasing investment base results in a higher ROI for the San Francisco hotel—24% in this example. This higher rate may mislead decision makers into thinking that the earning power of the San Francisco hotel has not decreased.

The proponents of using net book value as an investment base maintain that it is less confusing because (1) it is consistent with the amount of total assets shown in the conventional balance sheet, and (2) it is consistent with income computations that include deductions for depreciation expense. Surveys report that the net book value is the measure of assets most commonly used by companies for internal performance evaluation.

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