Asset and Liability Valuation in Accounting

CHAPTER 2
ASSET AND LIABILITY VALUATION
AND INCOME RECOGNITION
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases
2.1 Relevance versus Representational Faithfulness. Relevance describes accounting
information that is timely and has the capacity to affect a user’s decisions based on
the information; relevant asset valuations incorporate all available information,
including the acquisition cost and subsequent developments. Relevant asset
valuations may or may not be subjective; the existence of subjectivity in an asset
valuation does not necessarily mean the valuation will not be reliable. Reliability is
an attribute of accounting information that relates to the degree of verifiability of
the reported amounts; representationally faithful asset valuations are supported by
source documents, liquid market prices, or other credible evidence. There is limited
room for subjectivity in these valuations. For example, reporting assets at
acquisition cost provides management with fewer opportunities to bias the valuation
compared to using current replacement costs or fair value inputs.
Examples:
Historical cost/relevant and representationally faithful: accounts receivable,
fixed assets, and other assets with values that remain relatively stable
Historical cost/representationally faithful but less relevant: LIFO inventory
layers, acquired research and development and other intangible assets, and real
estate that has appreciated
Fair value/representationally faithful: Marketable equity securities, commodities,
and financial assets traded in liquid markets
Fair value/relevant but less representationally faithful: Real estate valuations
based on comparable analysis, internally generated intangible asset valuations, and
pension plan assets invested in illiquid investments
2.2 Asset Valuation and Income Recognition. The important part of the question is
that it focuses on net income (as opposed to comprehensive income). Changes in the
valuation of assets generally result in an increase in shareholders’ equity (to
maintain the balance of the accounting equation), which is accomplished through
associated effects captured as part of net income. For example, sales generate cash
or receivables, which increase both assets and net income. Similarly, recognition of
depreciation expense decreases both assets and net income. However, certain
changes in asset valuations result in corresponding amounts being temporarily held
as part of “accumulated other comprehensive income” on the balance sheet (in
shareholders’ equity). Such changes would be part of Approach 2 as shown in
Exhibit 2.3 and discussed in the text. In these situations, asset valuations do not
have to relate to the recognition of net income (although such asset valuations relate
to comprehensive income).