Solutions for Asset and Liability Valuation and Income Recognition

This document provides detailed solutions to questions, exercises, and problems related to asset and liability valuation and income recognition, focusing on key concepts such as relevance versus representational faithfulness, the relationship between asset valuation and income recognition, trade-off...Read More

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).

2.3 Trade-offs among Acceptable Accounting Alternatives. For the balance sheet,
FIFO results in inventory that was purchased most recently before the fiscal year (or
quarter) end remaining on the balance sheet. Relative to inventory purchases made
earlier, those purchases are probably more closely aligned with prevailing prices at
year end. As a consequence, relative to LIFO, FIFO more accurately captures the
value of the inventory (close to replacement cost). For the income statement, the
opposite inference is made. The income statement should pair the appropriate costs
of revenues with the revenues recognized. Matching the current costs of inventory
with the currently recognized revenues is accomplished with LIFO. Thus,
depending on a user’s perspective, either FIFO or LIFO can be the preferable
accounting method.
2.4 Income Flows versus Cash Flows. The analysis below demonstrates that the
change in cash for the five years as a whole is $117,000. Subtracting the $100,000
cash contribution by the owners equals $17,000, which equals the amount of net
income for the five years and the balance in retained earnings at the end of five
years. Note that the cash outflow to purchase the machine occurs at the beginning of
the first year, whereas depreciation on the machine occurs throughout the five
years, and the remaining book value of the machine of $20,000 affects computation
of the gain on sale at the end of five years. Thus, the statement about the
equivalence of cash flows and earnings holds for this example and in general