Accounting: The Language of Business - Vol. 2 (Intermediate: Part 13)

At the crash of economic collapse of which the rumblings can already be heard, the sleeping soldiers of the proletariat will awake as at the fanfare of the Last Judgment and the corpses of the victims of the struggle will arise and demand an accounting from those who are loaded down with curses.

Karl Liebknecht

Financial Reporting Theory (Part G)

by

Charles Lamson

Bases of Measurement

Recall from part 12 that recognition is the process of reporting an economic event in the financial statements. Recognized events are included in a line item on the financial statements as opposed to in the notes to the statements. And also recall that the financial markets' emphasis on reported earnings makes revenue and expense recognition principles important. Recall from part 8 that Johnson & Johnson beat analysts' forecasts in the fourth quarter of 2016. The ability to report earnings in line with or higher than forecasts can be critical to a company's stock price. The intent of the revenue and expense recognition principle is to recognize revenue and expenses in the appropriate time period.

Also recall from part 12 that commonly, firms reduce an asset or increase a liability when expected future cash flows change. For example, in the period that a company determines it can no longer sell certain inventory, it will record a loss on the income statement and write the inventory down on the balance sheet. Exhibit 2.9 (from part 12 and reintroduced below) summarizes these examples. 

EXHIBIT 2.9 Examples of Expense Recognition

So, bearing all that in mind, after a company determines that it should recognize an item, it has to measure the item. For example, when a company purchases inventory from a supplier, it also encourages freight costs to have the inventory shipped to its stores. The company recognizes inventory as an asset. It measures the value of the inventory asset as the purchase price plus the freight costs and reports that amount on the balance sheet.

The initial measurement of elements in the financial statements and their subsequent measurement are both pertinent to financial reporting. U.S. GAAP identifies five measurement bases used in financial reporting (FASB, Statement of Financial Accounting Concepts No. 5, "Recognition and Measurement in Financial Statement of Business Enterprises," Paragraph 67.)

1. Historical cost is the amount of cash (or equivalent) that the firm pays to acquire the asset. In the case of a liability, historical cost is the amount of cash (or equivalent) that the firm received when it entered the obligation. The historical cost of an asset may be adjusted for depreciation or amortization [Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time. Concerning a loan, amortization focuses on spreading out loan payments over time. When applied to an asset, amortization is similar to depreciation (investopedia.com).]

2.  Current cost is the amount of cash (or equivalent) that would be required if the firm acquired the asset currently.

3.  Current market value is the amount of cash (or equivalent) that the firm would receive by selling the asset in an orderly liquidation. Liabilities may also be measured at current market value.

4.  Net realizable value is the amount of cash (or equivalent) to be received in exchange for an asset, less the direct costs of the disposal. In the case of liability, it is the amount of cash (or equivalent) expected to be paid to liquidate the obligation, including any direct costs of liquidation.

5.  Present value of future cash flows results from discounting net cash flows the firm expects to receive on the exchange of an asset or to pay to liquidate liability [under U.S. GAAP, the present value measurement attribute is discussed in much greater length in the FASB's Statement of Financial Accounting Concept No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements" (Norwalk CT: FASB, 2000)].

The historical cost approach results in the general policy that firms initially record assets (and liabilities) at cost and maintain them at cost until selling, consuming, or otherwise disposing of them. Historical cost is the agreed-upon acquisition price arrived at objectively through an arms length transaction. An arms length transaction involves a buyer and seller who are independent and unrelated parties, each bargaining to maximize his or her own wealth. Although historical costs are unrelated to current market values, firms continue to use historical cost information for most assets and in most industries. The use of historical cost is justified because it is objective and subject to verification.

The current cost, current market value, net realizable value, present value of future cash flows measurement bases are all consistent with fair value reporting (FASB, Statement of Financial Accounting Concepts No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements," Paragraph 7.) There are times when fair value is observable, such as for a publicly-traded equity security. When fair value is not directly observable---for example, an equity security that is not publicly traded---management uses judgement-based models to determine its fair value.

Fair value measurements and the fair value hierarchy. The trend toward measuring financial assets and liabilities at fair value discussed in part 6 impacts the amounts reported on the balance sheet. In order to improve user confidence in fair value measurements reported, the FASB requires disclosures that indicate the reliability of the inputs used and all fair-value measures reported on the financial statements. The disclosure takes the form of a fair value hierarchy that provides three levels of reliability from the most to the least objective inputs used in the fair value measurement process.

Exhibit 2.10 Presents the three levels of the fair value hierarchy.

Ideally, companies would measure all financial assets and liabilities using Level 1 inputs, but that is not possible. Nevertheless, companies should use the highest level of reliability possible when determining fair values of financial assets or liabilities.

The standard setters' decision as to whether a particular asset or liability should be measured at fair value often trades off the relevance of information provided with the ability of the information to be a faithful representation of the value of the asset or liability. For example, fair value is more relevant than historical cost, but it is typically a less faithful representation in terms of measuring the economic event than a historical cost

However, U.S. companies generally do not report their nonfinancial assets such as equipment or land at market or appraisal values or adjusted for inflation. An exception is when an asset is impaired. For declines in fair value, firms are required to write down, or reduce, asset values. We will discuss accounting for long-lived asset write-downs, impairments, in a later post. In most industries, nonfinancial assets are not valued above initial cost.     

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 38-40*               

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