Asset and Liability Valuation and the Trade-Off between Relevance and Representational Faithfulness
A useful way to think about assets, liabilities, and shareholders’ equity is that liabilities and shareholders’ equity represent the capital contributed by suppliers, lending institutions, and shareholders so that the company can acquire operating assets to use in profit-generating activities. Our focus in this section is on a conceptual understanding of how assets and liabilities should be valued and reported in the financialstatements.
A useful way to think about assets, liabilities, and shareholders’ equity is that liabilities and shareholders’ equity represent the capital contributed by suppliers, lending institutions, and shareholders so that the company can acquire operating assets to use in profit-generating activities. Our focus in this section is on a conceptual understanding of how assets and liabilities should be valued and reported in the financialstatements.
Assets provide economic benefits to a firm in the future, and liabilities require firms to sacrifice economic resources in the future. Although assets and liabilities clearly have a future orientation, balance sheet accounting for assets and liabilities under U.S. GAAP and IFRS follows a mixed attribute accounting model. Some assets are reported based on original (historic) cost, some are based on current fair values, some are based on realizable values, and others are based on a hybrid approach. Similarly, some liabilities are measured at the initial amount of the incurred liability, whereas others are measured at the current value of the liability based on prevailing interest rates and other factors. An obvious question is, why aren’t all assets and liabilities measured and recorded using the same measurement attribute? Wouldn’t that greatly simplify financial statement analysis? For example, it might seem obvious that reporting all assets and liabilities at historical values or all at current fair values would make it easier for users to understand financial statements. The reason most high-quality accounting standards follow a mixed attribute model is because regulators attempt to provide an optimal mix of relevant and representationally faithful information in the financial statements, which helps users better translate the information into assessments of the risk, timing, and amounts of future cash flows.
Relevance and Representational Faithfulness
Financial information is relevant if it can affect a user’s decision based on the reported financial statements. Making financial information available in a timely manner, for example, is one aspect of relevance. Information is representationally faithful if it represents what it purports to represent.
Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or already are aware of it from other sources. Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.
As a consequence of this balancing act to make the overall financial statements as useful as possible to external users, accounting standards require that some assets and liabilities be valued based on more representationally faithful information and others must be based on more representaionally faithful information
Accounting Quality
One way to view financial accounting amounts is that they reflect the following symbolic equation,
Financial Accounting Amounts = f(Economics, Measurement Error, Bias
In words, this means that users can view financial accounting numbers as a function of several features of the financial reporting process. First, and most importantly, the aim of financial statements is to provide useful information regarding the ‘true economics’ of a firm’s financial position or operations. This means that the financial statements capture and report, in an unbiased manner, the underlying economics. Managers are responsible for preparing financial statements because they should be in the best position to do so, given their intimate involvement in and knowledge of the firms’ operations. Such information is clearly relevant to users who analyze financial information.
The other two features offset the quality of financial statements. Measurement error in reported financial numbers exists because many events and circumstances require estimates. For example, managers must estimate the collectability of accounts receivable, the depreciation parameters for fixed assets, the ultimate liability for postretirement benefits, and so on. Good faith estimates sometimes turn out to be too high, and sometimes too low. The hope is that, on average, such measurement errors cancel each other out. The accounting discretion available to managers in making and reporting accounting estimates, which can lead to measurement error, is granted because this discretion can increase the relevance of the financial statements.
However, managers can also misuse their accounting discretion to inject bias into the reported financial amounts. Managers might bias their estimates in order to help the company appear more profitable or less risky to stakeholders, or for their own personal gain. Managers commonly receive bonus compensation based on realized earnings. The incentive to produce higher earnings, and thus realize higher compensation, can induce a manager to bias necessary estimates. For example, a manager might underestimate the amount of receivables that will ultimately be uncollectible. As a consequence, bad debt expense would be understated, and earnings would be overstated.
Trade-Off
Both measurement error and bias decrease the relevance and representational faithfulness of reported financial information. As noted, these features of reported financial numbers are due to discretion available to managers. Thus, why not remove discretion from managers? The answer pertains to the trade-off of relevance and representational faithfulness already discussed. Without discretion, all firms would have to apply the same accounting principles. For example, accounting rules might stipulate that all firms must recognize a 5% allowance for uncollectible accounts receivable. This would certainly be representationally faithful to the extent that it can be mathematically verified, and it would prevent managers from introducing any subjective bias into the valuationof the allowance for bad debts. However, it would probably not be relevant for many firms where the experienced actual default rate is other than 5%.
As accounting standards are developed, standard setters are mindful of this tradeoff between relevance and representational faithfulness and whether capturing the economics outweighs the incidence of measurement error or bias. What results is the mixed attribute accounting model, whereby valuations of assets and liabilities reflect various combinations of historical data, current up-to-date information, andexpectations of future outcomes. The astute analyst draws advantage from the information available in the mixed attributes of asset and liability valuation. The remainder of this section provides brief descriptions and examples of the primary valuation alternatives that are most common for balance sheet accounts
Relevance and Representational Faithfulness
Financial information is relevant if it can affect a user’s decision based on the reported financial statements. Making financial information available in a timely manner, for example, is one aspect of relevance. Information is representationally faithful if it represents what it purports to represent.
Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or already are aware of it from other sources. Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.
As a consequence of this balancing act to make the overall financial statements as useful as possible to external users, accounting standards require that some assets and liabilities be valued based on more representationally faithful information and others must be based on more representaionally faithful information
Accounting Quality
One way to view financial accounting amounts is that they reflect the following symbolic equation,
Financial Accounting Amounts = f(Economics, Measurement Error, Bias
In words, this means that users can view financial accounting numbers as a function of several features of the financial reporting process. First, and most importantly, the aim of financial statements is to provide useful information regarding the ‘true economics’ of a firm’s financial position or operations. This means that the financial statements capture and report, in an unbiased manner, the underlying economics. Managers are responsible for preparing financial statements because they should be in the best position to do so, given their intimate involvement in and knowledge of the firms’ operations. Such information is clearly relevant to users who analyze financial information.
The other two features offset the quality of financial statements. Measurement error in reported financial numbers exists because many events and circumstances require estimates. For example, managers must estimate the collectability of accounts receivable, the depreciation parameters for fixed assets, the ultimate liability for postretirement benefits, and so on. Good faith estimates sometimes turn out to be too high, and sometimes too low. The hope is that, on average, such measurement errors cancel each other out. The accounting discretion available to managers in making and reporting accounting estimates, which can lead to measurement error, is granted because this discretion can increase the relevance of the financial statements.
However, managers can also misuse their accounting discretion to inject bias into the reported financial amounts. Managers might bias their estimates in order to help the company appear more profitable or less risky to stakeholders, or for their own personal gain. Managers commonly receive bonus compensation based on realized earnings. The incentive to produce higher earnings, and thus realize higher compensation, can induce a manager to bias necessary estimates. For example, a manager might underestimate the amount of receivables that will ultimately be uncollectible. As a consequence, bad debt expense would be understated, and earnings would be overstated.
Trade-Off
Both measurement error and bias decrease the relevance and representational faithfulness of reported financial information. As noted, these features of reported financial numbers are due to discretion available to managers. Thus, why not remove discretion from managers? The answer pertains to the trade-off of relevance and representational faithfulness already discussed. Without discretion, all firms would have to apply the same accounting principles. For example, accounting rules might stipulate that all firms must recognize a 5% allowance for uncollectible accounts receivable. This would certainly be representationally faithful to the extent that it can be mathematically verified, and it would prevent managers from introducing any subjective bias into the valuationof the allowance for bad debts. However, it would probably not be relevant for many firms where the experienced actual default rate is other than 5%.
As accounting standards are developed, standard setters are mindful of this tradeoff between relevance and representational faithfulness and whether capturing the economics outweighs the incidence of measurement error or bias. What results is the mixed attribute accounting model, whereby valuations of assets and liabilities reflect various combinations of historical data, current up-to-date information, andexpectations of future outcomes. The astute analyst draws advantage from the information available in the mixed attributes of asset and liability valuation. The remainder of this section provides brief descriptions and examples of the primary valuation alternatives that are most common for balance sheet accounts
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