Introduction to the Mixed Attribute Accounting Model
Consider the fundamental accounting identity:
Assets= Liabilities + Shareholders’ Equity
At the instant a firm is formed and receives financing (through equity investments of shareholders and/or debt financing from banks), the balance sheet of a company is simple and the valuation of the assets and liabilities is straightforward. For example, suppose an entrepreneur starts a consulting company by borrowing $1,000,000 from a bank. Initially, the value of the assets—all cash at this point—would be $1,000,000, equal to the entrepreneur’s liability to the bank. However, valuing the company’s assets and the liability becomes less clear (but more interesting) as the company begins deploying that cash, as time progresses, and as operating activities commence. The
1. The entrepreneur purchases an automobile for use in the business. Is the value of the automobile what the entrepreneur paid for it or what the entrepreneur could sell it for in the used market? If the company also had to pay registration and certain legal fees as part of the acquisition of the automobile, are those fees a part of the value of the automobile?
Consider the fundamental accounting identity:
Assets= Liabilities + Shareholders’ Equity
At the instant a firm is formed and receives financing (through equity investments of shareholders and/or debt financing from banks), the balance sheet of a company is simple and the valuation of the assets and liabilities is straightforward. For example, suppose an entrepreneur starts a consulting company by borrowing $1,000,000 from a bank. Initially, the value of the assets—all cash at this point—would be $1,000,000, equal to the entrepreneur’s liability to the bank. However, valuing the company’s assets and the liability becomes less clear (but more interesting) as the company begins deploying that cash, as time progresses, and as operating activities commence. The
1. The entrepreneur purchases an automobile for use in the business. Is the value of the automobile what the entrepreneur paid for it or what the entrepreneur could sell it for in the used market? If the company also had to pay registration and certain legal fees as part of the acquisition of the automobile, are those fees a part of the value of the automobile?
2. Should the company have to periodically reduce the value of the automobile to reflect the wear and tear and associated decline in its value? If so, how should the company compute the amount of the decline in value each period?
3. If the company acquires a building in which the entrepreneur will work, should the company periodically adjust the value of the building, as it does with the automobile? Unlike an automobile that clearly declines in value over time, the value of a building might increase. If so, should the amount at which the company values the building on the balance sheet be increased? Absent a sale of the building, how would someone estimate the value of the building?
4. The entrepreneur performs consulting services for ten clients and bills each client $5,000. The company now has an asset (accounts receivable) reflecting the amount due from each client, totaling $50,000. However, it is statistically likely that one of the clients will end up not paying the entire bill. Should the company adjust the value of the $50,000 asset to reflect this fact? If so, how much should the value of the asset be reduced? Is the reason for reflecting this amount in the financial statements to value the accounts receivable on the balance sheet appropriately, or is it to ensure that a cost of doing business (that is, selling to people who do not pay) is properly reflected on the income statement, or is it both?
5. The entrepreneur invests some of the remaining cash from the bank loan into a mutual fund. After several months, the value of the mutual fund investment has increased. Should the company adjust the value of this investment on its balance sheet? What should the company do if the investment falls back to the initial amount invested? What if the value falls below the initial amount invested? Should the company report each of these adjustments to the balance sheet as again or a loss on the income statement?
If these hypothetical questions are prompted by an example of a company with limited assets and liabilities, imagine how the valuation of assets and liabilities becomes increasingly complex when real companies engage in numerous and diverse activities. There are the many different approaches companies must use to value assets and liabilities in their financial statements under U.S. GAAP and IFRS, depending on the nature of the asset or liability. This variety provides insight into what is meant by the term mixed attribute accounting model.
Double-Entry Bookkeeping
An important feature of accounting is that the valuation of assets and liabilities on the balance sheet and the recognition and measurement of income on the income statement are not separable. Double-entry bookkeeping views transactions as having two equal sides, which requires that at least two accounts be affected when transactions and events are recorded. That is, the ‘‘double’’ in double-entry bookkeeping refers to the fact that there must be at least one debit to some account and at least one credit to another. For example, the incorporation of the hypothetical business above led to an increase in an asset (cash) and an increase in a liability (the bank loan and promise to repay). Exhibit 2.1 provides additional examples of transactions effecting combined financial statement impacts on the accounting equation
Relative Usefulness
The intent of the accounting system is to provide relevant and representationally faithful information about both the balance sheet and the income statement, but emphasizing the usefulness of one often affects the usefulness of the other. The two statements are obviously complementary as the balance sheet presents information as of a point in time, whereas the income statement presents information about flows between two points in time. The mixed attribute accounting model that
If these hypothetical questions are prompted by an example of a company with limited assets and liabilities, imagine how the valuation of assets and liabilities becomes increasingly complex when real companies engage in numerous and diverse activities. There are the many different approaches companies must use to value assets and liabilities in their financial statements under U.S. GAAP and IFRS, depending on the nature of the asset or liability. This variety provides insight into what is meant by the term mixed attribute accounting model.
Double-Entry Bookkeeping
An important feature of accounting is that the valuation of assets and liabilities on the balance sheet and the recognition and measurement of income on the income statement are not separable. Double-entry bookkeeping views transactions as having two equal sides, which requires that at least two accounts be affected when transactions and events are recorded. That is, the ‘‘double’’ in double-entry bookkeeping refers to the fact that there must be at least one debit to some account and at least one credit to another. For example, the incorporation of the hypothetical business above led to an increase in an asset (cash) and an increase in a liability (the bank loan and promise to repay). Exhibit 2.1 provides additional examples of transactions effecting combined financial statement impacts on the accounting equation
Relative Usefulness
The intent of the accounting system is to provide relevant and representationally faithful information about both the balance sheet and the income statement, but emphasizing the usefulness of one often affects the usefulness of the other. The two statements are obviously complementary as the balance sheet presents information as of a point in time, whereas the income statement presents information about flows between two points in time. The mixed attribute accounting model that
characterizes most accounting standards implies that there is a mix of emphases on balance sheet versus income statement accounts. The varying emphases on different accounts are a direct result of the attempt by standard setters to optimize relevant information given various constraints on the representational faithfulness of measurement. Academic research has examined the overall relative usefulness of the balance sheet and income statement to explain common stock prices. The evidence supports the notion that over the past several decades, financial statements appear to have become more in line with a balance sheet emphasis relative to an income statement emphasis. Based on data from a study by Collins, Maydew, and Weiss (1997), Exhibit 2.2 shows the incremental power of earnings (income statement emphasis) and book value of equity (balance sheet emphasis) to explain common stock prices over four decades. A decreasing trend line suggests a decline in the ability of a measure to explain security prices relative to the other. Consistent with the claims of many observers, the incremental explanatory power of book values increased relative to earnings over the period
Moreover, the study documented that the overall ability of both book value and earnings has increased over this four-decade period, consistent with increasing usefulness of financial statements.
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