When analyzing any firm, we would like to know the types of assets that it owns, the values of these assets and the degree of uncertainty about these values. Accounting statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the values of these assets, and a poor job of reporting uncertainty about asset values. In this section, we will begin by looking at the accounting principles underlying asset categorization and measurement and the limitations of financial statements in providing relevant information about assets.
The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for loss in value associated with the aging of the asset. This historical cost is called the book value. Although the generally accepted accounting principles for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements.
á An abiding belief in book value as the best estimate of value: Accounting estimates of asset value begin with the book value. Unless a substantial reason is given to do otherwise, accountants view the historical cost as the best estimate of the value of an asset.
á A distrust of market or estimated value: When a current market value exists for an asset that is different from the book value, accounting convention seems to view it with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when values are estimated for an asset based on expected future cash flows.
á A preference for underestimating value rather than overestimating it: When there is more than one approach to valuing an asset, accounting convention takes the view that the more conservative (lower) estimate of value should be used rather than the less conservative (higher) estimate of value.
The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balance sheet.
á First, there are the fixed assets, which include the long-term assets of the firm, such as plant, equipment, land, and buildings. Generally accepted accounting principles (GAAPs) in the United States require the valuation of fixed assets at historical cost, adjusted for any estimated gain and loss in value from improvements and the aging, respectively, of these assets. Although in theory the adjustments for aging should reflect the loss of earning power of the asset as it ages, in practice they are much more a product of accounting rules and convention, and these adjustments are called depreciation. Depreciation methods can very broadly be categorized into straight line (where the loss in asset value is assumed to be the same every year over its lifetime) and accelerated (where the asset loses more value in the earlier years and less in the later years).
á Next, we have the short-term assets of the firm, including inventory (such as raw materials, works in progress, and finished goods), receivables (summarizing moneys owed to the firm), and cash; these are categorized as current assets. It is in this category accountants are most amenable to the use of market value. Accounts receivable are generally recorded as the amount owed to the firm based on the billing at the time of the credit sale. The only major valuation and accounting issue is when the firm has to recognize accounts receivable that are not collectible. There is some discretion allowed to firms in the valuation of inventory, with three commonly used approaches – First-in, first-out (FIFO), where the inventory is valued based upon the cost of material bought latest in the year, Last-in, first-out (LIFO), where inventory is valued based upon the cost of material bought earliest in the year and Weighted Average, which uses the average cost over the year.
á In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms and other marketable securities, including Treasury bills or bonds. The way these assets are valued depends on the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment; a minority, active investment; or a majority, active investment. If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm, an investment is treated as a minority, passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities, and often a market value. For investments held to maturity, the valuation is at acquisition value, and interest or dividends from this investment are shown in the income statement under net interest expenses. Investments that are available for sale or trading investments are shown at current market value. If the securities or assets owned in another firm represent between 20 percent and 50 percent of the overall ownership of that firm, an investment is treated as a minority, active investment. Although these investments have an initial acquisition value, a proportional share (based on ownership proportion) of the net income and losses made by the firm in which the investment was made, is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach. If the securities or assets owned in another firm represent more than 50 percent of the overall ownership of that firm, an investment is treated as a majority active investment. In this case, the investment is no longer shown as a financial investment but is replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the equity in the subsidiary that is owned by other investors is shown as a minority interest on the liability side of the balance sheet.
á Finally, we have what is loosely categorized as intangible assets. These include patents and trademarks that presumably will create future earnings and cash flows and also uniquely accounting assets, such as goodwill, that arise because of acquisitions made by the firm. Patents and trademarks are valued differently depending on whether they are generated internally or acquired. When patents and trademarks are generated from internal sources, such as research, the costs incurred in developing the asset are expensed in that period, even though the asset might have a life of several accounting periods. Thus, the intangible asset is not usually valued in the balance sheet of the firm. In contrast, when an intangible asset is acquired from an external party, it is treated as an asset. When a firm acquires another firm, the purchase price is first allocated to tangible assets and then allocated to any intangible assets, such as patents or trade names. Any residual becomes goodwill. While accounting standards in the United States gave firms latitude in how they dealt with goodwill until recently, the current requirement is much more stringent. All firms that do acquisitions and pay more than book value have to record goodwill as assets, and this goodwill has to be written off, if the accountants deem it to be impaired.