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Chapter 2: Accounting Judgements
Case 2-1 AeroTravel Inc.
2-2 Dubois Limited
2-3 BLX Shipping Limited
TR2-1 Underlying Assumptions 10
TR2-2 Qualitative Characteristics…………………………. 15
TR2-3 Concepts Identification ……………………………… 15
TR2-4 Capital Maintenance …………………………………. 15
TR2-5 Capital Maintenance …………………………………. 20
Assignment A2-1 Relevance versus Reliability………………………. 15
A2-2 Relevance and Reliability ………………………….. 15
A2-3 Questions on Principles……………………………… 15
A2-4 Questions on Principles……………………………… 15
A2-5 Applications of Principles (*W) …………………. 10
A2-6 Realization versus Recognition…………………… 15
A2-7 Recognition of Elements……………………………. 10
A2-8 Elements of Financial Statements……………….. 10
A2-9 Questions on Principles (*W)…………………….. 10
A2-10 Identification of Accounting Principles (*W)… 10
A2-11 Revenue Recognition………………………………… 15
A2-12 Recognition and Elements …………………………. 15
A2-13 Application of Principles …………………………… 15
A2-14 Application of Principles …………………………… 15
A2-15 Implementation of Principles……………………… 30
A2-16 Implementation of Principles (*W)……………… 30
A2-17 Implementation of Principles……………………… 30
A2-18 Recognition Criteria………………………………….. 25
A2-19 Implementation of Principles (*W) …………….. 30
*W The solution to this assignment is on the text website, Connect.
This solution is marked WEB.
1. Accounting principles include:
a. Underlying assumptions—basic underlying assumptions that make accounting
b. Qualitative characteristics—standards to judge policy choices in conjunction with
c. Measurement methods—ways to measure results and financial position.
2. Underlying assumptions include:
a. Time-period—financial information can be reported over a series of time spans
shorter than the total life of the enterprise.
b. Separate-entity—financial reports relate to the activities of the business enterprise
separate from its owners.
c. Continuity—the business entity will continue in operations for the foreseeable
future (going concern assumption).
d. Proprietary approach—results are reported from the perspective of the owners,
who hold residual return and risk.
e. Unit-of-measure—results can be meaningfully expressed in monetary terms.
f. Nominal dollar financial capital maintenance—profits are earned after historical
cost is recovered; neither general inflation nor specific changing prices are
3. The time-period assumption requires accruals and deferrals in accounting because
cash transactions are not always completed in the accounting period to which the
underlying transaction relates. Accruals and deferrals move income recognition to
the year to which they relate. Accruals record revenues and expenses for which
there have as yet been no cash transactions; deferrals delay recognition of revenues
4. The continuity assumption justifies the use of historical cost to record assets because
the cost will be recovered over the assets‘ economic life in operations. If this
assumption is not valid, assets should be valued at net recoverable amounts.
5. Owners are viewed as the residual risk-takers in the proprietary view; they receive
the residual profit or loss after all other claims are met. Under the entity view, the
shareholders are only one of several stakeholders in the financial success of an
6. Inflation is a major factor when dealing with the nominal dollar financial capital
maintenance assumption. This presumes that income has been earned when the
financial capital invested in an item, not adjusted for inflation, has been recouped.
The stable dollar assumption is made.
For example, if an item bought for $10 is sold for $14.50, $4.50 of income is
earned. But if the invested capital of $10, has been eroded by inflation, then income
is overstated. If inflation had been 10% during the holding period, the entity should
retain $11 ($10 × 1.10) and only consider $3.50 ($14.50 – $11.00) income. This
would be an application of constant dollar financial capital maintenance.
7. Financial capital maintenance is the concept that residual (and distributable) income
remains only after preserving financial capital; the closing amount of net assets must
exceed the amount at the start before net income is present. In contrast, physical
capital maintenance is the concept that residual income results only after preserving
physical capital or productive capacity.
The difference between the two concepts relates to the amount of income earned
through a given transaction. For example, if an item bought for $10 is sold for
$14.50, $4.50 of income is earned under financial capital (measured in nominal
dollars). But if it would cost $12 to replace the item, then income is only $14.50 –
$12 = $2.50. The entity must retain $12.00 in order to replace its physical (or
8. Three measures of income:
a. Nominal dollar financial capital maintenance: $1,500 – $1,000 = $500. Income is
earned as long as the original investment, $1,000, is retained.
b. Constant dollar financial capital maintenance: $1,500 – ($1,000 × 1.04) = $460.
Income is earned as long as the inflation-adjusted original investment, $1,040, is
c. Physical capital maintenance: $1,500 – $1,120 = $380. Income is earned as long
as the amount need for (physical capital) inventory replacement value is retained.
9. The two fundamental characteristics of accounting information are:
a. Relevance—accounting measurements must be useful to the needs of financial
statement users for making decisions.
b. Representational faithfulness—accounting measurements must be reasonably
accurate measures of what they purport to measure, without bias.
10. To be relevant, information must be presented in a timely fashion. However, in many
instances, accuracy (i.e., representational faithfulness) can be improved with the
passage of time when the ultimate outcomes of year-end balances (such as accounts
receivable, inventory, contingent liabilities, etc.) become known. Such a delay makes
the information less relevant, however, because it comes too late for effective
decision-making by users.
11. The statement is not true. Accounting measures complex economic phenomona and
the results cannot be understood unless the financial statement user is reasonably
knowledgeable about (1) business and economic activities and (2) accounting
concepts and measurement methods. Users who are not sophisticated or
knowledgeable about accounting are expected to hire experts to provide
interpretation and advice.
12. Comparability is the ability to ascertain differences and similarities between two
pieces of information. Consistency eliminates differences between years, as it
requires entities to use the same policies from year to year. Uniformity eliminates
differences between companies, as it requires different companies to use the same
policies for similar transactions, if all circumstances are similar.
13. When evaluating cost/benefit effectiveness, costs refer to the costs to prepare the
information, and also the costs of, for example, making information available to the
general public, which would include competitors. Benefits are felt by the user
groups, in the form of ̳better‘ decisions. The entity participates in these decisions
only indirectly, through a ̳more accurate‘ share price or loan cost.
14. The definitions of assets and liabilities embody three components and three time
a. Economic benefits must be received or given up in the future.
b. The rights (obligations) to (for) economic benefits must be clear in the present.
c. The asset or liability must be the result of a past event.
15. IFRS makes no distinction between revenue and gains; all are simply part of
enterprise income. Under ASPE, however, revenue is derived from ordinary business
activities of the enterprise; gains arise from peripheral or incidental transactions or
16. Recognition means recording a transaction or event in the books, while realization
means cash flow. Realization always triggers simultaneous recognition because cash
transactions require immediate recognition in the accounts.
17. An orderly transaction is one in which neither the buyer nor the seller is under undue
pressure to enter the transaction.
18. The fair value hierarchy specifies the correct sequence for estimating fair values. If a
direct observation of value is available, that value should be used. If the value of an
item cannot be observed directly in the market place, an estimate based on market
valuations for comparable items should be used. If that estimate also is not available,
only then should an indirect valuation technique be used.
19. If an asset has several possible valuations, based on differing uses, the chosen
valuation should be based on its most advantageous use, either as the asset on its
own in the most favourable market on a stand-alone basis, or when combined with
other assets in use.
20. Ethical professional judgement is a necessary element in the process of selecting
accounting policies. It involves the ability to weigh (1) the objectives of financial
reporting in a given situation, (2) the facts of the business environment and
operations, and (3) the organization‘s reporting constraints, blended with appropriate
reference to qualitative criteria.
Case 2-1 AeroTravel Inc.
This case gives students an opportunity to look closely at revenue and related cost issues
in a fairly complex but realistic business – one that most students will be well familiar
with in their role as consumers. There are rather complex interactions, and some
important estimations that raise significant potential ethical issues. This case is non-
numerical; it requires visualizing the business situation and the flow of revenues and
expenses, with concurrent ramifactions for the SFP.
Dear Ms. Yang:
As you requested, I have studied the operations of AeroTravel Inc. with a view to
identifying the accounting and reporting ramifications for the company. I believe that
while the revenue and expense issues are fairly straight-forward on the surface, there are
important estimates and accounting judgements that can affect the numbers reported. The
necessary accounting policies involve the timing of revenue and expense recognition as
well as matching and periodic reporting. The principal issues are as follows:
ATI obtains its revenue by selling loyalty units to its corporate clients. Although the cash
is received upon sale, the revenue will not be earned until the clients‘ customers redeem
their units for travel or merchandise. Only then can the revenue be reported on the
income statement. Until redemption, the amount received from clients must be shown as
a liability on ATI‘s statement of financial position (i.e., as unearned revenue).
Revenue measurement is complicated by the fact that not all units are redeemed. A
significant portion of units are never redeemed and therefore represent ―free‖ revenue for
ATI—revenue that is never ―earned‖ through the delivery of goods or services. The
revenue from never-redeemed units must be estimated; this proportionate amount of
revenue can be recognized as revenue in the year the units are sold. Each year, the
company reviews its estimate of the proportion of outstanding units that will never be
redeemed. Thus, the amount of revenue recognized from unredeemed units will fluctuate
from year to year on the basis of both (1) the number of units sold during the year and (2)
the accumulated quantity of unredeemed units from past seven years; most members‘
units expire thereafter.
For ―earned‖ revenue, recognition will occur when the units are redeemed and the
rewards have been delivered, as mentioned above.
An additional source of revenue is obtained as fees from client corporations for
marketing and for assisting client companies with their own loyalty programs. These
revenues should be recognized as the services are rendered, however specified in the
contracts. If billings lag expenses, ATI‘s net expenses should be shown as inventory on
the SFP. If contract revenue is received in advance of incurring the expenses, the
unearned amount should be shown as a current liability.
When ATI buys airline seats, merchandise, or other rewards in response to redemption,
the company can recognize the revenue and related cost once the rewards have been
delivered. Delivery of merchandise occurs when it is shipped.
However, ATI does not always (and perhaps does not usually) acquire reward travel
at the point of unit redemption. ATI buys blocks of airline seats in advance and makes
them available to unit-holders, most likely via the ATI website.
For travel rewards, primarily airline seats, delivery does not necessarily occur when
the unit-holder selects his or her reward and relinquishes points, because the reward
travel may be cancellable prior to use. Thus delivery occurs only when the travel rewards
are actually used by the unit-holder—that is, after the cancellation period has expired or
when the unit-holder actually makes the trip. Until ―delivery‖, the travel rewards and
merchandise that ATI has purchased must remain as inventory on ATI‘s statement of
The revenue and expense recognition issues for ATI are rather complex because there are
multiple parties involved. Also, the timing of revenue receipt and cost incurrence do not
coincide. Matching is a major issue.
Estimation is a signficant issue. The information given me does not reveal the level of
unclaimed rewards. However, one can surmise that the inventory of outstanding loyalty
units is very large, given the tendency of clients‘ customers to accumulate units with little
regard to actually using them. Therefore, a small change in estimated redemption rate (or,
conversely, non-redemption) most likely can have a material impact on reported revenue.
While the revenue recognized by adjustments in the non-redemption estimate may be
relatively small as a part of total revenue, it can have a quite significant impact on net
income because it flows directly into earnings without incurring related expenses.
Therefore, estimation involves an important ethical dimension. It is important that
our firm, Hetu & Fauré, endeavour to verify ATI‘s annual estimate of non-redemption via
independent consultants and analysis. Other estimates are important too, but the non-
redemption estimate is the most important one, in my estimation.
In conclusion, I would like to thank you for this opportunity to review the operations of
ATI. I hope that I have fulfilled your expectations.
Case 2-2 Dubois Limited
Essentially, this case requires students to perceive how the reporting environment of a
company has changed. A private company has tapped new sources of financing in order
to meet competition, and those sources are imposing an ASPE GAAP constraint on the
company for the first time. The company must reconsider its financial reporting
objectives and therefore the company‘s accounting policies.
The ―required‖ asks for a report from an accounting advisor to the company‘s board of
directors. A good response should be in report format.
Note that this response includes reference to the disparity between IFRS and ASPE in the
matter of revaluation accounting, which students may not be aware of at this point.
The case also can be used later in the course, following Chapter 9 or 10.
Dear Ms. Bissau:
I am pleased to honour your request for advice concerning Dubois Limited‘s financial
reporting objectives and financial measurement methods. Congratulations on obtaining
the necessary financing for your new and expanded facilities and processes.
Dubois Limited has been a private enterprise since its inception. As a private enterprise, it
has not been necessary for your company to provide financial statements to external
users, except perhaps occasionally to a bank for a credit line or a short-term loan.
However, you have issued a significant number of shares to a venture capital company
that now owns 35% of the company‘s outstanding shares. Although you are still a private
company, Dubois will henceforth be required to provide audited financial statements to
the Mangle Group, prepared on the basis of Canadian accounting standards for private
As well, you have an arrangement with a major bank to provide substantial secured
working capital support. In our discussion, you didn‘t mention whether the bank requires
audited statements, but most likely they do because they need assurance that the collateral
(i.e., accounts receiveable, inventory, and buildings and equipment) is reported at an
amount that is not in excess of net realizable value.
In the past, you probably prepared financial statements primarily for your own
assessment of operations and for income tax purposes. So far as you indicated, you had
no external users of your financial statements (other than CRA). Clearly, that situation
Both Mangle and the bank will be quite interested in cash flow prediction, since the cash
flow will provide dividends for Mangle and debt service for the bank. The bank most
likely will not object to increasing assets (and credit based on those assets) as long as the
cash flow remains strong. In addition, Mange will be interested in evaluating the general
economic performance of Dubois, with a particular eye on the quality of management in
an increasingly competitive international market.
Dubois will no longer be able to use accounting measurement methods that are not
generally accepted. For example, the company must begin to use acceptable depreciation
methods for its tangible capital assets. Impairment tests will still be relevant, but those
tests will not eliminate the need for systematic depreciation. Company managers must be
able to show the auditors suitable rationales for their many estimates used in preparing
the financial statements.
There remains the question of selecting the most appropriate accounting and reporting
basis. Clearly, the previous methology (known in the profession as a ―disclosed basis of
accounting‖) will not result in the unqualified audit report that Mangle requires. The two
other options are (1) international financial reporting standards (IFRS) or (2) Canadian
accounting standards for private enteprises (ASPE).
IFRS are mandatory for Canadian public companies, but that set of standards is much
more complex than ASPE. Dubois is still a private company and as such has no
requirement to report under IFRS. A major advantage of ASPE is that it has far fewer
reporting requirements and more closely corresponds to the historical-cost accounting
that Dubois has been using. As well, the financial statements are simpler and will be quite
adequate for Mangle and the bank.
On the other hand, IFRS permits the use of ―valuation accounting‖ for real property while
ASPE does not. The company could switch to using IFRS, but this would require
substantial cost for restating prior years‘ financial statements and an increased
continuing cost of compliance. In my opinion, gaining the perceived advantage of
continuing use of valuation accounting is not worth the additional cost.
If the company decides to ―go public‖ in the future, the accounting basis will need to
change to IFRS. The prospectus for an initial public offering (IPO) must have
comparative financial statements prepared on the basis of IFRS. Therefore, if and when
Dubois becomes a public company, prior year‘s financial statements will need to be
adjusted to a new basis. I see little reason to use IFRS at present, however.
Instead, I recommend that Dubois continue to use ASPE and change the building
accounting to comply with ASPE‘s requirements for systematic depreciation.
One further observation; Dubois Limited can always prepare special purpose financial
statements for specific users, including the board of directors. In such statements, Dubois
could revert to revaluation accounting. Frankly, I can‘t see any sufficiently strong reason
to report on two different bases; I recommend adhering to the requirements of ASPE.
I am very glad to be of assistance. If I can provide any additional information or advice,
please contact me at 555-217-1937.
G. Washbourne Wells, ACE (Accounting Consultant Extrodinaire)
Note: While this sample response ends with a recommendation for ASPE, students could
also recommend IFRS on the basis that if an IPO is in the future, it would be better to get
the accounting system operating on that basis now. Also, depending on students‘
knowledge from introductory accounting, they may perceive that IFRS‘s relatively
increased emphasis on NRV and its option for revaluation accounting for capital assets
could enhance the financial statements, especially for the bank because the bank is
concerned about the value of collateral.
Case 2-3 BLX Shipping Limited
BLX Shipping Limited is a public company with considerable incentive to manipulate
financial results. They have not met market expectations in the past year, and share price
has declined from $20 to $14. The company had to restate prior earnings, and they
replaced the CFO. The container shipping industry in which they operate is highly price
competitive and cyclical. There may be ethical issues in the accruals and estimates used.
Issues – Accounting policy for:
1. Revenue recognition
2. Dry-docking expenditures
1. Revenue is recognized when all significant acts of the seller have been performed,
consideration is measurable and collection is reasonably assured. There do not seem to
be any direct concerns about these criteria, except that the costs associated with the
revenues must be measured. Actual invoices for costs are slow to surface. Because of
the distance – and perhaps cultures – involved, time spans are long for receiving actual
cost data. One of the recognition criteria is that items must be measurable to be
recognized. If costs are not measurable, they cannot be recognized. Accrued
liabilities are improperly stated if not completely measured. If costs can’t be accrued,
then revenue should not be, either. Matching cannot be accomplished unless costs are
accrued to match to revenue.
On one hand, management may be well qualified to make estimates, and since revenue
has clearly been earned in the year (delivery has been made) the financial statement
reader is better informed with the revenue recongnized as it is now. On the other hand,
the material restatement of prior years provides evidence that management has not
always been correct in their estimates. While the mis-estimate was flagged as related
to unsettled industry conditions and adverse exchange rates, this can hardly be viewed
as unusual in the industry or world economy. Concern about the policy chosen seems
justified. One wonders whether management was acting ethically, and whether the
replacement of the CEO was somehow related.
Financial statement readers may be misled by the trends in revenue and net income
shown that include the accrued amounts. See the discussion below.
2. The company defers and amortizes dry-dock expenditures. One can argue that the
expenditures create a future benefit in that they ensure that the vessels are in working
order until the next scheduled dry-dock. Since dry-dock costs are sporadic, matching is
better served by deferral and amortization. Future revenue from the vessel establishes
the future benefit. On the other hand, regular maintenance does not make the vessel
―better‖ or enhance its future revenue generation, and normal repairs are expensed.
Recognition criteria are not met because future benefit is not proven.
Financial statement readers may be misled by the trends in revenue and net income
shown that include the accrued amounts. See the discussion below.
Impact on revenue and net income
Refer to Exhibit 1 for restated revenue and net income. Revenue from contracts for
which costs are not known is apparently up and down. Trends are changed when one
adjusts this revenue, delaying it until the following year when costs would presumably
become known. While the reported revenue showed a steadily increasing trend, the
revised revenue stream looks negative for the last two years ($932 versus $1,035), and
has shown great volatility (reducing to $658 in 20X3, and rebounding to $1,035 in
20X4). It should be emphasized that, since the reported numbers are based on
containers actually delivered to customers, the originally reported numbers are a better
indication of the effort expended in the year. However, the reasons for the volatility of
accruals is not clear.
In particular, there appears to be a wide range associated with the cost of services
accrued. In 20X5, for instance, the $95 cost is 30% of revenue, while the 20X4 restated
cost, presumably now accurate after restatement, is 41%. The 20X3 year has 35% cost,
and 20X2, 38%. The low cost percentage in 20X5 is suspicious because it is out of line
with prior years.
Dry-docking cost is sporadic, and amortization is a smoother pattern. If dry-docking is
expensed as incurred, the overall pattern of net income is less smooth but more
indicative of the company‘s actual expense incurrance.
Overall, when both revenue and dry-docking costs are adjusted, net income becomes
far more volatile, with losses recorded in two years (20X5 and 20X3) and higher net
incomes in the other two years. Perhaps accounting policies are being used to smooth
income, a result that might have unethical overtones.
An individual investor is in no position to effect change in a company‘s accounting
policies. Her or his task is to understand the implications of these policies. For BLX,
accrual of revenue where costs are unknown may or may not be defensible. Dry-docking
costs appear to fail the recognition tests and are more appropriately expensed. The
outcome of the two chosen policies is that the financial statement reader might believe
that BLX had more stable revenue and earnings history that the underlying economics of
the industry might support. Knowledgeable readers and efficient markets should not be
fooled by this, and the reduced stock price in the current year might indeed reflect current
economic realities for the company.
Technical Review 2-1
Technical Review 2-2
1. Qualitative criteria require that a measure be a faithful representation of the value of
the land, but also verifiable and free from material misstatement or bias. Independent
appraisals are acceptable (preferrably two or three independent appraisals, to establish
verifiability), but not an internal appraisal by a company ―expert‖ unless it is subject
to external validation. Instead, the shares should be used as the valuation basis despite
being lightly traded. The are traded, so there is some basis for indendent valuation.
2. Delaying the statements would most likely increase the representational faithfulness
of the accounts receivable and improve the estimate of uncollectible accounts.
However, issuing statements six months after year-end definitely would decrease
relevance—old information with little usefulness for predictive purposes; the
following year is half over by that time.
3. Completed contract does require far fewer estimates than percentage-of-completion,
and therefore representational faithfulness is increased. On the other hand, the
absence of any profitability information prior to completion definitely decreases
relevance, giving the earnings information little predictive or confirmatory value. As
well, comparability is greatly impaired because other companies in the industry are
using the percentage-completion method.
4. It is true that many intangible ̳assets‘ are not shown on the company‘s balance sheet
because they were internally generated. There is no assurance that those assets will
produce revenue-generating products, even though the company believes they will.
Costs were expenses when incurred due to the impossibility of estimating future
revenues; revenues cannot be recognized until earned. The company should attempt
to disclose of the nature of the assets rather than try to measure it by a highly biased
and unverifiable quantitative measure.
5. In substance, a long-term rental arrangement, or lease, may be the same in substance
as buying the asset and borrowing the money to finance the purchase. When this is
true, the financial statements show the rented asset as a capital asset, and the future
rent payments as a liability. The resulting measurements have high representational
faithfulness because the asset and liability reflect the true substance of the long-term
Technical Review 2-3
C/E 1. Any accounting method is acceptable for small items that will not change
I 2. Assumes that all financial statement elements can be meaningfully described in
H 3. Long-term assets that increase in value are not normally written up in the
J 4. Assets and earnings should be neither understated nor overstated.
G 5. The estimated future cost of fulfilling warranties that may not arise until two
years into the future are accrued in the period of the sale.
C/E 6. It is not necessary to use a complex accounting method for minor items that are
highly unlikely to improve the decisions of financial statement users.
K 7. It must be possible to numerically confirm all amounts reported in the body of
the financial statements.
F/G 8. The various costs associated with a revenue transaction may be deferred until
the revenue is earned.
A 9. The personal transactions of owners should be kept separate from transactions
of the business.
L 10. Significant recognized and many non-recognized items should be fully
described in the notes to the financial statements.
B 11. Enables historical cost, rather than liquidation values, to be used.
D 12. Enables measurement of the income and financial position of entities at regular
Three measures of income:
a. Nominal dollar financial capital maintenance:
$140,000 – $94,000 = $49.000
b. Constant dollar financial capital maintenance:
$140,000 – ($94,000 × 1.05) = $41,300
c. Physical capital maintenance:
$140,000 – $115,000 = $25,000
a. Nominal dollar financial capital maintenance: $140,000 – $49,000 = $94,000;
this is the original dollar investment in inventory.
b. Constant dollar financial capital maintenance: $140,000 – $41,300 = $98,700;
this is the original dollar investment of $94,000 stated in inflation-adjusted
dollars: $94,000 × 1.045= $98,700.
c. Physical capital maintenance: $140,000 – $25,000 = $115,000; this is the
replacement value of the physical capacity.
In each case, the company has ̳capital‘ left over in dollars—either (1) the original
financial investment in dollars, (2) the original financial investment in constant dollars, or
(3) the ability to replace the physical capital in units.
Only in alternative c is there enough money left to replace inventory. In the first two
cases, the company does NOT have enough money left over to replace inventory, and
would have to raise additional capital to do so.
Nominal dollar financial capital maintenance is by far the most common in Canada and
the USA, but physical capital mainenance is permitted under IFRS. IFRS also permits
constant dollar capital maintenance in hyperinflationary economies.
Technical Review 2-5
1. Nominal dollar capital maintentance
Sales revenue $160,000
Cost of goods sold ($64,000 – $25,000) $ 39,000
Depreciation ($300,000 × 20%) 60,000
Total expenses $ 99,000
Net income $ 61,000
2. Physical capital maintenance
Sales revenue $160,000
Cost of goods sold ($64,000 – $25,000) × 0.90 $ 35,100
Depreciation ($300,000 × 20% × 1.03) 61,800
Total expenses $ 96,900
Net income $ 63,100
Relevance is the characteristic of usefulness. Information should be useful for making
decisions. Reliability includes several characteristics: representational faithfulness,
verifiability, and freedom from bias. This investment portfolio can be reported at
historical cost or at fair market value.
Tannino Ltd. is a private investment company. Its stakeholders are the 30 investors, the
two owner-managers (who own all of the shares), and the bank. The investors need to
know the value of their holdings and need to be able to evaluate the investment
performance of the managers. The bank needs to know the value of assets against which
it is lending money. The shareholders need to know how much the company is earning so
they can judge their return accordingly. For all three types of investments, market value
would theoretically be more useful than historical cost.
For investments in publicly traded securities, market value is readily obtainable and is
highly reliable. Investors will be able to see how well the investments are performing,
and will be able to see if the managers miss opportunities to realize earnings (e.g., sell
prior to a fall in prices). Historical cost is of little or no relevance.
Market value information for investments in real estate are less reliable, because there
is no open auction market as there is for securities. Market value for real estate
investments is often established as the discounted prospective cash flow. Professional
appraisers would be required to estimate real estate market values, and estimates would
vary among appraisers. Real estate investments cannot be liquidated quickly, and
therefore market values have less relevance. Historical cost may be used on the financial
statements for verifiability and freedom from bias. If appraisals occasionally are carried
out, the appraised values can be presented in the notes.
Venture capital is the most difficult type of investment to report at market value. By
definition, venture capital investments involve a high level of risk. Risk leads to volatility
in price (or value). Therefore, it would likely be impossible to report market values with
any reasonable degree of reliability. A reliable valuation would be based on the equity
value of the underlying companies, but this probably would not be very relevant. A
relevant measure would be based on the discounted value of future cash flows, which
would be speculative and therefore unreliable.
2. Feedback value
3. Predictive value
4. Verifiability (also freedom from bias)
5. Freedom from bias (also representational faithfulness)
7. Representational faithfulness
8. Predictive value
9. Representational faithfulness
10. Predictive value