Subject 2. Measurement Bases of Assets and Liabilities

#cfa-level-1 #financial-reporting-and-analysis #reading-26-understanding-balance-sheets

Asset and liability values reported on a balance sheet may be measured on the basis of fair value or historical cost. Historical cost values may be quite different from economic values. The balance sheet must be evaluated critically in light of accounting policies applied in order to answer the question of how the values relate to economic reality and to each other.

Current Assets

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section are:

  • Cash. Valued at its stated value. Cash restricted for purpose other than payment of current obligations or for use in current operations should be excluded from the current asset section.
  • Marketable securities. Valued at cost or lower of cost and market value.
  • Accounts receivables. Amounts owed to the company by its customers for goods and services delivered. Valued at the estimated amount collectible.
  • Inventories. Products that will be sold in the normal course of business. They should be measured at the lower of cost or net realizable value. Refer to Reading 28 [Inventories] for details.
  • Pre-paid expenses. These are expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. Typical examples are pre-paid rent, advertising, taxes, insurance policies, and office or operating supplies. They are reported at the amount of un-expired or unconsumed cost.

Current Liabilities

Current liabilities are typically paid from current assets or by incurring new short-term liabilities. They are not reported in any consistent order. A typical order is: accounts payable, notes payable, accrued items (e.g., accrued warranty costs, compensation and benefits), income taxes payable, current maturities of long-term debt, unearned revenue, etc.

Tangible Assets

These are carried at their historical cost less any accumulated depreciation or accumulated depletion. See Reading 29 [Long-Lived Assets] for details.

Intangible Assets

Intangible assets are long-term assets that have no physical substance but have a value based on rights or privileges that belong to their owner. Generally, identifiable intangible assets are recorded only when purchased (at acquisition costs). The cost of internally developed identifiable intangible assets is typically expensed when incurred. For example, R&D costs are not in themselves intangible assets. They should be treated as revenue expenditures and charged to expense in the period in which they are incurred. One exception is that IFRS allows costs in the development stage to be capitalized if certain criteria (including technological feasibility) are met.

A company should assess whether the useful life of an intangible asset is finite or infinite and, if finite, the length of its life. The straight-line method is typically used for amortization.

Goodwill is an example of an unidentifiable intangible asset which cannot be acquired singly and typically possesses an indefinite benefit period. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility, however, that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified.

Under U.S. GAAP SFAS No. 142, goodwill is no longer amortized, but is tested annually for impairment. It is not amortized. Impairment of goodwill is a non-cash expense which is charged against income in the current period.


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