RECOGNITION OF ASSETS
Accountants define assets as resources that a firm owns or controls as a result of past business transactions, and which are expected to produce future economic benefits that can be measured with a reasonable degree of certainty.
Distortions in asset values generally arise because there is ambiguity about whether:
* The firm owns or controls the economic resources in question:
* Are the ventures controlled?
* Are the leased assets owned by the lessee or the lessor?
* Have the revenues resulting in the receivables been earned?
* The economic resources are likely to provide future economic benefits that can be measured with reasonable ...view middle of the document...
* Fair value estimates are accurate.
* One other use of fair value estimates is to adjust the book value of assets when firms use the revaluation method instead of the historical cost method. When doing so, firms must regularly assess whether the reported book values deviate too much from the assets’ fair values and, if necessary make adjustments. Although revaluation adjustments are recorded in the statement of comprehensive income (not in the income statement), revaluations do affect earnings through the depreciation expense because, under this method, depreciation is determined by reference to the assets’ fair value.
* Fair value estimates are also needed to calculate goodwill in business combinations. Specifically, the amount by which the acquisition cost exceeds the fair value of the acquired net assets is recorded on the balance sheet as goodwill. The international standard for business combinations (IFRS 3) requires that the amount of goodwill is not amortized but regularly tested for impairment. This may create the incentive for managers to understate the fair value of acquired net assets and, consequently, overstate goodwill.
* Finally, new international rules on the recognition and measurement of financial instruments (IFRS 9) require a firm to recognize equity investments and debt investments held for trading (rather than for the purpose of collecting contractual cash flows till maturity) at their fair values. With a few exceptions, changes in the fair value of such assets are immediately recognized in profit or loss
* To reduce management’s discretion in determining the fair value of financial assets:
* their values must be derived from quoted market prices if an active market for the assets exists (typically referred to as marking to market).
* If quoted market prices are not available, firms can use their own valuation technique to determine the assets’ fair values (referred to as marking to model); however, their valuation should be based on assumptions that outside market participants would reasonably make, not management’s own assumptions.
Opportunities for accounting adjustments can arise in these situations if:
* Accounting rules do not do a good job of capturing the firm’s economics.
* Managers use their discretion to distort the firm’s performance.
* There are legitimate differences in opinion between managers and analysts about economic uncertainties facing the firm that are reflected in asset values.
* Asset overstatements are likely to arise when managers have incentives to increase reported earnings. Thus, adjustments to assets also typically require adjustments to the income statement in the form of either increased expenses or reduced revenues.
* Asset understatements typically arise when managers have incentives to deflate reported earnings – Income smoothing
* When the firm is performing exceptionally well and...