Valuation of Property, Plant, Equipment, Sellable Securities and Assets developed from internal research and development
The financial statement of a company or the balance gives information to stakeholders for decision making. As such, the statement has to represent the correct position of the company's financial situation within a given period to avoid misleading decision-makers. Incorrect statements may lead to incorrect decisions and, in some cases, even lawsuits. For accuracy in the financial statement, companies must ensure that all elements of the statement are accurate hence making them reliable and relevant in decision making. Accounting policies adopted on the valuation of assets (both long term, short terms, and contingencies) and liabilities should be accurate and effective in ensuring relevance and reliability.
Delegate your assignment to our experts and they will do the rest.
For property, plant, and equipment, the balance sheet should give a faithful representation. Assets are valued at cost or the assets carrying amount and accustomed to reflect the impairment of the asset. Impairment is done annually and follows the following steps; a qualitative assessment is carried out, and an impairment test is done where the fair value of a reporting unit is lower than its amount. The asset impairment value is determined as the amount by which the reporting unit's carrying value exceeds its fair value. Available for sale securities are valued at fair value under GAAP. Changes in the value of the securities within an accounting period are accumulated and reported in the statement of financial position as other comprehensive income. Assets developed from internal research and development are accounted for as an expense as they occur. Under GAAP, they are not valued as assets since their streams of income in the future are uncertain and can only be estimated. The IFRS standard, however, allows companies to capitalize on certain research and development costs in the statement of financial position instead of expensing them in the income statement.
Why the income statement would not be needed in an environment with perfect information
The income statement also referred to as the profit and loss statement, is a financial report that indicated the total revenue of a company's operation activities within a certain period and the expenses related to earning the revenue. It gives an estimate in profit before tax or loss for the company. The income statement serves different purposes to different stakeholders within and outside the organization. Investors, for example, may be interested in knowing how much a company is making for investment considerations. The management would be interested in the income statement to make decisions on reduction or minimization of costs to increase shareholder's wealth and become more competitive. Lenders, on the other hand, determine the amount of credit or financing to give to companies based on the profits or losses they make within a specified period since this determines their cash flow and ability to pay.
A market environment with perfect information implies that all market players, including consumers, producers, and stakeholders, have perfect, accurate, and instate nous knowledge of market conditions such as market prices, utility, cost functions, and even competition information. As stated, the income statement serves the purpose of giving financial information to interested parties in a company. In a perfect information situation, for example, a lender would not need the income statement to determine the profitability of a company or their cash flow abilities to reduce the risk of default. This information would be in the market, and the lender would not face any risks. Companies would also be able to determine their utilities and costs without the income statement from the information in the market. A perfect information scenario hence implies that an income statement would not have any use to investors, lenders, suppliers, consumers, and other parties interested in a company.
Construct Validity of Restatements
In research, construct validity refers to how well variables used in a study accurately capture the events and ideas used to build the hypothesis. Variables are measurable events and conditions. They are easily observed or determined. Certain variables in research are difficult to determine. Others, on the other hand, are clear and can be used to determine their relationship with the dependent variable. The dependent variable is the unknown event and is determined by the independent variables. Construct validity hence refers to the extent to which the variables selected in a study related to the events. When carrying out a study, it is important to have control variables to improve the internal validity of the study.
Restatements refer to revisions or corrections in one or more of a company's financial statements to correct an error. Even though managers and accountants are tasked with ensuring that a company's financial statements are accurate and give a true and fair view of a company's affairs, errors can be spotted by different parties, including auditors. Depending on the materiality of the error, a restatement can be done. Restatements provide high construct validity. They are determined by the effect of the change on the overall financial position of a company. Material errors can lead to misinformation hence bad decisions that could adversely affect the company and the stakeholders. FASB requires that companies issue restatements to correct previous material errors.
Advantages and disadvantages of having the FASB as opposed to Congress develop GAAP on oil and gas reserves
Policymaking is a crucial element of decision making that affects businesses. Reporting standards are some of the policies implemented by different bodies to ensure uniformity in accounting. Accounting for gas and oil reserves has been in discussion for decades, with some people supporting that accounting standards in the oil and gas reserve industry be formulated by FASB as opposed to GAAP while others opted for GAAP. In 1978 the SEC, with help from companies operating in the oil and gas industry, rejected the FASB statement that required successful efforts in costing. The SEC suggested the use of current value in accounting for oil and gas reserves.
Companies in the oil and gas reserve industry can decide between the successful effort accounting method and the full cost method. The two methods are different in how they treat operating expenses relating to the oil and gas industry. The successful effort gives companies the option of capitalizing expenses directly related to locating new gas and oil reserves regardless of the outcome. The full cost accounting method on the other hand gives companies the option of capitalizing on all operating expenses incurred while locating new gas and oil sites. GAAP requires that companies charge costs incurred to acquire assets and machinery used in oil and gas exploration against revenue. The GAAP method, established by the FASB, provides a better method that gives a true and transparent format for companies to account for oil and gas reserves.
The implication of Having Disclosure as Part of Audited Financial Statements
Company financial statements often give all the relevant information about the company to enable users of financial information to make sound decisions. It is, however, important that companies further expound on the information given so that users understand how the company came up with the figures it portrays in its financials. Statement financial disclosures hence communicate relevant information not directly captured in the financial statement to users of information. GAAP requires that companies disclose certain elements of their financials, including any changes in accounting methods such as valuation of assets, impairment of assets any accounting errors, and any other information deemed relevant in decision making. Accounting changes for companies would include valuation of inventory, changes in deprecation methods, or accounting policies used, such as GAAP. Such changes are important in communicating any rapid changes to the financials to users of information.
Accounting errors and any restatements in previous books should also be communicated. Errors have to be material for them to impact the overall financial position of a company. For companies operating in the gas and oil reserve industry, they have to disclose the method used in valuing their assets and how they account for expenses relating to exploration activities. Audited financials of a company must hence disclose information on certain elements of the business for purposes of decision making by all stakeholders. Failure to do so often leads to misleading financial information, which could affect the decision-making process, both internally and externally. Other than for decision-making, companies are also required by legal systems within which they operate to disclose their accounting policies and statements. Countries across the world have developed laws on when and how accounting information is disclosed for purposes of taxation. Such disclosures are also important for potential and current investors and help them make decisions regarding their investments.
The Bayes Theorem and Effect on New Information on Stock Market
The Bayesian probability, also known as the Bayes Theorem, is used in financial modeling depending on historical events and historical frequencies or probabilities. The rule is used in calculating the posterior probability of an event occurring, such as the probability of a risk affecting a financial instrument or stocks. The calculated probability is called the posterior probability or the conditional probability as it depends on the probability of occurrence of other events. The posterior probability refers to the probability of a future uncertain even based on relevant historical data already available. The fact that the probability is based on experience implies that new information about the past can change the conditional probability of a future uncertain event. As such, new accurate information leads to an automatic change in the probability of the event occurring using the Bayes Theorem. According to the theory, the probability of an event based on current un-updated information is called prior probability. Once new information affecting the event is collected and updated, the probability of the event occurring is referred to as posterior probability.
The theorem has been applied in the equity market and the stock exchange to determine risks before investment hence allowing investors to select their viable investment opportunities based on their risk appetite. In such investments, high risks attract higher returns. An investor needs to however be aware of the kind of risk they are taking and the probability of uncertain adverse events on their investments Addition of historical information or even current information on say interest rates lead to changes in the probability of the uncertain event leading investors to either increase their investment in a certain instrument or stocks or reduce them. In the stock market, for example, information about the rise of interest rates would lead to a decrease in the stock market index.
Congress Debates over Current Expected Credit Losses
The debate on the best approach in determining how much credit loss reserves should be recorded by banks on their financial statement has been ongoing in the United States. The United States GAAP requires banks and other financial institutions to use an incurred loss method when recognizing credit losses in their financial statements. Under this method, a bank must be aware of the occurrence of a loss and must be able to estimate the expected loss reasonable. Based on past experiences and the current economic conditions, banks can estimate their expected credit loss and the reserves to hold for the expected loss ( Gnanarajah, 2018). The incurred loss method was hence in use by banks in the United States until June 2016 when the FASB replaced it with the CECL method, which was more straight forward and provided more information on the financial statement ( Gnanarajah, 2018) . The method requires that banks consider a broader range of information, which they believe is more reasonable and supportable. The method is used to determine the expected credit loss by considering current and future economic conditions.
One of the expected implications of the new standard on banks and other financial institutions is that they are now expected to have relatively more accurate estimates on reserves relating to expected credit loss as opposed to what they had based on the more conservative method which focused more accurately reporting assets, liabilities, and earnings of the banks in the financial statements. The advantage is that the approach places banks in a risker situation where they do not overvalue or undervalue their reserves, which was common with the old method of determining expected losses and reserves. Banks that are traded publicly in the stock exchange benefit from earnings management, which reduces adverse effects on stock prices. This is because a new method considers the potential loss over the lifetime of a loan, allowing banks to hold enough credit reserves to absorb losses that may arise due to hard economic times.
Disclosure of Government Subsidies per GAAP
Disclosure of certain loss contingencies is an issue that has been debated on. The underlying issue has been whether the existing implementation of FASB accounting standards provides accurate and sufficient information to users of financial institutions. (Desir et al., 2010) discusses the effects of disclosure on companies based on negative lawsuit outcomes about the disclosures of companies. The Covid-19 pandemic has hit the world in different aspects, including economically. The impact on most companies is adverse, with some making huge losses and others even closing down. (Desir et al., 2020) analysis of different companies indicated that there were many incidents of non-disclosure of contingent losses arising from litigation. Many of these losses cannot be well explained by the extent of disclosure for items as per the FASB's exposure draft. The paper raises concerns by users on non-disclosure behavior by companies on matters relating to litigation contingencies.
Companies must disclose any government subsidies in their financials as they affect the profitability of a company by reducing costs or acquiring zero-rated items or assets. Failure to disclose such subsidies gives users the implication that the company has higher profits and that return on investment for the company is high. This is so because profits are affected by costs and revenue. Lowering costs through subsidies means that there are fewer costs associated with revenue generation for the company. Failure to disclose such information misguides the management, investors and even leads to tax discrepancies calculated from profit before tax, which could, in turn, lead to lawsuits against the company. Companies should hence disclose any subsidies and adopt proper valuation methods for assets acquired from donations by either the government or other sources. This is so because it would not be appropriate to value an asset obtained without purchase at no value in the balance sheet. Proper standards and procedures should also be followed when accounting for such subsidies.
The reason why People Opposed Standard to Enhance Disclosure on Expected Losses
A statement issued by FASB on the existing guidelines for statement no5 referring to disclosures about loss and contingencies stipulated that investors and other users of financial information did not receive adequate from the financials of a company. The argument was that the financials were not efficient in helping users assess the probability, timing, and amount of expected cash flows associated with loss contingencies. Under this standard initial disclosure of specific information relating to contingency does not occur until a company realizes a material accrual for the loss contingency. The amounts recognized in the financial statements relating to loss contingencies are not as transparent to the users. The concerns led to suggestions on how best to disclose financial information that would allow users of financial information to access accurate and transparent information for their decision making.
The first reason was that the initial recognition of a contingency loss does not occur until the company recognizes a material accrual. Secondly, the amounts portrayed in the financial statements did not give a transparent position to users of financial information. Other concerns regarding the standards were that the option by companies to the state than "an estimate of the expected loss or range of loss could not be made" was being exercised by companies so often implying that users of financial information had no solid basis of determining the entities possible cash flows related to the loss contingencies. Users of financial information were also concerned that the reasonable level for disclosing contingencies did not allow for the disclosure of the entire entity's existing loss contingencies. FASB suggested addressing the above issues; companies adopt an expanded disclosure on loss contingencies such that specific items would be included in financial statements and any assumptions disclosed for accuracy and transparency in financial information given to users.
References
Desir, R, Pfeiffer, R., & Fanning, K. (2010). Accounting Horizons . American Accounting Association.
Gnanarajah, R. (2018). Banking: Current Expected Credit Loss (CECL) . Fas.org. Retrieved 18 June 2020, from https://fas.org/sgp/crs/misc/R45339.pdf .
