Explain the bases used to measure assets and liabilities
The idea
Balance sheet items are not measured on one basis. Historical cost records the original transaction amount and is verifiable but can become badly stale for long-held assets. Amortised cost adjusts historical cost for depreciation or for the unwinding of a discount. Fair value measures the price in an orderly transaction today, and is subdivided by the quality of the inputs used: quoted prices, observable inputs, or unobservable model inputs. The result is that total assets is a sum of numbers determined on different bases, which is a reason to read the components rather than the total.
A practice question
What does historical cost measurement record?
- The amount of the original transaction — correct
- The price the asset would fetch todayWhy not: That is fair value, which is what historical cost deliberately does not track.
- The asset's replacement costWhy not: An entry price for buying the asset again today — neither the original transaction nor what it would sell for.
It is verifiable and objective, which is its advantage, and it takes no account of subsequent changes in value, which is its limitation.
A harder one
What distinguishes the levels of the fair value hierarchy?
- The size of the asset being measuredWhy not: Size plays no part. A small holding with a quoted price is level one; a large one valued by model is level three.
- The observability of the inputs used, from quoted prices to unobservable model inputs — correct
- Whether the asset is current or non-currentWhy not: That is a balance sheet classification question, and independent of how the measurement was arrived at.
A level three measurement rests on management's own assumptions, which is a different kind of number from a quoted market price even though both appear as fair value.
The hardest tier
What follows for the analyst from assets being measured on several bases at once?
- Total assets is a sum of incomparable numbers and the components should be read instead — correct
- Total assets should be adjusted to fair value before any ratio is computedWhy not: Rarely possible and rarely necessary. The information to fair-value fifty-year-old land is not disclosed, and reading the components usually answers the question.
- The balance sheet should be ignoredWhy not: It carries a great deal of usable information at the line level. What deserves suspicion is the single total, not the statement.
Adding a fair-valued portfolio to fifty-year-old land produces a total that does not measure anything in particular, which is why the composition matters more than the sum.
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