Reliability As a Means to Achieve Relevance in
Valuation: What Qualifies As “WhatItPurportsto
Represent”?
Myojung Cho
Fordham University
Oliver Kim Steve Lim
University of Maryland Texas Christian University
May 29, 2006
Abstract
In this paper we propose a framework that would clarify issues on the
concepts of relevance and reliability to the valuation of assets, analyzing
the role of "what it purports to represent." Relevance is the statistical
closeness of the relation between the fundamental (e.g., the firm value for
investors) and the accounting number while reliability is the closeness
between the benchmark (i.e., what it purports to represent) and the
accounting number. A benchmark plays a role as a surrogate for the
fundamental so that the accounting number can be directly compared to
the benchmark in the evaluation of its reliability. In this framework, a
benchmark is thus chosen in such a way that reliability is an effective
means to attain relevance. We believe that the proposed framework with
a clear understanding of the role of reliability provides guidance to
standard-setting for asset valuations which has been often elusive.
1 Introduction
Relevance and reliability are treated in the current U.S. and international
conceptual framework as the two main qualities of accounting information that
1
make it decision-useful. Accompanied with the FASB-IASB joint project to revisit
the Conceptual Framework started in October 2004, the FASB Exposure Draft
“Fair Value Measurements” issued in June, 2004 rekindled the long-standing
debates on trade-offsbetween the two characteristics with respect to different
asset valuation methods (historical costing versus fair value costing). We discuss
the confusion around relevance and reliability with existing interpretations and
resolve the impasse with an alternative framework of relevance and reliability in a
valuation setting. Importantly, the proposed framework provides a clear
understanding of the role of reliability with respect to the usefulness of accounting
information, which would assist the standard-setters.
In a valuation setting, a single accounting number is chosen to represent an
asset (or a liability) value. An accounting standard for valuing an asset first
specifies a benchmark and describes acceptable valuation methods to obtain an
estimate of the benchmark. This estimate is used as the accounting value of the
asset. Such a benchmark is also called a ‘measurement attribute’ or ‘what it
purports to represent’ in the FASB Concepts Statement No. 2. The Statement
defines relevance and reliability of a reported accounting value in terms of the
benchmark: relevance concerns how closely the benchmark is related to the
firm’s fundamental value to the accounting
1 According to the FASB Board Meeting Handout paragraph 12 in July, 2005, FASB decided to
drop the widely misinterpreted term reliability from the qualitative characteristics and replace it
with a new umbrella term "faithful representation." The reason for the change is because reliability
is often understood as verifiability or precision and different Board members mean different things
for reliability. In this paper we will keep using the term “reliability” for convenience, because other
countries and existing studies are still using the term and the FASB considers the
representational faithfulness is just upgraded from a component of old reliability to its own primary
characteristics without substantial changes.
information user; reliability concerns how closely the accounting value is related
to the benchmark. The choice of a benchmark is thus critical in determining
relevance and reliability of an accounting number, and its usefulness. It is
surprising to find, however, that little explicit guidance is provided by the FASB
and existing literature on how to choose a benchmark.
For example, consider the debate on the fair value method and the historical
cost method in valuing assets, where fair value and historical cost are the
respective benchmarks for the two methods. An accounting measurement of an
asset value based on fair value is highly relevant but may not be very reliable if it
is difficult to obtain a good estimate of fair value. An accounting measurement of
an asset value based on historical cost is often considered to be highly reliable
but not very relevant. A choice of one method over the other is thus a trade-off
between relevance and reliability. Yet, there is little guidance on how the
trade-offsare evaluated orwhat the objective function is. As a result, an impasse
is reached between the advocates of the two methods with no convincing solution
to resolve the impasse.
We present a framework of the accounting information usefulness in order to
enhance the understanding of interactions between relevance and reliability in a
valuation setting. We propose the definition of relevance to be the closeness of
the relation between the fundamental and the accounting numbers rather than
that of the relation between the fundamental and the benchmark. Our framework
builds on the premise that the objective of financial reporting with respect to
assets (and liabilities) valuation is to provide useful information by reporting asset
values closely aligned with the firm’s fundamental. However, the fundamental is
not directly comparable to reported accounting numbers because it is by nature
abstract and affected by many other factors in addition to the value of individual
assets. Thus, a benchmark is chosen to act as a surrogate for the fundamental
such that it is specific enough to be directly comparable to accounting
measurements of individual assets (or liabilities). In this framework, reliability, the
closeness between the benchmark and the accounting numbers, plays as a
medium to establish the relation between the fundamental and the accounting
measurement. In other words, the benchmark is chosen such that achieving
reliability leads to the establishment of relevance, and as a result, of usefulness
of the accounting information.
When our view is applied to the fair value versus historical cost debate,
historical cost would not qualify as a reasonable benchmark if evidence shows
that it is not very relevant. A benchmark should be chosen so that accounting
value close to the benchmark would also be closely related to the fundamental,
and historical cost does not satisfy this condition. Assuming that fair value can be
shown to be closely related to the fundamental, it qualifies as a good benchmark
provided that a reasonable estimate can be found. If no good estimate is
available for fair value, historical cost can be considered as an estimate of fair
value, but not as a benchmark.
The paper is organized as follows. In Section 2 we explain how the concepts
of relevance and reliability are defined and understood by the FASB and existing
literature. We note two possible interpretations of the concept of relevance and
propose that relevanceofanaccounting valuebedefined as the closeness of the
relation between the fundamental and the accounting value. Section 3
emphasizes the need to clearly specify the objective in setting valuation
standards, which is to maximize relevance. In Section 4 we explain two existing
views of meanings and roles of reliability. We then propose our new view of
reliability as a means to achieve relevance. In Section 5 we apply our view to the
valuation of two broad classes of assets: (1) assets for sale and (2) assets for
use. We note that a diligent pursuit of relevance in valuation would lead to a
divergence from the traditional earnings-centered accounting. As a reconciliation,
we propose a dirty-surplus accounting system. In Section 8 concludes the study.
2The Definitions of Relevance and Reliability
2.1 The Current Definitions
In the FASB Concepts Statement No. 2, accounting information is considered
relevant if it is capable of making a difference in a decision by helping users to
form predictions about the outcomes of past, present, and future events or to
confirm or correct prior expectations. Reliability rests upon the extent to which the
accounting description or measurement is representationally faithful, verifiable
and neutral. Representational faithfulness refers to the correspondence or
agreement between the accounting numbers and the resources or events those
numbers purport to represent. Verifiability is a quality that may be demonstrated
by securing a high degree of consensus among independent measurers using
the same measurement methods. Neutrality means that financial information
must be free from bias intended to influence a decision or outcome. When the
FASB and IASB decide to upgrade the representational faithfulness to a main
quality in May 2005, they concluded that information cannot be representationally
faithful unless related measures and descriptions are verifiable and neutral.
2
We apply these definitions to a setting in which reported accounting numbers
are values of assets and liabilities. When setting a standard for valuing a given
asset (or liability), the accounting information is a single number, the value of the
asset, which we denote by y. We alsouse asymbol V , called the fundamental,
which represents
2 See the FASB-IASB Joint Conceptual Framework Project, June 2005, Attachment F.
what the users are ultimately concerned about. The fundamental V may differ for
3
different types of users and for different types of assets. In this study, we focus
4
on the concepts of relevance and reliability for a given V . An example of V is
stock price (or its change) when the users are investors.
Given the fundamental V and the reported accounting value y, weneed
onemore object to define relevance and reliability in the valuation setting. This
mysterious object has many names and has been elusive to accounting users,
practitioners, standard-setters, and researchers for decades. Its names include
(real-world) ‘economic phenomenon’ (the Concepts Statement No 2 paragraph
68; the IASB/FASB Board Meeting Handout, July 2005, paragraph 7),
‘measurement attribute’ (the Concepts Statement No 2 paragraph 50), and ‘what
it purports to represent.’ We will use a neutral name, “benchmark” for this object
and denote it by x.
In the valuation setting, the FASB definitions of relevance and reliability of
accounting information can be stated in terms of V , x,and y. The reliability of
accounting value x is the closeness of the relation between the benchmark x and
the accounting value y. The relevance of accounting value y can be definedintwo
alternative ways depending on the interpretation. The next subsection discusses
the two definitions of relevance.
2.2 Two Alternative Definitions of Relevance
It seems that the FASB discussions of relevance as well as related discussions in
academic studies leave room for two different interpretations of what relevance
means.
The relevance of accounting value y can be defined as the closeness of the
relation
3 The Concepts Statement No 2 paragraph 45 discusses this point. For example, V for investors
would be the stock price (minus the market noise). It seems more difficult to pinpoint what V
should be for creditors. However, not being able to clearly understand V does not affect our
discussion.
4 See Barth (2000) for a discussion of models that link equity price to values of assets and
liabilities.
between the fundamental V and the benchmark x, and this interpretation seems
5
to reflect the dominating view. For example, Sloan (1999, p195) states relevance
basically requires that if the underlying attribute (x) of an item (such as the
current value of a fixed asset) were perfectly measured, then the resulting
measurement (y) would be useful to investors. This statement can be interpreted
as the accounting measurement y being useful to the extent that its benchmark x
is closely related to the fundamental V .
However, this definition of relevance can be counter-intuitive. Consider the fair
value accounting for securities held for short-term investment. Then, a good
benchmark x in this case would be the fair market value of the securities because
there is usually an active market for short-term securities. The estimate y of the
fair value is reported as the value of the asset under the fair value accounting.
The accounting number y, the estimate of x, should be the quoted fair market
price. The market price of securities in this case is a very good estimate of the
fair value with little error. In contrast, suppose the fair value is estimated based
on a formula with many assumptions and parameters. The resulting
measurement y would contain much greater error. However, if the relevance of y
is measured with the relation between V and x which is an estimate y obtained
from the formula is as relevant as the quoted market price. That is, the relevance
of the accounting measurement y is unaffected by how good an estimate y is of
fair value x. If an accounting measurement y is a very
5 Considering the benchmark x is unobservable, it would be difficult to separate relevance from
reliability under this view, as stated in the Concepts Statement No. 2 paragraph 68. Barth, Beaver
and Landsman (2001, p81) agree with this view stating that value relevance tests using equity
market value and particular accounting amounts are generally joint tests of relevance and
reliability. Similarly, the IASB/FASB Board Meeting Handout, May 2005, paragraph 36 points out
that value-relevance and experimental market studies have accumulated considerable evidence
supporting the measurability of the combined relevance and reliability of accounting information
by correlation to market price changes.
crude estimate of x, however, such information is irrelevant because it is not
capable of making a difference in the users’ decisions, according to the generic
definition of relevance in the Concepts Statement.
The ambiguity related to the first definition of relevance can be also discussed
with respect to the role of the benchmark and thus of reliability. The following
example demonstrates the need to clarify their roles. Consider an asset whose
fair value is very difficult to estimate because the asset is unique and is not
frequently traded. First, suppose its historical cost is chosen as a benchmark x.
Since historical cost can be found without errors in general, the reported
accounting amount would be exactly the historical cost, i.e., x = y. Thus, the
accounting value generated by the historical cost method is perfectly reliable but
relevant only to the extent that the historical cost is closely related to the
fundamental.
Now, suppose the fair value of the asset is chosen as the benchmark x.The
fair value is very difficult to estimate for this asset. In this case, historical cost
could be used as one estimate of fair value, because it incorporates all the
specificities of the asset despite being outdated. If fair value x is very closely
related to the fundamental V , the historical cost y is very relevant but reliable
only to the extent that it is a good estimate of fair value under this definition of
relevance. This example raises a question about the role of reliability as well as
the definition of relevance because the same historical cost of an asset can be
both (1) very reliable but not so relevant and
(2) very relevant but not so reliable, depending upon the choice of the
benchmark.
Alternatively, relevance of accounting value y is defined as the extent of the
relation between the fundamental V and y in the literature. The Concepts
Statement No. 2 paragraph 61 explains that relevance is like effectiveness of a
drug. In this example, adrugiseffective if it cures or alleviates the condition for
which it was prescribed.
This definition of relevance seems to be more consistent with the everyday use of
the term as well as with the term ‘value-relevance.’ We propose the second
definition of relevance be formally adopted. The closeness of the relation
between V and x should simply be regarded as the relevance of the benchmark
x, not of the accounting amount y.
The adoption of the first definition by the FASB may stem from the attempt to
understand relevance and reliability as two conceptually separable and equally
essential qualities of useful accounting information. While the proposed adoption
of the second definition would only be a cosmetic change, it would reflect a very
different view on the interaction between relevance and reliability, as will be
explained below.
3 The
Objectives in Setting Valuation Standards
The Concepts Statement No. 2 paragraph 50 states that one of the most
fundamental questions raised in the search for relevance is the choice of the
attribute to be measured for financial reporting purposes (i.e., x). In the setting for
the valuation of an asset (or a liability), the main choice problem is to choose a
single benchmark x and specify amethodtoobtainanestimateof x. An application
of this standard would create an accounting measurement y. The benchmark x
can be best understood as a theoretical value related to V . The benchmark x is
in general unobservable, even ex post, while accounting value y is observable. In
the fair value accounting of an asset, x is the unobservable fair value and y is the
reported and thus observable estimate of the benchmark.
The choice of a valuation standard is thus the choice of an (x, y) pair.
Assuming that the fundamental V is given, the choice problem will be well defined
once the objective function is specified. The clear objective of financial reporting
is to provide useful information to its users, and in our setting it can be interpreted
as providing accounting measurement y that is closely related to the fundamental
V . This implies that the choice problem of a valuation standard is to choose
among feasible (x, y) pairs to maximize the closeness of the relation between V
and y.
6
If the goal is to maximize the usefulness of an accounting information by
strengthening its relevance (the relation between the fundamental V and the
reported value y), then what is the role of the benchmark x? In another word, if
the same y is generated by two different benchmarks, does it matter how y is
generated as long as it is useful? We discuss different views on the role of a
benchmark and reliability in the next section.
4
The Role of the Benchmark and Reliability: Three
Views
There are at least two different views about the role of the benchmark and
reliability that are expressed in the related literature. We explain these two
views and present our third view that, we believe, would significantly enhance
the understanding of the concepts of relevance and reliability, resulting in a
greater consensus in standard-setting.
6 We assume that other factors that we do not examine in this paper such as the cost of
producing information are either neutral or negligible. Some qualities that are not included in
the discussion such as comparability, completeness, materiality, timeliness, and
understandability would not affect general implications of this study partly because of the
simplicity of x and y in our setting and partly because they are couched in our notion of the
fundamental V .
4.1
The practitioners’ View: Reliability As the Dominant Quality
The FASB Concepts Statement No. 2 paragraph 44 acknowledges the strong
existence of a view that treats reliability as the dominant quality over relevance. It
is understandable that the demand for reliability is especially strong among
accounting practitioners. Particularly, accounting information preparers are likely
to consider reliability more important because they want to defend the information
they generate from auditors. Some accounting information users like auditors
would take a similar position because they would want to ensure that the
information is reasonably free from error or bias. For example, McCarthy (2004)
asserts that the reliability of historical cost reporting is ‘infinitely more valuable’ to
the majority of information users than the benefits of fair value reporting where
the cost of fair value estimation surpasses its benefits with the auditor
independence in danger, especially for private firms. Heffes (2005) also reports
that some practitioners are highly concerned about the FASB’s proposal of fair
value measurement fearing that the proposed measurement would decrease the
verifiability and auditability.
This view where reliability is the dominant quality usually entails a benchmark
x whose estimate is very easy to obtain, resulting in high reliability (close x and
y). Thus, when the benchmark is chosen, relevance is often sacrificedinorder to
accomplish high reliability. A good example is the case where historical cost is
adopted as a benchmark for valuing assets. Historical cost is often easy to verify
and thus highly reliable. However, historical cost often does not serve as a good
benchmark for valuing assets under many circumstances partly due to the lack of
timeliness.
4.2
The FASB’s View: Reliability and Reliability As Two
Necessary Qualities
Though the voice of the dominance of reliability seems still strong among
accounting practitioners, the FASB Concepts Statement No. 2 paragraph 44
warns that if reliability only were protected over relevance, the most useful
information in financial reporting would be generated outside the financial
statements. Then, the audited financial statements would increasingly convey
highly reliable but largely irrelevant, and thus useless, information. Thus, it is
clear that the FASB’s position is to deny the dominance of reliability over
relevance, as discussed in Johnson (2005).
To be specific, the current FASB position is to deny dominance by either
quality. The Concepts Statement No. 2 paragraph 42 states that although
financial information must be both relevant and reliable to be useful, information
may posses both characteristics to varying degrees, and that it may be possible
to trade relevance for reliability or vice versa, though not to the point of
dispensing with one of them altogether. The board considers both characteristics
to be essential but does not provide clear guidance about how to achieve the
optimal mix of or trade-offs between the two qualities.
7
Even though the FASB understands that the choice of the benchmark is
critical in standard-setting, it seems that the Board allows any relevant economic
8
phenomenon as a candidate for the benchmark. For example, for asset
valuations, fair value and historical cost are regarded as two prominent
candidates for the benchmark. For many
7 See the FASB Board Meeting Handout on Conceptual Framework paragraph 46, May 2005. 8
The Concept Statement No. 2 paragraph 50 states that one of the most fundamental questions
raised by the search for relevance in accounting concerns the choice of attribute to be measure
for financial reporting purposes. The paragraph further states that because of lack of experience
with information providing measures of several of those attributes and differences of opinion
about their relevance and reliability, it is not surprising that agreement on the question is so
difficult to obtain
assets including liquid assets such as marketable securities, fair value is
considered as highly relevant but sometimes unreliable when the market values
of the assets are not readily available. In contrast, historical cost is considered as
highly reliable but not very relevant. Thus, ambiguities in the objective function in
standard-setting lead to ambiguities in the choice of the benchmark.
4.3
The Proposed View: Reliability As the Means to Achieve
Relevance
We propose alternative view of the relevance and reliability with the role of the
benchmark. In Section 3 we stated that in our framework the objective function in
standard setting is to maximize relevance with the V − y relation. An immediate
question is then what is the role of the benchmark x and of reliability? A quick
answer is: reliability is the means to achieve relevance. In other words, relevance
cannot be attained unless reliability is achieved. This line of logic is shared by the
practitioners and researchers. Carroll, Linsmeier and Petroni (2003, p3) state that
opponents of fair value reporting are most concerned about the significant
reliability problems for some fair value estimates that would impair or perhaps
even destroy the relevance of reported accounting amounts. In addition,
McCaslin and Stanga (1983), from a survey from accounting preparers and users
about the relevance and reliability of accounting information, conclude that the
respondents tend to believe that unless information is sufficiently reliable, the
information will lack relevance.
The benchmark plays an important role in understanding the usefulness of
accounting information especially because it is not always easy to establish a
relationship between the fundamental V and accounting measurement y. The
fundamental V is what the information users of accounting information are
9
ultimately concerned about. Though individual accounting users may have clear
ideas of what they are concerned about a firm, it is not easy for standard-setters
to decide what the specific objectiveshouldbefocused on, given
diversegroupsofusers. Evenfor asinglegroup of users such as investors, it is not
always easy to determine what the group’s specific needs are.
Even when the fundamental V can be determined, it is not easy to establish
an individual link between V and an accounting value y, because the fundamental
is generally affected by many factors other than the value of an asset. Even if it is
assumed that stock price is a good manifestation of the fundamental, stock price
moves for many different reasons and a change in the value of an individual
asset may not be perfectly related to stock price change. Therefore, accounting
studies examine a statistical association using econometric methods such as
regressions when there are sufficient observations.
In addition, the fundamental V and an accounting number y are not in general
of the same scale and thus not directly comparable. In the above example with
stock price as the fundamental, stock price is in dollars per share while the value
of an asset is in dollars. The difference in units of V and x will not, however,
hinder the detection of a statistical relation from econometric methods such as
regressions.
Therefore, relevance ( i.e., the closeness of the relation between the
fundamental V and the accounting report y)isabstractand statistical,
anditisaconsequencerather than a means. Simply emphasizing the importance of
relevance does not provide practical guidance to standard-setters for the
usefulness of accounting information. Abenchmark x is thus chosen as a means
to bridge the accounting amount y to the fundamental V . The characteristics of a
benchmark that fulfills this role are the
9 For example, a firm’s stock price seems what investors are ultimately concerned about.
following.
First, a benchmark has to be sufficiently well defined so that it means the
same thing by different users. For example, the FASB lays out in detail the
definition of fair value of an asset/liability as a benchmark in the FASB Exposure
Draft, Fair Value Measurements, June 2004, paragraphs 4 and 5. It defines fair
value as ‘the price at which an asset or liability could be exchanged in a current
transaction between knowledgeable, unrelated willing parties’ with more details.
This requirement for clear specification of a benchmark does not necessarily
imply that the benchmark must be observable. Often, a benchmark is not easily
observable, even ex post.For example, the fair value of a unique asset at a given
point in time may never be observable because no similar asset was sold at that
time.
Second, a benchmark and the variable that the standard-setters intend to
capture with the accounting value y should preferably be affected by the same or
at least very similar set of factors. In other words, the benchmark should be a
close surrogate for the fundamental. In the above example, the fair value, i.e., the
price that would be received if sold now, of an asset expected to be sold soon
would be very closely related to stock price in any reasonable theoretical model
with rational investors.
Third, a benchmark and an accounting value should be of the same scale and
thus directly comparable to each other. For example, fair value and an
accounting value of an asset are of the same scale and directly comparable to
each other. Given direct comparability, reliability can be redefined as the
closeness between x and y instead of the closeness of the relation between x
and y. Direct comparability is critical for assuring individual comparability, which
in turn enables audits of individual accounting values.
Summarizing the above three points, reliability (i.e., the closeness between
the benchmark x and the accounting report y)isspecific and individual, and it is a
means rather than a consequence. A benchmark x is chosen so that achieving
reliability leads to relevance. In other words, reliability is the way to achieve
relevance. A notable difference of this view from the other two views is that the
requirements for a benchmark are stringent so that many that would be
considered as candidates for a benchmark would readily not qualify with this
view. In the next section we discuss possible choices of a benchmark for two
types of assets under this view.
5 The
Choice of the Benchmark: Two Examples
In this section we apply the proposed view of relevance and reliability to the
valuation of specific types of assets. We consider two broad classes of assets:
assets for sale and assets for use. For each of the two classes of assets, we
contemplate on what would be the most appropriate benchmark. For
convenience, we assume that stock price can be used as a firm’s fundamental.
10
5.1 Assets for Sale
Assets for sale are assets to be sold some time in the near future. They include
trading and available-for-sale securities and inventories. These assets have been
purchased or produced to be sold, and the firm is ready to sell them whenever
the conditions for sale are acceptable. The standard-setters want to find a
benchmark that satisfies two requirements. It should be closely related to stock
price and there has to be an accounting value that the accounting preparers can
readily compute and is close to the benchmark. Since the current market price of
any asset is the best estimate
10There
are other important groups of users of accounting information than investors such as
creditors, and even for investors stock price may only be a noisy proxy for the firm’s fundamental.
However, the points of this section are largely independent of these concerns.
of its future price in a frictionless market, the current (exit) price of the asset in a
hypothetical frictionless market can be called fair value and would be a good
candidate for a benchmark.
If a frequently traded market exists for an asset for sale, there is a consensus
that fair value is the most appropriate benchmark. When only a crude estimate of
fair valueisavailable, however, thereisoften adebateonhow fair valuecompares
with historical cost as a benchmark. The ultimate criterion for the comparison is
the achieved relevance, i.e., the closeness of the relation between the share
price (i.e. the fundamental) and the accounting measurements of the asset’s
value generated under the two methods. The relevance under the fair value
method would suffer to the extent of the estimation errors of the fair value
estimate. In contrast, the relevance under the historical cost method would suffer
to the extent that historical cost is not closely related to the share price.
The insight gained from the view of this study is that reliability is important
only to the extent that it helps establish relevance. Therefore, the results of
value-relevance studies can be used as evidence of relevance. The results seem
to suggest that historical cost does not qualify as a benchmark for most assets
under many circumstances. Even if in some rare occasions the historical cost
method generates more relevant asset values, there is a dynamic aspects that
should not be ignored when it comes to choose one method over the other.
Specifically, it is reasonable to expect that the reliability of fair market method
would improve over time. Techniques of estimating fair value would advance over
time by developments of new formulae or markets once the fair value method is
adopted, because the adoption would increase the demand for better estimates.
In contrast, historical cost is already measured without error and no
improvements in reliability or relevance are expected over time.
This observation leads to the conclusion that relevance, the closeness of the
relation between the fundamental and the accounting numbers, becomes more
important than reliability in the long run to the extent that reliability is improved
over time.
In sum, a historical cost would not qualify as a reasonable benchmark if
evidence shows that it is not very relevant. An accounting number close to a
historical cost would not guarantee relevance. On the other hand, a fair value
qualifies as a good benchmark provided that a reasonable estimate can be found.
If no good estimate is available for the fair value, the historical cost can be
considered as an estimate of fair value, but not as a benchmark.
5.2 Assets for Use
Assets for use are long-lived assets used to generate income for a number of
years. They include PP&E, intangible assets, and long-term investments in
affiliated company’s stock. Assets for use are planned to be used for a number of
years. A firm intends to use them until the condition changes so that it is better to
dispose of the assets. Under the assumption that share price is the firm’s
fundamental, the most appropriatebenchmark dependson how themarketwould
valuesuch an asset. Suppose a firm uses an asset as of time 0 and plans to use
it until time T.The firm sells theassetattime T. The total discounted net cash flows
generated from this asset is CS. The other option for the firm is to usethe
0
0
assetuntil theend of theuseful life at time T where T >Tand the corresponding
total discounted net cash flows CU . Suppose there are two possibilities: (1) the
total discounted net cash flows from the asset will be CU <CS with probability
αand (2) CU >CS with probability 1 − α where CU = CS + Gwith G>0. This
uncertainty will be resolved at time T.The firm will choose at time T to use the
0
asset until time T if and only if CU >CS.
Otherwise it will sell the asset for CS at time T . Therefore, the market’s
assessment of the value of the asset at time 0,denoted by A,is
A = αCS +(1 − α)CU
= αCS +(1 − α)(CS + G)
= CS +(1 − α)G. (1)
Equation (1) shows that the possibility to use the asset beyond time T ,which is
reflected in (1 − α)G, increases the market’s assessment of the incremental value
G of the the asset. Moreover, as the firm’s future prospect on the asset improves,
α would decrease and the firm will more likely to use the asset until the end of its
useful life. This is consistent with Aboody, Barth and Kasznik (1999) who find that
upward revaluations of fixed assets by UK firms are positively related changes in
future performance.
The intuition obtained from equation (1) could be used as a basis for
constructing a benchmark in valuing assets for use. For example, techniques can
be developed to estimate the premium for continued use, i.e., (1 − α)G. Fair value
can be considered as a proxy for CS if we consider time T as very close to time
0. It is not, however, the intention of this paper to construct an elaborate theory
for the valuation of assets for use. An important message here is that there have
to be explicit attempts, like this one, to construct a good benchmark by theories,
and also by tests of the theories, explicitly taking into account that the objective
function is to maximize the relevance of accounting reports.
5.3
Valuation Diverges
Accounting
from
Recognition:
Dirty
Surplus
We make one observation in this subsection that has a significant implication on
the future financial accounting standards. Suppose standards are significantly
revised to increase the relevance of accounting values of assets and liabilities in
the future. Since investors constitute the one of the most important classes of the
users of accounting information, the increased relevance necessarily implies the
increased value-relevance, i.e., relevance with respect to stock price. Then, due
to the forward-looking nature of stock price, accounting values of assets and
liabilities will include more of expected, but yet unearned, future benefits and
costs related to the assets and liabilities. Inevitably, this will violate the revenue
recognition principle along with the matching principle that essentially prevent the
recognition of unearned revenues and the corresponding expenses.
An obvious way to have values of assets and liabilities closely related to stock
price and not recognize unearned revenues is a dirty surplus accounting. In such
a system, values of assets and liabilities can incorporate unearned future benefits
and costs but revenues and expenses only includes the earned portions. Any
differences between the two are reported as items of shareholders’ equity without
flowing through the income statement. The income statement in this case is and
has been for a long time “a stage” where certain selected items are highlighted
and aggregated to generate an income number to be used as a performance
measure for the fiscal period. Allowing dirty surpluses enables the values of
assets and liabilities to be more in line with stock price and will add value to the
so-far-neglected balance sheet without diminishing the role of the income
statement. In short, it seems a win-win movement. Indeed, we are seeing the list
of dirty surpluses growing over the recent years, which includes unrealized gain
or loss on available-for-sale securities and cash flow hedges (e.g., futures
contracts and put options).
6Conclusion
In this paper we have proposed a few changes and augmentations to the
concepts of relevance and reliability that we believe would significantly improve
11
the understanding and fruitful applications of the concepts. Realizing that these
concepts have been in a constant process of evolution, we hope to contribute to
the process. The main conclusion of this paper is that achieving relevance,
defined as the closeness of the relation between the firm’s fundamental and the
reported accounting value of an asset or a liability, should be the objective of
accounting. Reliability, defined as the closeness between the benchmark and the
reported accounting value, is interpreted as a means to achieve relevance.
11In
expressing our views, our focus is on the two main qualities of relevance and reliability to be
parsimonious, omitting discussions of some other qualities of useful information.
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