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Financial Reporting, Financial Statement Analysis and Valuation 9th Edition

Financial Reporting, Financial Statement Analysis and Valuation (9th Edition)

Book Edition9th Edition
Author(s)Wahlen
ISBN9781337614689
PublisherCengage
SubjectFinance
Chapter 2, End of Chapter, Questions and Exercises, Exercise 2.1
Page 110

Relevance versus Representational Faithfulness.  

 

"Some asset valuations using historical costs are highly relevant and very representationally faithful, whereas others may be representationally faithful but lack relevance. Some asset valuations based on fair values are highly relevant and very representationally faithful, whereas others may be relevant but lack representational faithfulness." Explain and provide examples of each.

Verified Answer

The two important qualities of accounting information are relevance and reliability. Reliability is related to the extent at which the reported values have authenticity. This information is backed by appropriate document evidence. Relevance of the information is the degree at which the periodic information is useful for shareholders in decision making. Thus, this information might be subjective to each shareholder. 

 

Consider reporting the assets at historical costs and fair market value. If the assets are recorded as historical, it will be reliable information, but the shareholder might not be interested as it does not provide the current value of the asset. Conversely, the fair market value is very relevant information, but its accuracy can be questionable. This is because the fair market value can be manipulated by considering inaccurate developments. 

 

Below are few more examples:

 

Relevant and representationally faithful, based on historical cost: Fixed assets, the values of which remain relatively constant, accounts receivable.

 

Representationally faithful, but less relevant, based on historical cost: Appreciated real estate, purchased intangible assets.

 

Relevant and representationally faithful, based on fair value:  securities that are marketable, commodities.

 

Relevant, but less representationally faithful, based on fair value:  Appreciation or depreciation in the value of assets based on comparative analysis, funds for pension plans which are invested in less liquid investments.

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