Question

The following information is provided for two items of property for a company. Property A was purchased five years ago for $400,000. It was intended to be used to build another factory, but the company has now reorganised its original factory and it is no longer required. The company now intends to sell it. The current property market has dropped but it is expected to rise when interest rates fall. If sold now, the property is expected to realise $360,000. Real estate experts have predicted that if the company wait for the property market to recover, it could realise $450,000.

Property B is the current factory. It was purchased ten years ago for $200,000. If sold now, it would be expected to realise $380,000 (and $500,000 if the property market recovers). The company has various estimates about its contribution to the profit of the company. Using current interest rates and various assumptions about future sales and costs, the property is calculated to have a present value (in terms of future cash flows) of $900,000. It is insured for $600,000 because this is the cost required to rebuild it.

The company has always recorded property using the historic cost basis. Other companies in the same industry have traditionally used the same basis, although about 40% now use the fair value basis.

Required:

1. For each of the properties, identify which cost or value would best meet each of the following qualitative characteristics (consider each separately) of:

> Faithful representation

> Verifiability

> Comparability

> Understandability

> Relevance

2. For each of the properties, consider which option would provide the highest quality accounting information. Explain why.

3. Do you think everyone would agree with your choices? Why or why not?

Answer 1

1. For each of the properties, identify which cost or value would best meet each of the following qualitative characteristics (consider each separately) of:

a. Faithful representation:

Faithful representation means that price which depicts the correct price of the property. Faithful representation of the property A shall be by using the fair value of the property which is $360,000 where as for property B it shall be the amount it is expected to realise from the property during its useful life i.e. the present value of future cash flows which is $900,000

b. Verifiability:

The value of property is said to be verifiable when given the data of the purchase amount, year of purchase and rate of depreciation; any other account would also be able to come up with the same value. Thus for property A and B it shall be the acquisition cost less depreciation if any. But since in the present case, rate of depreciation is not provided, the company can use historic cost.

c. Comparability:

The value of property is said to be comparable when it is value using the same principles and assumptions as that of the industry or other company with which the data is being compared. So the company should as per common industry practise either value it at historic cost or at fair value depending upon the company or major competitors with which its data is expected of being compared.

d. Understandability:

Underdstandability means presenting the information/data in a way which is easily understandable by the users of information. Historic value or fair value can be the best alternative in this case. Proper disclosure of other values in these cases is must as it will make the data more understandable and relevant for users.

e. Relevance:

When the vale of the property is such that it can help or have an impact on the decision of users of information or someone pursuing it, the value is relevant. Hence in such cases, property A should be value at fair market value and a disclosure of the revised market value if expected rate cut happens. While for property B it shall be either market value or the insured value or present value of discounted future cashflows. Proper disclosure in these cases is must as it will make the data more understandable and relevant for users.

2. For each of the properties, consider which option would provide the highest quality accounting information. Explain why.

For property A, faithful representation i.e. fair value of the asset is a good alternative as it provides more relevant and truthful data.

For property B, historic cost should be followed along with full disclosure of its market value, insured value and present value of discounted cashflows.

3. Do you think everyone would agree with your choices? Why or why not?

Yes, everyone would agree with the choice as the valuation of the properties reflect the true value of the assets company holds.