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have foreign subsidiaries that subject their assets to exchange rate ¬‚uctuations. How are
these ¬‚uctuations recognized? Are assets of foreign subsidiaries translated into local
currency at the historical rates when the assets were acquired? Alternatively, are they
translated at current rates?
U.S. rules for reporting foreign currency effects on assets require management to
make a decision about the exchange rate risk borne by a new foreign venture at the time
it is undertaken. A foreign subsidiary is considered to be largely insulated from the effect
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of exchange rates if its sales, costs, and sources of ¬nancing primarily occur in the local
currency rather than in the parent™s currency, and there are few transactions between the
parent and subsidiary. In this case, the subsidiary™s assets and liabilities provide a natural
hedge against much of any exchange rate volatility. Only the net asset value is consid-
ered to be subject to exchange rate effects. SFAS 52 therefore requires the subsidiary™s
assets (and liabilities) to be translated at the current rate. The parent will only be subject
to the effect of changes in exchange rates on net assets. These effects are re¬‚ected in
shareholders™ equity as a translation adjustment.5
Foreign currency risks for the combined ¬rm are considered to be more severe if the
subsidiary™s sales or costs are incurred in the parent™s currency or if there are frequent
transactions between the two. SFAS 52 then requires assets and liabilities for the subsid-
iary to be valued using the monetary/nonmonetary method. Under this approach, mone-
tary assets and liabilities (such as cash, receivables, payables, and ¬nancing) are translated
at current rates, whereas nonmonetary assets and liabilities (such as inventory, ¬xed as-
sets, and intangibles) are valued at the historical rate (when the transaction occurred). 6


Key Analysis Questions
The above discussion indicates that the management judgment involved in report-
ing the effect of changes in asset values depends on the type of asset, the country
in which the ¬rm operates, and the way it manages its businesses. For ¬nancial an-
alysts, these factors raise the following questions:
• Do operating assets appear to be impaired? Evidence of impairment could in-
clude systemic poor performance and/or write-downs by other firms in the in-
dustry. If assets appear to be impaired but are not written down, what is
management™s justification for not recognizing any impairment?
• Does management appear to have over- or understated prior impairment loss-
es for operating assets, making it difficult to evaluate future performance?
Has the firm consistently reported impairment losses, indicating an unwill-
ingness to appreciate the full extent of the impairment? Does management
appear to have a viable business model or plan to correct the problems?
• If management revalues operating assets, either up or down, what is the basis
for the estimation of the fair value? Is the valuation based on an independent
appraisal, or is it a management estimate?
• What are management™s reasons for revaluing assets that have increased in
value?
• What is management™s motive for holding financial instruments? Is that mo-
tivation consistent with shareholders™ interests? For example, is the firm
hedging risks for shareholders™ benefits or for the benefit of managers?
• What is the market value of all financial instruments?
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• What are the foreign currency risks the company is exposed to from its for-
eign operations? What foreign currency gains and losses are reported, either
in the income statement or in the equity section of the balance sheet? Does
management hedge foreign currency risks? How effective are these hedges?




COMMON MISCONCEPTIONS ABOUT ASSET ACCOUNTING
The above discussion of accounting for assets reveals a number of popular misconcep-
tions about the nature of accounting.


1. If a firm paid for a resource, it must be an asset.
This logic is frequently used to justify showing goodwill as an asset. It gives manage-
ment the bene¬t of the doubt in recording the full value of acquisition outlays as an asset,
presupposing that management would not have made the outlay if it did not anticipate
the prospect of some future bene¬t.
However, this logic ignores the possibility that well-intended managers can make
mistakes or that some managers take actions that are not in the best interests of share-
holders. Mergers and acquisitions have frequently been cited as such events. Recent ev-
idence indicates that mergers and acquisitions typically do not create value for acquiring
shareholders. The value of the goodwill recorded for these transactions may very well
not be an asset, but simply re¬‚ect management™s overpayment for the target or its over-
estimate of any merger bene¬ts. Indeed, the negative stock returns for many acquirers at
the announcement of an acquisition indicate that investors are skeptical of merger ben-
e¬ts. Accountants, however, do not re¬‚ect this skepticism in goodwill values until there
is evidence of its impairment.
It is also worth noting that the logic that payment is evidence of an asset is not used
consistently in accounting. For example, outlays for research and development are not
viewed as assets, even though managers also make outlays for R&D in expectation of
generating future bene¬ts. Several justi¬cations for the apparent contradiction in treat-
ment have been offered. One is that there is considerable risk of failure for any single
research project. However, a research program is more likely to generate successes. In-
deed, it is not obvious which is more risky”a research program or a takeover program.
A second justi¬cation for the different treatments is that R&D is more dif¬cult to verify
than goodwill. However, even this is not clear. After all, for many acquisitions it is not
clear exactly what bene¬ts are likely to be generated from the acquisition, making it dif-
¬cult to verify whether goodwill has been impaired. In contrast, research programs have
identi¬able output to verify whether outlays generated successful products.
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2. If you can™t kick a resource, it really isn™t an asset.
This view is commonly used to justify the rapid write-off or exclusion of intangibles
from the balance sheet. It is certainly true that it can be dif¬cult to estimate the economic
bene¬ts from some intangibles. As noted above, this is particularly true for goodwill.
However, the intangible nature of some assets does not mean that they do not have value.
Indeed, for many ¬rms these types of assets are their most valued. For example, Merck™s
two most valued assets are its research capabilities which permit it to generate new
drugs, and its sales force which enables it to sell those drugs to doctors. Yet neither is
recorded on Merck™s balance sheet.
From the investors™ point of view, accountants™ reluctance to value intangible assets
does not diminish their importance. If they are not included in ¬nancial statements, in-
vestors have to look to alternative sources of information on these assets.


3. If you bought a resource, it must be an asset; if you developed it, it
must not be.
This statement is frequently used to justify recording acquired intangible assets, such as
R&D and brands, but not recording assets for the cost of internally generated intangi-
bles. The logic for this distinction seems to be that intangible assets that are completed,
such as completed R&D and established brands, can be valued more readily than intan-
gible assets that are in development. While this may be true, it permits two ¬rms that
own the same types of intangible assets to have very different accounting for their activ-
ities. Firms that generate these assets internally show no values for the assets, whereas
¬rms that purchase these assets re¬‚ect them on the balance sheet.
The real question for investors in distinguishing between purchased and internally
developed assets is whether there is any difference in the certainty of expected future
bene¬ts for the two assets. If there is no difference, investors will view both as valuable
assets and are interested in assessing their value, how they are managed, and whether
they have been impaired during the period. Consequently, if accountants do not choose
to recognize internally generated assets, investors will be forced to ¬nd alternative
sources of information on these assets.


4. Market values are only relevant if you intend to sell an asset.
It has been common among accountants to regard fair values of assets as only being rel-
evant if the owner intends to sell them. For example, as discussed above, U.S. rules for
valuing marketable securities held as a store for cash require owners to value these assets
at their fair values only if they intend to sell them or the instruments are available for
sale. If management intends to hold these instruments to maturity, they are valued at
their historical cost.
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This logic implies that it is possible to avoid incurring an economic loss by simply
not selling the asset. An economist would view such an approach as ludicrous. If you
own stock in Microsoft and its fair value increases, your own equity increases accord-
ingly. This is true regardless of whether you intend to sell the Microsoft stock. The fair
value of the stock re¬‚ects the market™s best estimate of the resources that would be avail-
able if you sold the asset. Your plans to sell or hold are irrelevant to its value. Note that
this may not be true for operating assets. A plant™s fair value may be less than its value
in use. Further, assets with high values in use are precisely the types of assets that ¬rms
are likely to retain. Thus, fair values of separable operating assets may not be fully re-
¬‚ected in their values to the ¬rm.


SUMMARY
The recording of assets is primarily determined by the principles of historical cost and
conservatism. Under the historical cost principle, resources owned by a ¬rm that are
likely to produce reasonably certain future bene¬ts are valued at their cost. However, if
an asset™s cost exceeds its fair value, the conservatism principle requires that the re-
source be written down to fair value. The U.S. has been a strong advocate of the histor-
ical cost/conservatism approach to valuing assets. However, even in the U.S., adherence
to these rules has diminished during the last twenty years as ¬rms have been permitted
to revalue marketable securities to fair values. Outside the U.S., some countries permit
¬rms to revalue other types of assets, including intangibles.
The implementation of the principles of historical cost and conservatism can be chal-
lenging if:
1. There is uncertainty about the ownership of those resources, as is the case for lease
transactions and training outlays.
2. Future benefits associated with resources are highly uncertain and/or difficult to
measure, such as for goodwill, R&D, brands, and deferred tax assets.
3. Resource values have changed, as in the case of impaired operating assets, chang-
es in fair values of financial instruments, and changes in exchange rates for valu-
ing foreign subsidiaries.
Corporate managers are likely to have the best information on the ownership risks
and uncertainty about future bene¬ts associated with their ¬rms™ resources. As a result,
they are assigned the primary responsibility for deciding which outlays qualify as assets
and which do not, and for assessing whether assets have been impaired. Of course, given
managers™ incentives to report favorably on their stewardship of owners™ investments
and accounting requirements that preclude recording some key economic assets (e.g.,
R&D, brands, human capital), there is ample opportunity for analysts to independently
assess how a ¬rm™s resources are being managed.
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DISCUSSION QUESTIONS
1. An airline operator signs an agreement to lease an aircraft for twenty years. Annual
lease obligations, payable at the beginning of the year, are $4.7 million. What are the
financial statement effects of this transaction if the lease is recorded as (a) a capital
lease or (b) an operating lease? As a corporate manager, what forecasts do you have
to make to decide which alternative to use? Which method would you prefer to use
to report the lease? Why? As a financial analyst, what questions would you raise with
the firm™s CFO?
2. The American Society for Training and Development has recently advocated that
firms be permitted to report training costs as an asset on their balance sheet. As a cor-
porate manager, how would you respond to this proposal? What are its merits and
what concerns would you have?
3. In 1991 AT&T, the largest long-distance telephone operator in the U.S., paid $7.5 bil-
lion to acquire NCR, a computer manufacturer. Prior to the acquisition, the book val-
ue of NCR™s assets was $4.5 billion, and its liabilities were $1.5 billion. Assuming
that there was little significant difference between the fair value and the book value
of NCR™s assets, show the effect of the acquisition on AT&T™s balance sheet from us-
ing (a) the pooling of interests method and (b) the purchase method.
4. AT&T™s managers had a strong preference for recording the acquisition of NCR under
the pooling of interests method. Indeed, the offer was actually contingent on approval
for pooling. Why do you think AT&T™s managers were so concerned about the ac-
counting used for the transaction? As a financial analyst, what questions would you
raise with the firm™s CFO?
5. What approaches would you use to estimate the value of brands? What assumptions
underlie these approaches? As a financial analyst, what would you use to assess
whether the brand value of £1.575 billion reported by Cadbury Schweppes in 1997
was a reasonable reflection of the future benefits from these brands? What questions
would you raise with the firm™s CFO about the firm™s brand assets?
6. A firm records bad debt expenses on an accrual basis for financial reporting and on
a cash basis for tax reporting. In its 1999 annual report, it reported that the opening
and closing balances in Allowance for Uncollectibles (a contra against receivables)
were $1,200 million and $1,650 million, respectively, and that customers owing $550
million defaulted during the year. The company™s tax rate is 40 percent. How much
is the deferred tax asset as a result of this temporary difference between financial and
tax reporting? If 30 percent of the asset is deemed to be unrecoverable, how would
the transaction be recorded? As a financial analyst, what questions would you raise
with the firm™s CFO about the firm™s deferred tax asset?
7. As the CFO of a company, what indicators would you look at to assess whether your
firm™s long-term assets were impaired? What approaches could be used, either by
management or an independent valuation firm, to assess the dollar value of any asset
impairment? As a financial analyst, what indicators would you look at to assess
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