ACC 6050 Module 6 Written Assignment: Measurement on the Balance Sheet and Income Statement Example

How Reliable Is the Number? Fair Value Levels, Measurement Choices and What They Do to Income

Student Name

Master of Science in Accounting, Thomas Edison State University

ACC-6050: Fundamentals of Accounting II

Mentor Name

Month Day, Year

How Reliable Is the Number? Fair Value Levels, Measurement Choices and What They Do to Income

Introduction

Every number on a balance sheet rests on a measurement basis, and every change in that number affects income or equity. Wolk et al. (2017) present measurement as the point where relevance and reliability most directly collide: the more current a measure, the more it may rely on estimates.

Measurement Bases

U.S. GAAP uses a mix: historical cost for inventory and plant, fair value for many financial instruments, and present value for some liabilities.

The Fair Value Hierarchy

Because fair value can be estimated in many ways, the standard ranks inputs into three levels (Financial Accounting Standards Board [FASB], 2006). Level 1 uses quoted prices in active markets for identical items, such as a listed stock. Level 2 uses observable inputs other than those prices, such as quoted prices for similar bonds or interest rate curves. Level 3 uses unobservable inputs, chiefly management's own assumptions, such as forecasts for a private company's warrants. Disclosure requirements increase down the hierarchy, including a roll-forward of Level 3 balances and the key assumptions behind them.

Level 3 measurements carry extra disclosure: a reconciliation of opening to closing balances, the valuation techniques and key unobservable inputs, and for public companies a narrative on how sensitive the values are to changes in those inputs.

Evidence on Reliability

Investors appear to recognize these differences. Song et al. (2010) studied banks' fair value disclosures and found that Level 1 and Level 2 amounts were valued closely in line with their reported amounts, while Level 3 amounts were valued at a discount, and that stronger corporate governance reduced the discount. The finding suggests that investors treat Level 3 estimates as less reliable, and that governance can make them more credible.

How Measurement Flows Into Income

The choice of basis determines when gains and losses appear. Under historical cost, an asset's value change is recognized only on sale or impairment. Under fair value through net income, every change appears in income, increasing volatility. Some fair value changes, such as those on available-for-sale debt securities, go to other comprehensive income until realized. Measurement on the balance sheet and performance on the income statement are therefore linked: a more current balance sheet usually means a more volatile income statement.

Application: Bergen Medical Capital

Bergen Medical Capital, a composite lender to young medical device companies, holds $420 million of assets at year end.

The warrants are only 4 percent of assets but drive much of the volatility in Bergen's income, because their value depends on assumptions about the borrowers' future financing rounds. An investor would want the Level 3 roll-forward, the valuation method and the key inputs, and might discount the reported warrant value as the evidence suggests. The loans, by far the largest asset, are not at fair value at all; their reported amount depends on the expected credit loss estimate, another judgment-heavy number. Bergen's balance sheet thus combines market prices, model estimates and amortized cost in one total.

Conclusion

Measurement bases trade relevance against reliability, and the fair value hierarchy makes that trade-off visible by ranking inputs. Evidence shows that investors discount the least observable estimates, so disclosure and governance matter. Because measurement drives the timing of gains and losses, the balance sheet and income statement cannot be evaluated separately. Bergen's portfolio shows how a single company's statements can mix all of these at once.

References

Financial Accounting Standards Board. (2006). Fair value measurements (Statement of Financial Accounting Standards No. 157).

Song, C. J., Thomas, W. B., & Yi, H. (2010). Value relevance of FAS No. 157 fair value hierarchy information and the impact of corporate governance mechanisms. The Accounting Review, 85(4), 1375-1410. https://doi.org/10.2308/accr.2010.85.4.1375

Wolk, H. I., Dodd, J. L., & Rozycki, J. J. (2017). Accounting theory: Conceptual issues in a political and economic environment (9th ed.). Sage Publications.