Measuring assets and liabilities

Industry must keep abreast of the changing ways in which investors evaluate companies as evidence suggests a shift in the role of the balance sheet.

In an ongoing effort to understand the views of investors about financial reporting issues, a PricewaterhouseCoopers team interviewed more than 50 professional investors about their use of the balance sheet in their analysis of companies' performance.

The results – outlined below – described by Sir David Tweedy as "an important contribution to the fair value debate", may impact not just the future of company balance sheets, but also the direction of financial reporting and other primary statements.

In July 2006, the FASB and IASB jointly issued a discussion paper entitled "Preliminary Views on an improved Conceptual Framework for Financial Reporting". This paper, the first of a series, is a major step in the evolution of financial reporting.

One of the key points to be debated as part of the proposed revisions to the Conceptual Framework is the purpose of the balance sheet and its interaction with the other primary financial statements.

The outcome of this debate will impact not just the amounts represented on the balance sheet; it will also have direct consequences for the other primary statements. For instance, when assets are measured at fair value, how should the change in fair value be recognised in the income statement?

The findings of our extensive research have already influenced our own understanding of the role of the balance sheet, and they have been used to enrich our submissions to the roundtable discussions on measurement hosted in January by the FASB and IASB.

Top-level findings of our research include:

Current value has its place. Concerning liquid financial assets, there is little debate among the respondents that current value is useful. But this does not indicate a desire for the wholesale adoption of current values.

Don't muddy the waters. Many investors point out the fallacy of analysing the balance sheet in isolation. Measurement decisions in the balance sheet have a direct impact on amounts reported in the income statement, and there is widespread concern that an increase in the use of current values might make it more difficult to understand the underlying operating performance. The message is clear: the format of the income statement should be considered in conjunction with any proposed changes to the measurement of assets and liabilities.

Additional disclosure in the notes can add tremendous value. It is clear that a "one-size-fits-all" model will struggle to meet the diverse needs of the investment community. The fixed income user, for example, might be interested in the proceeds that could be realised through an asset sale, while an equity investor may be more interested in the cash spent on acquiring an asset so that returns on invested capital can be calculated. If "current value" means different things to different people, a suite of disclosures in the notes rather than recognition of a single number in the balance sheet could be more useful.

Valuation is as much art as science. Investors' core competency is valuing businesses. To do this effectively, they need reliable and relevant information that provides insight into the quality and sustainability of performance. If a current value measure is adopted for illiquid assets or liabilities, investors would like to see management's inputs into the valuation model so that they have the option of independently assessing the resulting amount. This observation highlights once again the critical role of disclosure in reporting.

To download the full research, click on the pdf on the right.