With marketable securities, prices can be expected to fluctuate. Further, in a deep market these fluctuations will be unpredictable. (See, e.g., Malkiel, B., A Random Walk Down Wall Street.) So there is no issue of estimating future values. There is, however, a big issue in keeping up with changes in market values. Further, because these are market values, there is often little controversy about their validity since the prices reflect arms-length transactions between some parties, even if the holder of the marketable security didn’t itself engage in a transaction.
Under U.S. GAAP, some Marketable Securities must be adjusted at each balance sheet date so that the value shown on the balance sheet is the market value. This is called mark-to-market accounting. These gains and losses are considered unrealized gains and losses because they have not been sold by the entity. All marketable securities that are equities must be marked-to-market and the unrealized gain or loss shown on the income statement. For example, if a marketable security’s market price was greater than its book value, the book value would be adjusted upward by debiting Marketable Securities and crediting Unrealized Holding Gain on Marketable Securities. The Unrealized Holding Gain on Marketable Securities account is a temporary account that must be closed to Retained Earnings. (Unrealized Holding Losses on Marketable Securities would be the debit if the market price was below the book value.)
Marketable securities that are debt instruments can be marked-to-market if the entity elects to do so, but there are two other treatments available. If the entity has the intention and ability to hold the security to maturity, it can ignore unexpected changes in market value and account for the debt security using amortized cost. This method involves adjusting for interest as it is earned but does not involve recognizing value changes for reasons other than the passage of time.
Another alternative is to classify debt securities as Available-for-Sale. Any debt security that is not marked-to-market or classified as held-to-maturity will be adjusted to mark value but the resulting Unrealized Holding Gains or Unrealized Holding Losses will not be closed into Retained Earnings and therefore will not appear on the income statement. That is, they will not be treated as temporary accounts.
If these accounts are not closed into Retained Earnings, their effects must be included somewhere else. By process of elimination, you can arrive at the conclusion that the Equities section of the balance sheet is the most logic place to include them. Therefore, we will add an equity account, Accumulated Other Comprehensive Income, to hold the cumulative effects of unrealized holding gains and losses on these debt securities. (Look at the equity section of the balance sheet of your favorite publicly traded company, and you will almost surely see Accumulated Other Comprehensive Income there.
Finally, consider Long-lived Assets. If they are purchased, long-lived assets are initially recorded at their cost. That cost includes all costs to get the asset ready for intended use, including transportation, installation, and testing.
However, this can be very different from what the economic value of an asset will be for an organization. Consider a drill press used in manufacturing an innovative and desirable new product. The value of the drill press in that use may end up far exceeding its original cost. (After all, the idea of a for-profit entity is to make the whole be worth more than the sum of the parts.)
The economic value of an asset is a function of the (uncertain) future cash flows it will generate. This link between a particular long-lived asset and future cash flows might be complicated, indirect, and intertwined with a lot of other assets. Nonetheless, those (uncertain) future cash flows still determine its economic value.So is there anything we can say about this current value and uncertain future cash flows?
At the time of acquisition, surely the current value equaled or exceeded the asset’s cost. Otherwise, it would not have been acquired. After acquisition, suppose there is a cash flow in each future period that we could be fairly confident of getting. The value of asset surely can’t be less than the sum of these cash flows. (Ignore negative interest rates!)
However, in many cases these future cash flows can change depending on regulation, consumer preferences, increased competition, and ever-changing economic conditions.If an asset has separately identifiable cash flows and if it becomes known that the raw sum of the future cash flows becomes less than the book value, U.S. GAAP requires the entity to record an impairment loss. That is, the asset account is credited, and Impairment Loss is debited. This account is deemed to be temporary and is included in the calculation of net income and is closed into Retained Earnings.
In the United States, GAAP does not recognize any increases in value of long-lived assets. Only if the asset were sold would we recognize any increase in value and, of course, it would then no longer be owned or controlled by the entity and would be off the books.
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Although accounting policy makers prefer the term “Fair Value” instead of “Mark-to-Market” (after all, who could object to Fair Value) some people in practice have believed they could take advantage of the wiggle-room such rules provide:
Source: The Smartest Guys in the Room (2005).
