Accounting Principles Underlying Liability and Equity Measurement

Just as with the measurement of asset value, the accounting categorization of liabilities and equity is governed by a set of fairly rigid principles. The first is a strict categorization of financing into either a liability or equity based upon the nature of the obligation. For an obligation to be recognized as a liability, it must meet three requirements:

• It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date,

• The firm cannot avoid the obligation.

• The transaction giving rise to the obligation has happened already.

In keeping with the earlier principle of conservatism in estimating asset value, accountants recognize as liabilities only cash flow obligations that cannot be avoided.

2 The Financial Accounting Standards Board (FASB) was considering eliminating the use of pooling and reducing the amortization period for goodwill in purchase accounting to 20 years at the time this book went to print.

The second principle is that the value of both liabilities and equity in a firm are better estimated using historical costs with accounting adjustments, rather than with expected future cash flows or market value. The process by which accountants measure the value of liabilities and equities is inextricably linked to the way they value assets. Since assets are primarily valued at historical cost or at book value, both debt and equity also get measured primarily at book value. In the section that follows, we will examine the accounting measurement of both liabilities and equity.

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