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Financial Statements: Reported asset values to market values

Comment on the statement following, focusing on the relation between asset values on the balance sheet to market values of assets. Please assist with getting me started.

A manager complained about the amount of depreciation charged on the plant for which he was responsible: "The market value of my plant just continues to increase, yet I am hit with large depreciation charges on my income statement and the value of my plant and equipment on the balance sheet goes down each year. This doesn't seem fair."

Comment on this statement, focusing on the relation between asset values on the balance sheet to market values of assets. Do not simply "define" depreciation" and "explain it to the manager! The scenario suggests that assets owned might increase in market value (for example, the market value of my house has increased substantially since purchase) but always decrease in "balance sheet value."

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Within generally accepted accounting principles (GAAP), there are four constraints that are basic to the preparation of financial statements and related accounting information.

They are:

Objectivity principle
Materiality principle
Consistency principle
Conservatism principle

Objectivity means that the company financial statements should be based on objective evidence. In the case of a plant building, the objective evidence is the purchase price and the cost of any major improvements. Any other value is an estimate and therefore not objective as defined in the constraints.

The estimate involves depreciation, and the reason it is an estimate is that the actual life of a plant building is not known. Before standardized depreciation tables, companies were all over the map with respect to depreciation methods and lives. In comparison to other companies, one could say that the objectivity principle did not allow for true comparatives for stakeholders. Stakeholders, of course, would include owners, investors, bankers, creditors and others.

Materiality suggests that items should be ...

Solution Summary

The 685 word cited response provides a good understanding of the GAAP concepts complete with examples as appropriate.