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Q11-26Q

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Intermediate Accounting (Kieso)
Found in: Page 583

Short Answer

The following statement appeared in a financial magazine: “RRA—or Rah-Rah, as it’s sometimes dubbed— has kicked up quite a storm. Oil companies, for example, are convinced that the approach is misleading. Major accounting firms agree.” What is RRA? Why might oil companies believe that this approach is misleading?

Answer

Oil companies are concerned because the valuation issue is extremely tenuous.

See the step by step solution

Step by Step Solution

Step-by-Step SolutionStep 1: Meaning of RRA

The SEC recommended Reserve Recognition Accounting (RRA) as a mechanism (a fair value approach) of accounting for oil and gas resources. According to proponents of this concept, oil and gas should be priced at the time of discovery. The reserve value that remains on earth is calculated, and this amount is recorded on the balance sheet as "oil deposits" after being correctly discounted.

Step 2: Explaining the reasons for the approach that is misleading.

Oil firms are worried because the value situation is precarious. To appropriately evaluate reserves, for example, the following must be estimated:

  1. reserve value,
  2. future production costs,
  3. estimated disposal times,
  4. discount rate, and
  5. selling price.

Most popular questions for Business-studies Textbooks

Companies following international accounting standards can revalue fixed assets above the assets’ historical costs. Such revaluations are allowed under various countries’ standards and the standards issued by the IASB. Liberty International, a real estate company headquartered in the United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty’s stockholders’ equity.

Liberty International

Completed Investment Properties

Completed investment properties are professionally valued on a market value basis by external valuers at the balance sheet date. Surpluses and deficits arising during the year are reflected in the revalution reserve.

Liberty reported the following additional data. Amounts for Kimco Realty (which follows GAAP) in the same year are provided for comparison.

Liberty

(pounds sterling, in thousands)

Kimco

(dollars, in millions)

Total revenues

£ 741

$ 517

Average total assets

5,577

4,696

Net income

125

297

Instructions

  1. Compute the following ratios for Liberty and Kimco.
    1. Return on assets.
    2. Profit margin on sales.
    3. Asset turnover.

How do these companies compare on these performance measures?

  1. Liberty reports a revaluation surplus of £1,952. Assume that £1,550 of this amount arose from an increase in the net replacement value of investment properties during the year. Prepare the journal entry to record this increase.
  2. Under U.K. (and IASB) standards, are Liberty’s assets and equity overstated? If so, why? When comparing Liberty to U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above?
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