The Daily Technical #108: Why are most assets recorded at their historical cost under accrual accounting?

Good morning. Welcome to the 108th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Why would it be incorrect to use enterprise value and net income in a multiple?

There would be a mismatch between the represented investor groups in the numerator and denominator.

Enterprise value represents the value of the operations to all stakeholders in a company, meaning the cash flows belonging to both lenders and equity providers of capital.

Net income, however, represents the residual value that flows just to equity shareholders.

Common Mistakes

1. Confusing which stakeholders are included in enterprise value versus net income. While enterprise value considers both lenders and equity providers, net income pertains only to equity shareholders. To avoid this, remember that aligning the numerator and denominator in terms of stakeholder interests is critical.

2. Assuming net income is equivalent to other income measures. It measures what’s left for equity holders after obligations. Understand net income's limitations within the broader income spectrum for proper financial analysis alignment.

TL;DR

• Enterprise value includes debt holders and equity shareholders' interests.

• Net income reflects returns exclusive to equity shareholders.

• Mismatch arises when combining enterprise value with net income.

• Aligning metrics ensures fair representation of investor groups.

• Incompatibility occurs when enterprise value and net income are used in a multiple.

TODAY’S QUESTION
Why are most assets recorded at their historical cost under accrual accounting?

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