Topic 8 - Measurement Methods

Topic 8 - Measurement Methods

1. determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the BS and IS

   • Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.    
   • Measurement allows us to attribute numbers to the items that appear in financial reports.

2. Choices

   •  – Objective of Financial Reports                        
   • – Concept of profit and thus capital maintenance
   • – Reliability of the measurement information required
   • Historic Cost
     • What
       • Assets and liabilities (and associated revenue and expenses) are measured at original cost of the transaction
     • Conventions
       • Matching Principal
         • Emphasis the definition and measurement of profit by direct reference to the matching principal  – Matches revenue to associated costs measured on a historic cost basis
         • Alternative theory emphasises in definition and measurement of profit by reference to changes in wealth (value of assets and liabilities) in the balance sheet 
         • Balance sheet reports unallocated costs  The matching principal implies the income statement is the primary statement under HC    
         • Under fair value accounting the balance sheet and profit & loss are of equal importance but definition of elements in B/S used as basis for transaction recognition
         • The matching principle used for historic cost accounting requires expenditure associated with generating revenue to be expensed in the same period as the revenue is recognized
           • The matching principle used for historic cost accounting requires expenditure associated with generating revenue to be expensed in the same period as the revenue is recognized
           • This is accomplished via the accrual process
           • The balance sheet accounts are mostly the residual from this process (e.g. PPE = unexpired allocated costs)
           • FV accounting does not adopt the matching principal since measurement of FV of assets and liabilities in balance sheet is the primary focus/statement
       • Timing of revenue recognition
         •  –  HC Revenue Recognition principle requires a firm to recognize revenues when all or a substantial portion of the service has been performed and cash receipt is reasonably certain   –  In contrast FV recognizes revenue as changes in a the fair value of assets or liabilities occur
         • – HC Revenue Recognition principle requires a firm to recognize revenues when all or a substantial portion of the service has been performed and cash receipt is reasonably certain – In contrast FV recognizes revenue as changes in a the fair value of assets or liabilities occur
       • Conservatism
     • Advantages
       • Past transactions (past performance) is an important input into the prediction of future cash flows Profit concept provides a measure of past economic value added using nominal financial capital as the definition of wealth:  • Assume a definition of profit as the excess of selling price over historical cost – Penman shows HC may be relevant to measuring operating performance of a business and if margins are stable then then HC may be suitable for predicting future operating return. 
       • Past transactions and events are important for stewardship to make management accountable
       • Reliable
       • Historical numbers provide integrity to the forecasts by providing a means to confirm their accuract after the fact
       • •  Predominant method used for many years so tended to maintain support of profession         
       • •  If not found useful, business entities would have abandoned it        
       • •  Nevertheless, recent accounting standards being released have embraced ‘fair values’ as the basis of measurement. However, various assets are still measured on an historical cost basis          – e.g. inventory, which is measured at the lower of cost and net realisable value; property, plant and equipment where the ‘cost model’ and not the ‘fair-value model’ has been adopted; many intangible assets    
     • Arguments against
       • IS
         • Revenue recognition lag (since revenue is not recognition until receipt of cash is probable)    - No recognition in P&L of losses or gains from simply holding assets (or liabilities) due to their changing value
         • Problem with PL in times of rising prices   – Including holding gains from selling an asset which accrued in previous periods in current year’s income distorts the current year’s operating results
         • HC may not match current revenue with current operating costs – HC matches current revenue against historic operating cost. If current operating costs differ from HC operating costs reported profit may be uninformative of future profits        – Can overstate profits in times of rising prices, with distribution of profits leading to an erosion of operating capacity
         • Operating
       • BS
         • No recognition in balance sheet of the current value of assets and liabilities        – Balance sheet reflects unallocated/unamortized costs
         • Aggregation of different measurement units   – Problem of additivity (adding together assets bought at different times) If prices of different assets acquired in different periods are simply added together then the total figure can be quite meaningless, like adding together different currencies. The final figure will generally understate the current market value of the assets. If assets are understated then this will in turn mean that the net book value of the entity (assets minus liabilities) is understated. This could perhaps, lead to the owners selling an entity for less than it is actually worth 
         • Equity value
       • Additivity problem
         • If we add together the costs of assets acquired in different periods then the combined amount is quite misleading. The total figure does not actually reflect the value of anything.
         • However, if assets are recorded in a currency with the same purchasing power, such as in terms of the market value as at reporting date, then the combined number does mean something. The numbers can logically be added together and the combined number represents the market value of the assets as at reporting date. 
         • Purchasing power of currency
       • Lack of relevance
         • Profits
   • Current Value
     • Fair Value (Exit pricing)
       • What
         • Uses market selling prices to measure the value of the firm's assets and liabilities at year end in the balance sheet (and thus capital and wealth)
       • Concept of Capital and Profit
         • Present (selling) price is seen as the correct valuation of wealth at a point in time - past prices are a matter of history so not relevant to current actions
         • Profit is the increase/decrease in the current net selling prices of the entity's assets and liabilities
         • No distinction between realised and unrealised gains - all gains are treated as part of profit
         • Profit is the amount that can be distributed, while maintaining the total exit values
         • Total exit values reflect what an entity can invest in alternate investment opportunities (adaptive capital)
         • Profit is the amount that can be distributed, while maintaining the entity's adaptive ability (adaptive capital.alternate opportunities)
       • Capacity to adapt and opportunity costs
         • Exit values provides information in relation to new opportunities - the ability of the entity to adapt to changing circumstances - provides information to measure opportunity costs
         • The ability of the firm to 'go into the market with cash for the purposes of adapting oneself to contemporary conditions'
         • Assumes the objective of accounting is to guid future actions (As opposed to stewardship)
       • Adaptive Capital
         • The balance sheet considered to be the prime financial statement as it shows the net selling prices of the entity's assets
         • Abandons notion of realisation in terms of recognising revenue - revenues are recognised at point of production rather than sales to external parties
       • Advantages
         • Relevance
           • Current fair values may provide more relevant information for forecasting the future
         • Opportunity Cost
           • FV in the BS provides information to measure a firm's opportunity costs from selling the firms assets and using in an alternate investment
         • Additivity
           • The measurement scales of all assets and liabilities are the same
         • Free of cost allocation decisions
         • Comparability
       • Arguments against
         • Measures profit based on value-in-exchange (exit pricing) but for firm valuation primary interest is value-in-use - Firm values based on prospects for future cash flows based on assets being used - A firm can consider an asset to have value because of its use in a business and the synergistic value added by combing with other assets
         • Not as reliable: - market prices may not be available for all the firm's assets and liabilities - markets may be inefficient
         • Ignores transaction costs in measuring FV
         • HC may provide a clearer perspective about what management has done with the funds that were entrusted to it. - 'stewardship' is likely to lay greater emphasis on past, rather than prospective, transations (HOWEVER, also argument that in assessing stewardship, interested parties may want to know about how monies spent have increased in value, and HC accounting may be deficient in this respect)
     • Current Cost (Entry Pricing)
       • Advantages
         • Differentiating operating profit from holding gains and losses can enhance the usefulness of information provided  - holding gains different to trading income as due to market-wide movements that are often beyond management's control
       • Arguments Against
         • Difficult to precisely estimate replacement costs
       • What
         • Current operating profit is the excess of the current value of the output sold over the current replacement cost of the related inputs    
         • Measurement based on replacement costs
         • Advocated by Edwards and Bell                  
         • Valuations in Balance sheet based on replacement costs
         • Generatres a measure of income that represents the maximum amount that can be distributed, while maintaining operating capacity intact
         • Holding gains excluded in calculating current cost operating profit - not available for dividends BUT holding gains are included in calculating business profit
         • Business profit shows how the entity has gained in financial terms from the increase in cost of its resources
     • Value-in-use
     • Edwards
       • Opposes the use of exit prices to value all assets on the basis that an entity, operating as a going concern, would not be expected to dispose of all of its assets at a point in time. Further, if an entity is expanding the notion that they would dispose of all of their assets is even more questionable. 
       • An advocate of using replacement costs, suggests that in some circumstances the use of exit values might be appropriate when they are less than the replacement costs of an asset ‘and the firm has taken a definite decision not to replace the asset or even the function it performs’.
       • As we can see, Edwards’ approach to valuation admits the possibility that a consideration of management’s intention at a point in time might influence a decision as to how an asset will be valued. This in itself could introduce some problems as allowing such considerations to influence asset valuation could introduce issues associated with biases and manipulations. 
       • A change in intention would lead to a change in valuation—we can imagine that Chambers would oppose such a possibility. Also, if some assets are valued at replacement costs and others at exit prices then we again will encounter problems associated with ‘additivity’.
       • Opposes use of exit prics
       • Advocates replacement costs
       • consideration of management’s intention at a point in time might influence a decision as to how an asset will be valued

3. Historic Costs v. Fair Value accounting

   • Trying to implement FV under ideal conditions when such conditions do not exist, so accounting standards appear to have a mixed measurement model of part HC and part FV
   • Trade off: Reliability vs Relevance
     • between: - relevance and reliability
   • -'different value bases for different purposes' approach
     •  (Financial instruments, Non-current assets)
     • - FV is more relevant to the valuation of assets held for sale - A cost value is more relevant for items that will be used as inputs into the business
   • What are managers motives?
     • The answer to this question depends upon whether we assume that managers are motivated by efficiency considerations or whether they are motivated by opportunistic considerations.
     • Efficiency
       • HC provides a more objective measure (i.e., more reliable as it is based on occurred external party transaction)of the value of an item and this is preferable in terms of demonstrating proper stewardship over the resources contributed to an organisation.
       • They might also consider that other bases of measurement— such as market values—provide less relevant or reliable information. e.g. In an industry that has high volatility in asset values and they may consider that if assets were valued on the basis of fluctuating market values then this might create confusion in the minds of the financial statement readers. Subject to market-wide movement, beyond the control of management (less relevant).          –  Fair value can be subject to managerial discretion/subjectivity (less reliable)  
       • HC provides a more objective measure (i.e., more reliable as it is based on occurred external party transaction)of the value of an item and this is preferable in terms of demonstrating proper stewardship over the resources contributed to an organisation.
     • Opportunistic
       • HC as it can allow them to manipulate profit by determining when to sell an asset that has appreciated in value—with such appreciation not being acknowledged until the asset is ultimately sold. The accumulated gain will be fully recognised in the period of the sale (i.e., revenue recognition lag).    
       • HC as can lead to higher profits (given that depreciation will be based on the original cost of an asset which could be significantly lower than its current marker value). This attribute of historical cost might be particularly attractive to managers who are paid a bonus tied to reported profits.(i.e., lack of relevance)
       • HC as it can allow them to manipulate profit by determining when to sell an asset that has appreciated in value—with such appreciation not being acknowledged until the asset is ultimately sold. The accumulated gain will be fully recognised in the period of the sale (i.e., revenue recognition lag).

4. Recognition

   • Recognition is the process for bringing to account assets and liabilities in financial statements.
   • Not all the assets and liabilities are recognised ( for example internally generated intangible assets)
   • The current standards/framework uses two criteria for recognition:  – probability of a flow of economic benefits; and  – reliable measurement. 

5. Factors influencing section of alternative measurement

   • apparent at the current time is that the IASB and the FASB are not likely to ultimately favour one basis of measurement in preference to other alternatives due to a view that different measurement techniques will be appropriate in different circumstances
   • Current Accounting Standards
     •  AASB 116 provides reporting entities with the choice to either adopt the ‘cost model’ (measuring property, plant and equipment at historical cost) or the fair value model (Revaluation model)
     • Understand that they use a variety of measurement bases - referred to as mixed measurement model of accounting (issues with additivity)
     • There is no conceptual framework for measurement. - Different measurement bases may be warranted in different situation to reflect economic substance - For comparability need to ensure that similar items are measured in a similar manner - However creates issues with additive
     • Controversy
       • How we measure particular assets and liabilities (which, in turn, has implications for income and expenses) can have profound effects upon financial reports, and therefore also on agreements, or contracts, that utilise numbers from the financial statements. 
       •  For example, organisations might be subject to borrowing agreements (i.e., debt contract) that only allow additional borrowing if specified debt to asset ratios are not breached (and conversely, might require repayment of borrowed funds if the prescribed accounting ratios are breached – often referred to as a ‘technical default’ of a borrowing agreement), or perhaps there are requirements that the organisation’s reported profits (with various negotiated adjustments) covers interest expense by a specified number of times (referred to as an ‘interest coverage clause’). 
       • Also, management might be paid bonuses tied to some proportion of reported profits (executive compensation contract)
       • Or perhaps government provides funding to the organisation based on some measure of efficiency – such as its ‘return on assets’ (other contracts).
       • Financial accounting numbers are used in many agreements that an organisation is party to. Therefore, how items are measured can be a very political issue as it can have many cash-flow implications for an organisation, and therefore for the wealth of many stakeholders.
   • Capital Maintenance
     • Income
       • How we measure assets will be influenced by how we define income
       • Income has been defined as the maximum amount that can be consumed during the period, while still expecting to be as well off at the end of the period as at the beginning of the period (Hicks 1946)        
       • Consideration of ‘well-offness’ requires the stipulation of a notion of wealth or capital maintenance Different notions of capital maintenance will provide different perspectives of income  - different notions of ‘capital maintenance’ have implications for how assets are measured   
     • Financial capital maintenance
       •  – perspective taken in historical cost accounting – profit earned only if money capital at the end of the period is more than money capital at the beginning of the period 
       • Historic cost
       • Holding Gains
         • The gains that accrue from holding an asset can be distributed to shareholders to the extent that financial capital remains intact.
         • Changes in the purchasing power of the dollar, or the fact that the cost of assets of the entity has increase is taken into account
         • Income
       • Problems
         •  If historical cost accounting was employed and if the organisation elected to distribute all holding gains then the organisation could realistically find that it is unable to operate at the same level as it could at the beginning of the period because it will be unable to replace the depreciable assets when they are fully depreciated, or the inventory when it has been sold. 
     • Purchasing power maintenance
       •  – historical cost accounts adjusted for changes in the purchasing power of the dollar    
       • Historic cost adjusted for inflation
       • Holding Gains
         • Only permit the payment of dividends to the extent that the purchasing power of the entity is not eroded relative to what it was at the beginning of the period
     • Physical operating capital maintenance
       •  – profit earned if operating capacity at the end of the period is greater than the operating capacity at the beginning of the period
       • Current entry prices
       • Holding gains
         • only distributable to the extent that it does not erode the physical operating ability of an entity
         • Capital adjustments
     • Current cash equivalents (opportunity cost)
       • Exit prices
   • Value/flow weighting and separation
     • The relative importance to users of information about the current value of the asset or liability versus information about the cash flows generated by the item, as well as the ease and precision with which the flows can be separated from the value changes (an indication of relevance)
   • Confidence level
     • The level of confidence that can be placed on alternative measurements as representations of the asset or liability being measured (an indication of faithful representation) 
   • Measurement of similar items
     • Items of a similar nature should be measured in similar ways (an indication of comparability)
   • Measurement of items that generate cash flows together
     • Items that generate cash flows as a unit should be measured the same way (an indication of understandability)
   • Cost-benefit
     • An assessment of the ratio of the benefits that would be derived from alternative measurements to the costs of preparing those measurements (an indication of the primary limiting factor in financial reporting).

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