Topic 4: Measurement in Accounting

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Topic 4 Measurement in Accounting

• Take the attitude of a student. Never be too big
  to ask questions. Never know too much to learn
  something new.

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Objectives

• To examine the concept of measurement
• To consider the role of measurement in accounting
• Evaluate historical cost accounting
• To identify and evaluate alternative valuation
  systems to historical cost accounting
• To be aware of current developments in accounting
  valuation/measurement

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General Measurement Theory

• What is measurement?

Assignment of numerals to represent properties of
material systems other than numbers, in virtues
of the laws governing these properties (Campbell
1938)
The assignment of numerals to objects or events
according to rules (Stevens 1946)
The assignment of numbers to objects and events
according to rules specifying the property to be
measured, the scale to be used and dimension of
the unit. (Chambers 1966)
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Measurement

• Measurement process involves
• an object or event
• a property, characteristic or attribute to
  quantify
• a scale or set of units that can be used to
  quantify the property
• The measurement debate is one of the most
  significant contemporary issues in financial
  reporting

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Measurement Theory

• Scales
• nominal scale
• numbers used only as labels
• classification only
• ordinal scale
• rank ordering of objects
• intervals between not necessarily equal

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Measurement Theory

• Scales
• interval scale
• rank ordering of objects with a known equal
  distance between them
• ratio scale
• rank ordering of objects
• intervals known and equal
• a unique origin exists

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Measurement Theory

• Permissible operations of scales
• ordinal scale
• no arithmetic operations
• interval scale
• addition and subtraction
• ratio scale
• all arithmetic operations

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Measurement Theory

• Types of measurement
• fundamental measurements
• numbers assigned by reference to natural laws
  (e.g. length, volume)
• derived measurement
• depends on the measurement of 2 or more other
  quantities (e.g. density - depends on measure of
  mass and volume)

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Measurement Theory

• Types of measurement
• fiat measurements
• based on arbitrary definitions
• numerous ways in which scales can be constructed
• may lead to poor confidence (e.g. measurement of
  income)

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Measurement Theory

• Reliability and accuracy
• sources of error
• measurement operations stated imprecisely
• measurer
• instrument
• environment
• attribute unclear

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Measurement Theory

• Reliable measurement
• proven consistency
• repeatable or reproducible
• accuracy certainty of measurement
• representative faithfulness

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Measurement Theory

• Accurate measurement
• how close the measurement is to the true value
  of the attribute measure
• true value may not be known
• consistency of results, precision and reliability
  may not lead to accuracy

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Measurement of Assets Liabilities

• Key question?
• What value for assets, liabilities, revenues
  and expenses provides relevant and reliable
  accounting information to financial statement
  users?

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The Development of GAAP (Descriptive Era)

• Observation and description of accounting
  practice led to the statement of fundamental
  principles or conventions.
• Entity convention
• Going concern assumption
• Money convention
• Consistency
• Conservatism
• Materiality
• The Accounting Period

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ACCOUNTING SYSTEM HISTORICAL COST AND ACCRUAL
BASED
Thus we developed an accounting system based on
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Historical Cost

• A traditional objective of financial reporting
• STEWARDSHIP or ACCOUNTABILITY to providers of
  funds (i.e. managers must periodically report
  to equity providers their management of that
  investment)

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Historical Cost

• Hence, the P L Statement is the most important
  financial report - the focus is on income
  determination.
• The income stream reflects the earning power of
  the firm, which is the basis of value for the
  enterprise.
• The requirement to periodically report meant that
  items must be measured

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Historical Cost

• Income determination for the period requires the
  matching of revenues and expenses.
• Accountants must trace the flow of costs
• to determine which costs have expired
• to match the expired costs against revenue to
  determine income for the period
• to record the unexpired costs as assets on the
  balance sheet

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Historical Cost

• Why should we use historical cost?
• It is relevant in making economic decisions
• It is based on actual transactions (objective)
• HC-based financial statements have always been
  found to be useful
• The best understood concept of profit is the
  excess of selling price over historical cost
• It is less subject to manipulation
• It has not been shown that useful information is
  provided by alternative measures
• Changes in market prices of assets can be
  disclosed as supplementary data
• There is insufficient evidence to justify the
  rejection of historical cost accounting

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Criticisms of Historical Cost

• The objective of accounting
• Its relevance for decision making
• The going concern assumption
• The matching principle
• The needs of investors

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So, what are the alternative models of
accounting measurement?

• Major normative proposals
• Base accounting on current (replacement) costs
• Base accounting on net selling price (exit price)
  of assets
• Adjust HC by a index of changes in the general
  price level
• Deprival value or value to owner should be
  the basis of valuation

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Alternative Valuation Models

• These normative theories did not start from a
  specified objective, then progress by logic
  through a set of hypotheses to a result
  consistent with the objective. They were based on
  remedying perceived shortcomings in existing
  practice.
• These theories were concerned with
• True Income and
• Decision-Usefulness

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Wealth Income Measurement Systems (Barton 1968)
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Current Cost Accounting (CCA)

• Valuation Basis
• Current entry/ buy value - recognition of
  specific changes in price of assets
• Underlying Rationale
• That current cost information is
• more decision-useful.

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Support of CCAs Usefulness

• Managers need a/c information to make decisions
  on the allocation of the firms resources to
  maximise profits.
• - the amount of assets to held
• - the types of assets, and
• - how they should be financed.
• Users need accounting information to evaluate the
  performance of managers.

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• To be useful, accounting information must measure
  the actual events of a particular period as far
  as it is possible.
• To evaluate the holding and operating decisions
  of managers, CCA proposes

BUSINESS INCOME OPERATING PROFIT HOLDING
GAINS/LOSSES
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Holding Gains/Losses

• Q. Why should they be included, or excluded, as a
  component of reported income?

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Criticisms of Current Cost

• From HC point of view
• highly subjective
• high volatility in financial statements
• violates realisation principle
• From Exit Price point of view
• exit price is the logical opportunity cost
• changes in technology ignored
• allocation of costs

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Exit Price Accounting

• Definition
• the net realisable value of an asset sold in the
  ordinary course of business
• Rationale
• the adaptive nature of the company involves
  actions in markets and hence the need for regular
  information about what it may obtain by selling
  its assets. It needs to know the cash and cash
  equivalents of its net assets.

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• Assumption
• an asset will only be kept if the PV of its
  future cash flows is greater than that of an
  alternative investment made using the exit price
  of that asset
• Characteristics
• capital to be maintained is the total current
  cash equivalent (exit prices) of net assets at
  the beginning of the period
• capital is indexed for general price level
  changes over the period (the adjustment is
  charged to income)

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• Assets are re-stated to their current cash
  equivalent value at end of period (adjustments to
  value are charged to the income statement)
• the need for depreciation disappears
• An asset must have the characteristics of
  exchangeability and the existence of a market.
• Q. What effect would this system have on the
  financial statements?

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Evaluation of Exit Pricing

• Value-in-use v. Value-in-Exchange
• Restrictive concept of an asset
• Objectivity of exit values
• Financial statement variability
• Concept of profit -
• evaluation of past or measure of future?

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• Current cost accounting and exit price accounting
  represent market/fair value accounting
• Issues
• market imperfection
• different markets
• entry price vs exit price
• alternate accounting systems
• objectivity

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Present value

• Closest to true economic concept of value
• Involves
• future cash flows
• behavioral assumption
• discount rate
• Subjective value (moving away from objectivity)

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Q. What is the current state of play?

• Conceptual Framework projects recognise the
  importance of cash
• Financial analysts began referring to the cash
  generating ability of assets (along with their
  cash equivalent values) as a prime indicator of
  the state of a business
• Over time the historical cost system has been
  modified
• New accounting standards are increasingly
  requiring asset valuations at market values

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Valuation The Issues

• Refer to handout summarising the alternative
  valuation models
• What is the concept of capital?
• What is the concept of capital to be maintained?
• Single measurement base versus multiple
  measurement base?
• Recognition of
• changes in the value of the monetary unit?
• changes in specific values of assets and
  liabilities?

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Valuation The Concepts of Capital

• Financial Capital
• amount invested must be maintained before income
  is earned
• Physical Capital
• operating capability of the firm must be
  maintained before income is earned

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Valuation concepts used in accounting standards

• Examples of elements to be reflected at cost (or
  allocated cost)
• land fixed assets (until revalued)
• nominal amounts for employee entitlements
• goodwill
• inventory
• Question How is cost determined?

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Valuation concepts used in accounting standards

• Examples of elements allowed at current cost
• written down current cost is an acceptable basis
  for revaluation of non current assets,
  infrastructure, heritage and community assets
• SAP1 (non mandatory)
• Question How is current cost determined?

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Valuation concepts used in accounting standards

• Examples of elements required at selling price/
  market value
• inventories
• assets of superannuation plans
• insurance companies assets and liabilities
• financial instruments
• SGARAS
• Question How is market value determined?

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Valuation concepts used in accounting standards

• Examples of Elements required at present value
• leased assets and liabilities
• employee entitlements comprising LSL and post
  employee benefits
• recoverable amount (discounting is not necessary)
• Question How is present value determined?

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Theory Monograph No. 10

• Measurement in Financial Accounting - produced
  by AARF as part of Conceptual Framework.
  Precursor to eventual SAC 5 on Measurement
• Evaluates alternative measurement bases and
  techniques
• Proposes improvements to conventional modified
  historical cost model

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• Suggests Relative Current Value as the optimal
  measurement model
• assets liabilities re-measured at balance date
  at value to entity
• changes in general purchasing power of monetary
  unit recognised
• capital is value to entity of net assets
• capital maintenance is current general purchasing
  power of the entitys capital
• profits include increases/decreases in
  assets/liabilities relative to change in general
  price levels

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Summary What We Know About Valuation

• HC system has persisted over time
• HC has been modified over time
• revaluation of non-current assets
• Our accounting system now increasingly includes
  assets valued at market/cash equivalent values.
• Financial statements include assets valued using
  several different methods.

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• Opposition to prior attempts to introduce CCA
• Business favours HC model
• Tension between theoretically pure accounting
  models and pragmatic business applications

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Summary

• Assets and liabilities are given a value for
  decision making purposes
• If we accept that the most useful value is true
  economic value, how is it arrived at
• We use a variety of methods for different assets
  liabilities to approximate true economic value
• Value is bound by time and place so it is argued
  that market values must be included in valuation
  methods

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Summary

• What is the current state of play?
• SAC 2 The Objective of GPFR
• Moves to market values in new accounting
  standards
• The Development of SAC 5 on Measurement???
• Theory monograph now published

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Key Terms Concepts

• Four scales
• nominal ordinal interval ratio
• Three types
• fundamental derived fiat
• Errors in measurement

• Value
• True economic value
• Present value
• Market value
• Current value
• Alternative valuation systems