Chapter 4 – Measurement

Measurement in accounting

 Measuring can be described as

o Determining the dimensions, quantity or capacity of something
o Estimating by evaluation or comparison
o Bringing into comparison
o Marking off or apportioning
o Allotting or distributing
 It is the process of determining the monetary amounts at which the elements of the financial
statements are to be recognized and carried in the balance sheet and income statement
 The way items are measured impacts the quality of accounting information produced
 Poor quality accounting information will mislead users and result in wrong decisions
 It is crucial to be able to provide decision-useful accounting information and accurately
appraise the performance of management
 Benefits of measurement
o Assists in making financial statements decision useful
o Allows investors, management and other users to assess the financial performance
and financial position of the entity
o Allows investors, management and other users to compare performance and
position over time
o Allows investors, management and other users to compare entities together
 Limitations of measurement
o Often little or no agreement on what accounting measures should be used
o Inherent flexibility and nature of a mixed measurement approach reduces
comparability of accounting information
o Measurement can be quite subjective
o Creates opportunistic accounting choices for management
o Additivity problem (many argue that items on the financial statements should not be
added up into totals, e.g. total assets, net assets, since they are meaningless)

Measurement approaches and the accounting standards

 Measurement approaches
o Historical cost
 Most dominant measurement
 Items recorded at amount they were purchased or received with
 Based on transactions which actually occurred in the past
 Assets are recorded at the amount paid to purchase them or the fair value of
what was given up for them
 Liabilities are recorded at the amount received in exchange for incurring the
obligation or the amount expected to be paid off
 The value of the amount paid or received is the value at the time of the
transaction
o Current/replacement cost
 Costs incurred to replace an item
 Current cost – item is valued and recorded at the amount that would be paid
at the current time to provide the economic benefits expected to be derived
from the item (broader)
  Replacement cost – item is valued at the amount that would be paid at the
current time to purchase an identical item (more specific)
 Focus is on the current acquisition cost rather than the amount paid to
purchase it
 Deals with some limitations of the historical cost
o Fair value/realisable or settlement value
 More relevant in decision usefulness
 It is an exit value – the value an entity would derive by selling the item
 Represents market value
 Realisable value – amount expected to be derived upon disposing of the
asset
 Fair value should be measured by considering
 Characteristics of the item
 The most advantageous market for the asset
 The market participants
 Realisable value is an entity specific measurement
 Fair value is a market-based approach
o Present value
 More subjective, involving more uncertainty
 Involves identifying and estimating future cash flows associated with the
item ad choosing the appropriate discount rate
o Deprival value
 The loss that would be suffered if an entity was deprived of the asset
 Determination of value includes
 Present value
 Net realisable value
 Replacement costs
 Measurement and international accounting standards
o Mixed measurement method – several different measurement bases are employed
to different degrees in varying combinations in the preparation of the financial
statements
o There is need for flexibility and mixed measurement model due to differing
circumstances each entity is in
o However, this allows for opportunistic accounting choices, creating a biased picture,
and misleading users
o IASB and IFRS are conducting the conceptual framework project to provide guidance
for selecting measurement bases that satisfy the objectives and qualitative
characteristics of financial reporting
 Factors that should be considered when making decisions about
measurement (according to the project)
 Method of value realisation
 Confidence level
 Measurement of similar items
 Separability of changes in measurement
 Cost/benefit
 Possible measurement approaches
 Actual or estimated current prices
 Actual past entry prices
 Prescribed computations or calculations based on future cash flows
 Decision criteria and influences on choice of measurement approach
 o Most prominent influences include
 Potential users of the financial statements (before determining the
appropriate measurement, the potential users of the information and their
needs in relation to the accounting information must be understood)
 Practical considerations (determination of a cost or value of using an
approach must be considered practically. Benefits must outweigh the cost)
 Management’s motivations and objectives

Measurement and the quality of accounting information

Historical Current value Fair value Present value Deprival

cost value
Faithfully yes yes No No No
representative
Relevance No Yes Yes Yes No
Verifiability yes yes Yes/no Yes/no No
Comparability No No Yes No No
Understandability Yes No Yes No No

Fair value

 Valuation methods
o Three valuation techniques
 Market approach (market transactions involving identical or comparable
items)
 Cost approach (amount required currently to replace the service capacity of
the asset. Also known as current replacement cost)
 Income approach (future cashflows expected to be derived from the item
and converting them to determine the current amount of income and
expenses)
 Arguments for fair value
o More relevant than other measurements
o Highly relevant form a decision usefulness perspective
o Faithfully representative
o Neutral depiction of the accounting information produced (based on objective
market prices)
o More comparable accounting information
o More understandable than other measurements (simple and straight forward)
 Arguments against fair value
o Subjectivity and judgement forming estimations of market value when there is no
objective market price or no active market
o Calculations for these judgements are complex, costly and time consuming
o Hypothetical in nature, resulting in unrealised gains and losses, which when realised
may lead to volatility in earnings and potential for misleading information

Stakeholders and the political nature of accounting measurement

 Users have different and sometimes conflicting needs for accounting information
 Conceptual framework prescribes board of directors to seek to provide the information set
that will meet the needs of the maximum number of primary users
 There are needs that are common
  The best approach is to target the financial statements towards these common needs of the
primary users
 Two crucial questions raised when making decisions on the measurement approach
o What do users really need to know?
o How do users influence the measurement approach?
 Main user groups
o Existing and potential investors
 Concerned with risk and return provided by their investment
 Main interest is in the information that
 assists them in deciding whether to buy, hold or sell their shares
 enables them to assess the entity’s ability to pay dividends
 entity needs to adopt the measurement approach that is forward looking
and focuses on current values
 fair value would be most useful for investors
 profit is based on historical cost which is evidence of the entity’s
current ability to generate profit
o lenders and other creditors
 interested in information that
 enables them to determine whether amounts owing to them will be
paid when they are due
 reflects the entity’s net position
 reflects the current value of assets and liabilities of the entity
 fair value most useful approach
 also interested in profits made in shorter term as an indicator of funds
available to pay the debts (profits based on historical approach)

Current measurement challenges

 green assets and other sustainability issues

o key issues that need to be considered socially and environmentally
 what needs to be measured and accounted for?
 How can the discretion and subjectivity associated within the estimation of
values be managed?
 What are the consequences associated with accounting for social and
environmental aspects of the entity?
o Environmental cost and impact often extend beyond the boundaries of the entity
o Since there are no actual transactions, accountants are unable to access appropriate
data to form an accurate estimate
o Relevant items need to be measured in monetary terms, which will result in a
subjective process
o The impact of measurement on the environment and the financial statements need
to be considered
o Information may become misleading and not convey the appropriate message to
users if measurement bases are inappropriate or if the activities cannot be measured
o The goal is to develop a measurement strategy that achieves both environmental
objectives and profit or growth objectives consistently
o Key issues associated with green assets
 Effects of environment protection on economic growth
 Distributional effects of natural resource policies
 Links between trade and natural resource policies
 o Measurement of green assets is quite complex
 Intangible assets
o Initially measured at cost
o Cost depends on whether the asset was acquired separately, as a part of a business
combination or internally generated
o After initial recognition, the entity may subsequently measure the intangible assets
using
 Cost model (cost less accumulated depreciation less accumulated
impairment)
 Revaluation model (fair value at date of revaluation less accumulated
depreciation less accumulated impairment)
o Issue that arise
 It is difficult to measure the fair value of assets lacking physical substance
 Estimates of fair values are very subjective and are based on the
methodology and assumptions applied during the valuation process
 Most intangibles are difficult to measure because they do not have an active
market
 There is a risk of earning management because of the use of unsupportable
fair value measures