Chapter 6 - Measurement Theory

Question

1. According to historical cost system, what is the objective of accounting and the role of
profit? What criticisms are made of profit calculated under the historical cost system?

 According to the historical cost system:

◦ The objective of accounting

 Seen as monitoring the stewardship function of management by

calculating income and valuing net assets in a conservation way.

◦ The role of profit

 The accounting entity must first retain the same amount of capital that it
had at the beginning of the same period where all assets and liabilities are
valued at their historical purchase cost.

 The criticisms that are made of profit calculated under the historical cost system is:

◦ Income with no recognition of the changing value of assets and liabilities is

misleading and results in incorrect dividend policies

◦ This is because there maybe losses or gains simply from holding assets and this
should be recognized when evaluating performance on regular basis.

Second answer

Stewardship is emphasised as the objective of accounting in traditional historical theory—

enunciated by Paton and Littleton. Accountability to equity holders is primary.Owners and
creditors are considered to be especially interested in what the firm(management) has done with
the funds they have entrusted to it. Therefore, informationshould be provided to give an
accounting of the performance of the firm in using thefunds from a creditors point of view.
Hence conservatism is required in valuation.Determining ‘net worth’ to owners is not of primary
importance.

Critics say that stewardship is too narrow an interpretation of the objective ofaccounting. The
stewardship emphasis causes a preoccupation with the past. Users wantinformation for decision
making, which calls for a ‘forward looking’ position. This isnow the principles based approach
championed by the IASB for internationalaccounting standards.

Because accountability and stewardship is emphasised, the belief is that equity holdersare
primarily interested in the results of the use of their funds. Thus an emphasis onflows and hence
to earnings as the primary statement; the statement of financialperformance is more important
than the statement of financial position. After all, theobjective of the firm is to make a profit a
concept that is embedded in business. Thebalance sheet (now statement of financial position) is a
link between two statements offinancial performance. It is a repository (dumping ground?) of
unamortised historicalcosts.

Critics charge that we claim the balance sheet is a statement of financial position; but, ineffect,
historical theory downplays this interpretation. We should be more serious aboutmaking the
statement of financial position a meaningful statement, one that fits theclaims we make about it.
Useful information for decision making implies that thestatement of financial position items
should be as important as the income statementitems. Current values would be more relevant

2. Explain the concept of ‘costs attach’. What do critics say about the concept? What is
meant by the terms ‘unexpired costs’ and ‘expired costs’?

• ‘The theory is that the dollar amount of the historical cost of purchased goods and services
‘attaches’ to those goods and services. As the goods and services are used in the production of
the product, the cost of the product can be determined by counting the attached costs of the
goods and services that constitute the final product. – labour, materials, overhead.

• In general terms, it may be stated that cost which enter into production relate to materials,
labour and overheads for the factory, office and selling and distribution channels. All such costs
are then attached or accumulated to from the total costs of the products.

The cost attach is that accountants trace the movement of costs and attach (match) them to the
revenues received as they flow through the business if the firm purchases goods and services. Be
specific, the accountants must decide which costs have ‘expired’ and therefore are to be matched
against income (as expenses) in the income statement, and which costs remain ‘unexpired’ and
are to be placed on the balance sheet as the residual (unmatched assets).

Critics:

The matching concept is practically impossible in HCA, which stated by Thomas. Matching may
lead to allocation problem, as it is a subjective process. Costs can be classified as direct costs
(variable costs) and indirect costs (fixed costs). The direct costs can be allocated to each item,
such as calculating the raw materials directly to each item; however, the indirect costs, such as
electricity and depreciation, do not attach the movement of costs.

Critics believe the notion of ‘sacrifice’ is the only meaningful cost. This is supported by economic theory.
There is no evidence that dollar amounts of historical cost attach themselves to physical times. This is
purely an abstract view, not supported by evidence. Why this attaching takes place only for historical
cost is not clear. If an item is valued at replacement cost because of the lower of cost or market method,
then cost suddenly ‘detaches’.
These terms relate to the theory of costs attach. If the dollar amount of cost attaches to the physical
items, then assets can be seen as ‘unexpired’ or ‘unamortised’ costs. Assets (or portions of them) and
services that have been expensed are ‘expired’ costs.

Costs that are expected to benefit the future are defined as ‘unexpired’ and those that have no future
benefits are defined as ‘expired’.

‘Unexpired costs’ is an old fashion to say asset. The expired costs are expenses, which have
expired and matched against income. For instance, plant is initially purchased at $10 million at
the begging of the year. During the year, the plant depreciates at $2m and has a book value of
$8m at the end of the year. The depreciation expense of $2m is expired cost (I/S). The residual
value of plant is unexpired cost (B/S), namely, $8m.

3. would market value adjusted statements be more decision useful than those prepared
applying historical cost measures ? would using current market values reduce the number
of decision required to prepare financial statements ?

4. what are the three types of decision managers are faced with in running a business ? how
does accounting enter the decision making process

In running a business, the financial manager faces three basic decisions: (1) which productive
assets should the firm buy (capital budgeting), (2) how should the firm finance the productive
assets purchased (financing decision), and (3) how should the firm manage its day-to-day
financial activities (working capital decisions). The financial manager should make these
decisions in a way that maximizes the current value of the firm’s stock price.

5. Explain the Edward and Bell concept of business profit

 Current operating profit

◦ Current operating profit is excess of the current value of the output sold over the
current cost of the related inputs.

 Realisable cost saving

◦ Realisable cost saving are the increase in the current cost of the assets held by the
firm in the current period

◦ They include both realized and unrealized cost changes and the business profit is
therefore calculated on a real basis that is the fictional element due to changes in
the general price level is eliminated
 ◦ Edwards and Bell believe that holding gains represent “a saving attributable to the
fact that the input was acquired in advance of use”

The financial capital concept is the traditional view. It keeps track of capital in terms of the
dollar amount invested in the company. A return on financial capital means that there is an
excess of the dollar amount of capital at the end compared with the dollar amount of capital at
the beginning, excluding the effect of transactions with owners. In other words, there has been an
increase in the value of money capital.The physical capital concept looks at capital in terms of its
physical aspect, and then translates it into dollars. Usually, the physical aspect relates to the
firm’s producing capacity. A return on physical capital results only if the physical productive
capacity at the end of the period exceeds the physical productive capacity at the beginning of the
period, excluding effects of transactions with owners. For example, if at the beginning of the
year, Xhas the capability of producing 10 000 units of product, thenprofit occurs only after the
current dollar amount of that capability at the end of the year is maintained. The capability to
produce 10 000 units may be expressed in termsof plant and equipment. Only current cost (or
replacement cost) is relevant for a physical capital view.The main difference between the two is
the placement of price changes of non-monetary assets and long-term debt during the period.
Under the financial capital view, these price changes are included in profit as holding
gains/losses. Under the physical capital view, these are placed directly into shareholders’ equity
as a capital maintenance adjustment

6. What are the benefits of separating out the holding gains (or losses) in profit
determination? What are some shortcomings of this separation?

Benefits

• Holding a certain composition of assets and liabilities will enhance the firm's market position.
Managers and other want to know if these holding activities are successful.
• Under HCA, gains are recorded only when the assets are disposed of. Thus, determining
whether management's holding activities are successful or not is virtually impossible unless
assets are bought and sold in the same period. So, when comparing firms we may be misled as to
which firm is more efficient. Therefore, the separation of holding gains and operating profit
gives credit to the appropriate managers.

Shortcomings

• Confuse the valuation of management decision.

• Hinders the allocation of resources in the economy

7. There are several explanation to justify the inclusion of holding gains as profit. Discuss
them.
  Revsine suggests that the inclusion of holding gains as income may be justified on the
ground that changes in the current cost of the given asset reflects changes in the future
cash flow expected to be generated from the use of assets.

 Holding qualify as profit because the price increases on which they are based are
reflection of greater future earning power

 If this assertion is true, then a profit figure that include holding gains is highly relevant to
users who are trying to predict the future cash flows of a company.

8. Explain the difference between the concepts of financial capital and physical capital.

Capital is synonymous with the net assets or equity of the entity, measured either in terms of the
actual amount of dollars by subtracting the total of liabilities from assets, or in terms of the
purchasing power of the dollar amount recorded as equity. Profit exists only after the entity has
maintained its capital, measured as either the dollar value of equity at the beginning of the period,
or the purchasing power of those dollars in the equity at the beginning of the period.
Capital is seen not so much as the equity recorded by the entity but as the operating capability of
the entity's assets. Profit exists only after the entity has set aside enough capital to maintain the
operating capability of its assets.

9.Explain Samuelson’s argument for changes in current cost as a capitalmaintenance

adjustment.

Answer Samuelson menyatakan holding gainssebaiknya dimasukkan sebagai penyesuaian modal

karena:

▪Pemisahan antara aktivitas memiliki dan operasi tidak jelas

▪Aset yang telah dibeli adalah sunk cost(tidak relevan), sehingga opportunity gainpada dasarnya
tidak ada. Keputusan yang ada adalah menggunakan atau menjual
▪Holding gainsadalah forgone cash flows
Arus kas tidak dapat diidentifikasi kepada setiap aset, hanya secara keseluruhan perusahaan
sehingga tidak dapat dikatakan bahwa perubahan pada biaya berjalan berkaitan dengan
perubahan dalam nilai sekarang dari aset karena itu physical viewlebih rasional.

11.Explain the concept of ‘adaptive behaviour’ of the firm by Chambers, andhow ‘financial
position’ relates to it.

Answer Proposal Chambers awalnya disebut CoCoA (continuously contemporary accounting)

yang ditingkatkan menjadi CCE (current cash equivalents). Chambers melihat perusahaan
sebagai entitas adaptif yang menghadapi aktivitas pembelian dan penjualan barang dan jasa.
Gagasan dari perilaku adaptif diimplikasikan pada penyesuaian terhadap lingkungan secara terus
menerus demi keberlangsungan usaha perusahaan. Meskipun manager perusahaan peka terhadap
ekspektasi dari pihak berkepentingan (pemilik, pelanggan, karyawan, kreditur). Kondisi dari
eksistensi perusahaan adalah ekspektasi dari kepuasan pihak-pihak yang berkepentingan,
setidaknya untuk derajat yang lebih tinggi daripada kepuasan yang terlihat dari alternatif
tindakan yang dilakukan. Terutama, mereka tertarik dengan cash receiptkarena mereka
terasosiasi dengan perusahaan.

13. What is the basis of Sterling’s conclusion that exit price should be used for the
valuation of the items ?

Sterling’s conclusion:

 Relevant to all users

 Reliable

 Empirically meaningful

 Additive in the sense that the sum of the parts is equal to the independent measurement as
a whole

18. Evaluate the argument that a mixed or piecemeal approach to standard setting is
required in order to 'better' measure profit and financial position.

The IASB discussion paper Measurement Bases for Financial Accounting – Measurement on
Initial Recognition proposes, very broadly, the following hierarchy:

 fair value should be used where it can be measured reliably;

 where fair value cannot be measured reliably,

 current cost should be used where it can be measured reliably

 where neither fair value nor current cost can be measured reliably, historical cost should
be used.

Although such an approach would result in a mixture of different bases being used for
measurement, which might seem to fit the working hypothesis suggested in this report, there are
some important potential objections to it

 There is an assumption that one basis of measurement (fair value) is always the most
relevant to users’ needs, but this has yet to be demonstrated.

 There is an assumption that another basis of measurement (current cost) is always the
second most relevant to users’ needs, but this too has yet to be demonstrated.
  The reliability test in this context is open to a wide variety of interpretations in practice,
and might well lead to the reporting of measurements that users would regard as
unreliable.

 Hierarchical approaches involve additional expense in the consideration of theoretically

preferred measurement alternatives that will ultimately be rejected, because of reliability
problems, in favour of less preferred options.

 The complexity of the approach may make it difficult for users to understand

20. Explain the concept of 'fair value' as defined in IAS 16/AASB 116 and outlinebenefits to
financial statement users of continually revaluing assets to their currentvalue.

Students are encouraged to read this standard before answering the question.This standard relates
to tangible assets - property, plant and equipment.

First, fair valueaccounting has a commercial focus and is generally interpreted as current market
priceaccounting or else some form of discounted present value. General guidance is to use
amarket price if markets are reliable or discounted present value if they are not or
theasset/liability is not traded. However, what market price is appropriate is not always spelt
out(should you use selling prices or buying prices?). Some guidance is provided but one may
usea cost model or a revaluation model. For example, PPE coulod have a mixture of current
cost,selling prices, and historical cost.

21. The following questions relate to the apparent divergence in view between the standard
setters and the private sector, with respect to the need to shift from historical cost to
current value accounting.

a) In your opinion, why do standard setters require measurement methods other than
traditional historical cost accounting?

 Objective: it is not relevant to use the objective of meeting the stewardship purpose
anymore.

 Going concern : in reality, the assets need to be dispose in longer term period due to
changes in technology.

 Matching concept : result to a very subjective information.

 Notion of investor : investors want a current information rather than past infomation

b) Why do you think that some in the business community and the public accountant firms
are strongly opposed to a move away from historical cost accounting?
  Relevant in making decision

- to determine which decision rules to use, managers need to information about the
quality of their past decision.

- some decision makers more concern on how much has already earn rather than how
much more they can earn.

 Based on actual, not merely possible transaction

- record actual transaction made by management

- necessary for accountability

 Data/model found to be useful

- changed in accounting would long have been made if financial report using historical
cost accounting is not useful over the years.

 The best understood concept of profit

- actual revenue and expenses, successful measure to calculate profit.

 Must guard data against any internal modification

- historical cost accounting is less subject to manipulation of figures

 How useful is income information based on current cost/exit price accounting

- current cost accounting and exit price accounting show a short run view of profit

 Market price changes can be supplementary data

- historical cost accounting is argued as not differ materially from current cost accounting

- therefore, supplementary data on current price are practical to deal with such
information, no need to shift from HCA to current basis

 Insufficient evidence to reject it

- no proof that CCA or EPA are more useful than HCA

c) Measurement principles are fundamental to any accounting system. Why does the
Framework lack fully developed measurement concepts?

 Because it is not easy to come into agreement by a lots of entities.

 This is due to the convergence.

  different countries used a different accounting practices.

 It is difficult to standardized the practices because there will be a debate in defending

their own support.

22. Has the complexity of alternative rules in the historical cost approach becomes a valid
reason for rejecting the historical cost system?

Complexity of alternative rules refers to the different choice of measuring rules, such as
inventory and depreciation. This is not a good rule to reject HCA. Given that if you are
consistent, such as using keeping using LIFO, you can still provide some useful and comparable
information.

With the level of technology available, the complexity of alternative measurement and reporting
models is not really an issue. The reasons could include:

 both academics and practitioners cannot agree on what is an appropriate model

 end users may not understand more complex information ?

 the overall costs of reporting may prohibit adoption of alternative models

 such models are still subject to the weaknesses of the historical cost system, particularly in
terms of the ability of directors to pick and choose applications and the timing of disclosures.

24. Explain the underlying approach to intangibles under IAS 38AASB 138. Is the
approach consistent with the matching principle? Is the splitting of the research and
development components of expenditure and the different accounting treatments justified
given that the nature of the expenditure is the same?

Aset tidak berwujud baru bisa diakui hanya jika sudah jelas terdapat manfaat ekonomi di masa
depan dan atas aset tidak berwujud tersebut nilainya dapat diukur dengan handal atau lebih
sederhana adalah prinsipprobable dan measurable. Hal ini sejalan dengan prinsip matching cost
against revenue. Standar juga menyatakan bahwa seluruh biaya R&D untuk dibebankan pada
saat terjadinya, kecuali jika biaya pengembangan tersebut sudah memenuhi kriteria-kriteria
untuk dikapitalisasi terhadap nilai aset tidak berwujud. Pemisahan biaya antara biaya riset dan
biaya pengembangan tersebut juga berkaitan dengan matching principle.

25. if you were the auditor of the company in question 23, what evidence would you seek to
support your opinion about the fair presentation of the asset

CASE STUDY 6.1

1. How are assets and liabilities measured under IAS 39?

According to IAS 39, Financial Instruments: Recognition and Measurement, financial instrument
are to be stated at their ‘fair value’- defined as ‘the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction’.

‘If the market for a financial instrument is not active, an entity establishes a fair value by using
valuation technique….(including) discounted cashflow analysis and option pricing models,’ says
IAS 39.

‘A gain or loss on a financial asset or financial liability classified as at fair value through profit
or loss shall be recognized in profit or loss.’

2. What impact according to the author, will fair value accounting have on the balance
sheet and income statement?

As far as financial instruments are concerned, fair value accounting is notable for its closeness to
the long-cherished academic ideal of ‘income as present value growth’. The possible objection
can there be to fair value accounting, IAS 39 looks like a passport to the promised land of ‘truth
and Fairness of view’.

Using fair value accounting make reporting the financial statement in the real condition even it
was had a great impact of the economic condition such as the financial position of a company
who had the impact of national inflation. In accounting we still need to present all the financial
position based on the economic reality so all the stakeholders as a user of the financial statement
can knew exactly the real condition of a company.

So, accounting as current economic reality is balance sheet and income statement should be
based on a valuation basis that is more reflective of economic reality rather than historical costs.
Focus on current and future prices

3. What measurement requirement of historical cost accounting is violated

 It is based on Stewardship as it is not more the primary objectives because it represent

past information and not latest information, we want forward looking information which
help the investors/lenders make decision.
  Besides it focuses on going concern concept in which they believe the firm continue
exist or operate in the foresable future. However in reality the company might collapses.

 It also focuses on matching concept which is very subjective. It don’t really reflect the
reality.

4. Is a change value asset value an increase in wealth or income? Are they the same

 Yes. The change in asset value in increase in wealth or income are same because:

◦ Gain or loss indicate economic events to the company

◦ Reflects current market condition

◦ More accurate, updated and comparable for economic decision making.

5. What do you think fundamental value in accounting should be? Refer to the debate
regarding value in use add value in exchange outlined in this chapter when answering this
questions.

 Fundamental value in accounting should be value in use.

 Value in use.

- Emphasis on long term approach.

- A value in use approach uses an external investor or a production oriented entity as the
relevant benchmark.

- Such an investor (firm) rarely focuses on current liquidation values but is interested in
the prospect for future cash flows, which are more accurately predicted by earnings rather than
current cash flow.

- It is required to measure of income that matches the current costs of asset inputs against
outputs.

- More focus on obtaining the most efficient results from assets in use and does not
consider adaptability as an option.

 Value in exchange

- Concentrates on a short term approach to valuation.

 - Exit prices as a value in exchange approach take the viewpoint of an internal manager
or creditor who has to make decisions related to the liquidity is more important.

- This approach is particularly important for firms which liquidity problems (high-debt
firms), or firms engaged in tradeable goods and which are able to quickly adapt their operations
to market conditions (such as mutual funds that invest in tradeable bonds or shares)

Concept of 'adaptive behaviour' of the firm as implied by Chamber, and hw financial position relates to it

The concept of 'adaptive behaviour' as defined by Chamber implies a continual attempt by a

firm to adjust to the competitive business environment for the sake of survival.
To continue in business, a firm must be able to engage in market transactions, and this is
revealed by its financial position.
This related to the firm's capability as an adaptive entity engaged in buying and selling goods
and services.
The survival of the firm depends on the amount of cash it can command.
Adaptive behaviour, therefore calls for knowledge of the cash and current cash equivalents of
the firm's net assets at any particular time. That time must be the present.