Chapter 6 - Measurement Theory

Theory in Action 6.2 Outsourcing and costs

1. Identify the potential problems associated with allocating costs that ‘attach’ to
services provided by firms such as Infosys Technologies.

The allocation of costs to a service provided by a firm can be problematic. While direct costs can
normally be easily traced to a particular service, indirect costs such as depreciation and
overheads may not be so easily determined for a particular service. The allocation of these costs
may require the use of an arbitrary allocation method or the determination of cost drivers in order
to allocate the costs over multiple services.

2. What criteria would management use when deciding to expense or capitalise

expenditures associated with its services?

Under the historical cost approach, management would need to determine which costs have
‘expired’ as these will need to be matched (expensed) against income. Any unexpired costs will
be capitalised and carried forward as unmatched assets on the balance sheet. Ready to be
matched against future revenue as it flows in.

3. Why is the decision to expense or capitalise expenditures so important to the costs

attach principle which underlies the historical cost system?

The historical system of accounting relies on the “correct” matching of expenses against
revenues in determining profit. Expenditures under the historical system are broken into expense
and asset components, with the asset component transferred progressively from the statement of
financial position to the income statement as the future economic benefit of revenue is received.
The reliability of this system relies on costs being measured and attached correctly and the
correct allocation of these costs to expenses or assets. However, the decision to capitalise or
expense is not always straight-forward and often judgement may need to be made on whether the
expenditures have expired and what the probability is of that asset generating future revenue.
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.

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 ?

This of course very much depends on the decision proposed. If the decision was related to
protecting creditors producing conservative accounting reports to monitor managers’
compensation then the answer is no. If financial statements were determined to aid decision
making by investors then the answer is probably more positive. Edwards and Bell also argue
that a current cost system is also appropriate as a management accounting system. Students after
reading this chapter should realise that there are several accounting systems because the
decisions to be made in the business world are varied and complex.

Using current market values requires a more complex accounting system and more decisions to
be made in preparing reports.
4. what are the three types of decision managers are faced with in running a business ? how
does accounting enter the decision making process

The three types of decisions pertain to the allocation of resources within the firm in order to
maximise profits. They are:
1. Those relating to the expansion of the firm. What amount of assets should be held at any
particular time?

2. Those relating to the composition of the assets. What should be the form of the assets? How
much working capital, how much of equipment, of plant, etc.?

3. Those relating to financing. How should the assets be financed? How much debt financing,
of new equity, of retained equity, etc.?

To make decisions regarding the three problems mentioned above, managers need to form
expectations about future events. Expectations are based on past events, and therefore past
decisions relating to the past events must be evaluated. Accounting information helps managers
to evaluate their past decisions. In so doing, accounting information serves as a basis for forming
expectations.

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”

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.

Samuelson argues first that the separation between holding activities and operating activities is
not clear-cut; therefore, holding gains/losses should be excluded from income. Second, cost
savings (holding gains) are an opportunity gain resulting from taking one course of action as
opposed to another. But the alternative has already been forgone by the actual course of action
taken. Once the asset is acquired, its cost is a sunk cost that cannot be avoided by any future
action. The only choice is to sell or continue using the asset, but holding gains are not based on
these choices. They are based on the course of action not taken and which no longer exists. Third,
income relates to net cash flows, realised or expected. Cost savings (holding gains) are neither
realised cash flows nor expected cash flows, but forgone cash flows. For these reasons, the
physical view is more rational.

10. According to MacNeal, why was the ‘going value’ theory, which assumes the firm is a
going concern, formulated?

Because there are times when the value of assets sold by the company, even when shortly after
the Financial Report is published, has a value higher than the value of the assets recorded, so that
the going concern assumption is used to justify it.

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

Answer Chambers proposal was originally called CoCoA (continuously contemporary

accounting) which was upgraded to CCE (current cash equivalents). Chambers sees the company
as an adaptive entity that faces buying and selling activities of goods and services. The notion of
adaptive behavior is implied for continuous adjustments to the environment for the survival of
the company's business. Even though the company manager is sensitive to expectations from
interested parties (owner, customer, employee, creditor). The condition of the existence of a
company is the expectation of the satisfaction of the parties concerned, at least for a higher
degree of satisfaction than that seen from the alternative actions taken. Especially, they are
attracted to cash receipts because they are associated with the company.

12. Why is Chambers critical of the notion of ‘value in use’?

Because Chambers believes that value in use is the sum of the percentage of expectations and
describes the level of confidence in the future, not the facts that exist today. While the market is
determined by the market so that it is more objective so that it reflects the company's ability to
buy goods and pay its debts.
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

15. What are the criticisms of the profit concept under exit price accounting?

Profit is a measure of how effective the performance of the company is in a given period.
Performance has to do with the operations of a company. Exit price accounting puts emphasis on
changes in the exit price of assets rather than operations. In most cases, the firm has little control
over these price changes.

Performance relates to the decisions made by management, which are formulated into plans. An
evaluation of the expected plans against the actual outcome must be made; then the firm can
decide whether to continue to use the assets for the purpose they were acquired. One concept of
profit is to measure performance in terms of what was originally intended. Only after the plan
that resulted in a given profit is evaluated is it then rational to decide whether the plan should be
changed. Chambers’ concept of profit, it is argued, ignores this type of evaluation. The plan for
each period is to maximise the current cash equivalent of the net assets for that period. Exit price
accounting does not match costs with revenues to measure the performance of the firm.

16. Assume that you favour exit price accounting. Give at least three reasons for your
support.

In support of exit price accounting:

 Exit prices are objective because they are market determined. If there is no market price,
then the item is stated at zero.
 Current (exit) values reveal the financial condition of the firm, its ability to adapt to the
environment — that is, to go into the market to buy and sell.
 All the values in the financial statements are additive — that is, they refer to one
characteristic: cash or current cash equivalent.
 Current values are relevant to users for their decision models.
 There is no problem concerning the allocation of costs.
 Exit price accounting is based on events that actually happened — increases and decreases
in values as determined in the market, as well as items purchased, sold or paid. Values in the
financial statements are based on reality.
 Research studies show that in many cases current (exit) values are more objective than
historical cost. In any event, current values are less subjective than most people believe.

17. How can exit value accounting be used to assess the financial risk of a balance sheet.

The difference between entry prices and exit prices indicates the liquidity (financial) risk of
investing in an asset. If this difference is high then the operating risk of the asset should be lower
as the value in use becomes the primary income recovery mechanism.

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

19 Explain how both exit price and current entry price accounting systems can be used
to make decisions about retaining or selling assets.

First, there are some assumptions made:

 Market prices are more relevant for financial decision making

 Additivity and reliability are important requirements for accounting measurement systems
 Conventional historic cost has many defects
 Accounting outputs and decision making is similar when markets are liquid

When markets are very liquid and exit and entry prices are virtually the same they can be viewed
as substitutes. However, when markets are not very liquid and prices deviate then these systems
are compliments. They give information on value in use and liquidation value. The divergence in
price can also be viewed as a measure of investment risk. See page 191 which also uses NPV.

 If CCAc > EXAc; and CCAc > NPVc, then assets have value in current use (c) — maintain
current operations.
 If EXAc > CCAc; and CCAa > NPVa, then liquidate assets currently used (c) —
continually adapt assets to other alternative investments (a).
 If EXAc > CCAc; and CCAa < NPVa, then liquidate and discontinue all operations.

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 value accounting has a commercial focus and is generally interpreted as current market
price accounting or else some form of discounted present value. General guidance is to use a
market price if markets are reliable or discounted present value if they are not or the
asset/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 use
a cost model or a revaluation model. For example, PPE could 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?

New intangible assets can be recognized only if there is clearly economic benefit in the future
and for those intangible assets the value can be measured reliably or more simply is the principle
of being portable and measurable. This is in line with the principle of matching cost against
revenue. The standard also states that all R & D costs are charged when incurred, unless the
development costs have met the criteria to be capitalized against the value of intangible assets.
The separation of costs between research costs and development costs is also related to the
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.