Chapter 4 Measurement Notes PDF

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Chapter 4 Measurement Notes These notes are created to be used with PowerPoints slides and the assigned book for this course Flexibility of Measurement in Accounting Standards Advantages 

The inherent flexibility is necessary to allow entities to choose the method that will result in the most true and accurate reflection of the fundamental value of the item. Sometimes different approaches might be necessary in different circumstances. Disadvantages

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There is often little or no agreement on what accounting measures should be used. This means the same or similar items may be measured using different measurement methods and as a consequence be recorded at different amounts or values.

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reduces comparability of accounting information.

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Measurement can be quite subjective.

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With this flexibility, however, comes opportunity for management to make opportunistic accounting choices. The consequence of this being production of accounting information which is potentially misleading and which may even lead to corporate collapse.

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The current approach to measurement results in what is called the additivity problem.

Explain the additivity problem Many argue that the items on the financial statements should not be summed and that the totals, such as total assets and net assets, are meaningless. If we think about it, we are potentially adding an item measured at historical cost, to an item measured at present value, to an item measured at fair value. This is the equivalent of adding apples and oranges. Why would you? So what does the total assets figure tell us? Is it logical to try to derive meaning from this total? Similarly, even if the same measurement approach were used for a number of items throughout, it is likely that items were measured at different points in time. This also contributes to the additivity problem.

The difference between fair value and realizable value is that while realisable value and fair value are similar concepts, realisable value is an entity- specific measurement and fair value is a market-based measurement. Table 4.1 Comparison of measurement approaches page 92 ( Very important) Questions 1. Define measurement in the context of accounting and financial reporting. The Conceptual Framework defines measurement as: 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 Measurement in an accounting context therefore refers to the way the figures on the financial statements are determined. It is described as an act or process which may involve calculations, making estimates and comparisons, and apportioning or distributing amounts. 2. Why is measurement so important in accounting? Measurement is crucial to be able to provide decision-useful accounting information and to accurately appraise the performance of management. These are the primary purposes for which financial statements are prepared. 3. Discuss the current approach to measurement adopted by standard setters. Why have they adopted such an approach? What are the issues and problems associated with this approach? Under the international standards we adopt what we call a mixed measurement model. Under this approach a number of different measurement bases are employed in the preparation of the financial statements. Historical cost, current cost, realisable value and present value are all employed to different degrees and in varying combinations during the preparation of the financial statements. (Mixed Approach) The main reason for adopting such an approach is the need for flexibility. This model allows for use of a number of different measurement bases. This is necessary due to the differences in the substance or nature of transactions between entities and also due to the differing circumstances that entities can find themselves in.

Identify Issues and problems associated with the Mixed Measurement Approach adopted by the standard setters  Variations in accounting practice – entities may choose to account for the same or similar items in different ways using different measurement methods. How they measure and account for an item may be appropriate for the individual entity but could reduce comparability across entities.  Potential for different financial results being reported when different measurement methods are allowed and used.  Discretion means opportunity for management to make opportunistic accounting choices, creating a biased picture of reality and perhaps even misleading users. In summary, the approach is necessary but subjective in nature. This highlights the importance of professional judgement and ethics in accounting. 4. Explain the arguments for and against using historical cost as a measurement base. Key arguments for historical cost include:  

Most objective measurement approach - amounts are determined based on actual transactions. Clear audit trail – amounts can usually be proven by documentation.

Key arguments against historical cost include: 

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Amounts determined may not be relevant to current decision making if there is a long time span since the transaction occurred. Historical cost does not take into account changes in the value of money over time. In other words, it ignores price inflation. The amount paid for an item or received for an item may not necessarily be indicative of its value. Judgement involved in determining depreciation rates can create inconsistencies and opportunity for manipulation. Inability to determine the cost of some items. Items may be donated with no actual cost to the entity. Items may be internally generated rather than purchased.

5. Explain the arguments for and against using fair value as a measurement base. Key arguments for fair value include: 

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Most relevant measurement approach for current decision making. The amount that will be received for an item or that will need to be paid for an item is decision useful information. Objective if determined by reference to the market price for an item. The market price is set by forces outside the entity. It is not biased by judgement and cannot be manipulated or influenced by management.

Key arguments against fair value include:  

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Subjective where a market price is unavailable. Some items are not regularly traded in an active market and an estimate of the items fair value must be made. The focus on exit values is not logical and contradicts the going concern assumption. We are measuring as though we are going to sell off all the assets which is not usually the case. Market prices can be volatile and therefore sometimes may not be indicative of the true value of an item. Short term fluctuations in fair value may be irrelevant and cause confusion from a user perspective.

6. Identify factors that may influence the choice of measurement approach. Discuss how the measurement approach adopted impacts on the quality of accounting information produced. Key influences include: 

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Potential users of the financial statements - user needs must be understood in order to choose the measurement approach which will provide the most decision useful information. Practical considerations – a particular cost or value may be too difficult or even impossible to determine. Choice of measurement approach also needs to be cost effective. The cost of obtaining or calculating the cost or value must be considered. Management’s motivations and objectives – motivations, underlying objectives and time horizon can all influence management behaviour in terms of choice of measurement approach. For example, if management have a short term focus, are on a shorter term employment contract, or have bonuses tied to profits, they will

most likely choose the measurement approach which produces the best results in terms of higher profits. 7. Why has measurement become such a controversial accounting issue in recent times? In recent years there has been a significant paradigm shift in relation to accounting measurement. There has been a distinct move away from historical cost toward fair value and fair value is by far the most controversial measurement approach. Key reasons for such controversy include:     

Subjective nature of estimates involved in determining fair value where no active market exists for an item Role of management assumptions and judgement make accounting information produced more prone to manipulation Variability in valuation techniques used between entities Volatility in earnings reported as a consequence of changes in fair value from period to period Potentially misleading nature of the earnings figure produced under fair value

Some points regarding the controversial nature of accounting measurement in a more general sense follow:     

Potential for inappropriate choices in measurement approach Variability in measurement approaches adopted for the same or similar assets Political influences on measurement decisions Subjectivity and discretion involved in determination of some values Impact of measurement on achievement of other organisational objectives...