Tut 4 Solutions - HOMEWORK HELPS PDF

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Q1. Define measurement in the context of accounting and financial reporting. Why is measurement so important in accounting? 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. 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. The way items are measured in accounting impacts on the quality of accounting information produced. In order to fulfil the decision-usefulness objective, the financial statements produced must contain good quality accounting information which will assist decision makers in making the right (appropriate) decisions. Poor quality accounting information, resulting from the use of inappropriate measurement methods, may mislead users and this could potentially cause them to make wrong (inappropriate) decisions. If accounting information leads to wrong or inappropriate decisions it is not useful. The financial statements produced must also contain good quality accounting information in order to accurately determine how well management has performed its role in managing the resources of the entity. Poor quality accounting information, resulting from the use of inappropriate measurement methods, will give the wrong impression as to how well management has performed its role.

Q2. 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. 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. Issues and problems associated with this approach include:  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.

Q3. 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.

Arguments against historical cost accounting:  

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The assumption that the purchasing power of the dollar remains constant is simplistic and flawed. Information generated through historical costs accounting suffers from the ‘additivity problem’—it is argued that it makes little sense to add together the costs of assets acquired in different time periods. Historical cost accounting relies upon arbitrary cost allocations (for example, in relation to depreciation) which may have little correspondence to the actual changes in an asset’s values. Historical cost accounting can lead to an overstatement of profits in times of rising prices and this overstatement can cause a reduction in the operating capacity of the entity because an excess amount of dividends might be distributed (because historical cost accounting relies upon a financial capital maintenance perspective). Historical cost accounting data is of limited relevance to current decisions. Historical cost accounting assists an organisation to manipulate its profits given that the decision to dispose of a non-current asset can directly lead to the recognition of gains on disposal, even though those gains actually related to prior periods. The decision to sell an asset might be made in an effort to offset other losses that will be recorded.

Q4. Explain the difference between current and replacement costs. Current costs and replacement costs are both essentially the costs that would be incurred if we were to replace the items now. However, these terms represent two different methods of measuring the cost of replacing the items. Current cost requires the item be valued and recorded at the amount that would be paid at the current time to provide the future economic benefits expected to be derived from the current item. Replacement cost requires the item to

be valued and recorded at the amount that would be paid at the current time to purchase an identical item. Current cost is a broader concept in that it represents the cost of obtaining the same expected future economic benefits, but these benefits may be assumed to be achieved in different ways, not necessarily through purchase of an identical item. Replacement cost is much more specific in that it represents the cost of purchasing another item identical to the current one. Q5. Explain the arguments for and against using fair value as a measurement base. Key arguments for fair value include:  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:  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.

Q6. Identify factors that may influence the choice of measurement approach. Discuss how the measurement approach adopted impacts on the quality of accounting information produced. (LO3) Key influences include:  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. The measurement approach adopted impacts on the quality of accounting information because it has a direct impact on the relevance, faithful representation, understandability, comparability and verifiability of the information produced. Accounting information which

possesses these characteristics is more decision useful, therefore fulfilling the decision usefulness objective, the purpose for which financial statements are prepared. A detailed analysis of how each of the individual measurement approaches discussed in the text impacts on the quality of accounting information can be found on pages 104-107.

Contemporary issue 4.2 The subprime lending crisis and reliable reporting Questions 1. In practice, which measurement base, historical cost or fair value, would provide the most relevant and reliable accounting information? Draw on the facts presented in the situation above, as well as your knowledge of the global financial crisis, to justify your response. 2. Discuss the role of market stability and the financial business cycle in determining the relevance and reliability of the accounting information produced. 1. Responses may vary from student to student as there are many paths that discussion could take. Some key discussion points follow.    

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Fair value or historical cost on their own, are not likely to achieve both characteristics. Inherent trade-off between relevance and reliability – the information which is most relevant is often less reliable. The information which is most reliable tends to be that which is less relevant. There has been a move towards fair value and away from historical cost on the basis of relevance. It is argued that reporting assets and liabilities at their fair values provides more relevant information for investment decisions than historical cost. Reliability is difficult to achieve under fair value when we are dealing with hypothetical transactions that are not objectively measureable. This is the situation we face when observable market prices are not available. In other words, when an active and liquid market does not exist for the asset. Some argue that once reliability becomes compromised, the information produced also becomes less relevant. Integration of the two measurement bases suggested. For example, historical cost financial reports could be enhanced by providing fair value information through footnote disclosures. A balance to achieve both greater relevance and reliability.

2. Market stability and the nature of the financial business cycle play a large role in the determination of market prices, and therefore impact upon the relevance and reliability of accounting information produced using fair value. Falling prices in an unstable market may worsen market stability. Companies tend to react to falling prices by rushing out to sell their assets before their competitors, causing a further downward spiral in prices. In a market bubble, values may be overstated, and values will most likely not be realisable if many market participants decide to sell those assets at the same time. The bubble bursts and prices fall again.

Financial statements measuring assets and liabilities at fair value in unstable or illiquid markets are not likely to be relevant or reliable for the purpose of decision usefulness. Students may refer to the subprime lending crisis or other examples to illustrate the role of market stability and the financial business cycle....