ATPB 313 ACCOUNTING THEORY AND PRACTICE SEM I 2013/2014

(updated July 2013)

TOPIC 6 (part A) RECOGNITION & MEASUREMENT

Learning Outcome
At the end of this lecture, students should be able to :
1
Examine the concept of measurement in accounting

Explain different types of measurement systems in accounting i.e. historical cost and its alternative measurement i.e. current cost (entry value) , current selling price (exit value), and fair value

2
Discuss the advantages and disadvantages of each measurement system

Be aware of current development in accounting measurement

What is measurement?
.the assignment of numerals to represent properties of material systems other than numbers, in virtue of the laws governing these properties. (Campbell, 1938)

.the assignment of numerals to objects or events according to rules. (Stevens, 1946)

Types of measurement

Fundamental measurement Derived measurement Fiat measurement

Numbers assigned by reference to natural laws

Depends on the measurement of two or more other quantities

Based on arbitrary definitions May lead to poor confidence

Godfrey et al Chapter 5 (138 140) & 145

Measurement in accounting

Key questions: What value for assets, liabilities, revenues and expenses provides relevant and reliable accounting information to financial statement users?

Development of accounting systems based: - Historical cost accounting - Current cost accounting - Exit price accounting - Present value - Latest: Fair value accounting

Historical cost accounting (HCA) What is it?

The traditional method of accounting, in which accountants record revenue, expenditure, and asset acquisition and disposal at historical cost i.e. the actual amounts of money or money worth, received or paid to complete the transactions

However, it is usually modified in its application by the revaluation of fixed assets such as land and buildings.

Historical cost accounting (HCA) Basic concepts

Objective of accounting: Stewardship or accountability

Capital and profit

Matching of costs theory

Conservatism

Godfrey et al Chapter 6 (162 165)

Historical cost accounting (HCA) Arguments for

Relevant in making economic decisions Based on actual, not merely possible, transactions

Data have been found to be useful

The best understood concept of profit Must guard data against internal modifications Profit based on alternatives may not be useful Market prices can be supplementary data

Insufficient evidence to reject it

Godfrey et al Chapter 6 (166 - 168)

Historical cost accounting (HCA) Arguments against

Objectives of accounting

Information for decision making

Basis of HCA Matching Notion of investor needs
Godfrey et al Chapter 6 (168 - 171)

So, what are the alternative models of accounting measurement?

Major normative proposals:

o Base accounting on current (replacement) costs o Base accounting on net selling price (exit price) of assets o Adjust HC by an index of changes in the general price level

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Current cost accounting (CCA) What is it? Definition: Assets are valued at their current market buying price and profit is determined using matching expense allocations based on the current cost to buy Underlying rationale: CCA information is more decision-useful Edward & Bell (1961) concepts of business profit is current operation profit plus realizable cost saving / holding gains or losses resulted from holding the asset Holding gains represent a saving attributable to the fact that the input was acquired in advance of use and determine whether holding activities are successful
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Godfrey et al Chapter 6 (171 - 174)

Current cost accounting (CCA) 2 views on CCA Financial capital versus physical capital: An illustration
Consider a company begins operations with RM1000 cash on 1 January and immediately purchases 100 units for RM10 each. On 31 January, it sells all the units for RM 18 each. On this date, the current cost has risen to RM12 a unit. Assume that profit is paid out as dividends at the end. The calculation of profit is as follows:

Godfrey et al Chapter 6 (174-179)

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Current cost accounting (CCA) 2 views on CCA

Financial capital view Physical capital view

Profit is RM800 because this is the increase after FC is maintained. If RM800 is distributed to the owners as dividends, the company still has RM1000, which is the amount of the beginning capital

The firm has 100 units at the beginning and it must in a position to purchase 100 units at the end of the period

Because the price has risen RM2, the firm needs RM200 more at the end of the period to maintain its beginning operating capability Therefore, the RM200 is not a holding gain, but a capital maintenance adjustment

Godfrey et al Chapter 6 (174-179)

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Current cost accounting (CCA) Arguments for/against

Recognition principle

Objectivity of CCA

Technological change

CCA vs. HCA and exit price

Godfrey et al Chapter 6 (179-183)

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Exit price accounting (EPA) What is it?

Definition: A system of accounting which uses market selling prices to measure firms financial position and performance

Underlying rationale: The adaptive nature of a company involves actions in market and hence the need for regular information about what it may obtain by selling its assets The company, therefore, needs to know the cash and cash equivalents of its net assets i.e. based on current market selling price

Godfrey et al Chapter 6 (183 - 185)

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Exit price accounting (EPA) Arguments for

Providing useful information

Provides relevant and reliable information Additivity Allocation Reality Objectivity A measure of risk
Godfrey et al Chapter 6 (185-188)

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Exit price accounting (EPA) Arguments against

Profit concept

Additivity

The valuation of liabilities

CCA vs. EPA

Godfrey et al Chapter 6 (188-190)

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Fair value accounting (FVA) What is it?

Definition: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (MFRS 13). It is a market-based measurement and not entity specific measurement.

IASB/FASB have agreed that FV is the best measurement basis (2004). In May 2011, both IASB and FASB issued guidance on FV measurement and disclosure requirement that makes both standards largely identical (for details guidance please refer to MFRS 13). CCA and EPA can be said as represent market/fair value accounting

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Fair value accounting (FVA) Arguments for

Reflects current market condition Transparency More accurate, updated, timely, and comparable

Gains/losses indicates economic events worthy as additional disclosure

Limit companies ability to manipulate the income A warning system to stay away from highly volatile assets

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Fair value accounting (FVA) Arguments against

Reliability in illiquid market

Subjective

Uncertainty

Reported losses can be misleading and increase the risk of overall financial system
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Present value
o Closest to true economic concept of value o Involves: future cash flows behavioral assumption discount rate o Subjective value (moving away from objectivity)

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Understanding IFRS measurements: The cross-cutting issues

o Example of issues to consider: Single measurement or mixed measurement model for all assets and liabilities How to consider and apply relevance and faithful representation to the selected measurements? If items are remeasured, how to display the effect of changes of measurement in the statement of comprehensive income? o What is the latest update of IASBs discussion?

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Summary of Topic 6 (part A)

Measurement

Fundamental

Derived

Fiat

Accounting How to measure A, L, E, & R

HCA The actual amount received/paid to complete the transaction Advantages? Disadvantages?

CCA Current market buying price Advantages? Disadvantages?

EPA Current market selling price Advantages? Disadvantages?

Present Value Discounted cash flow Advantages? Disadvantages?

FVA Refer to MFRS 13 Advantages? Disadvantages?

Current interest of IASB & MASB

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