4 - Measurement and valuation Flashcards
Explain the need to measure in accounting and what measurement involves.
Measurement in financial reporting is required to be able to put a number (a monetary amount) against the items in the financial statements.
Without these amounts, the financial statements would be of little use.
Measurement involves two steps:
(1) Deciding what attribute to measure.
The choice of the appropriate attribute will depend on the purpose of measurement.
(2) Deciding how to measure the chosen attribute.
This requires a choice of scale and unit. In accounting, we use monetary amounts as the scale and traditionally use nominal dollars (although constant dollars is an alternative unit).
Explain the difference between cost and value.
Cost is a sacrifice.
Cost is something that a person or entity ‘gives up or foregoes’.
It is a behavioural concept. In economic theory, the sacrifice pertains to the next best alternative forgone.
We can measure the sacrifice by determining what was sacrificed if that is quantifiable.
If money is used, then this is simple to determine, since the sacrifice is the amount of money given.
Value Something has value because it is desired, that is, preferred to something else.
In economic theory, the sacrifice pertains to the next best alternative forgone.
We can measure the sacrifice by determining what was sacrificed if that is quantifiable.
Cost and value Cost relates to value because one must forego something of value if there is to be a sacrifice.
If the ‘thing’ given up has no value, there is no sacrifice.
If money is used, then this is simple to determine, since the sacrifice is the amount of money given.
At the time the sacrifice is made, we can say that value is at least equal to cost.
Presumably, a rational person would not sacrifice more than the value then placed on the object or right obtained.
In accounting, we usually think of the cost as represented by the amount of money or other consideration given (sacrificed) to acquire something.
Objectively, value is quantified by the market price system.
Explain the advantages and disadvantages of using historic cost as a measure.
Historic cost is the money (dollars) sacrificed or given up to obtain an item.
The key advantages are: It is reliable because it is objective (the amount paid can usually be verified).
It is easily understood by both preparers and users.
Also, the cost of measuring is minimal (usually there is no need to undertake valuations or make estimates).
The main disadvantage of historic cost is relevance as:
What you have paid for an item is not relevant to future decisions.
It provides no indication of the value of an item to an entity It fails to take into account the time value of money and price changes.
It can restrict recognition of items which are not purchased or where cost is difficult to establish.
Explain the difference between current and replacement costs.
Both current and replacement costs are entry prices (i.e. the costs that would be incurred to bring the asset into the entity).
The difference relates to the view of what the ‘asset’ is;
one view as identical in form to the current asset; the other as identical in terms of future economic benefits that the current asset provides.
Replacement cost:
Replacement cost is the present cost of replacing an asset with an identical or similar asset.
The focus is on the replacement of the asset currently held.
The availability of an identical or similar asset must be considered.
If an identical or similar asset is not available, then the cost of the modern equivalent would be used.
For example, an entity purchased a forklift truck with a useful life of 10 years, for $40 000 three years ago.
The replacement cost would be:
The market price of a second-hand forklift in an identical condition to the forklift currently held (that is, at the end of the three years);
or if no second-hand market existed, the current market price of a new forklift, adjusted (via depreciation charges) to take into account the fact that the new forklift would provide 10 years’ service, yet the current forklift has only seven years’ service remaining;
or if forklifts were no longer available, then the current market price of the ‘modern equivalent’ asset (for example, a conveyor belt) would be used, and adjusted as before, for any difference in future years of service between the forklift currently held and the conveyor belt.
Current cost:
The current cost of an item is the lowest amount that would be paid at the current time to provide or replace the future economic benefits expected from the current item.
Current cost is the lowest cost at which the service potential (i.e. the future economic benefits) of the asset could be obtained.
Its focus is on the service potential (the benefits for which the asset is acquired) rather than the form of the asset itself.
In many cases, this will be identical to the replacement cost.
However, this concept takes into account the fact it may be possible to replace the existing asset with a different asset which would replace the service potential at a lower cost (than replacing it with the same asset).
Explain the advantages and disadvantages of using current or replacement cost as a measure.
The key advantages of using current or replacement cost are that these are:
Reliable in the sense that it is determined by market prices and therefore, less able to be manipulated by management.
Also, as it reflects current prices, it does not have the disadvantage of historic cost in relation to ignoring time, the value of money and price changes.
Possibly more relevant as it is assumed that if a business is to continue it needs to be able to replace the resources that it consumes.
The costs measure the costs of replacing the resources that the entity currently has.
The key disadvantages of using current or replacement cost are that these are:
May not be relevant.
Recall that accounting is to provide information relevant to decision making.
Replacement and current costs are relevant if deciding whether or not to replace an item; however, the entity already has the item.
As these are costs, they do not provide any measure of the benefits that are expected from the asset by the entity.
Also, as these costs are entry prices they are determined by the market and do not take into account the specific entity context.
Explain the advantages and disadvantages of using fair value as a measure.
Fair value is the amount for which an item could be exchanged between knowledgeable, willing parties in an arm’s length transaction.
The key advantages of using fair value as a measure is that:
It is reliable in the sense that it is objective as determined by market forces and hence, less open to influence by management.
This assumes that fair value can be readily obtained in the market place.
It has relevance.
Many consider that what an asset could obtain in the market place (i.e. its fair value) is relevant.
However, this would depend on the asset and how it is used by the entity.
For example, a machine could have little resale value in the market place but could be used to generate high revenues by an individual company.
The fair value would be assumed to be relevant to decisions relating to creditors if trying to determine whether the company if closed, would have enough funds to pay of debts.
The key disadvantages of using fair value as a measure is that:
Unless there is an active market estimating fair value can be subjective.
Explain the advantages and disadvantages of using present value as a measure.
The key advantage of using present value as a measure is that it is often considered the ideal measure of ‘value’ because:
- it is conceptually consistent with the definitions of the elements of the financial statements (as it measures inflows/outflows of economic benefits)
- it measures cash flows which are the source of ‘value’ for business entities
- it takes into account the time value of money.
The present value concept measures ‘value’ as the present value of the future net cash flows expected to be obtained from the asset.
The present value of money is the value now of a sum of money arising in the future.
Money now is worth more than money in the future, because it could be invested now to produce a greater sum in the future.
The present value of money in the future is calculated by discounting the future money at a rate of interest equivalent to the rate at which that money could be invested.
Disadvantages/Problems in Measuring Present Value
Although present value may be theoretically the ideal measure of value, the lack of reliability (recall that the recognition criteria in the Framework require that ‘a cost or other value that can be measured reliably’) limits the use of present value.
There are three problems in calculating the present value:
(1) How to predict the amounts and timing of future cash flows
We need to determine what cash flows will be realised and when.
This involves predictions of a number of variables including the services expected to be provided by the asset and conversion of these into cash flows; the length of time the asset will last and future demand, prices, operating costs.
(2) How to allocate cash flows between assets
Many assets are used jointly to produce cash flow – it is the combination of a number of assets that produces the cash flows; not any single asset.
In such cases, it is impossible to determine the cash flows specifically identifiable with any particular asset.
For example, how much of the cash flow belongs to the spray painting equipment used by Mitsubishi?
Choice of interest/discount rate.
There is a number of alternative interest or discount rates that may be used (for example, interest rate implicit in the contract, current market rate, cost of capital) and various views as to which is the most appropriate rate to use.
Thus, the choice of the interest or discount rate to use is problematic.
Given that the above is based on expectations and management’s predictions about cash flows, this is also problematic if used for assessing the performance of management.
For the above reasons, the use of present value has historically been restricted to:
monetary assets and liabilities.
Some assets hired out (for example, buildings).
In these cases, unique cash flows for the assets concerned can be predicted relatively easily as such assets produce cash flow streams relatively independently of other assets held.
Explain what is meant by deprival value.
Deprival value (or value to the owner as it is often known) is the loss that a rational businessman or businesswoman would suffer if he or she was deprived of the asset.
To decide the deprival value of an item, what action would be taken if the item that the entity currently holds was lost needs to be considered?
The entity could either:
Do nothing, in which case the loss suffered is the value or recoverable amount that would have obtained from the asset (either present value if the asset was held for use, or net realisable value if the asset was held for sale), or
Replace the services that would have been provided by the asset, in which case the loss suffered is the current cost of replacing the services (by replacing the services the owner regains the value and is restored to the original position).
A rational owner will choose the action that minimizes the loss.
Deprival value assumes that the entity will take the action that results in the lowest cost or loss.
This choice requires two comparisons to be made:
Compare PV (value in use) and NRV (value in exchange) to determine the value/recoverable amount of the asset (value is the greater of the two).
Compare CC and value/recoverable amount (established from the first comparison) to determine the minimal loss.
What role does judgement have in measuring items in the financial statements?
Professional judgment has two key roles in measuring items in the financial statements:
(1) Choosing the way in which an item is to be measured (i.e. choosing attribute/scale)
The Framework allows a choice and does not prescribe a specific measurement method.
Particular accounting standards may prescribe the way in which particular items are to be measured.
However, in relation to other items, the measurement may not be prescribed by a standard or there may be a in such cases, judgment will be required to determine the most appropriate measurement basis to use.
This requires consideration of users’ needs and the relative relevance and reliability of alternative measures.
(2) Estimating particular measures
For example, we need to use judgment in estimating useful life and the residual value of assets that are being depreciated;
we need to use judgment in determining how to estimate fair value if market values are not readily available for an item.
