Chapter 6 - Measurement Flashcards
A part of measurement relates to capital maintenance perspectives. Explain these perspectives.
Financial capital maintenance perspective: Under this perspective of capital maintenance, a profit is earned if the amount of net assets at the end of the reporting period exceeds the amount at the beginning of the year, excluding any contributions from, or distributions to, owners.
Physical capital maintenance perspective: Under this perspective, a profit is earned only if the organisation’s productive or operating capacity at the end of the reporting period exceeds the capacity at the beginning of the period, excluding any contributions from, or distributions to, owner
Explain these perspectives and how each perspective can be seen in a measurement model including pros & cons.
Can be understood through entry price branch within c.urrent cost accounting.
Some versions of CCA, such as that proposed by Edwards and Bell, adopt a physical capital maintenance approach to income recognition. In this approach, which determines valuations on the basis of replacement costs, operating income represents realised revenues, less the replacement cost of the assets in question. It is considered that this generates a measure of income which represents the maximum amount that can be distributed, while maintaining operating capacity intact.
**Physical Capital Maintenance Approach - Current Cost Accounting
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For example, assume that an entity acquired 150 items of inventory at a cost of $10 each (1500$) and sold 100 of the items for $15 each when the replacement cost to the entity had risen to $12 each. Assume also that the replacement cost of the 50 remaining items of inventory at year end was $14. Under the Edwards and Bell approach, the operating profit that would be available for dividends would be $300, which is 100 × ($15 – $12). There would be a realised holding gain on the goods that were sold, which would amount to 100 × ($12 – $10), or $200, and there would be an unrealised holding gain in relation to closing inventory of 50 × ($14 – $10), or $200. Neither the realised nor the unrealised holding gain would be considered to be available for dividend distribution
Conclusion: Neither the realised- nor the unrealised holding gain would be considered to be available for dividend distribution. In coherence with the physical capital maintenance perspective: a profit is only earned if the organisations productive or operating capacity at the end of the reporting period exceeds the capacity at the beginning of the period, excluding any contributions, from, or distributions to, owners. However, holding gains will be recognized as business profit on income statement but not as operating profit. If a Financial capital maintenance perspective was adopted the realised and unrealised holding gains would be recognized as profit.
**Key principles of Physical Capital Maintenance Perspective on Current value - entry price (replacement cost) **
The goal is to ensure that the physical productive capacity of the business is intact or improved before any profits are recognized.
Only excess over replacement costs (realized gains) can be recognized as profit.
Unrealized and realized gains are treated cautiously to avoid overstating operating income (EBIT), as they do not represent resources available for maintaining operational capacity.
Pros of Current value - entry price (replacement costs)
Pros Physical Capital Maintenance
Ensures that profit is only recognized after maintaining the entity’s ability to replace physical assets, securing long-term operational capacity.
Excludes unrealized and realised holding gains from operating profit (EBIT), preventing the distribution of funds needed for maintaining physical capital.
Cons of Physical Maintenance
Unrealized and realized holding gains are not treated as operating profit, which may not reflect the full economic reality of asset appreciation.
Profit may appear understated because it prioritizes operational continuity over financial outcomes.
**Pros Financial Capital Maintenance
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Includes both realized and unrealized holding gains as part of profit that can be distributed to shareholders, providing a broader view of financial performance.
Reflects changes in asset values, aligning with shareholder expectations and financial reporting standards.
Cons Financial Capital Maintenance
In periods of high inflation, financial capital maintenance may boost operational profits while operational capacity is differently affected.
Historical costs
Historical cost, which will be based on prices paid in the past (and which perhaps are not reflective of current costs and therefore can suffer problems pertaining to relevance).
Critics of historical cost accounting suggest that, because historical cost** adopts a capital maintenance perspective which is tied to maintaining financial capital intact**, it tends to overstate profits in periods of rising prices. Historical cost accounting adopts an assumption that the purchasing power of currency remains constant over time.
Another key criticism of historical cost accounting is that it is illogical to add together assets that have beem acquired in different periods when the amounts paid had different purchasing power. This is the “additivity problem”.
Explain fair-value measurement and explain the input hierarchy.
Fair value (exit price) represents 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 (IFRS 13)
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (ie an exit price) regardless of whether that price is directly observable or estimated using another valuation technique (emphasis added). (IFRS 13, paragraph 24).
When fair-value of assets increase (or decrease) some accounting standards require it to be included in profit or loss while some requires gains to go to a measure known as “other comprehensive income”. Both leads to an increase in equity.
To increase consistency and comparability in fair value measurement and related disclosures, this Standard establishes a fair value hierarchy that categorises into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (market value) (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). (IFRS 13, paragraph 76).
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. This perspective of market participant is different to what value the org would attribute an asset.
Mark-to-market = An approach where the value of assets is determined on the basis of observable market values.
Mark-to-model = An approach where the value of assets is determined by the reference to valuation models.
Fair value effect on the economy
Procyclicality
* a rising (declining) economy will give increasing (decreasing) values
* banks lending depends on their capital
* increased (decreased) lending will impact the values more (less)
Use of fair value may lead to a lot of volatility in the statement of financial position (balance sheet). Will also affect profit and loss (or other comprehensive income) in income statement.
Some argue that fair value measurement exacerbated to the financial crisis between 2007-2010. In the same way during times of increasing prises a boom will occur, more lending etc.
Some scholars argue that it did not have such a big effect as investors are well aware of assets underlying value. Thus, historical cost would not change anything.
Lack of active market
The lack of an active market requires a lot of judgement and assumptions which will affect measurement and may decrease its comparability cause of implementation differences. Fair values are seen by some researchers as potential vehicles for manipulating financial reports. Ability is greater compared to historical cost.
Generally
Fair-value goes in accordance with the view that the objective of financial reporting is to provide useful information to investors, lenders and other creditor for resource allocation. Historical cost puts more emphasis on Stewardsship that is to evaluate how the organisation has manage their resources.
Some scholars argue that the demise of Enron was much due to the fraud through creative accounting within fair-value measurement. They extensively used mark-to-model measurement of assets.
“A study of the Enron hearings of 2001-2002 shows that regulators, stadard-setters, professionals, and most commentators, in general, either did not understand sufficiently the consequences of FVA and how it was prone to manipulation, or, if they did understand it, chose to remain silent.”
