Lecture 3 - Measurement Flashcards
4 reasons for historic cost
PSRC
Predictive ability:
- Past transactions are important to predict future cash flows:
- Assume past performance is indicative of true performance.
Stewardship
- Past transactions and events are important for stewardship to keep management accountable.
Reliable and verifiable:
- Was an actual transaction.
- Not subject to opportunistic behaviour
Confirmatory value:
- Basis for forecasts ability to confirm accuracy of forecasts
- Disciplines (compare actual vs forecasts)
4 reasons against historic cost
MARR
Matching:
- Matching current period revenues against historic operating costs if matched incorrectly = profit is uninformative.
- In times of rising prices can overstate profits
• Distribution of profits (dividends) erosion of operating capacity.
Revenue recognition lag:
- We must wait until a transaction with an external company occurs.
e.g. Oil well, discovers oil cannot record revenue until actual extracted.
Current value of Assets or Liabilities:
- Balance sheet is a record of unallocated costs
- e.g. net amount of PPE future cost of depreciation to generate economic return.
Rising prices holding gains:
- Sell asset – becomes realised gain.
Aggregation of different measurement units:
- Currency unites are different at each point in time (inflation)
- E.g. asset bought in 2006 and 1991, the resource would be the same, but bought at different times.
Reduce comparability
Additivity problem adding together assets bought at different times.
What is the additivity problem?
Adding together non-current assets purchased in different periods is like adding different currencies together.
Not decision useful.
What is fair value?
Why is it called exit pricing?
The price that would be received to sell an asset, or paid to transfer a liability, in an orderly, arm’s length transaction between market participants.
- Market based measurements.
• Not the value generated through the unique use of an asset in a specific business.
Why is fair value helpful?
Fair value helps:
- Provide information in relation to new opportunities (i.e. the funds available to a corporate manager for an alternative investment strategy)
• Capacity to adapt (liquidate) – opportunity cost
Profit now because an expansion in the ability of the firm to adapt to new contemporary conditions.
- Adaptive capital: total exit values reflect what an entity can invest in alternate investment opportunities.
- Alternate opportunities: profit is the amount that can be distributed, while maintaining the entity’s adaptive ability.
4 arguments for FV
ROCF
Relevance:
- More relevant information for forecasting (more current).
Opportunity Cost:
- Fair value in the balance sheet demonstrates firms OC from selling the asset and using in an alternate investment.
Comparability, Consistency and Additivity:
- Market based measure
Free of Cost allocation decisions
- E.g. depreciation error in straight line. (do we use depreciation in FV)
4 arguments against FV
REVS
Valuation:
- Valuation uses value-in-use (prospective future cash flows), not value-in-exchange.
- Value derived from synergy with other assets.
Reliability:
- When market is not available, or active market.
Excess income volatility:
- Not caused by firm.
Stewardship:
- Lays greater emphasis on past, rather than prospective.
- However, can also demonstrate how monies spent have increased in value.
What is Value-in-use?
- Present value of future cash flows (continued use of the asset + its disposal)
- Unique to the entity’s situation.
- Use for impairment testing.
- Use comes from impairment testing
• E.g. recoverable amount = the higher of its FV – Cost of disposal and its value in use.
1 argument for VIU
Valuation:
- Predictive value – future cash flows
2 arguments against VIU
Standards:
- On the basis on individual assets
- Value of firm is derived based on synergies use in combination.
- Value may include synergies with another asset.
Complex and unreliable.
What are the 3 measurement errors?
- Biased Measurement error:
a. Systemic – GAAP rules and standards
b. E.g. Omission of internally generated intangibles - Random Estimation errors:
a. Incomplete knowledge of the future (or lack of perfect foresight)
b. E.g. provision of doubtful debts or useful life of an asset. - Biased Measurement errors:
a. Use of standards
b. Intentionally misrepresenting accounting estimates.
How are accurals and provisions subject to random error and bias?
- Annual leave or long service leave estimates
* Bad debt baths
How are Inventory and COGS and provisions subject to random error and bias?
- Whether costs should be capitalised or classified as regular period expenses.
• E.g. allocating depreciation (HC does not reflect current costs) - Allocating fixed costs
• Absorption costing
• Managers will overproduce to spread this cost over a larger base of units.
i. Overhead stored in balance sheet not in P&L - Fixed (and variable) mfg overhead used to produce both products A and B, determination on how to allocate these costs can produce errors or systematic bias.
• Remain on balance sheet until sold
What error does FIFO create compared to weighted average cost?
In periods of increasing stock cost –> FIFO will yield a higher gross profit because lower cost inventories are matched against sales revenue.
Measurement errors in PPE and Depreciation
Old plant trap:
- older assets have a smaller equity base, due to contra asset, but continues to generate the same economic benefit.
Overstated ROE
