Topic 4 - Measurement and Disclosure Flashcards
What is the common perception of accounting?
that the numbers in financial statements are ‘exact’, ‘accurate’, ‘objective’
where is there Choice in Accounting? (2)
- Nature of measurement:
a) The process
b) The desired goal
c) Trade-off of relevance and reliability, etc
Incentives: The story in financial statements matters:
a) people act on the information
b) Economic consequences
Why do we measure? (5)
- to convey info
- to represent reality
- to allow us to compare different objects over different times and locations using a common attribute
- facilitate decision making
- allow precision
Why do accountants measure? (4)
- to assess financial position
- compare performance over time
- compare between entities
- info for decisions
List two reasons why measurement may not be objective?
- value judgements in measurement
- purpose/objective-goals differ across user and preparer groups, so will the ‘desired’ accounting measurement system
four Key components of measurement process/ how subjectivity is incorporated into accounting numbers?
i. Specifying the property/attribute to measure
ii. Measuring according to rules and an appropriate scale
iii. The temporal dimension of measurement and the need to measure a common characteristic if individual measures are to be added; and
iv. Are numbers assigned systematically with reference to the facts?
How were items traditionally measured? which type of measurement is now preferred?
- historical financial based properties (cost)
- Current or future cash flows/profits
What are 4 issues in regards to ‘Measuring according to rules and an appropriate scale”?
- accounting rules can change
- lack of a complete conceptual framework
- weak guidance on measurement
- which measurement scale should be used (historical, purchasing power, replacement cost)
What is meant by “Temporal Dimension of Measurement & the Need for ‘Additive’ Accounting Numbers”? why is it important that this be considered?
time value of money makes measurement less objective ie historical costs do not reflect purchasing power accurately.
measurement should be comparable over time and space
List 3 issues with “Objective Assignment of Numbers”?
- values may not be empirically verifiable (e.g., depreciation)
- relate to uncertain future events
- Basis for ‘earnings management’ eg Enron
as a summary what are accounting numbers based on that make them not exact?
Accounting numbers are the result of judgement, estimation, and political processes. slide 19
what are Accounting numbers the result of? why is this dangerous?
judgemental, estimation, and political processes
Danger that users are over-confident in the apparent ‘objectivity’ of financial statements
what is the notion of capital maintenance, with regards to income?
income is the surplus after capital has been maintained
any excess in wealth beyond opening amount can then be distributed as “profit”
what are 5 alternative measurement bases?
- Historical Cost
- Current cost / Replacement Costs
- Realisable value/current selling cost (also Net Market Value)
- Present Value
- Fair Value
what are the 3 categories for historical cost?
- Pure Historical Cost
- Historical Cost with ad hoc adjustments
- Historical Cost adjusted for changes in purchasing power
what are four things to consider with
Historical Cost vs some form of Current Value Measurement System?
- Trade-off between relevance and reliability
- Cost versus benefits?
- Impact of volatility on reported profits
- Role of management intentions – e.g., is asset to be held to end of its life?
for Financial Capital -Contributed Capital what is the Objective of Capital Maintenance and the Measurement System?
Maintaining original equity contribution
Historical Costs
for Financial Capital- Purchasing Power what is the Objective of Capital Maintenance and the Measurement System?
Maintaining buying power of opening net assets
Historical Costs adjusted for changes in inflation
for Financial Capital- Cash & Cash Equivalents what is the Objective of Capital Maintenance and the Measurement System?
Maintaining opening level of adaptive ability
realisable value
for Physical Capital -Operating Capacity what is the Objective of Capital Maintenance and the Measurement System?
Maintaining opening operating capacity
Current Replacement Costs
- Golden Chains Ltd starts business with capital investment of 4 gold bracelets, each costing $250
- Sells 4 bracelets for $400 each at the end of the year
- At the end of the year, replacement cost is $300 per bracelet
- How much profit can Golden Chains Ltd distribute to its shareholders if it wants to maintain financial capital - purchasing power?
Income - historical cost
400x4 - 250x4 = $600
- Can distribute $600 and will still have $1,000 left
- Capital is maintained because Golden Chains Ltd has $1,000 in capital at end of year, same nominal amount of money as at the beginning of the year
- Golden Chains Ltd starts business with capital investment of 4 gold bracelets, each costing $250
- Sells 4 bracelets for $400 each at the end of the year
- At the end of the year, replacement cost is $300 per bracelet
- How much profit can Golden Chains Ltd distribute to its shareholders if it wants to maintain physical capital?
income - current cost
400x4 - 300x4 = $400
Can distribute $400 and will still have $1,200 left
Capital is maintained because Golden Chains Ltd has enough money to maintain operating capacity of 4 gold bracelets
In times of inflation, which measurement systems will tend to report lower profits than historical cost?
some current value
replacement cost system – profit will be lower than historical cost because cost of goods sold must be restated to current replacement costs
what are key limitations of Measurement
& Decision Making?
Objectivity of estimates may be overstated
The view that because measurement is ‘scientific’ it’s better to measure than not measure BUT what are at least two dangers for decision making?
• Anything can be “proven” by statistics,
e.g., “ethics pays because firms with more integrity have higher stock returns” (correlation not causality)
• Financial cost-benefit analysis can ignore other important decision criteria
– How people would feel about the loss of a heritage building
– Effect on current and future generations
– Time saved in reduced distance to travel to airport
what are two way to measure fair value?
– Observed market value
– Estimate using a model
• Disclosure of how we estimate fair value, assumptions, parameters
why is fair value considered Highly controversial? 5
– Valuation issues – Decision usefulness issues – Profit/balance sheet volatility issues – Economic impact – Accountability issues – Perceived ‘social’ costs
Highest and best use is the use of an asset by market participants that maximises the value of the asset – Physically possible – Legally permissible – Financially feasible what are two problems with this?
- Highest and best use is usually (but not always) the current use
- The highest and best use concept does not apply to financial instruments or liabilities but it does apply to other assets, e.g., land
The current AASB 141 (biological assets) doesn’t draw on the capital/profit distinction and treats all sources of change in value as impacting what?
profit
What if no “active market”?
– Estimate fair value
– Alternatives include: most recent market
transaction price; market prices for similar assets; industry benchmarks; present values
for biological assets, What if unable to measure FV reliably?
– cost – accumulated depreciation and impairment (AASB 141, para. 30)
what Disclosures must be made in regards to FV? why?
include information on “methods and significant assumptions” used to determine fair value
Assists users to assess risk and level of sensitivity in reported fair values
what is considered an active market?
Frequency and volume of transactions
provide ongoing pricing information
what are 2 problems with Relying on Market Value ?
overpriced- over optimistic
underpriced - intrinsic value worth more
Somearguethatamodelprovidesa better measure of intrinsic value if financial markets are currently inactive, i.e., illiquid and transactions, disorderly, what is the main problems with this?
- i.e., assumptions of active market (level 1 of hierarchy) not met
- Observed price might not be based on an orderly transaction
If the transaction is orderly (i.e., not a forced sale), what are the implications for the price of the seller?
– Does not need to liquidate;
– Isn’t desperate enough to undertake a transaction on adverse terms;
– Isn’t forced to sell
to solve problems, what should you do when a market is inactive?
- question if the transaction is orderly?
if yes then use quoted price
if no use model to measure fair value; i.e. 3 level inputs
Which one of the following statements about the mixed measurement model adopted by standard-setters is correct?
(A) It avoids the additivity problem in the balance sheet.
(B) It reflects the lack of guidance on measurement in the Conceptual Framework.
(C) It assumes that a single measurement base is relevant in diverse contexts.
(D) It enhances the comparability of financial statements.
(B) It reflects the lack of guidance on measurement in the Conceptual Framework.
