Topic 4 Tutorial sach Flashcards
(9 cards)
5.1 What does ‘measurement’ mean from an accounting perpective?
5.1 What does ‘measurement’ mean from an accounting perpective?
According to paragraph 4.54 of the IASB Conceptual Framework for Financial Reporting, from an accounting perspective:
Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.
Measurement allows us to attribute numbers to the items that appear in financial reports.
5.6 Why do you think that corporate management might prefer to be allowed to use historical costs rather than being required to value assets on the basis of current values?
5.6 Why do you think that corporate management might prefer to be allowed to use historical costs rather than being required to value assets on the basis of current values?
The answer to this question depends upon whether we assume that managers are motivated by efficiency considerations or whether they are motivated by opportunistic considerations.
From an efficiency perspective, managers might consider that historical cost provides a more objective measure of the value of an item and this is preferable in terms of demonstrating proper stewardship over the resources contributed to an organisation. They might also consider that other bases of measurement—such as market values—provide less relevant or reliable information. For example, perhaps they operate in an industry that has high volatility in asset values and they may consider that if assets were valued on the basis of fluctuating market values then this might create confusion in the minds of the financial statement readers.
From an opportunistic perspective managers might prefer to retain the use of historical cost accounting as it can allow them to manipulate profit by determining when to sell an asset that has appreciated in value—with such appreciation not being acknowledged until the asset is ultimately sold. The accumulated gain will be fully recognised in the period of the sale. Also, historical cost accounting can lead to higher profits (due to such factors as lower depreciation given that depreciation will be based on the original cost of an asset which could be significantly lower than its current marker value). This attribute of historical cost might be particularly attractive to managers who are paid a bonus tied to reported profits.
5.7 Evaluate the following statement:
Measures such as the lower of cost and net realisable value, which is required for inventory, can perhaps be justified in terms of conservatism but are very difficult to justify in terms of decision usefulnes
5.7 Evaluate the following statement:
Measures such as the lower of cost and net realisable value, which is required for inventory, can perhaps be justified in terms of conservatism but are very difficult to justify in terms of decision usefulnes
The lower of cost and net realisable value rule as applied to accounting for inventory is very conservative. Conservative accounting methods tend to understate net assets and profits relative to less conservative accounting methods. Conservative accounting methods are preferred by some users of financial statements as they tend to restrict the ability of management to exercise their own judgement in terms of valuation, the view being that such judgement might at times be based on opportunistic motivations, rather than being based on objective reasoning.
By contrast, it is generally considered in documents such as the IASB Conceptual Framework for Financial Reporting that users of financial statements are predominantly interested in determining whether they should invest in, or loan funds to, a reporting entity. To determine this, they need information that is ‘useful’ for their decisions. Arguably, information based on current values is more ‘relevant’ than historical cost (although it might not be as ‘reliable’).
There will be a trade-off between allowing management the ability to use judgement to determine current (fair) values, or to restrict their ability to use their own judgement (as would be the case if historical cost was used). There will be advantages and disadvantages to users from either approach.
5.12 Explain the difference between between income derived from the viewpoint of maintaining financial capital (as in historical cost accounting) and income devired from a system of ensuring that physical capital remains intact
5.12 Explain the difference between between income derived from the viewpoint of maintaining financial capital (as in historical cost accounting) and income devired from a system of ensuring that physical capital remains intact
The financial capital maintenance approach adopted within historical cost requires that dividends should only be distributed to the extent that financial capital is not eroded by the dividends. For example, assume that an entity started the year with $200 in assets and $50 in liabilities (that is, net assets or owners’ equity of $150 which we also will assume was contributed by the owners). Also assume that at the end of the year the net assets had increased by $100 to $250
and that no additional capital contributions had been made by the owners throughout the year. To maintain financial capital intact (the approach to capital maintenance adopted within historical cost accounting), $100 can be distributed as dividends. The financial capital maintenance approach adopted within historical cost accounting ignores the fact that the replacement costs of many assets could have changed during the year and that while the financial capital has remained intact, if the entity was required to replace certain assets it may not be able to. That is, its real operating capacity may have decreased. Within historical cost accounting, realised holding gains or losses are treated as part of income. This can be contrasted with other methods of accounting, such as current cost accounting, which treats holding gains as capital adjustments rather than treating them all as part of distributable income.
Under a physical capital maintenance approach to determining income the reporting entity calculates how much income can be distributed yet allow it to retain sufficient funds to replace current assets as required. Under methods of accounting, such as current cost accounting, a measure of profit is determined that represents the maximum amount that can be distributed while maintaining the operating capital intact. Holding gains are not generally considered to be available for dividend distribution.
- 13 In current purchasing power accounting:
(a) why is it necessary to consider monetary assets separtely from non-monetary assets?
5.13 In current purchasing power accounting:
(a) why is it necessary to consider monetary assets separtely from non-monetary assets?
(a) Current purchasing power accounting (CPPA) separately considers monetary items and non-monetary items. Monetary items are those assets and liabilities that remain fixed in terms of their monetary value regardless of changes in the purchasing power of money (the majority of liabilities would be monetary items). Conversely, the monetary equivalent of non-monetary items will be expected to change over time as a result of factors such as inflation. Under current purchasing power accounting, gains and losses are deemed to relate to the holding of monetary items (typically a loss if monetary assets exceeds monetary liabilities, otherwise a gain), but do not arise from holding non-monetary items. Further, in undertaking current purchasing power accounting adjustments are made to the book value of non-monetary items, generally by way of a general price index. The carrying value of monetary items however, is not adjusted. Hence, from this brief description we can see that CPPA treats monetary and non-monetary items differently and hence they must be considered separately.
- 13 In current purchasing power accounting:
(b) Why will holding monetary assets lead to a purchasing power loss, but holding non-monetary assets not lead to a purchasing power loss?
5.13 In current purchasing power accounting:
(b) Why will holding monetary assets lead to a purchasing power loss, but holding non-monetary assets not lead to a purchasing power loss?
(b) The view is that if an entity holds a monetary asset (such as cash) and if there is a general decrease in the purchasing power of money (for example, because of inflation), then that cash will buy less – it will suffer from a purchasing power loss. With non-monetary assets it is assumed that the assets will retain their equivalent purchasing power. For example, if an entity holds land that cost $10 000 and inflation has been recorded at 5 per cent then the adjusted value of the land might be shown as $10 500 and if this land was sold then it is assumed that the cash received would have the same purchasing power. Although the monetary equivalent of the land has increased, no gain or loss would be recognised. By comparison, $10 in cash held now is still worth $10 in cash 2 years later, but its purchasing power would have declined and this reduction in purchasing power would be recognised in determining the entity’s financial performance.
5.15 If Continuously Contemporary Accounting is adopted and an organisation is involved with selling goods, when would the profit from the sale of goods be recognised? How does this compare with historical cost accounting?
5.15 If Continuously Contemporary Accounting is adopted and an organisation is involved with selling goods, when would the profit from the sale of goods be recognised? How does this compare with historical cost accounting?
Under Continuously Contemporary Accounting (CoCoA), the profits associated with selling inventory would be recorded at the time the inventory was purchased with the amount being the difference between the expected retail prices, net of related expenses and the cost to the entity. This can be contrasted to historical cost accounting wherein profits related to a sale would be deferred until such time as the sale had occurred.
5.19 Under what circumstances is fair value likely to provide a ‘ representationally faithful’ measure of the value of an asset?
5.19 Under what circumstances is fair value likely to provide a ‘ representationally faithful’ measure of the value of an asset?
To answer this question we need to firstly define what we mean by ‘representationally faithful’. According to paragraph QC 12 of the IASB Conceptual Framework for Financial Reporting:
To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible.
It would appear that valuations based on fair value will be more ‘representationally faithful’ when they are based on quoted prices in active markets. Such valuations would tend to be more objective and relatively less based on individual judgement. Indeed, where fair value is to be used, this is the IASB’s preferred basis for determining fair value. In this regard the IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 of IFRS 13 states:
To increase consistency and comparability in fair value measurements and related disclosures, this IFRS establishes a fair value hierarchy that categorises into three levels (see paragraphs 76–90) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1, being (paragraph 76 of IFRS 13):
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 of IFRS 13 states:
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. Paragraph 87 of IFRS 13 states:
Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.
So in summary, if fair value is to be used it would generally be accepted that Level 1 inputs to the valuation process would be more representationally faithful that Level 2 or Level 3.
5.25 Despite the efforts of authors such as Chambers, Edwards and Bell, and Sterling, historial cost accounting is still used within financial accounting. Why do you think that historical cost accounting has remained an accepted method of accounting
5.25 Despite the efforts of authors such as Chambers, Edwards and Bell, and Sterling, historial cost accounting is still used within financial accounting. Why do you think that historical cost accounting has remained an accepted method of accounting
This is an interesting issue. Certainly historical cost accounting has been the subject of many critical attacks over the years by many notable scholars—yet it has in large part held its position of dominance (although accounting standards being released in recent years are increasingly requiring the use of market values). Possible reasons could include:
The arguments against historical cost accounting were simply not convincing.
- Users of historical accounting information considered the information to be suitable for their decision-making purposes and did not seek change.
- Various studies of users’ demands for alternative valuations approaches have tended to show that the alternatives have not appeared to generate significant demand.
- Preparers of financial statements were reluctant to change. There could be many reasons for this. Perhaps they considered that the information they were preparing was superior to alternative forms of information and
that it was useful to the financial statement readers. As another alternative, perhaps they had a number of accounting-based contractual arrangements in place with various parties such as lenders, and changing accounting methods might have had negative implications for these agreements, and for the value of the organisation.
- Tied to the above point, major shifts in how financial accounting valuations are undertaken could have major economic and social implications for many different people and this in itself might have meant that the adoption of alternative forms of accounting were unlikely.
- Because historical cost accounting is generally accepted, and because it would take time to learn new methods of valuation, there might be a general reluctance to change.
- Within historical cost accounting holding, gains on assets are not recognised until the time an asset is sold. As such, management might plan to sell particular non-current assets at times when it is suitable to them to record the gains (for example, when other significant losses have occurred and they want to offset the losses). Historical cost accounting gives the management a degree of discretion in terms of when they recognise gains and management might maintain their support for historical cost because they fear losing such discretion. However, it should be appreciated that across time this level of discretion is being eroded as more accounting standards are being released which require the use of fair values for particular assets.
Of course there could be many other reasons why historical cost accounting has maintained its position. However, it should be appreciated that in many countries reporting entities can revalue their assets above cost. Further, in some countries particular industries are required to value their assets other than in accordance with historical cost accounting. For example, in Australia, Accounting Standards require reporting entities in the general insurance industry to value certain assets at net-market value. Superannuation funds are also required to value their assets on the basis of net-market values. Other specific assets, such as investments and agricultural assets, are now also required to be valued at fair values. Hence, there is a gradual shift away from historical cost—but nevertheless many assets can still be recorded on an historical cost basis.
