Week 3 Notes: Measurement Issues and the Conceptual framework

Measurement

Financial information should both be useful and representational

Use for decision = decision useful + stewardship (stewardship is demonstrating as how resources are
used)

- Measuring all assets at fair value is the direction that IASB is heading
- However historical cost may better represent stewardship hence the measurement strategies
must be balanced.
- Demonstrating how money is spent and assets change value is a key aspect of stewardship so
both historical cost and fair value have merit

There are alternative measurement methods within the standards (mixed measurement methods)

- Historical cost
- Fair value

The choice is determined upon

- Value/flow rating
- Confidence: how confident can we be in the alternative measurement of value
- Comparability between similar assets
- Understandability: can users easily understand the information
- Cost/benefit assessment: how much do alternative measurements cost and how much
benefit is derived from them

Limitation to historic cost

- Historic cost Assumes money can hold a constant purchasing power

- Money does not hold a constant purchasing power undermining the assumption of historic
cost
- Money changes in value due to inflation, changes of exchange rate and changes in price level
of assets
- Changes due to inflation, changes of exchange rate
- Holding gains
- Profit overstatement can occur in times of rising prices as current years operating results are
distorted
- Yet there is some support still for historical cost as it is simple and people seem to stick to
what they know
- Rising prices really determine and change what cost base should be used for measurement

Criticisms of Historic cost model

- The historic cost model assumes money holds constant purchasing power and also negates
any holding gains from acquiring assets that rise in value
- Money does not hold constant purchasing power due to inflation and changes in exchange
rate
- In times of rising prices adding together figures of assets that are purchased at different
times the figure of historic cost assets can become quite meaningless like adding together
different currencies for a total currency figure.
 - Historic cost model (in times of rising prices which is generally always) can lead to assets
being understated in value. This could lead to owners selling an entity for less than its fair
value
- As depreciation is used as an expense, this is understated when assets rise in value and are
recorded at historic cost (as value is not fair value).
- If depreciation is understated, costs are understated, which means profit is overstated.
- As dividends are paid out of profits this can erode the true value/operating capacity of the
firm as not enough has been retained to actually replace certain asset.
- With historic cost accounting holding gains are only realised when the asset is disposed of,
hence distorting profit figures. The profit figures are overstated in the year that the asset is
disposed of and understated in the other years it is held (assuming a rise in value)

Relationship between measurement method for assets and objective for general-purpose financial
reporting

- The general purpose of financial reporting is to provide financial information that is both
useful, relevant, comparable and reliable for financial decision making
- The way the assets values is measured has a huge impact of how this information is
composed and how useful it is
- The measurement method be it historic cost, fair value or a combination of both has a
massive impact on how true this financial information is
- Determining how an asset or liability is measured should be linked to the objective of general
purpose financial reporting
- According to chapter 1 AASB the conceptual framework for financial reporting is:
o To provide financial information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making decisions relating to
providing resources to the entity, those decisions involve buying, selling or holding
equity and debt instruments
o The above is often referred to as decision usefulness perspective
- Decision usefulness criteria is considered to be satisfied if it can answer questions on how to
allocate scare resources
- Stewardship is the other criteria of general purpose financial reporting, it refers to how a
manager is said to have demonstrated the useful allocation of resources to acquire assets,
this is one of the key roles of historic cost accounting
- For information to be decision useful it should be both relevant and representationally
faithful, allowing informed financial decisions to be made from available sources
- Accounting is moving towards fair value accounting as the IASB as it believes this will provide
information that is more relevant and representationally faithful to users
- If the prime role of financial reporting was stewardship then there is some argument that
historic cost provides a clearer picture on this, but the counter is that interested parties
would want to know how much was spent originally then how the assets have changed in
value since then.

Rising Prices and changing market conditions

- In times of rising prices, as assets are acquired at different times, the added together sum or
net book value of assets understates the true value of the assets when using historic cost
accounting, making the sum rather meaningless on paper
 - Income is defined as the maximum amount that can be consumed during the period that
allows us to be as well off at the start as we are at the end of the period
- There are a few alternate measurement methods that have been proposed
- CPPA: current purchasing power accounting
o Developed by sweeny
o Restates historic cost accounts using indices
o Adjustment at the end of the period
o Monetary assets and non-monetary assets are considered separately
o Strengths:
o Weaknesses: May be confusing to use,
- CCA: Current cost accounting
o Based on actual valuations
o There are actual gains and holding gains under this model
o Depreciation of non-current assets are based on replacement costs
o Strengths: there are differentiations between operating profit and holding gains,
gives more enhanced comparability
o Weaknesses: replacement costs may not be the same for all firms, replacement cost
is not that accurate
- CoCoA
o Based on valuing assets on current cash equivalents
o Strengths: valuing all assets at existing value makes the assets value additive
o Weaknesses: would be a massive shift in accounting policy, how relevant are exit
prices if we do not intend to sell the asset?
- FVA: Fair Value Accounting
o Strengths: It is more relevant than historic cost
o Weaknesses: more subjective if there is no current market for an asset

Conceptual framework Building blocks: Reporting entities, users, objectives, qualitative

characteristics and element definition

There is a practical tool that assists in the development of standards (building blocks 1)

- Assists preparers to develop consistent accounting policies

- Helps others interpret and understand standards

We have:

- General purpose financial statements: meet the information needs of common users (users
who cannot command the production of special purpose financial statements).
- Reporting entities: boundary is determined by the users information needs
- Users: primarily there are present and potential investors & creditors.

Then we have objectives of financial reporting

- Decision usefulness
- Stewardship

We also have qualitative characteristics

- Fundamental (relevant and faithfully representative)

 - Enhancing (comparable, verifiable, timely & understandable)

Furthermore, there are elements definitions

- Assets
- Liabilities
- Expenses
- Income
- Equity

Conceptual framework building blocks: Recognition and Measurement

Recognition criteria are included to determine if an item can be included in a financial statement

Measurement: the process of determining the amount to be included in the financial statement

- Two categories of measurement bases have been determined to be useful, historic cost and
current value (can include fair value, value in use, performance value)

Why is there a conceptual framework?

- The conceptual framework allows people developing accounting standards to agree upon
some key issues such as:
o What is the objective of general purpose financial accounting?
o What are the qualitative characteristics of information produced desired?
o How do we define, recognise and measure elements of that system in a consistent
way?

What does the conceptual framework act as?

- The conceptual framework acts as building blocks for a logical system of accounting.

What are these building blocks?

- We need consensus on the definition of the objective of general purpose financial

accounting, reporting entities and users
- Once we have defined the objective of financial reporting we can start thinking about
qualitative characteristics and define them

What occurs without a conceptual framework?

- Inconsistent financial information appears to be what was produced in many countries

before the introduction of the conceptual framework (building blocks) of financial accounting
standards)
- There was great inconsistency between various standards in how the implied definitions of
the elements were applied and how they were measured.

What are the two main qualitative characteristics that financial information should possess?

- The two main qualitative characteristics that financial information should possess are:
o Relevance &
o Faithfully representational
- If an item is not relevant to financial decision making then there is no point including it in
financial statements as it has no impact on decision making
 - If an item is not representationally faithful then the information that is presented is
misleading and can lead to different decision making than would have otherwise occurred.
- No one attribute is more important than the other as both must be considered at the same
time to get useful financial information

Why do accounting standards setters often experience resistance to major changes to existing
practices?

- People familiar with existing standards are used to them, normally through bias towards
what they are used to they will think that the old ways are better as they know them. They
will also be sceptical if the costs of implementing the changes will be beneficial enough to
justify implementing them.

Socio-political Issues:

Who benefits from the financial accounting framework?

- Users of financial information

- Society as a whole (