accounting measurement

LECTURE 5 & 6

MEASUREMENT IN ACCOUNTING

MEASUREMENT THEORY

ARTHIK DAVIANTI, SE. MSI. AK. CA.

IMPORTANCE OF MEASUREMENT

Campbell:

The assignment of numerals to represent properties of material systems other than numbers

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Assignment of numerals to objects or events

according to rules. (Stevens)

Involves linking the formal number system to some property of objects or events by means of semantic rules e.g. semantic rules in accounting are

represented by transactions

In accounting we measure profit by: first assigning a value to capital

then calculating profit as the change in capital over the period

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IMPORTANCE OF MEASUREMENT

SCALES

Every measurement is made on a scale

Created when a semantic rule is used to relate the mathematical statement to objects or events

The scale shows what information the numbers represent

Scales: nominal, ordinal, interval and ratio

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NOMINAL SCALE

In this scale, numbers used only as labels

Numbers represent classification

e.g. numbering footballers

e.g. the classification of assets and liabilities into different classes

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ORDINAL SCALE

In this scale, rank orders objects with respect to a given property e.g. tallest to shortest person

e.g. investment alternatives that are ranked 1, 2, 3 according to the size of their net present values

Intervals between the numbers are not necessarily equal

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INTERVAL SCALE

In this scale, rank orders objects with respect to a given property

The distance between each interval is equal and known

An arbitrarily selected zero point exists on the scale e.g. celsius temperature scale e.g. standard cost accounting

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RATIO SCALE

In this scale, rank orders objects with respect to a given property

Intervals between objects are known and equal

A unique origin exists e.g. measurement of length e.g. use of dollars to measure assets

and liabilities

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PERMISSIBLE OPERATIONS OF SCALES

Invariance of a scale means that the measurement system will provide the same general form of the variables, and the decision maker will make the same decisions

This is not the case in accounting – there is more than one accounting system

The information they provide will differ and different decisions will be made

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PERMISSIBLE OPERATIONS OF SCALES

Nominal and ordinal scales no arithmetic operations

Interval scale addition and subtraction

Ratio scale all arithmetic operations

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TYPES OF MEASUREMENT

There must be a rule to assign numbers before there can be measurement

The formulation of the rules gives rise to a scale

Measurement can be made only on a scale

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FUNDAMENTAL MEASUREMENTS

Numbers are assigned by reference to natural laws

Fundamental properties are additive e.g. length, number and volume

In accounting there is considerable debate over the nature of fundamental value

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DERIVED MEASUREMENTS

Is one that depends on the measurement of two or more other quantities

Depends on known relationships to fundamental properties e.g. the measurement of density depends

on the measurement of both mass and volume

e.g. the measurement of profit depends on the measurement of both income and expenses

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FIAT MEASUREMENTS

Typical in social sciences including accounting

Based on arbitrary definitions - e.g. of profit

Numerous ways in which scales can be constructed

May lead to poor levels of confidence in the scale – e.g. there are hundreds of ways to measure profit

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RELIABILITY AND ACCURACY

No measurement is free of error except counting e.g. we can count the chairs in a room

and be exactly correct

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SOURCES OF ERROR

The sources of error include the following:

Measurement operations stated imprecisely

Measurer

Instrument

Environment

Attribute unclear

Risk and uncertainty

We need to establish limits of acceptable error

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RELIABLE MEASUREMENT

What is reliable measurement? proven consistency repeatable or reproducible precision

Reliability incorporates two aspects accuracy and certainty of

measurement representative faithfulness

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ACCURATE MEASUREMENT

Consistency of results, precision and reliability do not necessarily lead to accuracy

Accuracy has to do with how close the measurement is to the ‘true value’ of the attribute measure - representation

‘True value’ may not be known

e.g. in accounting accuracy relates to the pragmatic notion of usefulness

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ACCURATE MEASUREMENT

Many accounting measurements are on a ratio scale

This is the most informative scale

Weakest theoretical foundation as they are fiat measurements

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Two fundamental measures capital & profit

Capital and profit can be defined & derived in various ways

Concepts of capital & profit have changed over time number of concepts of fundamental

measurement

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Two notable developments in international standards (2005, IASB) profit measurement and revenue

recognition should be linked to timely recognition

the fair value approach should be adopted as the working measurement principle

At no stage has the principle of capital maintenance been explicitly discussed

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MEASUREMENT ISSUES FOR AUDITORS

The focus of profit measurement has shifted from matching revenues and expenses to assessing the changes in the fair value of net assets e.g. immediate recognition of

impairment losses

Auditors must determine whether management has made appropriate and reasonable valuationse.g. at least 12 methods of valuing intangibles

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MEASUREMENT ISSUES FOR AUDITORS

It is possible for several different but reasonable measurements and impairment losses to be recognised by management

These would all be acceptable to an auditor if management have applied the valuation models correctly

used appropriate data

made appropriate assumptions

acted in a consistent manner24

ACCOUNTING MEASUREMENT SYSTEM

THREE MAIN INCOME AND CAPITAL MEASUREMENT SYSTEMS

The historic cost accounting system emerged after the 1929 Wall Street collapse

In the 1960s several alternatives were developed

current cost accounting

financial capital maintenance (the purchasing power of the financial capital)

physical capital maintenance (the physical ability to produce goods and services)

exit price accounting

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HISTORIC COST ACCOUNTING

Separation of ownership and control information asymmetry

Most critical objective of accounting is accountability - stewardship (conservatism)

The income statement is paramount transaction based

revenue recognition

matching

profit measurement27

ARGUMENTS FOR HISTORIC COST ACCOUNTINGRelevant in making economic decisions

Based on actual, not merely possible, transactions

Data have been found to be useful

The best understood concept of profit

Must guard data against internal modifications

Profit based on alternatives may not be useful

Market prices can be supplementary data

Insufficient evidence to reject it

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CRITICISMS: OBJECTIVE OF ACCOUNTING

Stewardship is only a secondary objective

Providing the decision making needs of users is the primary objective and historic cost data is a failure in this regard

Historic cost information is not objective

can be easily manipulated

does not maintain the entity’s capital

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CRITICISMS: INFORMATION FOR DECISION MAKING

Is irrelevant when evaluating past decisions

After acquisition, historic cost data is fictional

Connected to inconsequential measures of capital

Produces only flawed measures of profit

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CRITICISMS: BASIS OF HISTORIC COST

The going concern assumption does not justify the use of historic cost accounting many businesses fail

no businesses continue indefinitely doing only or at all what they are presently doing

all businesses, except those presently existing, cease operations

All businesses have alternatives and choices going forward

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CRITICISMS: MATCHING

Is a practical impossibility

Is totally arbitrary

The balance sheet is important

Resulted in non-assets being classified as assets and non-liabilities being classified as liabilities

Leads to volatility and smoothing

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CRITICISMS: NOTIONS OF INVESTOR NEEDS

Distorts and conceals

Its goals are ill-conceived

Creative accounting is commonplace

Incentives to produce misleading data

Today, investors pay little attention to historic cost accounting data about a firm

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OBJECTIVE OF CURRENT COST ACCOUNTING

CCA values assets at their current market buying price and profit is determined using matching expense allocations based on the current cost to buy

Profit is more precisely defined as the change in capital over the accounting period

Managers are better able to evaluate their past decisions and better use the firm’s resources to maximise future profits

Shareholders, investors and others are able to make better allocations of their resources

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OBJECTIVE OF CURRENT COST ACCOUNTING

Managers will examine the current operating profit

the excess of the current value of the output sold over the current cost of the related inputs

realisable cost savings

increases in the current cost of assets held

holding gains/losses

realised/unrealised

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FINANCIAL CAPITAL VERSUS PHYSICAL CAPITAL

Profit is the change in capital

Holding gains are included in profit under financial capital

Holding gains are excluded from profit under physical capital

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ARGUMENTS FOR AND AGAINST CURRENT COST

Recognition principle violates the conservatism principle - but

actual phenomena

are holding gains profits or revaluation adjustments?

Objectivity of current cost lacks objectivity

Technological change appears to ignore technological advances

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MORE SPECIFIC CRITICISMS

Advocates of historic cost accounting violates the realisation principle; subjectivity of increase

Comparisons of the results with historic cost industry variations

Advocates of exit price the logical expression of opportunity cost is the current selling price

the arbitrary allocation of expenses is still a problem issue

additivity problem exists

number of reasons for an asset having value to a business

irrelevant to most business decisions

physical capital concept fraught with weaknesses

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EXIT PRICE ACCOUNTING

Exit price = selling price = fair market value

Has two major departures from historic cost accounting:

the values of non-monetary assets are selling prices and any changes are included in profit as unrealised gains

changes in the general purchasing power of money affect both financial capital and profits

Represents clean surplus accounting

The income statement explains all of the differences existing between the opening and closing balance sheets

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OBJECTIVE OF ACCOUNTING

Objective = data for adaptive decision making

The assumption is that the business world is dynamic and business must adapt to survive

Firms and those associated with them go into markets to take advantage of opportunities as they arise

The ability to engage in market transactions is revealed by net financial position (net current market value)

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OBJECTIVE OF ACCOUNTING

Ultimately all accounting information users are interested in cash and cash equivalent values

In the final analysis, the economic survival and performance of a firm depends on the amount of cash it can command

Chambers:

…the single financial property which is uniformly relevant at a point of time for all possible future actions in markets is the market selling price or realisable price of any or all goods held.

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ARGUMENTS FOR EXIT PRICE ACCOUNTING

Provides useful information

Provides relevant and reliable information there is one way to determine profit that is

superior to all others

profit is the difference between capital at two points in time exclusive of additional investments by and distributions to owners

to be relevant, information must be useful in the decision models of accounting data users

the present selling price is the only item of information that is relevant to all decisions

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Additivity

if we use different measurement systems then no practical or commercial meaning can be deduced from the aggregate

even if we use historic cost accounting as the sole measurement system, the jumble of historic costs on different dates means we cannot put any meaning on the calculation of net assets or profit

exit price accounting does not have this problem

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Allocation the financial statements are allocation

free

Reality references are to the real-world in that

every disclosed amount refers to a present, actual market price

exchangeability

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Objectivity market prices are relatively more

objective than most believe

A measure of risk can indicate the financial risk of

purchasing an asset

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ARGUMENTS AGAINST EXIT PRICE ACCOUNTING

Profit concept

does not provide a meaningful concept of profit

the critical event does not relate to the performance of the firm

does not produce realistic financial reports

Additivity

violates the principle of exclusion of anticipatory calculation that it claims to reject

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ARGUMENTS AGAINST EXIT PRICE ACCOUNTING

The valuation of liabilities

valuing liabilities at face value and not market value is internally inconsistent

Current cost or exit price

at what stage of the operating cycle should exit price dominate asset valuation?

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VALUE IN USE VERSUS VALUE IN EXCHANGE

Similar when markets are liquid and efficient

There are factors common to both

market prices are more relevant for decision making

additivity and reliability are prime requirements

historic cost accounting has too many defects

They are complements not substitutes

Value in use assesses long term survival (solvency), value in exchange assesses the ability to adapt in the short term (liquidity)

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A GLOBAL PERSPECTIVE AND INTERNATIONAL FINANCIAL REPORTING STANDARDS

Current cost in the United Statesan experiment but abandoned (1976 -1984)

Current cost in the United Kingdom implemented but abandoned (1975 – 1985)

Current cost in Australia recommended but abandoned (1976 – 1980’s)

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INTERNATIONAL ACCOUNTING STANDARDS AND CURRENT COSTS

IASB/FASB have agreed that fair value is the best measurement basis (2004) the amount for which an asset could

be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction

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INTERNATIONAL ACCOUNTING STANDARDS AND CURRENT COSTSHistoric cost accounting still generally applied

Distinct movement toward current value systems

IASB moving toward exit prices (2004)

But still a mixed valuation approach

Fair value means – current market entry price, current market selling price, historic cost and discounted future cash flows

There is no mention in the standards of capital maintenance concepts

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HISTORIC COST

Subjectivity is involved in the determination of the acquisition cost of an item

Thereafter the measurements are even more subjective

The era of historic cost accounting has ‘ended’ it produces irrelevant, unreliable, non-

comparable and non-understandable data

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A MIXED MEASUREMENT SYSTEM AND INTERNATIONAL STANDARDS

Market values - exit prices - are implied in the ‘fair value’ approach in international financial reporting standards

A lack of a theoretical concept of valuation, capital maintenance and profit measure, has resulted in a still mixed measurement system and a lack of consistency

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ISSUES FOR AUDITORS

The mixed measurement model creates misstatement so that auditors struggle to meet one of their primary objectives determining whether the financial

statements present a true and fair view

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accounting measurement

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