Deegan fat4e ppt_ch05

5-1Copyright © 2014 McGraw-Hill Education (Australia) Pty Ltd PPTs to accompany Deegan, Financial Accounting Theory 4e

FINANCIAL ACCOUNTING THEORYCraig Deegan

Slides written by Craig Deegan

CHAPTER 5Measurement issues: accounting for the effects of changing prices and changing market conditions


Learning objectives5.1 Understand what ‘measurement’ means, why it is a potentially

controversial issue, and some of the factors that accounting standard-setters might consider when prescribing a particular measurement approach in favour of another.

5.2 Be aware of the various measurement approaches currently, and potentially, in use.

5.3 Be aware of some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices and changing market conditions.

5.4 Be aware of a number of alternative methods of asset valuation that have been developed to address problems associated with changing prices and market conditions, including fair value accounting.


Learning objectives (continued)

5.5 Be able to identify some of the strengths and weaknesses of the various alternative measurement approaches.

5.6 Understand that the calculation of income under a particular method of accounting will depend on the perspective of capital maintenance that has been adopted.

5.7 Be aware of the increasing use of fair value measurement in accounting standards.

5.8 Be aware of evidence about the demand for, and professional support of, alternative measurement approaches.


Measurement• What is it?

• According to paragraph 4.54 of the IASB Conceptual Framework for Financial Reporting:

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 is obviously a very fundamental issue in financial accounting. Measurement allows us to attribute numbers to the items that appear in financial reports


Process of mandating a particular measurement approach could be controversial

• When standard-setters require a particular method of measurement in preference to others, this can be controversial

• it can have profound effects upon financial reports, and therefore also on agreements, or contracts, that utilise numbers from the financial statements


Alternative bases of measurement• There are various bases of measurement that

could be used, including:

– historical cost

– current costs

– realisable value

– present value

– deprival value


Choosing between alternative measurement bases• Determining how an asset or liability should be measured

should ideally be linked to the perceived objectives of general purpose financial reporting

• According to paragraph OB2 of the IASB Conceptual Framework for Financial Reporting, the objective of general purpose financial reporting is:

to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.

• The above perspective is often referred to as a ‘decision usefulness’ perspective


Decision usefulness versus stewardship functions• ‘Decision usefulness’ and ‘stewardship’ are two terms

that are often used in relation to the role of financial information

• The ‘decision usefulness’ criterion is considered to be satisfied if particular information is useful (decision-useful) for making particular decisions, such as decisions about the allocation of scarce resources

• Decision usefulness appears to be the focus of financial reporting currently embraced by the IASB and FASB

• An alternative focus other than ‘decision usefulness’ would be ‘stewardship’


What attributes should financial information have for it to be ‘decision useful’?• According to the IASB Conceptual Framework, to fulfill the

requirement that information is ‘decision useful’, financial information should be both ‘relevant’ and ‘representationally faithful’ and allow financial statement readers to make informed resource allocation decisions

• The IASB and FASB’s ultimate selection of a particular measurement base will supposedly be tied to whether a particular measurement approach enables the above objective of general purpose financial reporting to be satisfied

• The IASB has identified three fundamental principles of measurement that flow from the objective of financial reporting


Three fundamental principles of measurement• As IASB (paragraph 5, 2013b) states:

The following three fundamental principles of measurement are derived from the objectives of financial reporting and the qualitative characteristics of useful financial information as described in Chapters 1 and 3 of the Conceptual Framework.

• Principle 1 The objective of measurement is to represent faithfully the most relevant information about the economic resources of the reporting entity, the claims against the entity, and how efficiently the entity’s management and governing board have discharged their responsibilities to use the entity’s resources

• Principle 2 Although measurement generally starts with an item in the statement of financial position, the relevance of information provided by a particular measurement method also depends on how it affects the statement of comprehensive income and if applicable, the statements of cash flows and of equity and the notes to the financial statements

• Principle 3 The cost of a particular measurement must be justified by the benefits of that information to existing and potential investors, lenders, and other creditors of reporting that information


The use of fair value – good for assessing stewardship?

• Based on the increasing use of fair value in various newly-released accounting standards it appears that the IASB considers that measuring many classes of assets at fair value will provide more relevant and representationally faithful information than measuring all assets at ‘cost’

• However, if by contrast, the primary objective of general purpose financial reporting was considered to be ‘stewardship’, rather than decision usefulness, then there is some argument that historical cost provides a clearer perspective about what management has done with the funds that were entrusted to it

• Demonstrating how funds have been used is a key component of stewardship. However, there is also an argument that in assessing the stewardship of management, interested parties would not only want to know about the original amounts spent by managers, but also about how monies spent have increased in value, and historical cost accounting might be deficient in this respect


Variety of measurement bases frequently used

• To this point we should understand that the accounting standards issued by the IASB, and therefore used within many countries globally, use a variety of measurement bases

– for example, historical cost, fair value, present value

• This has been referred to as a mixed measurement model of accounting

– creates issues associated with additivity


Factors to consider in selecting between alternative measurement approaches• The IASB and the FASB have identified a number of factors that

need consideration before a preferred approach (or a number of approaches) to measurement is selected

• According to the website of the FASB, five factors that might be considered in selecting among alternative measurement bases (such as historical cost versus fair value) are:

– Value/flow weighting and separation The relative importance to users of information about the current value of the asset or liability versus information about the cash flows generated by the item, as well as the ease and precision with which the flows can be separated from the value changes (an indication of relevance)

– Confidence level The level of confidence that can be placed on alternative measurements as representations of the asset or liability being measured (an indication of faithful representation) continued


Factors to consider in selecting measurement approaches (cont.)– The measurement of similar items Items of a similar nature

should be measured in similar ways (an indication of comparability)

– The measurement of items that generate cash flows together Items that generate cash flows as a unit should be measured the same way (an indication of understandability)

– Cost-benefit An assessment of the ratio of the benefits that would be derived from alternative measurements to the costs of preparing those measurements (an indication of the primary limiting factor in financial reporting)

Obviously, as we can see from the above points, selecting the appropriate measurement bases requires many judgments to be made


One measurement option: historical cost• Under historical cost

– assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given, to acquire them at the time of their acquisition

– liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business


Limitations of historical cost in times of rising prices• Historical cost assumes money holds a constant

purchasing power

• Three aspects of the economy which make the assumption less valid than when historical cost was developed

– specific price level changes (shifts in consumer preference; technological advances)

– general price level changes (inflation)

– fluctuation in exchange rates


Limitations of historical cost in times of rising prices (cont.)

• Problem of relevance in times of rising prices

– asset’s current value may be different from historical cost

• Problem of additivity (adding together assets bought at different times)

• Can overstate profits in times of rising prices, with distribution of profits leading to an erosion of operating capacity

• Including holding gains which accrued in previous periods in current year’s income distorts the current year’s operating results


Support for historical cost accounting• Predominant method used for many years so tended

to maintain support of profession

• If not found useful, business entities would have abandoned it

• Nevertheless, recent accounting standards being released have embraced ‘fair values’ as the basis of measurement. However, various assets are still measured on an historical cost basis

– e.g. inventory, which is measured at the lower of cost and net realisable value; property, plant and equipment where the ‘cost model’ and not the ‘fair-value model’ has been adopted; many intangible assets


Definition of income• How we measure assets will be influenced by how we

define income

• Income has been defined as the maximum amount that can be consumed during the period, while still expecting to be as well off at the end of the period as at the beginning of the period (Hicks 1946)

• Consideration of ‘well-offness’ requires the stipulation of a notion of capital maintenance

• Different notions of capital maintenance will provide different perspectives of income

– different notions of ‘capital maintenance’ have implications for how assets are measured


Capital maintenance perspectives

• Financial capital maintenance

– perspective taken in historical cost accounting

– profit earned only if money capital at the end of the period is more than money capital at the beginning of the period

• Purchasing power maintenance

– historical cost accounts adjusted for changes in the purchasing power of the dollar

• Physical operating capital maintenance

– profit earned if operating capacity at the end of the period is greater than the operating capacity at the beginning of the period


Development of accounting for changing prices• Perceived problems associated with historical cost

in times of changing prices lead to different proposals for change away from historical cost

• Research initially related to using price indices to restate historical costs to account for changing prices

• Literature then moved towards current cost accounting

– the basis of measurement changed to current values not historical values


Current purchasing power accounting (CPPA)

• One alternative to historical cost was CPPA

• Also called general purchasing power accounting; general price level accounting; constant dollar accounting

• Based on the view that in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs, in real terms the entity could be distributing part of its capital


Calculating indices

• A price index is used when applying general price level accounting

• A price index is a weighted average of the current prices of goods and services related to a weighted average of prices in a prior period (base period)

– e.g. Australian Consumer Price Index (CPI)

• Can use a general or specific price index


Performing current purchase power adjustments• All adjustments are performed at the end of the

period

• Adjustments are applied to historical cost accounts

• Monetary and non-monetary assets considered separately

– values of monetary assets do not change as a result of inflation

– liabilities generally considered monetary items

continued


Performing current purchase power adjustments (cont.)

• In times of inflation, holders of monetary assets will lose in real terms

– the assets have less purchasing power at the end of the period relative to the beginning of the period

• Holders of monetary liabilities gain, given the amount they have to repay at the end of the period is worth less than at the beginning


Performing current purchase power adjustments (cont.)

• No change in purchasing power arises from holding non-monetary assets

– non-monetary assets are restated to current purchasing power so no gain or loss is recognised

• Purchasing power gains or losses are included in income for the period


Movements in net monetary assets

• Must identify changes in net monetary assets as a result of revenues or expenses

• In times of rising prices there will be a loss in purchasing power of cash received during the year

• More expenses are able to be paid earlier in the year as more cash required for expenses incurred later in the year


Example of CPPA Adjustments(Deegan p. 182) Calculation of gain/loss of purchasing power of net monetary assets

Unadjusted Index Adjusted

Opening net monetary assets

(10,000) 140/130 (10,769)

Sales 200,000 140/135 207,407

Purchase of goods (110,000) 140/135 (114,074)

Payment of interest (1,000) 140/135 (1,037)

Payment of admin expenses

(9,000) 140/135 (9,335)

Tax expense (26,000) 140/140 (26,000)

Dividends (15,000) 140/140 (15,000)

Closing net monetary assets

29,000 31,194

The difference between the adjusted closing net monetary assets and the unadjusted net monetary assets is treated as a loss - the company would have needed to have $2194 more to have the same ‘purchasing power’ they had at the beginning of the year


Advantages of current purchasing power adjustments

• Relies on data already available under historical cost accounting

• No need to incur cost or effort to collect data about current asset values

• CPI data also readily available


Disadvantages of current purchasing power adjustments

• Movements in the prices of goods and services included in a general price index (CPI) may not reflect specific price movements in different industries

• Information generated under CPPA may be confusing to users

• Studies of share price reactions failed to find much support for decision usefulness of CPPA data


Current cost accounting (CCA)

• Another alternative to historical cost that was proposed was CCA

• CCA was based on actual valuations not adjusted historical cost

• Differentiates between profits from trading and holding gains

• Holding gains can be realised or unrealised

• Income perspective adopted will determine whether holding gains or losses treated as income


Treatment of holding gains or losses under alternative capital maintenance approaches

• Financial capital maintenance perspective

– holding gains or losses can be treated as income

• Physical capital maintenance perspective

– holding gains or losses can be treated as capital adjustments


CCA under physical capital maintenance approach

• Advocated by Edwards and Bell

• Valuations based on replacement costs

• Operating income represents realised revenues less the replacement cost of assets in question

• Generates a measure of income that represents the maximum amount that can be distributed, while maintaining operating capacity intact


Adjustments using Edwards and Bell approach

• Adjustments usually made at year end

• Historical cost accounts used as basis of adjustments

• Operating profit calculated by using replacement costs

• Holding gains excluded in calculating current cost operating profit

– not available for dividendscontinued


Adjustments using Edwards and Bell approach (cont.)

• BUT holding gains are included in calculating business profit

• Business profit shows how the entity has gained in financial terms from the increase in cost of its resources

• Depreciation of non-current assets based on the replacement cost

• As with CPPA no restatement of monetary assets required


Advantages of current cost accounting

• Differentiating operating profit from holding gains and losses can enhance the usefulness of information provided

– holding gains different to trading income as due to market-wide movements that are often beyond management’s control

• Better comparability of various entities’ performance


Criticisms of current cost accounting• Replacement cost of assets may not be the same

for all firms

– some firms may not choose to replace the asset

• If the entity requires replacement assets it may be more efficient and less costly to acquire different assets

• Replacement cost does not reflect what the asset would be worth if sold

continued


Criticisms of current cost accounting (cont.)

• Often difficult to determine replacement costs

• Allocating replacement cost via depreciation is still arbitrary as with historical cost accounting

• Chambers (1995) claimed products of CCA were irrelevant and misleading


Continuously Contemporary Accounting (CoCoA)• Yet another alternative to historical cost accounting

was CoCoA

• Proposed by Chambers as well as others

• Based on valuing assets at net selling prices (exit prices) at reporting dates on the basis or orderly sales

– referred to as current cash equivalent

• Chambers argued that key information for decision making relates to ‘capacity to adapt’ continued


Continuously Contemporary Accounting (CoCoA) (cont.)

• The balance sheet (statement of financial position) considered to be the prime financial statement

– shows the net selling prices of the entity’s assets

• Profit directly relates to changes in adaptive capital

• Adaptive capital reflected by the total exit values of assets


Capacity to adapt

• Chambers approach focuses on new opportunities

– the ability of the entity to adapt to changing circumstances

• The ability of the firm to ‘go into the market with cash for the purposes of adapting oneself to contemporary conditions’ (Chambers 1966, p.91)

• Assumes the objective of accounting is to guide future actions (as opposed to, for example, stewardship)


Definition of wealth under CoCoA• Present (selling) price is seen as the correct

valuation of wealth at a point in time

– past prices are a matter of history so not relevant to current actions

• Profit is tied to the increase (or decrease) in the current net selling prices of the entity’s assets

• No distinction between realised and unrealised gains—all gains are treated as part of profit

continued


Definition of wealth under CoCoA (cont.)

• Profit is the amount that can be distributed, while maintaining the entity’s adaptive ability (adaptive capital)

• Abandons notion of realisation in terms of recognising revenue

– revenues are recognised at point of purchase or production rather than sales


Capital maintenance adjustment

• Unlike CCA there is an adjustment to take account of changes in general purchasing power (inflation adjustment)

• Capital maintenance adjustments form part of the period’s income with a corresponding credit to a capital maintenance reserve (part of owners’ equity)

• Calculated by multiplying net assets by the proportional change in a general price index over the period


Advantages of CoCoA

• By using one method of valuation for all assets (exit values) the resulting numbers can be logically added together (additivity)

• No need for arbitrary cost allocation for depreciation as gains or losses on assets are based on movements in exit price


Criticisms of CoCoA

• If implemented CoCoA would involve a fundamental shift in financial accounting

– revenue recognition points and asset valuations

– could lead to unacceptable social and environmental consequences

• Relevance of exit prices questioned if we do not expect to sell the assets

continued


Criticisms of CoCoA (cont.)

• Assets of a specific nature considered to have no value under CoCoA because cannot be separately disposed of

– CoCoA ignores the ‘value in use’ of an asset

• Questioned whether appropriate to value all assets at exit prices if the entity is a going concern

• Determining exit prices for unique assets introduces subjectivity into accounts

continued


Criticisms of CoCoA (cont.)

• CoCoA requires assets to be valued separately rather than as a bundle

– therefore would not recognise goodwill as an asset

– value of assets sold together can be very different from separate sale


Fair value accounting• Whilst CPPA, CCA and CoCoA as just described were

proposed as alternatives to historical cost accounting, another approach that has been adopted is to simply measure selected assets at fair value

• Fair value is an asset (and liability) measurement approach that is now used within an increasing number of accounting standards

• In the IASB’s accounting standard on fair value, IFRS 13 Fair Value Measurement, fair value is defined as:

– the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date


Fair value definition – key terms• The definition of fair value uses a number of terms that

require further consideration, in particular ‘orderly transaction’, and ‘market participants’

• These terms are defined in IFRS 13 as follows:

– orderly transaction A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale)

– market participants Buyers and sellers are independent of each other, are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, and are willing and able to enter into a transaction for the asset or liability


How do we determine fair values?

• Fair values can be determined in different ways

• Techniques that rely upon observable market values (market prices) are often referred to as mark-to-market approaches

• Techniques that rely upon valuation models are often known as mark-to-model approaches and require the identification of both an accepted valuation model, and the inputs required by the model to arrive at a valuation


Fair value versus historical cost• In comparing fair value to historical cost, fair value is

typically considered to be more relevant to the intended users of general purpose financial reports

• However, it is a more subjective measurement basis if an active market does not exist for an item

• If a valuation model is applied – because there is not an active market – then many assumptions and professional judgments must be made

• Determining fair value can be problematic when markets are volatile, for example when there is a serious financial crisis, or when an asset is of a type that is not regularly traded. In such situation, management’s own judgments and assumptions will impact measurement


A fair value hierarchy

• The IASB’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).

continued


A fair value hierarchy (cont.)

• 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).

– Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead.


Fair values and its relationship to volatility and procyclicality in accounting measures – a problem?

• A quantity or measure that tends to increase when the overall economy is growing, or decreases when the economy is declining, is classified as being procyclical

• During the sub-prime banking crisis it was claimed by many (especially banks themselves) that accounting requirements – as reflected in various accounting standards – that require reporting entities to measure many of their assets at fair value actually exacerbated the financial crisis

continued


Procyclicality attribute of fair values (cont.)• It is argued that when markets for financial assets

(such as shares, bonds and derivatives) are booming, the value of these assets held by banks, and shown at fair value within their statements of financial position, will similarly rise significantly above their historical cost – thus increasing the reported net assets and capital and reserves of the bank

• As banking regulations usually set bank lending limits in terms of a proportion (or multiple) of capital and reserves, this increase in the reported fair value of the assets of a bank will enable a bank to lend more

continued


Procyclicality attribute of fair values (cont.)• Some of this additional lending will fuel further

demand in the markets for financial assets – thus further increasing the market values/prices of these assets held by banks and further increasing their reported capital and reserves

• This, it is argued, will enable banks to lend even more and thus will help to create an upward spiral in financial assets prices, and bank lending, that becomes increasingly disconnected from the underlying real economic values of the assets in these markets

continued


Procyclicality attribute of fair values (cont.)• Conversely, it has been argued that at the time of the sub-prime banking

crisis when markets for financial assets were in free-fall, fair value accounting exacerbated a downward spiral of asset prices and bank lending that is equally unreflective of (and significantly overstates) decreases in real underlying economic values

• Requirements to mark-to-market financial assets held by banks may lead to a rapid erosion in the capital and reserves shown in the banks’ statements of financial position

• This will reduce their lending limits and will both reduce bank lending (thus reducing demand in financial markets, putting further downward pressure on the assets prices in these markets) and possibly require the banks to sell some of the financial assets they hold to release liquidity

• This will put further downward pressure on the asset prices, leading to a downward price spiral as these reduced prices further reduce the reported net assets of the banks

continued


Procyclicality attribute of fair values (cont.)• Although these impacts of fair value accounting were widely articulated

at the time of the sub-prime banking crisis, Laux and Leuz (2009) argue many of these claimed empirical effects were not caused by fair value accounting, so the volatility and procyclicality case against fair value accounting is not as clear cut as the above arguments indicate

• IFRS permit fair values to be determined using data other than direct market observations in many circumstances – for example level 2 and level 3 in the fair value measurement hierarchy

• In situations where markets are demonstrably not providing values based on orderly transactions, or are for any other reason not operating efficiently (for example due to illiquidity in the markets), then rather than using level 1 fair value measurements (directly observed market prices for identical assets), then level 2 mark-to-market or level 3 mark-to-model valuations should be used

continued


Procyclicality attribute of fair values (cont.)

• Laux and Leuz (2009) explain that during the sub-prime banking crisis, many banks moved to using level 2 and 3 valuations rather than level 1 valuations for many financial assets, and also took advantage of provisions to allow some assets to be reclassified from fair value to historical cost categories in special circumstances, thus acting as a ‘damper’, reducing the speed (or acceleration) of any procyclical effects

• They also argue that any failure to provide fair values in financial statements during economic downturns could in itself cause markets to overreact and/or misprice company shares

• Hence, there are arguments for and against the position that the use of fair values contributed to the impacts of the global financial crisis

• Nevertheless, an interesting issue for accounting standard-setters to consider – did fair values contribute to the global financial crisis and therefore to various social and economic problems of the time?


Demand for price adjusted and value adjusted accounting information• Earlier we discussed various normative theories of

accounting (CPPA, CCA, CoCoA)

• Limited evidence that stock markets react to current cost and CPPA information

– little or no share price reaction to price adjusted accounting information found

– results may have been due to limitations with research methods used

reaction to other information released at the same time could not be distinguished

users may have obtained information from other sources prior to release of annual reports

continued


Demand for price adjusted accounting information (cont.)

• Surveys of managers find limited corporate support for current cost accounting

– cost, limited benefits from disclosure and lack of agreement as to approach are all considerations

• Surveys of users indicate information not helpful, not used and information does not tell users anything new

• Findings interesting given the extent of voluntary disclosure by corporations


Reasons for lobbying

• Watts and Zimmerman examined lobbying reaction to the release of FASB Discussion Memorandum on general price level accounting

• Found that political visibility is a major factor in explaining lobbying positions

– large firms favour general price level accounting as leads to lower reported profits

continued


Reasons for lobbying (cont.)

• Supported in New Zealand by Wong (1988)

– corporations adopting CCA during period of rising prices had higher effective tax rates and larger market concentrations than those that did not

• In UK Sutton (1988) found politically sensitive firms more likely to lobby in support of exposure draft recommending disclosure of CCA


Professional support for various approaches• Current purchasing power accounting generally

supported by standard-setters from 1960s to mid-1970s

• From about 1975 preference shifted to current cost accounting

• Late 1970s and early 1980s standard-setters issued recommendations which favoured a mixture of CPPA and CCA

• From mid-1980s support waned (time of falling inflation)


Potential reasons for lack of continued support

• May question the relevance of current cost information in times of falling inflation

• Drastic change to accounting conventions could cause disruption and confusion in capital markets

• New method of accounting could have taxation consequences

continued


Potential reasons for lack of continued support (cont.)

• Self-interest motives of corporations

• Limited relevance to decision makers

• Nevertheless, in recent years there have been movements towards the use of ‘fair values’ as new accounting standards are being released