Digital Garden of Paul

Measurements can be approached subjectively

Measurement is the process of determining the monetary amounts at which elements of the financial statements are to be recognised and carried in the balance sheet and income statement. Or in other words, how do we determine the figures in the financial statement.

Measurement has four key benefits (Rankin, 2012):

  1. It assists in making financial statements decision useful by giving meaning to the included items.
  2. It allows investors, management and other users of account information to assess the financial performance and financial position of the entity.
  3. It allows investors, management and other users of account information to compare the entity's performance and position over time.
  4. It allows investors, management and other users of account information to compare entities.

Limitations do exists as well:

  1. Little or no agreement on what accounting measures should be used. Allowing for choice in approach to represent the financial wellbeing of a company.
  2. A mixed measurement approach reduces comparability of accounting information.
  3. Measurement can be quite subjective.
  4. While flexibility of choosing measurement approach is required, it could lead to misleading information and bad decisions based on that information.
  5. Additivity problem. Items on the financial statement should not be summed into a total.

Stakeholders and the political nature

Financial statements are created to satisfy the different needs for information. This can vary from lenders, existing and potential investors, and other creditors. When choosing the right measurement approach, two questions are crucial:

  • What do users really need to know? The chosen measurement will determine if the information to the user is right and delivered as intended.
  • How do users influence the measurement approach? The potential impact of particular users or stakeholders on measurement and measurement choices can dominate toward a certain outcome. This impact can lead to low-quality information to be produced and distributed.

Existing and potential investors are concerned with the risk inherent in, and the return provide by, their investments. Their mains interes is in accounting information which assists them in deciding to buy, hold or sell their shares. Knowing if the entity is able to pay their dividends. As such the entity needs to provide information about potential value and forward looking with a focus on current value. Fair value will predominantly be used.

Lenders and other creditors are interested in information that gives them the trust that amounts owing will be paid when due. The entity;s net position is of primary interest. The accounting information needs to reflect the current value of assets and liabilities of the entity. Fair value would be the most useful approach. Profits is another interest. These should be produced by a historical cost approach.

Measurement approaches

Historical cost

Value determined using- the actual amount paid for an item
- the actual amount received for an item
- actual transactions
Relevance / usefulness- not relevant to current decision making if time span since transaction occurred is long
- not necessarily indicative of value
Subjectivity- most objective measurement approach
- clear audit trail -- can usually be proven by documentation
Issues and criticisms- does not take into account changes in the value of money over time, ignoring price inflation
- judgement involved in determining depreciation creates opportunities for inconsistencies or manipulation
- unable to determine the cost of some items

Current cost - replacement cost

Value determined using- the amount that would be paid at the current time to purchase an identical item
- the lowest amount that would be paid at the current time to provide the future economic benefits expected from the current item
- the cost to obtain the same benefits from a different item
Relevance / usefulness- relevant to current decision making if inflation is high or relative prices are changing
- more relevant and useful if asset has no resale value and is used by the entity to provide future economic benefits
Subjectivity- objective where market prices are used to determine current cost
Issues and criticisms- current or replacement cost is not necessarily indicative of the value of the asset is expected to generate for the entity

Fair value

Fair value can be valued by three different methods:

  • Market approach. Uses prices and other relevant information generated by market transactions involving identical or comparable items.
  • Cost approach. Reflects the amount that would be required currently to replace the service capacity of an asset.
  • Income approach. Approximation of current market value by estimating the future cash flows or income and expenses to be derived from the item and converting them to determine the current amount of those cash flows or income and expenses.

Arguments for fair value

  • More relevant than other measurement approaches as it uses the market prices to assess its valuation based on active and liquid market. This provides high relevance for decision usefulness.
  • Fair value can faithfully represent reality where other approaches cannot. For example, a natural asset as an apple tree has a higher value from fair value perspective. In this perspective the tree is valued against it revenue when selling the fruit. The historical cost price would yield a different and irrelevant valuation.
  • Fair value produces more comparable accounting information.
  • Fair value is under more understandable then other measurement bases.

Arguments against fair value

  • Amount of subjectivity and judgement involved in forming estimations of market value in the absence of an objective market price in an active and liquid market.
  • Reported items following fair value perspective are hypothetical in nature. Therefore it includes gains and losses that are not realised.
  • Many argue that accounting information produced using fair value is less faithfully represented. Largely due to the subjective nature of the valuation process.
  • Fair value is the most controversial measurement approach.
Value determined using- 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
- market prices
Relevance / usefulness- most relevant measure of value for current decision making
- the amount that will be received or will need to be paid for an item is decision-useful information
Subjectivity- objective if fair value is determined by reference to the market price for an item, set by forces outside the entity -- not biased by judgement and cannot be manipulated or influenced by management
- subjective where items are not regularly traded in an active market and an estimate of fair value is made
Issues and criticisms- focus on exit values means we are measuring as if we are going to sell of the assets -- not logical and goes against the going concern assumption
- short-term fluctuations in fair value may be irrelevant and in fact confusing from a user perspective
- market prices can be volatile and therefore sometimes not indicative of the market value of an item

Present value

Value determined using- the present discounted value of the future net cash flows associated with the item
- the future cash inflows and outflows associated with the item which need to be identified and then estimated
- an appropriate discount rate, which recognises that an amount of money received in one year has a different value to the same amount of money received today
Relevance / usefulness- very relevant to current decision making
- directly measures future economic benefits
- takes into account the time value of money
Subjectivity- much subjectivity involved in estimating cash flows expected in the future
- subjective in the sense that there is a range of discount rates to choose from and there is often much variation between entities in the discount rate
- the need for management assertions and assumptions make reliability questionable
Issues and criticisms- can be difficult or impossible to identify the cash flows attributable to a particular item because the item is used in conjunction with other items to produce cash flows for the entity
- lacks objectivity -- based on what management think will happen
- in effect management's own opinions and biases are incorporated into the measure of its performance

Deprival value

Value determined using- the loss that a rational person would suffer if they were deprived of the asset
- consideration of the action to be taken if the item currently held by the entity was lost (i.e. do nothing or replace the item)
- information as to whether the item will actually be replaced and the individual consequences of the entity
Relevance / usefulness- not so relevant given that the entity still holds the asset and has not been deprived of it
- value based on a scenario that may never happen
Subjectivity- fairly subjective in that there are a range of measures to choose from depending upon the assumptions and decisions made by management
Issues and criticisms- depends upon the measure used and how value is determined

Measurement approaches allowed in the Netherlands

According to the Dutch law fixed assets are:

bedrijfsgebouwen en –terreinen; machines en installaties; andere vaste bedrijfsmiddelen, zoals technische en administratieve uitrusting; materiële bedrijfsactiva in uitvoering en vooruitbetalingen op materiële vaste activa; en niet aan het productieproces dienstbare materiële vaste activa.

For Dutch listed companies these fixed assets should be measured according to IFRS: cost price or fair value. Non-listed companies can use cost price, fair value, or present value. Voluntarily non-listed companies can choose to comply to IFRS.

Measurements can be approached subjectively