Chapter (04) – Measurement & Its Problems

4.2 What is the historic cost?

 Historic cost is the money (dollars) sacrificed or given up to obtain an item.

• It is reliable and both preparers and users easily understand it.

• However, What you have paid for an item is not relevant to future decisions and fails
to take into account the time value of money and price changes.

4.3 Explain the difference between current and replacement costs.

1. Replacement Cost:
 Replacement cost is the present cost of replacing an asset with an identical or similar
asset. The focus is on the replacement of the asset currently held.

 For example, an entity purchased a forklift truck with a useful life of 10 years, for $40
000 three years ago. The replacement cost would be:

• The market price of a second-hand forklift in identical condition to the forklift currently
held (that is, at the end of the three years); or

• If no second-hand market existed, the current market price of a new forklift, adjusted
(via depreciation charges) to take into account the fact that the new forklift would
provide 10 years’ service, yet the current forklift has only seven years’ service
remaining; or

• If forklifts were no longer available, then the current market price of the ‘modern
equivalent’ asset (for example, a conveyor belt) would be used, and adjusted as before,
for any difference in future years of service between the forklift currently held and the
conveyor belt.

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2. Current Cost:

The current cost of an item is the lowest amount that would be paid at the current time
to provide or replace the future economic benefits expected from the current item. Its
focus is on the service potential (the benefits for which the asset is acquired) rather than
the form of the asset itself.

4.5 Explain the advantages and disadvantages of using fair value as a measure.
 Fair value is the amount for which an item could be exchanged between
knowledgeable, willing parties in an arm’s length transaction.
 The key advantages of using fair value as a measure is that:
1- It is reliable in the sense that it is objective as determined by market forces and hence,
less open to influence by management. This assumes that fair value can be readily
obtained in the market place.
2- It has relevance. Many consider that what an asset could obtain in the market place
(i.e. its fair value) is relevant.
 The key disadvantages of using fair value as a measure is that:

1- Unless there is an active market estimating fair value can be subjective.

4.6 Explain the advantages and disadvantages of using present value as a measure.

The present value concept measures ‘value’ as the present value of the future net cash
flows expected to be obtained from the asset. The present value of money in the future is
calculated by discounting the future money at a rate of interest equivalent to the rate at
which that money could be invested.

 The key advantage of using present value, as a measure is that it is often considered
the ideal measure of ‘value’ because:

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1- It is conceptually consistent with the definitions of the elements of the financial
statements (as it measures inflows/outflows of economic benefits)
2- It measures cash flows which are the source of ‘value’ for business entities
3- It takes into account the time value of money.
 Disadvantages/Problems in Measuring Present Value

There are three problems in calculating present value:

1. How to predict the amounts and timing of future cash flows

2. How to allocate cash flows between assets

3. Choice of interest/discount rate

4.8 The following information is provided about a specialised machine that is used
by a company in its operations. The machine originally cost $50 000 and it would
cost $120 000 now to replace this machine. The company expects to receive
(discounted to present value) $98 000 by using this machine over the next five years.
If sold now, the machine would bring in $60 000. Consider how useful each of these
measures is to the following users:
• Shareholders
Shareholders are interested in the long-term cash flows of the company as this is
reflected in the share price. Hence, from the shareholders perspective, the discounted
present value would probably be the most relevant.
However, recall that this relies on judgments being made and is thus less reliable.
• Creditors
Creditors may be more interested in the sales price now if they are worried about whether
or not they would be repaid if the company was wound up. Therefore, selling price may
be more relevant and assuming a market-based appraisal would be reliable.
Of course creditors would also be interested in the continuing profitably of the firm (as
this would also ensure their repayment) and therefore, present value may also be useful.

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• Managers.
Managers need to make decisions about how to use assets and whether to replace. By
comparing sales price now and present value, clearly these are relevant to the decision
as to whether to retain the current asset or to sell.
However, Given the entity has the asset presently; the replacement cost would not
currently be relevant.
4.7 Explain what is meant by deprival value.

 Deprival value is the loss that a rational businessman or business woman would suffer
if he or she was deprived of the asset.
 To decide the deprival value of an item, what action would be taken if the item that
the entity currently holds was lost needs to be considered. The entity could either:

• This choice requires two comparisons to be made:

1 • Do nothing — the loss suffered is the value that would have been obtained from the
asset. Compare PV (value in use) and NRV (value in exchange) to determine the
value/recoverable amount of the asset (value is the greater of the two)

2- Replace the services that would have been provided by the asset — the loss suffered
is the cost of replacing the services. Compare CC and value/recoverable amount
(established from first comparison) to determine the minimal loss.

A rational owner will choose the action that minimizes the loss. Deprival value assumes
that the entity will take the action that results in the lowest cost or loss.

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4.9 Company ABC buys and sells antique furniture. One piece of furniture was
purchased at auction for $6000 about six months ago. To replace (repurchase) this
piece of furniture now would cost $8000 because demand for furniture like it has
increased. If this piece of furniture was sold by ABC Company, it would be expected
to receive $14 000. The company has no alternative use for this piece of furniture.
Calculate the deprival value for the piece of furniture
Deprival value is found by asking how an owner would minimise the loss if deprived of
an asset. An owner can either:
 Do nothing — the loss suffered is the value that would have been obtained from
the asset. In this case the asset is held for sale as NRV > PV, so value would be
net realisable value of $14 000; or
 Replace the services that would have been provided by the asset — the loss
suffered is the cost of replacing the services (in this case $8000 for an equivalent
piece of furniture). By replacing the furniture the owner regains the value and is
restored to the original position.
A rational owner will choose the action that minimises the loss.

In this case, the deprival value is current cost of $8000. As this cost is less than the
recoverable amount, a rational owner would replace the asset with the new piece of