ACC3011 Seminar 3 – Discussions

4.1 CONTEMPORARY ISSUE

The standard setters search for the ‘best’ measurement basis

The current thinking of accounting standard setters about measurement seems to be based on an
idealised view of markets as being complete and in perfectly competitive equilibrium. In such
conditions, there is a unique market price based on full information for every asset and liability, and
there is an obvious attraction in using this price as the measure for accounting. This explains the
apparent enthusiasm for single ideal measurement methods based on market price, such as fair value.
In reality, markets are imperfect and incomplete, so ideal unique market prices are not available for all
assets and liabilities. This is why the accounting standards have to resort to a fair value hierarchy. The
lower levels of this hierarchy require estimation of what a market price might be if one existed. The
liquidity problems evident in the global financial crisis have demonstrated the limitations of markets and
the difficulty associated with estimating market prices.

An important source of market imperfection is the existence of information asymmetry, which means
that not all market participants are equally well informed. This is the principal reason why accounts are
needed. The measurement methods used in preparation of the accounts should be selected with the
market context in mind. The idea of having a single preselected measurement method may not best
reflect market conditions or meet users’ needs.

The IASB and FASB are currently involved in a project to develop a joint conceptual framework. As part
of this project they have attempted to identify the single measurement basis that best conforms with
criteria such as relevance and representational faithfulness that are prescribed by the Conceptual
Framework. These measurement bases are ‘pure’ bases of measurement such as historical cost,
replacement cost, value-in-use or fair value. The objective under this approach being to always estimate
the selected measurement basis, other bases allowed only as proxies, where direct measurement is
impossible. An example of this concept and the use of proxies is the fair value hierarchy. Fair value
(selling price) is the measurement basis, but estimates using other information are allowed when selling
prices cannot be directly observed.

This approach does not favour mixed measurement approaches, such as the traditional ‘lower of
historical cost or market value’ approach. The view is that there is a problem with mixing different ‘pure’
measurement bases, even if they are combined in a logical or systematic way. The mixing of different
measurement methods is believed to create mismatch problems. The mismatch problem refers to the
fact that different items in the same set of accounts are measured on a different basis, making
aggregation (totals) misleading. The two boards, after much recent deliberation, have now considered a
new approach which might allow mixed measurements. A discussion of the cases for and against a single
ideal measurement basis follows.

A single method approach would promote consistency within accounts, avoiding mismatches and
allowing more meaningful aggregation. Aggregation problems may still exist within each pure approach.
This approach would also improve comparability of accounts across entities.

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Fair value has tended to be favoured as a pure measurement base. In the standard setters’
deliberations, it has been claimed that this method has the property of relevance because it measures
the market’s expectation of future cash flows to be derived by the entity. It is also claimed that it has the
property of objectivity, reflecting the market’s view, rather than the views of the managers associated
with the entity.

The adoption of a single measurement method is predicated on the belief that a particular measure will
always be the most relevant and will always be able to be reliably measured. This will only be the case if
markets are complete and are in perfectly competitive equilibrium. In this situation, a unique market
value can be attributed to every asset and liability, so a single measurement method, consistent with
fair value is appropriate. Therefore, properties of consistency and comparability can be achieved in a
very precise sense.

In reality, markets are not perfect and complete. This ideal information is therefore not available. Beaver
and Demski pointed out that in a world of perfect and complete markets accounting would not be
required. This is because everybody would be fully informed. They state that the very existence of
accounting implies some degree of market imperfection. Beaver and Demski’s response to this dilemma
is to suggest that, in a realistic setting where market imperfections will always exist, we should regard
accounts as providing useful information for decision making rather than definitive measurements. In
practical terms, for the standard setters, this means abandoning the search for the single ideal measure
and instead, adopting the objective of identifying the information that is most likely to meet the needs
of users’ decision models. The informational approach is not concerned with measuring the present
value of the future cash flows to value the business, but rather to provide information that will help
users such as financial analysts to predict future cash flows and perform their own valuations. The
nature of such information is likely to be more dependent on specific circumstances than that implied by
the ‘single ideal’ approach. However, it does not preclude the universal use of a single measure if that is
justified by users’ information needs.

The global financial crisis provided a vivid illustration of the practical importance of market imperfection
and incompleteness. Standard setters believed that financial markets were commonly deep and liquid,
and therefore financial instruments were selected, in IAS 39, as being suitable for fair value
measurement. However, during the global financial crisis, the markets for many financial instruments
have become very illiquid and in some cases non-existent. This led the IASB and FASB to relax their fair
value reporting requirements.

QUESTIONS

1. What is meant by the term ‘market context’? Why is context so important in accounting
measurement?
Measurement methods used in the preparation of the financial statements should be
selected with the market context in mind. Values determined without market context in
mind may not be reflective of market conditions or meet user’s needs. In other words, to
provide the most accurate and decision useful accounting information, the most
appropriate measurement approach is likely to be dependent on specific circumstances
such as the nature of the market for the asset at the time. If the market is to play a role in
valuation, we want to ensure that the resulting value reflects the fundamental value of the
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 asset and that the operation of market forces does not lead to over or under valuation of the
asset. What is important to users may also change from time to time

2. Is adoption of a single measurement base approach likely to work in practice? Justify your
response.
 Arguments for adoption of a single measurement base approach are based on an idealised
view of markets being complete and in perfectly competitive equilibrium. In reality,
markets are imperfect and incomplete and ideal unique market prices are not available for
all assets and liabilities. This has led to the use of the fair value hierarchy. The lower levels
of the hierarchy requiring estimation of what the market price might be if one existed. The
information produced is therefore not ideal.
 A single preselected measurement method may not best reflect market conditions or meet
user needs at that time.
 Assumes a particular measure will always be the most relevant and will always be able to
be reliably measured.
 Some argue that there is no single ideal measure and that the focus should be on
identifying the information that is most likely to meet the needs of user’s decision models.
 Application of IAS 39 during the recent GFC as an illustration of the practical importance
of market imperfection and incompleteness.

3. Why do you think standard setters have considered a single measurement base approach? In
your response, consider the fundamental problems that such an approach could help resolve
and how such an approach would fit with the qualitative characteristics of accounting

In perfect market conditions, there is a unique market price based on full information for
every asset and liability. This provides a relevant, reliable and objective measure of an
assets fair value when such observable market prices are available. This argument seems to
be a key driver behind the push for fair value as the single ideal measurement base
approach.
- Mixing different measurement bases is believed to create mismatch problems. This
problem refers to the fact that different items in the same set of accounts are measured
on a different basis, making aggregation (totals) misleading. A single measurement
base approach would promote consistency within accounts, avoiding this mismatch,
and allowing more meaningful aggregation. This approach would also improve
comparability of accounts between different entities.
- Fair value favoured approach due to its
relevance – measures market expectations of future cash flows to be derived by the
entity
objectivity – reflecting the markets view rather than views of management associated
with the entity

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4.2 CONTEMPORARY ISSUE
The subprime lending crisis and reliable reporting

A question currently faced by the accounting profession, particularly in light of the mortgage meltdown,
is whether to use fair value or historical cost for the reporting of assets and liabilities. It is argued that
for accounting information to be useful for decision making, it should embody the two primary qualities
of relevance and reliability. Fair value or historical cost on their own are not likely to achieve both
characteristics. In practice, there seems to be an inherent trade-off between these two characteristics.
The information which is most relevant is quite often less reliable, depending upon the nature of the
item being measured. The information which is the most reliable usually tends to be that which is less
relevant. Perhaps, an integration of the two measurement bases may be necessary. Both the IASB and
FASB support the use of fair value and are moving away from historical cost and more towards fair value
in the financial reporting standards. This means we are unlikely to go back to the strict use of traditional
historical-cost based accounting despite the issues we face with fair-value accounting.

It is argued that reporting assets and liabilities at their fair value provides more relevant information for
investment decisions than historical cost. Under fair-value accounting, when there is an active and liquid
market for the asset or liability, mark-to-market reporting can be used. This provides extremely relevant
information because it requires a downward adjustment when the market value of investments decline,
thereby revealing problems more quickly. As an example, the savings and loan crisis may have been
avoided had fair-value accounting been used. The crisis developed when variable interest rates paid on
deposits exceeded the fixed interest rates charged on mortgages. Accounting under historical cost
allowed resulting losses to be reported gradually over time, where fair-value rules would have required
earlier recognition3. Lastly, use of the lower of cost or market rule does not provide relevant accounting
reports when fair value significantly exceeds historical cost.

Fair value certainly provides relevant information for decision making, when the information is also
reliable. Reliability may be difficult to achieve when we are dealing with hypothetical transactions that
are not objectively measurable. This is the situation we face once we move away from the mark-to-
market approach when determining fair value. Determining fair value for securities with no active
markets using level 3 inputs is extremely difficult, and may therefore adversely affect the reliability and
relevance of financial reports.

It is argued that the lower cost or market rule could be effectively adapted, making reports both
relevant and reliable. When fair values exceed costs by a material amount, information related to
increases in the value of assets could be provided in footnotes or pro forma statements. In other words,
the reliability and relevance of historical-cost financial reports could be enhanced by providing fair value
information through footnote disclosures or pro forma statements, while the assets are measured using
traditional historical cost. Perhaps a nice balance to achieve both greater relevance and greater
reliability.

Some financial models indicate that using fair value to report financial instruments at market value leads
financial institutions to react to market changes in ways they would not normally act. For example,
falling prices in an unstable market may worsen market stability. This is because companies tend to
react to falling prices by rushing out to sell their assets before their competitors. In comparison, the use
of historical-cost information by financial institutions tends to dampen the financial business cycle and,

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as a consequence, adds stability to the financial markets. Market stability and the nature of the financial
business cycle play a large role in the determination of market prices and therefore have an impact upon
the relevance and reliability of accounting information produced.

Obtaining fair values that are reliable can be elusive, particularly for market based instruments that lack
objective substance, such as subprime debt obligations. The move to fair value accounting requires
inclusion of more hypothetical transactions in the financial statements, which allowed subprime lenders
to recognise income well before it was actually earned or received.4 This increases the risk of
overstatement of accrual based income not realised in actual transactions. Zoe-Vonna Palmrose, former
deputy chief accountant for professional practice at SEC, saw parallels between the subprime lending
debacle in 2007 and the stock market crash of 1929. She noted that fair value accounting was popular in
the 1920s but was banned by SEC for a number of decades after the stock market crash in 1929.

In a market bubble, values may be overstated and bubble values will not be realisable if many
participants in the market decide to sell those assets at the same time. Consequently, financial
statements incorporating fair values of assets and liabilities in unstable or illiquid markets are not likely
to be relevant or reliable for the purpose of decision usefulness. This problem can be illustrated in
subprime lending. When markets for subprime-backed securities were active, applying the market value
at which securities were traded might have appeared reasonable and fair. However, the market for
subprime securities was not stable and active for long. In the absence of an active and liquid market,
how does one establish assumptions for developing estimates for fair values for delinquent loans in a
declining market. It is particularly difficult to determine fair values in a speculative and high risk
environment like the subprime lending market. Much of the risk due to deceptive practices used in
lending to those who did not have the means to repay, encouraging borrowers to take loans with
variable interest rates and securitising mortgage loans to relieve lenders of credit risk. Fair value rules
require much judgement when adjusting or modifying initially recorded costs for reporting financial
assets, including mortgage-backed instruments. The rules may be viewed as weak or ambiguous. We
therefore end up suffering in terms of the compromise to relevance and reliability.

QUESTIONS

1. In practice, which measurement base, historical cost or fair value would provide the most
relevant and reliable accounting information? Draw on the facts presented in the situation
above, as well as your knowledge of the global financial crisis, to justify your response.
- Fair value or historical cost on their own are not likely to achieve both characteristics.
- Inherent trade-off between relevance and reliability – the information which is most
relevant is often less reliable. The information which is most reliable tends to be that
which is less relevant.
- There has been a move towards fair value and away from historical cost on the basis of
relevance. It is argued that reporting assets and liabilities at their fair values provides more
relevant information for investment decisions than historical cost.
- Reliability is difficult to achieve under fair value when we are dealing with hypothetical
transactions that are not objectively measurable. This is the situation we face when
observable market prices are not available. In other words, when an active and liquid
market does not exist for the asset. Some argue that once reliability becomes
compromised, the information produced also becomes less relevant.
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- Integration of the two measurement bases suggested. For example, historical cost financial
reports could be enhanced by providing fair value information through footnote
disclosures. A balance to achieve both greater relevance and reliability.

2. Discuss the role of market stability and the financial business cycle in determining the relevance
and reliability of the accounting information produced.
- Market stability and the nature of the financial business cycle play a large role in the
determination of market prices, and therefore impact upon the relevance and reliability of
accounting information produced using fair value.
- Falling prices in an unstable market may worsen market stability. Companies tend to react
to falling prices by rushing out to sell their assets before their competitors, causing a
further downward spiral in prices.
- In a market bubble, values may be overstated, and values will most likely not be realisable
if many market participants decide to sell those assets at the same time. The bubble bursts
and prices fall again.
- Financial statements measuring assets and liabilities at fair value in unstable or illiquid
markets are not likely to be relevant or reliable for the purpose of decision usefulness.
- Students may refer to the subprime lending crisis or other examples to illustrate the role
of market stability and the financial business cycle.

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Additional Questions

1. Why is measurement so important in accounting?

Measurement is crucial to be able to provide decision-useful accounting information and to
accurately appraise the performance of management. These are the primary purposes for
which financial statements are prepared.
The way items are measured in accounting impacts on the quality of accounting information
produced. To fulfil the decision-usefulness objective, the financial statements produced must
contain good quality accounting information which will assist decision makers in making the
right (appropriate) decisions. Poor quality accounting information, resulting from the use of
inappropriate measurement methods, may mislead users and this could potentially cause them
to make wrong (inappropriate) decisions. If accounting information leads to wrong or
inappropriate decisions it is not useful.
The financial statements produced must also contain good quality accounting information in
order to accurately determine how well management has performed its role in managing the
resources of the entity. Poor quality accounting information, resulting from the use of
inappropriate measurement methods, will give the wrong impression as to how well
management has performed its role.

2. Explain the arguments for and against using historical cost as a measurement base.
Key arguments for historical cost include:
 Most objective measurement approach - amounts are determined based on actual
transactions.
 Clear audit trail – amounts can usually be proven by documentation.
Key arguments against historical cost include:
 Amounts determined may not be relevant to current decision making if there is a long time
span since the transaction occurred. Historical cost does not take into account changes in
the value of money over time. In other words, it ignores price inflation.
 The amount paid for an item or received for an item may not necessarily be indicative of
its value.
 Judgement involved in determining depreciation rates can create inconsistencies and
opportunity for manipulation.
 Inability to determine the cost of some items. Items may be donated with no actual cost to
the entity. Items may be internally generated rather than purchased.

3. Explain the arguments for and against using fair value as a measurement base.
Key arguments for fair value include:
 Most relevant measurement approach for current decision making. The amount that will be
received for an item or that will need to be paid for an item is decision useful information.
 Objective if determined by reference to the market price for an item. The market price is
set by forces outside the entity. It is not biased by judgement and cannot be manipulated or
influenced by management.
Key arguments against fair value include:
 Subjective where a market price is unavailable. Some items are not regularly traded in an
active market and an estimate of the items fair value must be made.

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 The focus on exit values is not logical and contradicts the going concern assumption. We
are measuring as though we are going to sell off all the assets which is not usually the
case.
 Market prices can be volatile and therefore sometimes may not be indicative of the true
value of an item. Short term fluctuations in fair value may be irrelevant and cause
confusion from a user perspective.

4. What is the current approach to measurement adopted by standard setters? Why

have they adopted such an approach? What are the issues and problems associated
with this approach?
Under the international standards we adopt what we call a mixed measurement model. Under
this approach a number of different measurement bases are employed in the preparation of the
financial statements. Historical cost, current cost, realisable value and present value are all
employed to different degrees and in varying combinations during the preparation of the
financial statements.
The main reason for adopting such an approach is the need for flexibility. This model allows
for use of a number of different measurement bases. This is necessary due to the differences in
the substance or nature of transactions between entities and also due to the differing
circumstances that entities can find themselves in.
Issues and problems associated with this approach include:
- Variations in accounting practice – entities may choose to account for the same or similar
items in different ways using different measurement methods. How they measure and
account for an item may be appropriate for the individual entity but could reduce
comparability across entities.
- Potential for different financial results being reported when different measurement
methods are allowed and used.
- Discretion means opportunity for management to make opportunistic accounting choices,
creating a biased picture of reality and perhaps even misleading users. In summary, the
approach is necessary but subjective in nature. This highlights the importance of
professional judgement and ethics in accounting

5. Identify factors that may influence the choice of measurement approach. Discuss
how the measurement approach adopted impacts on the quality of accounting
information produced.
Key influences include:
- Potential users of the financial statements - user needs must be understood in order to
choose the measurement approach which will provide the most decision useful
information.
- Practical considerations – a particular cost or value may be too difficult or even impossible
to determine. Choice of measurement approach also needs to be cost effective. The cost of
obtaining or calculating the cost or value must be considered.
- Management’s motivations and objectives – motivations, underlying objectives and time
horizon can all influence management behaviour in terms of choice of measurement
approach. For example, if management have a short term focus, are on a shorter term
employment contract, or have bonuses tied to profits, they will most likely choose the
measurement approach which produces the best results in terms of higher profits.
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The measurement approach adopted impacts on the quality of accounting information because
it has a direct impact on the relevance, faithful representation, understandability, comparability
and verifiability of the information produced. Accounting information which possesses these
characteristics is more decision useful, therefore fulfilling the decision usefulness objective,
the purpose for which financial statements are prepared.

6. Describe the valuation techniques that can be used to fair value an asset, which
method is preferred and why?