Accounting measurement systems

Learning objective

• To explain different measurement methods

used in financial reporting
• To evaluate suitability of the different
methods for assessing stewardship and for
decision making
• To explain and evaluate the concept of fair
value
 Relevance of ‘income’ concept

• basis for taxation and redistribution of wealth

• guide to an entity’s dividend and retention policy

• guide to investment decision making

• predicting future income and future economic

events

• measure of management’s efficiency

Traditional accounting concept of income (HCA)
Key features:
•Based on actual transactions entered by entity.
•In general, the revenue recognition is based on the
realisation principle.
•Expenses are regarded as expired assets costs.
•Revenue and expenses are matched for a
corresponding period.
Advantages of historical cost accounting (HCA)
• Relatively reliable and less subject to bias

• Maintains greater stability and prudence by

recognising only realised gains

• Concept is best understood by non-

accountants

• Suitable for control purposes, especially in

reporting on stewardship.
 Limitations of HCA
• Assumes money holds a constant purchasing power
• Assumption less valid because of:
- general price level changes (inflation)
- specific price level changes (shifts in consumer preference;
technological advances)
- fluctuation in exchange rates

• Asset values may not be relevant

• Ignores holding gains and distorts profit
• Can overstate profits in times of rising prices
distribution could erode operating capacity
 Economic concept of income

• Hicks-
.... being ‘well-off’ at the end of the
period as at the beginning of the period
 Concepts of capital maintenance
• Broadly two concepts of capital:
– financial capital maintenance and physical capital
maintenance
• FCM sets aside profits in order to preserve the
value of shareholders funds
• FCM is adopted by most enterprises
• FCM is sub-divided into:
– ‘money financial capital maintenance’ and
– ‘real financial capital maintenance’
 Physical capital maintenance concept
(PCM
• sets aside profits in order to allow the business
to continue to operate at current levels of
activity

• requires the adoption of the current cost basis

of measurement

• Holding gains are excluded under PCM

 Constant purchasing power accounting (CPP)

Key features
• May use historical cost accounts and restates
relevant figures to CPP
• Monetary items are not adjusted
– will remain the same value regardless of inflation
• Non-monetary items will be adjusted
A profit is earned only if the money amount of the net assets at the end of the
period exceeds the money amounts of the net assets at the beginning of the
period, restated in units in the same purchasing power (after excluding
distributions to, or contribution from owners.
The total amount of the restatement is known as ‘capital maintenance adjustment’
and is transferred to a capital maintenance reserve, which is part of equity (but not of
retained profits)
 Illustration 1
 A company started up in business on 1 January 20X1 with
£11,000 cash as its capital. It spent the entire cash on inventory
which it sold for £13,000 by 31 December 20X1. Assume that no
other transactions took place during the year. During the year
the retail price index moved from 110 to 120.
Required:
•What is the maximum amount that the company can distribute
and still remain well off at the end of the year as it was at the
beginning, under?
i.Historical cost accounting
ii.Current purchasing power accounting
 Illustration 1 _ Solution
Maximum distribution
•Historical cost accounting  
13,000-11,000 = 2,000

•Current purchasing power accounting 

CPP cost of sales 120/110 x11,000=12,000

Max distribution (in real terms) = 13,000-12,000 = 1,000

 Advantages of CPP

• Easy to apply – uses HC accounts adjusted by

price indices

• True system of inflation accounting as it

adjusts for changes in value of money

• It measures the impact on the company in

terms of shareholders’ purchasing power.
 Disadvantages of CPP

• General price index may not be appropriate for all

assets in all businesses

• Does not show current values of assets and

liabilities

• Unfamiliarity with information of CPP units might

confuse users

• Physical capital of the business is not maintained 

 Current Cost Accounting (CCA)
Key features
•  Distinguishes between trading profits and holding
gains
• Monetary assets are not adjusted
• Additional charge to COS i.r.o. replacement cost of
inventory
• Additional depreciation charge i.r.o. replacement
cost of NCAs
 Illustration 2
A company started up business on 1 January 20X1with £11,000
cash as its capital. It spent the entire cash in buying 200 units of
inventory at £55 per unit. The entire inventory was sold on 31
December 20X1 for £65 per unit. At that date the replacement
cost of the inventory was £58 per unit. Assume that no other
transactions took place during the year.
Required:
•What is the maximum amount that the company can distribute
and still remain well off at the end of the year as it was at the
beginning, under?
i.Historical cost accounting
ii.Current cost accounting
 Illustration 2_Solution
Maximum distribution:
•Historical cost accounting  
Operating profit 13,000-11,000 = 2,000

•Current cost accounting 

Operating profit (65-58)K x 200 =1,400

  Realised holding gains = (58-55)k x 200 = 600

Max. amount to distribute is £1400 leaving retained capital

at the end of £11,600 (sufficient to buy 200 units@£58 per unit)
Do you share this view about CCA?
‘a curious dream world where companies
subtract savings they did not realise from costs
they did not incur’
Edward Stamp (1977) ED 18 and Current Cost Accounting: A Review
Article, Accounting and Business Research
 CCA - Advantages
1. Improves usefulness of information by incorporating
valuable information for decision-making
2. It embodies a concept of capital which is particularly
relevant to industries which are capital intensive
3. It provides more prudent statement of profit in times
of rising prices than HC accounting.
 CCA - Disadvantages
1. Possible greater subjectivity and lower reliability than HCA.
2. Allocating replacement cost via depreciation is still arbitrary
- just as it is with historical cost accounting
3. Not popular – CCA had been tested and had been found to be
unpopular with the majority of preparers.
4. Separation of holding gains from other results may be
inappropriate
- acquiring assets in advance of price movements might also be part of
efficient operations
5. Essentially not an inflation system of accounting
– only adjusts values for non-monetary assets
6. Practical issues e.g. services businesses, market value for
specialist assets etc
 Current Value Accounting

Current values can be calculated on the basis of:

• Current entry price
• Current exit price (or realisable value);
• Value in use (or capitalisation or present
value method); or
• a combination of values derived from these
three methods
 Concept of fair value
• IFRS 13 defines fair value 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 is explicitly an exit price  concept

• Exactly the FASB definition, FAS 157

– Previous IASB definition based on exchange value
 3 Levels of fair value hierarchy
• Level 1: assets and liabilities for which a
reasonable well-working market price exists
 
• Level 2: Assets and liabilities for which a
market price can be inferred
 
• Level 3: Assets and liabilities for which a
market value cannot be observed or inferred.  
 Arguments for using fair valuation in financial
statements
• Items with no historical cost are ignored in
conventional accounting

• Fair valuation reports unrealised gains and losses as

they arise
 
• Uses more up-to-date fair values.

• Fair values have more predictive value

 
• It is practical to use for financial instruments since
many of such instruments are traded on active
markets.
 Arguments against using fair valuation
• It will lead to the statement of financial position
including assets and liabilities using mixed valuation
– most assets are non-financial and so would be measured at historical cost,
while most liabilities are financial and so would be measured at fair value.

• Reporting changes in fair value will result in volatile

profits
• Many of the changes in fair value may never be
realised
– therefore the income statement will show losses that never arise and gains
that are never realised

• Well-working market prices do not exist for many

assets and liabilities and so their valuation could be
subject to estimation and bias
 Different measurement concepts in IFRS
• IAS 2 – Inventories
• IAS16 – PPE
• IAS 36 Impairment of assets
• IAS 37 Provisions
• IAS 7 Financial instruments
• IFRS Share based payments
• IFRS 5 – Non-current assets held for sale and
discontinued operations
• IAS 19 – Employee Benefits
• IFRS 13 Fair values
 Usual measurement systems adopted in
financial statements
• Historical cost
• Fair value
• Net realisable value
• Present value
 Discussion question
Compare historical cost accounting and
current value measurement bases using the
following yardsticks:
 
• Relevance versus reliability
• Revenue recognition
• Recognition lag
• Matching costs and revenues
 Comparison of different measurement bases
• Relevance and reliability
HCA is relatively reliable but it is low in relevance; relevance of current value
accounting generally exceeds that of historical cost.

• Revenue recognition
Under HCA revenue is recognised on realisation; more generally, current
valuation revenue is recognised as changes in current value occurs
• Recognition lag
Current value accounting has little recognition lag, since changes in economic
value are recognised as they occur. HCA has greater recognition lag
• Matching of costs and revenues
Matching is primarily associated with HCA leading to accruals which smoothens
out profits. Matching is not required under current cost accounting since values
are driven by market forces
 Discussion
• Regulation: global accounting standards, a reality?
• Measurement bases: communicating reality – the
search for an appropriate measurement basis. Is fair
value the answer?
• Corporate reporting: how could it be made less
complex and more relevant?
• Corporate governance – what’s the role of accounting
and audit?
• SER – extending the scope of financial reporting:
human capital accounting, environmental accounting?
• Positive accounting – issues, relevance?
 Discussion
• Who determines the relevance of a
measurement system- preparers or users of
financial statements, or regulators?
 
• Is there a best method of accounting
measurement?