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LECTURE 5 & 6
MEASUREMENT IN ACCOUNTING
MEASUREMENT THEORY
ARTHIK DAVIANTI, SE. MSI. AK. CA.
IMPORTANCE OF MEASUREMENT
Campbell:
The assignment of numerals to represent properties of material systems other than numbers
3
Assignment of numerals to objects or events
according to rules. (Stevens)
Involves linking the formal number system to some property of objects or events by means of semantic rules e.g. semantic rules in accounting are
represented by transactions
In accounting we measure profit by: first assigning a value to capital
then calculating profit as the change in capital over the period
4
IMPORTANCE OF MEASUREMENT
SCALES
Every measurement is made on a scale
Created when a semantic rule is used to relate the mathematical statement to objects or events
The scale shows what information the numbers represent
Scales: nominal, ordinal, interval and ratio
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NOMINAL SCALE
In this scale, numbers used only as labels
Numbers represent classification
e.g. numbering footballers
e.g. the classification of assets and liabilities into different classes
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ORDINAL SCALE
In this scale, rank orders objects with respect to a given property e.g. tallest to shortest person
e.g. investment alternatives that are ranked 1, 2, 3 according to the size of their net present values
Intervals between the numbers are not necessarily equal
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INTERVAL SCALE
In this scale, rank orders objects with respect to a given property
The distance between each interval is equal and known
An arbitrarily selected zero point exists on the scale e.g. celsius temperature scale e.g. standard cost accounting
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RATIO SCALE
In this scale, rank orders objects with respect to a given property
Intervals between objects are known and equal
A unique origin exists e.g. measurement of length e.g. use of dollars to measure assets
and liabilities
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PERMISSIBLE OPERATIONS OF SCALES
Invariance of a scale means that the measurement system will provide the same general form of the variables, and the decision maker will make the same decisions
This is not the case in accounting – there is more than one accounting system
The information they provide will differ and different decisions will be made
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PERMISSIBLE OPERATIONS OF SCALES
Nominal and ordinal scales no arithmetic operations
Interval scale addition and subtraction
Ratio scale all arithmetic operations
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TYPES OF MEASUREMENT
There must be a rule to assign numbers before there can be measurement
The formulation of the rules gives rise to a scale
Measurement can be made only on a scale
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FUNDAMENTAL MEASUREMENTS
Numbers are assigned by reference to natural laws
Fundamental properties are additive e.g. length, number and volume
In accounting there is considerable debate over the nature of fundamental value
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DERIVED MEASUREMENTS
Is one that depends on the measurement of two or more other quantities
Depends on known relationships to fundamental properties e.g. the measurement of density depends
on the measurement of both mass and volume
e.g. the measurement of profit depends on the measurement of both income and expenses
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FIAT MEASUREMENTS
Typical in social sciences including accounting
Based on arbitrary definitions - e.g. of profit
Numerous ways in which scales can be constructed
May lead to poor levels of confidence in the scale – e.g. there are hundreds of ways to measure profit
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RELIABILITY AND ACCURACY
No measurement is free of error except counting e.g. we can count the chairs in a room
and be exactly correct
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SOURCES OF ERROR
The sources of error include the following:
Measurement operations stated imprecisely
Measurer
Instrument
Environment
Attribute unclear
Risk and uncertainty
We need to establish limits of acceptable error
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RELIABLE MEASUREMENT
What is reliable measurement? proven consistency repeatable or reproducible precision
Reliability incorporates two aspects accuracy and certainty of
measurement representative faithfulness
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ACCURATE MEASUREMENT
Consistency of results, precision and reliability do not necessarily lead to accuracy
Accuracy has to do with how close the measurement is to the ‘true value’ of the attribute measure - representation
‘True value’ may not be known
e.g. in accounting accuracy relates to the pragmatic notion of usefulness
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ACCURATE MEASUREMENT
Many accounting measurements are on a ratio scale
This is the most informative scale
Weakest theoretical foundation as they are fiat measurements
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MEASUREMENT IN ACCOUNTING
Two fundamental measures capital & profit
Capital and profit can be defined & derived in various ways
Concepts of capital & profit have changed over time number of concepts of fundamental
measurement
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MEASUREMENT IN ACCOUNTING
Two notable developments in international standards (2005, IASB) profit measurement and revenue
recognition should be linked to timely recognition
the fair value approach should be adopted as the working measurement principle
At no stage has the principle of capital maintenance been explicitly discussed
22
MEASUREMENT ISSUES FOR AUDITORS
The focus of profit measurement has shifted from matching revenues and expenses to assessing the changes in the fair value of net assets e.g. immediate recognition of
impairment losses
Auditors must determine whether management has made appropriate and reasonable valuationse.g. at least 12 methods of valuing intangibles
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MEASUREMENT ISSUES FOR AUDITORS
It is possible for several different but reasonable measurements and impairment losses to be recognised by management
These would all be acceptable to an auditor if management have applied the valuation models correctly
used appropriate data
made appropriate assumptions
acted in a consistent manner24
ACCOUNTING MEASUREMENT SYSTEM
THREE MAIN INCOME AND CAPITAL MEASUREMENT SYSTEMS
The historic cost accounting system emerged after the 1929 Wall Street collapse
In the 1960s several alternatives were developed
current cost accounting
financial capital maintenance (the purchasing power of the financial capital)
physical capital maintenance (the physical ability to produce goods and services)
exit price accounting
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HISTORIC COST ACCOUNTING
Separation of ownership and control information asymmetry
Most critical objective of accounting is accountability - stewardship (conservatism)
The income statement is paramount transaction based
revenue recognition
matching
profit measurement27
ARGUMENTS FOR HISTORIC COST ACCOUNTINGRelevant in making economic decisions
Based on actual, not merely possible, transactions
Data have been found to be useful
The best understood concept of profit
Must guard data against internal modifications
Profit based on alternatives may not be useful
Market prices can be supplementary data
Insufficient evidence to reject it
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CRITICISMS: OBJECTIVE OF ACCOUNTING
Stewardship is only a secondary objective
Providing the decision making needs of users is the primary objective and historic cost data is a failure in this regard
Historic cost information is not objective
can be easily manipulated
does not maintain the entity’s capital
29
CRITICISMS: INFORMATION FOR DECISION MAKING
Is irrelevant when evaluating past decisions
After acquisition, historic cost data is fictional
Connected to inconsequential measures of capital
Produces only flawed measures of profit
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CRITICISMS: BASIS OF HISTORIC COST
The going concern assumption does not justify the use of historic cost accounting many businesses fail
no businesses continue indefinitely doing only or at all what they are presently doing
all businesses, except those presently existing, cease operations
All businesses have alternatives and choices going forward
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CRITICISMS: MATCHING
Is a practical impossibility
Is totally arbitrary
The balance sheet is important
Resulted in non-assets being classified as assets and non-liabilities being classified as liabilities
Leads to volatility and smoothing
32
CRITICISMS: NOTIONS OF INVESTOR NEEDS
Distorts and conceals
Its goals are ill-conceived
Creative accounting is commonplace
Incentives to produce misleading data
Today, investors pay little attention to historic cost accounting data about a firm
33
OBJECTIVE OF CURRENT COST ACCOUNTING
CCA values assets at their current market buying price and profit is determined using matching expense allocations based on the current cost to buy
Profit is more precisely defined as the change in capital over the accounting period
Managers are better able to evaluate their past decisions and better use the firm’s resources to maximise future profits
Shareholders, investors and others are able to make better allocations of their resources
34
OBJECTIVE OF CURRENT COST ACCOUNTING
Managers will examine the current operating profit
the excess of the current value of the output sold over the current cost of the related inputs
realisable cost savings
increases in the current cost of assets held
holding gains/losses
realised/unrealised
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FINANCIAL CAPITAL VERSUS PHYSICAL CAPITAL
Profit is the change in capital
Holding gains are included in profit under financial capital
Holding gains are excluded from profit under physical capital
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ARGUMENTS FOR AND AGAINST CURRENT COST
Recognition principle violates the conservatism principle - but
actual phenomena
are holding gains profits or revaluation adjustments?
Objectivity of current cost lacks objectivity
Technological change appears to ignore technological advances
37
MORE SPECIFIC CRITICISMS
Advocates of historic cost accounting violates the realisation principle; subjectivity of increase
Comparisons of the results with historic cost industry variations
Advocates of exit price the logical expression of opportunity cost is the current selling price
the arbitrary allocation of expenses is still a problem issue
additivity problem exists
number of reasons for an asset having value to a business
irrelevant to most business decisions
physical capital concept fraught with weaknesses
38
EXIT PRICE ACCOUNTING
Exit price = selling price = fair market value
Has two major departures from historic cost accounting:
the values of non-monetary assets are selling prices and any changes are included in profit as unrealised gains
changes in the general purchasing power of money affect both financial capital and profits
Represents clean surplus accounting
The income statement explains all of the differences existing between the opening and closing balance sheets
39
OBJECTIVE OF ACCOUNTING
Objective = data for adaptive decision making
The assumption is that the business world is dynamic and business must adapt to survive
Firms and those associated with them go into markets to take advantage of opportunities as they arise
The ability to engage in market transactions is revealed by net financial position (net current market value)
40
OBJECTIVE OF ACCOUNTING
Ultimately all accounting information users are interested in cash and cash equivalent values
In the final analysis, the economic survival and performance of a firm depends on the amount of cash it can command
Chambers:
…the single financial property which is uniformly relevant at a point of time for all possible future actions in markets is the market selling price or realisable price of any or all goods held.
41
ARGUMENTS FOR EXIT PRICE ACCOUNTING
Provides useful information
Provides relevant and reliable information there is one way to determine profit that is
superior to all others
profit is the difference between capital at two points in time exclusive of additional investments by and distributions to owners
to be relevant, information must be useful in the decision models of accounting data users
the present selling price is the only item of information that is relevant to all decisions
42
ARGUMENTS FOR EXIT PRICE ACCOUNTING
Additivity
if we use different measurement systems then no practical or commercial meaning can be deduced from the aggregate
even if we use historic cost accounting as the sole measurement system, the jumble of historic costs on different dates means we cannot put any meaning on the calculation of net assets or profit
exit price accounting does not have this problem
43
ARGUMENTS FOR EXIT PRICE ACCOUNTING
Allocation the financial statements are allocation
free
Reality references are to the real-world in that
every disclosed amount refers to a present, actual market price
exchangeability
44
ARGUMENTS FOR EXIT PRICE ACCOUNTING
Objectivity market prices are relatively more
objective than most believe
A measure of risk can indicate the financial risk of
purchasing an asset
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ARGUMENTS AGAINST EXIT PRICE ACCOUNTING
Profit concept
does not provide a meaningful concept of profit
the critical event does not relate to the performance of the firm
does not produce realistic financial reports
Additivity
violates the principle of exclusion of anticipatory calculation that it claims to reject
46
ARGUMENTS AGAINST EXIT PRICE ACCOUNTING
The valuation of liabilities
valuing liabilities at face value and not market value is internally inconsistent
Current cost or exit price
at what stage of the operating cycle should exit price dominate asset valuation?
47
VALUE IN USE VERSUS VALUE IN EXCHANGE
Similar when markets are liquid and efficient
There are factors common to both
market prices are more relevant for decision making
additivity and reliability are prime requirements
historic cost accounting has too many defects
They are complements not substitutes
Value in use assesses long term survival (solvency), value in exchange assesses the ability to adapt in the short term (liquidity)
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A GLOBAL PERSPECTIVE AND INTERNATIONAL FINANCIAL REPORTING STANDARDS
Current cost in the United Statesan experiment but abandoned (1976 -1984)
Current cost in the United Kingdom implemented but abandoned (1975 – 1985)
Current cost in Australia recommended but abandoned (1976 – 1980’s)
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INTERNATIONAL ACCOUNTING STANDARDS AND CURRENT COSTS
IASB/FASB have agreed that fair value is the best measurement basis (2004) the amount for which an asset could
be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction
50
INTERNATIONAL ACCOUNTING STANDARDS AND CURRENT COSTSHistoric cost accounting still generally applied
Distinct movement toward current value systems
IASB moving toward exit prices (2004)
But still a mixed valuation approach
Fair value means – current market entry price, current market selling price, historic cost and discounted future cash flows
There is no mention in the standards of capital maintenance concepts
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HISTORIC COST
Subjectivity is involved in the determination of the acquisition cost of an item
Thereafter the measurements are even more subjective
The era of historic cost accounting has ‘ended’ it produces irrelevant, unreliable, non-
comparable and non-understandable data
52
A MIXED MEASUREMENT SYSTEM AND INTERNATIONAL STANDARDS
Market values - exit prices - are implied in the ‘fair value’ approach in international financial reporting standards
A lack of a theoretical concept of valuation, capital maintenance and profit measure, has resulted in a still mixed measurement system and a lack of consistency
53
ISSUES FOR AUDITORS
The mixed measurement model creates misstatement so that auditors struggle to meet one of their primary objectives determining whether the financial
statements present a true and fair view
54
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