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Advanced Accounting

Advanced Accounting . Week 2 lecture Measurement issues in Accounting Rankin Ch 4 Reading 1: Whittington . Lecture Overview. Revise: what is decision usefulness? What are the measurement issues facing accountants? We examine some examples.

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Advanced Accounting

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  1. Advanced Accounting Week 2 lecture Measurement issues in Accounting Rankin Ch 4 Reading 1: Whittington

  2. Lecture Overview • Revise: what is decision usefulness? • What are the measurement issues facing accountants? We examine some examples. • How can theories and research help us to resolve these dilemmas? • Should our conceptual framework and standards allow choices of measurement methods? • How does this choice of measurement methods connect to ideas of decision usefulness?

  3. To recap from last week:What is decision usefulness? The Framework paragraph 12: The Objective of Financial Reports 12. The objective of financial reports is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making (their) economic decisions.

  4. What are the issues when trying to measure something? • What are the measurement issues faced by anyone? A choice of scale and unit. • As an non accounting example, measuring the health of new babies, a nurse looks at their weight, length and measures their breathing and reactions to other stimulus on the “Apgar scale”.

  5. Measurement The scales are weight, length, and the Agpar scale. The units are kgs, cm, or a rating out of 10. If we have triplets and we measure one baby’s weight, one baby’s length, and one baby’s Apgar rating, does the total of these three measures tell us anything about the health of the triplets? Probably not! 2.8kg +50cm+9/10 =

  6. What are the measurement dilemmas faced by accountants? • In accounting, our scale for financial reporting is normally Australian dollars….but which unit should we use? • Should we measure using units of: • historical cost dollars or (dollars in name) • current dollars ? (dollars in purchasing power) • fair value dollars? (exit value of dollars/ deprival value) This is one of the biggest debates in accounting, even today.

  7. An example of the additivity problem in accounting Property Plant & Equipment Land at valuation 400,000 Motor Vehicles 30,000 Less accum depn (4 000) 26,000 (straight line) Plant at cost 120,000 Less accum depn and (50,000) 70,000 Impairment losses TOTAL 496,000

  8. Measurement dilemmas • We run into problems because the conceptual framework states that to be included in the financial statements, an item must have a cost or value that can be measured reliably. • Measurement in accounting is considered in the standards item by item, not holistically. Individual parts (AASBs) may make sense, but does the whole accounting picture?

  9. Some basic questions: • Are current values (reflecting the purchasing power of money) more relevant? • Why are current values viewed as being less reliable? • What does FV mean for income definitions? • Can we add oranges, apples and pears and come out with a sensible statement? (the additivity issue) (historical cost, fair value, value in use)

  10. More examples of measurements • Inventory: AASB102 para 9: value at lower of cost & net realisable value • Financial instruments: it depends on the class (trading, avail for sale, held to maturity, loans & receivables are all measured differently) AASB 132 (presentation)and AASB 139 (recognition & measurement) AASB 7 (disclosures including FV hierarchy in para 27A) • Goodwill is recognised as the: purchase consideration – identifiable net assets (at fair value). It is then subject to impairment testing (AASB136)

  11. When is measurement NOT a problem? Complete and perfect markets • In complete and perfect markets, it would be easy to use market price as a single measurement method. Choice of measurement methods would not be a problem. Entry prices = exit prices. • complete markets: prices are readily observable for all assets and liabilities (Whittington 2010) • Efficient & perfect markets: all information is instantly reflected in prices, the state is known, and there are no transaction costs (also called frictionless)

  12. In complete and perfect markets in equilibrium the market value is equal to the present value of expected future cash flows from an asset • There is no information asymmetry • “True” Accounting income is clear: the change in value of the firm (Owners’ equity) • As the balance sheet records value and changes in value, the balance sheet is the only statement needed to value the firm (Fellingham et al, 1997)

  13. So why IS measurement a problem? • The trouble with this is complete and perfect markets rarely exist. (if they did, accountants wouldn’t have a job!). Information asymmetry is a feature of most markets. 2 forms: moral hazard and adverse selection. • Asymmetry: not matched or not equal, in accounting each person in the transaction does not have the same information symmetry asymmetry

  14. So why IS measurement a problem? • Standard setters often consider complete and perfect markets when deciding on appropriate measurement methods. According to Whittington (2010): “Much of the current thinking of accounting standard setters about measurement seems to be based on an idealized 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.”

  15. How can theory and research help?

  16. Use normative theory to help in measurement choices The framework offers several choices of measurement methods, but does not prescribe any one method • Historical cost • Current cost • Realisable (settlement) value • Present value Each method of measurement has its own strengths and weaknesses and should be judged against the qualitative characteristics in the framework.

  17. Use Research into decision usefulness to help with measurement choices The research into decision usefulness can be viewed in two “camps”. • The information approach: the role of accounting is to act as one information input into users’ decision making models. Useful information alters users’ expectations. • The measurement approach: the role of accounting is to assist users in valuing the firm. The numbers measure value. This will lead us to using more fair valuation.

  18. Factors in the choice of accounting measurement methods: is measurement choice good or bad? • Users’ information needs (decision usefulness [future], stewardship [past]) • Practical issues: Can we get to a number? Level of difficulty for account preparers and directors • Managements’ motivations & objectives (agency theory, positive accounting theory) • Impact on the financial statements • Impact on share prices?

  19. Measurement choice: good or bad? • Choice in measurement can lead to variations in accounting practice and therefore varying financial results being reported • Is there a need for flexibility? Yes, due to differing circumstances, differences in the substance or nature of transactions. So choice is good? • Is flexibility a drawback? Yes, it creates comparability issues, management make opportunistic accounting choices - creating biased pictures, misleading users, which can lead to corporate failures, and also. So choice is bad?

  20. Linking measurement choice to decision usefulnessChoice = decision useful?

  21. In summary

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