The accounting measurement bases identified by relevant regulatory authorities shall be critically analyzed in this assignment. The issue of the additivity problem shall be highlighted in this respect. We shall then identify the measurement approaches adopted by four separate organizations in different industries. In the latter part of the assignment we shall also discuss the effect that financial statements pose on different stakeholders.
1 Introduction – Accounting Measurement Bases Regulations
Presently there are a number of different accounting standards that govern accounting procedures in different countries. For instance, in Europe there is the International Accounting Standards recognized in countries members of the European Union, while in the United States one can find the American Standards. Such regulations pose different accounting treatments for assets and liabilities held by the business. However, the accounting principles controlling the measurement base are fairly stable and the same in different accounting standards. In this respect, we will adopt a generic approach in the discussion of the different measurement bases available in accounting standards.
Critical analysis of different measurement basis available
The basis of measurements recognized in the Financial Accounting Standards Board Framework that are generally employed to varying degrees in the preparation of financial statements entail: historical cost, current cost, net realizable value, fair value, deprival value and value in use (Financial Accounting Standards Board 2005, p 8).
The historical cost measurement basis relies on the original cost of the asset purchased plus any expenditure incurred in enabling the asset to produce economic benefits. The framework of the accounting standards board states that one of the underlying assumptions upon which financial accounting is based is the accruals concept (International Accounting Standards 2000, p 49). Such principle denotes that revenue incurred in a particular period should be matched with expenditure incurred in that period. When the historical cost base is used the additivity problem will arise due to such concept.
In practice when an organization buys an asset that lasts for more than one year, it is very complex to determine with accuracy the part of the asset that remains unused after the end of the financial year (Lewis R. et al 1996, p 45). For example, if a firm buys a machine costing $10,000 with an expected useful life of 5 years. How will management be able to determine the amount of the asset used at the end of year one.
Thus reasonable approximations are taken in these instances, like for example spread evenly over the five years, which limit the accuracy of the financial reports, which is one of the qualitative characteristics stated in the framework of such reports (International Accounting Standards 2000, p 51).
Difficulties with the utilization of the historical cost measure also arise when valuing stock, especially work in progress and finished goods in case of manufacturing firms. In such instances allocation and apportionment of expenses incurred in the production of such goods is necessary, which again limit the accuracy of the results. Identical problems are encountered when tangible fixed assets are made by the firm for its own use (Lewis R. et al 1996, p 46).
Assets that are purchased through barter or exchange are also difficult to measure through such method. A particular problem that arose with the historical cost measure is when an organization buys a substantial amount of differing assets from a company. This usually arises in takeover or amalgamation situations.
It was frequently contended by critics that in such situations the value of the assets acquired was unrealistic leading to underestimation of the firm’s assets and exaggeration of the purchased goodwill figure (Lewis R. et al 1996, p 46). As a result, the accountancy standard boards developed a new measurement bases, commonly known as the fair value approach.
Such system kept abreast the market value measurement objective, which comprises that an asset or liability should be valued at a price that would be agreed under present competitive market conditions (Financial Accounting Standards Board 2006, p 8). Indeed the fair value method is considered as the best measurement system at initial recognition of an asset, because it reflects the market conditions and avoids underestimation of the company’s value in the capital market.
Accounting standards, however contend that such measurement bases is adopted when the market value of an asset can be reliably measured (Financial Accounting Standards Board 2006, p 12). This thus limits the adoption of such methods when assets are bought in isolation. Yet it is ideal during purchase considerations of other corporations because the value of the asset can be properly determined.
The adoption of the current costs bases consists of valuing assets and liabilities at the present cost of the balance sheet date. Differing systems are utilized to value the assets under such bases depending on their nature and information available. For example, inventories value is determined according to the current purchase price of the commodity, or the present cost to manufacture it (Hendricksen S. E. et al. 1992, p 426).
This current cost approach possess certain benefits over the historical cost bases, such as it represent the value of the assets to the organization if it intends to continue purchasing such assets. It also avoids underestimation of the firm’s assets. Proponents of such measurement bases also contend that it allows the identification of holding losses and gains at that present date, thus revealing asset management stewardship. However, critics dispute that the inclusion of income arising from holding assets at a higher cost value together with current operating profit is confusing and artificial (Hendriksen S. E. et al. 1992, p 430).
This confusing element disturbs one of the financial statements qualitative characteristics of the accounting standards framework of understandability (International Accounting Standards 2000, p 50). In addition by including unrealized profits, there is the risk of overstating the financial performance of the organization, because current costs do not necessarily represent the value of the firm, since it is subject to a dynamic market.
Another argument put against the current cost measurement bases is that the objectivity of financial figures is lost by including them at current cost, unless the assets presently sold in the market are the same and under identical market conditions (Henriksen S. E. et al. 1992, p 430). Objective is a very important principle in financial accounting, which highly affects the reliability of the financial statements. Financial accountants have posed considerable importance on the objectivity concept, because it is a useful way of justifying the measurement choice or procedure (Belkaoui R. A. 1994, p 242).
The net realizable value measurement bases consider the net realizable value of an asset. Net realizable value comprises the expected amount received from the disposal of an asset less anticipated costs incurred in such sale. The net realizable value is more difficult to quantify than the current cost because one have to enumerate the asset value from the point of the purchaser. In addition, the expected costs incurred in the disposal are very complex to amount especially for work in progress. The unit of service approach is suggested for the determination of net realizable value. (Lewis R. et al 1996, p 48 and 49).
The Financial Accounting Standards Board Framework also recognize the present-value approach as a measurement bases, as already stated in the opening paragraph of this section (Financial Accounting Standards Board 2005, p 8). Such scheme entails management to fix a projected succession of future cash flows to particular assets and identify and adopt a proper discount rate.
Such approach can be possible in instances of individual assets, however when assets are combined with each other, like for example, a manufacturing corporation acquires raw materials, which are processed in different machines to fabricate different products, which are eventually sold in different markets. In such cases as the one mentioned above it is very complex to measure which proportion of the total net cash flow should be allocated to a particular machine (Lewis R. et al 1996, p 49). This will thus lead to subjective decisions which will thus hinder the accuracy and reliability of financial reports.
The latter method recognized by the Financial Accounting Standards Board Framework is the deprival value measurement bases. This method consists of the loss that an organization would face if events or conditions existed at the Balance Sheet date or during the year that deprived the firm from such asset. In practice, such measurement base is commonly applied to inventories. Stock is valued at the lower of cost or net realizable value.
Thus if during the year something adverse happened to such stock, like damaged due to uncontrolled events or is no longer demanded by the market, the stock value is reduced from its historical cost to its net realizable value. This measurement base is also sometimes applied to intangible assets like goodwill and property, plant and equipment, in which an impairment loss is recognized on such assets and the relief value, is recognized in the accounts (Deloitte IAS Plus).
Such measurement approach stems in order to abide with the prudence concept, which states that due to uncertainties facing in the market, we have to be prudent and doubtful losses should be recognized in the accounts (International Accounting Standards 2000, p 53).
Additivity problem in measurement bases
A main criticism put against financial accounting is that the financial figures cannot be meaningful when added together due to:
The use of different attributes; and
The financial units in periods of changing prices.
The identification and adoption of the current cost approach eradicates the first criticism put forward. The basic argument of the second disapproval is that for summation to be meaningful due to changing prices one must add like with like and thus adding dollars from different years comprises totaling unlike things. To further compound the situation, in accounting literature as stated by Myddleton in 1984, the special case of simple enumeration is equated with the general case of measurement (Salvary S. 1997, p 89-103).
Yet, proponents of financial accounting state that under measurement one is dealing with a specified belonging of an object. For example, when commodities are transported, the carrying costs of transporting the goods are based either on the volume or the weight of the objects. In such instances, we are adding unlike things together. An attribute in measurement that is ordinary to all the items considered is that of being added together.
Therefore, the opposition towards the addition of monetary figures that when it portrays the summing up of the recoverable cost property is unfounded, because such addition of the measurement assets observed in a heterogeneous group of items is undeniably consistent with basic measurement principles (Salvary S. 1997, p 89-103).
Measurement bases of Australian Firms listed in ASX
From the Australian Financial Services Directory website, we identified four companies in different industries in order to determine the measurement bases used by such corporations. The firms selected are the following:
Retail Industry – Rebel Sports Limited
Telecommunications industry – Queste Communications Limited
Bank Industry – National Australia Bank Limited
Food & Household Goods Industry – Bonlac Foods Limited
All the organizations listed above follow the Australian Accounting Standards as clearly indicated in their annual reports for the financial year ended 2006. Therefore the measurement bases utilized will be similar because they will adhere to the same individual accounting standards. Indeed the property, plant and equipment of all these corporations are based on the historical cost bases. Such tangible fixed assets are also valued for impairment losses, therefore the deprival measurement bases is also used. All organizations also apply the deprival approach on inventory.
The financial assets of the firms are based on the fair value measurement bases, in line with the accounting standard that covers financial instruments. It was also noted that the fair value approach was adopted on initial recognition during business amalgamations for consolidation purposes by all firms involved in such activity, such as Queste Communications Ltd (Queste Communications Limited, p 27).
Effect of financial statements on stakeholders
The financial information presented in the financial statements aid interested external users in their economic decisions. The better the financial performance and position, the more inclined will be investors, lenders, suppliers, and more to invest and trade with the company. The financial statements are frequently considered as the report which helps external persons and entities to assess management stewardship.
For example, investors, usually before investing in a company are interested in the risk inherent in the organisation. They also seek the potential return that the firm can give in terms of dividends (International Accounting Standards 2000, p 44). Such examinations will continue each year in order to aid the investor in the decision of selling, holding or buying new shares in this firm. With respect to assessment of risk, financial statements provide relevant information by examining the capital structure and stability of the firm.
The gearing ratio can be adopted in order to determine if the firm is a high geared company or a low geared company. High geared companies are usually riskier organisations due to higher debts. Thus risk averse investors will perceive such high risk as danger and will thus be less inclined to invest or keep their investment in such corporations. Other stability ratios, like debt to total assets, debt to equity and times interest earned can be adopted in order to examine the ability of the organisation to meet its long-term financial obligations (Tutur 2u).
Final thought – Importance of Financial Statements
As one can note, financial statements are a very important medium to external users that help them in performing economic decisions. This fact is universally recognized around the globe and it is one the main reasons why accounting standards and frameworks had been set. Indeed the qualitative characteristics of understandability, relevance, reliability, faithful representation and comparability had been set in order to safeguard the interest of external users and ensure that proper financial statements are set to guide interested users to the right decision (International Accounting Standards 2000, p 50-54).
In additional the Companies Legislations in a number of countries like United States, United Kingdom and Australia, demand that before being issued, financial statement are reviewed by an independent auditor, who shall issue a report on the truth and fairness of the financial statements. Such auditor’s report is usually attached the annual report published.
Australian Financial Services Directory. Australian Stock Exchange Categories (on line). Available from: http://www.afsd.com.au/subindex.html (Accessed 5th April 2007).
Belkaoui R. A. (1994). Accounting Theory. Third Edition. London: The Dryden Press.
Bonlac Foods Limited. Annual Report 2006 (on line). Available from: http://www.fonterra.com/pdfs/05-06FonterraAnnualReportFinal.pdf (Accessed 5th April 2007).
Deloitte IAS Plus (2003). Agendas and Decisions at past IASB Meetings (on line). Available from: http://www.iasplus.com/agenda/0310.htm (Accessed 6th April 207).
Financial Accounting Standards Board (2005). Measurement Basis for Financial Accounting (on line). Available from: http://www.fasb.org/project/Canadian_Measurement_Discussion_Paper.pdf (Accessed 5th April 2007).
Hendriksen S. E.; Breda V. M. (1992). Accounting Theory. Fifth Edition. United State of America: McGraw-Hill Companies Incorporation.
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National Australia Bank Limited. Annual Report 2006 (on line). Available from: http://www.nabgroup.com/0,,32863,00.html (Accessed 5th April 2007).
Queste Communications Limited. Full Year Reports (on line). Available from: http://www.queste.com.au/fileadmin/QuesteCommunications/archive/FinancialReports/FullYearly/20060919_QUE_2006_Directors_and_Financial_Reports.pdf (Accessed 5th April 2007).
Rebel Sports Limited. Annual Report 2006 (on line). Available from: http://rebelsport.com.au/data/news/178/0/2006%20Annual%20Report.pdf (Accessed 5th April 2007).
Salvary S. (1997). Financial Accounting Measurement: A Reconsideration of SFAC 5 by the FASB is needed, Journal of Applied Business Research, Vol. 13, No. 3.
Tutur 2U. Introduction to Financial Ratios (on line). Available from: http://www.tutor2u.net/business/accounts/main_ratios.htm (Accessed 6th April 2007).
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