Problematic Measurement Issues in Accounting - Essay Example

Table of Contents Particulars Page No. 1.0 Introduction 2 2.0 Measurement in Accounting Framework 3 3.0 Measurement under IFRS 4 4.0 Issues in Financial Reporting Measurement 5 5.0 Measurement Choices 7 6.0 Problematic Measurement Issues in Accounting 10 7.0 Public Policy Considerations in Measurement of Accounting 11 8.0 Conclusion 12 9.0 References 13 1.0 Introduction This report has been designed in a synchronized and comprehensive manner to focus on the measurement issues in accounting. Directly or directly financial reporting measurement is linked to every stakeholder of the company and has a large impact on the success or failure of any organization. Growing controversies now surround the question of measurement issues in financial accounting primarily because of its shift from the traditional measurement basis of historical cost to new measurement basis of Fair Value concept. With changing requirements in measurement concepts there has been an emergence of lot of critical issues in financial measurement which has been looked upon in this report. Financial reporting makes a continuous attempt to measure abstract and debatable concepts related with income and net assets which has features which makes it inevitably subjective and arbitrary. It tries to measure a reality which is constantly changing partly because of changes in the measurement rules and techniques itself which further makes it a matter of evolving conventions. This report thus focuses on the current measurement issues in accounting to ensure that the readers are equipped with not just theoretical knowledge but gains a practical understanding of the entire topic. 2.0 Measurement in Accounting Framework Before actually understanding the major or current issues in accounting it is first important to understand the basis or the evolution of measurement concepts in accounting. Different jurisdictions have developed their own financial reporting requirements which had evolved as a response of solution to diverse problems. However historical cost still is regarded as a predominant basis for financial reporting. Transactions are initially recorded as soon as they occur which form a major basis of historical cost measurement. Historical cost therefore can be regarded as the cheapest and the easiest way of financial reporting measurement which forms a basis of the book keeping records and management information systems. However with time there has been a shift from the historical measurement techniques to another current value and now to the latest use of fair value measurement. The question still remains why there has been a shift in such a system. It is therefore possible to identify a number of reasons for such a change in the measurement concept of which all responses to financial reporting problems. New ways and style of doing business: Financial reporting has been changing to cope up with new ways of business. For example, new concepts in business such as leasing, share based payment, complex financial instruments etc all have led to new challenges in the field of measurement in which there is no historical cost or historical cost is zero. Further for example insurance companies create long term liabilities which lack a definite cost at the time they occur and it is difficult to know the historical cost of the same. It can be concluded that historical cost is not well designed to meet the expectations of such transaction however they are equally important for understanding the financial performance and position of business. Disparity between current cost and historical cost: There can be large disparity in terms of measurement issues in context to an asset’s historical and current cost. For example a building purchased 25 years ago which is now worth many times than its historical cost is more relevant to be displaced at its current value than historical cost. The ability to manipulate the historical cost: Historical cost can be manipulated to produce figures which are misleading and reflect a wrong disclosure of financial statements. For example, a portfolio of investments whose value changes on a constant basis can be realized piecemeal so as to reflect a constant stream of historical cost profits or losses. Thus we see there had been many such problems in measurement of historical cost which lead to a new concept of measurement in fair value to reflect a more transparent and accurate system of financial reporting and disclosures. 3.0 Measurement under IFRS International Financial Reporting Standard (IFRS) is of significant importance as a large number of increasing companies are required to comply with same. It is to be noted that IFRS is not a complete new and unique solution to the problem but has emerged as a long and continuing evolution. Area where measurement concepts in IFRS are still required to be improved is the accounting and measurement for insurance contracts. Since the ultimate outcome of an insurance contact may remain uncertain for many long years and if profits are recognized when all uncertainties are resolved the accounts shall be misleading. The question still remains unresolved of how the uncertain outcomes can be measured so as to provide a true and transparent picture of both the current position and performance to date (Ball, 2006). To resolve all such problems IFRS has developed different measurement choices for different category of assets and liabilities for example the same assets (Plants and equipments) can be measured on different bases. Further market value can be measured in different ways (Example, sometimes market value, sometimes depreciated replacement cost). The effects of inflation can also be treated in different ways (For example, sometimes reflecting the changing value of money and sometimes not). Thus we see, measurement has now become a critical issue in accounting and there are different manner in which the same can be done which has made the accounting system complex. 4.0 Issues in Financial Reporting Measurement Financial reporting measurement is inevitably a matter of judgment and conviction. In daily life measurement is generally done for physical objects like weight, height, temperature etc. However in context to accounting measurement are expressed in monetary terms and are abstract concepts of uncertain meaning of income and assets which makes it controversial in nature. There are lot of problems in measurement issues in accounting which has been discussed as under. Determination of Separable Assets: Business is a complete effort of bring together different resources and generate synergy from the same. A combination of these resources is more likely to sold at a higher price than sold separately. This brings the problem of measurement of separate assets and their real value. For example, in the case of valuation of brands it is almost practically impossible to separate the value of brand from the value of business it belongs and to measure them separately. Prediction: Measurement in accounting involves prediction which is again uncertain and can lead to misleading results. For example, a fixed asset remaining useful life is predicted to calculate its current reflective cost, the recoveries of debts and realizable value of stocks are predicted to measure them on balance sheet date, future cash flows are pure prediction to calculate the assets value in use or recoverable amount etc. Thus when the very basis of measurement in many cases is based on estimation or prediction there always is an uncertainty in the concept of measurement in accounting. Allocation to periods and assets: there are many measurements in accounting which involves allocations of costs and revenue to different accounting periods and assets which brings an element of arbitrariness and subjectivity. For example, measurement of discounted future liabilities depends on the interest rate of different accounting periods which involves a judgment further many times depreciation of fixed assets in many cases involves judgmental allocation decisions. Further there is lot many such measurement problems on account of subjectivity and judgmental decisions involved. Items which are affected by one or more of the aforesaid problems, when one measurement technique is used and it may be well faced by another problem if cases where another alternative to measurement is applied has certainly has no escape from the subjectivity of measurement. 5.0 Measurement Choices As already had been explained that accounting have seen a series of challenges and developments in terms of measurement concepts. There are five bases of measurement which are Historical cost measurement technique. Value to the business or current cost. Fair value measurement concept. Realizable value and Value in Use. All these bases are based on accrual system of financial recording as they intend to measure cost as when they occur and realize income as they are earned as opposed to simply recording the cash flows. The last four of the aforesaid tools are all forms of current value measurement technique (Godfery, Hodgson, Tarca, Hamilton, and Holmes, 2010). Let us look at the all bases and their reliability and relevance in terms of their benefits and criticism to more apparently understand the measurement issues in accounting. Bases Reliability Relevance Historical Cost This is more reliable when measurement is done on actual transactions however the same is subjective when based on predictions, judgment and allocation. For: It is the real evolution of measurement in accounting and matches costs with realized income. It is a useful tool for management information alignment. Against: Concept of Historical cost is outdated as it fails in many instances when key assets and liabilities are measured at zero. Further it ignores the unrealized gain which is one of its major drawbacks. Value to the Business These are likely to be more reliable when there available markets for comparable replacement assets. However the same are subjective when changes in technology and markets occurs and when based on predictions and allocations. For: It is of great use for new entrants into the market as it highlights or help in analyzing the cost of entry and clearly reflects whether operating capability is being achieved and maintained in the market. Against: Investors do not seek to look at the maintenance of operating capability of the new entrants hence not relevant for existing investors. Fair Value Concept of Measurement These are more reliable as a measurement tool when based on active markets. However, they are likely to be subjective in cases where there are no reliable market values For: Many financials regard it as the most appropriate and most relevant measurement for financial decision making perspective at it highlights the sales value i.e. the gross value and therefore the opportunity cost involved in financial transactions. It also shows the risk adjusted cash flows for many assets which makes it unique and most appropriate for current business scenarios and situations (Rayman, 2007). Against: It is highly criticized for showing the measurement based on rejected alternatives as assets can be valued at sub-optimal value of aggregation giving misleading information. For example, fixed assets based on disposable value as opposed to the depreciated replacement cost of such assets (Benston, 2008). Realizable Value These are more likely to reliable measurement tools when based on active markets or actual realization of assets and liabilities. However, the same is subjected in cases of vice-versa i.e. no active markets or actual realizations. The arguments on realizable value of For and Against are the same as those which has already been discussed in the fair value concept of measurement. Value in Use These concept of measurement is more subjective in nature as these are purely based on predictions and estimations along with judgmental decisions For: Value in use concept of measurement is of great importance and significance as it reflects the present value of expected future cash flows which is widely used in financial management and economist measure of income. They occupy a dominant position in standard setters stated objectives. Against: The highest criticism for Value in Use concept of measurement technique is that it is used to measure the changes in expectations than on the actual performance which brings a subjectivity concept and uncertainty element in the measurement tool. 6.0 Problematic Measurement Issues in Accounting With rising complexity in accounting and contemporary accounting field, accounting measurement issues had become a challenging task. The very problem of accuracy and transparency adds to the very first basic problem in measurement of accounts. There are some intangible and financial assets like goodwill and derivatives which leads to controversies among the academics as to the measurement of such exchangeable intangible assets along with the reversal of intangible assets and their disclosure requirements. Further the concept of fair value measurement technique has gained much controversial after the occurrence of financial crisis. Secondly the framework designed by the International Accounting Standards had failed to bring in strict regulations in terms of application of the five aforesaid discussed measurement tools or bases. It allows multiple measurement basis for same assets or liabilities which again creates doubts and complexity in the measurement concepts. Companies look to exploit these leakages or loop holes in the measurement tools to decrease the accuracy and transparency of their financial accounting information and disclosure. In addition to the same it also makes the accounting measurement concepts full of questions and doubts to the experts and users of accounting information (Ding, Hope, Jeanjean & Stolowy, 2007). In addition to the above problems how to measure the effect of changes in assets and liabilities on the profitability of the company along with how to establish a perfect accounting measurement system which confronts to the measurement principles are other areas of controversy (Deegan, 2009). Although there has been some efforts to convergence the accounting standards of different countries there is still a long way for policy makers of measurement tools in accounting to improve the quality, standard and comparability of accounting information on a global basis. 7.0 Public Policy Considerations in Measurement of Accounting It is to be noted that both internal and external financial reporting faces a challenging task on the selection of an underlying measurement bases as the same involve a different cost and benefit analysis which is a complex one. Furthermore Financial Reporting Measurement is regarded as a public policy and should be dealt in terms of how other public policies are regulated. The effect of measurement on financial stability is a controversial area which requires immediate research to solve the basic problem of selection of measurement bases and ensure transparency and accuracy in financial reporting. Laws and regulations should be developed which should be mandatory to disclose in addition to the measurement affecting income statement and balance sheet in matters such as disclosure of alternative measurement techniques, assurance, process requirements etc. Thus, in a nutshell measurement issues in accounting is growing at a rapid and it is of urgent need to regulate the same even though financial reporting is regulated but the question still remains of how far it is appropriate to impose uniformity in measurement tools and techniques. 8.0 Conclusion This report has been designed to deal with the critical issues of measurement in accounting. The report highlights the evolution of measurement bases from historical cost to currently used fair value measurement techniques along with measurement issues in IFRS. The report also provides an understanding of the five bases of measurement and criticism and advantages of all the bases in a tabulated manner for easy understanding and significant issues in measurement in context to accounting. Further major issues or problems in measurement of accounting has been explained in detail along with problematic controversies in measurement and public policy measurement of measurement in accounting to highlight the basic need and requirements which is required in measurement techniques to ensure better transparency and accuracy in measurement concepts of accounting. 9.0 References Benston, G.. J, 2008. “ The shortcomings of fair value accounting described in SFAS 157. Journal of Accounting and Public Policy. 27, 101-114 Deegan, C.2009. Financial Accounting Theory, 3rd edition, McGraw Hill Australia Pty Limited. Ding, Y. , & Hope, O. K. , & Jeanjean, T. & Stolowy, H, 2007. Differences between domestic accounting standards and IAS: Measurement, determinants and implications. Journal of Accounting and Public Policy. 26, 1-38. Godfery, J, Hodgson, A, Tarca, A, Hamilton, J and Holmes, S, 2010, Accounting Theory 7th edn, John Wiley and Sons. Ray Ball, 2006. ‘IFRS: pros and cons for investors’, International Accounting Policy Forum, special issue of Accounting and Business Research, forthcoming. Rayman, R. A, 2007. Fair value accounting and the present value fallacy: The need for an alternative conceptual framework. The British Accounting Review. 39, 211-225 Read More