Measurement Bases for Financial Accounting - Example

Measurement Issues Name: Institution Measurement issues Introduction The issue of measurement is a crucial factor in accounting. Measurement is a vital to the accounting fraternity for the purposes of recording, summarising, preparation of financial statements and reporting financial statements that aim at indicating the trues position of the specific entity [Bhi06]. However, the accounting measurement issues are perceived to be problematic for as many as the number of measurement techniques that are involved This paper analyses the role of measurement in accounting and the reasons that make measurement issues to be perceived as problematic. For us to understand the issues that are present in accounting, one must also understand the major the measurement tools in accounting so as to have a better understanding of the issues in Accounting. Each accounting measurement technique has a unique issue that is applicable to it. What measurements Encompasses According to the International Accounting Standards board (IASB), measurement is defined as the as “the process of determining the monetary amounts at which various components of the financial statements are to be identified and forwarded in income statement and the balance sheet. Measurement are mainly used in two main ways in accounting [IAS06]. They are mainly used for initial recognition purposes of an item in the financial statements and also for Re-measurement purposes of a previously recognized liability or asset when circumstances are considered to require re-measurement. There are five measurement techniques in accounting, these are the historical cost, the value of the business, fair value, value in use and the realisable value. All these are the major forms of accrual accounting in that they aim to measure the costs that are incurred and income as it is earned. We are going to evaluate each of the accounting measurement technique and identify the measurement issue that pertains to each of them [ICA06]. Historical costs Historical cost of an asset refers to the amount paid for the asset whereas historical cost of a liability refers to the amount that has been received in respect to the asset. The historical cost concept, states that the book value of an asset should never exceed the amount the amount that a business expects to recover from its use or its sale [Jon062]. Because of this principle, the recoverable amount is always considered to be higher than the asset’s value in use and realisable value. Information prepared via historical cost basis is always advantageous in various ways compared to the other methods of measurement. First this is always applicable to lenders and creditors who perceive that their interests are better served and protected if their net assets are measured in a conservative way since this reduces the chances in which a company’s asset can be paid out as dividends to the shareholders [Eis00]. They are likely to disregard the distribution of unrealised gains, which the historical cost concept views as extremely risky. Shareholders are also likely to benefit from this method considering the fact that it will be now a lot easier for the business to raise loans and other forms of credit [Jon062]. The second way is that the business is taxed on the reported profit, the historical cost provides an advantage, from the taxpayers' point of view. Issues relating to Historical cost measurement The critics of historical cost value argue that there are strong weakness that are brought about by the historical cost measurement method. There are three major issues relating to the historical measurement method. One of the major issues is that the concepts are inherently irrelevant to the modern accounting decisions because they are obsolete information and provide no clear guidelines to business’ current financial position [Jon062]. The second issue is that the historical cost measurement technique ignores the intangibles that are generated internally which are progressively critical to entities as well as the financial instruments that have no costs. Thirdly, the historical cost concept, fails to take into account the unrealised gains and therefore this is likely to significantly understate both net income and net assets [Eis00]. Value to the business Value of the business is the second method of measurement in accounting. For any given assets, the value to the business tries to evaluate and answer the question, how much worse off the business would be if it were deprived of the asset. The answer to this is given by the asset’s replacement costs. In case of liability, value to the business evaluates how better off the business would be if it were relieved of the liability [Jon062]. The information provided by the value of the business is likely to be relevant to some purpose compared to information provided by other forms of measurements. Issues relating the Use of Value to the business as a method of measurement The critics argue that the main issue that is relevant to the business’ owners and investors is the profit after maintaining the financial capital and not profit after maintaining a business’ operating capability. They further argue that a business can increase its owner’s wealth while reducing its operating capability and therefore don’t see the reasons as to why management should focus on capital maintenance [Eis00]. The second issue is that the information is measured from a potential market entrant perspective does not provide effective information on financial position and performance of the business. Fair Value This method of measurement, treats both the asset sale and purchase as same prices. In practical terms, for any given market participant, both prices are supposed to be different. The definition therefore implies that far value is neither an actual selling price neither is it an actual buying price, but rather a theoretical value [Bhi06]. Issues relating to fair value as a method of measurement The issues related to fair value has led to its little use for management purposes. The fair value shows value that would have been realized had all the assets of the business been sold and all its liabilities settled at the balance sheet. The fact that a liability or an asset appears in the balance sheet shows that the option to sell it at the specific indicated date was rejected and therefore values that reflect a rejected value cannot be the best method of measuring performance of a business [ICA06]. The other argument is that the assets that are sold jointly tend to achieve higher value compared to assets that are sold separately and therefore user who are interested in market values, the fair values for separable assets appear to be irrelevant to them. Realisable Value An asset’s realisable value refers to the value in which the asset can be sold for. On the other hand assets liability value refers to the amount for which the liability could be settled. It is important to note that the realisable value is always on a net basis and therefore refered to as net realisable value [ICA06]. Measurement issues that relate to realisable value The issues that face realisable value, relate to those that face fair value, the only addition is that realisable value has advantage in that it uses net measurement and its application to entities that are expected to be sustained [Bhi06]. Value in use The value in use of a liability or an asset refers to the discounted value of the future Cash flow value that is attributed to it. Value in use involve involves the recognition of gains as they come up rather than as they are gained [ICA06]. Measurement issues that relate Value in Use The first issue is that the value in use tends to collapse forecast of future cash flows into values of a recent past on the basis of discounting. The other issue is that its usefulness in the use of information is significantly limited not unless there is full disclosure of the fundamental assumptions, sensitivities and forecast. The final issue is that the critics argue that valuation of the business is best carried out by the market other than the management in the financial reporting [Bhi06]. General Measurement Issues in Accounting There is a general consensus in the accounting fraternity that the accounting research has not been able to create a theory of measurement from the observation of accounting practices that relate to measurement [Bhi06]. Assigning of Monetary Units to Represent Value According to the research, it has been identified that there are no specific scales to determine measurement and the attributes of the accounting phenomena that are of interest to measure. The theory of measurement require that any process of measurement must identify the scale of measurement and the specific attribute that is being measured [Bhi06]. The accounting concepts tends to assign monetary units to value the components of the financial statements. It is important to note that the scale that is used to give monetary units to the specific units of value is not stated. This is an issue because every process of measurement must state the scale that has been used in the process. It can therefore be inferred that the process of giving monetary value to the components of the financial statements is therefore not a process of measurement [Eis00]. Definition of Accounting and Objectives of Accounting Lack Harmony Both the experts and critics argue that the definition and objective of accounting are not in line with the theory representational measurement. One of the major criticism is that there is lack of an empirically accurate value of a measured quantity that exists in accounting [Jon062]. From most analysis it was observed that almost all the measurements had an error of some kind. This evidently proves the inadequacy of the accounting measurement concept in dealing with the errors of measurement. Absence of Scale of Measurement The concept of scale is perceived to be misused and misapplied in the discipline of accounting yet every form of measurement requires a specification of the scale of measurement that is supposed to be used to determine the extent in which an object of a particular class possess a specific property. On the other hand measurement is only useful and meaningful when the scale of measurement has been specified. It therefore shows that the absence of scale of measurement in accounting imply that the accounting measurements are not meaningful [ICA06]. The scale of measurement are also crucial to explain the relationship between empirical relational structure and the numerical relational structure that it aims to represents. The absence of a specified scale of measurement in accounting means that it would be impossible for individuals and the potential investors whether or not they are drawing appropriate inferences about the numerical relational structure and empirical relational structure [ICA06]. The Concept of going concern and Representational theory of Measurement are not in Harmony The other issue in accounting measurement is that the accounting concept of measurement under the concept of going concern is not in accord with the representational theory of measurement. From this discovery it is vivid that it is impossible to measure accounting under the concept of going concern [ICA06]. Accounting rules state that financial statements of businesses whose operations are expected to continue for a very long time in the future are to be prepared under the assumption of going concern From this analysis it can therefore be concluded that the financial statements of such entities that are prepared using the assumption of going concern do not contain the measurement information [Eis00]. Lack of Objectivity in Accounting Measurement The accounting measurements are always not objective yet the theory of measurement states and requires that all the forms of measurements must be objective. This therefore indicates that accounting measurements don’t contain the characteristics of a real representation measurement [Eis00]. It is further stated that the accounting phenomena lacks objectivity and specifically the value and the cost lack objectivity. Way of Presenting Information in Financial Statements The systems that are used are criticized heavily by experts. Experts argue that the method of presentation in the financial statements are not in line with the measurement representational theory. It is therefore important to find other ways in which presentation of financial information can be consistent with the representational theory of measurement. It is further argued that the conditions under which the accounting information may be considered meaningful are not specified [Eis00]. Every single measurement requires specifications of the conditions that approve or determine whether the specific measurement information is meaningful. However, the conditions for meaningfulness are specified after a scale is identified [Bhi06]. Therefore accounting makes this next to impossible since both the scale is also not determined in accounting. Accountants are not familiar with the Measurements After conducting a research via questionnaire by the accounting board, it was identified that most accountants are not familiar with the representational theory measurement [Bhi06]. This creates a major issue in the accounting discipline since the very people that are responsible for creating the measurement knowledge in the accounting discipline are not familiar with very principles and theories. It is important that such an issue is addressed to prevent further in the accounting presentation of information. The main way in which such an issue can be addressed is by incorporating the theory into the accountants’ education curriculum. This effort will make accountants familiar with the theory. Measurement versus Indicants in Accounting The measurement problem in accounting is facilitated by the lack of a clear distinction between the indicants and measurements. From the analysis above it has been identified the accounting measures are not even measurements at all, most of them fall under indicants and not measurement [Bhi06]. According to critics, the indicants are most times confused as measurements by many individuals. It is important for people to understand that indicants are correlates or effects related to psychological dimensions by unidentified laws. However, measurements only occurs when the relationship between the dimension and indicants of the specific entity in question are identified. In the accounting discipline, the term discipline is used to refer to both indicants and measurement [ICA06]. The main issue that presently exists in the accounting discipline is that the monetary units paid for the value of a certain commodity is most times considered as the measure of value of that commodity. This is misleading since the amount of monetary units offered for any commodity is basically an indicant and not a measurement. Measurement and Accounting reality The principle of measurement can only be applied when an object or asset is real. In accounting it has been identified that magnitude are theoretically and historically determined replications of the quantitative facets of objectively existing entities and not the outcome of measuring procedures [ICA06]. This therefore implies that for accounting to be a measurement discipline, its measurement scales must account of objectively existing accounting entities. In the accounting discipline, the realities are created by events and the events are about what happened [Jon062]. So as to be able to measure the characteristics of the accounting events, there must be a clear understanding of the qualitative structure of the specific accounting event. Conclusion There are several accounting issues that have been raised by this paper. It is important that the main issues are addressed so as to prevent contention in the accounting discipline. There are ways in which these issues can be addressed and one of the main ways is incorporating measurement techniques in the accounting programs so as to equip the accountants with the necessary skills that are required. References Bhi06: , (Bhimani, 2006), IAS06: , (IASB , 2006), ICA06: , (ICAEW, 2006), Jon062: , ( Jones, 2006), Eis00: , ( Eisen, 2000), Read More