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OK, the requirements:
The measurement in accounting has been a critical and controversial issue. Firms use different methods to measure the elements of financial statements depending upon the nature of business and it creates several controversies when it comes to the reporting of fair value.
Measurement is translated into information and information can be categorised into financial and non-financial information, which is subsequently displayed in the market value of both equities and liabilities of firms.
REQUIRED:
A. Review AASB framework and provide a critical analysis of different measurement bases.
B. Critically discuss the notion that the use of different measurement bases creates a problem of additivity with the help of research literature.
C. Discuss with the help of theoretical framework and research literature, how does firms’ reported information affects stakeholders’ perception?
Here is mine:
Abstract
The purpose of this essay is to analyse four different measurement bases. It will state the advantages and disadvantages for each measurement base. Then discuss the notion that the use of different measurement bases creates a problem of additivity, explain how and why the additivity problem comes out. Finally, using the positive accounting theory and capital market research to explain how firms’ reported information affects stakeholders’ perception.
Introduction
According to AASB Framework, qualitative characteristics are attributes that make the information provided in financial reports useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability. (Claire Locke, 2008, p.37) So, it is very important to choose a suitable measure base when an entity preparing its financial reports. This essay will discuss some issues about measure bases. Part A will provide a critical analysis of different measurement bases. Part B discuss about an additivity problem when using different measurement bases. Part C shows how does firms’ reported information affects stakeholders’ perception.
Part A
As AASB framework states, there are four measurement bases are employed in financial report.
(a) Historical cost
Historical cost is the most commonly used by entities in preparing their financial reports, as its advantages are very clearly. Firstly, historical cost is easy to use, and no need to reference to market values. Second, historical cost is easy to understand. So the users will easily understand the financial reports based on the historical cost, even they don’t have financial background. In contrast, it also has some disadvantages. When using historical cost, it is assuming that the purchasing power of the dollar remains constant. But in fact, the purchasing power can not be stable. In the inflation period, the price of asset is changing a lot, so it doesn’t make sense to record the value of asset under historical cost when suffering changing price. It can not reflect the real financial position of the entity. Also, historical cost relies on a financial capital maintenance perspective, so it can lead to an overstatement of profits in times of inflation. It is not good for the company, because it need to distribute more dividends, and may cause decreasing the entities’ capacity to adapt to changing circumstances.
(b) Current Cost
The primary advantage of current cost results from the breakdown and segregation of current-value income into current operation profit and holding gains and losses. The company can get prominent benefit from distinguishing these two kinds income. The purpose of running a company is making profit. The profit can make the company keep running as well as distributing dividend to the shareholders. Under current cost base, the holding gain doesn’t put into dividend, so the company can have enough money to adopt the changing of circumstance. That make sure the purchase power of the company is stable, and it can goes well in the future no matter how the price level is changed. In the other hand, current cost also has the shortcoming. Firstly, when using current cost base, the value of the asset is difficult to determine. Sometimes, it is not easy to define the meaning of “the same asset”. The entity should choose use the value of the asset in the new-goods market or in the second-hand market. Secondly, for some kinds of asset, there is no activity market, such as goodwill, brand, trademarket. Therefore, they can’t be valued under current cost.
(c) Realisable value
Realizable value provides relevant and necessary information on which to evaluate the capacity for adaptation and liquidity of a firm. But, some significant disadvantages to the realisale value base. First, realisable value relies on the net selling price, but for some kinds of assets, such as goodwill, it can not be sold separately. Therefore, the realisable value is not easy to decide. It needs professional judgement. Secondly, for the same asset, put it in the different markets, it can be sold in different value. So that’s a problem about which market’s “selling price” or “realisable value” should be used. Thirdly, for the groups of the assets, the price of selling the group of assets maybe not equal to the prices of selling each asset separately.
(d) present value
The present value basis is deemed useful for such long-term operation decisions as capital budgeting and product development. The options yielding the highest positive capitalized values are deemed to be best method. The present value is generally considered to be an ideal attribute of assets and liabilities, although it presents some conceptual and practical limitations. (Ahmed & Stewart, 2000, p.421) Using this basis, it bases on some calculations. It need to estimation of future net cash receipts as well as choose an appropriate discount rate. But both of two factors are subjective, it can not present the really value of asset objectively. Secondly, it is not easy for users to understand the value of asset which is measured under present value. So it may lead the Financial Reports not understandable.
Part B
When the company is preparing the Financial Reports, it is very common that the entity use different measurement bases to value different kinds of assets.
And for Balance Sheet, it need add all the assets and liability up. During this process, it is need consider very carefully whether it is really logical to add together assets and liability. Generally, there are two problems of additivity, the first one is about the purchasing power, and the other is about the real value of the asset.
(a) Purchasing power
Different measurement focuses on different period. Historical cost focuses on the past, current cost and realisable value focuses on the present, present value focuses on the future.(Ahmed & Stewart, 2000, p.477) And because of inflation and some other factors, the purchasing power in different period are dissimilar. It doesn’t make sense that just simply add the assets but they don’t represent the same purchasing power. For example, a company bought two same computers in Year 1 and Year 2, but separately cost the company $1000 and $1500 because of inflation. Ignore the depression, at the end of Year 2, if the company just adds $1000 and $1500 to record the value of the computers, the Balance Sheet will mean nothing to users. Because that the Balance Sheet is not reliable and comparable. What is more, at the balance sheet if the cash is measure in historical cost, accounting receivable measurement by the net realisable value and all the other asset measure by current cost, the difference between purchasing power in different time period will be huge, the Financial Statement will cause more misleading. Although there are some methods to avoid this kind of addivitity problem, such as Current Cost Accounting which bases on the current cost or Continuously Contemporary Accounting bases on realisable value. If all the assets are measure at current cost or realisable value, then logically they can be added together. It can solve additivity problem. But in fact, because of the limitations of the current cost and realisable value, not all the assets can be value at current cost or realisable value, such as goodwill and trademark.
(b) Value of the asset
Finally, the Financial Statement is evaluated by the “amount”. Form the amounts, the users can see how much money the entity made or what’s the value of the asset. But whether these “amount” is correct or makes sense, it depends on which measurement bases they used. The same asset under different measure bases, the value of it will be different. For example, AA company bought a car two years ago for $10000, and expected to keep the car for five years. In the used-car market, this car can be sold at $2500. And replace cost for the car in similar condition is $3000. The future cash flow will be $4000 for the next three years, and discount rate is 10%. Under this situation, there are four options for AA company to record this car. (1) under historical cost, the asset is $6000 ($10000 less two years’ depression) (2) under realisable value, the asset should be $2500 (3) $3000 under current cost, or (4) $9947 under present value, which is calculate by:
Discount Factors amount
Year 1 $4000 0.9091 $3636
Year 2 $4000 0.8264 $3306
Year 3 $4000 0.7513 $3005 total $9947
(Michael Jones, 2006, p291)
From this example, it shows that different measurement bases give different asset valuations. There are thus four different valuations ranging from $2500 to $9947 and each amount has different meaning. From this example, it is clearly that, just one asset under different measure base has different value. Moreover, in practical, an entity can not hold only one asset, there are so many asset should be valued. If the entity adds up all the assets, but these assets are measure by different measure bases, in another word, they have different meaning in value. So that its Financial Reports will be confused the users, also they are not comparable.
Part C
The Financial Reports are prepaid to be used, and the stakeholders can be treated as the main users of the Financial Reports. A corporate stakeholder is a party that affects or can be affected by the actions of the business as a whole. (http://en.wikipedia.org, 2009) The stakeholders can classify into two categories- internal stakeholders and external stakeholders (Figure 1)
And each stakeholder may interest in the different parts of the firms’ reported information, also they will take actions according to the information they get from the firms’ reported information. To analysis how firms’ reported information does affects stakeholders’ perception, the share price can be used to measure the relationship between reported information and stakeholders’ perception, as no matter internal or external stakeholders, they both have more or less interest in share price. And also there are two theories need to be applied- Positive Accounting Theory and capital market research.
Information can be categorised into financial and non-financial information. The financial information will be shown on the Financial Reports, and the stakeholders most interest in will be the “earn” or the “profit” part. Under Positive Accounting Theory, it focuses on relationships between various individuals within and outside an organisation and explains how financial accounting can be used to minmise the costly implications associated with each contracting party operation in his or her own self-interest. (Deegan, 2006, p.260) Also, there are three central hypotheses: bonus hypothesis, the debt hypothesis and the political cost hypothesis. So using the bonus hypothesis, it is easily to explain that why the manager would like choose an accounting method which can show more profit. From the efficiency perspective, many organisations will elect to provide their mangers with bonuses tied to the performance of the firm, with these bonuses often being directly related to accounting numbers. (Deegan, 2006, p.261) So that, the more profit is shown on the Financial Reports, the more manager will make. And under the opportunistic perspective, PAT predicts that once bonus schemes are in place, managers will, to the extent that they can get away with it, manipulate performance indicators such as profits to generate higher individual rewards. (Deegan, 2006, p.261) Besides the bonus plan hypothesis, there are also debt hypothesis and political cost hypothesis, both the hypotheses can shown that, when the manager choose the accounting method they use, they always choose the one which can shown more profit, can have good affect to the share price.
About another kind of information-non-financial information, the relationship between non-financial information and stakeholders can be explained under Capital Market Research. The researchers investigated share market reactions to the releases of information, often specifically the release of accounting information. The view taken was that the accounting disclosures often revealed new information and in a market that was deemed to be informationally efficient with regard to acting upon new information share prices react to this information. (Deegan, 2006, p.428)Also CMR relies on the assumption that equity markets are efficient, it is to say all publicly available information is rapidly and fully impounded into share prices in an unbiased manner when released. Share price and share returns can be treated as the benchmark of the market reaction on the information. Favorable reactions to information mare presumed to be evidenced by a price increase in the particular security, whereas unfavorable reactions to information are evidenced by a price decrease. (Deegan, 2006, p.412) When there is good news reported by the entity, it may cause the increase of the share price. In contrast, when there is bad news released, the share price will decrease. And the investors may consider cut their investment, that is absolute not a good news for the company. Consequently, the manager will prefer to release some new which is good for the entity, and that will have a good impact on the share price.
Conclusion
There are four different measurement bases- historical cost, current cost, realisable (settlement) value and present value. Each measurement base has its own strengths and weaknesses. Compare to other measurement bases, the historical cost is the easiest way to use and understand. So with some rare exceptions, most companies worldwide still use historical cost. (Micheal Jones, 2006, p292) It is not to say the historical cost is better than the others, the other three bases has their own advantages. They can solve the problem of changing price which the historical cost can not. Nowadays, historical cost usually combined with other measurement bases. (Claire Locke, 2008, p.37)
When the entity is preparing the Financial Reports, it need add up all kinds of assets and liabilities. During this process, the additivity problem will come out. Because of changing of purchase power, it is not logically just put them together. Unfortunately, so far there is no way to solve the additivy problem because no matter each measurement base has some shortcomings. In the last part of this essay, it uses the positive accounting theory and capital market research to analyse the connection between the firms’ reported information and the stakeholders.
Reference
Deegan, C., 2006, Financial Accounting Theory, 2nd edition, McGraw-Hill, Australia
Jones, M., 2006, Accounting, 2nd edition, John Wiley & Sons Australia, NSW
Locke, C., 2008, Financial Reporting Handbook 2008, 2008 edition, John Wiley & Sons Australia, NSW
Riahi-Belkaoui, A. & Jones, S., 2000, Accounting Theory, 2nd edition, Nelson Australia Pty Ltd. VIC
Stakeholder_ corporate, (2009), Available from: http://en.wikipedia.org/wiki/Stakeholder_(corporate) [accessed 9th May 2009]
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