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Approaches of Measurement

Discuss about the Financial Instruments for Disclosure and Presentation.

Measurement can be defined as criteria for measurement of various elements in financial statement that are essential in the process of financial reporting. Measurement can also be defined as a process in which association of number is done with some elements of items or occurrence (Suppes, 1959). The calculation of quantifiable items for comparison and evaluation of the data in monetary terms is measurement. In order to understand the concept of measurement, the different methods for comparison and evolution of measurement must be considered. 

Measurement theory contains three major issues. The first one is representation which contains the extent to which any measured aspect provides a precise description of the material authenticity of the object in question (Charles, 2013). The second issue is uniqueness and it contains the extent to which the selected representation is the sole possible representation for the concerned object. The last issue is the issue of error. As the name suggests, error shows the difference between the same aspects over different points of time.

The concept of measurement is very broad in nature (Beaver, 1989). There can be many different interpretations of approaches when discussing about measurement. An analysis of the following approaches of measurement has been made in this report: historical cost, current cost, fair value, realizable value and value in use (ICAEW, 2006). In order to decide which one is the correct approach of measurement (Ijiri, 1975) for a given case, the cost effectiveness and the competency of the purpose should be viewed. In case of ambiguity, numerous secondary attributes should be taken into consideration. Examples of such secondary attributes include accuracy, reliability (ACS Distance Education, 2016), clarity, time frame and relevancy.

As the name suggests, the historical cost of any asset or liability is the cost which was paid or is to be received in respect of the respective asset or liability. Any change in the market value of the said asset or liability is not considered (Ryan, 2001). The net is decided on the basis of the transaction that happens on the day the asset and liability are met. Example a company acquired some asset in 2010 for $1000. In 2013, the market value of that asset was $2000 and the company sold the asset in 2013 for $1500. As per the historical cost method, the profit of $500 has been made on such sale. The major principle behind this rule is that only that cost has to be considered which is being met; any cost which is not being dealt with is not relevant to the transaction.

Historical Cost

This method is very easy to calculate as the gains are not recorded until they are realized (Australian Accounting Standards Board, 2009). Even though this method is used in many accounting systems, it has some major drawbacks. The first one is that the historical cost method does not consider the present day market value of the asset. Hence, the real time gain or loss cannot be ascertained. The various opportunity costs and intangibles are not considered. So, there is no clarity and accuracy of the data and also the time factor is simply ignored.

Current cost is completely the opposite in comparison to historical cost. The problems faced due to use of obsolete data in historical cost method sowed the inception seeds of current cost approach. Current cost is also known as deprival value or value to the business (Ayers, Lefanowicz & Robinson, 2000). The concept of value to the business holds that the gains should be recognized as and when they arise rather than when they are actually realized. Some assets do not have an origin value and hence the historical cost approach cannot be applied to them but such assets can be easily recognized through this approach. This approach measures the profits of the business to main the service potential or the operating capabilities.

The major drawback of this approach comes when the replacement cost of a liability is to be ascertained. The costs of assets can still be ascertained from the market but until the liabilities are realized, the true value of such liabilities cannot be ascertained. Another drawback relates to the new and potential marketer entrants as the values put forward by them cannot be anticipated.

Fair value can be elucidated as the price that will be received when an asset is sold or the price that will be paid to meet the liability in an ordinary transaction between different market participator at the date of measurement in the present market conditions. When the price of an asset or liability cannot be determined on basis of historical and current cost, the fair value of such asset or liability is taken. Since this concept is based on measurement of market, the price is calculated under the presumption that the market participators will use this pricing taking into consideration the risk factor. So, the intention to hold the asset or sell the asset is not relevant in the fair value measurement approach. In short, fair value is a market based measurement and not an entity specific measurement. A chart depicting the various stages under Fair Value Measurement is presented in Chart 1.

Current Cost

Fair value measurement gained acceptance as it overcomes the limitations of historical cost measurement approach (McConnell, 2010). As defined above, the fair value is the value at which an asset if purchased or sold between the parties to transaction. The key here is that this price is decided by the parties. Yes the definition states that such price is the price quoted in other ordinary transactions too. But there is no clear indication or demarcation on whether the chosen price is really the price in normal transactions. In other words, one may consider one set of figures and the other may consider a completely different of figures and so the fair value will be different in these cases. To accurately compute the fair value, a lot of factors are considered and the lack of even a single factor may result in completely different result. In other words, fair value is no longer fair (Chasan, 2008).

The other point in this regard is that fair value measurement of an asset is impacted highly by the decisions and investments made by management (Moyer, 2008). Example, in order to calculate the cost of an asset, the expenses is adjusted. The decision taken on which expenses can be considered as ‘fair’ will impact the fair value of the given asset.

The biggest reason of such disparity in the usage of fair value is the ambiguity in the accounting standards that are presented for fair value measurement. The Australian Accounting Standards Board has issued (AASB) AASB 13 for fair value measurement (Landgate, 2013). The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have issued common fair value measurement and disclosure requirements (FASB, 2011). These requirements are stated in IFRS 13.

The IASB has issued certain guidelines to be followed in order to use the measurement techniques. These include that a single approach of measurement might not provide useful data for all the assets and liabilities. And in such cases that approach should be selected which provides the best set of information. Various disclosures (Australian Accounting Standards Board, 2004) are to be made for selecting any approach or valuation method. This is what regulates the proper application of measurement approaches (Australian Accounting Standards Board, 2013).

AASB 13 provides certain criteria for the methods that determine the fair value of any asset and liability. In order to determine the said value, an imaginary future transaction is drawn up and various factors which could affect the transactions are also taken into consideration. A number of potential market participants and even potential entrants are also estimated for such calculation. Most importantly, the price of such transaction, keeping in mind the above points is also drawn up and that price acts as the fair value of the transaction of future.

Fair Value

The other reasons include the lack of study curriculums which could inscribe the various aspects of fair value measurement (Singh, 2015). There is also a lack of the basic studies in universities regarding the fair value system. Further, the rules and guidelines for fair value measurement are quite complex. The easy and stable nature of historical cost accounting is usually preferred over this method. Lastly, the numbers of businesses where this approach can be applied are very less.

Fair value approach of measurement is gaining popularity and also a lot of criticism. This approach has been blamed for the questionable practices that resulted in the Wall Street crash in 1929 and was nearly banned by United States Securities and Exchange Commission during 1930s to 1970s. Because of the financial crisis of 2008, the fair value approach again came under the fire. The actions of some bankers (Badertscher, B. A., Burks & Easton, 2012) and management level personnel were the reason behind this escalation especially during depression stages of market.  Those actions resulted in a major fall of prices of assets and people blamed this approach for the downfall.

Fair value measurement approach is followed worldwide on the basis of certain standards set by the relevant authorities. The base of conceptual framework was to act as an equivalent to the constitution (Ramanna, 2008). It could have acted as a shield to some extent for the accounting standard process. It could have been free from interferences if more importance was diverted on the interests of the users. As in the case of a legal system, the accounting system was adopted as jurisdictional structure which is the first indication to the political nature of the standard setting process. This way, the standards could be easily influenced for the benefit of certain set of individuals or corporations rather than as a benefit to everyone equally.

During the establishment of these codes, many critiques raised queries. The major point raised in this regard was the complexity faced by the user of the financial information (Laux & Leuz, 2009). Further, it was said that the reports of finance should provide relevant and needful information for every user. But the contention given for this query by the authorities was that each user has its own need and that it was not possible to satisfy every persons need. And so certain potential creditors and investors were selected as the primary group of users and the standards were set as per their conditions. The very selection of potential creditors and investors is of political nature (Fogarty, Hussein & Ketz, 1994).

Controversy regarding Fair Value Measurement

Realizable value is the net of the selling costs of assets and the settlement costs of liabilities. Broadly, the realizable value and the fair vale are similar apart from the fact that realizable value is measured at the net of the costs of realization. The net realizable value is an entity specific measurement approach and it covers the value that the entity is expected to realize on the sale of asset. For example, a company decides to calculate the materials at cost rather than the market value even though the market value is lower than the cost. The company will do so in the expectation that they could sell the final product at a price higher than the cost.

Even though this is a very effective approach as the costs are calculated using the net value for every product but in this, lies its biggest drawback. A lot of information is needed for calculations under this approach. Also, this approach does somewhere make assumptions of the expected results of future decisions.

Value in use can be described as the present value of the future cash flows which are expected to attain from some asset. In other words, it is the discounted value (applicable to any business) of the future cash flow an asset. In this approach there is always an anticipation of possible variations in the value and time of the future cash flows. Many factors can affect the future cash flow of an asset, for example, liquidity, market participants. In order to calculate the value of an asset under this approach firstly an estimate of future cash flows (both incoming and outgoing) are to be calculated and then the proper discount rate has to be applied to the expected cash flows of future.

The very basis of this concept forms its biggest drawback. Everything is based on what happens in future and estimates in this regards are made. The process of estimation itself is unreliable as it is prone to fluctuations and variations. Also, there are numerous factors which cannot e foreseen and there is always the risk of partial disclosures.

Aurizon Holdings Limited is an ASX (Australian Securities Exchange) listed company and is number 41 in the ASX 100. Aurizon is an Australian based rail freight operator. The company works in different areas like transportation of coal from the coal mines to the port for export markets; the network area provides entry to the operation and management of the Coal Rail Network of Central Queensland; hauling iron ore for export; and also works as a heavy haul freight operator. Numerous other projects are taken up by the company, for example, Staurt Intermodal Facility Project, Moorebank Intermodal Project. Aurizon was earlier owned by the Government of Queensland. Currently, it is the country’s largest rail freight company (Aurizon, 2016).

The Annual Report 2016 of Aurizon Holdings Limited states clearly that the financial statements have been prepared under the Historical Cost convention but it has also been adjusted by revaluating the assets and liabilities at Fair Value. Taking a finer look at the annual report clarifies that the company uses Fair Value measurement approach. The cash, cash equivalents and non interest bearing financial assets and liabilities are all measured at the fair value and it calculates the cost of the asset due to their short maturity. But, when the question comes of the fair value of those financial instruments which are not traded in any active market, the cost is calculated by using valuation techniques. The reason behind the use of valuation techniques is to attain recognizable market data and not to rely simply on the entry specific estimates (historical cost).

The assets and liabilities which are measured at the fair value on recurring basis include interest rate swaps; cross currency interest rate swaps; and forward foreign exchange contract. The company has measured the fair value of interest rate swaps by net present value method of contracted cash flows. For the same calculation of cross currency interest rate swaps, the company has used the net present value of contracted cash flows (Aurizon, 2016). The reasons for such uses have been given.

At critically analyzing the use of fair value by different methods by Aurizon Holdings limited, it is clear that the methods are used by thoroughly analyzing the market. This also means that the statement of the discussion is true and that the very use of fair value is controversial. In this given company, the company has used different methods for fair value calculations. The company adopts the method most suited to its financial reports; it may or may not be the most appropriately applicable method for the company.

The AASB 13 does define the inputs to valuation techniques on basis of the level but by constricting a market base or potential participants, these levels and inputs can be influenced. This does not in any way mean that Aurizon has done that. The validity on which is the correct method for fair value measurement cannot be clarified unless each and every decision taken by management is known or the factors behind such decisions is clear.

Conclusion

Looking at all the above points we can conclude that fair value system is widely accepted principle and is still gaining a lot of attention. Though there are a lot political issues and criticism revolving around the concept, yet it has it inherent benefits. It needs to be kept in mind that no system is problem free. Every aspect of life is covered with some or the other drawback and hence, each person has to choose which decision has to be made. After evaluating the different approaches, it is clear that fair value is the most practical approach. It is the responsibility of the individuals, businesses and industries to follow the spirit of the standards.

References

ACS Distance Education. (2016). Accounting Conventions and Standards. Retrieved from https://www.acs.edu.au/info/business/management/accounting-standards.aspx

Aurizon. (2016). Annual Report 2016. Retrieved from https://www.aurizon.com.au/~/media/aurizon/files/investors/documents%20and%20webcasts/2016/full%20year%20results/annual%20report%202016.ashx

Aurizon. (2016). Why invest in Aurizon? Retrieved from https://www.aurizon.com.au/investors/overview

Australian Accounting Standards Board. (2004). Financial Instruments: Disclosure and Presentation. Retrieved from https://www.aasb.gov.au/admin/file/content105/c9/aasb132_07-04.pdf

Australian Accounting Standards Board. (2009). Financial Reporting in Hyperinflationary Economies. Retrieved from https://www.aasb.gov.au/admin/file/content105/c9/AASB129_07-04_COMPjun09_01-09.pdf

Australian Accounting Standards Board. (2013). A Review of the IASB’s Conceptual Framework for Financial Reporting. Retrieved from https://www.aasb.gov.au/admin/file/content105/c9/ITC29_07-13.pdf

Ayers, B. C., Lefanowicz, C. E., & Robinson, J. R. (2000). The financial statement effects of eliminating the pooling-of-interests method of acquisition accounting. Accounting Horizons, 14(1), 1-19.

Badertscher, B. A., Burks, J. J., & Easton, P. D. (2012). A Convenient Scapegoat: Fair Value Accounting by Commercial Banks during the Financial Crisis. Accounting Review, 87(1), 59-90. https://dx.doi.org/10.2308/accr-10166

Beaver, W. H. (1989). Financial Reporting: An Accounting Revolution. Englewood Cliffs, NJ: Prenctice Hall.

Charles, R. B. (2013). A Critique of the Concept of Measurement in Financial Accounting. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2200860

Chasan, E. (2008). Is Fair Value Accounting Really Fair? Reuters. February 26

FASB. (2011). IASB and FASB Issue Common Fair Value Measurement and Disclosure Requirements. Retrieved from https://www.gasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB/FASBContent_C/NewsPage&cid=1176158544944

Fogarty, T. J., Hussein, M. A., & Ketz, J. E. (1994). Political aspects of financial accounting standard setting in the USA. Accounting, Auditing & Accountability Journal, 7(4), 24-46.

ICAEW. (2006). Measurement in financial reporting: information for better markets initiative. Retrieved from https://www.icaew.com/~/media/corporate/files/technical/financial%20reporting/information%20for%20better%20markets/ifbm/measurement%20in%20financial%20reporting.ashx

Ijiri, Y. (1975). Theory of Accounting Measurement, Studies in Accounting Research # 10. Sarasota, FL: American Accounting Association.

KPMG. (2013). Fair Value Measurement. Retrieved from https://www.kpmg.com/FR/fr/IssuesAndInsights/ArticlesPublications/Documents/Convergence-US-GAAP-IFRS-Fair-Value-Measurement-QuestionsandAnswers-112013.pdf

Landgate. (2013). Government Asset Valuation Policy 7.101 Fair value measurement of property, plant and equipment. Retrieved from https://www0.landgate.wa.gov.au/docvault.nsf/web/PS_PI_PV_VSP/$file/INF_VGO_POLICY_Measurement_of_Asset_Values7_101.pdf

Laux, C., & Leuz, C. (2009). The crisis of fair-value accounting: making sense of the recent debate. Accounting, Organizations and Society, 34(6-7), 826-834.

McConnell, P. (2010). Response to “Fair Value Accounting, Financial Economics, and the Transformation of Reliability.” Accounting and Business Research. Vol. 40, No. 3.

Moyer, L. (2008). How Fair Is Fair-Value Accounting? Forbes. June 25.

Ramanna, K. (2008). The implications of unverifiable fair-value accounting: evidence from the political economy of goodwill accounting. Journal of Accounting and Economics, 45(2-3), 253-281.

Ryan, J. B. (2001). Measurement in financial accounting: critical support for historical cost (Doctor of Philosophy thesis, Department of Accounting and Finance, University of Wollongong). Retrieved from https://ro.uow.edu.au/cgi/viewcontent.cgi?article=2022&context=theses

 Singh, J. P. (2015). Fair Value Accounting: A Practitioner's Perspective. IUP Journal of Accounting Research & Audit Practices, 14(2), 53-65.

Suppes, P. (1959) Measurement, empirical meaningfulness, and three-valued logic, in: C.W. Churchman and P. Ratoosh (Eds), pp. 129-43, Measurement: Definitions and Theories (New York: John Wiley and Sons, Inc.)

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