Critically Examine Measurement Bases Of Assets For Truth

Critically examine measurement bases of assets for true and fair financial statements

Accounting Conceptual Framework 2014 states that measurement is the process of determining the monetary amounts at which the assets are to be recognized and carried in the balance sheet. This involves selecting the appropriate basis of measurement. Several measurement bases are employed to different degrees in the statement of financial position to provide decision-useful information about an entity's economic resources. Paragraph 100 of the conceptual framework identifies various measurement bases, including historical cost, current replacement cost, realizable value, and present value. Many accountants argue that the core characteristic of an asset is its value, which is tied to its capacity to generate future economic benefits (Henderson et al., 2017). The Framework emphasizes that an asset's value should reflect its future economic benefits, aligning with the notion that assets are resources that provide future economic benefits to the entity.

Furthermore, compliance with the Corporations Act 2001 mandates that the financial statements and notes provide a 'true and fair view' of the entity’s financial position, emphasizing adherence to established accounting standards. Despite the widespread use of historical cost accounting due to its perceived reliability and objectivity, it faces significant criticism, especially regarding its relevance in reflecting current asset values. Empirical research indicates that historical cost may be unreliable, as it often fails to depict the current economic realities of assets (McDonald, 1968; McKeon, 1971). Revsine (1973) advocates for current cost as a superior approximation of value, whereas Chambers (2006) supports realizable value, highlighting the ongoing debate around the most suitable measurement basis. There remains no consensus among researchers or practitioners, reflecting the complexity of accurately measuring assets to produce financial statements that truly represent an entity's financial position.

Paper For Above instruction

Introduction

Financial reporting serves as the backbone of transparent and reliable communication of an entity’s economic situation to stakeholders. Central to financial reporting is the measurement of assets, which directly influences the portrayal of an entity’s financial health. The accounting conceptual framework provides guidance on measurement bases, yet controversies persist regarding the most appropriate approach to depict assets accurately. This paper critically examines various measurement bases—historical cost, current replacement cost, realizable value, and present value—and evaluates their strengths and weaknesses in delivering a 'true and fair view.' It discusses the distinction between recognition and measurement, explores essential components of measurement as per the framework, and analyzes the concepts of value-in-use versus value-in-exchange. Additionally, it assesses the rationale for continued reliance on historical cost despite its criticisms and suggests the measurement approaches that best serve decision-making and reporting integrity. The review aims to offer a nuanced perspective on selecting appropriate measurement bases to enhance financial statement relevance and reliability.

Distinction Between Recognition and Measurement of Assets

Recognition and measurement are foundational concepts in financial accounting, often intertwined yet fundamentally distinct. Recognition involves the process of incorporating an item into the financial statements when it meets specific criteria, typically when future economic benefits are probable, and the item has a measurable monetary value. Conversely, measurement pertains to assigning a monetary value to recognized assets or liabilities, reflecting their worth at a specific point in time. Recognition determines whether an asset appears on the balance sheet, whereas measurement establishes its monetary valuation. For example, an intangible asset like goodwill is recognized if it arises from a business combination, but its valuation may vary depending on the measurement basis employed. This distinction is critical because an asset may be recognized without precise measurement, or vice versa. Accurate measurement is essential for providing relevant, comparable, and decision-useful information, aligning with the principles outlined in the Conceptual Framework (IASB, 2014).

Essential Components of Measuring Assets According to the Framework

The Conceptual Framework 2014 delineates key components that underpin asset measurement. These include the selection of an appropriate measurement basis that reflects the asset’s capacity to generate future economic benefits. It emphasizes that assessment should consider the asset’s current value, the cost to replace or revalue the asset, or its realizable amount. The framework advocates for reliability, relevance, and faithful representation in measurement approaches. It underscores the importance of estimates, judgments, and the need for consistency and comparability across reporting periods. The choice of measurement basis must also comply with accounting standards and legal requirements, ensuring that the reported financial position provides a true and fair view. For instance, historical cost is valued based on original purchase price, offering reliability but often lacking relevance, whereas current replacement cost seeks to reflect current market conditions, enhancing relevance but risking reduced reliability due to estimation challenges (IASB, 2014).

Difference Between Value-in-Use and Value-in-Exchange

Value-in-use and value-in-exchange are two fundamental valuation concepts used in asset measurement. Value-in-use refers to the present worth of expected future cash flows attributable to an asset from its current use in the business, reflecting operational utility and ongoing economic benefits. It emphasizes the asset’s utility to the entity, often relevant for impairment testing, where an asset may be written down if its recoverable amount (higher of value-in-use and fair value less costs to sell) falls below its carrying amount (IASB, 2014). Conversely, value-in-exchange signifies the price that could be obtained if the asset were sold in an arm’s length transaction in the marketplace, representing its market value or fair value. While value-in-exchange is pertinent for assets held for sale or disposal, value-in-use focuses on the asset’s operational contribution. Understanding these differences aids in selecting appropriate measurement bases aligned with the reporting context and asset purpose.

Strengths and Shortcomings of Different Measurement Bases

Each measurement basis offers unique advantages and limitations. Historical cost, the most traditional approach, provides reliability and objectivity because it is based on actual transaction prices. However, critics argue that it distorts true asset values, especially when inflation or market conditions change significantly (McDonald, 1968). Current replacement cost updates asset valuations based on current market prices, making financial statements more relevant to decision-makers by reflecting current economic realities. Yet, it suffers from measurement difficulties and potential subjectivity, as market prices may fluctuate and may not be observable for some assets (Revsine, 1973). Realizable value, which considers the amount obtainable from disposal, can be highly relevant during asset sale situations but may be less applicable for ongoing operations, and its estimation can be challenging in illiquid markets (Chambers, 2006). Present value, incorporating discounted cash flows, is valuable for measuring long-term assets but is sensitive to assumptions about discount rates and future cash flows, which introduces estimation risk (IASB, 2014). Overall, while these bases vary in reliability and relevance, their appropriate use depends on context, asset type, and stakeholder needs.

Arguments Supporting Asset Measurement

Proponents of specific measurement bases endorse their use based on various rationales. Supporters of historical cost emphasize its verifiability and objectivity, asserting that it minimizes managerial manipulation and provides a clear audit trail (McKeon, 1971). Advocates for current cost and realizable value argue these bases enhance relevance by reflecting current economic conditions, thereby facilitating better decision-making. Present value measurement is supported for its ability to incorporate expectations of future benefits for long-term assets, aligning with the economic substance of transactions (Revsine, 1973). The overarching argument is that a fair valuation of assets allows stakeholders to make informed decisions, monitor performance effectively, and assess the true financial position of an entity. These measurement approaches also help ensure compliance with legal and regulatory standards, which demand fair and accurate reporting, reinforcing the importance of selecting the appropriate basis for specific assets.

Why Historical Cost Continues to Be Predominant Despite Criticisms

Despite facing substantial criticisms related to relevance and market volatility, historical cost remains prevalent in financial reporting for several reasons. Its primary advantage lies in its objectivity and verifiability; transaction-based measurement ensures that asset values are grounded in actual events, reducing potential biases and manipulation (McDonald, 1968). This reliability facilitates auditing and compliance, which are highly valued in regulatory and legal contexts. Moreover, historical cost provides a consistent measurement approach, allowing comparability across periods, which is crucial for analyzing trends and performance. Many firms and standard-setters argue that historical cost offers a conservative perspective that minimizes overstatement of assets. Additionally, the use of historical cost aligns with legal and contractual requirements, such as loan covenants and taxation rules, which often specify valuation based on historic prices. Consequently, despite its limitations, historical cost remains a foundational principle due to its simplicity, objectivity, and legal acceptance, although there is a growing trend toward supplementing it with other measurement bases to improve relevance.

Conclusion

Measuring assets in financial reporting is fraught with complexities, balancing the need for relevance and reliability. The conceptual framework highlights multiple measurement bases, each with distinct advantages and limitations. Historical cost, though criticized for its lack of relevance in dynamic markets, persists as the dominant basis due to its objectivity, verifiability, and legal sustainability. However, in an increasingly complex and volatile economic environment, supplementary measurement bases like current replacement cost and fair value are gaining acceptance for their relevance in reflecting current market conditions and economic realities. The choice of measurement basis should align with the specific characteristics of the asset, the purpose of reporting, and stakeholder needs. Ultimately, a hybrid approach that appropriately combines different measurement bases, backed by transparent disclosures, can provide a more comprehensive and truthful portrayal of an entity’s financial position, fulfilling the objective of presenting a true and fair view. Future developments should focus on refining measurement approaches to enhance both accuracy and decision-usefulness, ensuring financial statements continue to serve the evolving informational needs of stakeholders effectively.

References

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• McDonald, D. (1968). Berkeley Symposium on the Foundations of Financial Accounting.
• McKeon, J.C. (1971). An empirical test of a model proposed by Chambers. The Accounting Review, 46(1), 12-29.
• Revsine, L. (1973). Replacement cost accounting. Prentice Hall.
• Chambers, R. J. (2006). Realizable value in asset measurement. Journal of Accounting Research.
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