This article considers the relevance of information provided by different measurement methods and explains the effect that they may have on the financial statements.
The relevance of information provided by a particular measurement method depends on how it affects the financial statements. The cost should be justified by the benefits of reporting that information to existing and potential users. The different measures used should be the minimum necessary to provide relevant information and there should be infrequent changes with any necessary changes clearly explained. Further it makes sense for comparability and consistency purposes, to use the same method for initial and subsequent measurement unless there is a good reason from not doing so.
The existing Conceptual Framework for Financial Reporting® (the framework) provides very little guidance on measurement, which constitutes a serious gap in the Framework. A single measurement basis may not provide the most relevant information to users and therefore IFRS® standards adopt a mixed measurement basis, which includes fair value, historical cost, and net realisable value. Different information from different measurement bases may be relevant in different circumstances. A particular measurement bases may be easier to understand, more verifiable and less costly to implement. However, if different measurement bases are used, it can be argued that the totals in financial statements have little meaning. Those that prefer a single measurement method favour the use of current values to provide the most relevant information.
A business that is profit orientated has processes to transform market input values (inventory for example) into market output values.(sales of finished products).Thus it makes sense that current values should play a key role in measurement. Current market value would appear to be the most relevant measure of assets and liabilities for financial reporting purposes.
The International Accounting Standards Board favour a mixed measurement approach whereby the most relevant measurement method is selected. It appears that investors feel that this approach is consistent with how they analyse financial statements and that the problems of mixed measurement are outweighed by the greater relevance achieved. In recent standards, it seems that the Board felt that fair value would not provide the most relevant information in all circumstances. For example, IFRS 9 requires the use of cost in some cases and fair value in other cases, while IFRS 15 essentially applies cost allocation.
A factor to be considered when selecting a measurement basis is the degree of measurement uncertainty. The Exposure Draft on the Conceptual Framework states that for some estimates, a high level of measurement uncertainty may outweigh other factors to such an extent that the resulting information may have little relevance. Most measurement is uncertain and requires estimation. For example, recoverable value for impairment, depreciation estimates and fair value measures at level 2 and 3 under IFRS 13.Consequently, the Board believes that the level of uncertainty associated with the measurement of an item should be considered when assessing whether a particular measurement basis provides relevant information.
Measurement uncertainty could be considered too great with the result that the entity may not recognise the asset or liability. An example of this would be research activities. However, sometimes a measure with a high degree of uncertainty provides the most relevant information about an item. For example, financial instruments for which prices are not observable. The Board thinks that the level of measurement uncertainty that makes information lack relevance depends on the circumstances and can only be decided when developing particular standards.
It would be easier if measurement bases were categorised as either historical cost or current value. The Exposure Draft on the Conceptual Framework describes these two categories but also states that cash-flow-based measurement techniques are generally used to estimate the measure of an asset or a liability as part of a prescribed measurement basis. Cash-flow-based measurement can be used to customise measurement bases, which can result in more relevant information but it may also be more difficult for users to understand. As a result the Exposure Draft does not identify those techniques as a separate category.
There are several areas of debate about measurement. For example,should any discussion of measurement bases include the use of entry and exit values, entity-specific values and the role of deprival value. Again should an entity’s business model affect the measurement of its assets and liabilities. Many would advocate that different measurement methods should be applied that are dependent both on the nature of assets and liabilities and also, importantly, on how these are used in the business. For example, property can be measured at historical cost or fair value depending upon the business model.
In order to meet the objective of financial reporting, information provided by a particular measurement basis must be useful to users of financial statements. A measurement basis achieves this if the information is relevant and faithfully represents what it essentially is supposed to represent. In addition, the measurement basis needs to provide information that is comparable, verifiable, timely and understandable. The Board believes that when selecting a measurement basis, the amount is more relevant if the way in which an asset or a liability contributes to future cash flows is considered. The Board considers that the way in which an asset or a liability contributes to future cash flows depends, in part, on the nature of the business activities.
There are many different ways in which an asset or liability can be measured. Historical cost seems to be the easiest of these measures but even here, complexity can arise where there is a deferred payment or a payment, which involves an asset exchange. Subsequent accounting after initial recognition is not necessarily straightforward with historical cost as such matters as impairment of assets have to be taken into account and the latter is dependent upon rules, which can be sometimes subjective.
Current values have a variety of alternative valuation methods. These include market value, value-in-use and fulfilment value. Of these various methods, there is less ambiguity around current market prices as with any other measure of current value, there is likely to be specific rules in place to avoid inconsistency. In the main, the details of how these different measurement methods are applied, are set out in each accounting standard.
Written by a member of the Strategic Business Reporting examining team