Contemporary Issue 4.1The standard setters search for the ‘best’
measurement basis
1. What is meant by the term market context? Why is context so important in
accounting measurement? (K)
Measurement methods used in the preparation of the financial statements should be
selected with the market context in mind. Values determined without market context in
mind may not be reflective of market conditions or meet user’s needs. In other words, to
provide the most accurate and decision useful accounting information, the most
appropriate measurement approach is likely to be dependent on specific circumstances
such as the nature of the market for the asset at the time. If the market is to play a role in
valuation, we want to ensure that the resulting value reflects the fundamental value of the
asset and that the operation of market forces does not lead to over or under valuation of
the asset. What is important to users may also change from time to time.
2. Is adoption of a single measurement base approach likely to work in practice?
Justify your response. (J, K)
. Some key points of relevance include:
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Arguments for adoption of a single measurement base approach are based on an
idealised view of markets being complete and in perfectly competitive
equilibrium. In reality, markets are imperfect and incomplete and ideal unique
market prices are not available for all assets and liabilities. This has led to the use
of the fair value hierarchy. The lower levels of the hierarchy requiring estimation
of what the market price might be if one existed. The information produced is
therefore not ideal.
A single preselected measurement method may not best reflect market conditions
or meet user needs at that time.
Assumes a particular measure will always be the most relevant and will always
be able to be reliably measured.
Some argue that there is no single ideal measure and that the focus should be on
identifying the information that is most likely to meet the needs of user’s decision
models.
Application of IAS 39 during the recent GFC as an illustration of the practical
importance of market imperfection and incompleteness.
3. Why do you think standard setters have considered a single measurement base
approach? In your response, consider the fundamental problems that such an
approach could help resolve and how such an approach would fit with the
qualitative characteristics of accounting information prescribed under the
Conceptual Framework. (K, CT)
Some key points of relevance include:
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In perfect market conditions, there is a unique market price based on full
information for every asset and liability. This provides a relevant, reliable and
objective measure of an assets fair value when such observable market prices are
available. This argument seems to be a key driver behind the push for fair value as
the single ideal measurement base approach.
Mixing different measurement bases is believed to create mismatch problems.
This problem refers to the fact that different items in the same set of accounts are
measured on a different basis, making aggregation (totals) misleading. A single
measurement base approach would promote consistency within accounts,
avoiding this mismatch, and allowing more meaningful aggregation. This
approach would also improve comparability of accounts between different
entities.
Fair value favoured approach due to its relevance – measures market expectations
of future cash flows to be derived by the entity and objectivity – reflecting the
markets view rather than views of management associated with the entity.
Contemporary Issue 4.2 The subprime lending crisis and reliable
reporting
1. In practice, which measurement base, historical cost or fair value, would provide
the most relevant and reliable accounting information? Draw on the facts
presented in the situation above, as well as your knowledge of the global financial
crisis, to justify your response. (J, K)
Responses may vary from student to student as there are many paths that discussion could
take. Some key discussion points follow.
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Fair value or historical cost on their own are not likely to achieve both
characteristics.
Inherent trade-off between relevance and reliability – the information which is
most relevant is often less reliable. The information which is most reliable tends
to be that which is less relevant.
There has been a move towards fair value and away from historical cost on the
basis of relevance. It is argued that reporting assets and liabilities at their fair
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values provides more relevant information for investment decisions than
historical cost.
Reliability is difficult to achieve under fair value when we are dealing with
hypothetical transactions that are not objectively measureable. This is the
situation we face when observable market prices are not available. In other
words, when an active and liquid market does not exist for the asset. Some argue
that once reliability becomes compromised, the information produced also
becomes less relevant.
Integration of the two measurement bases suggested. For example, historical cost
financial reports could be enhanced by providing fair value information through
footnote disclosures. A balance to achieve both greater relevance and reliability.
2. Discuss the role of market stability and the financial business cycle in
determining the relevance and reliability of the accounting information
produced. (J, K)
Market stability and the nature of the financial business cycle play a large role in the
determination of market prices, and therefore impact upon the relevance and
reliability of accounting information produced using fair value.
Falling prices in an unstable market may worsen market stability. Companies tend to
react to falling prices by rushing out to sell their assets before their competitors,
causing a further downward spiral in prices.
In a market bubble, values may be overstated, and values will most likely not be
realisable if many market participants decide to sell those assets at the same time. The
bubble bursts and prices fall again.
Financial statements measuring assets and liabilities at fair value in unstable or
illiquid markets are not likely to be relevant or reliable for the purpose of decision
usefulness.
Students may refer to the subprime lending crisis or other examples to illustrate the
role of market stability and the financial business cycle.
Case Study Questions
Case Study 4.1Taking account of water
1. Is it appropriate to place a dollar value on water? Justify your response. (J)
Responses will vary from student to student. Some argue that it is inappropriate to place a
dollar value on water. Some argue that it would be very difficult given the seasonal
uncertainty of environmental assets and the inconsistent relationship between cost and
use across the various seasons.
However, the discussion in this case highlights that this complexity has actually created
the need for better seasonal measurement of available water volume. This would allow us
to make better decisions regarding the use of available water, promoting greater
efficiency and sustainability of water use. Sustainability is the key driver behind the
initiatives to place a value on water assets.
2. In the case above, what is actually measured and how is it measured? (K)
What is measured?
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volume of water available disaggregated by the individual river systems
Contributing to the basin
how much water, in a particular season, should be made available for industrial
and urban uses
How is it measured?
It is argued that the value of water is derived though the cost of making it available,
reflected by a water planning and management charge which requires water authorities to
determine their administrative, planning and management costs in providing water. A
user pays approach should be adopted to fully recover these costs and the amount paid by
users is therefore representative of the value of water. Hopefully this will highlight the
value of water to users, portraying it as a valuable asset rather than a public good, and
contributing to sustainability.
3. What are the potential issues associated with measurement of water? (J,K)
Potential issues highlighted in this case include:
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Lack of acceptance of a user pays approach. This approach promotes water as a
valuable asset, while institutionalised low water usage charges in the past reflect
the traditional emphasis on the ‘public good’ nature of water.
Effective pricing has proven to be important because water pollution has been
found to be directly attributable to the lack of an effective pricing system.
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If water authorities seek to fully recover costs, user charges may become
unreasonable. The key industry impacted is agriculture which is one that we
would expect to maintain low prices. The approach outlined in the case certainly
has potential to adversely impact on agricultural produce prices and local
communities.
Will disclosures in relation to the detail of the water authorities water planning
and management costs and the methodologies used for calculating them really
impact on the decision making of users? To promote greater efficiency and
sustainability of water use the requirement for disclosures must focus on
information which is critical in terms of relevance to users in sustainability
decision making. This is difficult to ascertain and requires further understanding
of this decision making process.
Seasonal uncertainty of environmental assets and an inconsistent relationship
between cost and use across the various seasons, make information about user
charges and how they relate to the costs of activities less meaningful from a user
perspective.
Given that measurement of water and the provision of relevant information could
become quite a costly process for water entities, can we be sure that governments
will respond to the data appropriately and make the tough decisions about
reducing allocations where appropriate, so that we are able to achieve that
ecologically sensible net surplus and work toward the overall objectives of greater
efficiency and sustainability.
4. Discuss whether such information is decision useful from the perspective of
various stakeholders. (J)
Responses will vary from student to student. Students should however provide a fairly in
depth analysis of relevant stakeholder needs with a focus on the key issues such as a need
for greater efficiency when it comes to water usage and long term sustainability. The
main stakeholders include water authorities, water users and government. Students could
also take this a step further and break down the different stakeholder groups mentioned
above. For example, water users could be broken down into industrial and urban users.
Industrial users could then be explored from the perspective of different industries.
Students should be encouraged to explore decision usefulness of such information at a
general level and then drill down to get as specific as possible when discussing key
stakeholders.
5. What can we expect to achieve through accounting for water? Explain the
connection to sustainability decision making. (J, K)
The problem highlighted in the case is that in the MDB, the water available is insufficient
to meet the demands of all agricultural and urban uses as well as the needs of the
environment. It is hoped that accounting for water will lead to greater efficiency with
regard to water usage and longer term sustainability. The logic being that if we can
highlight its value to users and decision makers by allocating a monetary value, it will be
portrayed and treated as a valuable asset moving forward.
Case Study 4.2CMG Worldwide: intangible assets
1. What is an intangible asset? Describe the nature of intangible assets that might
be associated with celebrity personalities. (K)
An intangible asset is essentially something of value which we cannot physically see or
touch. For example, the reputation associated with a brand name, the goodwill associated
with a business.
The nature of intangible assets that might be associated with celebrity personalities may
include intellectual property rights. In this case, CMG worldwide is a licensing agency
which works to manage, market and protect the valuable intellectual property of celebrity
personalities. Something else which is also of great value is the goodwill associated with
their name and with them as a person. It is important that this valuable asset be protected
and managed.
2. Explain how we might measure such assets under AASB 138/IAS 38Intangible
Assets.(K, AS)
Responses may vary from student to student. It is important that you as a student explore
the issues in some depth, incorporating application of IAS 38 into your response. Points
of relevance to guide discussion include:
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Were the assets internally generated or acquired by the entity? These assets are of
a nature that value is created internally by the entity. Students should explain their
response in some depth. They should also be able to explain why this distinction
is important. The key point being that it impacts on how the intangible asset will
be recognised initially.
How should the assets be measured upon initial recognition? Refer to table 4.2, pg
119.
After initial recognition, should the cost model or the revaluation model be used
to measure the asset? Students should provide some in depth analysis here in
relation to the nature of the asset and each of the two models. Students should be
encouraged to explore ideas thinking about what makes sense and what would be
most indicative of the value of the asset. Relevance, accuracy and reliability from
a user perspective should also be considered.
3. What are the practical difficulties in measuring an asset of this kind? (J, K)
Practical difficulties include:
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Intangible assets lack physical substance and are not usually something that can
be bought and sold in an active market. This makes measurement at fair value
very difficult.
Intangible assets such as these are often unique in nature. There are no readily
observable market prices available for the same or similar assets. This also makes
measurement at fair value very difficult.
There may be little reliable information available regarding costs of developing
the asset.
Ability to generate revenue may be considered to be most indicative of the value
of the asset. The issue with this approach is that the estimates made reflect
management’s own assumptions and biases, making it less reliable.
In summary, determining an accurate and reliable measurement presents a challenge. The
nature of an intangible asset does not really fit or work with the concept of fair value and
depending on the nature of the asset and how it is developed or generated, associated
costs and relevant expenditure may be difficult to determine.