There are various accounting measurement bases. However, these can be broadly sub- divided into cost-based measures, market based measures and a hybrid of some description. Jensen (2007) discusses the different measurement bases found in U.S. GAAP. These include: Historical Cost Accounting (Unadjusted Historical Cost), Price-
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Level Adjusted Historical Cost Accounting, Entry Value (Current cost, replacement cost) Accounting, Current exit value (Liquidation, Fair value) Accounting, Economic Value (Discounted Cash Flow, and Present Value) Accounting. Table 3.1 below, presents a summary of the advantages and disadvantages of these measurement bases in the context of the decision-usefulness doctrine of the FASB:
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TABLE 3.1: Advantages and Disadvantages of Various Accounting Measurement Bases
Historical Cost Accounting (Unadjusted Historical Cost) [HCA]
Price-Level Adjusted Historical Cost Accounting (PLA) - the FASB in 1979 issued SFAS 33 for company financials to be adjusted for inflation, however it failed to get traction as the U.S. had low inflation rates during the period and follow-up studies suggested that financial analysts and investors did not find the new information relevant.
Entry Value (Current cost, replacement cost) Accounting - Entry value is a buyer’s acquisition cost (net of discounts) plus transaction fees and installation expenses. This can also be referred to as replacement cost and in the sense of SFAS 33 referred to as Current Cost. This standard was later rescinded by the FASB.
Current exit value (Liquidation, Fair value) - Exit value is the seller’s liquidation value (net of disposal transaction costs). Whereas entry value is what it will cost to replace an item for a buyer, exit value is the value in disposing of the item.
Economic Value (Discounted Cash Flow, Present Value) Accounting - These apply in situations where future cash inflows and outflows can be reliably estimated and are attributable to the particular asset or liability being valued on a discounted cash flow basis. U.S. GAAP allows this for example when computing the fair values of derivative financial instruments. Advantages
i. Survival Concept: The belief that HCA has met the Darwin survival test for at least the period subsequent to the discovery of double entry bookkeeping. U.S. GAAP has employed the HCA concept in its standards from its inception. ii. It agrees with the matching concept. Hence, costs of resources consumed in production should be matched with revenues of the products and services of the production function.
iii. HCA possesses the attribute of leaving an Audit trail.
iv. Predictive Value: Empirical studies suggest that Historical cost earnings today are reasonable predictors of future historical cost earnings. This is contestable considering it depends on the settings from which the study is being carried out.
v. Accuracy: HCA measurement is believed to be more accurate, relative to alternatives, more uniform, consistent and less prone to measurement error.
Disadvantages
Advantages
i. Attempts to perfect historical cost accounting by converting costs to a common purchasing power unit of measurement.
ii. Impacts on Return on Investment calculations in many industries even in times of low inflation.
iii. Is essential in periods of hyperinflation.
iv. Uses a readily available and reasonably accurate government- generated consumer price index (CPI) (usually the price index for urban households).
Disadvantages
i. No general consensus on the exact price-index to use.
Advantages
i. It conforms to capital maintenance theory that argues in favour of matching current revenues with what the current costs are of generating those revenues. ii. If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price-level adjustments are avoided.
Disadvantages
i. Discovering accurate replacement
Advantages
i. In the case of financial assets and liabilities, historical costs may be meaningless relative to exit values. For example a forward contract or swap generally has zero historical cost but may be valued at millions at the current time. Failure to require fair value accounting provides all sorts of misleading earnings management opportunities for firms.
ii. Exit value does not require arbitrary cost allocation decisions such as whether to use FIFO or LIFO or what depreciation rate is best for allocating cost over time.
iii. In many instances exit value accounting is easier to compute than entry values. For example it is easier to estimate what an old computer will bring, in the used computer market than to estimate what the cost of ‘equivalent’ computing power is in the new computer market.
Disadvantages
i. The exit value is the seller’s liquidation value of a particular asset or liabilities at a particular time and place. It may differ greatly from ‘valuation in use’ among a larger set of items in an entire department, division, or company as a whole.
ii. Operating assets are bought to use rather than sell. Thus if no consideration is being given to selling or abandoning a manufacturing plant,
Advantages:
i. Economic value is based upon management’s intended use (Value-in- Use) for the item in question rather than upon some other use such as exit or entry value.
ii. Economic value conforms to the economic theory of the firm.
Disadvantages:
i. Complications in the models used to perform such valuations.
54 i. Simplistic, especially for complex
schemes such as off balance sheet financing and complex contracting issues e.g. derivatives whose historical cost may be zero at the outset but the fair value in future maybe millions of dollars.
ii. HCA is highly limited during hyperinflation periods in the economy as it can overstate earnings during this period and understate how a firm is maintaining its capital assets. It also creates mix-up when one uses Last In First Out (LIFO) at different periods with other inventory valuation techniques.
iii. HCA assumes a going-concern. When this is not the case the relevance of HCA diminishes significantly.
iv. HCA is also subjected to a barrage of underlying subjective estimates such as depreciation estimates, allocation of joint costs, allocation of indirect costs, bad debt reserves, warranty liabilities, pension liabilities, etc.
ii. No common index across nations as nations differ in terms of effort to derive price indices.
iii. Empirical studies in the U.S.A have not shown PLA accounting data to have better predictive powers than historical cost data not adjusted for inflation.
costs is difficult in times of changing technologies and newer production alternatives.
ii. Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.
iii. Accurate derivation of replacement cost is very difficult for items having high variations in quality.
iv. Use of ‘sector’ price indices as surrogates compounds the price- index problem of general price- level adjustments.
v. Current costs tend to give rise to recognition of holding gains and losses not yet realised.
recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility.
iii. Difficulties come in valuing assets that are not separable. For example, assets such as software, knowledge databases and web servers may be impossible to unbundle from the firm as a whole and may have immense value if the entire firm is sold, but they may have no market as unbundled assets.
iv. Exit value accounting records anticipated profits well in advance of transactions; hence it may be far from conservative in its approach. v. Value of a subsystem of items differs from the sum of the value of its parts. Hence liquidation or fair values of the subsystems may not be a true reflection of the value of the system of these net assets.
vi. Appraisals of exit values are both too expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion.
vii. Exit values are affected by how something is sold. If quick cash is needed, the best price may only be half of what the price would be after waiting for the right time and the right buyer. viii. Financial contracts that for one reason or another are deemed to be ‘held-to-maturity’ items may cause misleading increases and decreases in reported values that will never realised. A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates. ix. Exit value markets may often be thin and inefficient markets.
ii. It is virtually impossible to estimate cash flows except when they are contractually specified.
iii. Even when cash flows can be reliably estimated, there are endless disputes regarding the appropriate discount rates.
iv. Endless disputes arise as to assumptions underlying economic valuations.
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Other measurement bases include Value-in-Use (Barth and Landsman, 1995; Beaver and Demski, 1979) which looks similar to level 3 fair values based on models and managers’ estimations, and the Deprival value method which provides an algorithm for choosing a measurement method (rather than prescribing one universal method) that is grounded in the economics of the firm (Baxter, 1975; Whittington, 2008). Deprival value (alternatively, described as Value to the Business) asks the question: what would the owner of an asset lose if they were deprived of this asset? In other words, it is a measurement of the additional value accruing to the business as a result of owning the asset (van Zijl & Whittington, 2006).
Whittington (2008) describes the IASB’s (albeit implicit) move in following the FASB in the prescription of fair value principles and practices to be as a result of the unresolved debate in the 1970’s where standard setters were unable to find a solution to the inflation accounting problem that was acceptable to users and preparers of published financial statements. Also, the move by standard setters in making decision- usefulness the primary focus of General Purpose Financial Reports (GPFR), has swept away the traditionalist view that published financial statements arise out of the need to satisfy narrowly defined legal and stewardship requirements. Hitz (2007) highlights that the FASB and IASB are shifting in measurement paradigms from cost-based measures to market-based measures because they believe market values incorporate, in an efficient and virtually unbiased manner, market consensus expectations about future cash flows. Barth (2006b) argues that fair value accounting is the only comprehensive and internally consistent approach the IASB has been able to identify.
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Penman (2007) using a demand approach from the shareholder’s perspective considered the pluses and minuses of fair value accounting and asks:
“Does fair value enhance the task of equity valuation and stewardship assessment”?
He argues that at a conceptual level, fair value accounting is a plus as equity value is read from the balance sheet with no further analysis needed, while the income statement reports realisations for determining value at risk. However, he takes issue with the implementation of fair value accounting using exit prices. This is where the minuses come in. As usually discussed in the literature, fair value accounting works well, for both valuation and stewardship, with investment funds (where shareholders trade in and out of the fund at net asset value). This case is instructive, for it is the situation where the one-to-one relationship between exit prices and fair value to shareholders holds. That one-to-one condition fails, however when a firm holds net assets whose value comes from execution of a business plan rather than fluctuations in market prices, even when exit prices are observed in active markets. Asset and liability matching problems confound the problem further. Overlay the minuses of estimated fair values when actual prices are not observed, and the minuses do add up. Finally, Penman (2007) argues that historical cost accounting, which he termed as “historical transaction accounting”, can produce earnings from which the value of the firm can be extrapolated. Hence, he agrees that although historical cost has its own implementation problems, especially through difficulties of revenue and expense matching, he thinks fair value accounting has its own problems - particularly with regard to asset and liability matching problems. Penman (2007) expresses particular concern with regard to implementation of fair values - especially levels 2 and 3 - fair values as this is where the one-to-one relationship between values and associated market prices may not exist.
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It is also argued that the process of firm valuation can be done with historical cost earnings without significant difference from valuations made using fair value accounting.
Whittington (2008) also discusses the link between the objectives of financial reporting and fair value accounting. He articulates the view that the differences between the fair value accounting view of financial reporting and views of financial reporting based on alternative measurement bases may be summarised in terms of the following table:
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TABLE 3.2: The Fair Value View Versus The Alternative View
The Fair Value View
This is a view that is apparent in many of the proposed revisions of the Conceptual Framework. Some of its features are also in the existing framework. This broad view would be supported by a significant number (but not necessarily a majority) of members of the FASB and the IASB, and possibly by a majority of the staff who have worked or are working on the frameworks of the two Boards. Because of its articulation by professional standard setters (albeit with individual differences of view on some aspects) this has been more clearly expressed in a “joined” up’ systematic way than has the Alternative View.
The Alternative View
This view is not as articulated as the fair value view, considering that it consists of diverse views of people and institutions commenting on specific valuation issues often from a practical perspective.
The main features of the Fair Value View are:
The implications of the Fair Value View are: The main features of the Alternative View are:
The implications of the Alternative View are:
• Usefulness for economic decisions is the sole objective of financial reporting. • Current and prospective investors and creditors are the reference users for general purpose financial statements. • Forecasting future cash flows, preferably as directly as possible, is the principal need of those users
• Relevance is the primary characteristic required in financial statements.
• Reliability is less important and is better replaced by representational faithfulness, which implies a greater
concern for capturing economic
substance, and less with statistical accuracy.
• Accounting information needs ideally to reflect the future, not the past, so past
transactions and events are only
peripherally relevant.
• Market prices should give an informed, non-entity specific estimate of cash flow potential, and markets are generally sufficiently complete and efficient to provide evidence for representationally faithful measurement on this basis.
• Stewardship is not a distinct objective of financial statements, although its needs may be met incidentally to others.
• Present shareholders have no special status amongst investors as users of financial statements.
• Past transactions and events are relevant only insofar as they can assist in predicting future cash flows.
• Prudence is a distortion of accounting measurement, violating faithful representation. • Cost (entry value) is an inappropriate measurement basis because it relates to a past event (acquisition) whereas future cash flow will result from future exit, measured by fair value.
• Fair value, defined as market selling (exit) price, as in SFAS 157 (FASB, 2006a), should be the measurement objective.
• The balance sheet is the fundamental financial statement, especially if it is fair valued. • Comprehensive income is an essential element of the income statement: it is consistent with changes in net assets reported in the balance sheet.
• Stewardship, defined as accountability to present shareholders, is a distinct objective, ranking equally with decision usefulness.
• Present shareholders of the holding company have a special status as users of financial statements.
• Future cash flows may be endogenous: feedback from shareholders (and markets) in response to accounting reports may influence management decisions. • Financial reporting relieves information asymmetry in an uncertain world, so reliability is an essential characteristic. • Past transactions and events are important both for stewardship and as inputs to the prediction of future cash flows (as indirect rather than direct measurement).
• The economic environment is one of imperfect and incomplete markets in which market opportunities will be entity- specific.
• The information needs of present shareholders, including stewardship requirements must be met. • Past transactions and events are relevant information and together with reliability of measurement and probability of existence, are critical requirements for the recognition of elements of accounts, in order to achieve reliability.
• Prudence, as explained in the current IASB Framework and in the ASB’s Statement of Principles can enhance reliability.
• Cost (historic or current) can be a relevant measurement basis, for example as an input to the prediction of future cash flows, as well as for stewardship purposes.
•Financial statements should reflect the financial performance and position of a specific entity, and entity specific assumptions should be made when these reflect the real opportunities available to the entity.
• Performance statements and earnings measures can be more important than balance sheets in some circumstances (but there should be arithmetic consistency— articulation—between flow statements and balance sheets).
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According to Whittington (2008) fair value may be seen as “alright in theory but not in practice”, considering it assumes that markets are efficient and complete. Hence, he argues that accepting fair value as a “super system” without reservations would be naive and simplistic, noting that earlier advocates of a somewhat different system of fair value accounting in Chambers (1966) and Sterling (1970) would not have been unqualified supporters of fair value principles and practices endorsed by the FASB. The Alternative View on the other hand sounds “practical but not alright in theory” considering that it arose from a variety of people with diverse views commenting on specific issues often from a practical standpoint (Whittington, 2008).
Whittington (2008) argues further that neither of the above conclusions would be correct considering that the two views make different assumptions about the nature of the economic environment, and he argues that it is the accuracy of these assumptions that determines the relevance of the respective views of accounting standards.27 He argues that it is important to recognise that theories are not likely to offer panaceas such as a universally valid single measurement method and that it would be better instead to work in a more limited way to solve specific problems. He believes that the Alternative View documented in Table 3.2 is consistent with this type of theorizing and that it offers a more fruitful and practical approach than the fair value view. He subsequently recommended the use of the “deprival value” approach to accounting measurement as