The University of Sydney Page 1
ACCT2011
Reporting on Business
Performance
Module 2: Measurement; Choice
of Accounting Methods
By Timothy Wang
The University of Sydney Page 2
Measurement; Choice of Accounting Methods
Text Readings:
– H&P Chapters:
– Ch 3 pp. 58 & 60-61;
– Ch 4 pp. 98-105; and
– Ch 5 pp. 118-139.
Other Readings:
– “Financial Reporting” 3rd ed, Loftus et al. (2020), pages
30-32
– AASB Conceptual Framework
– AASB 13: Fair Value Measurement
– AASB108: Accounting Policies, Changes in Accounting
Estimates and Errors
– Conceptual Framework for Financial Reporting, IFRS
Conceptual Framework Project Summary, March 2018
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Learning objectives
Measurement & Fair Value:
1. Describe measurement in the context of accounting (H&P LO
3.4, H&P pages 58 & 60-61, Loftus et al pages 30-32 )
2. Describe the importance of fair value measurement (H&P LO
4.1, H&P pages 98-100)
3. Define fair value and describe its various components (H&P LO
4.2 – 4.2.4, H&P pages 100-105)
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Learning objectives
Choice of Accounting Methods:
4. Explain the process used by accounting standard setters to
make choices between alternative accounting policies (H&P LO
5.1, H&P pages 118-122)
5. Discuss reasons why choices of accounting policies are
available to preparers of financial statements and the
attempts by Australian accounting standard setters to limit this
choice (H&P LO 5.2, H&P pages 122-123)
6. Explain ‘creative accounting’ by preparers of financial
statements (H&P LO 5.3, H&P pages 123-125), and
understand what is meant by ‘earnings management’
7. Discuss preparers of financial statements incentives to engage
in earnings management (H&P LO 5.4 & LO 5.5, H&P pages
(125-139)
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Objective 1
Describe measurement in the
context of accounting*
(H&P LO 3.4, H&P pages 58 & 60-61, Loftus et al pages 30-32)
*The following information is based on the
AASB Conceptual Framework
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Measurement in accounting
AASB Conceptual Framework
- Broad definition of measurement: “the assignment of numerals to
objects or events” (H&P p.58).
- Accountants use money to measure, so all accounting measures have
a dollar sign.
– Elements of financial statements could be measured in many ways:
– Historical cost;
– current (replacement cost);
– Fair value;
– Net realisable (settlement) value;
– present value.
Refer to Table 1.1 Loftus et al page 30
– .
Entry price
Exit price
Also called cost-based amount
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Measurement in accounting
– AASB Conceptual Framework lists these measurement bases but
does not decide.
– These are all financial measures, but which should be used?
– But to be able to aggregate the measures, i.e. to add them, or
subtract them, the measures need to be the same.
– If, for example, we use historical cost for some items and
realisable value for others, the totals are not meaningful.
– In accounting practice, multiple different measures are used for
different types of elements (eg. Accounts receivable, plant and
equipment).
- Measurement basis is important - When you see a company’s
total assets, what does that total mean?
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Measurement baseAccounts
Active Learning:
Inventory The lower of cost and net realisable value
Net accounts receivable Amortised cost/expected cash receipts
Property, plant and equipment Modified historical cost/cost-based amount
A mixed measurement system
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Measurement in accounting
Example 1– Different measurement bases
Source: H&P page 61
Do 1 dollar in 2007 and 1 dollar in 2017 have the same purchasing power
Because of inflation?
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Measurement in accounting
Factors to consider when choosing a measurement basis
AASB Conceptual Framework
– Choice of a measurement basis is a professional judgment based
on the facts and circumstances for each account balance
– For “relevant” consider characteristics of the asset or liability and
its related income/expense and contributions to future cash flows
– For “faithfully represent” consider consistency/inconsistency of
measurement basis between related asset and liability accounts,
will financial statement users find the information useful and does it
faithfully represent the underlying transactions
– Hans Hoogervorst, Chair of the IASB, provides an overview of the
RCF approach that has been adopted by the AASB
https://www.ifrs.org/news-and-events/2018/03/iasb-completes-
revisions-to-its-conceptual-framework/
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IASB Conceptual Framework - Measurement
Source: Conceptual Framework for Financial Reporting, IFRS Conceptual Framework Project Summary, March 2018
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IASB Revised Conceptual Framework - Measurement
Source: Conceptual Framework for Financial Reporting, IFRS Conceptual Framework Project Summary, March 2018
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Objective 2
Describe the importance of fair value
measurement
(H&P LO 4.1, pages 98-100)
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Fair value
– Accounting standard setters have increasingly been using 'fair value'
as a measure in various accounting standards. (see list H&P p. 98).
– What is fair value?
– The exit or selling price of an asset (or the price paid to transfer
a liability) at the measurement date.
– Fair values change as market prices change.
– If changes in fair value are recognised in financial statements,
they will affect the financial performance and financial position
of the entity.
– Although fair values have been used in Australia for many years
for property, plant and equipment (Modules 3-4), standard-
setters’ efforts to apply fair values to financial instruments have
received significant attention and has been most controversial.
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Criticisms of fair value
– Fair value can be unreliable, especially when there is no active
market to provide evidence of fair value.
– Fair values might not be relevant under some circumstances, and
so recognition of unrealised gains or losses might be misleading.
– During global financial crisis (GFC) of 2007-2009, it was
argued that fair value accounting caused the GFC. (Not correct,
but the accounting standard setters were placed under pressure
and made some changes).
– Concerns about the effect of fair value accounting on company
contracts, such as management remuneration contracts, debt
covenants.
– AASB 13: Fair Value Measurement was issued in response to the
increased criticisms that arose during the GFC.
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Objective of AASB 13
– Define fair value.
– Set out in one accounting standard the framework for measuring
fair value.
– Disclosure requirements for fair value measurements (AASB 13
paragraph 1).
– Objective of a fair value measurement to estimate the price at
which an orderly transaction to sell the asset or to transfer the
liability would take place between market participants at the
measurement date under current market conditions (AASB 13
paragraph 2).
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Objective 3
Define fair value and describe its Various
components
(H&P LO 4.2-4.2.4, pages 100-106)
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Define fair value
– “The price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at
the measurement date” (AASB 13 paragraph 9).
– Fair value is based on a “hypothetical transaction” for an asset or
liability as measured by market participants. Therefore, market-
based, and not based on the intentions of the entity holding the
item.
– Key characteristics:
1. Identification of the asset or liability that is being measured at
fair value.
2. Characteristics of the transaction for the purpose of measuring
fair value.
3. Characteristics of assumed market participants.
4. Concept of an exit price.
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Characteristic 1: Identify the asset (or liability)
– Asset (or liability) may be:
– A stand-alone asset (or liability), e.g. a non-financial asset; or
– A group of assets, a group of liabilities or a group of assets and
liabilities (e.g. a business).
– Identification of what is being measured depends on the
specific accounting standard (eg, an item of property, plant
and equipment (PPE) would be as a stand-alone asset under
AASB 116 Property Plant and Equipment).
– Specific characteristics of the asset (or liability) must be taken
into account if market participants would consider those
characteristics when pricing the asset (or liability).
– For non-financial assets such as PPE, value at “highest and best
use” by market participants.
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Characteristic 1: Identify the asset (or liability)
Example 2: Identifying the asset
Source: Example 4.1 H&P page 102
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Characteristic 1: Identify the asset (or liability)
Example 3: Highest and best use
As a by-product of its own manufacturing, Maggie Ltd has
developed a tool that enables certain machines to run more
productively. Rather than manufacture and sell this tool, Maggie
Ltd has decided to allow other companies to manufacture and use
the tool under a licencing program.
Required: How would Maggie Ltd measure the fair value of the
licence?
Discussion: Maggie Ltd has determine the highest and best use of
the licence is in conjunction with other assets in the manufacturing
process, that is an “in-combination” valuation premise.
Adapted from “Financial Reporting” 3rd ed, Loftus et al. (2020), page 78
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Characteristic 2: Characteristics of the transaction
– Assumption of exchange in an orderly (not a forced) transaction
(AASB 13 para. 15).
– Also assumption that the transaction to sell the asset or transfer the
liability takes place in the principal market or, in the absence of a
principal market, the most advantageous market (AASB 13 para.
16).
– The principal market is the market with the greatest volume and level
of activity for the asset or liability (Appendix A).
– The most advantageous market is the market that maximises the
amount that would be received to sell the asset or minimises the
amount that would be paid to transfer the liability, after taking into
account transaction costs and transport costs (Appendix A).
– Transaction costs must be considered when deciding the most
advantageous market, but transaction costs are excluded from fair
value.
most advantageous market formula: estimated price – transport cost – transaction cost
= profit
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Characteristic 3: Market participants
– Market participants are buyers and sellers in the principal (or
most advantageous) market. They are independent,
knowledgeable, able and willing to transact.
– Will seek to maximise fair value of asset (or minimise fair value
of liability) (AASB 13 paragraph 22).
– Fair value based on assumptions of market participants who act
in their economic best interest (AASB 13 paragraph 22).
– Need not identify specific market participants.
– Identify characteristics of market participants associated
with:
– the particular asset or liability;
– the principal (or most advantageous market); and
– the types of market participants that would transact in that market
(AASB 13 paragraph 23).
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Characteristic 4: Price
– Fair value is an exit price (see definition)
– Price may be directly observable or estimated using
another valuation technique (AASB 13 paragraph 24).
– Fair value must not be adjusted for “transaction
costs” (AASB 13 paragraphs 25).
– Transaction costs do not include transport costs.
Transport costs deducted from price if location is a
characteristic of the asset (AASB 13 paragraph 26).
During this semester you will be learning about accounting
standards that use fair value
Fair value formula: estimated price – transport cost = estimated fair value
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Applying Fair Value
Example 4: Transaction costs and transport costs
Pilbara Ltd is a mining company that is considering selling one of its
machines and wishes to determine the fair value of the machine. Similar
machines are sold in the market for $100,000. In order to sell the machine,
Pilbara Ltd would incur advertising costs of $250, legal costs of $300 and
information costs of $120. The cost of transporting the machine to the
nearest town with shipping facilities is $300.
Required:
Determine the transaction costs, transport costs and fair value of the
machine.
Transaction costs: $250 (advertising) + $300 (legal costs) + $120
(information costs) = $670
Transport costs: $300 (transport costs to nearest town with shipping)
Fair value: $100,000 - $300 (transport costs only) = $99,700
Adapted from “Financial Reporting” 3rd ed, Loftus et al. (2020), page 71
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Applying Fair Value
Example 5: Most advantageous market
Source: Example 4.2 H&P page 105
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Summary of measurement and fair value
Think back to Topic 1
AASB Conceptual Framework
– The Conceptual Framework does not take a position on
measurement.
– In practice, multiple different measures are used, and this means
that totals in financial statements not very useful.
– Although fair value is increasingly being used in accounting
standard-setting, it seems unlikely to be used for all account
balances.
– However, by examining the factors to consider when choosing a
measurement basis for each account balance, useful information
may be drawn from general purpose financial statements.
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Objective 4
Explain the process used by accounting standard setters to
make choices between alternative accounting policies
(H&P LO 5.1, H&P pages 118-122)
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The history (in periods)
– Historically, the process of accounting standard setting has been
very political and required compromise
– The ad hoc period
– Discussion and negotiation of accounting standards.
– The conceptual framework period
– Strengthened standard setter’s power by drawing on CF.
– The harmonisation period
– Increased efforts to harmonise (make similar) Australian
accounting standards internationally.
– The convergence period
– Effectively adoption in Australia of international (IASB’s)
accounting standards (make the same).
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Choices by accounting standard setters
– When developing an accounting standard, standard
setters must choose the most appropriate policies from
a range of alternatives.
– The 'most appropriate' choice is not always clear.
– Assistance from the Framework is limited.
– Historically the process has been very political and
has required compromise.
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Objective 5
Discuss the reasons why choices of accounting policies are
available to preparers of financial statements and the attempts
by Australian accounting standard setters to limit this choice
(H&P LO 5.2, H&P pages 122-123)
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Choices by preparers
What is an accounting policy?
AASB 108, paragraph 5
– The need for preparers to choose between accounting
policies arises from three causes:
1. Aspects of financial reporting are not covered in
accounting standards.
2. Accounting standards may contain alternative
policies.
3. There is often a need to make judgments or
estimates. e.g. useful life and residual value
estimations.
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Choices by preparers
– Preparers must choose accounting policies that result in relevant
and reliable financial information.
– Refer to AASB108 paras 7, 10, 11, 12 and summarise the key
points: Write down the steps required in the correct order.
If a AASB applies have to use it as the accounting policy Para 7:
If there is no applicable accounting standard, use judgment, info has
to satisfy the qualitative factors in para. 10
Para 10:
To help with the para 10 judgement firstly look at AASB for similar
transactions and then definitions of elements in the Framework.
Para 11:
To help with para. 10 judgement, can also look at other accounting
setting bodies announcements, accounting literature, industry practice
Para 12:
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Objective 6
Explain ‘creative accounting’ by financial
statement preparers (H&P LO 5.3, H&P pages 123-125)
and understand what is meant by ‘earnings management’
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Creative accounting
– Is when accounting policies are made or chosen to
ensure financial statements present the impression
desired by financial statement preparers.
– Also known as "window dressing“.
– It has been suggested that creative accounting
provides an opportunity to present unreliable
financial statements.
– Creative accounting also has other meanings and this is
just one meaning. For example earnings management
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Creative accounting
– Four ways to be “creative” in preparing and
presenting financial statements are:
– choice of accounting policies.
– estimates or predictions of future events.
– disclosure of transactions or events.
– timing of transactions.
– Note also emergence of new transactions and events
calls for creative financial reporting solutions
("creative" is used here in a positive sense).
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Earnings management
– Idea of earnings management
– 'That managers use judgement in financial reporting and in
structuring transactions to alter financial reports to either
mislead some stakeholders about the underlying economic
performance of the company or to influence contractual
outcomes that depend on reporting accounting numbers'
(H&P p.126).
– Implies opportunistic management of both accounting policy choices
and transactions;
– Implies misleading users of financial reports.
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Objective 7
Discuss preparers of financial statements incentives to engage
in earnings management
(H&P LO 5.4 & LO 5.5, H&P pages (125-139)
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Possible reasons for earnings management
– Possible reasons for making particular policy choices:
– Income-smoothing motivations
– Capital market motivations
– Contractual motivations
– The income-smoothing hypothesis
– Gordon (1964) suggested that:
– Managers choose policies to maximise own welfare
– Managers should, within accounting rules:
– First, smooth reported profit
– Second, smooth the rate of growth in profit
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Possible reasons for earnings management
– Capital markets motivations
– Accounting information used to value shares:
– Managers may manipulate profit to influence the share price
– Research on managers’ incentives to meet earnings
benchmarks:
– Avoiding losses
– Sustaining last year’s performance
– Meeting analysts’ forecasts
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Possible reasons for earnings management
Agency Theory & Contractual motivations
– A firm is a collection of self-interested individuals
– Securing ‘co-operation’ requires an explicit agreement (contract) OR
an implicit understanding
– Agency relationships are where one party (the principal) delegates
decision-making authority to another (the agent)
– Separation between ownership and control
– ‘Agency’ relationships exist between:
– Shareholders and managers
– Managers and debtholders
– What is debt covenant?
– Debt covenants refer to restrictions lenders imposed in lending
agreements to restrict the actions of the borrower (debtor). For
example, loan covenants require that the debtor maintains a
minimum current ratio of 2.2 at the end of the reporting period.
– Module 12: Presentation of loan arrangements subject to debt
covenants as current or non-current under AASB 101
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Summary of choice of accounting methods
– Accounting standard setting process leads to the existence and
content of the standards.
– Accounting standards do not cover every transaction or
event.
– Standard setters decide which standards to set and what
policies to require in them.
– Preparers, who typically have legal and/or professional
ethical requirements to comply with accounting standards
(Module 1), also need to make choices both when there is an
applicable accounting standard and when there is not.
– Within the choices available, there is scope for creative
accounting/earnings management.
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– In the next class we will
start looking at accounting
standards that apply to
individual account balances
in an entity’s financial
statements.
– In particular, how to account
for property plant &
equipment (PPE) and
related impairment issues.
Next topic – Module 3