SCALES
Q: How could accounting programs appropriately prepare students for the fair value accounting measurements they will inevitably deal with when they enter the business
world?
A: There is no doubt that the movement toward the increased use of fair value accounting and estimation methods requires additional skill sets in accountants, auditors, analysts and financial reporting specialists, than were previously required. I would argue that the enhanced fair value requirements may significantly increase the workloads of these individuals, given the complexity and the need for more continuous updating of fair values estimates than before. Unfortunately, this comes at a time of already stretched resources of both corporate accounting and financial reporting staffs and external auditors.
Accounting programs are going to have to ensure that there is a focus on teaching the next generation of CPAs valuation techniques and in-depth financial statement analysis tools. Additionally, higher education institutions may need to consider providing more opportunities for students to specialize in areas of economics, finance, and statistics Un addition to accounting degrees], to ensure that today's students are adequately prepared to tackle tomorrow's challenges.
Source: Review of Ru5ines:;, pp. 6·"9, Coll(·!ge of Busim·~s Administration at St. John's University Nc'w York. Copyright of R('vh-•v.· of BtNm'ss is the property of St John's University Colh•ge.
IJ!ll--1 MEASUREMENT IN ACCOUNTING
Measurement in accounting falls into the category of derived measurement for both capital and profit. Accounting profit is now derived, under international accounting standards, from the change in capital over the period from all activities including increases and decreases in the fair value of net assets excluding transactions with owners. Capital is derived from the net of 'fair value' measure of assets and liabilities.
That means we have to measure the value of opening capital, the amount of income received, the amount of capital usage, and the change in the fair value of net assets. The increase in capital over the period will then measure the amount of profit from various sources including operations and remeasurements (after adjusting for the infusion of new capital or payment of dividends). The restated fair value of net assets will then constitute opening capital in the next period.
Contrast this measurement approach with the approach taken before the introduction of international accounting standards. Revenue received was matched against net assets used up in a period and if income was greater than net capital usage ( or expenses), then we had an increase in capital. Profit was not earned until initial opening historical cost capital was maintained and profit realised. That is, capital was always stated at historical costs and changes in net assets were not considered as profit. Hence, we can see that derived profit depends very much on how we measure opening capital and how we measure expense and capital allocation. We can also see that the concept of capital valuation in accounting has evolved over time with the result that we have several capital maintenance measurements and profit concepts. A brief historical overview will illustrate this point.
In the first thousand years AD, the economic structure was represented by decentralised, self-contained fiefdoms. The purpose of accounting was to count and safeguard the assets of the steward using single-entry accounting. Under this system, capital was measured as the stock of land, animals and agricultural produce with
CHAPTER 5 Measuremenl theory 145
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the purpose of producing output (income) for sustenance. Capital was not usually measured in financial terms but simply counted and itemised.
After the crusades to the Holy Land in the eleventh century, the opening up of the Middle Eastern and Asian trade routes created a demand for tradeable goods ( silk, spices, carpets). The Italian trading cities played a major role transporting crusaders to the Holy Land and returning with goods. This activity created a requirement for venture capital. Profit was based on the returns from (usually) single return voyages, which were financed by venture partners and calculated after returning original capital. Thus, ending capital was measured as the accumulation of wealth from individual ventures plus original capital. From a venture shareholder's point of view, profit represented an increase in wealth. Moreover, the use of the Arabic numbering system together with the concept of returnable capital led to the evolution of double-entry accounting. This system was used widely by Italian merchants from the twelfth to the sixteenth centuries and was first documented by Luca Pacioli as the 'System of Venice' in 1494.
The eighteenth century in England saw the development of joint stock companies with limited liability, a separate management class, and transferability of shares. A number of these companies were declared bankrupt, resulting in large losses to creditors, which in turn, led to the introduction of the 1844 Joint Stock Companies Regulation and Registration Act. This Act emphasised creditor protection and conservative accounting valuations. Thus, the definition of derived capital moved towards 'creditor capital' and resulted in an acceptance of the lower of cost and market value rule as a measurement principle. In the nineteenth century another concept of capital emerged following the railway expansion in the United States. This concept of capital revolved around maintaining intact the stock of going concern assets ( railroad assets such as engines, coaches and track) so as to continue the ability of railroads to provide the same level of uansport services. This resulted in the concept of depreciation as a method to retain funds ( capital) in order to replace assets, and the going concern concept of capital maintenance.
To this point in history there was little developed theory of capital maintenance and profit, only a collection of vague concepts. However, in 1940 Paton and Littleton 16 produced the first definitive statement on the concepts of capital and profit. They defined profit as being derived from the matching or allocation of historical costs against revenue earned. Profit measurement was seen as the major focus of accounting with the derived balance sheet simply the repository of all yet-to-be-allocated historical costs. Hence, the balance sheet was not seen as a measurement of the net market value ( or fair value) of a business. The concepts and principles of the Paton and Littleton system formed the basis of the conventional historical cost accounting system which was the dominant system before the introduction ofinternational accounting standards in 2005.
The normative period of the 1960s saw a number of challenges to the historical cost principle of valuation and hence capital maintenance. Critics deductively argued that the valuation of firms based on outdated historical costs was not all that useful for economic decision making, and the derived profit did not measure contemporary resource usage.
They developed several capital maintenance and profit systems based on maintaining intact opening capital adjusted for general and specific inflation. Thus, profit was derived after maintaining intact some concept of 'market priced' capital, and viewed as a real increase in purchasing power or an ability to maintain the supply of goods and services.
There was robust debate about which was the 'dominant' profit measurement system, but the debate was never settled and lapsed somewhat in the literature. These debates can be considered the forerunner of the 'fair value' approach to derived accounting measurement.
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Consequently, we were left with a number of accounting measurement systems.
These different perspectives reflect various boundaries of accounting and a lack
or
agreement on measurement principles, but with the historical cost allocation system as the conventional and dominant model. Added to this were a number of academic accounting papers that suggested the value relevance of conventional profit had significantly declined over time, but balance sheet items and intangible assets had become more important.17 More recently, the International Accounting Standards Board (IASB) has taken the view that globalisation of business supports the need for one set of accounting standards to be used throughout the world in order to produce comparable financial information.
This has resulted in two notable developments in international accounting standards 1s
as signalled through accounting standards such as !AS 39/MSB 139 Financial Instruments: Recognition and Measurement and the IASB/FASB joint project on reporting financial performance19 - (1) that profit measurement and revenue recognition should be linked to timely recognition, and (2) that the 'fair value' approach should be adopted as a working measurement principle. Thus, from 2005 we see the use (in part) of a measurement principle that focuses on the change in the value of assets and liabilities rather than the completion of an earnings process. In short, this means that changes in the fair value of assets and liabilities are recognised immediately they occur and reported as a component of income. Furthermore, the focus has shifted towards a valuation concept, with the balance sheet the major repository of value-relevant information, and the main users of accounting information stated to be shareholders and investors. Al no stage has the principle of capital maintenance been explicitly discussed. These measurement concepts are not without controversy. Theory in action 5.1 comments on fair value measurement within IASB and FASB standards and raises a number of concerns surrounding fair value accounting and whether it has an underlying measurement principle.
Fair value measurement
1 - - - --- -
'True and fair' and 'fair value' - accounting and legal will-o'-the-wisps
by Graeme Dean and Frank Clarke
This issue of Abacus goes to press as the convergence to an international financial reporting
standards (IFRS) regime begins. More than thirty years since the lengthy gestation of the International Accounting Standards (IAS) Committee, application and enforcement of international standards under the guidance of the International Accounting Standards Board (IASB) is nigh ...
Within this setting the suggestion by rnany commentators (including the IASB in its public documents) that the IFRS regime is principles- rather than rules-based is contestable. This
matter has been discussed in several recent Abacus editorials and is further examined here.
Whereas those promoting the principles rather than rules mantra have failed to specify what
those principles are, the general tenor of their comments gives reason to imagine that such a distinction is underpinned by the qualitative criterion, 'true and falr view' (or its equivalent)
legal or professional override. Frequent recourse to 'fair value' in many IFRS adds further support to a principled approach to things commercial. It will be shown that both settings, however, illustrate the contestable nature of what is meant by those preferring principles.
Those settings represent potential difficulties in achieving convergence of an effective IFRS
regime ...
CHAPTER 5 Measurement theory
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Richard Macve in his submission adopts a different, albeit equally critical, perspective.
An extract from his conclusion is followed by an earlier summary paragraph outlining specifics:
Even though it fFASB] argues that 'conceptually, fair value is a market-based measurement that is not affected by factors specific to a particular entity' (para C2), this ED necessarily acknowledges that there may be different market prices available to different enterprises, and correspondingly different measures of fair value. It proposes to resolve this divergence by requiring that entities choose as their reference market the most advantageous market to which they have immediate access (para C45). This issue is discussed further below. However, the more fundamental issue of 'entry' versus 'exit' prices is left undiscussed and unresolved (and the definition of fair value is therefore itself necessarily left ambiguous) primarily because there is no discussion of the underlying conceptual framework of valuation which has been fully explored elsewhere in the academic and professional literature using the concept of 'deprival value' for assets (and the related concept of 'relief value' for liabilities) (e.g., Baxter, 1975, Chapter 12; AARF, 1998; ASB, 1999). It is not clear whether the Board has come to a view on these conceptual issues or whether they are still to be addressed in the conceptual phase of the project. At present the ED gives the impression that the Board is merely avoiding these issues - but until they are addressed and explained the implications of the definition of fair value and related requirements of this proposed standard are necessarily left incomplete and essentially unclear. (For further discussion see Horton and Macve, 2000.) [R. Macve, FASB
Submission #6, p. 21
Brief discussion of those two events reveals the difficult path ahead for the IASB countering such will-o'-the wisp issues to achieve a convergence regime that produces financial reporting comparability across countries.
Source [xcerpts !rom Abc1cu.,, vo!. •11, no. 2, 200.S.
Questions
1. What do you think the authors mean by a principles- versus a rules-based system of accounting?
2. What are the measurement problems they allude to?
3. What does Macve mean by the underlying conceptual framework? What problems does he
see with a 'fair value' approach?
4. Do you think there is any difference between 'measures' and 'values'?
For some firms it is argued that fair value accounting fundamentally changes the focus of risk management. That is, firms will decrease their hedging activity because they are worried about the accounting impact of profits under !AS 39/AASB 139. One other consequence is that a company's pension fund now shows up as a liability on the balance sheet (!AS 19 / AASB 119 Employee Benefits) and this may need to be hedged. The derivatives a firm uses to hedge this liability might depend on whether the pension scheme is in surplus or deficit. Thus, international accounting standards may reduce hedging activity if it results in an increased volatility in income while increasing hedging and risk management for pension liabilities.
The lASB also makes a trade-off between reliable measures and relevant measures.
Sometimes that judgement is made by the IASB. For example, in !AS 39/AASB 139, for available-for-sale securities the IASB determines that fair value (selling price) must be used instead of historical cost. However, for !AS 41/AASB 141 Agriculture, although fair value is required where possible, the Board states that it may be difficult to obtain reliable measures of fair value. In this case the reliability exception allows preparers to make a trade-off between fair value and reliability when measuring value.
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Capilal or income?
Dr Nadine Fry and Dr David Bence are senior lecturers at the Bristol Business School
Despite the established link between asset and liability measurement and capital maintenance, the latter represents a second order issue for the IASB, say Nadine Fry and David Bence.
In May 2005, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) launched a joint project to develop a common conceptual framework that could be used to develop new and revised International Accounting Standards (IASs), As part of the project, much time will be spent considering the measurement of business income.
The 'debit' side of the problem has received a substantial amount of attention in recent years with the JASB's drive towards fair value as a solution to accounting measurement problems. Yet despite the established link between asset and liability measurement and capital maintenance, the latter represents a second order Issue for the IASB. So if a futures contract has a fair value of £1 Om but an historical cost of zero, should one credit income or capital?
Interestingly, although the IASB's Framework claims that financial statements should enable users to determine distributable profits and dividends, the IASB argues that such issues constitute part of the legal framework of individual countries for which there is little international convergence.
Regrettable
However, even if one accepts that there will always be different distributable profit rules around the world, the IASB's failure to decide on a capital maintenance concept is regrettable as users have no idea as to whether total gains represent income or capital and are therefore unable to identify a meaningful 'bottom line'.
The IASB does not appear willing to tackle capital maintenance issues. !AS 1, Presentation of F;nancial Statements, permits companies to produce either a 'statement of recognised gains and losses1 or a 'statement of changes in equity', but both ignore capital maintenance.
Although it may be argued that sophisticated users can make up their own minds as to the nature of total gains, this decision is not in line with the FASB/JASB conceptual framework project, which aims to deal explicitly with the issue of capital maintenance.
The approach currently adopted by IASs generally provides a measurement of income based on the nominal unit of currency, a mixed system for measuring assets and liabilities and money capital maintenance (see for example, !AS 19, Employee Benefits; !AS 21, The Effects of Changes in Foreign Exchange Rates, !AS 39, Financial Instruments: Recognition and Measurement, and !AS 40, Investment Property).
Inconsistent
Surely a mixed measurement system and money capital maintenance do not go together well? However, the concept of money capital maintenance is not consistently applied across international standards. For example, !AS 29, Financial Reporting in Hyperinflationary Economies, has the effect of real financial capital maintenance, whereas !AS 16, Property, Plant and Equipment, and !AS 38, Intangible Assets, apply physical capital maintenance.
It seems fair to conclude that even if the JASB continues to apply capital maintenance on a line-by-line (or element-by-element) basis, an additional financial accounting element, a 'capital maintenance adjustment', should be included below 'total gains' in the 'statement of recognised income and expense'.
The IASB could provide guidance on the items that would make up the capital maintenance adjustment, presumably including changes in the unit of currency, unrealised gains, realised gains where replacement is required, and so on. Such a financial accounting element would enable users to determine the proportion of total gains represented by capital and income and would help to alert users to the fact that some gains may reverse because they are unrealised.
Sourcx•: A.ccountancy, April 2007, p. 3 ! , www.<1ccoun!<mcymagaz:in0.com. i;y,J
CHAPTER 5 Measurement theory --149
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Questions
1. Why is the measurement distinction between capital and income important?
2. What do you think is real financial capital maintenance and what is physical capital
maintenance?
3. Is the increase in the value of a house you live in income or capital? Provide explanations.
4. Does your answer to question 3 change if your house is an investment property? Give reasons for your answer.
The FASB/IASB joint project on Financial Statement Presentation (previously Reporting Comprehensive Income or Performance Reporting) highlights the IASB's thinking on income and asset measurement, pa1ticularly the application of fair value measurement. Some agreed concepts include the following.20
1. Accounting information should be aimed at decision makers making economic decisions about the entity.
2. Entities should present a single statement of all recognised income and expense items as a component of a complete set of financial statements.
3. The statement should be all-inclusive:
( a) It should include the effects of all changes in net assets and liabilities during the period, other than transactions with owners.
(b) Assets and liabilities should be valued at fair value which presumes market prices but substitutes such as discounted future cash flows, depreciated market prices or asset-pricing models can be used in the absence of a liquid market.
( c) Income determination should be split between profit before remeasurement and remeasurement effects.
4. All income and expenses should be categorised and displayed in a way that (a) enhances users' understanding of achieved performance
(b) assists in forming expectations of future performance.
5. Profits should not be based on a notion of realisation.
6. The focus should be on (a) greater transparency
(b) useful information to investors and relevance of data for decision making ( c) the concept of reliability has been replaced by representational faithfulness.
Under this approach the income statement would become the residual between opening net assets and closing net assets, rather than the balance sheet becoming the residual of unallocated costs after the matching process, which is the case under historical cost measurement. The concepts stated above give an indication of the Boards' thinking about financial statement presentation and measurement issues.