MEASUREMENT ISSUES FOR AUDITORS
6. What are the sources of error in 1neasurement?
7. Explain whether the following statements are facts:
(a) Canberra is 320 kilometres from Sydney.
(b) Depreciation expense for Kambah Pty Ltd for 2008 was $1 294 000. (This is the amount reported on the income statement.)
( c) Smoking leads to lung cancer.
( d) Sales revenue for Telex Ltd for 2009 was $2 800 000. (This is the amount reported on the income statement.)
( e) Equipment ( net of accumulated depreciation of $400 000) for McNair Ltd for 2008 was worth $1800000. (This is the amount reported on the statement of financial positon.)
8. What is the difference between accuracy and reliability in measurement? How are these notions related to the testing of a theory?
9. Discuss whether accounting measurement is fiat or fundamental. Can accounting numbers ever be related to fundamental values? If so, what are some possible measurements that can be used?
10. Discuss how recent accounting standards using 'fair value' accounting such as
!AS 39 and !AS 41 have moved away from fundamental measurement.
11. Why will international financial reporting standards induce an increased demand for risk management techniques?
12. How will the use of fair values affect the role of auditors and the audit function?
Do you think it will affect the training of accounting students? How so?
13. What would be included in overhead costs assigned to inventory? How many ways can you think of assigning these costs when there are multiple products and departments? What are the audit implications?
Additional readings
Alfredson, K, Leo, K, Picker, R, Loftus, J, Clark, K, & Wise, V 2009, Applying international financial reporting standards, 2nd edn, Brisbane: John Wiley & Sons.
Charles, E 2002, 'Mixed bag', Australian CPA, May, pp. 26-30.
Churchman, CW, & Ratoosh, P (eds) 1959, Measurements: definitions and theories.
New York: John Wiley.
Institute of Chartered Accountants in England and Wales (JCAEW) 2006, Information for better markets: measurement in financial reporting, ICAEW, www.icaew.co.uk/
bettermarkets.
Kam, V 1973, 'Judgements and the scientific trend in accounting', Journal of Accountancy, February.
The following article discusses 12 different ways lo value intangibles and brands using 'fair values'. The article highlights the difficulty involved in requiring reliability and
accuracy and in providing relevant information.
12 ways to value intangibles and brands
1. Net present value The mainslream discounlecl cash method, used by the Big Five and lnterbrand. This method looks at the proportion of business profits driven by brand and Lhe relative security of branded profit streams.
2. Capital asset pricing model The main method used by Brand Finance, which assigns a brand to the intangible. This is interchangeable wilh the CAPM's discount rate.
154 PART 2 Theory and accounting practice
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3. Cost of creation This attempts to calculate the cost of building from scratch. Some say this technique is unworkable and unrealistic.
4. Market-based comparisons This is literally what it says. A comparison is made lo a similar brand in the market. In practice difficult lo achieve. One only need compare two similar tasting drinks, Coke and Pepsi, and their respective brand values of US$68.95bn and US$6.21 bn respectively.
5. Royalty relief method If a brand is licensed from a third party, a royalty is paid.
Here future sales are estimated and applied to a royalty rate to arrive at future brand value. The cash flow is discounted back to a net present value or brand value.
6. Relative value This looks at valuing the progress a company has made towards meeting target. For example: have 80 per cent of employees been with the customer in some meaningful way?
7. Balanced scorecard Supplements traditional financial measures with three additional perspectives such as customers, internal business processes, and learning/
growth.
8. Competency models This would typically calculate the market value of the behaviours of a company's most successful employees.
9. Benchmarking Involves idenlifying companies that are recognised leaders in leveraging their intellectual assets, determining how well they score on relevant criteria, and then comparing your own company's performance against them.
10. Business worth This approach centres on three questions. What would happen if the information we now use disappeared altogether? What would happen if we doubled the amount of key information available? How does the value of this information change after a day, a week, a year?
11. Business process auditing This measures how information increases value for a specific business process, such as accounting, production or rnarkeling.
12. Knowledge bank This turns around tr.iditional accounting by saying that capit.il spending is an expense rather than ;in asset. In contrast, salaries are treated as an asset rather th.in an expense as they create future cashflows.
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Questions
1. Evaluate the advantages and disadvantages of each suggested measurement technique.
2. Make a recommendation as to which measurement technique should be used.
3. Would you consider using more than one measurement technique? Why or why not?
The following article raises concerns about the impact of international accounting standards on risk management strategies. In particular, it highlights the impact of IAS 39/AASB 139.
Risk management survey 2005: Take a risk. No chance
by [dward Thornton
How i<i 11\S <1flPcting corporates
'For some clients it's decreasing their hedging activity because they are worried about the accounting impact,' says Rashid Hoosenally, head of client strategies and product innovation at Deutsche Bank. 'But I think other clients have turned the corner.' Having
CHAPTER 5 Measurement theory 155
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been initially fearful of IAS 39, Hoosenally believes many corporales are determined
10 implement slralegies lhal are in the longHlerm economic interests of their company, even if it me.ins be.iring the pain of volatility in the short term ...
This observation is certainly borne out in [Corporate rinance'sl survey. While neurly half of respondents say that accounting considerations were 'very important', the vast majority (89.36(¼,) of corporates surveyed say the ratio of their hedging done via options and structured forwards had not changed since IAS 39 became an issue. Corporates seem to be in a quielly defiant mood: acknowledging the importance of accounting issues, but refusing to be cowed.
On the other hand, says Russell Schofield Bezer, managing director of the corporate financial engineering group at JPMorgan, the issue of stricter accounting regulalions h;is fundamentally changed the focus of risk management Before, much of a corporate's time was spent worrying about the steepness of the dollar curve or the Federal Reserve's next interest rates announcement 'We don't have many conversations around lhose micro topics anymore,' he says. 1 All the conversalions we have with our corporales are fundamental in terms of ''what's the impacl on the business now of risk management?" '
One consequence of the stringent accounting regulr1tions is that a company's pension fund now shows up as a liability on the billance sheet. And, like any other liability, it needs lo be hedged. The derivatives a corporate uses lo hedge this liability might depend on whether the pension scheme is in surplus or deficit.
'The companies lhal have large deficits are thinking, if they start lo hedge their liabilities now they effectively lock themselves into this large liability that has real losses,' sr1ys Deutsche Bc1nk1s !Riehl Herman.
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Questions
1. Why would firms be concerned with increasing or reducing hedging activities under different accounting systems?
2. What impact will inlernalional financial reporting str1ndards have on the income statement?
3. Why is the measurement and reporting of pension liabilities and assets a concern for risk management?
The trend toward fair value accounting
by I f~ussell Mddray, CTI\
The Debate:
Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant lo the financial analyst community. The fact that the market value of publicly traded firms on the New York Stock Exchange is an average of five limes their asset values serves lo highlight this deficiency. Many reformers, including FASB chairman Robert Herz, believe that fair value accounting must be part of the answer to making financial statements more relevant and useful.'' Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company.
But switching from historical cosl to fair value requires enormous effort. Valuing assets in the absence of active markets can be very subjective, making financi;il statements less reliable. ln fact, disputes can arise over the very definition of certain assets and liabilities.
156 PART 2 Theory and accounting practice
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Tl~e crux of the fair ~alue debate is Lhis: Each side agrees that relevance and reliability are tmporlant, but fair value advocates emphasize relevance, while historical cost advocates place greater weight on reliability.
Rc!t'vdnU' vcrsu~ !<(.'liability
The pertinent conceptual guidance for making trade-offs between relevance and reliability is provided by FASB Concepts Statement No. 2, Qualitative Characteristics ofAccounling Information. ll provides guidance for making standard-selling decisions aimed at producing information useful to investors and creditors. Concepts Statement No. 2 stales:
The qualities lhat distinguish "better" (more useful) informalion from "inferior" (less useful) information arc primarily the qualities of relevance and reliability ... The objective of accounting policy decisions is to produce accounting information that is relevant lo the purposes lo be served and is reliable.
Critics of fair value generally believe that reliability should be the dominant characteristic of financial statement measures. But the FASB has required greater use of fair value measurements in financial statements because il perceives that information ,is more relevant lo investors and creditors than historical cost information. In that regard, the FASB has not accepted the view that reliability should outweigh relevance for financial statement measures.
Some critics also interpret reliability as having a meaning that differs in al least certain respects from how that term is defined in the F/\SB's Conceptual Framework. Some critics equate reliability with precision, and others view it principally in terms of verifiability.
However, Concepts Statement No. 2 defines reliability as "the quality of information that assures that informt1tion ls reasonably free from error or bias and faithfully represenls what it purporls to represent." With respect to measures, it states that "[tlhe reliability of a measure rests on the faithfulness with which it represents what it purports to represenl, coupled with an assurance for the user, which comes through verification, that it has that representational quality." Thus, the principal components of reliability are representational faithfulness and verifiabiliLy.
Ahhough there are reliability concerns associated wilh fair value measures, particularly when such measures may not be able to be observed in active markets and greater reliance must be placed on estimates of those measures, present-day financial slatemenls are replele wilh estimates that are viewed as being sufficiently reliable.
Indeed, present-day measures of many assels and liabilities (and changes in them) are based on estimates, for example, the colleclibilily of receivables, salability of inventories, useful lives of equipment, amounts and timing of future cash flows from investments, or likelihood of loss in tort or environmental litigation.
Even though the precision of calculated measures such as those in depreciation accounting is not open to question since they can be calculated down lo the penny, the reliabilily of those measures is open lo question. Precision, therefore, is not ,1 compo- nent of reliability under Concepts Statement No. 2. In fact, Concepts Statement No. 2 expressly slates that reliability does not imply certainty or precision, and acids that any pretension to those qualities if they do not exisl is a negation of reliability.
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Questions
1. What you think is the fundarnental problem with financial statements based upon the historic cost measurement principle used under US GAAP ?
2. What do you think of the principle' ... accounts must reflect economic reality' as a core principle of measurement in accounting?
3. How would you measure economic reality?
4. What is reliabilily in accounting?
CHAPTER 5 Measurement theory 157
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The following article discusses share option schemes in the light of the international financial reporting standards.
IFRS put damper on share options schemes
by Barney /opson
lnlernalional financial reporting standards have triggered a sharp drop in the popularity of share option schemes, realising the fears of critics who said the rules would kill off a vital recruilrnenl tool.
Under IFRS, companies are required to deduct the cost of issuing options from earnings for the first time. This has led to sudden reductions in reported profit al some companies.
As a result, stock options are falling oul of favour in the remuneration of FTSE 100 chief executives. The proportion of incentive awards made up by options has dropped to 21 per cent this year from 36 per cent, according lo PwC.
Graham Ward-Thompson, partner at PwC1 said: 1IFRS is creating a fundamental shift in the design of stock-based incentive plans.'
Options have enabled many companies - notably small technology groups - to recruit elile and rank-and-file staff who are allracted by the chance of earning far more than cash salaries when share prices rise.
Opponents of option expensing have warned that its effect on profits could make the instruments unusable, leaving companies unable to altract good staff and inhibiting innovation.
PwC's research showed that granting actual shares had become a viable option.
'Performance share plans' now account for 68 per cent of FTSE 100 chief executive incentives, up from 57 per cent.
Performance share plans must also be expensed under IFRS, but Mr Ward-Thompson said they enabled companies to get the same 1incentive and retentive effects' for a lower accounting charge. 'Employees don't see as much value in options as they do in free shares.'
Companies that have introduced performance share plans for senior management or employees include BAA, British Land, Carphone Warehouse, Ernap and Legal &
General.
Stock option expensing is expected lo exert a drag of about 13 per cent on the pre- tax profit of LogicaCMG, an IT services group. Seamus Keating, chief financial officer, said the company was considering changes lo remuneration but would have clone so irrespective of lfRS.
'Stock options have probably been a less effective tool lo incentivise employees recently because the stock market has been flat and the tech sector has gone through some difficult years,' he said.
James Wheaton, finance director of Business Systems Group, which is listed on Aim, said: 'I don't think you should run the company on a change in accounting policy.
'If options were the right way lo find and retain people we would use them and explain it to shareholders.'
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Questions
1. How do share options schemes affect the measure of income under international financial reporting standards?
2. Why has this led lo the reduction in stock-based packages for staff?
3. How is the form of structuring and reporting financial statements important to {a) management?
(b) shareholders?
158 PART 2 Theory and accounting practice
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1. N Campbell, 'Symposium:
measurement and its importance for philosophy', Proceedings of the Aristotelian Society, 1938, p. 126.
2. SS Stevens, 'Mathematics, measurement and psychophysics', in SS Stevens (ed.), Handbook of experimental psychology, New York:
John Wiley, 1951, p. 1.
3. R Sterling, Theory of the measurement of enterprise income, Kansas: Kansas University, 1970, p. 70.
4. Stevens, op. cit., p. 2.
5. Stevens, op. cit., p. 23.
6. W Torgerson, Theory and methods of scaling, New York: John Wiley, 1958, p. 17.
7. ibid., pp. 21, 30-1.
8. R Mattessid1, Accounting and analytical methods, Homewood, Ill.:
llvVin, 1964, p. 71.
9. Stevens, op. cit., p. 25; Jum Nunnally, Psychometric theory, New York: McGraw-Hill, 1967, p. 15.
10. Nunnally, op. cit., pp. 16-17.
11. N Campbell, Physics, the elements, Cambridge: Cambridge University Press, 1920; N Campbell,'An account of the principles of measurement and calculations, London: Longmans, Green, 1928.
12. W Hays, Quantification in psychology, New York: Brooks/Cole, 1967, p. 17.
13. B Ellis, Concepts of measurement, Cambridge: Cambridge University Press, 1966, p. 53.
14. Torgerson, op. cit., p. 24.
15. SS Wilks, 'Some aspects of quantification in science', in Harry Woolf (ed.), Quantification, New York: Bobbs-Merrill, 1961, p. 7.
16. W Paton and AC Littleton, An introduction to corporate accounting standards, Florida: AAA, 1940.
17. See J Francis and K Schipper, 'Have financial statements lost their relevance?', Journal of Accounting Research, Autumn 1999, pp. 319-52.
18. International accounti11gstandards were adopted from 2005 in Australia and the EU countries (for consolid,ltt·d accounts of listed companies) and from 2007 in New Zealand.
19. Deloitte Toud1e Tohmatsu IASPlus website, IASB Agenda Project:
Reporting Comprehensive Income (Performance Reporting), ww,;v.iasplus.corn.
20. Financial Statement Presentation, www.iasb.org; see also Project Updates: Financial Statement Presentation - Joint Project of the IASB and FASB, www.fasb.org.
21. International Standard on Auditing 540: Auditing accounting estimates, including fair value accounting estimates, and related disclosures.
The equivalent Australian Auditing Standards are ASA 540 Audit of Accouming Estimates, and ASA 545 Auditing Fair Value Measurements and Disclosures.
CHAPTER 5 Measurement theory
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After reading this chapter, you should have an appreciation of the following:
D
an overview of the three main income and capital measurement systems in accounting - historical cost, current cost (entry value), and current selling price (exit value)fJ
the historical cost model (arguments for and against)D
current cost accounting: business profit, holding gains and operating capital (arguments for and against)D
financial capital versus physical capitalm
exit price accounting (arguments for and against)m
the difference between value in use and value in exchangeII
global initiatives and relationships with 1fair value' accounting under International Financial Reporting Standards (IFRS)m
issues for auditors.-.
THREE MAHN INCOME AND CAP~TAl MlEASURlEMENT SYSTEMS
The study of accounting practice normally stans with a consideration of the range of technical issues relating to recording and reporting financial or economic activity.
However, the basic tedmical processes have changed very little since the double-entry accounting system was described by Pacioli in the fifteenth centmy. Over the years that followed and with increased momentum during the industrial revolution, especially after the Wall Street collapse in 1929, the traditional historical cost system emerged.
However, the historical cost system was not systematically codified as the fundamental basis for measuring capital, and for recording and reporting the economic and related activities of an entity, until the late 1930s. In the 1960s, several alternative systems were then developed that challenged historical cost as the fundamental accounting system.
The first was an updated cost system that proposed lo measure the current costs of resource usage and to value capital al current buying prices. The second applied current selling prices.
There were two basic current buying price systems. In 1961, Edwards and Bell proposed a system of current cost accounting in The Theory and Measurement of Business Income.1 Because the system was based on current market costs, il can be regarded as the first methodical presentation of a fair value accounting system. The Edwards and Bell system was based on the concept of financial capital maintenance but, as illustrated in the second version of current cost that uses physical capital maintenance, the choice of the capital concept significantly affects the derived measure of profit. The second major system used selling prices or exit values to derive measures of income and capital. Suppon for different versions has varied, and the chapter goes on to outline and describe the advantages and disadvantages of each accounting system. We also note that the systems have attained varying support in a global context and recent international accounting standards partially incorporate each system within the notion of 'fair value'.
H~STOR~CAl COST ACCOUNTING
The rationale for historical cost came from several sources with the most influential a book by Paton and Littleton, An Introduction to Corporate Accounting Standards.2 We rely on their book for many of the arguments for the theoretical suppon of historical accounting today.
Objective of accounting
With the growth of the corporation over the last century and a half, accounting information took on greater significance as a source of information about firms. One reason for this is that the corporate form for a large busi caµsed a separation of.
business ownership and control. Absentee owners do not ~thrst-liand knowledge of the operations and conditions of the firm and, therefore, must depend to some extent on accounting reports for information. The large company also has made evident that the firm has an identity of its own, separate and distinct from owners, creditors and all other interested parties. Although owners and creditors supply the funds to the business entity, they are in most cases considered 'outsiders' and have no special access to the records and accounts of the entity.?Accountability, therefore, is seen to be the most critical objective of the reporting functf;;n, In panicular, the stewardship function of managers was seen as the focus of attention of accountants in ~eponing to· external
162 PART 2 Theory and accounting practice