The purpose of this discussion paper is to investigate possible measurement bases for asset and liability on initial recognition. The accounting literature had identified alternative measurement bases which are fair value, historical costs, current cost (reproduction cost and replacement cost), net realizable value and value in use. This paper also talks about deprival value, which combines value in use, net realizable value and replacement cost. Besides, it talks about the market versus entity-specific measurement objectives that examine the measurement. Next, the paper also considers which measurement bases are suitable to replace for fair value when the fair value fails to reliable measurement on initial recognition. The criteria derived from the conceptual framework use to evaluate the alternative measurement are decision usefulness, relevance, reliability, comparability and understandability.
Decision usefulness is a primary objective of financial reporting. Generally, decision usefulness is to give prominence useful in predictive purpose and feedback value relate to prediction purpose. Besides, decision usefulness is important to stewardship objective also.
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Relevant of accounting information which means that accounting information is help users to conduct predictions about the results of past, present, and future events or to verify expectations and make critical decision. There are two fundamental dimensions in relevance. There are predictive value and feedback value. Predictive value is the the quality of information that helps users to increase the likelihood of correctly or precisely forecasting the outcome of past or present events. Besides, feedback value is the quality of information that allows users to confirm or correct previously expectations.
Reliability of accounting information means that the accounting information is free from material error and can present faithfully that could reasonably expected to represent or purport to represent. There are three aspects in reliability which are representational faithfulness, neutrality and verifiability.
Comparability of accounting information is the quality of accounting information which enables users to identify differences and similarity between two sets of economic events.
Understandability of accounting information is the quality of accounting information which enables users' willingness to study the accounting information with reasonable diligence. This element is to make sure that the measurement bases are understandable for the users to make decision and expectation.
Possible base for Measurement on Initial Recognition
Generally, accounting standard determine that measurement of assets and liabilities should be initial recognised. This discussion paper has set out two presumption in the respect, one is about the measurement date to recognize the acquire asset on the earlier contract. The other presumption is about the difference of measurement on initial recognition and re- measurement that take time to construct.
In this discussion paper, there have six measurement bases those are fair value, historical cost, current value, net realizable value, value in use and deprival value.
IASB Glossary defined fair value as to the amount for which an asset and liability could be trade between knowledgeable, willing parties in an arm's length transaction. In neutral terms, fair value means by without seeming the exit value to be limited, as opposed to an entry, it is the sum that could be exchange for an asset or liability. The purpose to compute fair value is to imitate the market value of an asset or liability at the measurement date. When there is no observable market price, the purpose is to estimate, if there was a market, what the market price would be. However, the definition does not mention of the market value measurement objective. Therefore, some have suggested that the terminology of fair value should be changed to "fair market value" which is more descriptive. Some suggested that a statement about the market value measurement should incorporate within the definition. Nonetheless, these suggestions have not been adopted.
As mentioned above, fair value measurement objective is to imitate the market value of an asset or liability at the measurement date. Therefore, compared to those measurement bases that rely on entity-specific expectations, fair value considered more relevant on the initial recognition measurement, as long as the measurement is reliable. The determination of the reliability to estimate fair value is related to the faithfulness with which such estimates demonstrate the properties of market value. There is limitations to evaluate the reliability of estimates of fair value that while there is no directly observable market price for the assets/ liabilities on a measurement date. This is because observable market price that used to estimate fair value is the most reliable measurement. Valuation model and techniques used to estimate fair value while no observable market price occur. However, it must fulfill the objective of estimating fair value that more on market-based. When it is rely on entity-specific expectations, the model may not be used to measure fair value.
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There is an argument that whether the receipt and payment of the transactions for assets and liabilities should be constitute as fair value or not. The paper said that the transaction price should not use as fair value because infrequent transaction or one observable transaction cannot carry the meaning of a market that different with the common believe that said it should be. Nonetheless, entity-specific expectation and transaction price may be the best measurement of fair value when there is no reliable estimation on it. The paper said that to substitute fair value, the objective would be the most important criteria to choose the best substitute.
Therefore, the paper evaluates other measurement bases with regard to their relevance and reliability in order to view their potential to substitute fair value and whether there are factors can change the role played by fair value when fair value is preferred measurement basis.
Historical cost means that the assets and liabilities are recorded at fair values when first acquired the asset and liabilities but not measure at the market values of the asset or liabilities. Besides that, historical cost also can be considered as the value before any adjustment of impairment, amortization of interest and depreciation.
There have many cases express that fair values and historical cost have significant differences even on the initial measurement. However, fair value is the preferred measurement basis because it can estimate reliably and relevant. So the discussion will focus on whether historical cost has more relevant than fair value and whether historical cost can substitute fair value as the measurement basis on initial recognition if fair value not measurement ability.
For the first part, it will discuss about whether historical cost are more relevant than fair value. The answer is no because historical cost not only purports to measure the value received but also it will be supplement by additional measure of recoverable value. As the additional measure of recoverable value result the significant between fair value and the historical cost that will bring the historical cost more toward entity specific measurement. Although historical cost can predict future net income, but historical cost does not has the market's expectation for future cash flow which the fair value has. Therefore historical cost is less relevant than fair value on the initial recognition.
Second, it talks about whether historical costs can substitute the fair value on initial recognition if fair value cannot measure reliably. This discussion paper had suggested that historical cost is accepted replace for fair value on initial recognition if fair value is not estimate reliably. This is because historical cost is an actual transaction exchange amount as well as the measurement has existed for many years that supported by many experience in practice and allocation are guidance by the standard. However, there is still has some reliability limitation in historical cost. The historical cost will be more reliably when the amount paid or received for an asset in a single transaction. In addition, historical cost has less representational faithfulness. For example, the pre-recognition cost of the asset is not capitalized before an asset is recognized. However when asset is recognized, there have most standard not allow retroactive capitalization the pre-recognition cost.
Current cost approach is contrast with historical cost. Current cost means provide more realistic book value by valuing asset at the current reproduction cost and replacement cost. Current cost value always is the value of history cost after adjustment for inflation as well as generally adjustment like depreciation, impairment, and amortization of interest. Reproduction cost means the cost to reproduce the existence asset with a same asset. While, replacement cost means the cost to replace existence asset with the asset that have similar service potential and productive capacity.
It is also same as the historical cost which will look into two part of this measurement base. For the first part, it show that reproduction cost and replacement cost less relevant measurement base than fair value measurement as both of them subject to significant limitation.
In the reproduction cost, it is more similar with the historical cost however it still has some distinction. The difference is reproduction cost will allocate of the cost which incurred in past and pre-recognition cost. However the similarity is reproduction cost measure the value that would be spend on a measurement date and need to supplement by a recoverability condition. However, for the replacement cost it is more ambitious and objective than reproduction cost. In the periods of changing price, replacement cost is a suitable measurement of performance because it can show the ability of the entity recovers its replacement cost from revenue. Moreover, fair values combine the essential properties of replacement cost on the origin of market expectation. Although fair values and replacement cost have many similarities, there still have differences where replacement cost has use entity specific expectation to asset service potential and productivity capacity. Therefore replacement cost and reproduction cost are less relevant than fair value.
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Second, it discuss about whether the current cost measurement can substitute fair values measurement. This discussion paper has come out that current cost can substitute fair value when fair value is not reliably estimate. As current cost also can substitute the fair value as historical cost therefore the discussion paper has come out the hierarchy of cost substitution. Current cost is prefer substitution rather than historical cost because current cost has more information value than the historical cost which just focuses on the amount paid or received. It also have rank the two current cost and show that replacement cost is more substitution than reproduction cost because replacement purport to represent more than reproduction cost. Therefore the hierarchy of cost substitution is replacement cost at first next reproduction cost then lastly follows by the historical cost.
Current cost also has reliability limitation that lack of objective bases to define the most economic asset productive capacity and service potential which will result the asset's replacement cost is different with reproduction cost as both objectives is different.
Net Realizable value
Net realizable value is calculated by selling price minus selling cost. It will be used when the purchase price of the asset or liabilities cannot be used such as stock. This measurement base is to measure the benefit value of an asset.
For the part of comparison with the fair value, net realizable value is less relevant than fair value. This is because for net realizable value is more focus on sale rather than holding an asset. Besides, net realizable value more focus on entity specific expectations. This show from the estimate selling price for calculate the net realizable value which base on the entity specific context. Therefore net realization is less relevant than fair value.
For the second part, the net realizable value replace for fair value on initial recognition is not as sufficient as historical cost and the current cost above. If net realizable value needs to substitute the fair value, it need to reinterpretation. Those are interpreting the estimate selling price as a market value measurement objective. Next, net realizable value needs to exclude the transaction cost. Lastly interpret cost of completion within the fair value context. Then net realizable value only can substitute the fair value measurement. Therefore net realizable value cannot substitute the fair value measurement on initial recognition when fair value is not reliably estimate.
Value in use
Value in use (of an asset) defined in IASB Glossary from IAS 36.5, from as the present value (PV) of estimated future cash flows expected to come up from the ongoing use of an asset and from its disposal at the end of its useful life. The definition used by other accounting literature and standard setters. The purpose of the measurement of value in use is to reflect the ability of the reporting entity management to estimate future cash flows which then used to be considered as an entity-specific measurement objective. Therefore, value in use is not recommended as a relevant measurement basis compared as to fair value measurement on the initial recognition of the items.
However, value in use may be a substitute for fair value because discounting rates (PV technique) that estimate value in use used to reflect current market condition that includes to calculate risks and the time value of money which consistent with the fair value measurement objective. For example, benefit pension plan and assets retirement obligations because there are no comparable market prices and observable transactions.
Deprival value can also be said as the value of the business. It is not defined in IASB standards but explained in the UK ASB. It means by how much loss an entity would suffer if it were to be deprival of an asset. Deprival value is link to value in use, replacement costs and net realizable value. The value of an asset relied on the available opportunities to the entity for the use of sale of the asset. If there are no opportunities available to the entity or no economic sense being made, the measurement bases are irrelevant.
Rationally, when its recoverable amount is less than its replacement cost, an entity would not replace an asset that does not make economic sense. Recoverable value is the higher of the sale of the asset for its net realizable value or the uses the asset and gets its value in use. However, deprival value framework holds that the entity loses its recoverable value if deprived the asset.
Deprival value of an asset is its fair value when economic loss is calculated on the basis of market expectations. However, when there is a difference between the entity-specific expectations and the absolute market value measurement, deprival value could differ from fair value. Therefore, deprival value is subject to the entity-specific expectation limitations and it is not much relevant measurement basis compare to fair value on initial recognition.
Nonetheless, deprival value can be considered to substitute fair value when fair value does not have reliable measurement. Besides, it is more relevance than any value in use, replacement costs and net realizable value. This is because it overcomes the limitation of replacement costs. The deprival value of an asset is its recoverable amount and it is measure of the asset's benefit value to the entity when replacement costs exceeds recoverable amount. Another reason is because when net realizable value exceeds its value in use, it is measured as recoverable amount but only in the cases when the sale of an asset happens within deprival value while the value in use take into account as recoverable amount when the continuing use of asset is rational.
In the conclusion, the deprival value defined as to the lower of replacement cost and recoverable amount (the higher of the value in use and net realizable value).
General Conceptual Analysis: Market Versus Entity-Specific Measurement Objective
Approach to Conceptual Analysis
There are 2 fundamental sources of measurement bases on initial recognition, which are:
Market versus Entity-Specific Measurement Objectives
Differences in determining the value-affecting properties of assets and liabilities
Market versus Entity-Specific Measurement Objectives
Market Value Measurement Objective
The objective of the market value measurement is based on the efficient markets and market prices. This objective will reflect the price which is come from an open and competitive market process. It is the price that will 'clear the market', which means that the supply is equal to its demand for the particular asset or liability. Competitive market forces to decide the various expectations and risk preference of individual market participants. Besides, the expected current rate of return (which is available in the market place) is equal to the commensurate risk on the measurement date of an asset or liability. In the market place, it consists of an amount of willingness and arm's length participant who are knowledgeable. The individual market participant can access to all publicly available information, and the information is sufficient for them.
Entity-Specific Measurement Objective
Entity-Specific Measurement Objective is an alternative to a market-based measurement. This objective does not reflect the market price of the particular asset or liability. In contrast, the value of the asset or liability under this objective is according to the management's expectation which is based on its intention. Under this measurement objective, the valuation of asset and liability will inserts the assumptions made by the entity's management to replace the market price. It will exclude the factors that would consider in the price of a market transaction.
In this discussion paper, the objective of market measurement which has essential quality makes it more superior to entity-specific measurement objective. Specifically, it is proposed that market value measurement objective in initial recognition is more relevant and subject to discipline of the market place, if compare it with entities' individual expectation. By understanding the management's intentions, expectation and assumption, it may provide the important information to investors and external users in which those information implicit in market value. Nevertheless, it is more appropriate to disclose in the form of supplementary disclosures or separate forecast with those entity-specific information.
Value-Affecting Properties and Market Sources
In the main paper, it is proposed that under the market value measurement objective, for an item on any measurement date it can be only one market (fair) value.
Differences in market prices may be attributable to either:
Value-affecting properties of items traded in different markets
Entity-specific charges or credits
The above factors do not explain all differences. The different in market price might come from certain market inefficiencies.
Indentify precisely the value-affecting properties is the first step on market or entity-specific measurement. Liability and asset can be categorized as either contractual or non contractual.
For the contractual assets and liabilities, the value-affecting properties eventually flow from the contract, which provide the basis to gain expected cash flows, defining and pricing the related risks.
For the non-contractual asset and liabilities, the value-affecting properties consist of the tangible or intangible attribute, nature of the ownership rights, location and condition on the measurement date.
In the main paper, additional considerations associated with liability especially concerning to the handling of credit risk in measuring the liability. There have a similar fair value on the asset or liability on initial recognition that agree to pay. Market determination of fair value of a promise to pay is considering the item of credit risk associated with it.
The unit of account
Before decide the value-affecting properties of the assets or liabilities, it need to define their unit of account first. Unit of account may alter the value-affecting properties. Asset or liabilities can defined either as lowest identifiable unit or the basis of grouping with other items. Issues on two types of unit of account:
Level of aggregation
Portfolio formed from a set of similar asset or liability which the individual retain their identities. A portfolio could have a different market value in the sum of the market value individual item. The purchases of a portfolio may also consist of other asset or liability. For instance, the credit card receivable portfolio may also include an intangible asset that representing the future cash flow benefits expected to result from future business with card holders or depositors.
Level of Aggregation
Aggregation is the joining of individual asset or liability to generate a different asset or liability. The individual items will lose their identities and then change into a different asset or liability.
For contractual items, level of aggregation depends on the standards governing the particular asset or liability.
For non-contractual assets, difficult issues can arise from the process of determining the level of aggregation. The fair value of an aggregated asset might different with the sum of fair value of the individual inputs, depending on the market's valuation of possible synergistic effects which is resulting from their combination. It is proposed that lowest level of aggregation is the appropriate unit of account for a non-contractual asset.
Determining the Appropriate Market(s)
Entry and Exit Markets and Related Issues
It is proposed that an entity should look to the market in which they acquired asset or incurred the liability. The traded asset or liabilities will usually have the same value-affecting properties as the item being measured at the date of its initial recognition.
Market in which an Entity buy wholesale and sell retail
Retailing function will adds a fair value to enhance a property. It is recommending that the appropriate market for the retailer is entry (wholesale) market. (Notes: Entry market is wholesale and exit market is retail.)
Large Block and Volume Effects
Quantity or volume of an asset acquired will affect the market price. For the measurement on initial recognition, it is based on the market in which that market was acquired. An entity should determine the acquisition asset based on the most advantageous market open to it.
Warranty Liabilities and Similar Performance Obligations
The entry market for retailer is the market with its customers, in which it incurs the warranty liabilities. After that, the exit market is the market in which the retailer could pay a 3rd party insurer to presume the warranty service obligations.
Other Market-Related Consideration
Information asymmetry happened when some market participants have information about certain value-affecting properties of an item, while this information is not available to some market participant. Information asymmetry is an information that have uncertainty risk and market participant may place different value place on this risk seems to be same with entity-specific expectation.
In an actively traded assets market, quoted bid and asked prices signify the prices that the dealer will pay and receive on that date, and the spread will represent transaction costs to the buyer and seller. However, if the bid-asked spread is wide, is likely to have a large part of some significant uncertainties. Hence, it required to look for other sources to estimate the fair value.
Market Accessibility and Related Issues
It is improper to evaluate the fair value of an asset or liability when the market is not accessible by the entity. Market accessibility restriction may explain the situations in which more than one market that are different prices for the similar liability or asset.
Transaction cost is defined as the incremental costs that directly attributable to the acquisition, disposal of a liability or asset. Transaction cost not recoverable in market place on the measurement date. Transaction cost excluded from the fair value of a liability or asset. If the cost to acquire an asset or incurred a liability deemed to be recover in the market, that cost is not the transaction cost, it should be calculated in the fair value of the asset or liability.
Recommendation (Measurement Hierarchy on initial Recognition)
Fair value can be estimated straight forward when current trading price is observable on an active market however there is complex to measure if traded on the non-active market. In some condition, fair value is incapable of reliable estimation. It can consider reliable estimation if met the 4 level of measurement hierarchy on initial recognition. Level 1 and 2 is estimate of fair value however Level 3 and 4 is substitute for fair value.
Level 1 state that the most reliable estimation of fair value of an asset and liabilities is recognize market price for assets and liabilities on the measurement date. It can include market-based adjustment that reliable with market expectation about the total and timing of future cash flow.
Level 2 state that if fail to recognize the market price in the level 1, it need the model that accepted to estimate the market price for assets and liabilities to be measured on initial measurement.
Level 3 state that if fail the level 1 and 2 which mean that failed to estimate fair value with acceptable reliability. An asset and liabilities should be measured at current costs that are replacement cost and reproduction cost.
Level 4 state that if the level 1, 2 and 3 cannot be met, it needs to use the models that depend on entity-specific expectations. If the market-based data are not reliable, the model should use entity-specific data that are not consistent with the market expectation.
For level 3, current cost should be measured at replacement cost. If failed its reliable measurement, it should be measured at reproduction cost. When the situation that measurements of current cost are not met, it can use historical cost to replace with. Since the measurement do not meet the condition of reliable estimation of fair value, it should use the more limited terms of the models. Under the level 3, when the asset's recoverable amount less than current cost, its recoverable amount will be estimated under level 4. Under level 4, the amount which is higher between realizable value and present value amount will be used. The assets and liabilities are consider non-recognition if none of the condition of 4 levels have been met.