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This discussion paper deals with the investigation and analysis of few possible measurement bases for assets and liabilities which are being recognized in the financial statements. It aims to provide a basis to solve the problems of inconsistent, out of date measurement practices and measurements. Moreover, it does not deal with the fluctuation of purchasing power of monetary unit, the impact of a variety of measurement bases on financial statement performance, foreign currency translation, income tax, unique issues regarding particular industries and also assets and liabilities that arise from the non-arm's length transactions. In evaluating the possible measurement bases, the researchers used an approved set of criteria. Following are the criteria used to evaluate the measurement bases. They are relevance, reliability, comparability, and also understandability.
Possible Bases of Measurement on Initial Recognition
Following are a few possible bases of measurement on initial recognition:
Historical cost is the fair value of consideration agreed in acquisition of the assets. It determines the amount of recorded assets. The same goes to liabilities. They are recorded based on the fair value of consideration taken in for incurring the obligation when they were incurred.
Current cost accounting attempts to provide more realisticÂ book values by valuing assets at current replacement cost, rather than the amount actually paid for them. Current cost comprises of reproduction and replacement cost. Reproduction cost of an asset means that the most economical current cost of substituting an existing asset with a similar one. Replacement cost of an asset means that the cheapest cost of substituting an existing asset with an equivalent productive asset.
Net realizable value
Net realizable value means the expected selling price in the normal course of business less the expected cost of finishing the asset and expected costs used to make the sale.
Value in use
A value in use represents the present value of expected future cash flow projected to be generated from the continuing usage of the asset and from the disposal after the end of the useful life.
A fair value represents the value of assets or liabilities that could be traded between knowledgeable, willing parties in an arm's length transaction.
Deprival value is the value of loss incur by an entity when the entity is deprived of an asset. In other words, deprival value means "value to the business". It is not defined nor being implemented in IASB standards.
Market versus Entity-Specific Measurement Objectives
This market value measurement purpose reflects the price that would based on an open and active competitive market procedure which is based on expert who has financial background on the basis of all accessible information in public.
Management's own intention, expectations and assumptions are showed in entity-specific measurement objective. Some trust that these dimensions are more valuable to investors and creditors than market price. Management would be held responsible to its own strategy and expectations as it demonstrates that management knows more about its strategy.
Thus, it is said that the market measurement objective is more superior on initial recognition than entity-specific measurement objectives.
Chapter 5 Value Affecting Properties and Market Sources
An entity must classify the asset or liability's value-affecting for the intention to evaluate the market value or entity-specific value of the asset or liability.
The value-affecting properties of contractual assets and liabilities are ultimately flow from contract. It offers the basis for receiving expected cash flows as well as defining and pricing the associated risk. The value-affecting properties of a non-contractual asset consist of its tangible or intangible features, the characteristics of the possession rights, and their place and circumstances on the measurement date.
An entity has to classify their units of account in order to ascertain the value-affecting properties of the respective asset and liability. It relates to the portfolio creation and also level of aggregation.
A set of related assets or liabilities which the personal items retain their identities are known as portfolio. For example, if an entity creates personal loans, it is the personal loan. However, it is portfolio if the entity obtains portfolios of loans.
While the aggregation join personal assets and liabilities to generate a new asset or liability and the personal items lose their separate characteristics in the procedure of aggregation.
Hence, this paper proposes that the unit of account for measurement purposes is the lowest level of aggregation where an identifiable asset is ready to put into future cash flows.
Assumed the asset or liability has been defined, consist of its unit of account and critical value-affecting properties, the paper next consider the possible sources of market values.
This discussion discusses which market may start the market price of the asset or liability regarding their initial recognition when there is more than a market source.
Additional study is needed to access the characteristic and causes of various market prices when there are multiple markets exist for identical items. When this situation appears, then there would have to be some justifiable rule for selecting between the prices in these markets. An entity should select the most advantageous market value available. However, it would require major supporting assistance. Hence, it is not lowest market value available to the buyer or the higher market price available to the seller that decides the most advantageous market price.
It is suggested that in order to calculate the initial recognition of an asset or liability, we should generally explore the market that acquire the asset or incur the liability.
Chapter 6 Reliability
Most theoretical frameworks point out that it is a trade-off between relevance and reliability. However, for this paper, we have adopted to the position that the measurement bases do not have to be the most reliable one. As when it is more than one option of measurement basis reaches an acceptable point of reliability, the measurement base which is most relevant should be chosen.
The reliability of a measurement basis has limitations as a result of measurement uncertainty which are a) estimation uncertainty; and b) economic indeterminacy. Estimation uncertainty involves a finding about an unsure existing situation or future result.
Information on events or conditions that did not present at the measurement date may influence the actual outcomes. Thus, an entity should critic the reliability of measurement estimation on the base of the truth and the authority of assumption at the measurement date, not essentially by the successive result. The reliability of uncertain measurement can be enhanced by setting up, and documenting, an accurate system of measurement policies.
Besides that, an entity should look into the difference between estimation uncertainty and volatility. For example, spot foreign exchange rates. It may be highly volatile, liable to fluctuations over time as market situation change. However, the volatility over time merely reveals changing market situation and does not show that the measurements are unreliable.
Indeterminacy occurs when a phenomenon cannot be identified in sufficiently solid terms to enable it to be validly measured.
In summary, it is proposed that, a) the characteristic and degree of measurement uncertainty inbuilt in the measurement basis as well as b) the relevance and reliability of relating information that can be offered with that measurement basis have to be considered in evaluating the measurement basis's reliability.
Analysis of alternative measurement bases
The following are the examination of each alternative measurement basis according to the general conceptual analysis. The main reason of this analysis is to determine whether which basis or combination of bases is the most suitable on initial recognition.
Fair value is considered as a more relevant basis as compared to entity-specific measurements. Fair value indicates the market value of a certain item on the date of the measurement. However, it does not have definite observable market price for a particular item on a measurement date which is considered as the most reliable source of fair value. So, it is not reliable in certain situations on initial recognition. There, there is a need for other possible measurement bases on initial recognition to act as substitution of fair value base.
Following are the alternatives measurement bases on initial recognition. They are evaluated based on their relevance and reliability. For instance, this paper discusses the reliability limitation and the relevancy of each of these measurement bases.
1. Historical cost
Historical cost provided relevancy because it represents the fair value of the amount given in retrieving an asset or liability. It is eventually grounded in actual transaction exchange amounts and it has existed for many years. However, historical cost measurement that requires allocation of costs over assets, liability reduces its representational faithfulness when the interval of indeterminacy is large. Another problem is there are some pre-recognition costs that cannot be capitalized when asset is not recognized. For example, research and development costs.
2. Current cost
Current cost consists of reproduction cost and replacement cost. It measures the most profitable amount that have been received or paid on initial recognition. Replacement cost measure based is more appropriate compared to reproduction cost based as it shows the entity's ability to recover its replacement costs from revenue and as a basis for predicting future profitability of an entity. However, there is dilemma regarding current cost's capability for reliable estimation. This is because it is lack of objective bases for defining the most economic service potential capacity of assets in entity-specific contexts.
3. Net realizable value
Net realizable value is the evaluation regarding the benefit value of asset, which can be based on the information that is dependable with market expectations or dependent on entity-specific inputs. This analysis suggested that net realizable value is the least possible to be substituted over the fair value basis as it requires substantial reinterpretation.
4. Value in use
It is the present value of expected future cash flows projected to be gained from continuing using an asset and also from the disposal during the end of its useful life. It can realistically represent the fair value measurement objectives when significant market inputs are available. However, this basis is always subjected to very significant estimation uncertainty and serious indeterminacies in certain situations. Besides, there is a need for standards that meet reasonable reliability conditions for present value based estimates. Furthermore, many non-contractual assets do not generate independent cash flows which lead to disadvantage of this basis.
5. Deprival value
Combination of three component measurement bases which are replacement cost, value in use, and net realizable value to measure the value of an asset, which is also believed that the value of an asset is depend on the opportunities available to the particular entity for the sale or use of that asset. This basis overcomes some of the potential weaknesses in the three measurement bases as mentioned earlier.
Chapter 8: Conclusion
Based on the analysis, the researcher comes out with a four-level measurement hierarchy on initial recognition for assets and liabilities. According to level 1 and 2, fair value is estimated with a sufficient level of reliability towards its initial recognition. However, there are few conditions that must be met.
Level 1 is used when there is visible market price for the particular assets and liabilities. Besides, if there are any differences between the assets in the market and the assets measured, an appropriate adjustment that is consistent with the market expectations can be made.
Level 2 will be used when there is no identified market for assets and liabilities that are alike to the item to be measured. However, there is an accepted method for anticipating the price of the item in the market so that it can be measured on initial recognition.
If the conditions above are not met, substitutes for fair value will be used - Level 3 and 4.
Level 3 states that an asset should be valued on initial recognition at its current cost, providing that the amount can be anticipated to be recoverable and reliable estimating can be derived. Same goes to liabilities. Liabilities should be valued at its current consideration amount provided that the amount be reasonably anticipated to represent the amount owed and can be reliably estimated.
When the conditions of the level 1, 2 or 3 are not met, assets and liabilities should be valued on initial recognition based on accepted model or technique. However, the measurement should use a reliably estimable entity-specific data which is consistent with the visible market expectations.
The researchers proposed that if the alternatives above are not fulfilled, then the assets or liabilities do not meet the basic conditions for recognition.