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Contemporary Issues in Accounting, Special Topics in Accounting, MBA, University of Jordan
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  • 1. Solution Manual to accompany Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY: Kimberly Ferlauto John Wiley & Sons Australia, Ltd 2012
  • 2. Chapter 4: Measurement © John Wiley and Sons Australia, Ltd 2012 4.1 CHAPTER 4 MEASUREMENT Contemporary Issue 4.1 The standard setters search for the ‘best’ measurement basis 1. What is meant by the term market context? Why is context so important in accounting measurement? (K) Measurement methods used in the preparation of the financial statements should be selected with the market context in mind. Values determined without market context in mind may not be reflective of market conditions or meet user’s needs. In other words, to provide the most accurate and decision useful accounting information, the most appropriate measurement approach is likely to be dependent on specific circumstances such as the nature of the market for the asset at the time. If the market is to play a role in valuation, we want to ensure that the resulting value reflects the fundamental value of the asset and that the operation of market forces does not lead to over or under valuation of the asset. What is important to users may also change from time to time. 2. Is adoption of a single measurement base approach likely to work in practice? Justify your response. (J, K) Responses to this essay style question will vary from student to student. Students should be encouraged to form their own views and provide in depth discussion supported by references and examples. Some key points of relevance include:  Arguments for adoption of a single measurement base approach are based on an idealised view of markets being complete and in perfectly competitive equilibrium. In reality, markets are imperfect and incomplete and ideal unique market prices are not available for all assets and liabilities. This has led to the use of the fair value hierarchy. The lower levels of the hierarchy requiring estimation of what the market price might be if one existed. The information produced is therefore not ideal.  A single preselected measurement method may not best reflect market conditions or meet user needs at that time.  Assumes a particular measure will always be the most relevant and will always be able to be reliably measured.  Some argue that there is no single ideal measure and that the focus should be on identifying the information that is most likely to meet the needs of user’s decision models.
  • 3. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 4.2  Application of IAS 39 during the recent GFC as an illustration of the practical importance of market imperfection and incompleteness. 3. Why do you think standard setters have considered a single measurement base approach? In your response, consider the fundamental problems that such an approach could help resolve and how such an approach would fit with the qualitative characteristics of accounting information prescribed under the Conceptual Framework. (K, CT) Responses to this essay style question will vary from student to student. Students should be encouraged to form their own views and provide in depth discussion supported by references and examples. Some key points of relevance include:  In perfect market conditions, there is a unique market price based on full information for every asset and liability. This provides a relevant, reliable and objective measure of an assets fair value when such observable market prices are available. This argument seems to be a key driver behind the push for fair value as the single ideal measurement base approach.  Mixing different measurement bases is believed to create mismatch problems. This problem refers to the fact that different items in the same set of accounts are measured on a different basis, making aggregation (totals) misleading. A single measurement base approach would promote consistency within accounts, avoiding this mismatch, and allowing more meaningful aggregation. This approach would also improve comparability of accounts between different entities.  Fair value favoured approach due to its relevance – measures market expectations of future cash flows to be derived by the entity and objectivity – reflecting the markets view rather than views of management associated with the entity. Contemporary Issue 4.2 The subprime lending crisis and reliable reporting 1. In practice, which measurement base, historical cost or fair value, would provide the most relevant and reliable accounting information? Draw on the facts presented in the situation above, as well as your knowledge of the global financial crisis, to justify your response. (J, K) Responses may vary from student to student as there are many paths that discussion could take. Some key discussion points follow.  Fair value or historical cost on their own are not likely to achieve both characteristics.  Inherent trade-off between relevance and reliability – the information which is most relevant is often less reliable. The information which is most reliable tends to be that which is less relevant.
  • 4. Chapter 4: Measurement © John Wiley and Sons Australia, Ltd 2012 4.3  There has been a move towards fair value and away from historical cost on the basis of relevance. It is argued that reporting assets and liabilities at their fair values provides more relevant information for investment decisions than historical cost.  Reliability is difficult to achieve under fair value when we are dealing with hypothetical transactions that are not objectively measureable. This is the situation we face when observable market prices are not available. In other words, when an active and liquid market does not exist for the asset. Some argue that once reliability becomes compromised, the information produced also becomes less relevant.  Integration of the two measurement bases suggested. For example, historical cost financial reports could be enhanced by providing fair value information through footnote disclosures. A balance to achieve both greater relevance and reliability. 2. Discuss the role of market stability and the financial business cycle in determining the relevance and reliability of the accounting information produced. (J, K) Market stability and the nature of the financial business cycle play a large role in the determination of market prices, and therefore impact upon the relevance and reliability of accounting information produced using fair value. Falling prices in an unstable market may worsen market stability. Companies tend to react to falling prices by rushing out to sell their assets before their competitors, causing a further downward spiral in prices. In a market bubble, values may be overstated, and values will most likely not be realisable if many market participants decide to sell those assets at the same time. The bubble bursts and prices fall again. Financial statements measuring assets and liabilities at fair value in unstable or illiquid markets are not likely to be relevant or reliable for the purpose of decision usefulness. Students may refer to the subprime lending crisis or other examples to illustrate the role of market stability and the financial business cycle. Contemporary Issue 4.3 Current debates on accounting for financial instruments: perspectives in the aftermath of a crisis 1. ‘The market is far too complex to be captured by an accounting system.’ Discuss this statement, providing evidence from the global financial crisis. (J, K, SM) Responses to this essay style question may vary from student to student. Some points of relevance include:
  • 5. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 4.4  It seems appropriate that under normal circumstances, assets should be valued at what they are worth from the markets point of view, the market being the only valid standard of value. We are comfortable with this concept when markets are functioning normally. However, we do not know what to do when the market does not function normally.  The financial crisis has played a role in highlighting issues and bringing light to debates concerning the concept of fair value. Recent events have made us more aware of the complexity of the market and the associated issues that may arise when we choose to use market prices as an indicator of fair value.  Concerns regarding operation of financial markets and whether market values/prices are really reflective of the fundamental value of assets. The important thing here is that students are able to identify a few key arguments and discuss them in depth, providing specific examples to support and justify their views. 2. Analyse the players involved in the recent debate surrounding fair value and its contribution to the global financial crisis. Discuss how this demonstrates the political nature of accounting measurement. (J, K, SM) Responses to this question will vary from student to student. There were many players involved. Students should be encouraged to focus on two or three and analyse them in depth. Key players include accountants, regulators, management, banks, investors, just to name a few. Encourage students to read widely the literature surrounding fair value and its contribution to the global financial crisis. The amount of literature contributing to this debate is amazing. Students also need to be able to develop clear links to demonstrate the political nature of accounting measurement. T
  • 6. Chapter 4: Measurement © John Wiley and Sons Australia, Ltd 2012 4.5 Review Questions 1. Define measurement in the context of accounting and financial reporting. The Conceptual Framework defines measurement as: The process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement Measurement in an accounting context therefore refers to the way the figures on the financial statements are determined. It is described as an act or process which may involve calculations, making estimates and comparisons, and apportioning or distributing amounts. 2. Why is measurement so important in accounting? Measurement is crucial to be able to provide decision-useful accounting information and to accurately appraise the performance of management. These are the primary purposes for which financial statements are prepared. The way items are measured in accounting impacts on the quality of accounting information produced. In order to fulfil the decision-usefulness objective, the financial statements produced must contain good quality accounting information which will assist decision makers in making the right (appropriate) decisions. Poor quality accounting information, resulting from the use of inappropriate measurement methods, may mislead users and this could potentially cause them to make wrong (inappropriate) decisions. If accounting information leads to wrong or inappropriate decisions it is not useful. The financial statements produced must also contain good quality accounting information in order to accurately determine how well management has performed its role in managing the resources of the entity. Poor quality accounting information, resulting from the use of inappropriate measurement methods, will give the wrong impression as to how well management has performed its role. 3. Discuss the current approach to measurement adopted by standard setters. Why have they adopted such an approach? What are the issues and problems associated with this approach? Under the international standards we adopt what we call a mixed measurement model. Under this approach a number of different measurement bases are employed in the preparation of the financial statements. Historical cost, current cost, realisable value and present value are all employed to different degrees and in varying combinations during the preparation of the financial statements.
  • 7. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 4.6 The main reason for adopting such an approach is the need for flexibility. This model allows for use of a number of different measurement bases. This is necessary due to the differences in the substance or nature of transactions between entities and also due to the differing circumstances that entities can find themselves in. Issues and problems associated with this approach include:  Variations in accounting practice – entities may choose to account for the same or similar items in different ways using different measurement methods. How they measure and account for an item may be appropriate for the individual entity but could reduce comparability across entities.  Potential for different financial results being reported when different measurement methods are allowed and used.  Discretion means opportunity for management to make opportunistic accounting choices, creating a biased picture of reality and perhaps even misleading users. In summary, the approach is necessary but subjective in nature. This highlights the importance of professional judgement and ethics in accounting. 4. Explain the arguments for and against using historical cost as a measurement base. Key arguments for historical cost include:  Most objective measurement approach - amounts are determined based on actual transactions.  Clear audit trail – amounts can usually be proven by documentation. Key arguments against historical cost include:  Amounts determined may not be relevant to current decision making if there is a long time span since the transaction occurred. Historical cost does not take into account changes in the value of money over time. In other words, it ignores price inflation.  The amount paid for an item or received for an item may not necessarily be indicative of its value.  Judgement involved in determining depreciation rates can create inconsistencies and opportunity for manipulation.  Inability to determine the cost of some items. Items may be donated with no actual cost to the entity. Items may be internally generated rather than purchased. 5. Explain the difference between current and replacement costs. Current costs and replacement costs are both essentially the costs that would be incurred if we were to replace the items now. However, these terms represent two different methods of measuring the cost of replacing the items. Current cost requires the item be valued and
  • 8. Chapter 4: Measurement © John Wiley and Sons Australia, Ltd 2012 4.7 recorded at the amount that would be paid at the current time to provide the future economic benefits expected to be derived from the current item. Replacement cost requires the item to be valued and recorded at the amount that would be paid at the current time to purchase an identical item. Current cost is a broader concept in that it represents the cost of obtaining the same expected future economic benefits, but these benefits may be assumed to be achieved in different ways, not necessarily through purchase of an identical item. Replacement cost is much more specific in that it represents the cost of purchasing another item identical to the current one. 6. Explain the arguments for and against using fair value as a measurement base. Key arguments for fair value include:  Most relevant measurement approach for current decision making. The amount that will be received for an item or that will need to be paid for an item is decision useful information.  Objective if determined by reference to the market price for an item. The market price is set by forces outside the entity. It is not biased by judgement and cannot be manipulated or influenced by management. Key arguments against fair value include:  Subjective where a market price is unavailable. Some items are not regularly traded in an active market and an estimate of the items fair value must be made.  The focus on exit values is not logical and contradicts the going concern assumption. We are measuring as though we are going to sell off all the assets which is not usually the case.  Market prices can be volatile and therefore sometimes may not be indicative of the true value of an item. Short term fluctuations in fair value may be irrelevant and cause confusion from a user perspective. 7. What role does estimation and judgement play in accounting measurement? Discuss with particular reference to present value and deprival value. The key issue to note here is that certain measurement methods are more subjective than others. As a consequence, the relevance, usefulness and reliability of the accounting information produced using these more subjective measurement methods becomes questionable. Present value is a good example because managements estimations of cash flows expected to be received in the future can be quite subjective. The estimations are made at management’s discretion and their internal biases may come into play. Assertions and assumptions are made by management in forming such estimates, and for this reason, the values determined cannot
  • 9. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 4.8 be assumed to be objective. Present value is also subjective in the sense that there are also a wide range of discount rates to choose from. There is often much variation between entities in the discount rates applied. Deprival value is also quite a subjective measurement method for similar reasons. There are a range of ways in which deprival value may be determined, depending upon the assumptions and decisions made by management. 8. Identify factors that may influence the choice of measurement approach. Discuss how the measurement approach adopted impacts on the quality of accounting information produced. Key influences include:  Potential users of the financial statements - user needs must be understood in order to choose the measurement approach which will provide the most decision useful information.  Practical considerations – a particular cost or value may be too difficult or even impossible to determine. Choice of measurement approach also needs to be cost effective. The cost of obtaining or calculating the cost or value must be considered.  Management’s motivations and objectives – motivations, underlying objectives and time horizon can all influence management behaviour in terms of choice of measurement approach. For example, if management have a short term focus, are on a shorter term employment contract, or have bonuses tied to profits, they will most likely choose the measurement approach which produces the best results in terms of higher profits. The measurement approach adopted impacts on the quality of accounting information because it has a direct impact on the relevance, faithful representation, understandability, comparability and verifiability of the information produced. Accounting information which possesses these characteristics is more decision useful, therefore fulfilling the decision usefulness objective, the purpose for which financial statements are prepared. A detailed analysis of how each of the individual measurement approaches discussed in the text impacts on the quality of accounting information can be found on pages 104-107. 9. Why has measurement become such a controversial accounting issue in recent times? In recent years there has been a significant paradigm shift in relation to accounting measurement. There has been a distinct move away from historical cost toward fair value and fair value is by far the most controversial measurement approach. Key reasons for such controversy include:  Subjective nature of estimates involved in determining fair value where no active market exists for an item
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