Many measurements in financial reporting involve allocations of costs and revenues to different accounting periods and different assets. These allocations inevitably include an element of arbitrariness and therefore subjectivity. Just to name a few obvious items:
- Depreciation of fixed assets involves judgmental allocation decisions (See explanation below).
- Where assets are bought for stock (or inventory) and subsequent resale, unless the cost of each one can be individually identified (or unless their purchase price never changes), calculation of a particular asset’s purchase price involves a judgmental allocation.
- For measurements of discounted future liabilities, allocation to different accounting periods depends on the choice of an appropriate discount rate, which inevitably involves a significant element of judgment, especially in measuring pension liabilities and the long period it takes before these materialise into annuity payments. Allocation to periods and assets
- Where businesses acquire assets jointly, as in a takeover, deciding how the acquisition price should be divided among the separable underlying net assets involves judgmental allocation decisions. Allocation to periods and assets
- Allocation problems also arise from the attribution of a business’s outputs, whether measured in terms of money or service potential, to the individual assets that jointly produce them.
Depreciation involves more than one kind of fundamental problem. As already noted, it involves the problem of prediction because it requires assumptions about the future useful life of the asset being depreciated. However, even if we have perfect knowledge of the future, depreciation still involves judgmental decisions as to how the cost of the fixed asset will be allocated.
- It could be allocated by period or by item produced by or with the asset.
- Where it is allocated by period, there is a choice between allocating the cost:
- evenly across periods (the straight line basis); Allocation to periods and assets
- more heavily to earlier years (the reducing balance and sum of the digits bases); or
- more heavily to later years (using an actuarial basis so as to achieve a constant rate of return).
There are rational arguments in favor of each of these approaches, but the actual choice is a question of judgment.