Measurement basis

Measurement basis – An identified feature of an item being measured (for example, historical cost, fair value or fulfilment value). OR

The result of measuring an asset, a liability or equity, or an item of income or expense, on a specified measurement basis. OR

The process of quantifying, in monetary terms, information about an entity’s assets, liabilities, equity, income and expenses.


Measurement basis describes various measurement bases, the information they provide and factors to consider when selecting a measurement basis. The 2010 Conceptual Framework did not include much guidance on measurement.

In developing the revised Conceptual Framework, the Board considered whether a single measurement basis should be mandated. However, it concluded that different measurement bases could provide useful information to users in different circumstances. Therefore, two categories of measurement basis were identified:

  • Historical cost measurement basis
  • Current value measurement basis

Historical cost measures provide information about elements that is derived from the historical price of the transaction or event that gave rise to the item being considered for measurement; so, for an asset, this would be the cost incurred in acquiring/creating the asset. For a liability, this would be the value of the consideration received to incur/take on the liability.

The historical cost of both an asset and a liability will be updated over time to depict, for example, any consumption of the asset or fulfilment of the liability, or the impact of any events that cause the asset to become impaired or the liability onerous.

Current value measures provide monetary information about elements, using information updated to reflect conditions at the measurement date.

Measurement bases may include fair value, fair value less costs of disposal, value in use, and current cost (reproduction cost and replacement cost). The description of fair value in the revised Conceptual Framework is in line with IFRS 13 Fair Value Measurement, and the descriptions of value in use and fair value less costs of disposal are derived from IAS 36 Impairment of Assets. The description of current cost (reproduction cost and replacement cost) is derived from IAS 16 Property plant and equipment.

Selection of a measurement basis – consistent with the earlier chapters, the factors to be considered in selecting a measurement basis are in line with the qualitative characteristics of useful information – relevance and faithful representation:

  • Relevance of information provided by a measurement basis is affected by the characteristics of the asset or liability, and contribution to future cash flows
  • Faithful representation of information provided by a measurement basis is affected by measurement inconsistency and measurement uncertainty

In general, fair value is more relevant than the other identified bases on initial recognition. All of the alternative measurement bases other than fair value directly or indirectly incorporate entity-specific measurements. For this and other reasons, it is common practice under IFRS that fair value is used to measure assets and liabilities on initial recognition, provided it can be reliably measured.

However, there are significant measurement uncertainties in measuring fair value in some common situations. Some of the problems include determining what constitutes a market and adducing evidence concerning what data inputs market participants would likely use when a market does not exist for the item in question.

When selecting a measurement basis, the entity needs also to consider the nature of the information – whether it will be presented in the statement of financial position and/or the statement(s) of financial performance. Cost will also constrain the selection of a measurement basis. Consideration of all these factors is likely to result in the selection of different measurement bases for different assets, liabilities, income and expenses.

Fair value

Fair value is measured assuming a transaction in the principal market for the asset or liability (i.e. the market with the highest volume and level of activity). In the absence of a principal market, it is assumed that the transaction would occur in the most advantageous market. This is the market that would maximize the amount that would be received to sell an asset or minimize the amount that would be paid to transfer a liability, taking into account transaction and transportation costs. In either case, the entity needs to have access to that market, although it does not necessarily have to be able to transact in that market on the measurement date.

A fair value measurement is made up of one or more inputs, which are the assumptions that market participants would make in valuing the asset or liability. The most reliable evidence of fair value is a quoted price in an active market. When this is not available, entities use a valuation approach to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

These inputs also form the basis of the fair value hierarchy, which is used to categorize a fair value measurement (in its entirety) into one of three levels. This categorization is relevant for disclosure purposes. The disclosures about fair value measurements are extensive, with more disclosures being required for measurements in the lowest category (Level 3) of the hierarchy.

In complete summary:

Fair value – pros and cons

Reliability – Reliable when based on active markets. Subjective where there are no reliable market values.

Relevance:

Pro – Shows sale values (gross) and therefore opportunity costs. Shows expected value of risk-adjusted future cash flows for some assets. Some financial analysts regard it as the only information relevant for financial decision-making.

Con – Shows measurements based on a rejected alternative. Can show asset values at suboptimal level of aggregation.

Value in use

Estimate the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal and apply the appropriate discount rate to those future cash flows:

Composition of estimates of future cash flows

Basis for estimates of future cash flows

Estimates of future cash flows shall include:

  1. projections of cash inflows from the continuing use of the asset;

  2. projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset (including cash outflows to prepare the asset for use) and can be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and

  3. net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.

In measuring value in use an entity shall:

  1. base cash flow projections on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions

  2. base cash flow projections on the most recent financial budgets/forecasts approved by management.

  3. estimate cash flow projections beyond the period covered by the most recent budgets/forecasts by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years.

The discount rate(s) shall be a pre-tax rate(s) that reflect(s) current market assessments of:

  1. the time value of money; and
  2. the risks specific to the asset for which the future cash flow estimates have not been adjusted.

For foreign currency denominated future cash flows an entity translates the present value using the spot exchange rate at the date of the value in use calculation.

The value in use of an asset or liability is the discounted value of the future cash flows attributable to it. However, as cash flows are generated by businesses, or by units within businesses, rather than by individual assets, value in use is a basis of valuation applicable to businesses or business units rather than to separable assets and liabilities.

Value in use implies recognition of gains as they arise rather than as they are realised, but they are gains in the value of the business unit, rather than gains on transactions or in the values of separable net assets.

Where value in use is applied to a business or to a cash-generating unit, it implicitly incorporates in the valuation goodwill (whether acquired or internally generated) and any other unrecognised assets or liabilities (ie that would be unrecognised on other measurement bases).

Where it is attempted to apply value in use to individual assets or liabilities as traditionally conceived (for example, in recoverable amount tests), the valuation inevitably also incorporates goodwill and other intangibles in the valuation, as there is no way of dividing forecast cash flows into amounts that are attributable to separable recognised net assets, amounts attributable to separable but unrecognised assets, and amounts that are attributable to something else (goodwill).

Value in use – pros and cons

Reliability – Subjective because based on predictions.

Relevance:

Pro – Shows present value of expected future cash flows and economist’s measure of income.

Con – Measures changes in expectations rather than actual performance. The market should be left to value the business.

Fair value less costs of disposal

This is the amount obtainable from the sale of an asset or cash generating unit (CGU) in an arm’s length transaction between knowledgeable, willing parties, less the cost of disposal.

The best evidence of an assets fair value less cost to sell is a price in a binding sale agreement in an arm’s length transaction, adjusted for incremental costs that are directly attributable to the disposal of the asset. If there is no binding sale agreement, but an asset is traded in an active market, the asset’s market price less costs of disposal would provide the best evidence of fair value less cost to sell.

If there is no sale agreement or active market for an asset, fair value less costs to sell is determined based on the best information available to reflect the amount that an entity could obtain, at reporting date, from the disposal of the asset through an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal. Many times such a value is determined by a valuation specialist for the specific asset(s) or cash generating unit (industry, location, market (B-t-B, B-t-C)).

Cost of disposals include legal costs, stamp duty and similar transaction taxes, costs of removing the asset and direct incremental costs to bring an asset into condition for its sale.

Fair value less costs of disposal – pros and cons

Reliability – Reliable when based on recent comparable transactions. Subjective where there are no recent comparable transactions.

Relevance:

Pro – Shows best estimate of the shorter-term net sale value (net cash inflow at disposal).

Con – The estimate is highly dependent on the competence of the valuation expert.

Current cost

If an asset is of a specialised nature, and market-based fair value is not available, an entity may need to estimate the fair value using either the reproduction cost or replacement cost (together current costs). To determine the depreciated replacement cost of an asset, reference can be made to the cost of components used to produce the asset or the indexed price for similar assets based on a price of a previous period.

As per IAS 16 Property plant and equipment, there are two current cost methods:

  1. replacement cost method: a method that indicates value by calculating the cost of a similar asset offering equivalent utility, and
  2. reproduction cost method: a method that indicates value by calculating the cost to recreating a replica of an asset.

Replacement Cost Method

Generally, replacement cost is the cost that is relevant to determining the price that a participant would pay as it is based on replicating the utility of the asset, not the exact physical properties of the asset.

Usually replacement cost is adjusted for physical deterioration and all relevant forms of obsolescence. After such adjustments, this can be referred to as depreciated replacement cost.

The key steps in the replacement cost method are:

  1. calculate all of the costs that would be incurred by a typical participant seeking to create or obtain an asset providing equivalent utility,
  2. determine whether there is any deprecation related to physical, functional and external obsolescence associated with the subject asset, and
  3. deduct total deprecation from the total costs to arrive at a value for the subject asset.

The replacement cost is generally that of a modern equivalent asset, which is one that provides similar function and equivalent utility to the asset being valued, but which is of a current design and constructed or made using current cost-effective materials and techniques.

Reproduction Cost Method

Reproduction cost is appropriate in circumstances such as the following:

  1. the cost of a modern equivalent asset is greater than the cost of recreating a replica of the subject asset, or
  2. the utility offered by the subject asset could only be provided by a replica rather than a modern equivalent.

The key steps in the reproduction cost method are:

  1. calculate all of the costs that would be incurred by a typical participant seeking to create an exact replica of the subject asset,
  2. determine whether there is any deprecation related to physical, functional and external obsolescence associated with the subject asset, and
  3. deduct total deprecation from the total costs to arrive at a value for the subject asset.

Current cost – pros and cons

Reliability – Reliable when there are markets for comparable replacement/repoduction assets. Subjective when technologies and markets change, and when based on predictions and allocations.

Relevance:

Pro – Shows costs of entry to new entrants. Shows whether operating capability is being maintained.

Con – Maintenance of operating capability not the priority for investors. New entrants’ perspective not the most relevant for existing investors.

See also: Fair value measurement

General model of measurement of insurance contracts

Measurement basis    Measurement basis

Measurement basis Measurement basis Measurement basis Measurement basis Measurement basis

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