Need for accounting measurement the big 1

Need for accounting measurement

Need for accounting measurement provides a summary of the measurement bases in use in Financial Reporting
and the concepts behind these measurement bases.
The measurement bases that will be considered here are

All these bases are forms of accrual accounting – that is, they are intended to measure income as it is earned and costs as they are incurred, as opposed to simply recording cash flows. The last four are all forms of current value measurement.

In forming a judgment on the appropriateness of measurement bases, in literature, the overriding tests has been identified to be their cost-effectiveness and fitness for purpose. However, in the absence of direct evidence on these matters, it is usual to argue in terms of various secondary characteristics that ought to be relevant in assessing the quality of information (see the key indicators in What is useful information?).

The most important of these characteristics are generally considered to be relevance and faithful representation / reliability (older term).

For each basis, an outline is given of how it works and the relevance and faithful representation of the resulting measurements. The question of measurement costs is also considered briefly. In reading the analyses that follow, the following comments should be borne in mind.

Bases of measurement in financial reporting are not carved in stone. Different people have different views on how each basis should work, and meanings evolve as practice changes. Some readers may therefore find that the way a particular basis is described does not match how they understand it.

This does not mean either that their understanding is wrong or that the description in the report is wrong; views on these things simply differ.

  • Although it is conventional to consider questions of recognition (what items should be recognised in accounts) and measurement (how recognised items should be measured) as entirely separate, in practice different measurement bases lead to the recognition of different assets and liabilities.
  • Assertions on which financial reporting measurements are relevant and which are reliable are debatable, and the statements made in literature and in here can be disputed. Measurement choices for recording transactions
  • Broad generalizations about faithful representation are also open to the objection that faithful representation (just like reliability in the past) is often a question of shades of grey rather than black and white. A measurement may be accurate within a certain range or with a certain degree of probability. To describe it merely as reliable or unreliable remains a simplification.

Historical cost measurement

The historical cost of an asset is the amount paid for it and the historical cost of a liability is the amount received in respect of it or the amount expected to be paid to satisfy it.

Historical cost accounting is interpreted to require that the amount at which an asset is stated in the accounts should not exceed the amount expected to be recovered from either its use or its sale (its recoverable amount). Historical cost as it is understood is therefore recoverable historical cost.

Recoverable amount is usually considered to be the higher of an asset’s realisable value and its value in use. The resulting recoverable historical cost tree for determining an asset’s recoverable historical cost is summarised below:

Need for accounting measurement

For an item of stock (or inventory), value in use is not normally relevant, so the usual formula is the lower of historical cost and net realisable value. For a fixed asset in profitable use, net realisable value is not normally relevant, so the usual question is: which is the lower of historical cost and value in use? Sometimes fair value is used instead of either recoverable amount or one of its elements.

Under historical cost accounting, where an asset increases in value above its historical cost amount, the gain is not recognised until it is realised. Unrealised gains are excluded from income and from the balance sheet. The recognition of gains is therefore to some extent under the control of management, which can decide when assets are realised and so when any related gains are recognised. But also this measurement basis remains popular because of the relative low risk of high valuation or even manipulation.

Many intangible assets are not recognised under historical cost accounting because their capacity to generate future revenue is too uncertain at the time their costs are incurred for them to qualify as assets.

In terms of income measurement, the objective of historical cost is to match costs as they are incurred with income as it is realised (matching principle). The cost of a fixed asset is therefore written off over its expected useful life, and the measurement shown in a balance sheet represents costs incurred that will be written off against the future income they are expected to help generate.

Why we like historical cost measurement?

Historical costs can usually be measured reliably when they are taken from prices in actual transactions. For example, the original purchase price of a fixed asset or an item of stock (or inventory) may be clearly identifiable, and amounts received (giving a measurement of a liability) and amounts owed to the business (debtors) may also be objectively measurable.

Why we object historical cost measurement?

Many subjectivities in historical cost arise from the fundamental problems of prediction and allocation to periods and assets – for example, in relation to depreciation, the cost of self-produced assets, the estimation of recoverable amounts, and liabilities for future costs (disposal, environment).

Why is historical cost measurement still relevant?

Information prepared on a historical cost basis might be more relevant for some purposes than information prepared on other bases. For example, because it does not recognise unrealised gains on assets, historical cost is more conservative than any of the current value bases and this may appeal to some users.

  • Lenders and other creditors may consider that their interests are better protected if net assets are measured conservatively, as this reduces the extent to which the company’s assets can be paid out as dividends. They may regard the distribution of unrealised gains, which historical cost avoids, as especially risky. Shareholders also gain to the extent that it is therefore easier for the business to raise loans and other credit.
  • Where managers are rewarded on the basis of reported profit, investors may prefer it to be measured with caution. If profits subsequently prove to be overstated, investors are unlikely to be able to get the company’s money back from its managers.

Other important characteristics of historical cost information that may appeal to some users are that:

  • Its fundamental approach of comparing costs incurred with income realised seems to some users to match a fundamental objective of business.
  • For most businesses, it is more likely than other measurement bases to match the information that management uses.

What do we hold against historical cost measurement?

Critics of historical cost argue that its measurements:

  • are inherently irrelevant to any contemporary decision because they are out-of-date information and provide no guide to an entity’s current financial position;
  • typically ignore internally generated intangibles, which are increasingly critical to businesses, as well as financial instruments that have no (or marginal) cost; and
  • fail to take into account unrealised gains, and may therefore significantly understate both net assets and income or allocate income to particular years on grounds (realisation) that should be irrelevant to its measurement.

Fair value measurement

The key point in IFRS 13 is the market participant’s point of view (both buyer- and seller-side) in the principal (or most advantageous) market for the asset or liability. Both market participants. view are constructed (or objectified) around the following characteristics:

  • Buyer and Seller are independent of each other, i.e. Buyer and Seller are not related parties, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms.
  • Buyer and Seller are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary.
  • Buyer and Seller are able to enter into a transaction for the asset or liability.
  • Buyer and Seller are willing to enter into a transaction for the asset or liability, i.e. Buyer and Seller are motivated but not forced or otherwise compelled to do so.

Two other definitions that need to be mentioned in this context are:

  • A principal market is a market with the greatest volume and level of activity for the asset or liability.
  • The most advantageous market maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

The frame for fair value measurement

The asset or liability

A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date.

Such characteristics include, for example, the following:

  • the condition and location of the asset; and
  • restrictions, if any, on the sale or use of the asset.

The transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.

A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:

  • in the principal market for the asset or liability; or
  • in the absence of a principal market, in the most advantageous market for the asset or liability.

The price

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.

Market participants

An entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.

Something else -   Summary information provision by measurement bases

Highest and best use for non-financial assets

A fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use (see below) or by selling it to another market participant that would use the asset in its highest and best use.

The highest and best use of a non-financial asset takes into account the use of the asset that is physically possible, legally permissible and financially feasible, as follows:

  1. A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (e.g. the location or size of a property).
  2. A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (e.g. the zoning regulations applicable to a property).
  3. A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate inNeed for accounting measurementcome or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.

Fair value at initial recognition

When an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price is the price paid to acquire the asset or received to assume the liability (an entry price).

When determining whether fair value at initial recognition equals the transaction price, an entity shall take into account factors specific to the transaction and to the asset or liability.

For example, the transaction price might not represent the fair value of an asset or a liability at initial recognition if any of the following conditions exist:

  1. The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the entity has evidence that the transaction was entered into at market terms. Fair value measurement
  2. The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
  3. The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (e.g. in a business combination), the transaction includes unstated rights and privileges that are measured separately in accordance with another IFRS, or the transaction price includes transaction costs. Fair value measurement
  4. The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.

Valuation techniques

An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. Fair value measurement

This Standard requires entities to apply valuation techniques consistent with any of the following three methods: Fair value measurement

  1. Market approach – uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business Fair value measurement
  2. Cost approach – reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).
  3. Income approach – converts future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts. Fair value measurement

If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Fair value measurement

Fair value hierarchy

IFRS 13 introduces a fair value hierarchy that categorises inputs to valuation techniques into three levels. The highest priority is given to Level 1 inputs and the lowest priority to Level 3 inputs. An entity must maximize the use of Level 1 inputs and minimize the use of Level 3 inputs.

Level 1 inputs Fair value measurement Fair value measurement

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

An entity shall not make adjustments to quoted prices, only under specific circumstances, for example when a quoted price does not represent the fair value (i.e. when a significant event takes place between the measurement date and market closing date). Fair value measurement

Level 2 inputs Fair value measurement Fair value measurement

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Fair value measurement

Level 2 inputs include the following: Fair value measurementNeed for accounting measurement

  1. quoted prices for similar assets or liabilities in active markets.
  2. quoted prices for identical or similar assets or liabilities in markets that are not active.
  3. inputs other than quoted prices that are observable for the asset or liability, for example:
    1. interest rates and yield curves observable at commonly quoted intervals;
    2. implied volatilities; and Fair value measurement
    3. credit spreads. Fair value measurement
  4. market-corroborated inputs.  Fair value measurement

Level 3 inputs Fair value measurement

Level 3 inputs are unobservable inputs for the asset or liability. An entity shall use Level 3 inputs to measure fair value only when relevant observable inputs are not available.

Why we like fair value measurement?

Where fair values are taken from active markets, they are verifiable and objective.

Why we object fair value measurement?

Where fair values are not taken from active markets, they are estimates, made with more or less subjectivity, of what they would have been if there had been active markets. In practice, this problem has often been overcome by using forms of fair value measurement – present value, depreciated replacement cost and so on, as in IFRS 3 – that do not correspond to the defined sense of fair value. To the extent that these proxies are used, they carry the advantages and disadvantages of the particular measurement basis concerned. In terms of IFRS 13’s approach, fair value measurements become more subjective the more they depend on inputs from lower levels in the fair value hierarchy.

Why is historical fair value still relevant?

Information prepared on a fair value basis might be more relevant for some purposes than information prepared on other bases. For example, where fair value shows current market prices, it may be of interest to various users.

  • Investors and lenders will be able to see what could be realised (gross) on disposal of the business’s separable assets. This is also a measure of the opportunity cost of holding the assets. This information may be particularly relevant where assets – investments and properties, for example – could be disposed of separately without affecting the underlying business.
  • Where assets generate cash flows separately from the rest of the business, their fair value determined in an active market should provide the best available indication of the value of the probable risk-adjusted future cash flows from those assets. This information may be of interest to investors and creditors.

The CFA Institute, writing from the point of view of investment analysts, has argued that:

  • ‘Fair value information is the only information relevant for financial decision-making’;
  • ‘The clearest measures of a company’s wealth-generating or wealth-consuming patterns are changes in the fair values of [its] assets and obligations’; and

‘Investors who rely on fair values for decision-making must expend considerable effort trying to restate to fair value all decision-relevant financial statement items that are measured at historical cost’. It would help them if the items were stated at fair value in the first place.


Current costs measurement

– also referred to as Value to the business measurement – For any given asset, the value to the business (current costs) basis of measurement tries to answer the question:

How much worse off would the business be if it were deprived of it?

The answer, as a rule, is given by the asset’s replacement cost. For a liability, value to the business measures how much better off the business would be if it were relieved of it. Value to the business measurement

Something else -   Historical cost measurement

Because there are markets for only a proportion of the assets held by companies in the age and condition in which they exist at the balance sheet date, there is often no price available for a comparable replacement asset. For this reason, it is usual in practice to calculate replacement cost by taking the price of a new replacement asset and, in the case of fixed assets, making an appropriate charge for depreciation and an adjustment for differences in service potential between the original asset and its replacement.

The measurement of liabilities on a value to the business basis is full of difficulties. The key problem is that replacement cost, the central concept in value to the business accounting for assets, is of doubtful applicability for liabilities. Beyond noting that the experts are perplexed on this issue, it is not proposed to discuss it here.

Value to the business implies recognition of gains as they arise rather than as they are realised, but it excludes from operating profit gains that arise purely from holding assets (i.e, gains from changes in purchase prices between an item’s acquisition and its sale or consumption, subject to the recoverable amount test).

Value to the business also implies the recognition of assets and liabilities that are unrecognised under historical cost. For example, the historical cost of an intangible asset might be written off as it is incurred because it is uncertain at the time whether an asset is being created. Once the asset definitely exists, its value to the business should be recognised and measured in the same way as for any other asset. An alternative interpretation, however, would restrict the assets (and liabilities) recognised under value to the business to those recognised under historical cost.

Value to the business has been advocated as a way of measuring a business’s profit so as to maintain its operating capability (or service potential). The argument is that if a business is to maintain its operating capability, it needs to charge against profit the current replacement cost of the assets it consumes in its operations – which, at a time of rising prices, will be higher than their historical cost. Otherwise, it risks paying out as dividends amounts that are needed to finance its continuing operations.

For any given asset, value to the business tries to answer the question: how much worse off would the business be if it were deprived of it? There are various ways of answering this question.

  • If the asset is held for resale, then the business may be worse off by the amount, net of costs, for which it could have sold it (net realisable value).

  • If the asset is held to be used in the business to generate income, then the business may be worse off by the net amount that the asset’s use could have generated (value in use). As this amount is a stream of (net) future income, it would be usual to discount the expected future cash flows to a present value.

  • If the asset can be replaced, the business may be worse off by the amount that it would cost to replace it (replacement cost).

  • Which way of answering the question is most appropriate for any given asset depends on the relationship between the values calculated for net realisable value, value in use and replacement cost.

Whether it is more sensible for a business to sell an asset or to keep it and use it depends on which figure is higher: net realisable value or value in use.

If net realisable value is higher, then it makes sense to sell the asset; and the loss to the business if it is deprived of the asset is then shown by its net realisable value.

If value in use is higher, then it makes sense to use the asset; and the loss to the business if it is deprived of it is then shown by its value in use.

The higher of net realisable value and value in use is the asset’s recoverable amount. If an asset cannot be replaced, its recoverable amount shows its value to the business.

If an asset can be replaced, the question is then: is it worth replacing? If the asset’s replacement cost is less than its recoverable amount, then it is worth replacing.

If the asset’s replacement cost is more than its recoverable amount, it is not worth replacing. Where an asset is worth replacing, the replacement cost measures the loss the business would suffer if deprived of the asset. Where an asset is not worth replacing, the recoverable amount measures the loss.

The resulting value to the business tree is shown in the figure below.

Need for accounting measurement

How far the measurement of profit after maintaining operating capability should reflect the extent to which operating assets are financed by creditors (or by gearing), rather than by shareholders, is also a controversial issue. To the extent that they are financed by creditors, it is debatable whether the additional operating costs recognised on the value to the business basis should be charged against the profit attributable to shareholders.

Why we like value to the business measurement?

Some value to the business measurements, where assets are in fact being replaced by other assets with the same service potential, will be objective as they will reflect the prices the business is currently paying, without the need for further adjustment.

Why we object value to the business measurement?

Where assets are not being replaced, or are being replaced by different assets, or by assets with a different service potential, value to the business measurements are likely to be subjective. Such situations are common as markets and technologies change. Value to the business also shares the subjectivities inherent in historical cost’s reliance on predictions and allocations (in calculating depreciation, allocating costs for self-made assets, and predicting useful lives). Value to the business measurement

Why is value to the business measurement relevant?

Information prepared on a value to the business basis might be more relevant for some purposes than information prepared on other bases. For example, the value to the business basis typically leads to measurements at replacement cost, which might be of interest to the following types of user:

  • Potential competitors could use replacement cost information to assess the costs of entering a particular market. Existing investors could use the information in a similar way to assess how vulnerable the business is to competition from new entrants. Value to the business measurement
  • Competition authorities might also be interested in replacement costs to assess how easy it would be for new entrants to join a market, and to help form a judgment on whether rates of return in the industry appear to be excessive.
  • Investors may want to assess whether the business is maintaining its operating capability. Value to the business measurement

Value to the business is also sometimes argued to have the advantage of providing a compound basis of measurement, with the basis for each individual asset and liability being the most relevant for each item (As in the recoverable historical cost tree, above). However, that tree shows, recoverable historical cost provides a compound basis of measurement in a similar way.

What do we hold against value to the business measurement?

Critics of value to the business argue that what is relevant to a business’s owners is profit after maintaining financial capital, rather than profit after maintaining operating capability. A business can increase its owners’ wealth while reducing its operating capability or increase its operating capability while reducing its owners’ wealth. So why should investors focus on operating capital maintenance?

It may also be argued that information measured from the perspective of a potential market entrant does not provide the most relevant information on financial position or performance for users generally. Moreover, it may be felt that the concept of replacement which lies at the heart of value to the business has become less relevant in a modern economy, where there is usually significant change in markets and technologies.


Realisable value measurement

An asset’s realisable value is the amount for which it could be sold, and a liability’s realisable value is the amount for which it could be settled. Realisable value measurements are often made on a net basis, and here realisable value will be considered in the sense of net realisable value; that is, net of selling costs (for assets) and grossed up for settlement costs (for liabilities). As the actual use of realisable value is limited, it is difficult to say exactly how it would be calculated in practice if it were applied to assets and liabilities generally.

The view could be taken that, in substance, realisable value and fair value are the same except that the former is usually measured net of the costs of realisation. If an attempt were made to apply realisable value generally, therefore, alternative measures would need to be found to produce the numbers in situations where there is no active market to provide them. This would presumably result in the same kind of list of proxies for realisable value as that developed for fair value in IFRS 3.

An alternative view of realisable value is that it should be measured on the basis of disposal in the ordinary course of business. For example, the IASB states that:

Net realisable value refers to the amount that an entity expects to realise from the sale of inventory in the ordinary course of business. Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific value; the latter is not. Net realisable value for inventories may not equal fair value less costs to sell.’ (IAS 2 Inventories)

But this approach to realisable value is clearly limited to assets that would be disposed of in the ordinary course of business – such as inventories. It could not be applied sensibly to all of a business’s assets.

Another view of realisable value is that it reflects what could be received on a forced sale – if the business were liquidated, for example.

Why we like or object realisable value measurement?

The characteristics of the realisable value basis depend on how one interprets it. To the extent that it is in substance the same as fair value, but net of realisation costs, its strengths and weaknesses are similar.

Where realisable value is measured on the basis of disposal in the ordinary course of business, sometimes its measurements would be more objective than fair value, sometimes less. For example, stock (or inventory) subject to a contract-for-sale or actually sold shortly after the balance sheet date could be measured objectively in circumstances where a hypothetical market price might be more difficult to determine. In other cases, the adjustments required for an ordinary course of business basis might be more subjective.

Something else -   Acquisition of investment properties - How 2 best account it

Why is realisable value measurement relevant?

Information prepared on a realisable value basis might be more relevant for some purposes than information prepared on other bases. For example, where realisable value shows current market prices, net of realisation costs, it allows investors, lenders and regulators to see what could be realised (net) on disposal of the business’s separable assets. Some may see it as more useful than fair value because it adjusts for known entity-specific factors, such as contractual terms that would apply to the disposal of assets. Also, where realisable value shows what could be realised in a forced sale, it is particularly relevant where a business is not a going concern or is perhaps intended to have a limited life.

The argument for realisable value as a measure of opportunity cost is that a gross figure represents an amount that can never be wholly realised, because in practice there will always be relevant costs that will reduce the gain (or increase the loss) apparently sitting in the balance sheet waiting to be realised. The user of the accounts could therefore be misled as to the prospective value of realisations. Those who regard fair value, rather than realisable value, as a measurement of opportunity cost could be misled into overestimating the likely benefits of selling assets rather than using them within the business (the calculations for which will be net of relevant costs).

What do we hold against realisable value measurement?

The same objections to realisable value’s relevance apply as for fair value, except as regards the possible superiority of net measurements and its application to businesses that are either not expected or not intended to be sustained.


Value in use measurementValue in use measurement

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 (i.e, 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).

Why we like value in use measurement?

As value in use is based on forecasts of future cash flows, it is only objective to the extent that the cash flows it is forecasting have already occurred (ie, between the balance sheet date and the date of preparation of the forecast) or are contractual commitments to which no doubt attaches.

Why we object value in use measurement?

Because they are based on predictions, most value in use calculations are subjective, and the longer the period covered by the forecast, the more subjective they become. The choice of discount rate is also subjective.

Why is value to the business measurement relevant?

Information prepared on a value in use basis might be more relevant for some purposes than information prepared on other bases. For example, value in use information should be relevant to all those who have an interest in the present value of the business’s future cash flows: most obviously, investors, creditors, and employees. On certain assumptions, it provides a valuation of the business, and it is used for this purpose by investment analysts and private equity investors. Indeed, being based on future cash flows, value in use must be relevant to what standard-setters state to be the main purpose of financial reporting, assisting the forecasting of future cash flows.

Value in use also matches the economist’s concept of income. The economist’s concept of income is that ‘a man’s income [is] the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning. To measure income it therefore becomes necessary to measure well-offness, which it is usually considered means the present value of expected future income.


Accrual accounting

There are two basic type of accounting methodologies – one is cash accounting (see below) and the other is accrual accounting. Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. IFRS requires using accrual accounting (IAS 1 27). Accrual accounting is more complex than cash accounting, cash accounting may sometimes be used for tax return accounting for small businesses.

This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.


The accrual basis of accounting records income and expenses when they are earned.

This accounting method records receivables as income from the moment the service or goods are delivered, and records payables as expenses from the moment the expense is incurred, regardless of when money is received or paid. The accrual basis of accounting is the best method to represent an entity’s financial position since it does a better job at matching income with expenses (matching principle).

Financial reporting divides the economic life of a business into artificial time periods, such as a year, a quarter or a month.


Use of estimates

The accrual basis requires the use of estimates in certain areas. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, all expenses related to a revenue transaction are recorded at the same time as the revenue, which results in an income statement that fully reflects the results of operations. Similarly, the estimated amounts of product returns, sales allowances, and obsolete inventory may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements. Consequently, a considerable amount of care must be used when estimating accrued expenses.

The practical application of the accruals principle leads to the necessity of making the estimates of the following nature:

  • Accrued depreciation of fixed assets;
  • Accrued amounts for the write-off of intangible assets;
  • Provisions for doubtful debts.

Cash accounting

IFRS only accepts accounting for financial reporting on an accrual basis, see below. [IAS 1 27] However, tax authorities sometimes allow (smaller) entrepreneurs to prepare Financial Statements for tax filing purposes on a cash basis.

The cash basis is much simpler, but its financial statement results can be very misleading in the short run. Under this easy approach, revenue is recorded when cash is received (no matter when it is earned), and expenses are recognised when paid (no matter when incurred).

So this means that  income will be recorded when the company receives cash and expenses are recorded when they are actually paid out and not when the bill is raised.

Cash accounting Cash accounting Cash accounting Cash accounting Cash accounting

There are two basic type of accounting methodologies – one is cash accounting and the other is accrual accounting (see above).

Example cash accounting

An small example of cash accounting (with the IFRS accrual accounting in brackets) is as follows:

If your company ABC receives an order to supply 10 computers on October 10, but you deliver the goods in November, the sale will be recorded in the month of November only and not in the month of October.

Your firm ABC receives cash of €8,000 for the sale of 10 computers from company XYZ on November 10. The accountant will record the transaction of a sale on November 10 only, and not on October 10 (which it would be recorded based on accrual accounting).

Companies record expenses when they are actually paid out. Let’s understand the concept with the help of an example. If your company hires a contractor on November 1 and a bill is raised on that day, but the actual money was paid out on November 15.

Under cash accounting, November 15 would be the date when the transaction will be recorded and not November 1st (which it would be recorded based on accrual accounting). Cash accounting

This method is usually used by sole proprietors who have small, cash-based business or are involved in providing service to customers.

Also read: Investopedia – Accounting measurement

Need for accounting measurement

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