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The art of recording, categorizing and outlining the financial transactions in the preparation of the important financial statements is accounting. It is a process of identifying, evaluating and further communicating the economic information of a business enterprise.
The objective of accounting measurement is to represent the financial statements, which meets the need of different stakeholders of the business entity like creditors, investors, lenders, external users, regulators, tax authorities etc. It helps in rational decision making by the stakeholders.
There are many qualitative characteristics which need to be considered while selecting any measurement approach. Relevance and faithful representation are the two most basic qualitative characteristics. The most commonly used method is the historical cost method which is considered as irrelevant in the current market situation. The current cost method provides relevant and reliable information but have its own limitations. The realizable value method gives the market value of any assets and the present discounted value shows the present net cash inflows that is generated by an asset during a course of business.
Accounting measures the transactions of business and other events which have an impact on the financial position of the entity. Accounting measurement facilitates systematic record and rational decision making.
The purpose of this report is to give a glimpse of the meaning, objective and significance of accounting measurement. It is followed by the qualitative characteristics that are necessary to be judged while selecting measurement approaches. Also, different measurement bases defined by the framework of International Accounting Standards Boards are defined in this report. The concept of fair value hierarchy is also brought in.
Measurement in accounting is the calculation of financial and economic data in terms of hours, money or other units. It is basically to represent the data in terms of a particular method like hours, units or currency.
In accounting measurement, the method which is used is to ascertain, compare and appraise the accounting data. If standard measurements of accounting are used by the company, it results in an easy comparison of certain variables over a definite time frame, thus allowing the company, for better evaluating and analysing its operations. This includes the units sold, cost per hour, number of work hours, unit revenues etc. It aids the analysts and the investors in the comparison of one organisation to the other by digging into the accuracy of how specific information of accounting is being represented.
Different measurements of accounting give different perspectives on the overall functioning and health of a company. By the application of various accounting measurements, a more comprehensive view of operations of corporations can be gained which can be easily compared with other corporations henceforth.
The basic objective of accounting measurement is providing information which is very useful for the investors and creditors to predict, measure and analyse the future cash flows on the basis of timing, amount and related uncertainty.
The importance of accounting measurement can be for ascertaining the total value of assets and liabilities of a corporation. Accounting measurement gives an actual view of the financial position and performance of a company. It provides complete information about the value, that is, the value of assets and liabilities, the value of an entire business.
There are many qualitative characteristics which are necessary to be judged in the decision making of measurement approaches:
Relevance: Relevance means to assess whether to what extent the data available is helpful for the decision making process in finance. For any information to be relevant, the characteristics it must possess are:
Confirmatory Value: Details of the past events is given.
Predictive Value: This gives the predictive power about the plausible anticipated coming events.
Thus, the information is applicable only if it can give the necessary and required details about the past events and as well as assist to predict the upcoming events in view to deal with them.
Faithfulness: This reflects the extent of accuracy of the information about the resources of the company, its transactions, obligatory claims etc. For the data to be representational faithfulness, it should be:
Complete: Any transaction must not be excluded in the financial reports.
Neutral: The data must be bias-free.
Free from error: The accounting information should be error free.
Verifiability: The degree to which the data is replicable given the identical assumptions and information is verifiability.
Timeliness: Timeliness shows how quickly the data is made available to the users. Undoubtedly, the less timely, the less useful data is for making the decision.
Understandability: It is the extent that the data is easily understandable.
Comparability: It refers to the application of accounting policies and standards in a consistent manner from one interval to another. This helps the users for drawing intuitive results regarding the various trends and performance of company overtime. Comparability also means the ability to make an easy comparison of the financial reports of a business entity with other entities.
The above qualitative characteristics are very significant to be thoroughly analysed and judged in view to select accounting measurement approaches.
Accounting income, which is often called conventional income or business income, is measured according to the generally accepted accounting principles. The Profit or Loss Account helps in determining the operating performance or the net income of the business enterprise for a particular interval of time. Income of a business enterprise is ascertained by implementing the income statement approach that is by the comparison of sales, revenue and the costs which are related to the sales revenue.
Accounting income is the increase on the resources of the business entity resulting from the methods of operations and performing of an enterprise. In other terms, accounting income is basically the net increase in the equity of the owner which results from the operations of a corporate.
Whereas, on the other hand, economic income refers to the sum of operating earnings and the change in asset values during a specific period of time. Economic income can be defined as the sum of consumption and saving expected during a particular period of time.
Unlike accounting income, economic income is measured in real terms and is a result of the change in the worth of assets in spite of calculating revenues and expenses. In contrast, accounting income is based on money values.
The measurement task is the assignment of monetary amounts so that the components of the financial statements are ascertained and reported.
The Framework of International Accounting Standards Board (IASB) describes a variety of measurement bases. There are several measurement bases that are used these days in different combinations in the financial statements. Some of them are:
Historical Cost: This measurement basis is very commonly used these days. But this measurement basis is usually combined with the other bases. The Framework of International Accounting Standards simply explains this measurement basis as a basis which uses the fair value or the amount of cash which is paid at the time of acquisition of an asset. In other words, the recording of the assets in the historical cost method is done at the fair value or the cash equivalents which is paid at the time of purchase. Whereas, the liabilities are recorded at the amount of cash that will be received in exchange for the obligation.
The benefit if using historical method is its simplicity and certainty. Whereas, this method does not deal with the changing prices of non-monetary assets and are based on out of date costs. Therefore, this method does not show fair value of an asset or liability.
Current Cost: In the current cost method, assets are recorded as the amount of cash that would have to be paid if the same asset is bought today and for the liabilities, it will be the undiscounted amount of cash which will be in need to pay the commitment today.
Realizable (Settlement) Value: This value refers to the amount of cash which will be received currently if the asset is sold in an orderly disposal. Whereas, it is known as settlement values in the case of liabilities, which is the undiscounted amount of cash which is believed to be paid to satisfy the liabilities.
Present (Discounted) Value: Present discounted value can be defined as the present value of the upcoming cash inflows which will be generated by the asset over the period of time. For liabilities, it is defined as the present value of the future cash outflows that will be paid for the repayment of liabilities during the normal course of business.
As per the most commonly used measurement basis, historical costs, value of items are measured at their costs, which is actually paid at the date and time of the acquisition of the asset. This measurement basis does not consider either the rise in the value or fall in the value of asset in the current period. Although, the original values of any assets or liabilities is determined by the historical cost method in the financial statements. Historical cost method does not involve any subjective estimates.
In contrast to historical cost method, current cost provides up to date information of the financial market. Market value accounting is generally preferred by the investors and creditors for decision making.
The amount realised when the asset is sold in the market is its realizable value. It is basically the market value of any asset. Whereas, historical cost is the initial cost of any asset which is the cost which was incurred at the time of acquiring the asset. Current cost is the representation of the exchanges price which is acquired today for obtaining the similar assets or any equivalent. On the other hand, present discounted value can be defined as the net cash inflows, which is to be received by the usage of an asset or the net cash outflows which is expected to be spent for redeeming the liability.
The limitation of historical cost is that the valuation of the assets is done at the time of acquisition which may change over the time and further will have no significance. The historical cost method fails to realise the gains and losses of the assets at the time in which it actually occurs.
The disadvantage of the current cost is the price which is obtained from the quotations in that market in which the assets acquired by the firm. However, this current cost method has evolved as a significant measurement basis, specifically in presentation of information about the effect of inflation on a business entity.
In contrast, the limitation of realizable value is that it excludes the items that don’t have a contemporary price in the market from been shown in the position statement. However, the present discounted value method not only helps in ascertaining the opportunity cost but also gives an estimate about the probability to receive the amount expected.
International Financial Reporting Standards defines fair value in terms of an ‘exit price' along with the usage of fair value hierarchy resulting in a market based in spite of on the basis of entity specific measurement. The goal of International Financial Reporting Standards 13 is to describe fair value and provides a framework for measuring this value also IFRS 13 needs disclosure about its measurement. Fair value refers to the value which will be received by selling an asset or would be paid while transferring a liability in a transaction that will be held amongst market participants at the date of evaluation.
The assumption that is used while the measurement of the fair value of an asset or liability by a business enterprise is that the participants of the market will also use this while valuing the asset or liability. The basic assumption behind this is that the participants of market will perform according to their economic best interest.
International Financial Reporting Standards 13 through a fair value hierarchy tries to enhance the consistency and comparability interest measurements of fair value and the concern disclosure. The inputs which are used in the measurement techniques is categorized by the hierarchy into three levels. The highest priority is given to the unadjusted quoted prices in current markets for the same assets and liabilities by the hierarchy. The lowest priority is given to the unobserved inputs.
The measurement of fair value is divided in the lowest level input which is significant to the whole valuation. This is when the inputs to value the fair value is divided into various levels of the fair value hierarchy.
Level 1 inputs are the price which is quoted in active market for the assets and liabilities which could be assessed by the business entity at the date of measurement. This provides a reliable proof of fair value, which could be used without any adjustment for measuring the fair value with limited demerits whenever applicable.
Level 2 inputs are those inputs which are not included in level 1. They include quoted prices of assets and liabilities in the active market as well as that are not active. For example, credit spreads, yield curves and interest rates.
Level 3 are the unobservable inputs for the assets and liabilities. It helps to evaluate the fair value to the limit that the observable inputs are unavailable.
For an effective decision making, accounting is a must in any business enterprise. It provides essential financial information of a business entity to its various users like managers, shareholders, creditors, investors etc. The objective of accounting measurement is to ascertain the results of the operation and hence the financial position of the business. We have also seen different measurement bases. Historical cost method which is although easy to use, should be avoided as a measurement approach. This is because it ignores the current scenario of the market. Also, the historical cost information can be easily manipulated. Therefore, the qualitative characteristics are to be looked on while deciding the measurement approach.
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