Measurement Models in

Accounting and the

Conceptual framework

Prepared by Dr Subhash Abhayawansa

CRICOS 00111D

TOID 3059

Question to consider The

conceptual framework of accounting

What is the conceptual framework (CF) of accounting?

Why have an accounting CF?

What are the benefits of having an accounting CF?

Is the CF a means of legitimising the accounting profession?

What is the current accounting conceptual framework in Australia?

What are the components of the IASB accounting conceptual framework?

What is the objective of General Purpose Financial Reports (GPFRs)?

What are the qualitative characteristics of GPFRs

Should accounting be conservative

Why GPFRs cannot provide unbiased accounts of performance?

Why comparability as a qualitative characteristic is problematic?

What are assets, liabilities, incomes and expenses?

Question to consider
Measurement models in accounting

What is the model of measurement adopted in accounting?

How to choose between alternative measurement bases?

What are the problems with historical cost measurement?

What a various methods of accounting under inflation?

What is the link between capital maintenance perspective and measurement?

How does historical cost accounting, current purchasing power accounting,

current cost accounting and continuously contemporary accounting (CoCoA)
differ from each other?

How does inflation affect the value of monetary and non-monetary assets and
liabilities differently?

What are criticisms of CoCoA?

What is fair value measurement

How is fair value determined?

What are the problems associated with fair value measurement

What is the conceptual framework

of accounting?

The accounting conceptual framework is A coherent system of

interrelated objectives and fundamentals that is expected to lead to
consistent standards and that
prescribes the nature, function and
limits of financial accounting and financial statements. (Statement of Financial
Accounting Concepts No. 1: Objectives of Financial Reporting by Business
Enterprises 1978)

Hendriksens (1970, p.1) defined theory as a coherent set of hypothetical,

conceptual and pragmatic principles forming the general framework of
reference for a
field of inquiry

Conceptual framework provide a theory of financial accounting

A normative theory - as it prescribes

A conceptual framework provides guidance at a much broader level than

an accounting standard

Why have an accounting

conceptual framework?
Regulators an policy makers

assist in the development of future accounting standards and in its review of existing
accounting standards

assist in promoting harmonisation of regulations, accounting standards and procedures

relating to the presentation of financial statements by providing a basis for reducing the
number of alternative accounting treatments permitted

Preparers of financial statements

assist in understanding and interpreting accounting standards

assist preparers of financial statements in applying accounting standards and developing

accounting policies

assist preparers in dealing with topics that have yet to form the subject of an accounting
standard

Auditors and assurance providers

assist auditors in forming an opinion as to whether financial statements conform with

Accounting Standards

Users of financial statements

assist users of financial statements in interpreting the information contained in financial

statements prepared in conformity with accounting standards

Benefits of an accounting
conceptual framework?

Forces accountants to think about what they are doing and why they do them

Accounting standards will be more consistent and logical as they are developed
from an orderly set of concepts

Increased compatibility of accounting standards

Standard-setters become more accountable for their decisions as the thinking

behind specific requirements can be checked against the CF

Communication between standard-setters and their constituents will enhance

The development of accounting standards should be more economical

Where conceptual frameworks cover a particular issue, there might be a

reduced need for additional standards

Emphasise the 'decision usefulness' role of financial reports rather than

restricting concern to stewardship

A critical view of the accounting

conceptual framework

Conceptual frameworks are created primarily to provide benefits

to parties that actually develop or commission the framework

Hines (1989) suggests that CFs have been used as devices to help
ensure the ongoing existence of the accounting profession by
boosting their public standing
CFs provide social legitimacy to the accounting profession
Fundamental form of social power accrues to those who are able to
uphold objectivity. Legitimacy is achieved because accounts generated
around this proposition are perceived normal (as CF concerns objectivity)

Creating the perception of possessing a formal body of accounting

knowledge is an important part of creating the social identity of the
accounting profession

Increase the ability of the profession to self-regulate, thus counteracting

government intervention

What is the current accounting

conceptual framework in
Australia?

SAC 1 on Reporting entity

IASB is currently working on the Chapter
on Reporting entity in their CF. AASB
intends to incorporate that into its CF
and thus replace SAC 1.

Framework for the Preparation and

Presentation of Financial Statements (based
on IASB conceptual framework)
Chapter 1 - The objective of general
purpose financial reporting (GPFR)
Chapter 3 - Qualitative characteristics
that financial information should possess
for it to be useful (Chapter 3 of CF)

Components of the IASB accounting

conceptual framework
GPFRs are financial statements are
intended to meet the information needs
common to users who are unable to
command the preparation of reports
tailored so as to satisfy, specifically, all of
their information needs.
GPFSs should comply with accounting
standards and other generally accepted
accounting practices (GAAPs)

IASB defines a reporting entity as: a

circumscribed area of economic
activities whose financial information
has the potential to be useful to
existing and potential equity investors,
lenders and other creditors who cannot
directly obtain the information they
need in making decisions about
providing resources to the entity and in
assessing whether management and
Going concern assumption
the governing board of that entity have
made efficient and effective use of the
Fundamental
qualitative
resources provided.
characteristics
Relevance
Faithful representation
Enhancing qualitative
characteristics
Comparability
Verifiability
Timeliness
Understandability

Financial reports are

prepared for users who
have a reasonable
knowledge of business
and economic activities
and who review and
analyse the information
diligently.

Many existing and

potential investors,
lenders and other
creditors cannot
require reporting
entities to provide
information directly
to them and must
rely on general
purpose financial
reports for much of
the financial
information they
The objective of general
need. purpose

Accrual
basis

Source: Deegan, 2014, Financial Accounting Theory, McGregor Hill: Melbourne

financial reporting is to provide

financial information about the
reporting entity that is useful to
existing and potential investors,
lenders and other creditors in
making decisions about providing
resources to the entity. Those
decisions involve buying, selling or
holding equity and debt instruments,
Assets
and providing
or settling loans and
other formsofLiabilities
credit
Expenses
Income
Equity

What is the objective of GPFRs?

According to the IASB (and AASB) Conceptual Framework (paragraph OB2):
The objective of general purpose financial reporting is to provide financial information about the reporting
entity that is useful to existing and potential investors, lenders and other creditors in making decisions
about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt
instruments, and providing or settling loans and other forms of credit.

Stewardship

Decision-usefulness

This was the focus of financial accounting in the past

This is the focus of financial accounting now

Explain whether the resources entrusted to management

have been used for their intended or appropriate purposes

Providing information to assist users make

informed resource allocation decisions

Involves monitoring the past actions of managers (providing

an account of their past performance and how they have
utilised the resources)
Historical cost provides a clearer perspective about what
management has done with the funds that were entrusted
to it
Investors of private entities and stakeholders of not-forprofit and government entities

Involves understanding how the

organisation created value in the past and
will create value in the future
Fair values are more relevant for decision
making
Investors of listed companies and creditors
are interested in decision-usefulness

In the definition of a reporting entity IASB states accounting role in providing financial information useful to
existing and potential equity investors, lenders and other creditors to make decisions about:
1. providing resources to the entity (i.e., decision usefulness) and
2. in assessing whether management and the governing board of that entity have made efficient
and effective use of the resources provided (i.e., stewardship).

Fundamental qualitative
characteristics of GPFRs
Relevance

Faithful
Representation

Something is relevant if it
influences decisions on the
allocation of scarce
resources, i.e., if it is capable
of making a difference in a
decision

Transactions and events are

faithfully represented if the
economic substance
underlying them are
depicted (rather than their
legal form)

For information to be
relevant it should have:
predictive value, and
confirmatory value

To be a perfectly faithful
representation, a depiction
would have three
characteristics. It would be
complete, neutral and free
from error.

A complete depiction includes all information necessary

for a user to understand the phenomenon being
depicted, including all necessary descriptions and
explanations.
E.g. a complete depiction of a group of assets would
include, at a minimum:

a description of the nature of the assets

in the group

a numerical depiction of all the assets in

the group

a description of what the numerical

depiction represents (i.e. cost , FV etc.)

A neutral depiction - is the absence of bias in the selection or

presentation of financial information
Free from errors means: there are no errors of omissions in the
description of the phenomenon, and the process used to produce
the reported information has been selected and applied with no
errors in the process

Should accounting be conservative?

Traditionally, the doctrine of conservatism and the acceptance of

'prudence' has been adopted
asset amount should never be shown at amounts in excess of
their realisable values (but they could be understated)
liabilities should never be understated (although they could be
over stated)
bias towards understating asset values and overstating liabilities

Neutrality would mean that financial information should not be

biased in one direction

Hence, the doctrine of conservatism does not result in

representational faithfulness

Neutrality is not consistent with

conservatism

Why GPFRs cannot provide unbiased

accounts of performance?

The practice of accounting is heavily reliant on professional judgement

Prior to accounting standards being released, standard-setters attempt to

determine the economic consequences that might result from the standards

if they consider economic consequences, can accounting standards

really be considered objective or neutral?
If preparers are driven by self-interest notions of objectivity or neutrality are
unrealistic
Political nature of standard setting process also affects neutrality and
objectivity
the IASB considers various submissions from many (potentially selfinterested) parties before finalising any accounting standard
In communicating reality accountants construct reality (Hines 1988)
that is, if accountants identify something and start to place a monetary
value on it then it gains importance it becomes visible (and 'real')
conversely, if accountants ignore it such as many externalities caused
by business entities then for many people the 'issue' does not exist

A critical reflection of the qualitative

characteristic of comparability

Implies there are advantages in restricting the number of accounting methods

that can be used

Restricting the number of accounting methods reduce the efficiency with

which management can report results and financial position the efficiency
perspective

Efficiency perspective - managers adopt particular accounting methods

because those methods best reflect the underlying economic performance of
the entity

Particular accounting methods might be relevant when applied in some

situations. Forcing comparability will restrict the ability of management to use
methods that might be relevant in a limited number of situations

leads to inefficiencies as the resultant financial statements will no longer

provide the best reflection of the performance of the entity

What is an asset?

' a resource controlled by the entity as a result of

past events and from which future economic benefits
are expected to flow to the entity' (IASB Conceptual
Framework, paragraph 4.4)

must be an expected future economic benefit

The benefits can result from ongoing use, not necessarily a
value in exchange
the reporting entity must control the future economic benefit
Control relates to the capacity to benefit from the asset
and to deny or regulate others' access to the benefit
Examples: know-how obtained from R&D is an asset as it
keeps it secret - entity controls the benefits; Use of roads
generates economic benefits but the entity does not
control it
Legal enforceability is not a prerequisite for establishing
the existence of control. Example: assets obtained on
financial leases
the transaction or other past event giving rise to the reporting
entity's control must have occurred

An asset shall be
recognised when
it is probable that any
future economic
benefit associated with
the item will flow to or
from the entity, and
the item has a cost or
value that can be
measured with
reliability (IASB
Framework, para.83)

What is a liability?

' a present obligation of the entity arising from past

events, the settlement of which is expected to result
in an outflow from the entity of resources embodying
economic benefits' (IASB Conceptual Framework,
para.4.4)

present obligations not only refers to legally enforceable

obligations but also those imposed by notions of equity and
fairness, or by custom or other business practices
An equitable obligation is governed by social and moral
sanctions or custom rather than legal sanctions
A constructive obligation is created, inferred or
construed from the facts in a particular situation rather
than contracted by agreement with another entity or
imposed by government
To determining whether a liability exists in relation to
equitable and constructive obligations it is necessary to
ascertain: (1) the intentions or actions of management; (2)
whether the entity has any realistic alternative to making
the future sacrifice of economic benefits; and (3) whether
the entity has publicly committed to it.

A liability shall be
recognised when
it is probable that any
future economic
benefit associated with
the item will flow to or
from the entity, and
the item has a cost or
value that can be
measured with
reliability (IASB
Framework, para.83)

What are expenses and incomes?

Expenses
' decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity, other than those
relating to distributions to equity participants' (IASB Conceptual
Framework, para. 4.25)
Incomes
' increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating
to contributions from equity participants' (para. 4.25)
Income can be recognised from normal trading relations, as well as
from non-reciprocal transfers such as grants, donations, bequests
or where liabilities are forgiven

revenue arises in the course of the ordinary activities of an

entity

gains represent other items that meet the definition of income

and may, or may not, arise in the ordinary activities of an
enterprise

An expense shall be recognised when:

it is probable that the consumption
or loss of future economic benefits
resulting in a reduction in assets
and/or an increase in liabilities has
occurred, and
the consumption or loss of economic
benefits can be measured reliably

A income is recognised when:

it is probable that the inflow or other
enhancement or saving in outflows of
future economic benefits has
occurred; and
the inflow or other enhancement or
saving in outflows of future economic
benefits can be measured reliably

How to measure assets, liabilities,

incomes and expenses?

Measurement is 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. (Paragraph 4.54 of the IASB Conceptual Framework for
Financial Reporting)

Measurement allows us to attribute numbers to the items that appear in financial

reports

How we measure assets and liabilities has direct implication for income and expense
recognition, and therefore for profits.

Measurement of elements in financial statements has direct implications on

Debt covenants (debt-to-asset ratio, interest coverage ration)

Performance-linked management bonuses

Government funding tied to accounting measures such as efficiency

Distribution of wealth among various stakeholders

The conceptual frameworks of accounting provide very limited prescription in

relation to measurement issues

We currently have a mixed (or eclectic) approach to measurement

Eclectic approach to measurement

Advantages

Disadvantages

Flexibility as circumstances
of each company differ
No active market vs
active market
Market uncertainties /
low level of trading
resulting in volatile
prices vs stable market

Undermines
comparability
Additively problem (what
does total assets
represent?)
Room for managerial
opportunism to drive the
selection of
measurement basis

Fair
value
less
costs
to sell

Valuein-use

Histo
rical
cost
Net
reali
sabl
e
valu
e

Fair
value
Net
pres
ent
valu
e

How to choose between alternative

measurement bases?
Determining how an asset or liability should be measured should
ideally be linked to the perceived objectives of general purpose
financial reporting.
Objective of general purpose financial reporting (paragraph OB2
of the IASB Conceptual Framework for Financial Reporting) is to
provide financial information about the reporting entity that is
useful to existing and potential investors, lenders and other
creditors in making decisions about providing resources to the
entity.
Choice of measurement method depends on whether one
adopts a decision usefulness perspective or a stewardship
perspective

Problems with historical cost

Assumes money holds a constant purchasing

power (it ignores changing prices)
specific price level changes (shifts in consumer
preference; technological advances, market
forces)
general price level changes (inflation)
fluctuation in exchange rates

Problem of additivity (adding together assets

bought at different times when the
purchasing power of the dollar was different)
Can overstate profits in times of rising prices
distribution of profits leads to an erosion of
operating capacity

Holding gains are recognised in the year of

disposal rather than in the years in which the
gains actually occurred.
This distorts current and previous periods
income
Distortion of return on assets

Assets are recorded at the

amount of cash or cash
equivalents paid, or the fair value
of the consideration given, to
acquire them at the time of their
acquisition
liabilities are recorded at the
amount of proceeds received in
exchange for the obligation, or in
some circumstances (for example,
income taxes), at the amounts of
cash or cash equivalents expected
to be paid to satisfy the liability in
the normal course of business

Inflation accounting
in 2009 a person would starve
on with just a billion Zimbabwe
dollars
Zimbabwe recorded an estimated
inflation rate of
89,700,000,000,000,000,000,000%
(89.7 sextillion percent) in midNovember 2008

Use of the Zimbabwean dollar as an

official currency was effectively
abandoned on 12 April 2009

Inflation accounting is a term describing a range of accounting systems designed to correct

problems arising from historical cost accounting in the presence of inflation.

Inflation accounting is used in countries experiencing high inflation or hyperinflation.

Inflation accounting is not fair value accounting.

Some possible methods of accounting under inflationary conditions are:

Current Purchasing Power Accounting (CPPA)

Current Cost Accounting (CCA)
Continuously Contemporary Accounting (CoCoA)

Link between capital

maintenance perspective and
measurement?

How we measure assets will be influenced by how

we define income

Income has been defined as the maximum amount

that can be consumed during the period, while still
expecting to be as well off at the end of the period
as at the beginning of the period (Hicks 1946)

Consideration of well-offness requires the

stipulation of a notion of capital maintenance

Different notions of capital maintenance will

provide different perspectives of income

different notions of capital maintenance have

implications for how assets are measured

Concept
of
Income

Measureme
nt of assets

Various Capital maintenance

perspectives

Financial capital maintenance (Historical Cost Accounting)

perspective taken in historical cost accounting

Income = Money Capital Y1 Money Capital Y0 (excludes contributions from and distributions to
owners)

Purchasing power maintenance (Current Purchasing Power Accounting)

Physical capital (operating capacity) maintenance (Current Cost Accounting)

historical cost accounts adjusted for changes in the purchasing power of the dollar (using a price
index)
Income = Inflation Adjusted Capital Y1 Inflation Adjusted Capital Y0
Relies on current values which could be based on replacement cost
Income = Operating Capacity Y1 Operating Capacity Y0

Adaptive capacity capital maintenance (Continuously Contemporary Accounting)

Unlike other approaches income is calculated when items are purchased rather than when sold
Income = (Adaptive capacityY1 Adaptive capacity Y0) capital maintenance adjustment
Capital maintenance adjustment reflects the effect of movement in the general price level on the
purchasing power of opening capital
Relies on current values which are based on exist prices (net selling prices)

Lecture illustration measurement under

various capital maintenance perspectives

Comparison of measurement
methods

Does inflation affect the value of

assets differently?
Monetary assets and liabilities

Those assets that remain fixed in terms of their

monetary value

E.g. Cash, accounts receivable, investments

Liabilities are mostly monetary

In times of inflation, holders of monetary assets will lose

in real terms and holders of monetary liabilities will gain

the assets have less purchasing power at the end of

the period relative to the beginning of the period

The amount need to repay at the end of the period

is worth less than at the beginning

Under CPPA gains and

losses will relate to net
monetary assets NOT net
non-monetary assets

Non-monetary assets

Those assets whose monetary

equivalents will change over time as a
result of inflation

E.g. property plant and equipment,

intangible assets

Purchasing power of non-monetary

assets remain constant

Holding gains are Increase in the value

of assets or reduction in the value of
liabilities that arise as a result of
holding assets or liabilities over time
without transforming or modifying
them

Continuously Contemporary
Accounting (CoCoA)

Ray Chambers argued that key information for decision making

relates to capacity to adapt

Therefore, the objective of accounting is to guide future actions

(as opposed to, for example, stewardship)

The higher the current market value of the entitys assets the
greater the ability of the entity to adapt to changing
circumstances

Measurement of assets at net selling prices (exit prices) at reporting

dates on the basis of orderly sales (referred to as current cash
equivalent)

Profit directly relates to changes in the current net selling price of the
entitys assets (or adaptive capital, reflected by the total exit values of
assets)

No distinction between realised and unrealised gainsall gains are

treated as part of profit

revenues are recognised at point of purchase or production rather

than sales

The balance sheet considered to be the prime financial statement -It

shows the net selling prices of the entitys assets

Ray Chambers, Professor of Accounting, University of

Sydney - Farther of Continuously Contemporary
Accounting

Criticisms of CoCoA

Involve a fundamental shift in financial accounting in relation to

revenue recognition points and asset valuations
Relevance of exit prices questioned if we do not expect to sell the
assets
Ignores the value in use of an asset
Assets of a specialised nature considered to have no value under
CoCoA because cannot be separately disposed of
Determining exit prices for unique assets introduces subjectivity
into accounts
Questioned whether appropriate to value all assets at exit prices if
the entity is a going concern
Requires assets to be valued separately rather than as a bundle
therefore would not recognise goodwill as an asset
value of assets sold together can be very different from
separate sale

Fair value measurement

Fair value (FV) measurement is covered in IFRS 13 Fair Value

Measurement and is used within an increasing number of
accounting standards
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)(Para 21 IFRS 13)

Orderly transaction: A transaction that assumes exposure to the

market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions
involving such assets or liabilities; it is not a forced transaction (e.g. a
forced liquidation or distress sale)

Market participants: Buyers and sellers are independent of each other,

are knowledgeable, having a reasonable understanding about the
asset or liability and the transaction using all available information, and
are willing and able to enter into a transaction for the asset or liability

FV is measured using the assumptions that market participants

would use when pricing the asset or liability
Entitys intention to hold an asset or settle a liability is not relevant
in measuring fair value.

How to determine the fair value of

an asset?
Quoted prices (unadjusted) in active markets for
identical assets or liabilities that the entity can
access at the measurement date

Level 1

Market prices for similar assets or liabilities,

or market prices for identical assets but
that are observed in less active markets).

Level 2

Mark-to-model situations where observable

inputs are not available and risk-adjusted
valuation models need to be used instead.

Level 3

Mark-to-market
approach
Rely upon observable
market values (market
prices)

Mark-to-model
approach
Rely upon valuation
models. Require the
identification of both an
accepted valuation model,
and the inputs required
by the model to arrive at
a valuation

If a valuation model is applied because there is not an active market

then many assumptions and professional judgments must be made

Problems with fair value

measurement
Volatility in markets will be reflected in the values of the
assets measured at FV
If the change in the value of the asset or liability is
recognised in profit (rather than other comprehensive
income), this volatility can affect annual profit or loss.
FV measurement is affected by procyclicality.
A quantity or measure that tends to increase when the
overall economy is growing, or decreases when the
economy is declining, is classified as being procyclical
During the sub-prime banking crisis did the
requirements that require reporting entities to
measure many of their assets at fair value actually
exacerbated the financial crisis?

Upward spiral of Procyclicality

Some of this
additional
lending will fuel
further demand
in the markets
for financial
assets

Markets for
financial assets
(such as shares,
bonds and
derivatives) are
increasing

The value of the

financial assets
held by banks
(measured at
FV) rises above
HC

The banks
ability to lend
increases and
more lending
results

Bank lending limits are set

in terms of a proportion
(or multiple) of capital and
reserves

Increases in the
reported net
assets and
capital and
reserves of the
bank

Downward spiral of Procyclicality

Markets for
financial assets
(such as shares,
bonds and
derivatives) are
falling

Reducing
demand for &
increasing
supply of
financial assets

The banks
ability to lend
decreases and
less lending
results also

Bank lending limits are set

in terms of a proportion
(or multiple) of capital and
reserves

The value of the

financial assets held
by banks (measured
at FV) reduces below
HC
Decrease in the
reported net
assets and
capital and
reserves of the
bank

Past Exam Questions

This topic was tested in the following examinations
Semester 1, 2014 (2 questions)
Semester 2, 2014 (2 questions)
Semester 1, 2015 (2 questions)
Semester 2, 2015 (2 questions)
Semester 1, 2016 (1 Question)