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Chapter 11 Measurement systems ‘What is a Cynic? A man who knows the price of everything and the value of nothing.’ Oscar Wilde, Lady Windermere’s Fan (1892), Wiley Book of Business Quotations (1998), p. 349.

But the good news is that alternatives such as current purchasing power, current value accounting, net realisable value and fair value exist.

However, as we were all taught historical cost, it is easier for us to continue to use historical cost.

©MMI Mike Jones

As we all know historical cost is a flawed measurement system which doesn’t represent economic reality.

Learning Outcomes After completing this chapter you should be able to:

• Explore the importance of accounting measurement systems. • Critically evaluate historical costing. • Investigate the alternatives to historical costing.

Go online to discover the extra features for this chapter at www.wiley.com/college/jones

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Chapter Summary • Measurement systems determine asset valuation and profit measurement. • The capital maintenance concept is concerned with maintaining the capital of a company. • Historical cost, which records items at their original cost, is the most widely used measurement system. • Current purchasing power adjusts historical cost for changes in the purchasing power of money (i.e. inflation). • Replacement cost is based on the cost of replacing assets. • Realisable value is based on the orderly sale value of the assets. • Present value is based on the present value of the discounted net cash inflows of an asset. • Modifications to historical cost are the valuing of inventory at the lower of cost or net realisable value or, in the UK, the revaluation of property, plant and equipment. • Fair value is based on the amount that a market participant would pay for the assets.

Introduction

SOUNDBITE 11.1 Measurement ‘What you measure is what you get.’ Robert S. Kaplan and David P. Norton, Harvard Business Review, January– February, 1992 Source: The Wiley Book of Business Quotations (1998), p. 295.

Measurement systems underpin not only profit, but also asset valuation. Essentially, a measurement system is the way in which the elements in the accounts are valued. Traditionally, historical cost has been the accepted measurement system. Income, expenses, assets and liabilities have been recorded in the accounting system at cost at the time that they were first recognised. Unfortunately, historical cost, although easy to use, has several severe limitations; for example, it does not take inflation into account. However, although the limitations of historical cost accounting are well known, accountants have been unable to agree on any of the main alternatives such as current purchasing power, replacement cost, realisable value, present value or fair value.

Overview Measurement systems are the processes by which the monetary amounts of items in the financial statement are determined. These systems are fundamental to the determination of profit and to the measurement of net assets. In essence, the measurement system determines

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the values obtained. Potentially, there are six major measurement systems: historical cost, current purchasing power, replacement cost, realisable value, present value and fair value (see Figure 11.1). Figure 11.1 The Alternative Measurement Systems

Measurement System

Explanation

Capital Maintenance System

i. Historical cost

Monetary amounts recorded at the date of original transaction.

Financial capital maintenance.

ii. Current purchasing power

Historical cost adjusted by general changes in purchasing power of money (e.g., inflation), often measured using the retail price index (RPI).

Financial capital maintenance.

i. Replacement cost

Assets valued at the amounts needed to replace them with an equivalent asset.

Physical capital maintenance.

ii. Realisable value

Assets valued at the amount they would fetch in an orderly sale.

Physical capital maintenance.

iii. Present value

Assets valued at the discounted present values of future cash inflows.

Physical capital maintenance.

iv. Fair value

Assets valued at the amount that a market participant would pay for them.

Physical capital maintenance.

Historical Cost Systems

Current Value Systems

Measurement systems are underpinned by the idea of capital maintenance (see Figure 11.2). Capital maintenance determines that a profit is made only after capital is maintained. This capital can be monetary (monetary capital maintenance) or physical (physical capital maintenance). Figure 11.2 Capital Maintenance Concepts

What exactly is a capital maintenance concept and why is it important? A capital maintenance concept is essentially a way of determining whether the ‘capital’ of a business has improved, deteriorated or stayed the same over a period of time. There are two main capital maintenance concepts (financial capital maintenance and physical capital maintenance). Under financial capital maintenance we are primarily concerned with monetary measurement, in particular, the measurement of the net assets. This is true using both historical cost and current purchasing power. For example, under historical cost the capital maintenance unit is based on actual monetary units (i.e., actual pounds in the UK). Under current purchasing power, it is actual pounds adjusted by the rate of inflation. In both cases, if our closing net assets (as measured in ÂŁs) are higher than our opening net assets we make a profit. Under physical capital maintenance, the physical productive capacity (i.e. operating capacity of the business) must be maintained. For example, can we still produce the same amount of goods or services at the end of a period as we could at the start? We maintain the operating capacity in terms of replacement costs, realisable values, fair values or present values (i.e. discounted future cash flows). For example, under replacement costs, we are concerned with valuing the operating capacity of the business at the replacement cost of individual assets and liabilities.

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Historical cost and current purchasing power both stem from the normal bookkeeping practice of recording transactions at the date they occur in monetary amounts. For current purchasing power, these amounts are then adjusted by the general changes in the purchasing power of money. Under both measurement systems the concern is to maintain the monetary amount of the enterprise’s net assets. In both cases, we are therefore concerned with financial capital maintenance. Replacement cost, realisable value, present value and fair value are sometimes known as current value systems. They seek to maintain the physical (or operating) capital of the enterprise. The first three systems differ in how they seek to do this. Replacement cost measures assets at the amount it would cost to replace them with an equivalent asset. Realisable value (also known as net realisable value or settlement value) measures assets at their sale value. Present value measures the business at the present values of the future net cash flows. These three current value systems can be combined into a ‘value to the business’ model. A fourth measurement system, fair value, has recently grown in influence. This is sometimes known as a mark-to-market model as it seeks to capture an asset’s market value. It is most usually associated with valuing complex financial instruments such as those used by financial institutions. It is similar to realisable value, but ignores transaction costs and takes a market-based rather than an entity perspective. It takes into account a market participant’s ability to generate economic benefits by using the asset in the best way possible. It can be defined as the price that will be received when selling the asset or that is paid to transfer a liability between players in the market. See Definition 11.1 for a formal definition of fair value. Fair value has been a particularly contentious topic as many commentators have suggested that fair value accounting facilitated the asset bubble which led to the global financial crisis. Given its dependence on market prices fair value is crucially dependent on the reliability of active markets. A detailed description of fair value and the value to the business model (sometimes called current value accounting) are beyond the scope of this book.

DEFINITION 11.1 Fair Value ‘The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price).’ International Financial Reporting Standards IFRS13, May 2011, para. 9.

It is, however, important to realise two fundamental points. First, historical cost still remains the most common measurement basis adopted by enterprises. Second, although historical cost is much criticised, there is no consensus about which measurement system, if any, should replace it. Disagreement on measurement systems is where attempts to arrive at a consensual conceptual theory have all foundered.

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Measurement Systems In this section, we have discussed two of the most important measurement systems: historical cost and replacement cost. Readers interested in the other three measurement systems are referred to more advanced texts such as Geoffrey Whittington’s Inflation Accounting: An Introduction to the Debate.

Historical Cost Historical cost has always been the most widely used measurement system. Essentially, transactions are recorded in the books of account at the date the transaction occurred. This original cost is maintained in the books of account and not updated for any future changes in value that might occur. To illustrate, if we paid £5,000 for a building in 1980, this will be the cost that is shown in the statement of financial position when we prepare our accounts in 2012. This is even when the building has increased in value to say £20,000 through inflation. The depreciation will be based on the original value of the asset (i.e., £5,000 not £20,000). SOUNDBITE 11.2 The main strength of historical cost is Historical Cost that it is objective. In other words, you can objectively verify the original cost of the Accounting’s Limitations asset. You only need to refer to the original invoice. In addition, historical cost is very ‘Historical cost-based financial reporteasy to use and to understand. Finally, hising is not the most efficient way of torical cost enables businesses to keep track reflecting a company’s true value.’ of their assets. Mike Starr, Chairman of American There is, however, one crucial problem Institute of Certified Public Accountwith historical cost. It uses a fixed monetary ants Committee on Enhanced Business capital maintenance system, which does not Reporting take inflation into account. This failure to Source: Nicholas Neveling, Consortium take into account changing prices can cause Urges Reporting Reforms, Accountancy severe problems. In particular, as Soundbite Age, 17 February 2005, p. 11. 11.2 shows, it may not accurately value a company’s worth.

Replacement Cost Replacement cost attempts to place a realistic value on the assets of a company. It is concerned with maintaining the operating capacity of a business. Essentially, replacement cost asks the question: what would it cost to replace the existing business assets with identical, equivalent assets at today’s prices? Replacement cost is an alternative method of measuring the assets and profits of a business rather than principally a method of tackling inflation. In the Netherlands, replacement costing was successfully used by many businesses, such as Heineken. As Company Snapshot 11.1 shows, Heineken in 2004 valued its property, plant and equipment at replacement cost based on expert valuation. Dutch companies are still permitted to use replacement costing under Dutch

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law. However, Heineken now uses IFRS and has, therefore, discontinued replacement costing in its more recent accounts. Indeed, the problem for the Dutch is not so much the difficulties of using replacement cost, but of convincing the rest of the world that it is a worthwhile system.

PAUSE FOR THOUGHT 11.1 Historical Cost and Asset-Rich Companies The statements of financial position of asset-rich companies, such as banks, may not reflect their true asset values, if prepared under historical cost accounting. Why do you think this might be? If we take banks and building societies as examples of asset-rich companies, these businesses have substantial amounts of prime location property. Almost in every town, banks occupy key properties in central locations. These properties were also often acquired many years ago, indeed possibly centuries ago. Using strict historical cost, these buildings would be recorded in the statement of financial position at very low amounts. This is because over time money values have changed. If a prime site was purchased for £1,000 in 1,700 that might have been worth a lot then. Today, it might be worth say £400 million. Thus, property, plant and equipment will be radically understated, unless re-valued.

COMPANY SNAPSHOT 11.1 Replacement Cost and Heineken Property, Plant and Equipment (Tangible Fixed Assets) Except for land, which is not depreciated, tangible fixed assets are stated at replacement cost less accumulated depreciation. The following average useful lives are used for depreciation purposes: Buildings Plant and equipment Other fixed assets

30–40 years 10–30 years 5–10 years

The replacement cost is based on appraisals by internal and external experts, taking into account technical and economic developments. Other factors taken into account include the experience gained in the construction of breweries throughout the world. Grants received in respect of investments in tangible fixed assets are deducted from the amount of the investment. Projects under construction are included at cost. Source: Heineken, Annual Report 2004, pp. 84–5. Copyright Heineken H.V.

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The main problem with replacement cost is that although the concept is very simple, in practice, it is often difficult to arrive at an objective value for the replacement assets. However, in many cases specific indices are available for certain classes of assets, allowing more accurate valuations.

Deficiencies of Historical Cost Accounting Figure 11.3 on the next page shows how historical cost accounting can give a misleading impression of the profit for the year and of the value of assets in the statement of financial position. In particular, strictly following historical cost will have the effect of: (i) encouraging companies to pay out more dividends to shareholders than is wise, (ii) making companies appear more profitable than they really are, and, (iii) impairing the ability of companies to replace their assets. In practice, many UK companies now use a modified form of historical cost accounting. This involves revaluing property, often every five years. Depreciation is then based on the revised valuation. However, in some other countries, such as the US, Germany and France, there is still a closer adherence to historical cost.

Illustrative Example of Different Measurement Systems In Figure 11.4 on page 330, we pull together some of the threads and show how the valuation of an individual asset can vary considerably depending upon the chosen measurement system. We can, therefore, see that different measurement systems give different asset valuations There are thus six different valuations ranging from £2,500 to £9,947. Realisable value, which is an exit value, gives the lowest valuation at £2,500 while present value which looks to the future earnings of the company is £9,947. The most objective of the measurement systems are probably historical cost and current purchasing power. £ • Historical cost

6,000

• Current purchasing power

7,200

• Realisable value

2,500

• Replacement cost

4,000

• Present value

9,947

• Fair value

3,000

It is important to note that, in practice, each measurement system itself could potentially yield many different asset valuations, depending on the underlying assumptions and estimations. For example, present value is crucially dependent on the estimated discount rate (10%), the estimated future cash flows (£4,000), and the timing of those cash flows.

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Figure 11.3 The Deficiencies of Historical Cost Accounting

A company’s only asset is a building, purchased 10 years ago for £20,000. The replacement cost for an equivalent building is now £200,000. The company, which deals only in cash, has profits of £10,000 per annum before depreciation, it distributes 50% of its profits as dividends. The asset is depreciated over 20 years.

(i) Historical Cost Accounts in year 10 Income Statement

Statement of Financial Position

£ Profit before depreciation Depreciation Profit for year

£

10,000 (1,000) 9,000

Property, plant and equipment Accumulated depreciation Total property, plant and equipment Cash

20,000 (10,000) 10,000 55,000

Net assets

65,000

(a) Over the first ten years, the company’s net cash inflow is £100,000 (£10,000  10), minus £45,000 in dividends leaving £55,000 cash in the company. This looks healthy. (b) The shareholders are happy receiving an annual dividend. (c) Return on capital employed (taking closing net assets) is: £9,000

 13.8%

£65,000 Everything, therefore, seems pretty good. Unfortunately, the company has only £65,000 in net assets which is not enough to replace the property, plant and equipment which will cost £200,000!

(ii) Replacement Cost Accounts in year 10 Income Statement

Statement of Financial Position £

Profit before depreciation Depreciation

10,000 (10,000) —

£ Property, plant and equipment Accumulated depreciation Total Property, plant and equipment

200,000 (100,000) 100,000

Cash

100,000

Net assets

200,000

(a) In this case, the company makes no profit because the increased depreciation has wiped out all the profits. There is no profit out of which to pay dividends. If the company had paid out dividends during the 10 years it would have no money left to replace the property, plant and equipment. (b) The net worth has risen considerably. This is a plus for the company. However, not paying out dividends is a considerable minus. (c) There is no return on capital employed! Suddenly, everything appears less rosy. However, the firm can continue in business because it can just about replace its property, plant and equipment (in actual fact, its net assets equals the amount needed to replace the property, plant and equipment). This assumes that the building could be sold for £100,000!

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Figure 11.4 Example of Different Measurement Systems

JoJo bought a van two years ago for £10,000. She expects to keep the van for five years. The used van guide states the van is now worth £2,500. If sold, the general price in an active market for such vans is £3,000. Replacement cost for a van in a similar condition is £4,000. The future net cash flows will be £4,000 for the next three years (assume the cash flows occur at the end of the year) and she can borrow money at 10%. The retail price index was 100 when the van was bought and it is 120 now. Appropriate value £

Historical Cost We base our calculations on the original historical cost of £10,000. Using straight-line depreciation (£10,000  5)  £2,000 p.a. Thus, £10,000  £4,000 (two years’ depreciation)

6,000

Current Purchasing Power We base our calculation on the original historical cost less depreciation.In the calculation above, this was £10,000 – £4,000 = £6,000. We then adjust this for inflation. This is measured using the retail price index, which has increased from 100 to 120. Closing RPI 120 £6,000    Opening RPI 100

7,200

Realisable Value In this case, our calculations are based upon the amount of money we would receive for the van if we sold it. Used van guide

2,500

Replacement Cost In this case, we base our calculations on the amount it would cost to replace the van with a similar asset in a similar condition. Similar value asset

4,000

Present Value Here, we are interested in looking at the future cash flows generated by the asset. We then discount them back to today’s value (see Chapter 21 for further information about discounting). £

Discount Factor*

£

4,000

0.9091

3,636

4,000

0.8264

3,306

4,000

0.7513

3,005 9,947

9,947

Fair Value Fair value: with Fair Value we are interested in the current price which this asset would reach in an active market. We ignore transaction cases. This is similar to net realisable value.

3,000

*10% interest discounted back, assumes cash flow is on the last day of each year.

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Real Life The merits of historical cost accounting and the advantages and disadvantages of the competing alternative measurement systems have been debated vigorously for at least 40 years. However, with some rare exceptions, most companies worldwide still mainly use historical cost. This is not to say that experimentation has not occurred. In the Netherlands, for example, Philips, one of the world’s leading companies, used replacement cost accounting for over a generation. Finally, Philips abandoned replacement cost, not because of replacement cost’s inadequacies, but because of the failure of international financial analysts to understand Philips’ accounts. There are, however, still non-listed companies in the Netherlands which use replacement cost. In the UK too, there were a few companies, usually ex-privatised utilities with extensive infrastructure assets, such as British Gas, which until recently used replacement costs. In both the UK and the US in the 1970s, there were serious attempts to replace historical cost accounting initially with current purchasing power, but later with current value accounting (a mixture of the three current value systems). These methods were thought to be superior to historical cost accounting when dealing with inflation, which was at that time quite high. They were also believed to provide a more realistic valuation of company assets. In the end these attempts failed. The reasons for their failure were quite complex. However, in general, accountants preferred the objectivity of a tried-and-tested, if somewhat flawed, historical cost system to the subjectivity of the new systems. In addition, rates of inflation fell. The role of accounting measurement in the recent global credit crunch has aroused a lot of attention. This is particularly true of the role of fair value. When the value of financial assets declined then their fair value reduced and so did the valuation of the companies. Whereas some onlookers felt that accounting measurement was only measuring what had happened, others felt that accounting measurement had contributed to the economic problems by eroding company value. Although the backbone of the accounts is historical cost, there is some limited use of alternative measurement systems (see Figure 11.5). As we pointed out earlier, many

Figure 11.5 Use of Alternative Measurement Systems

‘The measurement basis most commonly adopted by enterprises in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some enterprises use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.’ Source: International Accounting Standards Board (2011), Conceptual Framework, para. 4.56. Copyright © 2012 IFRS Foundation. All rights reserved. No permission granted to reproduce or distribute.

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UK companies revalue their property every five years. This is particularly common in companies that have a great deal of property, such as hotel chains. However, this periodic revaluation of property means that UK accounts are prepared on a different basis to those in countries, such as France (using French domestic principles) or the US, where periodic revaluations are not permitted. Revaluations are, however, permitted under IFRS.

Conclusion Different measurement systems will give different figures in the accounts for profit and net assets. The mostly widely used measurement system, historical cost, records and carries transactions in the accounts at their original amounts. Historical cost, however, does not deal well with changes in asset values resulting from, for example, inflation. There are four other traditional main measurement systems (current purchasing power, replacement cost, realisable value, present value). Current purchasing power adjusts historical cost for general changes in the purchasing power of money. Replacement cost records assets at the amounts needed to replace them with equivalent assets. Realisable value records assets at the amounts they would fetch in an orderly sale. Finally, present value discounts future cash inflows to today’s monetary values. Although historical cost is the backbone of the accounting measurement systems, there are departures from it, such as the valuation of inventory at the lower of cost or realisable value. In particular, in the UK, many companies revalue their property. A relatively recent new measurement system is fair value, the price the asset would rate in an active market. This is similar to net realisable value. The role of fair value in the credit crunch has been hotly debated.

Selected Reading The topic of accounting measurement systems can be extremely complex. The first two readings below have been deliberately selected because they are quite accessible to students. Students wishing for a fuller insight into the debate are referred to the book by Geoffrey Whittington below. 1. Accounting Standards Steering Committee (1975), The Corporate Report, Section 7, pp. 61–73. Although now 30 years old, this report provides a very good, easy-to-read, introduction to the topic. 2. International Accounting Standards Board (IASB) (2011), ‘Conceptual Framework’, in International Financial Reporting (2011), paras 4.54–4.65. It presents more modern thinking on the topics and is reasonably easy to follow.

For the Enthusiast Whittington, G. (1983) Inflation Accounting: An Introduction to the Debate (Cambridge University Press). For students who enjoy a challenge. Gives a thorough grounding in the inflation debate, which is at the heart of choosing different measurement systems.

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Discussion Questions Questions with numbers in blue have answers at the back of the book. Q1 ‘Accounting measurement systems are the skeleton of the accounting body.’ Critically evaluate this statement. Q2 Why is historical cost still so widely used, if it is so deeply flawed? Q3 What is the difference between a financial capital maintenance concept and a physical capital maintenance concept? Q4 Why do many UK companies revalue their property? How might this affect profit? Why is this practice unusual internationally?

Go online to discover the extra features for this chapter at www.wiley.com/college/jones

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Accounting 3rd Edition by Mike Jones Sample Chapter 11