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MEASUREMENT AND RECOGNITION - Coggle Diagram
MEASUREMENT AND RECOGNITION
A. Cost
The
cost of acquisition
of an asset is the
fair value
of whatever is given in exchange for the asset plus any cost incidental to the acquisition.
Fair value
is defined as the
amount
for which an
asset
could be
exchanged
in an
arm’s length transaction between a buyer and a seller.
Historical cost
refers to the
cost
at the time the asset is
incurred
.
Current cost
refers to the
amount
that would be
paid now
to
acquire
the best asset available to undertake the function of the asset owned.
mesurement
Basically, the choice of measurement base will depend on whether the measurement is in terms of:
(a) Cost; or
(b) Value.
B. Value
Refers to
preference
people have for some items over others because of perceived
benefits
to themselves. It relates to the consumer’s willingness to give up something to obtain it.
measurement
Exit price
refers to the amount
received
from
selling an asset
either to a market for
new commodity or to a second-hand market.
Net realizable value
is defined as the
expected
selling price
less expected costs
of disposition.
HISTORICAL COST ACCOUNTING (HCA)
Historical Cost Accounting (HCA) is a measurement basis commonly used by entities in preparing their financial statements. Under HCA,
assets
are
recorded at their original purchase cost
, and this historical cost is used as the basis for
subsequent measurement and recognition
in the financial statements.
.
Flow of Costs
: HCA follows the principle of tracing the flow of costs through the business. It involves distinguishing between costs that have expired and should be matched against revenues in the income statement and costs that remain as assets on the balance sheet.
Stewardship Function
: HCA is often associated with the stewardship function of management, as it provides a record of the resources entrusted to management and their subsequent use. This historical perspective is valuable for assessing management's custodial responsibilities.
Why HCA is important
Objective
: less subject to manipulation than other alternative measurement system
Verifiable
: HC is based on actual transactions
Understandable
: best to understand concept of profit is the excess selling price over historical cost.
CRITICISMS OF HISTORICAL COST ACCOUNTING
Impact on Decision-Making
: Some argue that HCA's focus on historical costs may not provide decision-useful information for users who are more interested in the current economic value of assets and liabilities. This limitation can affect the ability of stakeholders to make informed decisions based on the financial information presented.
Relevance in Inflationary Environments
: In periods of significant inflation, the use of historical cost may result in carrying values of assets and liabilities that do not reflect their current economic worth. This can lead to distorted financial statements and reduced relevance for decision-making.
CURRENT COST ACCOUNTING
Current Cost Accounting (CCA) is an alternative measurement basis to Historical Cost Accounting (HCA) and is based on the concept of
valuing assets and liabilities at their current market
prices.
Replacement Cost Model
: CCA is often based on the replacement cost model, which assumes that the cost of consuming assets in the
profit generation process
is
equivalent to the cost of their replacement.
This reflects the idea that a firm is a
going concern and is continuously replacing its assets
.
Entity Concept
: CCA is based on the entity concept of
maintaining the firm's operating capacity
. It
values
assets at their
current market buying prices
, aiming to maintain the ability of the firm to
continue delivering the same amount
of goods and services.
Holding gain/loss
Holding gains and losses refer to changes in the value of assets or liabilities that are held by an entity over some time. These gains and losses arise from changes in the market value of the assets or liabilities, rather than from any operational activities of the entity.
A holding gain occurs when the market value of an asset or liability increases over time, resulting in a higher value than the original cost or carrying amount. Conversely, a holding loss occurs when the market value of an asset or liability decreases over time, resulting in a lower value than the original cost or carrying amount.
Under Historical Cost Accounting (HCA), holding gains and losses are typically not recognized in the financial statements until the asset or liability is sold or otherwise disposed of. This means that any changes in the market value of the asset or liability are not reflected in the financial statements until the point of sale.
In contrast, Current Cost Accounting (CCA) recognizes holding gains and losses as a component of profit, reflecting the current market value of the asset or liability. This approach aims to provide a more accurate reflection of the economic value of the asset or liability, rather than relying solely on historical cost.
Criticisms of CCA
Reliability of Current Market Prices
: One of the primary criticisms of CCA is the challenge of reliably determining current market prices for assets and liabilities. In practice, obtaining accurate and up-to-date market prices for all assets and liabilities can be difficult, particularly for non-traded or unique assets.
Subjectivity in Valuation
: The use of current market prices introduces a level of subjectivity into the valuation process, as it relies on estimates of what would be paid to acquire the same or equivalent assets at the current time. This subjectivity can raise concerns about the reliability and comparability of financial information.
Volatility in Financial Statements
: Critics argue that CCA can lead to increased volatility in financial statements, particularly in response to fluctuations in market prices. This volatility may make it challenging for users to assess the underlying performance and financial position of an entity.
Exit Price Accounting (EPA)
Exit Price Accounting (EPA) is an accounting approach that values assets and liabilities at their exit prices, which represent the
amount that would be received or paid to dispose of an asset or settle a liability
in an orderly transaction between market participants at the measurement date.
EPA focuses on using market values
, specifically exit prices, to measure an entity's financial position and performance.
Market-Based Valuation
: EPA relies on market values, specifically exit prices, to determine the financial position and performance of an entity. Exit prices represent the amounts that would be received to sell assets or paid to transfer liabilities in an orderly transaction between market participants.
Valuation of Assets and Liabilities
: Under EPA, assets are valued at their net realizable amounts, reflecting the expected proceeds from their disposal, while liabilities are valued at the amounts required to settle them as of the measurement date.
Recognition of Holding Gains and Losses
: EPA recognizes holding gains and losses as a component of profit, reflecting changes in the market value of assets or liabilities over time. This approach aims to provide a more current and relevant representation of an entity's financial position and performance.
Income Measurement
: The income statement under EPA is determined by the change in the net realizable value of the firm's net assets occurring during the period, excluding the effect of capital transactions. This reflects the focus on market-based measurements in determining the entity's financial results.
Income Measurement
: The income statement under EPA is determined by the change in the net realizable value of the firm's net assets occurring during the period, excluding the effect of capital transactions. This reflects the focus on market-based measurements in determining the entity's financial results.
CRITICISMS OF EPA
Relevance for Ongoing Operations
: Critics argue that the EPA may not provide relevant information for entities to continue their operations. The focus on exit prices, which represent the amounts that would be received to sell assets or paid to transfer liabilities, may not align to provide information about the entity's ongoing performance and financial position.
Forward-Looking Nature
: EPA has been criticized for having a more forward-looking, decision-usefulness objective rather than a stewardship objective. Critics argue that the emphasis on market values and exit prices may be more relevant for decision-making and investment analysis, but may not fully capture the historical stewardship role of financial reporting.