Recognition and Measurement
The Conceptual Framework for Financial Reporting provides guidance as to when any of the financial elements (i.e. assets, liabilities, equity, income and expenses) should be recognized or recorded in the financial statements and then how its value should be measured.
To be recognized, an item must meet the definition of an asset, liability, equity, income or expense. So for example, an asset must have value to the company, must be controlled by the company and must have arisen from past events.
Recognition is appropriate if it results in useful financial information about the company; i.e. it provides information that is relevant to the needs of the user and will provides a faithful representation of the company’s financial elements.
Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried at in the financial statements.
The method to be used to measure the value of a particular transactions is usually specified in the relevant financial reporting standard but sometimes a company may have a choice. When choosing the appropriate method, an accountant will take into account:
- The valuation methods permitted in the relevant financial reporting standard
- Whether the available methods will provide useful financial information
- Whether there is any uncertainties involved with some of the available methods
- The costs that would be incurred in providing the information
So for example, a company has the choice of valuing its property at its original cost (less accumulated depreciation) or at its current value. The directors believe that using its current value would provide more useful information but they also believe that the fees that would be incurred in obtaining the valuation would outweigh the benefit. The directors therefore decide to value the property at its cost.
There are two main measurement methods used when preparing financial statements; Historic Cost and Current Value.
Historic cost is the most common method used by accountants to measure the value of transactions and the resulting financial elements.
To measure an element using historic cost means that it will be measured at the amount at the date of the transaction. Then the carrying amount of non-financial items should be adjusted over time to reflect its use and any impairments.
For example, a company using the historic cost method to value its assets would record the purchase of a delivery van at its cost when it was purchased. The van would then be depreciated over its useful life so that its carrying value would fall over time to its residual value by the end of its useful life.
The Conceptual Framework describes three methods of calculating current value.
- Fair value which is the price an asset could be sold for in an orderly transaction between knowledgeable market participants. So fair value is the amount the company would expect to sell the asset for if it was not under pressure to sell the asset quickly
- Value in use which is the present value of the cash flows that are expected to be derived from the continuing use of an asset and its eventual disposal
- Current cost which is the current market price of the asset, that is, how much it would cost the company to buy
Identify which measurement method has been used in the following
a) A car has been valued using the amounts cars of similar age, mileage and condition are advertised at on the internet
b) A piece of equipment has been recorded at its cost less all the depreciation that has been charged against that asset since it was first acquired
c) A rental property has been valued by calculating the discounted amounts the owner expects to receive over its useful life
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The effects of going-concern on measurement
Financial statements are normally prepared on a going-concern basis. What this means that there is an assumption that the company will continue in operation for the foreseeable future.
This would not be a reasonable assumption where there is a need or intention to close a company’s operations down (e.g. if the company is insolvent and will be liquidated). Under these circumstances the company’s assets and liabilities would be valued at the amount that would be gained from the assets’ sale.