Accounting Theory: Measurement and Reporting

1. Introduction to Measurement and Reporting in Accounting

Accounting measurement is central to financial reporting and the preparation of financial

statements. It involves determining the monetary value at which assets, liabilities, income, and
expenses are recognized in the accounts. Measurement decisions affect how the financial
position of an entity is presented to external users like investors, creditors, and regulators.
Reporting in accounting involves the presentation of this information in a clear and standardized
format.

Measurement vs. Reporting: Measurement is concerned with assigning values to financial

elements, while reporting focuses on communicating those values to stakeholders in the form of
financial statements.

2. Types of Measurement Approaches

In accounting theory, there are various approaches to measuring financial elements, each
reflecting different assumptions about value. The main measurement bases used in accounting
include:

A. Subjective Value

-Definition: The subjective value reflects the personal or unique assessment of an asset's worth.
This type of measurement is inherently dependent on the individual or the context in which the
measurement is made.

Example: The value of goodwill or a brand, which may differ significantly from one owner to
another, depending on subjective factors such as market position or customer loyalty.

Accounting Implications: Subjective value is often difficult to justify for external users and may
lack reliability. Therefore, it is less frequently used in formal accounting practices.

B. True Economic Value

Definition: True economic value reflects the real, intrinsic value of an asset, based on its future
cash flows and its contribution to long-term wealth generation. This concept is primarily
concerned with future benefits and risks that an asset or liability carries.
Theoretical Perspective: The true economic value is aligned with the economic theory of value,
which focuses on the utility and wealth creation of an asset for its holder. Unlike market value,
which is dependent on external conditions, true economic value considers the long-term
sustainability of an asset’s contribution to the entity.

Example: Valuing a company based on the discounted future cash flows (DCF), considering
factors like market growth, risks, and future profitability

C. Cost (Historical Cost)

-Definition: The historical cost refers to the original price paid to acquire an asset, adjusted for
subsequent costs such as improvements or impairments. This is the most traditional method of
measurement in accounting and provides verifiable and objective figures.

-Theoretical Basis: Historical cost is rooted in conservatism theory in accounting, which aims to
prevent overstatement of financial performance by recording assets at their cost of acquisition,
not market value.

Example: Purchasing an asset for $100,000 and reporting it at that cost for the life of the asset,
even if its market value increases.

Limitations:

- Does not reflect current market conditions or asset depreciation due to wear and tear.

- May not give a true reflection of the economic value of an asset, especially in periods of
inflation.

D. Present Value

Definition: Present value is the current value of a future cash flow, discounted at a specific
interest rate, reflecting the time value of money. This method is commonly used for long-term
liabilities, leases, and other financial instruments.

Theoretical Basis: The time value of money theory is the foundation of present value
measurement. It recognizes that money today is worth more than the same amount of money in
the future, due to its potential to earn interest or returns.

Formula:

FV
PV =
¿¿
Where:

PV = Present Value
FV = Future Value

r = Discount rate

- n = Number of period

E. Market Value

Definition: Market value is the price at which an asset can be bought or sold in a competitive and
open market. It reflects the real-time supply and demand for that asset.

Theoretical Basis: Market value is associated with the efficient market hypothesis (EMH), which
suggests that asset prices reflect all available information at any given time. This is often used in
fair value accounting.

Example: The market price of publicly traded stocks, which fluctuates continuously based on
investor perception, news, and market conditions.

Advantages:

- Provides the most current and relevant value.

- Useful for assets that are actively traded, like securities and commodities.

Limitations:

- Highly volatile and subject to short-term fluctuations.

- May not be reliable for illiquid or unique assets that don't have a broad market.

F. Value to the Business or Owner

Definition: This is the value an asset holds for a specific entity, based on its utility to the
business. This type of measurement considers how the asset contributes to the business’s future
performance and how much it is worth from the owner’s perspective.

Example: A specialized piece of machinery may have a higher value to the owner of a business
than to other buyers because it is crucial to the company’s production process, even if the market
value is low.

3. Determining Value in Practice

In practice, determining the value of an asset or liability often involves a combination of

different measurement methods and judgment. The process typically involves:
1. Identifying the Asset or Liability: Clearly define what is being measured (e.g., tangible vs.
intangible assets, long-term vs. short-term liabilities).

2. Selecting the Measurement Basis:Choose the appropriate basis (cost, market value, present
value, etc.) depending on the asset's characteristics and the reporting requirements.

3. Applying Measurement Techniques:Use statistical, financial, or market models to quantify

value (e.g., discounted cash flow analysis for present value, market comparables for market
value).

4. Considering External Factors: Factor in market conditions, economic environment, legal

considerations, and any restrictions on asset use.

5. Reporting the Value: Ensure the value is reported in accordance with accounting standards,
such as IFRS or GAAP.

4. Measurement of Assets and Liabilities

A. Assets

Definition: Assets are resources controlled by the entity that are expected to bring future
economic benefits. They can be classified as current (short-term) or non-current (long-term).

Measurement Bases for Assets:

-Cost: Often used for tangible assets like property, plant, and equipment.

-Fair Value: More common for financial instruments or investment properties.

Present Value: Used for long-term receivables, pension obligations, or leases.

B. Liabilities Definition: Liabilities represent obligations that the entity must settle in the future,
often through the transfer of assets or the provision of services.

Measurement Bases for Liabilities:

Cost (Amortized Cost): Common for financial instruments and bonds.

Present Value: Frequently used for long-term liabilities, such as pension obligations or lease
liabilities.
5. Measurement of Income

Income measurement is critical for assessing a company's performance over a period. It can be
derived from revenue, gains, or other sources, and it is central to financial reporting.

A. Accounting vs. Economic Concepts of Income

-Accounting Income: Under accrual accounting, income is recognized when it is earned, not
when cash is received. It reflects the inflows of economic benefits that increase equity and are
realized through revenue-generating activities.

-Economic Income: This concept includes changes in the value of assets and liabilities, reflecting
an entity's overall increase in wealth over time. It encompasses not just earned income but also
gains or losses from changes in asset values, such as revaluation of property or investments.

B. Capital Maintenance

-Definition: Capital maintenance refers to the idea that an entity should maintain its capital
before it can recognize profit. It ensures that the business preserves its capacity to generate future
profits, and profits are recognized only when capital is preserved.

Types of Capital Maintenance:

1. Financial Capital Maintenance : Profit is recognized when the capital is restored to its
original amount (based on financial capital, i.e., monetary value).

2. Physical Capital Maintenance: Profit is recognized only when the entity’s capacity to
produce goods or services is maintained (based on physical capital, i.e., assets with productive
capacity).

6. Nature and Recognition of Revenue, Expenses, Gains, and Losses

A. Revenue

-Definition: Revenue is the inflow of resources from the sale of goods or services in the normal
course of business.
-Revenue Recognition : Revenue is recognized when it is earned, typically when the risks and
rewards of ownership have been transferred to the buyer.

B. Expenses

- Definition: Expenses represent the outflows of economic benefits in the process of generating
revenue.

- Expense Recognition: Expenses are recognized in the period in which they contribute to the
earning of revenue, in accordance with the matching principle.

C. Gains and Losses

- Gains: These represent increases in assets or decreases in liabilities from peripheral or

incidental transactions (e.g., profit from selling an

(investment).

- Losses: These represent decreases in assets or increases in liabilities from non-operational

activities (e.g., loss from the sale of a fixed asset).

7. Conclusion

- The concept of measurement in accounting is multifaceted, with various methods available

depending on the asset, liability, or income being measured.

- A clear understanding of these measurement bases, their theoretical underpinnings, and their
application is essential for accurate and reliable financial reporting.

- The recognition of revenue, expenses, gains, and losses is guided by a set of rules aimed at
ensuring consistency, comparability, and relevance in financial statements.