Measurement In The Statement Of Financial Position Is Crucial For Accurate Essay.

Discuss about the Measurement in the Statement of Financial Position.

The net worth of any entity can be computed by sum totalling the value of each asset owned and deducting the value of liabilities thereon (Blundel, Lockett and Wang, 2017). Every asset and liability needs an effective system of valuation, i.e. the way they convert into liquid assets or liabilities and the variables influencing such system. The value at which assets and liabilities are measured will not only affect the amount of revenue and expenses of an entity and the other elements of the financial statements, but it is also critical in terms of financial reporting requirements and transparent business practices. Measurement bases of assets and liabilities may use either entry or exit values (Berger, 2018). In case of assets, entry values indicate the cost of purchases and exit values indicate the cost of sales or the value in use. And for liabilities entry values denote the amounts at which the liabilities are accepted by an entity, while the exit values refer to the amounts at which the obligations are fulfilled (Berger, 2018). A number of factors contribute towards selection of an appropriate measurement basis, for a particular asset or a liability. The five most popular measurement bases are classified on lines of historical cost, replacement cost, fair value, net realisable value and measurement of value in use. The measurement bases should be relevant and should truly represent the assets and liabilities in the balance sheet and should be selected only after considering all the possible effects on the financial statements (Maynard, 2017, p. 81). Also the measurement bases must be disclosed in the financial statements for the users to be informed about the same as it significantly affects their analysis (Collings, 2016). The following segment describes various measurement bases and analysis of choice and effects of different measurement bases in case of Starbucks Corporation.

Historical cost basis conventionally records the value of an asset at the price at which it was originally acquired by the entity irrespective of significant changes that have occurred in its value over time (Greenberg, et al., 2013). This is inclusive of all the transaction costs incurred to bring the asset to use such as the shipping or delivery charges, set up or installation cost, training fees and so on. This basis works on the principle of realization i.e. the revenues must be recorded in the financial statements only when realised actually, until then the assets must be carried on their respective historical costs (Atrill, Harvey and McLaney, 2011). The original cost of the asset is recorded on the asset side of the statement of financial position and it remains the same till the time asset is owned by the entity. Though, the changes pertaining to obsolescence and deterioration are accounted for by providing for depreciation expense in the statement of profit and loss, distributed over the useful life of the asset. The most striking feature of this basis is that valuation is free from personal judgements and the cost transaction can be easily traced via invoices. Also the basis is cost effective iterms of its implementation and management. One of the limitations of this basis is that it does not considers the inflation rates and current economic opportunities. Therefore, historical costs tend to lose their relevance as time passes and opportunities change (Wahlen, Baginski and Bradshaw, 2017). Another limitation is that the depreciation is charged on the basis of the original asset cost, and not on the acquisition cost for the same asset. And therefore, the provision made for the replacement of the asset by way of depreciation may not be sufficient in light of inflation.

Historical cost

Replacement cost refers to the cost, an organization is required to pay in order to replace an asset today i.e. amount to be incurred to replace the current asset with a similar asset (Weil, Schipper and Francis, 2013). It does not necessarily be the same as market value of the asset; this is because replacement cost depends on the asset’s present condition of use. When assets enter into the organization, they can either take the form of original cost or the replacement cost. The adjustments for deterioration and obsolescence are made to arrive at the correct and relevant replacement costs of the assets. The steps to computing the replacement cost are described in the following segment. Firstly, determine the total cost required to be incurred for acquisition of the similar asset including the transaction costs if any. Then account for the physical damages or obsolescence in relation to the said asset in light of circumstances in which asset has the utility. Lastly deduct the amount accounted for damages or obsolescence from the cost mentioned in first step above. The replacement cost basis is backed on the grounds that while meeting cost revenue matching objective, it leads to maintenance of entity’s productive capacity.

Fair value is an exit price. In case of an asset it refers to the price that would be received to sell the asset, while in case of liabilities it refers to the amount payable for the transfer of liability (AASB, 2015). Fair value accounting is also known as the market based  accounting practice, which means that it reflects the amount an entity is required to pay to market participant for the liability to be taken over by the market participant. Quoted market prices in the active markets are the best source to determine the fair value and the same is used as the basis in this measurement. If there is an unavailability of the quoted market prices, then various valuation techniques are used to determine estimated fair value. The best information available is used to assist in determining the fair value (Graham and Carmichael, 2012). Best information available means the prices of the similar assets and liabilities in the market. Hence it can be concluded that in case of fair value accounting, value of certain assets and liabilities is measured and reported on the basis of their actual or estimated fair market prices. Various researchers support the fair value accounting approach as it leads to improvement in qualitative characteristics of the accounting information i.e. understand ability, relevance, reliability and comparability (Alaryan, Haija and Alrabei, 2014). One of the major weaknesses of the fair value measurement basis is that, it works on the presumption that the resulting fair value would be same in all the transactions between the market participants of the same market (Maynard, 2017, p. 82).

Replacement cost

Net realizable value refers to the amount a seller is expected to receive out of the sale of assets after deducting the related costs of selling of assets. For liabilities, it means the amount for which the liability can be settled, after grossing up for the settlement costs. Net realizable value or NRV can be calculated for any class or classes of assets but generally it is computed for inventory to value the inventory at lower of costs or NRV in the balance sheet.  NRV of an asset can be calculated by using the following formula.

NRV= Sale Value of an asset- Cost of sales

This is also known as hybrid approach of asset valuation because of possession of characteristics of both historical cost and current cost method of asset valuation (Wahlen, Baginski and Bradshaw, 2010). It is considered more useful than fair value because of consideration of known entity specific factors that would apply while disposing the assets, such as contractual terms, if any applicable.

Value in use is defined as the present value of future cash flows of an asset or a liability, computed by an entity using an appropriate discount rate. Thus, it represents the amount that would be derived by the entity through the continuous use of an asset, its operation and on disposal at the end of the useful life. It is a reflection of the market’s current time, liquidity and risk scenario (Walton, 2012). This measurement basis is suitable when the current value in use of an asset is less than the current replacement cost of the asset; in this case it is better to hold the asset. Conversely, when the value in use is less than the net selling price of the asset, this is not an appropriate basis for measurement, because in that scenario it would be better to sell off the asset than to use it further. And therefore, it can be concluded that it is most acceptable in the circumstance when it is greater than the net selling price but less than the current replacement cost (Pontoppidan and Andernack, 2016). One more weakness of this measurement basis is that it is a complicated method to use and requires a lot of information to arrive at correct value in use. While the more complex valuation system gives more information will lend better forecasts but there is a greater chance of error and consequently results can be misleading (Damodaran, 2011).

Fair value

In order to critically analyse the various measurement basis further, the company Starbucks Corporation has been chosen and the same has been presented in the following segment.

The two classes of noncurrent assets chosen are property, plant and equipment, and equity and cost investments. The two classes of currents assets chosen for the analysis are inventories and short term investments. In order to perform the analysis, the values have been taken from the published annual consolidated group balance sheet of financial year 2017. The net property, plant and equipment of the Starbucks Corporation, as valued on October 1^st, 2017 are $ 4,919.5 million (Starbucks, 2017). While the gross value of the property, plant and equipment is $ 11,584 million, the accumulated depreciation thereon is $ 6664.50 million, and therefore the net value. These are carried at original cost less accumulated depreciation. As stated in the balance sheet, all the direct costs such as necessary acquisition costs, internal labour charges and related overheads are capitalised in the cost of the asset. The depreciation is charged on the straight line basis over estimated useful life of the assets and the same is charged to the statement of profit and loss along with the cost of repairs and maintenance. The advantage of valuing property, plant and equipment according to historical cost basis and charging depreciation thereon is that it is less costly to maintain and simple to understand. The equity and cost investments as reported by the annual report amounts to $ 481.6 million as on October 1^st, 2017. Equity investments in which there is no scope of exercising significant influence are accounted for using the cost method of accounting. Under this method, investments are carried at cost itself till the time there is other than temporary decline in their values. In the event of such declines, adjustments are made. These are recorded as a part of the long term investments in the balance sheet. Moreover these investments are also reviewed annually to account for impairments, if any. When the circumstances indicate that the carrying value of these investments is not recoverable, and when the decline in the fair value is other than temporary, the impairment charge is provided for against the earnings of these investments.

As per the annual report of 2017, inventories are valued at $ 358.10 million (Starbucks, 2017). The same are stated at lower of cost or market value. The inventory reserves are also recorded for obsolete, slow moving inventories and possible deviation from in the physical inventory counts. The benefit and rationale of using this method to Starbucks Corporations is the conservatism approach i.e. avoidance of recording of gains and income till the time they are actually realised and consideration of losses and uncertainties today itself.  This method prevents the company from uncertainties in realisation of inventory costs pertaining to causes such as obsolescence, sudden and permanent declines in the prices, and many more. The total short-term investments of Starbucks Corporation as on October 1^st, 2017 amounts to $ 228.6 million (Starbucks, 2017). These are first entered into books of accounts on the basis of date of trade and are recorded at fair value at year end, while the unrealized gains and losses are recorded after providing for the tax effect. Unrealised gains or losses are recorded as a part of Statement of comprehensive incomes. The values of these investments are reviewed on a quarterly basis. In case of permanent unrealized losses, the same are taken into account and recorded against the earnings. The benefit of recording short term investments using this approach is that it marks the investments to the market price level at each year end and thus takes into account the unrealized gains or losses. The unrealised gains and losses of Starbucks Corporation are taken into account using the specific identification method.

Net realizable value

Thus, from the above analysis it can be concluded that there are various measurement bases available to record the assets and liabilities in the books of any entity. Each of the measurement basis has its own pros and cons and therefore selection of an appropriate measurement basis becomes vital. Also, the selection of a basis affects various elements of the financial statements, leading to overstatement or understatement of the profits in different scenarios. And hence it is the management’s responsibility to carefully assess and apply the suitable measurement basis to make the financial statements in line with the accounting framework and laws and regulations applicable and also to present a true and fair view of the state of activities of the organisation. The management is allowed to follow a mixed measurement approach for valuation of assets and liabilities, i.e. various elements of the financial statements may be valued according to different valuation bases, but the selected measurement basis should be applied consistently over the years to make the financial statements comparable over the years.

References

AASB. (2015) Fair Value Measurement. [online]  Available from: https://www.aasb.gov.au/admin/file/content105/c9/AASB13_08-15.pdf [Accessed 31/05/18].

Alaryan, L. A., Haija, A. A. A., and Alrabei, A. M. (2014) The Relationship between Fair Value Accounting and Presence of Manipulation in Financial Statements. International Journal of Accounting and Financial Reporting, 4(1), p. 224. doi: 10.5296/ijafr.v4i1.5405.

Atrill, P., Harvey, D., and McLaney, E. (2011) Accounting for Business. 3^rd ed. Oxon: Routledge, p. 445.

Berger, T. M. M. (2018) Ipsas Explained: A Summary of Standards and Principles of International Public Sector Accounting Standards. New Jersey: John Wiley and Sons.

Blundel, R., Lockett, N., and Wang, C. (2017) Exploring Entrepreneurship. 2^nd ed. Singapore: Sage Publications Asia- Pacific Pte Ltd, p. 184. 

Collings, S. (2016) UK GAAP Financial Statement Disclosures Manual. Hoboken: Wiley.

Damodaran, A. (2011) The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. New Jersey: John Wiley and Sons Inc., p. 11.

Graham, L., and Carmichael, D. R. (2012) Accountants' Handbook, Financial Accounting and General Topics. 12^th ed. New Jersey: John Wiley & Sons Inc, p. 14.38.

Greenberg, M. D., Helland, E., Clancy, N., and Dertouzos, J. N. (2013) Fair Value Accounting, Historical Cost Accounting, and Systemic Risk. Santa Monica: Rand Corporation.

Maynard, J. (2017) Financial Accounting, Reporting, and Analysis. 2^nd ed. UK: Oxford University Press, pp. 81-82.

Pontoppidan, C. A., and Andernack, I. (2016) Interpretation and Application of IPSAS. Hoboken: Wiley. p. 47.

Starbucks Corporation. (2018) Financial Data. [online] Available from: https://investor.starbucks.com/financial-data/annual-reports/default.aspx [Accessed 31/05/18].

Wahlen, J. M., Baginski, S. P. and Bradshaw, M. T. (2010) Financial Reporting, Financial Statement Analysis and Valuation: A strategic perspective. 7^th ed. Boston MA: Cengage Learning.

Wahlen, J. M., Baginski, S. P. and Bradshaw, M. T. (2017) Financial Reporting, Financial Statement Analysis and Valuation. 9^th ed. Boston MA: Cengage Learning.

Walton, P. (2012) The Routledge Companion to Fair Value and Financial Reporting. Oxon: Routledge. p. 79.

Weil, R. L., Schipper, K., and Francis, J. (2013) Financial Accounting: An Introduction to Concepts, Methods and Uses. 14^th ed. South Western Cengage Learning. p. 116.