Unit 6: Accounting as a Measurement Discipline – Valuation Principles, Acc. Estimates Chapter Notes | Accounting for CA Foundation PDF Download

Unit Overview

Understanding Measurement in Accounting

Measurement is a crucial aspect of accounting, as it involves quantifying transactions and events primarily in monetary terms. Any measurement discipline encompasses three fundamental elements:

1. Identification of Objects and Events: This involves recognizing the specific objects and events that need to be measured.
2. Selection of Standard or Scale: Choosing the appropriate standard or scale to be used for measurement is essential.
3. Evaluation of Dimension: Assessing the dimension of the measurement standard or scale is necessary to ensure accuracy.

(a) Prof. R. J. Chambers defined measurement as the assignment of numbers to objects and events based on specific rules regarding the property to be measured, the scale used, and the dimension of the unit. This definition highlights the core elements of measurement in accounting.
(b) Kohler further elaborated on measurement as the assignment of ordinal or cardinal numbers to the results of an inquiry or observation scheme, following logical or mathematical rules. Ordinal numbers indicate position in a sequence (e.g., first, second), while cardinal numbers indicate quantity (e.g., one, two).
(c) Chambers’ definition is widely used to assess the extent to which accounting can be considered a measurement discipline. It emphasizes the importance of identifying objects and events, selecting appropriate standards or scales, and evaluating their dimensions in the measurement process.

Objects or Events to be Measured

Accounting involves identifying, measuring, and communicating economic information to help users make informed judgments and decisions. At its core, accounting is about measuring "information."

• Decision makers require information from the past, present, and future. However, external users typically receive past information.
• There is no standard set of events and transactions in accounting that are universally needed for decision making. For instance, in cash management, various cash receipts and expenses are essential objects and events. Decision makers need data on past cash receipts and expenses, along with projected future receipts and expenses.
• When considering lending to a business, information about its ability to repay principal and interest (known as debt servicing) is crucial. This assessment includes past information, the current situation, and future projections. While past and present objects and events can be measured with a certain level of accuracy, future events and objects can only be predicted. Prediction is a vital aspect of accounting information. Decision makers must make choices about the uncertain future, for which they need appropriate information.

Standard or Scale of Measurement

In accounting, the scale of measurement is typically monetary, as per the money measurement concept. However, nowadays, quantitative information is also presented alongside monetary details.

Money as a Measurement Scale:Money does not have a universal denomination; it varies according to the currency of each country. For instance:

• India: Rupee (₹)
• United Kingdom: Pound Sterling (£)
• Germany: Deutschmark (DM)
• United States: Dollar ($)

Currency Exchange: There is no constant exchange relationship among different currencies. For example, if a businessman in India borrows $5,000 from a U.S. businessman, the transaction would be recorded in India as ₹, depending on the exchange rate at the time of the agreement.

Fluctuating Exchange Rates: If the exchange rate changes after the loan agreement (e.g., from $1 = ₹50 to $1 = ₹55), the value of the loan in Indian Rupees also changes (from ₹2,50,000 to ₹2,75,000). This illustrates that money as a unit of measurement lacks universal applicability across national boundaries due to fluctuating exchange rates.

Volatility of Money as a Measurement Scale: Since exchange rates between currencies fluctuate over time, using money as a measurement scale can also be volatile.

Dimension of Measurement Scale

• Stability Over Time: An ideal measurement scale should remain stable over time. For instance, if you buy 1 kg of cabbage today, you should receive the same quantity if you buy 1 kg of cabbage a year later. Similarly, the length of 1 meter of cloth will not change if purchased a few days later. In other words, a measurement scale should be stable in its dimension.
• Money as a Measurement Scale: Money is not a stable scale of measurement because input and output prices change continuously. The same amount of money may not be able to buy the same quantity of identical goods at different times. Therefore, information measured in money terms from one year may not be comparable with that of another year.

Example of Production and Sales: To illustrate this, consider the production and sales of a company in two different years:

• Year 1: 5,000 pcs sold at 4,500 pcs produced
• Year 2: 5,00,000 pcs sold at 5,40,000 pcs produced

At first glance, the monetary figures may suggest an 8% sales growth. However, there was actually a 10% decline in production and sales. The perceived growth in monetary figures is due to price changes.

Cost of Production: If we consider the cost of production for the two years:

• Year 1: 4,00,000
• Year 2: 4,50,000

Gross Profit Calculation: Gross profit is calculated as Sales minus Cost of Production. In the first year, the profit was ₹1,00,000, while in the second year, the profit was ₹90,000. This indicates a 10% decline in gross profit.

Conclusion: This example demonstrates that using money as a unit of measurement is not stable in dimension. Accounting often relies on money terms for measurement, which lacks universal applicability and stability over time. Therefore, it is not an exact measurement discipline.

Accounting as a Measurement Discipline

Introduction:

• Accounting is fundamentally about measuring transactions and events to create useful information for decision-making.
• Before recording and organizing data, we need to agree on how to measure it.
• This measurement is guided by certain principles or theorems.

Importance of Measurement in Accounting:

• Measurement is a crucial part of accounting because it reflects the performance of a business through profit or loss and shows its financial position.
• Accounting involves recording, classifying, and summarizing data to generate this information, but measurement is the first step.

Fundamental Accounting Assumptions:

• There are three key assumptions in accounting that guide measurement:
• Going Concern: This assumes that the business will continue to operate in the foreseeable future.
• Consistency: This means that the same accounting methods will be used over time, allowing for comparability.
• Accrual: This principle states that transactions are recorded when they occur, not when cash is exchanged.

Role of Money in Accounting:

• In accounting, all transactions and events are recorded in monetary terms.
• While quantitative information can be useful, it is secondary to monetary information.

Beyond Measurement: Other Aspects of Accounting:

• Accounting is not just about measurement. It also involves recording, classifying, summarizing, and communicating information.
• These aspects are important but fall outside the measurement discipline.

Conclusion

• While measurement is a fundamental part of accounting, it is not the only aspect.
• Accounting encompasses a range of activities aimed at providing accurate and useful financial information.

Valuation Principles

Historical Cost: This refers to the purchase price of an asset. For instance, if a businessman buys a machine for ₹ 7,00,000 and spends an additional ₹ 1,00,000 on installation, the total acquisition price is ₹ 8,00,000. Therefore, the historical cost of the machine is ₹ 8,00,000.

• Assets are recorded at the amount of cash or cash equivalent paid at the time of purchase.
• Liabilities are noted at the amount received in return for the obligation.
• Sometimes, a liability is recorded at the cash amount expected to be paid to settle it during normal business operations.
• For example, if a businessman takes a loan of ₹ 5,00,000 from a bank at 10% annual interest, this is recorded as ₹ 5,00,000, which is the historical cost of the transaction.
• In the case of income tax liabilities, which are due after a certain period, they should be recorded based on the expected amount to be paid to settle the liability.
• Companies often use historical cost for long-term assets like machinery, furniture, and licenses.

Current Cost: Consider Mr. X, who bought a machine on January 1, 2011, for ₹ 7,00,000. According to historical cost, he records the machine at ₹ 7,00,000.

• By January 1, 2022, he discovers that the current price to buy the same machine is ₹ 25,00,000.
• If Mr. X also borrowed ₹ 5,00,000 from a bank at 18% interest to be repaid at the end of 15 years, this liability is recorded at ₹ 5,00,000 based on historical cost.
• The current cost method provides an alternative way to value assets and liabilities.
• Assets are recorded at the cash amount needed if the same or equivalent asset were purchased now.
• Liabilities are recorded at the undiscounted cash amount needed to settle them right now.
• Thus, under current cost, the machine is valued at ₹ 25,00,000 and the bank loan at ₹ 5,05,000 (including the prepayment penalty).

Realisable Value: If Mr. X finds he can sell the machine for ₹ 20,00,000, the realisable value is the amount he could get from selling it now.

• The machine was bought for ₹ 7,00,000 and would currently cost ₹ 25,00,000 if purchased again.
• If Mr. X is unable to pay off his bank loan of ₹ 5,00,000immediately, the realisable value concept states that:
  • Assets should be recorded at the cash amount obtainable through a proper sale.
  • Liabilities should be noted at their settlement values—what needs to be paid to satisfy them in normal operations.
• Therefore, the machine should be recorded at ₹ 20,00,000 when sold properly, while the bank loan remains at ₹ 5,00,000 as its settlement value.
• This approach is often used for inventory, which is valued at the lower of cost and net realisable value.

Present Value: On January 1, 2022, consider that Mr. X's machine can operate for another 10 years, generating cash of ₹ 1,00,000 per year.

• He has a bank loan of ₹ 5,00,000, to be repaid by December 31, 2028, with annual interest of ₹ 90,000.
• According to present value accounting:
  • Assets are recorded at the present value of future cash inflows expected from their normal use.
  • Liabilities are recorded at the present value of future cash outflows needed to settle them.
• The concept of present value is important for accounting for investments and loans.
• The time value of money indicates that money today is worth more than the same amount in the future.
• For example, ₹ 100 today is not equal to ₹ 100 a year later due to the time lost.
• To compare future money with present money, future amounts need to be discounted.
• The compound interest formula: A = P (1 + i)n helps illustrate this relationship.Using the equation one can find out the present value if he knows the values of A, i and n.
  Suppose i = 20%, now what is the present value of ₹ 1,00,000 to be received as on 31.12.2022 (Take 1.1.2022 as the time of reference).

Similarly

Total of all these present values is ₹ 4,19,246. Since the machine purchased by Mr. X will produce cash equivalent to ₹ 4,19,246 in terms of present value, it is to be valued at such amount as per present value measurement basis.
Here, Mr. X will receive ` 1,00,000 at different points of time-these are cash inflows. In the other example, he has to pay interest and principal of bank loan-these are cash outflows.
Perhaps you also know the annuity rule:
Present value of an Annuity or Re. A for n periods is
A = Annuity
i = interest
t = time 1, 2, 3, ..........n

Applying this rule one can derive the present value of ₹ 1,00,000 for 10 years @ 20% p.a.

Similarly, the present value of bank loan is

= ₹ 2,69,155 + ₹2,00,939= ₹ 4,70,094
Thus, we get the four measurements as on 1.1.2022:

The accounting system we will cover in the upcoming chapters is known as historical cost accounting. However, this does not imply that only the historical cost basis will be used. As we progress through the CA course, we will explore various measurement bases, but traditionally, most transactions and events are recorded using historical cost.

Measurement and Valuation

• Value refers to the benefits derived from objects, abilities, or ideas. For economists, value represents the utility or satisfaction an economic resource provides to an individual considering its use. In accounting, value is expressed in monetary terms, using money as a surrogate measure. For example, when an individual buys a car for ₹2,50,000, the value lies in the future satisfaction the individual will derive from using the car.
• Economists often use an ordinal scale to indicate levels of satisfaction, while accountants use cardinal scales. The price paid for the car, ₹2,50,000, represents one type of value known as acquisition cost or historical cost. Therefore, value is indicated by measurement, and in accounting, it is always measured in monetary terms.

Understanding Accounting Estimates

• In the previous section, we discussed how to measure transactions that have already occurred, involving payment or valuation principles. However, there are instances where certain items need to be recorded in the books of accounts despite not having occurred yet, such as provisions for doubtful debts. In such cases, reasonable estimates based on the current situation and past experiences are necessary.
• The measurement of assets and liabilities often relies on estimates of uncertain future events. Due to the inherent uncertainties in business activities, many financial statement items cannot be measured precisely and can only be estimated. Therefore, management makes various estimates and assumptions regarding assets, liabilities, incomes, and expenses when preparing financial statements.
• These estimates are crucial for determining factors like depreciation, amortization, impairment losses, accruals, provisions, and employee benefit obligations. Additionally, estimates may be needed for bad debts, useful life and residual value of plant and machinery, and inventory obsolescence. The estimation process involves making judgments based on the most recent information available.

Revising Estimates: An estimate may need to be revised if there are changes in the circumstances on which it was based, or due to new information, increased experience, or subsequent developments. A change in accounting estimate refers to the difference between previously estimated parameters and re-estimated figures during the current period, or actual results achieved in the current period.

Examples of Accounting Estimates

1. Development of Patent:. company spends ₹10,00,000 on developing a patent and needs to estimate the number of years the patent will benefit the company. This estimation should be based on the latest information and logical judgment.
2. Long-Term Construction Contracts:. company involved in long-term construction contracts uses the percentage of completion method to recognize revenue at the end of the accounting year. This method requires making provisions for unforeseen contingencies that may arise during the remaining portion of the contract. Since provisioning for unseen contingencies involves estimation, there may be instances of excess or short provisioning, which will be adjusted in the period when recognized.
3. Tax Provisions: Companies need to make provisions for taxes based on estimates. There can be differences in interpretation regarding what expenses are acceptable, which may lead tax authorities to either accept or reject certain expenditures. This can result in different tax liabilities for the company.
4. Change in Estimate: For example, consider Company XY Ltd, which purchased a machine for ₹10 lakhs in 2021. The procurement head estimated that the machine would provide benefits for the next 10 years. However, after 3 years of use, the machine became obsolete due to the availability of new technologies that offer better productivity. As a result, the expected useful life of the machine has now been reduced to an additional 3 years. This situation illustrates a change in the estimate of the machine's useful life.