The Essential Role of Measurement in Accounting
Accounting measurement is defined as the computation of financial activities using standardised units such as money time and etcetera (Chambers, 2015). The process involves the quantification of company information using monetary terms (IASB, 2015). Measurement plays a fundamental role in accounting. Firstly, accounting measurement provides a basis for comparing and evaluating accounting data both internally and externally. A company is able to compare its operation at different times. Evaluating accounting information in different time frames helps the investor to understand how their company operates. Also, the information evaluated in accounting measurements is used to compare one company’s performance with another company. This helps investors to make informed investment decisions.
Secondly, accounting measurement provides the basis for consistency in accounting. Despite having various measurement methods, a company sticks to one measurement method, enhancing the consistency of information. As a result, accounting measurement data is useful for creditors, investors, and economic analysts.
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Thirdly, following the principle of objectivity, accounting measurement ensures that financial accounting provides verifiable and reliable information. This eliminates cases of errors or fraud in accounting. Lastly, accounting measurement provides the basis for generally accepted accounting principles (GAAP) (Flood, 2012). Choice of GAAP assists the accountants in their prospects to determine report and determine a company’s performance without ambiguity. GAAP provides the accounting standards to be followed, thus making the work of accountants easier. GAAP standards provide consistency in accounting and help to account for consolidated and unconsolidated companies. Overall, the essential role of accounting is to provide accounting data for comparison and evaluation.
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Measurement Model Currently Adopted by Accounting Standards Setters, Reasons for Choosing the Model, and Issues Related to the Model
Accounting standard setters are responsible for creating accounting rules and guidelines to be followed in financial reporting. Accounting standard setters aim to increase accuracy and consistency in financial reporting, thus enabling easy trading between companies even in a global business market (Rankin et al., 2012). Currently, the International Accounting Standards Board (IASB) has adopted the fair value measurement model. IASB has adopted the fair value model due to the reasons discussed below.
Reasons Why IASB has Adopted Fair Value Measurement Model
- The fair value measurement model is highly adaptable and can be used in the valuation of different assets. IASB wanted to provide a measurement model that can be alternated in the valuation of varying company assets. A company has a wide variety of assets and the fair value model is highly applicable for companies’ accounting.
- Fair value measurements promote accurate valuation due to the consideration of highly versatile prices.
- Fair value provides a realistic measure of income without conservative bias, thus avoiding overestimations.
- The fair value measurement model requires companies to disclose their assets’ real value, thus providing investors with reliable information. Fair value concentrates on equity analysis, which provides investors with information that is valuable in making investment decisions, thus avoiding major market crises.
Nevertheless, the fair value method has some issues, as outlined below.
Issues related with fair value measurement
- Susceptible to the manipulation of financial statements.
- Income is highly volatile, which causes changes in the fair value of assets within a short time. Financial reports prepared using the fair value measurement method may lose relevance within a short period.
Reasons that Prompted the Adoption of a Single Measurement Base Model
Although various measurement base models can be adopted in financial reporting, standard setters may adopt only one base, measurement model. Below are some of the reasons that may lead to adopting a single measurement base model instead of integrating various models.
- The use of a single measurement base model supports consistency (Power, 2010). The rationale is that companies operating in the same region will have similar financial reporting, thus eliminating inconsistencies that may arise from using mixed measurement approaches.
- Using a single method approach also promotes comparability. An entity can compare performance in two different periods. Also, an entity can compare performance with other entities. Using different measurement methods may lead to comparison disparities that may be challenging to identify. Comparability enables fair competition in international trade.
- Using a single measurement based method assist in the aggregation of accounting data. This enables an economic and financial analyst to evaluate and predict future market conditions. As a result, investors gain insight into market performance, which helps them make informed investment decisions. The use of mixed methods can limit accounting data aggregation and compromise analysis of the market conditions. This can lead to confusion for investors and possibly lead to a financial crisis.
Between historical cost and fair value, which measurement base model provides more relevant and reliable accounting information in practice?
The fair value measurement base model provides the most relevant and reliable accounting information better than the historical cost base model. Below are some of the reasons why the fair value base model is better than historical costs in providing accounting information.
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- Unlike historic cost, the fair value provides the transaction costs involved in incurring a liability. Information about the transaction costs involved in acquiring the liability offers a reliable basis for justifying the assets’ current price (IASB, 2018). The transaction cost can be used as proof of volatile prices. Such justification is impossible when using the historical cost base model.
- Fair value also provides information about changes in interests’ rates, risks, and estimated cash flows (IASB, 2015). Consequently, it is possible to remeasure the value of assets and liabilities, thus assisting in the valuation process. This information is relevant for accountants and can be applied while preparing financial statements. For instance, data concerning changes in interest rates provides a rationale for understanding an asset’s changing prices or a liability. Such information is not available when using the historic cost base model.
- Also, the fair value method provides price information about the cost of transferring liabilities. This provides a realistic valuation of liabilities. The historic cost method only includes information about the net costs of incurring the liability during the period of acquiring the liability without considering changes in the future.