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Accounting students are understandably keen to put numbers next to everything. But often our students don’t understand why and how numbers are attached to words in financial statements.  IFRS uses the term ‘measurement’ (rather than ‘valuation’) to describe the process of quantifying resources and obligations.

Measurement allows us to describe resources and obligations in monetary terms. It allows us to keep count of how well we are performing, to facilitate the understanding of the relative values of different resources, and to make comparisons between different businesses.

So I encourage students to understand that measurement is just one step, but an important one, in the process of deciding how to report events and transactions in the financial statements.

To put his into context, we deal first with recognition — whether there should there be an asset or liability in our accounts. See posts like this one about the elements of financial statements. Then, if the answer to that question is yes, we deal with measurement — how to quantify that asset or liability. 

Here are some examples that I use in class to illustrate measurement decisions for assets. In a later post I’ll add some examples of how I teach measurement of liabilities. 

Measurement basis

As part of the measurement process, we need to decide what basis we will use to measure our assets and liabilities — for example historical cost, market value, or a value derived from a model. The basis of measurement that we use for our assets should reflect the way in which we expect to obtain economic benefits from those assets and the basis of measurements that we use for our liabilities should reflect the way in which we expect to settle those liabilities.

Cost — vans and bonds

When my friend Mavis bought a van to deliver goods to her customers she knew that she would use up the benefits of the van over time. She estimates that it will last for five years, so after one year roughly one fifth of its benefits will have been consumed, and four fifths will be still available. So it would not make sense to include the van in the financial statements at its original cost because some of that resource has been used up. 

Our financial statements are a record of past transactions. But the information about those transactions should be relevant; it should be up-to-date so that it helps users of financial statements in their decision-making. Although we might look back to the original transaction and consider the cost of the asset at the point in time where we purchased it, we might sometimes update or modify that amount before including it in today’s financial statements. 

However, it would be no more relevant to measure the van at its current market value. On the day that Mavis purchased the van, she turned the key in the ignition and instantly reduced its market value. But that didn’t worry her because she was never planning to sell or rent out the van any time soon.  (She’s Mavis not Avis.) [1]  

We can apply the same logic to the government bonds which Mavis bought last week with the money that she had left over after buying the van. Although it would be easy to find today’s market price of the bonds that information would be irrelevant because Mavis intends not to sell those bonds but to keep hold of them until they mature, collecting the annual interest and the final repayment. (That is why IFRS effectively requires an accounting policy choice between measuring financial assets like this at either fair value or amortised cost.) [2]

Market value — buildings and shares 

Sometimes information about the market value of an asset might be more relevant than information about its cost. For example the Sankaset Hotel Corporation generates economic benefit from its hotels by renting out rooms to guests. The amount it can charge reflects the location of the hotel, how upmarket the surrounding area is, how well the local economy is doing and so on.  

And sometimes market value is the only relevant information, for example in the case of shares that we might purchase for trading hoping to make a profit when we sell those shares. Sometimes I test students by asking them if an investment in ordinary shares could be measured at amortised cost…[3]

And so to profit…

Once we have accepted that the market value of an asset is relevant information we need to remove any residual discomfort we might feel about recognising these changes as income in our financial statements. Remember income is defined in the Conceptual Framework as improvements in financial position i.e., increases in assets or decreases in liabilities.

If our assets have increased in value then our financial position has improved. That is income. We haven’t sold those assets, we haven’t converted them into cash, but we don’t need to do so to understand that they are more valuable to us. 

Of course we may decide to report different types of income differently, to improve the information given to users, to allow them to distinguish, for example, between income from sales and income from revaluations (of land, shares etc.) but that is an issue of presentation, not measurement. 

[1] The only reason she is called Mavis is so that I can make that awful joke. Word play keeps me entertained and it also helps students remember what they hear.

[2] IFRS 9 para 4.1.2. But you knew that!

[3] The answer is no because ordinary shares do not have a maturity date so you cannot calculate an effective interest rate. So ordinary shares cannot be measured at amortised cost and have to be measured at fair value.  Easy if the company is listed but a lot of work if it isn’t. 

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