More tips on teaching measurement

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.

In a previous post I shared some examples that I use in class to illustrate measurement decisions for assets.  Here I will suggest examples that can be used to teach measurement of liabilities.  

Performance obligations

A typical business, Big Operations plc, will have some performance obligations — promises that the company has made to customers to deliver goods or services. And these will be measured at the value of those goods or services, using the transaction price to determine the value.

Discussing performance obligations like this also nicely illustrates income which is explored in more detail in this post. As Big Operations plc delivers the goods or services to its customers (i.e., fulfils its obligations) so it reduces its outstanding liability. And a reduction in liabilities is shown as income, in this case sales revenue. 

In the language of the Conceptual Framework, income is recognised as the liability reduces. (In fact performance obligations like this are sometimes labelled ‘deferred revenue’ in the statement of financial position because they will result in revenue in a future accounting period.) 

Financial obligations

Big Operations plc also has some financial obligations. A few years ago it issued some bonds as a way of raising finance. Since then the world has changed: the economic situation has deteriorated and the business suffered a significant fall in sales volumes.

Lending money to Big Operations plc is much more risky now than it was a few years ago  and so the market value of Big Operations plc’s bonds has fallen. While this makes it more expensive for the company to borrow more money it does mean that it could redeem those existing bonds at a lower amount (bond holders see them as less attractive so they will be relatively happier to offload them and get the cash). In other words the value of the company’s liabilities has fallen.  

We may feel a bit unsure about recording income arising from a worsening of our credit rating…but this is consistent with faithful representation. There will be other things happening as well of course but this particular effect of this particular change is inescapable.

Big Operations plc can now redeem those bonds at lower cost and in fact the shareholders will benefit if it does so. The liabilities of the business can be extinguished more cheaply than before and so in relative terms this has made the shareholders better off. Of course we will only measure our liabilities at fair value if that reflects the way in which that liability will be settled.

Income that arises from a remeasurement of liabilities does not feel like the same kind of profit made from buying and selling goods and services. And so IFRS requires that that this particular type of income is included in other comprehensive income rather than profit or loss. But this is a question of presentation, rather than measurement. 

When teaching measurement,  I emphasise to students that measurement is different from valuation — only assets are valuable (because they are resources that we will use) but anything can be measured [1]. And in fact, anything that we want to appear on the face of the balance sheet must be measured. That is why measurement is so important — it is the logical result of recognising assets or liabilities and a pre-requisite to presenting them in the financial statements. 

[1] For a longer justification of this rather sweeping statement I recommend Douglas W. Hubbard’s excellent book ‘How to Measure Anything’ available here: https://amzn.to/3MdwCCz