Accounting — Accounting as a Measurement Discipline - Valuation Principles, Accounting Estimates

Figure 1: Measurement is a vital aspect of accounting — transactions and events are measured in terms of money.

Learning Outcomes

Understand the meaning of measurement and its basic elements.
Know how far accounting is a measurement discipline if considered from the standpoint of the basic elements of measurement.
Distinguish measurement from valuation.
Learn the different measurement bases namely historical cost, realizable value and present value.
Understand the measurement bases which can give objective and valuation to transactions and events.
Understand that the traditional accounting system mostly uses historical cost as measurement base, although in some cases other measurement bases are also used.

6.1 Meaning of Measurement

Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of money.
Any measurement discipline deals with three basic elements of measurement:
- Identification of objects and events to be measured;
- Selection of standard or scale to be used;
- Evaluation of dimension of measurement standards or scale.

DEFINITION — PROF. R.J. CHAMBERS

"Measurement" as "assignment of numbers to objects and events according to rules specifying the property to be measured, the scale to be used and the dimension of the unit".

(R.J. Chambers, Accounting Evaluation and Economic Behaviour, Prentice Hall, Englewood Cliffs, N.J. 1966, P.10)

DEFINITION — KOHLER

Measurement as "the assignment of a system of ordinal or cardinal numbers to the results of a scheme of inquiry or apparatus of observations in accordance with logical or mathematical rules".

(A Dictionary of Accountant)

ORDINAL vs CARDINAL NUMBERS

Ordinal numbers: Used to denote position in an ordered sequence: first, second, third, fourth, etc.
Cardinal numbers: Says 'how many there are': one, two, three, four, etc.

Chambers' definition has been widely used to judge how far accounting can be treated as a measurement discipline.
According to this definition, the three elements of measurement are:
- (1) Identification of objects and events to be measured;
- (2) Selection of standard or scale to be used;
- (3) Evaluation of dimension of measurement standard or scale.

6.2 Objects or Events to be Measured

Accounting essentially includes measurement of 'information'.
Decision makers need past, present and future information. For external users, generally the past information is communicated.
There is no uniform set of events and transactions in accounting which are required for decision making.
Past and present objects and events can be measured with some degree of accuracy but future events and objects are only predicted, not measured.
Prediction is an essential part of accounting information. Decision makers have to take decisions about the unseen future for which they need suitable information.

6.3 Standard or Scale of Measurement

In accounting, money is the scale of measurement (see money measurement concept), although quantitative information is also communicated along with monetary information.
Money as a measurement scale has no universal denomination. It takes the shape of currency ruling in a country:
- India — Rupee (₹)
- U.K. — Pound Sterling (£)
- Germany — Deutschmark (DM)
- United States — Dollar ($)
There is no constant exchange relationship among the currencies.

EXAMPLE — EXCHANGE RATE FLUCTUATION

If a businessman in India took loan $5,000 from a businessman in the U.S.A., he would enter the transaction in his books in terms of $1 = ₹50. Then loan amounted to ₹2,50,000.
Afterwards the exchange rate changed to $1 = ₹55. At the changed exchange rate, the loan amount becomes ₹2,75,000.
So money as a unit of measurement lacks universal applicability across the boundary of a country unless a common currency is in vogue.

6.4 Dimension of Measurement Scale

An ideal measurement scale should be stable over time.
Money as a scale of measurement is not stable. There occurs continuous change in the input-output prices. The same quantity of money may not have the ability to buy same quantity of identical goods at different dates.
Thus information of one year measured in money terms may not be comparable with that of another year.

EXAMPLE — COMPARABILITY ISSUE

	Year 1	Year 2
Sales	5,000 pcs — ₹5,00,000	4,500 pcs — ₹5,40,000
Cost of Production	5,000 pcs — ₹4,00,000	4,500 pcs — ₹4,50,000
Gross Profit	₹1,00,000	₹90,000

Looking at monetary figures one may be glad for 8% sales growth. In fact there was 10% production and sales decline. The growth envisaged through monetary figures is only due to price change.

Thus, Accounting measures information mostly in money terms which is not a stable scale having universal applicability and also not stable in dimension for comparison over time. So it is not an exact measurement discipline.

6.5 Accounting as a Measurement Discipline

Accounting is meant for generating information suitable for users' judgments and decisions. But generation of such information is preceded by recording, classifying and summarising data.
By that process it measures performance of the business entity by way of profit or loss and shows its financial position.
Accounting profession earmarked three theorems as fundamental accounting assumptions:
- Going Concern
- Consistency
- Accrual
Recording, classifying summarising and communication of information are also important part of accounting, which do not fall within the purview of measurement discipline. Therefore, we cannot simply say that accounting is a measurement discipline.
But in accounting money is the unit of measurement. All transactions and events are to be recorded in terms of money only. Quantitative information is only supplementary to monetary information.

6.6 Valuation Principles

There are four generally accepted measurement bases or valuation principles:

(i) Historical Cost
(ii) Current Cost
(iii) Realizable Value
(iv) Present Value

Historical Cost

It means acquisition price. According to this base, assets are recorded at an amount of cash or cash equivalent paid at the time of acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for the obligation.
Companies usually apply historical cost method in case of long-term assets like machinery, furniture, licenses etc.

Current Cost

Assets are carried out at the amount of cash or cash equivalent that would have to be paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

Realizable Value

Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the assets in an orderly disposal.
Liabilities are carried at their settlement values — the undiscounted amount of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Realizable value concept is commonly applied in case of inventories. Inventories are measured at the lower of cost and net realizable value.

Present Value

An asset is carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business.
Liabilities are carried at the present discounted value of future net cash outflows that are expected to be required to settle the liabilities.
The concept of Present Value is common in case of accounting for investments and loans.

FOUR MEASUREMENT BASES — COMPARISON

Historical Cost: Acquisition price
Current Cost: Cost to acquire currently
Realizable Value: Amount from orderly sale
Present Value: Discounted value of future cash flows

EXAMPLE — FOUR MEASUREMENTS

Suppose a machine purchased on 1.1.2011 at ₹7,00,000 and a bank loan of ₹5,00,000 taken on the same date.

	Historical Cost (₹)	Current Cost (₹)	Realizable Value (₹)	Present Value (₹)
Asset: Machine	7,00,000	25,00,000	20,00,000	4,19,246
Liability: Bank Loan	5,00,000	5,05,000	5,00,000	4,70,094

The accounting system which we shall discuss in the remaining chapters is also called historical cost accounting.
This need not mean that one shall follow only historical cost basis. The accounting system uses all types of measurement bases although under the traditional system most transactions and events are measured in terms of historical cost.

6.7 Measurement and Valuation

Value relates to the benefits to be derived from objects, abilities or ideas.
To the economist, value is the utility (satisfaction) of an economic resource.
In accounting, to mean value of an object, abilities or ideas, a monetary surrogate is used. That is to say, value is measured in terms of money.
Economists often use ordinal scale to indicate the level of satisfaction. But accountants use only cardinal scales.
In accounting the value is always measured in terms of money.

6.8 Accounting Estimates

Certain items have not occurred therefore cannot be measured using valuation principles, still they are necessary to record in the books of account, for example, provision for doubtful debts.
For such items, reasonable estimates based on the existing situation and past experiences are made.
The measurement of certain assets and liabilities is based on estimates of uncertain future events. As a result of uncertainties, many financial statement items cannot be measured with precision but can only be estimated.

AREAS REQUIRING ACCOUNTING ESTIMATES

Computation of depreciation, amortisation and impairment losses
Accruals, provisions and employee benefit obligations
Determining bad debts
Useful life and residual value of plant and machinery
Inventory obsolescence

An estimate may require revision if changes occur regarding circumstances on which the estimate was based, or as a result of new information, more experience or subsequent developments.
Change in accounting estimate means difference arises between certain parameters estimated earlier and re-estimated during the current period or actual result achieved during the current period.

EXAMPLES — ACCOUNTING ESTIMATES

Example 1: A company incurs expenditure of ₹10,00,000 on development of patent. The company must estimate for how many years the patent would benefit the company.
Example 2: A company dealing in long-term construction contracts uses percentage of completion method and must make provisions for unseen contingencies.
Example 3: Provision for taxes based on estimation due to interpretational differences with tax authorities.
Example 4: Company XY Ltd purchases a machine for ₹10 lakh in 2021 expected to offer benefits for 10 years. After 3 years, the machine becomes obsolete. This is a change in estimate in the useful life of the machine.

Summary

Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of money.
There are three elements of measurement:
- (i) Identification of objects and events to be measured;
- (ii) Selection of standard or scale to be used;
- (iii) Evaluation of dimension of measurement standard or scale.
There are four generally accepted measurement bases or valuation principles:
- (i) Historical Cost;
- (ii) Current Cost;
- (iii) Realizable Value;
- (iv) Present Value.

Test Your Knowledge

True and False

1. There are four generally accepted measurement bases: (i) Historical Cost; (ii) Current Cost; (iii) Realizable Value; (iv) Future Value. False
2. Historical Cost means price paid at time of acquisition. True
3. As per future value, assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the assets in an orderly disposal. False
4. At Present value, liabilities are carried at the value of future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. False
5. ABC purchased a machinery amounting ₹10,00,000 on 1st April, 2001. On 31st March, 2022, similar machinery could be purchased for ₹20,00,000. Historical cost of machine is ₹20,00,000. False
6. ABC purchased a machinery amounting ₹10,00,000 on 1st April, 2001. On 31st March, 2022, similar machinery could be purchased for ₹20,00,000. Current cost of machine is ₹20,00,000. True
7. Change in accounting estimate has to be given retrospective effect. False

Multiple Choice Questions

1. (i) Measurement discipline deals with	(a) Identification of objects and events. (b) Selection of scale. (c) Both (a) and (b)
(ii) All of the following are valuation principles except	(a) Historical cost. (b) Present value. (c) Future value
(iii) Book value of machinery on 31st March, 2022 ₹10,00,000. Market value as on 31st March, 2022 if sold ₹11,00,000. As on 31st March, 2022, if the company values the machinery at ₹11,00,000, which valuation principle is being followed?	(a) Historical Cost. (b) Present Value. (c) Realizable Value
2. Mohan purchased a machinery amounting ₹10,00,000 on 1st April, 2001. On 31st March, 2022, similar machinery could be purchased for ₹20,00,000 but the realizable value of the machinery was estimated at ₹15,00,000. The present discounted value of future net cash inflows was calculated as ₹12,00,000.
(i) The current cost of the machinery is	(a) ₹10,00,000 (b) ₹20,00,000 (c) ₹15,00,000
(ii) The present value of machinery is	(a) ₹10,00,000 (b) ₹20,00,000 (c) ₹12,00,000
(iii) The historical cost of machinery is	(a) ₹10,00,000 (b) ₹20,00,000 (c) ₹15,00,000
(iv) The realizable value of machinery is	(a) ₹10,00,000 (b) ₹20,00,000 (c) ₹15,00,000

High-Yield Interactive Quiz — Accounting as a Measurement Discipline

Q1. Which of the following is NOT an element of measurement according to Chambers' definition?

Correct Answer: C. The three elements of measurement are: (1) Identification of objects and events; (2) Selection of standard or scale; (3) Evaluation of dimension of measurement standard or scale. Classification of transactions is not an element.

Q2. In accounting, which is the scale of measurement?

Correct Answer: B. In accounting, money is the scale of measurement (see money measurement concept), although quantitative information is also communicated along with monetary information.

Q3. Historical Cost means:

Correct Answer: B. Historical Cost means acquisition price — the amount of cash or cash equivalent paid at the time of acquisition.

Q4. Which valuation principle is commonly applied in case of inventories?

Correct Answer: C. Realizable value concept is commonly applied in case of inventories. Inventories are measured at the lower of cost and net realizable value.

Q5. According to present value concept, assets are carried at:

Correct Answer: D. At Present value, an asset is carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business.

Q6. Which of the following is a fundamental accounting assumption?

Correct Answer: C. The three fundamental accounting assumptions are Going Concern, Consistency and Accrual.

Q7. Money as a scale of measurement is:

Correct Answer: B. Money as a scale of measurement is not stable. There occurs continuous change in input-output prices. The same quantity of money may not have the ability to buy same quantity of identical goods at different dates.

Q8. A change in accounting estimate is required when:

Correct Answer: C. An estimate may require revision if changes occur regarding circumstances on which the estimate was based, or as a result of new information, more experience or subsequent developments.

Q9. Which of the following is NOT a generally accepted measurement base?

Correct Answer: D. The four generally accepted measurement bases are Historical Cost, Current Cost, Realizable Value, and Present Value. Future Value is not a generally accepted measurement base.

Q10. At present value, liabilities are carried at:

Correct Answer: C. At Present value, liabilities are carried at the present discounted value of future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Q11. Which of the following would be considered a change in accounting estimate?

Correct Answer: B. Changing the estimated useful life of a machine is a change in accounting estimate. The other options are changes in accounting policy.

Q12. The traditional accounting system mostly uses which measurement base?

Correct Answer: B. The traditional accounting system mostly uses historical cost as measurement base, although in some cases other measurement bases are also used.

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