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Chapter 5 - Measurement Theory

THEORY IN ACTION

Theory in Action 5.1 ‘True and fair’ and ‘fair value’ — accounting and legal-o’-the-wisps

1. What do you think the authors mean by a principles-versus a rules-based system of


accounting
The authors means to compare between the principle based and the rules based and to found how
specific a standard is in regulating the preparation of financial statements in accounting system.

2. What are the measurement problems they allude to?


The measurement problems that they allude to is the fair value measurement, because the
definition of fair value itself is left ambiguous primarily because there are no discussion of the
underlying conceptual framework of valuation which has been fully explored elsewhere in
professional literature using the concept of “deprival and relief value”). It is not clear whether the
board has come to a view on these conceptual issues and now the board is merely avoiding these
issues

3. What does Macve mean by the underlying conceptual framework? What problems does
he see with a fair value approach

the underlying conceptual framework is a basic framework that provides an explanation of the
nature of the elements of financial statements, their limitations, and the main objectives of
reporting. Macve sees that the absence of underlying conceptual frameworks causes ambiguity in
valuation methods.

4. Do you think there is any difference between measures and values?


Yes there is difference between measures and values. What is meant by “value” is economic
benefits which are expected to be generated by an asset / cash generating unit. While “measures”
are the monetary unit of an element displayed in financial statements.

Theory in Action 5.2 Capital or income?

1. Why is the measurement distinction between capital and income important?


If it is associated with the purpose of financial reporting: decision-usefulness, then it becomes
important because capital and income provide different information.

2. What do you think is the real financial capital maintenance and what is physical capital
maintenance?
In the concept of financial capital maintenance, capital is defined as the amount of investment
invested in the company. Meanwhile, according to physical capital maintenance, capital is the
company's ability to produce goods / services.
3. Is the increase in the value of a house you live in income or capital? Provide
explanations.
If capital is defined as net assets (Asset - Liability) and income is defined as capital difference
(Capital0 - Capital0-1), then the addition of the house value used alone is a component of capital,
because it results in the addition of net assets.

4. Does your answer to question 3 change if your house is an investment property? Give
reason for your answer.
No, because the difference lies only in the purpose of property ownership, but the understanding
of capital and income remains the same.

Questions

1. Technically, what do we mean when we say ‘X was measured’?

First of all, we know that properties or characteristics of things are measured. That is, we do not
measure people, but we might measure their weight or height. When we say, ‘X was measured’,
we mean that a number (numeral) has been assigned to X according to certain rules governing the
property, of which X is one. Therefore, X must be a characteristic of something. The number
system used reveals the relationships involved, of which X is one. For example, if X is the
income of Y Company, we mean that a number such as $115 000 has been assigned according to
the accounting rules for determining income. The number system employed, having to do with
dollars in this case, reveals the relative relationship of the $115 000 figure to other income
figures.

2. How is a scale related to the process of measurement?

To measure is to establish a scale — that is, every measurement is made on a scale and the set of
operations used to assign the numbers creates a scale. The type of scale depends on the rule(s)
that have been formulated to relate the numbers and the property of the things being measured. A
scale shows how much information the numbers represent; it gives meaning to the numbers. For
example, to measure the income of Y Company we follow the accounting rule on how this is to
be done. By following these accounting rules, a scale is created in dollars, which relates the
number (say $115 000) to the property being measured (income). The scale used in accounting is
historical dollars.

3. Describe the following scales: nominal, ordinal, interval, ratio. Give an example of each.
Which scales are applied in accounting and where?

 Nominal scale. Numbers are used as labels or names. The number does not indicate a quality
or characteristic of the thing measured. The numbering of football players is a simple
example. The use of this scale does not constitute an act of measurement.
 Ordinal scale. The number assigned to each object of a set indicates its rank order with
respect to a given property. An example is the assignment of numbers to investment
alternatives according to their profitability (rate of return); or the assignment of numbers to
candidates for a certain job according to the measurer’s preference. The weakness of this
scale is that the intervals between the numbers are not necessarily equal, and the number does
not indicate the ‘quantity’ of the property.
 Interval scale. For an interval scale, the numbers show the rank order of the objects with
respect to a given property, but unlike the ordinal scale the distance between the numbers is
equal and is known. A ‘zero’ point is selected arbitrarily. An example is the Fahrenheit scale
of temperature, where the freezing point (the ‘zero’ point) is arbitrarily set at 32 degrees. The
weakness of the interval scale is that the zero point is arbitrarily established. In accounting,
standard costs are based on an interval scale, since the ‘capacity’ is arbitrarily selected.
 Ratio scale. The ratio scale conveys the most information. A ratio scale is one where:
- the rank order of the objects with respect to a given property is known
- the intervals between the objects are equal and are known
- a unique origin or a natural zero point exists.
An example is the measurement of length. Zero is naturally no length. Another is the use of
dollars to represent cost or value — zero is naturally no cost or value.

Ratio scales are applied to accounting. All measures used in the financial statements have a
natural origin ($0.00). Intervals between measurement units are identical amounts of currency,
and are known. And the rank order of the objects or events measured with respect to their values
is known. However, to the extent that different measurement methods are applied — historical
cost, net realisable value and present value, for instance — the scale is the same. But while the
scale is ratio, the relative measures are not always meaningful because the attributes being
measured are not the same.

4. Determine whether the following statements are correct and state why:
(a) The historical cost of inventory is $60 000 at year-end. When it is converted to
constant end-of-year dollars by multiplying by 110/100 to get $66 000, the $66 000 is
still the historical cost of the inventory.
(b) Last month the quantity variance was determined to be $12 000 favourable, and this
month it is $24 000 favourable: therefore, the efficient use of materials has been doubled.
(c) On the basis of saving income tax, Company X ascertained that the double-
declining-balance depreciation method is better than the straight-line method. By
using the double-declining-balance method for depreciation rather than the
straight-line method, Company X saved $10 000 in income tax this year; therefore,
the former method is 10 000 times better than the latter.
(d) On the basis of the amount of assets, we can say that Company X is twice as large as
Company Y, because its total assets amount to $1 000 000 compared with $500 000
for Y.

(a) Correct. A ratio scale is used, and thus it remains invariant over all transformations when
multiplied by a constant, which in this case is 110/100. The invariance of the scale makes the
rule (historical cost) the same even though the scale is expressed in different units, such as
from nominal dollars to constant end-of-current year dollars. However, the value of inventory
may or may not have appreciated at the same level as general inflation. Therefore this scaling
is not an appropriate measurement tool for assets but is a base that can be used as a
benchmark for the maintenance of purchasing power.

(b) Incorrect. Variances are based on an interval scale, because the ‘zero point’ is arbitrarily
selected — that is, it is not natural. The efficiency basis (capacity) could be theoretical,
average, practical or normal. One of these is selected by the company according to its
preference. For the interval scale, we cannot multiply or divide with respect to the particular
numbers. For example, if the temperature in a given room is 40 degrees Fahrenheit and in
another room it is 80 degrees Fahrenheit, we cannot say the second room is twice as hot as
the first. It is not mathematically permissible and empirically misleading. In this particular
case, the point of ‘no efficiency’ is a matter of conjecture; it is not measurable by variance
analysis.

(c) Incorrect. An interval scale is being used to determine which method is ‘better’ for saving
income taxes. For the reasons given in (b) above, Company X cannot say the double-
declining-balance method is 10 000 times better than the straight-line method.

(d) Correct, in theory. A ratio scale is used where zero means no value. For a ratio scale, it is
correct to multiply and divide the numbers (that is, to speak in ratio terms). However, we
know that, technically, because of inflation (or deflation) the dollars of the historical costs are
not the same comparatively over the years, and therefore this causes a problem. We can
correct this problem by adjusting for the change in the specific value of the assets. The
statement would be correct without qualification if the two companies purchased their assets
on the same day and those assets were exactly the same (with the same usage).

5. Describe the following types of measurement: fundamental, derived, fiat. In what sense
are fiat measurements ‘weak’? What type of measurement is inventory costing?

Fundamental measurement is one where the numbers can be assigned to properties based on
natural laws (confirmed empirical theories), and which does not depend on the measurement of
any other variable. Examples are length, electrical resistance, number and volume.

According to Campbell, derived measurement is one that depends on the measurement of two or
more quantities. However, perhaps it is better to say that it depends on at least one other quantity.
In any event, the measurement is still based on natural law. An example is density, which is
based on the measurements of mass and volume. An example in accounting is income, which
uses asset values as a basis to estimate cost (depreciation, bad debts, etc.).

A fiat measurement is one that depends on an arbitrary or stipulated definition rather than on a
confirmed theory. The weakness is that because there is no confirmed theory underlying the
measurement, there can be numerous ways to construct a scale for the measurement of the given
property. For example, there are different ways to measure income. Which is the proper or best
way? This type of measurement is prevalent in accounting. This basis was formulated by social
scientists in order to justify the measurements in the social sciences; otherwise, there can be no
measurement. There are some who do not believe in fiat measurement, and therefore question the
use of the term ‘measurement’ in accounting and the social sciences. If accounting theory can be
empirically validated, then instead of fiat measurements, we can have fundamental
measurements.

Inventory is a derived measure from fiat.

6. What are the sources of error in measurement?

All measurements involve errors. The sources of error are:


 Measurement operation (rule to assign numbers) stated imprecisely.
 Measurer. The measurer may misinterpret the rule, or be biased, or apply or read the
instrument incorrectly.
 Instrument. The instrument may be flawed. The instrument could be physical (for example, a
thermometer) or something abstract (such as a chart, graph or index or accountant’s
judgement).
 Environment. The setting in which the measurement operation is performed can have an
effect on the result, such as weather conditions, noise, pressure exerted by other people, or
imperfect or numerous markets.
 Attribute unclear. What is to be measured may be unclear. For example, is the value of an
asset the present value, acquisition cost, current cost or selling price?

7. Explain whether the following statements are facts:


(a) Canberra is 320 kilometres from Sydney.
(b) Depreciation expense for Kambah Pty Ltd for 2001 was $1 294 000. (This is the
amount reported on the statement of financial performance.)
(c) Smoking leads to lung cancer.
(d) Sales revenue for Telex Ltd for 2002 was $2 800 000. (This is the amount reported
on the statement of financial performance.)
(e) Equipment (net of accumulated depreciation of $400 000) for McNair Ltd for 2000
was worth $1 800 000. (This is the amount reported on the statement of financial
position.)

(a) Since all measurements involve error, the question is: How much error are we willing to
accept? This depends on the purpose of the measurement. The statement, for general
purposes, can be considered factual. Canberra is, roughly speaking, 320 kilometres from
Sydney.

(b) Unlike the first statement, which had to do with length (a fundamental type measurement),
this statement pertains to economic cost or value. This involves a fiat type measurement.
Accuracy of a measurement relates to how close a number is to the ‘bull’s eye’ (the true
standard). In a fiat type measurement, we do not have supporting evidence on the true
standard, and so we cannot really say that $1 294 000 represents the true amount of
depreciation, or how close it is to the true amount. The figure is simply that which is derived
by use of generally accepted accounting methods. The statement is a factual statement in the
sense that the amount was actually reported by Kambah Pty Ltd. But whether the amount is
the ‘true’ amount, no-one knows. There is no objective, empirical evidence supporting the
accounting measurement of depreciation. This question reveals one weakness of applying fiat
measurements.

(c) There is empirical evidence to support the statement, but whether the evidence is persuasive
is a matter of judgement. For some, the evidence is very persuasive; for others, it is not. The
statement reveals the probability character of general statements. First, nothing is mentioned
about the amount of smoking. The implication is that the greater amount of smoking (say,
five packs of cigarettes a day as opposed to one pack), the truer the statement. Second, actual
evidence will show that there are specific individuals who smoke, say, 10 packs of cigarettes
a day and have done so for 50 years and have not yet contracted lung cancer. Yet, this does
not necessarily negate the statement. The statement is a statistical one, appropriate to a large
number of people. In reference to a particular person, this entails ‘subjective probabilities’.
The theory of subjective probabilities is not presently supported mathematically. Considering
the statistical nature of the statement, it can be regarded as factual if we believe the evidence
is sufficiently persuasive.

(d) Although the amount is derived by accounting methods, unlike the statement on depreciation
in (b) above, this statement is based on observable data that can be verified. Assuming that
this verification has been made by the auditors, this statement is factual.

(e) Because the amount of $1 800 000 is mixed with accumulated depreciation, it cannot be
accepted as a factual statement of market value except in the sense that it is the amount
reported by McNair. The term ‘worth’ is used, which implies that the equipment can be sold
for $1 800 000. It is doubtful that the book value is the same as the market value of the
equipment. It is not a statement of fact with regards to value unless this is the case. The
verifiable facts are that the equipment was purchased at a cost of $1 800 000 and that after
amortising depreciation its book value is $400 000.

8. What is the difference between accuracy and reliability in measurement? How are these
notions related to the testing of a theory?

Reliability refers to the proven consistency of a measurement or the operations from which the
measurement is derived. We can speak of a measurement (the number) being reliable, or of the
set of operations (instrument) being reliable. In statistics, reliability refers to the agreement of the
results — consistency — among repeated application of the operation to a large number of cases.
In statistics, the variable must be random; therefore, reliability relates to the random error in
measurement, the unsystematic error component. If the random error is minimal, then the
measurement is reliable.

Reliability does not necessarily lead to accuracy. The reason is that accuracy has to do with how
close the measurement is to the ‘true value’ of the attribute measured. In statistics, the true value
is presented by the mean. In accounting, ‘true value’ pertains to the pragmatic notion of
usefulness, which is expressed in the objective of accounting. Because the term ‘accuracy’ is so
often misunderstood, the term ‘validity’ has been suggested to denote the same idea.
We can speak of a valid measurement in the sense that it is appropriate for the stated purpose —
that is, the measurement hits the ‘bull’s eye’ or is sufficiently close to it. Another way of putting
it is to say the measurement is relevant. Accuracy or validity relates to the relevance of
accounting information.

The testing of a theory involves the determination that the numbers involved in the theory are
reliable and accurate (valid). In accounting, we say that the data must be reliable and relevant —
that is, useful.

9. Discuss whether accounting measurement is fiat or fundamental. Can accounting


numbers ever be related to fundamental values? If so, what are they?
This question underlies a good deal of the debate in accounting theory and will provoke a
number of different answers from students. The tutor should lead discussion according to the
response of students. Some discussion points are:
 Accounting measurement, to a great degree, is determined by fiat, and is generally imposed
on society by accountants or government committees dominated by accountants.
 However, accounting outputs must have some fundamental value because there is a
correlation between outside referents such as stock prices, current prices, expected future
cash flows and risk.
 Accounting theorists cannot agree on fundamental value because it changes according to the
nature of the asset, the use of the asset and the use to which the demanded value is put. Is it
historical cost, buying price, selling price, discounted value or a variant of these?
 Some empirical researchers have examined these values to try and determine which ones are
more reliable or have the highest correlation with market or stock prices.

Case Study 5.1 — 12 ways to value intangibles and brands

1. Evaluate the advantages and disadvantages of each suggested measurement technique.


Tutors should note that all methods of valuing brands and intangibles are highly subjective,
because by their very nature they must be estimates of future cash inflows. Some observations on
each method follow:
 Net present value. This technique is derived from finance and requires the valuer to estimate
the proportion of future cash flows (or earnings) attributed to the brand and its impact on
risk. You need to question how to sort out the relative cash flows and how to derive the
discount rate.
 CAPM. CAPM will provide the discount rate to apply to the NPV method, but requires stock
prices to estimate. Most firms are not listed, and this requires the valuer to use a surrogate for
unlisted firms (such as a similar firm that is listed).
 Cost of creation. This, in its simplest form, just means adding up all the costs of creating a
brand. But some costs are sunk, some are irrelevant and some should be expensed.
 Market based comparisons. Comparisons with listed brand values used by other corporations
are valid if the techniques used by them are also valid and the asset being compared is the
same. This technique may be acceptable for tangible assets, like land or buildings; but
intangibles are not strictly comparable and values are subjective.
 Royalty relief method. This method is valid if the brand can be leased or licensed because the
payments are incremental cash flows. However, the market for these is limited and cash flow
payments are unique to individual brands or intangibles.
 Relative value. This method is subjective and qualitative, and difficult to estimate
quantitatively.
 Balanced scorecard. This method adds additional (mostly) qualitative measures. It enables
the valuer to obtain a greater sense of the brand’s worth, but does not provide value by itself.
 Competency models. These suffer from the subjective problems of determining who are the
most successful employees determining market value.
 Benchmarking. This provides an assessment of your performance against market leaders, but
does not provide a market value. It assumes that the scorecard can be linearly transposed.
 Business worth. Again, this technique provides benchmarks and has the same problems.
 Business process auditing. This method is subjective and lacks structure.
 Knowledge bank. This involves valuation by fiat that simply reverses the rules of accounting.

2. Make a recommendation as to which measurement technique should be used.

The most structured technique is the use of a discounted net present value model that applies
CAPM to estimate the discount risk rate (techniques 1 and 2). These techniques are grounded in
finance theory and the theory of diversification. It is suggested that the economic value-added
model is the most appropriate model to apply to intangibles (see chapter 9 and the Ohlson
model).

3. Would you consider using more than one measurement technique? Why or why not?

Yes. Given the subject nature of the estimations, the more information gleaned the better the feel
for the ultimate value. The use of qualitative factors — such as perceived customer loyalty,
retention rates of staff, demand for staff, intellectual property, internal business processes and
relative value — provide support for your ultimate calculations.

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