As we discussed here, the IASB has published for public consultation proposals to improve the Conceptual Framework for Financial Reporting, with comments to be received by October 26, 2015.
As you’d expect, a large chunk of the proposals deals with measurement, noting: “consideration of the objective of financial reporting, the qualitative characteristics of useful financial information and the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities and items of income and expense.” The document describes the characteristics of historical cost and of current value measurement bases, noting some of their relative strengths and weaknesses. For example, for historical cost:
- “In many situations, it is simpler and less expensive to provide information about historical cost than information using current value measurement bases. In addition, measures prepared using the historical cost measurement basis are generally well understood and, in many cases, verifiable.
- …historical cost can be difficult to determine when there is no observable transaction price for the asset or the liability being measured. In addition, estimating consumption and identifying impairment losses or onerous liabilities can be subjective. Hence, the historical cost of an asset or a liability can sometimes be as difficult to estimate as a current value.
- On the historical cost measurement basis, similar assets or liabilities that are acquired or incurred at different times can be reported in the financial statements at very different amounts. This can reduce comparability both between reporting entities and within the same reporting entity.”
And for fair value:
- “Information given about assets and liabilities when they are measured at fair value has predictive value, because fair value reflects expectations about the amount, timing and uncertainty of the cash flows (reflecting market participants’ expectations and priced in a manner that reflects their risk preferences). It may also have confirmatory value by providing feedback about previous estimates.
- … depending on the item that is being measured and the nature of the business activities conducted by the entity, users may not always find information about estimates of changes in expectations of market participants relevant. Hence, they may not always find income and expenses measured at fair value relevant. In particular, this may be the case when the business activities conducted by the entity do not involve selling the asset or transferring the liability; for example, if assets are held solely for use or to collect contractual cash flows, or if liabilities are to be fulfilled by the reporting entity itself.”
Although the total of this inherently points to one basis being far superior to the other for certain kinds of items (for instance, to fair value as the better basis for measuring quoted equities), the document mostly leaves it to individual standards to prescribe how these factors play out in specific circumstances. This prompted a dissent from one IASB member, summarized as follows:
- “Mr. Finnegan accepts that IASB members and many stakeholders believe that both historical cost measurement and current value measurement have a predictive ability and value relevance for investors. He acknowledges that there are circumstances in which the use of historical cost measurement would produce a result that would be materially consistent with the result produced by the use of current value measurement. For example, this would be the case when assets are consumed or converted to cash shortly after being recognized. However, Mr. Finnegan believes that current value measures would be more relevant for financial statement analysis and that financial statement analysis would be easier for users if all assets and liabilities were measured using a consistent approach. Moreover, he also believes that the debate about whether historical cost provides more relevant information, that is, information les subject to measurement uncertainty compared to current value, is unlikely to be resolved on the basis of the way in which the revised Conceptual Framework is drafted.
- Mr. Finnegan is also concerned that many of the decisions regarding how to subsequently measure an asset or a liability after initial recognition derive from trying to deal with the concern about volatility in reported profit or loss, and are not based on whether the measure provides information with the qualitative characteristics as proposed in the Conceptual Framework. The fact is that economic volatility exists in business and managers regularly make decisions to engage in transactions that subject their businesses to this volatility. If this is the case, then Mr. Finnegan believes that it seems entirely appropriate to report that volatility in the financial statements.”
In other words, perhaps, the proposed conceptual framework merely perpetuates what the great Alex Milburn once indelibly summarized as ““the inconsistent and unintegrated mix of measurement theories and pragmatics that underlie existing accounting standards and practice.” It seems to me Finnegan is correct that the use of historical cost is often based more on laziness and convention than on anything else, but there’s little sign of any collective will to move away from that. His point on volatility is dead on too, but the term “volatility” seems to shake standard-setters out of rational thinking, much as “terrorism” does with politicians…
The opinions expressed are solely those of the author