I thought it might be interesting to remind the world of Toward a Measurement Framework for Financial Reporting by Proﬁt-Oriented Entities, a paper by Alex Milburn, issued in 2012 by the Canadian Institute of Chartered Accountants (now CPA Canada)
As background, we know of course that IFRS employs different measurement bases for different assets and liabilities – the conceptual framework acknowledges this and describes some of the approaches taken without commenting on the relative merits of one versus the other. IASB Chair Hans Hoogervorst talked about this in a 2015 speech:
- I think the IASB was wise not to express a general preference for either historical cost on the one hand or for current measurement, or more specifically, fair value on the other hand. Instead, we acknowledge that in many cases mixed measurement is the expected outcome of our standard-setting.
He went to set out the following “high-level conclusions”:
- If the nature of business activities is to use assets in combination with other assets to produce goods or services, this generally points in the direction of historical cost
- If the nature of business activities is to trade assets or liabilities in active markets, this would generally point in the direction of current value measurement
- If the characteristics of an asset of a liability are such that they are highly sensitive to market factors or to other risks in the item, this would generally point in the direction of current value measurement.
A lot of this though seems based mainly in intuition and pragmatism (for instance, “it may not be extremely relevant to know the present market value of the robots of a car manufacturer if the company intends to keep them to produce cars.”) Milburn in contrast takes the view that “a conceptual measurement framework for financial reporting should be deduced as far as possible by reasoning rigorously from accepted financial reporting objectives, the economic purposes and wealth-generating processes of profit-oriented entities, and the effects of market forces. Among other things, he proposed the following:
- Market value created by a cash-generating process (revenue) should be recognized when the process (1) has achieved an output that has a current market value that is practicable of faithful representation, and (2) has generated the good and/or service that is the source of that output market value.
- Assets that are inputs to a cash-generating process should be measured at current prices in the markets in which the inputs would be acquired by the entity or, when such prices are not practicable of faithful representation, on the basis of the most relevant substitute that is practicable of faithful representation. Changes in current market values or in substitute measurement bases that reflect current input values would be reported immediately in the statement of income.
The paper painstakingly analyzes and addresses the traditional arguments in favour of historical cost, for example:
- The difference between an input asset’s transaction price and its current price in the market in which it was acquired represents a saving or loss relative to the price that the entity would have to pay for it currently. This is generally described as an “opportunity cost or saving”. Opportunity costs or savings are dismissed by advocates of historical cost on the basis that they do not have any real cash flow effects. They believe that the only real cash flow effects are those resulting from the transactions of the entity (i.e., the cash paid for the commodity and the cash received from the sale of the resulting outputs). The market-based opportunity cost concept interprets cash flow implications in a broader accrual context. In this broader context, the opportunity gains and losses resulting from input asset price changes do have relevant cash flow implications for the entity.
The paper acknowledges that its proposed approach would likely be labeled as more difficult or potentially confusing; for example, that situations might arise where an entity reports a profit from recognizing holding gains on assets, even though its operations are otherwise loss-making (in Canada, this complaint comes up most often nowadays in the context of biological assets in the cannabis industry). But at some point, you have to assume at least minimal engagement by readers:
- Financial reports are prepared for users who have a reasonable knowledge and analyze financial reports diligently (see IASB, 2010b: para. QC32). Such users can be presumed to be capable of distinguishing holding gains from operating profits and of understanding their potentially different implications.
Many of the recurring complaints about financial statements are implicitly based on rejecting this premise, and on assuming that users are incapable of seeing beyond a single headline profit number. I’ve argued here many times that it’s futile to try saving users from themselves: a reader who can’t see through basic aspects of financial statement presentation has little chance of using those statements as a meaningful input into risk-appropriate investing (the angst over non-GAAP measures often draws on comparably incoherent concepts of users).
Anyway, the paper was supported at the time by a blog and discussion forum, which seem to have been removed now. I don’t suppose the ideas it set out are too much closer to being implemented today than they were then. Even so, it remains an important resource, if only for sensitizing a reader to some of the limitations in the existing standards, and thereby perhaps for providing a basis for more productively engaging with them. I only had space above to trace the lightest of scratches across its surface: perhaps we’ll come back to it in the future.
The opinions expressed are solely those of the author