Measurement in Financial Reporting: The Need for Concepts

The following post comes to us from Mary Barth, Professor of Accounting at Stanford University.

Measurement concepts in financial reporting are sorely needed. A key role of accounting is to depict economic phenomena in numbers, i.e., to develop measurements to report in financial statements. It is shameful that neither is there a conceptual definition of accounting measurement nor are there concepts guiding standard setters’ choice of measurement base. The Framework has a glaring hole until these concepts are developed. In the paper, Measurement in Financial Reporting: The Need for Concepts, which was recently made publicly available on SSRN, I offer a starting point for developing such concepts by focusing on how the objective of financial reporting, qualitative characteristics of useful financial information, and the asset and liability definitions can be applied to measurement. The Framework should be a coherent whole and, thus, any measurement concepts should flow from, be consistent with, and embody these concepts.

To date the focus of measurement in standard setting has been on individual assets and liabilities, and the lack of concepts for these measurements is obvious. However, aggregate amounts are also fundamental to financial reporting—financial reports include key aggregate amounts such as total assets, total liabilities, and net income. Changes in measurements of assets and liabilities during the reporting period also are fundamental because they determine items of income and expense as well as comprehensive income itself. Thus, if financial reports are to achieve their objective, measurement concepts need to deal with aggregate amounts and changes in measurements, as well as the implications of the measurements for the information revealed in a set of financial statements taken together.

The analysis in this paper leads to the conclusion that in the context of measurement of individual asset and liabilities, fair value measurement is more consistent with the objective of financial reporting and the qualitative characteristics of useful financial information than either modified or unmodified historical cost. The analysis reveals that unmodified historical cost is consistent with some concepts but it is difficult to support a case for modified historical cost, at least given the myriad ways in which cost is modified in accounting standards today. The analysis highlights the fact that the aggregate of individual asset or liability amounts based on modified or unmodified historical cost lack meaning. The aggregate of fair values does have meaning, but it does not capture the effects of synergies among the assets. Separately reporting the difference between aggregate fair values and the value of the aggregate assets, which would reflect the value of synergies, could provide useful information to financial statement users. However, the conceptual issues—including how narrowly or broadly to define such asset groups—related to doing so are unresolved and beyond the scope of this paper.

Alternative measurement bases for assets and liabilities have different implications for the information reflected in comprehensive income. Thus, the development of measurement concepts also needs to consider whether comprehensive income based on a particular measurement base is more or less useful to financial statement users than another. The analysis raises several other open issues that need to be considered, including how best to display the information embedded in any particular measurement and whether, why, and how measurement should differ for financing and investing activities and for non-financial operating activities.

Because measurement in financial reporting is so fundamental, some might be afraid of the answer that follows from a serious effort at developing sound measurement concepts. In particular, opponents of fair value might be concerned that the development effort might confirm the analysis in this paper that fair value fits with the existing Framework concepts better than unmodified or modified historical cost. However, there are many unresolved issues and measurement in financial reporting is too fundamental to proceed without concepts. Simply crafting concepts to justify current practice is inappropriate. Concepts need to be just that, concepts. Once the concepts are developed, the next challenge is to follow them!

The full paper is available for download here.

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