Expense Recognition Criteria for ABC - Assignment Example

ACCOUNTING THEORY Student’s name Code & Course Professor’s name University City Date Table of Contents Question 1 3 Definition of an Expense 3 Expense Recognition Criteria for ABC 3 Question 2 3 Preference Shares Termed as liability 3 Question 3 4 3.0 Measurement issues in financial reporting 5 3.1 Creation of Fundamental Problems 5 3.2 Determining Separable Assets 6 3.3 Issue of Prediction 6 3.4 Assets and Periods Allocation 7 3.5 Identifying Transactions and Markets 7 3.6 Overlapping of Measurement Problems 8 4.0 Need for a Standard-Setting Perspective 9 4.0 Conclusion 11 5.0 Reference list 12 Question 1 Definition of an Expense The definition of an expense in ABC’s case is met. By definition, an expense is simply a reduction in the value of asset since it is used to facilitate revenue generation. In ABC’s case, $ 100,000 was recognized as an expense that would oversee the facilitation of creating a new factory to meet the company’s demands. Arguably, expenses are a representative of the cost of conducting business, and as such the expense incurred in improving and/or creating more facilities is justified (Steve, 2014). Expense Recognition Criteria for ABC In ABC’s case, the recognition criteria for the expense were met. Whereas expense recognition follows divergent strategies, ABC’s case showcases a typical approach of the associating cause and effect. More often than not, cost is associated to the revenue they help produce. In other words, some costs are thought as expenses on the approach of the presumed direct cost that is linked to a particular revenue sharing (Philbrick et al., 2013). This can be thought as both the “matching concept” and “associating cause and effect” principle. Whereas direct cause and effect relationship, can in most cases be demonstrated, in ABC’s case it appears as though the costs are linked to the anticipated revenue from future expansion (Steve, 2014). Contrariwise, recognizing them as expense necessitates that expenses are accompanied by revenue recognition as showcased in ABC’s case. Question 2 Preference Shares Termed as liability The preference shares should be considered as a liability. Steve (2014) asserts that when the holder of a preference share is subject to cash, or if the preference is redeemable at a later time the shares are treated as a liability, as opposed to equity. Evidently, in ABC case, there is the contractual obligation to redeem the shares at a later time. Evidently, the preference shares offered by ABC can termed as the redeemable preference shares where the company is attuned to purchase back the shares at a later time (Philbrick et al., 2013). In other words, such shares are termed as the non-current liabilities in SBC’s financial position. Question 3 Financial reporting measurements have direct or indirect effects on everyone. Measurement is crucial in the determination of capital allocation in individual businesses, companies, economic sectors and countries. Measurements are also significant in assessing among other things, taxes payable by businesses, dividends received by investors, employee bonuses and job retention as well as business success and failure. However, there is an increasingly growing controversy around the topic, especially with respect to the current trend of shifting towards fair value from the traditional historical cost basis (Macve 2015). IASB and FASB have invested their time in attempts to improve the practices applied in measurement and financial reporting. The international financial reporting standards given by IASB are just a single assemblage of practices employed in financial reporting. The need for IFRS is prompted by the upward trend in the number of companies globally that are obliged to comply with the standards and the rising number of countries that develop various financial reporting models based on IFRS (Whittington 2015). This paper presents a critical analysis of current measurement issues in financial accounting as well as the significance of a standard-setting perspective in resolving such issues with reference to the above article. 3.0 Measurement issues in financial reporting 3.1 Creation of Fundamental Problems Each measurement basis namely values in use, realizable value, fair value, value to the business and historical cost exhibit specific problems. Application of the term measurement in financial reporting can postulate misrepresentative notions of objectivity and certainty. More often than not, the term measurement is applied to objects with physical attributes like weight, height or temperature. Employment of accurate measurement tools leads to uncontroversial and objective information regarding such attributes (Berne 2012). However, in financial reporting, the term measurement is a representation of aspects such as net assets and income, which are abstract and possess uncertain meanings. This problem, even singlehandedly, subjects measurement to controversy. Financial reporting employs monetary terms in measurements, which are taken to be measurements of value. Nevertheless, the term value can denote a variety of things (Schipper & Trombetta 2012). A given asset can be valued, for instance, with respect to its market value, the replacement value of historical value. There is, therefore, no single basis deemed as the only correct approach. Rather, each basis’ applicability is determined by proper use. Financial reporting information can be used for diverse purposes. This means that measurement bases are only usable for given purposes, upon which they become inapplicable for other purposes. 3.2 Determining Separable Assets Creation of businesses is aimed at merging various resources while generating synergies realizable through collaborative cash flows. Businesses rely joint benefits from assets that are typically acquired separately. Lack of any foreseeable synergies would, therefore, render such merging of resources meaningless (Schryen 2013). For this reason, synergies command higher prices due to joint selling as opposed to separate selling. A problem is therefore created, regarding the realizable value and fair value bases, which revolve around assessing the amounts realizable from selling separable assets. A separable asset can fall in any of six layers namely the company, the division, the factory, all the plant for the process, item of the plant or the dismantled parts of such an item. In valuation of brands, jointness renders it particularly difficult or even impossible to separate practically a brand’s value from the parent business value. Similarly, a brand’s cash flows are inseparable from cash flows related to other assets of a given business. 3.3 Issue of Prediction Prediction is largely employed in most measurements. For instance, to calculate depreciation, the useful life of a fixed asset is predicted. Confirmation of balance sheet values of realizable stock values and debt recoverability employs prediction. Predicting the results of long-term contracts is used to assess profits or losses recognizable during such contracts (Schipper & Trombetta 2012). To calculate recoverable amounts or fixed assets values, predicting future cash flows is inevitable. These examples indicate the applicability of prediction which creates a problem of uncertainty and subjectivity as such predictions extend further into the future. 3.4 Assets and Periods Allocation In many measurements, revenues and costs are allocated to various assets and accounting periods. The result of such allocations is subjectivity and arbitrariness. In a case such as depreciation, even with perfect knowledge concerning the future of an asset, judgmental decisions are still made as to the allocation of cost for the asset (Schipper & Trombetta 2012). This could be done with respect to items produced with or by the asset or by a period. Periodical allocation is interplay among actuarial, sum of the digits, reducing balance and the straight line bases. Even with rational arguments to support each basis, they remain functions of judgment. 3.5 Identifying Transactions and Markets Numerous measurements assume or are inclined towards current market values. This is especially where such values can be deduced from active markets and are hence empirically measurable. According to IAS 39, an active market comprises of quoted prices regularly and readily available from a regulatory agency, pricing service, industry group, broker, and the dealer or from an exchange while such prices connote regular and actual market transactions at arm’s length (Schipper & Trombetta 2012). There exists a narrow range of assets in such a market while most market transactions are not in such active markets as requires the definition of such markets herein. As opposed to market transactions, many economic occur within the firms. Correspondingly, in any given company, there exist many assets that cannot enter markets with their prevailing forms and conditions as per a given date of such a company’s balance sheet. For instance in the manufacturing industry, businesses purchase raw materials, labor, and incomplete goods among other items. The items only enter the markets upon full manufacturing during which no transactions or markets are involved since there cannot be such markets for partially manufactured commodities (Schipper & Trombetta 2012). Thus, partly used fixed assets and partially manufactured commodities are not commonly sold. Hence their values are not subject to transactions and market quotes. Additionally, when assets held for the sole purpose of business and are not meant for selling are sold, their selling values are evidently lower in comparison to their initial values or the value they have in the business. This is because of the in-firm extent of economic processes such that the assets involved are specific to the particular business. Unless other parties acquire the business, then such assets are of limited value and use to them. Lack of such active markets poses a problem of the level to which measurement information can be reliable as well as its relevance. When measuring assets at current values, it is argued that, among others, that there exists equilibrium price for an asset, reflecting the expected an available and current market return rate for equivocal risk. Furthermore, knowledge of such a value enables assists user in predicting future business cash flows (Schipper & Trombetta 2012). But this is only applicable in efficient markets. Less active markets are not aligned to such market efficiency, and their market prices do not reflect the required information, especially for the purpose of predicting future cash flows. 3.6 Overlapping of Measurement Problems Convenience would be realized on the provision that fundamental measurement problems realized upon applying a given measurement basis are counterweighed by the absence of such problems in applying other bases. For instance, it would be significant that for items that depend on allocations and predictions, there exist readily identifiable markets and transactions (Schipper & Trombetta 2012). However, for most assets and liabilities of a business, fundamental problems overlap across all measurements. 4.0 Need for a Standard-Setting Perspective The IASB and FASB are striving to base financial accounting standards decisions on the renowned conceptual framework. Nevertheless, the conceptual framework does not include concepts of measurement. In essence, the framework does not provide the need for measurement in accounting; it does not issue a conceptual definition or basis for standard setters to employ (Hail et al. 2012). This is in the face of many bases of measurement that exist in accounting. As such, measurement has been left to be subject of impromptu decisions on the basis of historical precedents and judgments arising from intuition, expertise or experience. Failure to address measurement by the framework is an obstruction towards the achievement of a standard financial reporting framework. This further contributes to the existence of myriad measurement bases in the contemporary financial reporting system. The framework provides that the aim of financial reporting is the provision of financial information regarding a reporting entity, relevant to current and potential lenders and investors in order to provide necessary resources for that entity (Hail et al. 2012). The framework further requires faithful representation and relevance as primary qualitative attributes alongside understandability, timeliness, verifiability and comparability. Also, it identifies that measurement of all other financial elements is a subset of measuring assets and liabilities. Relevance denotes that upon receiving information; a user can make meaningful decisions. The relevant information comprises of either confirmatory value, predictive value or both. Predictive value is useful for forecasting future outcomes while the confirmatory value is relevant to feedback. Faithful representation provides that the information presented is a faithful portrayal of the purported economic phenomena. Such representations should be accurate, neutral and complete. Comparability allows accounting information users to evaluate similarities and differences across items. Comparability, therefore, provides that similar items should look alike while different items should appear different from each other. Verifiability attends to the confidence of a user with respect to the information. Verification of information is determined by independent and knowledgeable observers; when they reach a consensus (Cascino & Gassen 2014). Timeliness is an indication that the available information has reached the intended users or investors at such a time that they can make decisions promptly. Understandability provides that the available information is characterized and classified in a concise and clear manner such that interested users can generate the desired meaning from such information. All the attributes mentioned herein are qualitative. The main basis that applies these attributes, notably comparability is the fair value basis (Macve 2015). This basis, as mentioned earlier, is shifting measurement from the traditional historical cost basis to a newer basis. Fair value basis seems like the only basis that can unify measurement in financial reporting. It moves towards the measurement of all financial instruments in a similar manner, hence enhancing understandability and comparability of such information for various periods and entities. Fair value eliminates the need for fair value hedging, separate accounting, category transfers, impairment testing and classification (Hirst 2014). To make the practice more flexible to accommodate specific exceptions, amendment of the IAS 39 is crucial. This is in terms of existing requirements, replacement with the fair value principle and simplification of hedge accounting. 4.0 Conclusion There is a soaring need for measurement concepts in financial reporting. Given that the main role of accounting is to use numbers in representing economic phenomena, it is disturbing that there exists no conceptual definition for measurement nor are there guiding concepts for standard setters with respect to the choice of a relevant measurement basis from the available pool of bases. Lack of such concepts has led to a standard measurement setting that largely focuses on individual assets and liabilities. 5.0 Reference list Berne, R., 2012. The relationships between financial reporting and the measurement of financial condition. Governmental Accounting Standards Board of the Financial Accounting Foundation. Cascino, S. and Gassen, J., 2014. What drives the comparability effect of mandatory IFRS adoption?. Review of Accounting Studies, 20(1), pp.242-282. Hail, L., Leuz, C. and Wysocki, P., 2012. Global accounting convergence and the potential adoption of IFRS by the US (Part I): Conceptual underpinnings and economic analysis. Accounting Horizons, 24(3), pp.355-394. Hirst, D.E., Hopkins, P.E. and Wahlen, J.M., 2014. Fair values, income measurement, and bank analysts' risk and valuation judgments. The Accounting Review, 79(2), pp.453-472. Ittner, C.D., Larcker, D.F. and Meyer, M.W., 2013. Subjectivity and the weighting of performance measures: Evidence from a balanced scorecard. The Accounting Review, 78(3), pp.725-758. Macve, R.H., 2015. Fair value vs conservatism? Aspects of the history of accounting, auditing, business and finance from ancient Mesopotamia to modern China. The British Accounting Review, 47(2), pp.124-141. Schipper, K. and Trombetta, M., 2012. Measurement Issues in Financial Reporting. European Accounting Review, 19(3), pp.425-428. Schryen, G., 2013. Revisiting IS business value research: what we already know, what we still need to know, and how we can get there. European Journal of Information Systems, 22(2), pp.139-169. Steve, C., and Gee, P. 2014. Financial Reporting for Unlisted Companies in the UK and Republic of Ireland, Bloomsbury: London Philbrick, D., Elliott, J., Sundem, G., Horngren, C. 2014. Introduction to Financial Accounting. 11th ed. Prentice-Hall: NY Whittington, G., 2015. Fair value and IFRS. The Routledge Companion to Financial Accounting Theory, Routledge, London, pp.217-235. Read More