In: Accounting
The ‘Conceptual Framework for Financial Reporting’ permits four alternative measurement bases to be used in the valuation of assets and liabilities. These are:
Historical cost
Current cost
Realisable (settlement) value
Present value
Required:
Explain these four measurement bases and give an example of each being used in international financial reporting standards.
Historical cost- Historical cost is the amount of cash or cash equivalent paid to purchase an asset (any cost of acquisition and/ preparation). If asset is not bought for cash, historical cost is the fair value of the item that was given in order to buy the asset. Additionally for liabilities, the historical cost basis of measurement is the amount of proceeds received in exchange for the liability/obligation.
Current cost- For assets, going by the name current cost is the amount of cash or cash equivalents that would be paid to buy the same or an equivalent asset today. This is the accounting or “book” value. Additionally for liabilities, the current cost basis of measurement is the undiscounted amount of cash or cash equivalents that would be required to settle the obligation/liability today.
Realisable (settlement) value- For assets, as the name suggests realizable value is the amount of cash or cash equivalents that could be obtained by selling the asset in an orderly disposal as of today. Additionally for liabilities, the equivalent to realizable value is called “settlement value” which is the undiscounted amount of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Present value- For assets, present value is the present discounted value of the future net cash inflows. These inflows are the inflows that the asset is expected to generate in the normal course of business. In case for liabilities, present value is the present discounted value of the future net cash outflows. The outflows are expected to be required to settle the liabilities in the normal course of business.
Here's an example covering all the concepts:
A machine was purchased on 1st January, 2020 for 1 million. It has a useful life of 10 years. Under historical cost convention it will be carried at original cost less accumulated depreciation. Hence historical cost at December 31, 2020 will be (1-0.1)= 0.9
Next example is if two year old machine can currently be changed for 2.5 million this will be the current cost. If the machine had to be dismantled and transported to the buyer's premises at a cost of $200000. Net realisable value of the machine will be the amount that could be obtained from selling it minus any cost involved in making the sale. Hence NRV is 2.3 million.
For present value, if the machine is expected to generate $500000 per annum for the remainning eight years of its life and if the company's cost of capital is 10%. Present value will be calculated as :
$500000*5.335=$2667500