FINANCIAL ACCOUNTING THEORY

Chapter 7

Summarised by

Ahmad Karim, 202100969

Beirut Arab University

Beirut, Lebanon

Fall 2024-2025

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Table of Contents
7 Measurement Applications.......................................................................................................................2
7.1 Overview...............................................................................................................................................2
7.2 Current Value Accounting......................................................................................................................3
7.3 Longstanding Measurement Examples..................................................................................................5
7.4 Financial Instruments Defined...............................................................................................................7
7.5 Primary Financial Instruments...............................................................................................................7
7.6 Fair Value Versus Historical Cost...........................................................................................................9

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7 Measurement Applications
In this chapter, we analyze the use of various measurement methods in accounting, particularly
focusing on the adoption of current value accounting and its interplay with financial instruments,
historical cost, and fair value. Measurement applications are crucial because they affect how
companies report their financial position and performance, which in turn influences investor
decisions and financial markets. The chapter covers both longstanding and more recent examples
of measurement techniques in accounting.

7.1 Overview
The shift toward current value accounting—an approach that measures assets and liabilities at
their current market values—represents a significant evolution in financial reporting. However,
the movement is not without challenges. A primary concern is the tradeoff between relevance
and reliability. Current value accounting enhances relevance because it provides more up-to-date
information that reflects the firm’s current financial situation, allowing investors and
stakeholders to make better-informed decisions. Yet, this relevance may come at the expense of
reliability, particularly when market values are volatile or based on estimates and assumptions,
making financial statements less certain and harder to verify.

A key example of this tension occurred during the 2007–2008 financial crisis, where liquidity
pricing—the effect of forced sales in illiquid markets—led to dramatic declines in asset values.
This exposed a significant downside of fair value accounting: the incorporation of market
volatility into financial statements. Companies, especially financial institutions, faced large
write-downs that did not necessarily reflect the long-term value of their assets but rather short-
term market conditions. Consequently, many firms, auditors, and even standard setters
questioned the reliability of fair value during such turbulent periods.

Furthermore, management's skepticism toward current value accounting is persistent. Many

managers prefer conservative accounting, which tends to understate rather than overstate
financial results, thereby minimizing risks of overvaluation and future corrections. Conservative
accounting, as discussed in previous chapters, can also reduce auditor liability and support
corporate governance by discouraging excessive risk-taking. While conservative approaches may
shield managers from volatile swings in financial statements, they can also obscure the true
financial risks faced by a firm.

In summary, although the obstacles to adopting current value accounting are significant, there
has been a clear trend toward embracing measurement-oriented standards, particularly in areas
such as intangible assets, financial instruments, and risk reporting. This chapter delves deeper
into the two key versions of current value accounting and evaluates their application in financial
reporting.

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7.2 Current Value Accounting
Current value accounting is a broad concept that aims to report the value of assets and liabilities
based on their present worth, either through fair value or value in use. These two approaches
differ in how they determine the worth of an asset or liability, but both share the goal of
providing more relevant, up-to-date information compared to traditional historical cost
accounting.

7.2.1 Two Versions of Current Value Accounting

Value in Use
The value in use approach calculates the present value of expected future cash flows from an
asset or liability. This method is highly relevant because it directly links the asset’s worth to its
future economic benefits, making it a forward-looking measure. For example, if a company owns
a factory, value in use would reflect the expected income generated from the factory’s operations
over its useful life, discounted to the present.

However, value in use presents several challenges to reliability. First, it depends heavily on
management’s expectations about future cash flows. Since these expectations are subject to
change—due to strategic decisions, market conditions, or operational shifts—the valuation is
inherently uncertain. For instance, a company might decide to sell an asset rather than continue
using it, which changes the future cash flows and the asset’s value. This management discretion
introduces an element of bias, making it difficult to ensure that the value in use accurately
reflects reality. Moreover, estimating future cash flows requires assumptions about economic
conditions, interest rates, and market demand, all of which can be highly speculative.

Fair Value
Fair value accounting, as outlined by IFRS 13 and U.S. GAAP ASC 820-10, defines fair value as
the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction at the measurement date. This is often referred to as an exit price, meaning the price
at which an entity could sell an asset in the market. The advantage of fair value is that it reflects
market conditions at a specific point in time, making it highly relevant to investors who need
current information.

However, the fair value hierarchy introduces varying degrees of reliability based on the
availability of market data:

 Level 1 fair values are the most reliable because they are based on observable market
prices for identical assets or liabilities in active markets. These values are verifiable and
transparent, reducing the risk of error.
 Level 2 values are less reliable because they rely on observable inputs other than market
prices, such as prices for similar assets or adjusted inputs from inactive markets.
Estimating these values requires some level of judgment and inference.
 Level 3 values are the least reliable, as they depend entirely on unobservable inputs, such
as a firm’s internal models or assumptions. These values introduce significant estimation
risk and are more susceptible to management bias.

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For instance, in the absence of an active market, a company might use projected cash flows or
hypothetical market conditions to estimate fair value, reducing reliability. Still, empirical studies,
such as those by Song, Thomas, and Yi (2010), suggest that even Level 3 fair values can provide
value-relevant information, though their accuracy depends on the firm’s corporate governance
and the quality of the valuation process.

7.2.2 Current Value Accounting and the Income Statement

Current value accounting affects not only the balance sheet but also the income statement,
particularly in how revenue and gains are recognized. Under historical cost accounting, revenues
are recognized when they are realized, meaning when the transaction has occurred and the
amount is known. Current value accounting, however, recognizes gains and losses as they
happen, based on changes in asset and liability values, even if no actual transaction has taken
place.

Value in use recognizes revenue based on expected future cash flows, effectively allowing a
company to book revenue before it has been realized. This can create situations where revenue is
reported from anticipated economic benefits, which may or may not materialize.

Fair value accounting further changes the income statement by introducing gains and losses tied
to fluctuations in market prices. For instance, if the fair value of an investment increases, that
gain is recognized immediately, even though the asset has not been sold. This creates a more
forward-looking income statement, which can be useful for investors trying to predict a firm’s
future cash flows. However, it also introduces volatility. The income statement can fluctuate
significantly with market changes, which some argue makes it harder for investors to assess
long-term earnings stability.

A key tension in this shift is the tradeoff between volatility and predictability. Critics of fair
value argue that its volatility might obscure underlying business performance, while proponents
counter that this volatility simply reflects the firm’s true risk exposure and economic reality. This
debate ties back to the Paton and Littleton model (discussed in Chapter 1), which advocated for
historical cost because of its matching principle, reducing income volatility and emphasizing
predictability. Still, as the economic environment grows more complex, proponents of fair value
argue that income statements should reflect the real economic conditions firms face.

7.2.3 Summary

Current value accounting increases the relevance of financial information by focusing on future
expectations and market conditions, but this comes at the cost of reliability. Value in use faces
reliability issues due to the uncertainty and subjectivity of future cash flow estimates, while fair
value is more reliable when market prices are available but suffers when Level 3 estimates are

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used. Despite these challenges, both methods represent a shift toward more decision-useful
financial statements, though debates about their practicality and reliability remain.

7.3 Longstanding Measurement Examples

Before delving into newer standards, it’s important to recognize that current value accounting
has been applied in various forms for many years. Several traditional accounting practices,
particularly those related to the valuation of accounts receivable, payable, and inventory, already
incorporate elements of current value measurement.

7.3.1 Accounts Receivable and Payable

Most firms report accounts receivable at net realizable value, which is the expected amount of
cash to be received after accounting for allowances for doubtful accounts. Similarly, accounts
payable reflect the actual cash expected to be paid. Since these items are typically settled in the
short term, discounting for the time value of money is not necessary, and the book value closely
approximates present value.

This method is highly reliable because it involves minimal judgment or estimation. The value of
receivables and payables is usually straightforward, based on contractual obligations and
payments expected within a short period. However, for longer-term receivables or payables,
discounting to present value may be required, adding a time value of money component to the
measurement.

7.3.2 Cash Flows Fixed by Contract

In situations where cash flows are fixed by contract, such as with long-term debt, accounting
standards often prescribe amortized cost accounting. This means the asset or liability is valued
based on the present value of the remaining contractual payments, discounted at the effective
interest rate established when the debt was issued.

For example, a company issuing bonds would value the liability at the present value of future
interest and principal payments, using the initial interest rate as the discount rate. This approach
provides a balance between relevance and reliability, as it reflects the firm’s obligation to make
fixed payments while avoiding the volatility of marking the debt to market value unless the
company chooses to do so under fair value options.

However, if interest rates change after the debt is issued, the market value of the debt may
diverge from its book value, which remains based on the original discount rate. This creates a

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mismatch in reporting that some firms seek to mitigate through hedging or by electing to use fair
value accounting.

7.3.3 The Lower-of-Cost-or-Market Rule

The lower-of-cost-or-market rule applies to inventory and reflects a conservative measurement

approach. Under IAS 2, if the net realizable value of inventory falls below its original cost, the
firm must write down the inventory to its lower value. This ensures that inventory is not
overstated on the balance sheet, protecting investors from the risk of overvaluation.

While this approach limits overstatement of assets, it is asymmetric: inventory can be written
down when its market value falls, but if the market value subsequently increases, inventory
cannot be written up beyond its original cost (under U.S. GAAP). This bias toward conservatism
is intended to protect users of financial statements from overly optimistic valuations, but it may
reduce decision usefulness in cases where the value of inventory has clearly increased above
historical cost.

7.3.4 Revaluation Option for Property, Plant, and Equipment

Under IAS 16, firms can elect to revalue non-financial assets like property, plant, and equipment
to reflect their fair value. This represents a major departure from traditional historical cost
accounting. Once revalued, assets must be reassessed regularly to ensure their carrying value
remains close to fair value.

This option provides greater relevance because the value of these assets on the balance sheet will
more closely align with current market conditions. However, it also introduces volatility, as
revaluations can lead to large adjustments in the carrying amounts of assets, particularly in
periods of economic change. Additionally, revaluing assets requires careful consideration of
valuation reliability, especially when market prices are unavailable, and the firm must rely on
Level 2 or Level 3 estimates.

7.3.5 Impairment Test for Property, Plant, and Equipment

To prevent overstatement of assets, accounting standards require impairment testing for most
non-financial assets, such as property, plant, and equipment. Under IAS 36, if an asset’s carrying
amount exceeds its recoverable amount—the greater of fair value less costs to sell or value in use
—the asset must be written down.

Impairment tests contribute to conditional conservatism, as they force firms to recognize losses
when the value of an asset declines. This protects the reliability of financial statements by

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ensuring that assets are not carried at inflated values. Unlike the lower-of-cost-or-market rule,
impairment losses can be reversed under IAS standards if the asset’s recoverable amount
increases. However, U.S. GAAP does not allow such reversals, maintaining a stricter form of
conservatism.

7.3.6 Summary

While recent accounting standards have pushed for greater use of current value, traditional
accounting practices have long incorporated elements of current value-based measurement,
particularly for accounts receivable, payable, inventories, and impairments. These examples
underscore the mixed measurement model in accounting, where historical cost and current value
approaches coexist.

7.4 Financial Instruments Defined

Financial instruments play a central role in modern financial reporting, as they represent
contracts that create both financial assets for one party and financial liabilities or equity
instruments for another. The definition of a financial instrument includes:

 Cash
 Equity instruments (e.g., shares of another entity)
 Contractual rights to receive cash or exchange financial instruments under favorable
conditions
 Contractual obligations to deliver cash or exchange financial instruments under
unfavorable conditions

Financial instruments include primary instruments such as accounts receivable and payable, debt
and equity securities, as well as more complex derivatives like options, futures, and swaps
(covered in section 7.9).

7.5 Primary Financial Instruments

7.5.1 Standard Setters Back Down Somewhat on Fair Value Accounting

The financial crisis of 2007–2008 raised serious concerns about the use of fair value accounting.
As markets collapsed, many firms, particularly banks, were forced to write down their financial
assets to liquidity prices, reflecting distressed sales in an inactive market. These writedowns
were seen as excessive, as they did not always represent the long-term value of the assets.

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Faced with intense pressure from financial institutions and regulators, standard setters, including
the IASB and FASB, relaxed some of the fair value rules in 2008. Firms were allowed to use
internal estimates of future cash flows for fair value calculations when market prices were
unreliable or unavailable. This shift marked a temporary retreat from strict fair value accounting,
as firms were permitted to value some financial instruments using assumptions rather than
observable market data.

For example, Deutsche Bank reclassified some of its financial assets from a fair value basis to a
cost basis during the crisis, avoiding large writedowns that would have otherwise been required
under fair value rules. This move helped the bank report a profit for the quarter, reflecting how
changes to fair value rules can significantly impact financial performance.

7.5.2 Longer-Run Changes to Fair Value Accounting

In response to the financial crisis, the IASB embarked on a long-term project to revise its
approach to financial instruments, culminating in IFRS 9. This standard introduces the business
model concept, which governs the classification and measurement of financial assets. Under
IFRS 9, financial instruments are initially measured at fair value, but their subsequent
measurement depends on the firm’s intent regarding their use.

For financial assets that are held to collect contractual cash flows, such as interest and principal,
the asset is measured at amortized cost. However, if the asset becomes impaired, it must be
written down to its new expected present value, and any loss is recognized in net income.
Conversely, assets that are held for trading or sale continue to be measured at fair value, with
changes in value recognized in net income or other comprehensive income, depending on the
nature of the asset.

IFRS 9 also introduced restrictions on management’s ability to reclassify financial assets

between categories, reducing opportunities for earnings management. The business model under
IFRS 9 must remain consistent, preventing firms from strategically altering their classification of
assets to achieve desired financial outcomes.

7.5.3 The Fair Value Option

Both IFRS 9 and U.S. GAAP (ASC 825) allow firms to elect a fair value option for certain
financial instruments, provided that this reduces a mismatch between related assets and
liabilities. For example, if a firm finances a portfolio of interest-bearing loans with bonds, and
the loans are measured at fair value while the bonds are at amortized cost, this creates a natural
hedge. To align the accounting treatment with the firm’s economic reality, the firm may opt to
measure both the loans and the bonds at fair value.

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In the U.S., the fair value option is broader, allowing firms to apply fair value without the
requirement of a mismatch. However, the use of fair value for liabilities can create strange
results. For instance, when a firm’s own credit risk increases (causing the fair value of its debt to
fall), the firm could recognize a gain in net income because its liabilities are now worth less.
Critics argue that this does not represent a true improvement in financial health, as the firm’s
economic situation may have worsened.

7.6 Fair Value Versus Historical Cost

The debate between fair value accounting and historical cost accounting is a fundamental issue in
financial reporting. Fair value accounting provides real-time information by reflecting the current
market price of assets and liabilities, which is highly relevant for decision-making. Investors,
particularly in well-functioning markets, benefit from up-to-date valuations that reflect the firm’s
true financial position and risk exposure.

However, in illiquid or distressed markets, such as during the 2007–2008 financial crisis, fair
value accounting can lead to inaccurate or distorted valuations. In these situations, liquidity
pricing drives the fair value of long-term assets below their value in use, triggering large write-
downs that may not reflect the actual long-term economic benefit of holding the asset. This
creates the risk of overreacting to short-term market conditions, potentially exacerbating
financial instability.

Historical cost accounting, in contrast, provides a more stable and reliable measure, as it is based
on the original transaction price. This stability can prevent pro-cyclical behavior, such as fire
sales of assets during a downturn, and avoid over- or under-reacting to temporary market
fluctuations. However, it is less relevant in fast-changing markets because it does not reflect
current economic conditions, potentially leading to outdated financial information.

Empirical studies show that fair value accounting can serve as an early warning system for
financial distress, allowing regulators and investors to respond to deteriorating conditions more
quickly. However, the balance between reliability and relevance remains contentious,
particularly in the context of financial crises where market values may not accurately reflect
underlying asset performance.

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