Measurement Bases – Assets and Liabilities

Introduction

Financial assets are measured and reported at either fair value or amortized cost. IFRS defines fair value as the amount at which an asset could be exchanged or a liability settled in an arm’s length transaction between knowledgeable and willing parties.

Amortized cost may be defined as the historical cost of an asset after making adjustments for amortization and impairment.

Assets and their Measurement Bases

Current Assets

Current assets are primarily held for trading or are expected to be sold, used up or otherwise realized in cash within the greater of a year or one business operating cycle, after the reporting period. They include cash and cash equivalents, marketable securities, accounts receivable, and inventories.

  • Cash and cash equivalents: These include demand deposits with banks and highly liquid investments with original maturities of less than or equal to three months. Measuring cash and cash equivalents at amortized cost or fair value is not likely to produce materially different amounts.
  • Marketable securities: These include investments in debt or equity securities that are traded in a public market, and whose value can be determined from prices that are obtained in a public market. Further details on these financial assets tend to be provided in notes to the financial statements.
  • Trade receivables or accounts receivable: These refer to amounts that are owed to an entity by its customers for products and services that have already been delivered. They are usually reported at net realizable value, which is an approximation of fair value that is based on estimates of collectability. An allowance for doubtful accounts is made to reflect an entity’s estimate of amounts that will ultimately be uncollectible. Additions to this allowance in a particular period are reflected as bad debt expenses; the balance of the allowance for doubtful accounts reduces the gross receivables amount to a net amount which is an estimate of fair value.
  • Inventories: These are physical products which a company intends to sell to its customers, either in the form of finished goods or as inputs into a manufacturing process i.e. raw materials and work-in-process. Under IFRS, inventories are measured at the lower of cost and net realizable value, while under US GAAP, they are measured at the lower of cost or market value. Cost includes all associated costs of purchase, costs of conversion, and all other costs that are incurred in bringing the inventories to their present location and condition. Net realizable value (NRV) refers to the estimated selling price less the estimated costs of completion and costs necessary to make the sale. Market value is the current replacement cost, which cannot exceed the NRV and cannot be lower than the NRV less a normal profit margin. If the NRV or market value of inventory falls below its carrying amount, the company must write down the value of the inventory and reflect the loss in value in the profit and loss statement.
  • Other current assets: These are usually not sufficiently material to require a separate balance sheet line item. They include (i) prepaid expenses, which are normal operating expenses which have been paid in advance, and (ii) deferred tax assets, which represent income taxes that are incurred prior to the time that the income tax expense will be recognized on the income statement.

Non-current Assets

Non-current assets are assets which are not expected to be sold or used up within the greater of a year or one business operating cycle. They include property, plant, and equipment, investment property, intangible assets, and goodwill.

  • Property, plant, and equipment (PPE): These are tangible assets, including land, buildings, and machinery, that are used in an entity’s operations and expected to provide economic benefits over more than one financial year. Under IFRS, PPE may be reported using either the cost model or the revaluation model. Under US GAAP, however, only the cost model may be used.
    • When the cost model is used, PPE is carried at amortized cost i.e. its historical cost less accumulated depreciation or depletion, and less impairment losses.
    • When the revaluation model is used, the reported and carrying value of PPE is the fair value at the date of revaluation less any subsequent accumulated depreciation.
  • Investment property: This is property used solely to earn rental income, capital appreciation or both. Under IFRS, investment property may be reported using either the cost model or fair value model.
    • Similar to the case with PPE, when the cost model is used, investment property is carried at amortized cost i.e. its historical cost less accumulated depreciation and less any impairment losses.
    • When the fair value model is used, investment property is reported at its fair value. Gains or losses arising from a change in the fair value of investment property are recognized on the income statement in the period in which it arises.
  • Intangible assets: These include patents, licenses, and trademarks, or any other asset which is non-monetary, has no physical substance but is able to be identified. Similar to PPE’s, US GAAP permits intangible assets to be measured using only the cost model, while under IFRS, they may be reported using either the cost model or the revaluation model (when an active market is present). In the case of internally created identifiable intangibles, IFRS and US GAAP require that they are expensed rather than reported on the balance sheet. IFRS also requires that an entity separately identifies its research phase and its development phase; costs to internally generate intangible assets during the research phase must be expensed on the income statement, while costs incurred during the development stage can be capitalized as intangible assets if certain criteria are satisfied. US GAAP, on the other hand, does not permit the capitalization as an asset of most costs of internally generated intangibles; all such costs are usually expensed. The costs that are typically expensed under both IFRS and US GAAP include start-up costs, training costs, administrative and other general overhead costs.
  • Goodwill: This refers to the excess value created when the purchase price of a company exceeds the acquirer’s interest in the fair value of the identifiable assets and liabilities that were acquired. There are two types of goodwill: economic goodwill and accounting goodwill. Economic goodwill is related to the economic performance of an entity and is theoretically reflected in the entity’s stock price, while accounting goodwill is related to the accounting standards and is reported only when an acquisition is involved. Both IFRS and US GAAP require that accounting goodwill that arises from acquisitions is capitalized. It is, however, not amortized but rather tested for impairment on an annual basis. Impairment losses are charged against income in the current reporting period and result in reductions to current earnings and total assets.
  • Financial assets: A financial instrument is defined by IFRS as a contract which gives rise to a financial asset of one entity and a financial liability or equity instrument of another. Financial instruments are measured at either fair value or amortized cost.
    • Financial assets are measured at amortized cost if the entity intends to hold the financial asset until maturity and the asset’s cash flows will occur on specified dates and consist of principal and interest payments only. Such assets are referred to as ‘held-to-maturity’ assets. No unrealized gains or losses are reflected on the balance sheet, income statement, or through comprehensive income.
    • When financial assets are measured at fair value, net unrealized changes in fair value may be recognized as either profit (loss) on the income statement, or as other comprehensive income (loss). Realized gains or losses will be reported on the income statement.
    • ‘Held for trading’ securities refer to financial assets that are acquired primarily for selling in the near term. They are measured at fair value and any unrealized gains or losses are recognized as profit or loss on the income statement and therefore reflected in retained earnings within shareholders’ equity.
    • ‘Mark to market’ refers to the process of adjusting the value of a financial instrument to reflect current fair value based on market prices.
    • ‘Available-for-sale’ assets are measured at fair value, and any unrealized gains or losses are recognized in other comprehensive income and reflected in accumulated other comprehensive income within shareholders’ equity. This category of assets will however no longer be a choice under IFRS when IFRS9 becomes effective in the year 2018.

Liabilities and Their Measurement Bases

Current Liabilities

Current liabilities are liabilities which are expected to be settled during an entity’s normal operating cycle, are held primarily for trading, or are due to be settled within one year after the reporting period end. These include trade payables, notes payable, accrued expenses, and deferred income.

  • Trade payables or accounts payable: These are amounts which an entity owes its suppliers for goods and services that have been purchased.
  • Notes payable: These are financial liabilities that are owed by an entity to its creditors through a formal loan agreement.
  • Accrued expenses: These are expenses that have been recognized on an entity’s profit and loss statement but which have not yet been paid as of the reporting date.
  • Deferred income: This occurs whenever an entity receives payment prior to delivering goods and services that it was paid to provide.

Non-current Liabilities

Non-current liabilities refer to all liabilities that are not classified as current.

  • Long-term financial liabilities: These include loans and notes or bonds payable, and are usually reported at amortized cost on the balance sheet. Upon maturity, the bond’s amortized cost or carrying amount will be equal to its face value.
  • Deferred tax liabilities: These arise from temporary timing differences between an entity’s reported income (for financial statement purposes) and its taxable income (for tax purposes). Specifically, deferred tax liabilities occur whenever an entity’s taxable income, and the actual income tax payable derived from it, is less than the reported financial statement income before taxes, and the income tax derived from it.

Question 1

Which of the following statements is accurate?

A. ‘Held for trading’ securities are measured at fair value and any unrealized gains or losses are recognized as profit or loss on the income statement.

B. ‘Available-for-sale’ assets are measured at amortized cost.

C. ‘Held to maturity’ assets are measured at fair value, and any unrealized gains or losses are recognized in other comprehensive income.

Solution

The correct answer is A.

‘Held for trading’ securities are measured at fair value. ‘Choice B is incorrect because ‘available-for-sale’ assets are measured at fair value, and any unrealized gains or losses are recognized in other comprehensive income. Choice C is incorrect because ‘held to maturity’ assets are measured at amortized cost and not fair value.

Question 2

Under IFRS, Property, Plant and Equipment (PPE) could be measured using:

A. The cost model.

B. The revaluation model.

C. Both A & B.

Solution

The correct answer is C.

Under IFRS Property, Plant, and Equipment (PPE) could be measured using the cost model or the revaluation model. Under US GAAP they can be measured only using the cost model.

 

Reading 25 LOS 25e:

Describe different types of assets and liabilities and the measurement bases of each

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