Many different bodies of practices are used around the world for external financial reporting and these include different approaches to measurement.
- Different jurisdictions have developed their own financial reporting requirements, influenced by differences in the uses made of financial reporting information and in business and regulatory environments.
- Even within a single jurisdiction, different approaches are sometimes adopted for different entities in order to reflect variations in size, ownership and governance.
- Businesses undertake different types of transaction or hold different types of asset or liability. Practices develop that reflect the needs and experiences of particular types of business.
These bodies of practices are rarely systematic; they have evolved over time as collections of diverse responses to practical problems.
Historical cost remains the predominant basis of financial reporting. This reflects the foundation of financial reporting in book-keeping and the use of historical cost for management purposes. There are important exceptions to this generalisation: significant financial services businesses, for example, rely heavily on fair value information for management purposes. Nevertheless, transactions are initially recorded as they occur at amounts that form the basis of historical cost measurements. Historical cost is usually, therefore, the simplest and cheapest basis of financial reporting measurement to build on the foundations that are laid by a business’s bookkeeping records and management information systems.
Generally, however, there has been an evolution away from pure historical cost and towards one version or another of current value – and at present towards greater use of fair value specifically. In some respects, the meaning of historical cost has evolved to accommodate this tendency. Financial reporting in change
Why have measurement practices developed in this way? It is possible to identify a number of reasons, all of which are responses to financial reporting problems.
New ways of doing business. Financial reporting is constantly changing to cope with new ways of doing business. For example, leasing, complex financial instruments, and share-based payments have each presented fresh challenges. In all of these examples items that are apparently valuable may have no historical cost or a historical cost of zero. This is the case with leased assets, with certain financial instruments such as interest-rate swaps, and with goods and services acquired using shares or share-based instruments. New reporting practices have evolved that allow or require such items to be recorded at a current or fair value as a proxy for historical cost. Business has also evolved so that a wide range of entities – not just insurance companies – create long-term liabilities with no definite cost at the time they are incurred. Warranties, reinstatement obligations, and defined benefit pension commitments are examples. It is difficult to know what the historical cost of such indeterminate liabilities for future amounts could be, and their measurement in accounts necessarily reflects expectations of the future rather than actual historical amounts. What these examples have in common is a commitment, to or by the business, to a possibly indeterminate future transfer of value. Historical cost is not well-designed to cope with accounting for such future transactions, but they are clearly relevant to understanding a business’s financial performance and position.
Disparities between current value and historical cost. There are often large disparities between an asset’s historical cost and its current value. Questions inevitably arise, for example, as to whether the historical cost of a property bought 20 years ago, but now worth many times its historical cost, is more useful information to disclose than its current value. Practices have therefore developed that allow or require revaluations of certain assets. To deal with disparities in the opposite direction (i.e, where current value is significantly lower than historical cost), assets are written down to the amount that can be recovered from their sale or use. Financial reporting in change
The ability to manipulate historical cost results. Some historical cost measurements can be manipulated to produce figures that may be regarded as misleading. For example, a portfolio of investments, whose value goes up and down from one year to the next, could be realised piecemeal so as to show a constant stream of historical cost profits.
Again, therefore, practices have developed that require regular revaluations of such assets. Financial reporting in change
These different causes of evolution in measurement practices do not fit into a neat chronological pattern, but there is a clear logic to the evolution. From a starting-point of historical cost (which would include accruals of income and costs) there is first a prudent recognition of future liabilities and impairments in asset values, towards what may be described as recoverable historical cost and, second, increasing recognition of some assets and liabilities at a current value, leading to a system that may be described as modified historical cost (or, more precisely, modified recoverable historical cost)1. Financial reporting in change
The development of measurement practices is a dynamic and iterative process. This process is illustrated here:
Financial reporting measures result from the application of measurement practices to economic activities. Although economic activities and measurement practices are the result of a range of influences, it is important to appreciate that they are also affected by financial reporting measures themselves. Measures influence economic activities2 by affecting economic incentives. And arguably the most significant pressures for measurement practices to change arise because they are seen as failing to reflect economic activity appropriately or because they promote unwelcome economic activities. Financial reporting in change
Two of the examples just mentioned can be seen as instances of this process. Financial reporting in change
- When finance leases first emerged it was considered that financial reporting measurements failed to represent accurately this new form of economic activity. This led to new reporting requirements, which produced different measurements. But the new requirements provided economic incentives to change the structure of leases so that they fell outside the definition of a finance lease. This has left standard-setters with a decision as to whether they should amend measurement requirements so as to reflect the changed forms of economic activity.
- The disparity between the historical cost and current value of certain assets led to financial reporting measurements that were thought by some to be misleading. This resulted (in some jurisdictions) in a permissive approach to asset revaluations in accounts. But the new rules provided incentives to use the permission selectively so as to present the most favorable picture of financial position and performance. This led standard-setters to adopt a more restrictive approach, which has made it more difficult to use selective revaluations.
Reporting practices evolve in response to particular problems as they emerge. But the practices that develop to deal with one type of problem may well be inconsistent with those that develop to deal with another. IFRS illustrates the complexity that results. Financial reporting in change