Accounting as a Measurement Discipline – Valuation Principles. Accounting Estimates – CA Foundation, CPT notes, PDF

This article is about Accounting as a Measurement Discipline – Valuation Principles. Accounting Estimates for CA foundation CPT students. we also provide pdf file at the end.

Accounting as a Measurement Discipline – Valuation Principles. Accounting Estimates

7.1 MEASUREMENT: MEANING & NEED:

♦     Accounting is the language of communicating the performance and financial position of an enterprise.

♦     An enterprise enters into many types of transactions and events which involve goods, services, properties, benefits, liabilities, etc. each may have a different unit of measurement in a normal course like Kgs, Mtrs, Ltrs, Numbers, Hours, etc.

♦     All such items have to be considered together hence there is the need of having a common base of measurement so that all are counted in uniform terms.

♦     The result has been evolvement of money as a common basis of measurement. The expenses of goods in kgs, professional services in hours, electricity in units, etc. can be added only in money terms.

♦     Although money as a measurement scale has no common denomination on a global basis, it takes the form of the local currency of the country of the enterprise.

♦     Currency is different for different countries and they are unstable & keeps on fluctuating between each other.

♦     The purchasing power of money keeps on fluctuating hence in the same money value we might have got more or less of the same goods/services etc. over two different points of time.

♦     In spite of monetary unit not being universal and stable, this is the accepted basis of measurement in accounting and makes it possible to report information of varied nature of transactions and events together.

7.2 MEASUREMENT BASES (VALUATION PRINCIPLE) :

♦     There are four generally accepted measurement bases or valuation principles. These are:

(i)  Historical Cost

(ii) Current Cost

(iii) Realisable Value

(iv) Present Value

7.2.1 Historical Cost:

♦     It means acquisition price.

♦     According to this base, assets are recorded at an amount of cash or cash equivalent paid or the fair value of the consideration given at the time of acquisition.

♦     Liabilities are recorded at the number of proceeds received in exchange for the obligation. In some circumstances, a liability is recorded at the amount of cash or cash equivalent expected to be paid to satisfy it in the normal course of business.

Example:

(1)   On 1.1.1995, A businessman ‘Ram’ paid Rs. 5,00,000 to purchase the building, its acquisition price Rs. 5,00,000 is the historical cost of a building.

(2)   A loan taken from Bank Rs. 4,00,000 @ 15%, the liability will be recorded at the proceeds received Rs. 4,00,000.

(3)   Services received for which it is expected that Rs. 20,000 will be paid, hence liability will be recorded at Rs. 20,000 This base is most commonly followed in accounting.

7.2.2 Current Cost:

♦     The current cost gives an alternative measurement base (for existing assets and liabilities).

♦     Assets are carried at the amount of cash or cash equivalent that would have to be paid if the same or an equivalent asset was acquired currently.

♦     Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

Example:

(1)   Take that as on 1.1.06, ‘Ram’ found that it would cost Rs. 15,00,000 to purchase that building. So as per the current cost base, the machine value is Rs. 15,00,000.

(2)   Take also that as on 1.1.06 the bank announces a discount @10% on the loan amount if it is paid by 15 days starting from that day. So as per the current cost base, the value of bank loan is Rs. 3,60,000 (Rs. 4,00,000 less 10% discount).

At Foundation level of study, you may not use it anywhere in Accounting.

7.2.3 Realisable Value:

♦     As per realizable value, assets are carried at the amount of cash or equivalent that could currently be obtained by selling the assets in an orderly disposal. Haphazard disposal may yield something less.

♦     Liabilities are carried at their settlement values; i.e., the undiscounted amounts of cash or cash equivalents expressed to be paid to satisfy the liabilities in the normal course of business.

Example:

(1)   Suppose ‘Ram’ found that he can get Rs. 14,00,000 if he would sell the building purchased on 1.1.95. So the building should be recorded at Rs. 14,00,000 the realizable value in an orderly sale.

(2)   Take also that ‘Ram’ found that he had no money to pay off the bank loan currently and will pay in the normal course. So the bank loan should be recorded at Rs. 4,00,000 the settlement value in the normal course of business.

You may find the use of it only in Inventory Valuation which is valued at cost or net realizable value whichever is lower.

7.2.4 Present Value:

♦     As per the present value, an asset is carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business.

♦     Liabilities are carried at the present discounted value of future net cash flows that are expected to be required to settle the liabilities in the normal course of business.

Example:

(1)   Suppose we were talking as on 1.1.06 take it as a time of reference. Now think the building purchased by Ram’ on 1.1.95 can work for another 10 years and is supposed to generate cash @ Rs. 75,000 p.a. and scrap value Rs. 50,000.

Present value of building = 75,000 × 5.019 + 50,000 × .247 = 3,76,425 + 12,350 = Rs. 3,88,775

(2)   Also that bank loan taken by ‘Ram’ is to be repaid as on 31.12.2010, annual interest is Rs. 60,000.

Present value of loan = 60,000 × 5.019 + 4,00,000 × .247 = 3,01,140 + 98,800 = Rs. 3.99,940

(For above discounting 15% rate has been assumed)

This also you may not use in your Foundation syllabus except the small reference in goodwill valuation. The above used Present value factors (@15%) are available from Statistical tables. The calculation thereof is covered in the Intermediate syllabus.

7.3 ACCOUNTING ESTIMATE:

7.3.1    Meaning:

♦     Accounting estimates are an essential part of accounting.

♦     Accounting is a process of recording, classifying and analyzing transactions and events with reference to an accounting period usually a year, whereas transactions and events may occur at different points of time and may have an impact on longer periods hence requiring estimations.

♦     Ex: Estimating the life of the fixed assets for depreciation, Estimating bad & doubtful debts, etc.

7.3.2 Change in Accounting Estimate:

♦     An estimate may have to be revised if –

■     changes occur regarding the circumstances on which the estimate was based, or

■     as a result of new information, more experience or subsequent developments.

♦     The revision of the estimate is not an extraordinary item or a prior period item.

♦     If sometimes, it is difficult to distinguish between a change in an accounting policy and a change in an accounting estimate, the change should be treated as a change in an accounting estimate, with appropriate disclosures.

♦     The effect of a change in an accounting estimate should be included in the determination of net profit or loss in:

■     the period of the change, if the change affects the period only; or

■     the period of the change and future periods, if the change affects both.

♦     A change in an accounting estimate may affect the “current period only or both the current period and future periods.

♦     For example, a change in the estimate of the number of bad debts is recognized immediately and therefore affects only the current period.

♦     However, a change in the estimated useful life of a depreciable asset affects the depreciation in the current period and in each period during the remaining useful life of the asset.

♦     In both cases, the effect of the change relating to the current period is recognized as income or expense in the current period.

♦     The effect, if any, on future periods, is recognized in future periods.

♦     The nature and amount of a change in an accounting estimate which has a material effect in the current period, or which is expected to do so in subsequent periods, should be disclosed.

♦     If it is impracticable to quantify the amount, this fact should be disclosed.

♦     The effect of a change in an accounting estimate should be classified using the same classification in the statement of profit and loss as was used previously for the estimate.

7.3.3 Examples of changes in accounting estimates

1. Change in the useful life of fixed assets.
2. Actual bad debts turning out to be more or less than the provision.
3. Actual liability turning out to be more than or less than the provision.
4. Actual gratuity liability/retirement benefits turn out to be more than the provision.

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