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MEASUREMENT THEORY

Importance of
measurement
Campbell:
The assignment of numerals to represent
properties of material systems other than
numbers

Assignment
Assignment of
of numerals
numerals to
to objects
objects or
or events
events
according
(Stevens)
according to
to rules.
rules.
(Stevens)
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Importance of
measurement

Involves linking the formal number system


to some property of objects or events by
means of semantic rules
e.g. semantic rules in accounting are represented
by transactions

In accounting we measure profit by:


first assigning a value to capital
then calculating profit as the change in capital
over the period

Provide will differ and different


decisions

We examine the relationship between the fair value measurement and the
audit quality. Our evidence suggests that the fair value measurement has a
negative impact on the overall CPAs audit quality. And this negative effect
depends on the application scale of the fair value measurement.
Nowadays, large-scale application of the fair value measurement does
decrease the overall audit quality, but a modest application reflects the
intention of improving the value relevance of accounting information and
plays its proper role.
They should pay more attention to the audit of fair value and reduce the
adverse effect of fair value measurement on external audit, so that this
measurement can play its proper role as soon as possible.

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The Measurement Approach to Decision Usefulness

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What is the Measurement


Approach?
Greater Use of Current Values in the Financial
Statements Proper
Two versions of current value

Exit price: SFAS 157 defines fair value as exit price


Value-in-use: present value of future cash receipts
or payments

Role of measurement approach is to increase


decision usefulness over that of information
approach

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Why are Accountants Moving


Towards a Measurement
Approach?

Securities markets may not be as


efficient as previously believed

To extent markets not fully efficient, a


measurement perspective is supported

Low R2

Better measurement may increase accounting


market share in explaining share price
changes

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Why are Accountants Moving


Towards a Measurement
Approach?

Ohlsns clean surplus theory


A theoretical framework supportive of a
measurement approach

Auditor Liability
Better measurement may reduce auditor
liability when firms become financially
distressed

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Are Securities Markets Fully


Efficient?

Behavioural finance
Behavioural characteristics that question market
efficiency

Limited attention
Overconfidence
Representativeness
Self-attribution bias

Leading to momentum

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Scales
Every measurement is made on a scale
Created when a semantic rule is used to
relate the mathematical statement to
objects or events
The scale shows what information the
numbers represent

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Semantic Rules and Measure


Profit

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Scales

Nominal scales
Number used only for labels;
Numbers represent classifications;
e.g. the classification of assets and liabilities
into different classes

Ordinal scales
Rank orders objects with respect to a given
property
Intervals between the numbers are not
necessarily equal

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Scale

Interval scale

Rank orders objects with respect to a given


property
The distance between each interval is equal and
known
An arbitrarily selected zero point exists on the
scale
e.g. celsius temperature scale
e.g. standard cost accounting

Ratio scale

Rank orders objects with respect to a given


property
Intervals between objects are known and equal

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Nominal Scales

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RATIO SCALE

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Permissible operations of
scales
Invariance of a scale means that the
measurement system will provide the same
general form of the variables, and the
decision maker will make the same
decisions
This is not the case in accounting there is
more than one accounting system
The information they provide will differ and
different decisions will be made

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Types of measurement
There must be a rule to assign numbers
before there can be measurement
The formulation of the rules gives rise to a
scale
Measurement can be made only on a scale

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Fundamental
measurements
Numbers are assigned by reference to
natural laws
Fundamental properties are additive

e.g. length, number and volume

In accounting there is considerable debate


over the nature of fundamental value

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Derived measurements
Is one that depends on the measurement of
two or more other quantities
Depends on known relationships to
fundamental properties

e.g. the measurement of density depends on the


measurement of both mass and volume
e.g. the measurement of profit depends on the
measurement of both income and expenses

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Fiat measurements
Typical in social sciences including
accounting
Based on arbitrary definitions - e.g. of profit
Numerous ways in which scales can be
constructed
May lead to poor levels of confidence in the
scale e.g. there are hundreds of ways to
measure profit

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Reliability and accuracy

No measurement is free of error except


counting
e.g. we can count the chairs in a room and be
exactly correct

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Reliable measurement

What is reliable measurement?


proven consistency
repeatable or reproducible
precision

Reliability incorporates two aspects


accuracy and certainty of measurement
representative faithfulness

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Accurate measurement
Consistency of results, precision and
reliability do not necessarily lead to
accuracy
Accuracy has to do with how close the
measurement is to the true value of the
attribute measure - representation
True value may not be known

e.g. in accounting accuracy relates to the


pragmatic notion of usefulness

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Accurate measurement
Many accounting measurements are on a
ratio scale
This is the most informative scale
Weakest theoretical foundation as they are
fiat measurements

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Sources of error
The sources of error include the following:
Measurement operations stated imprecisely
Measurer
Instrument
Environment
Attribute unclear
Risk and uncertainty
We need to establish limits of acceptable
error

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Measurement in
accounting

Two fundamental measures


capital & profit

Capital and profit can be defined & derived


in various ways
Concepts of capital & profit have changed
over time

number of concepts of fundamental measurement

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Measurement in
accounting

Two notable developments in international


standards (2005, IASB)
profit measurement and revenue recognition
should be linked to timely recognition
the fair value approach should be adopted as the
working measurement principle
At no stage has the principle of capital
maintenance been explicitly discussed

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Measurement issues for


auditors

The focus of profit measurement has shifted


from matching revenues and expenses to
assessing the changes in the fair value of
net assets
e.g. immediate recognition of impairment losses

Auditors must determine whether


management has made appropriate and
reasonable valuations
e.g. at least 12 methods of valuing intangibles

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Measurement issues for


auditors
It is possible for several different but
reasonable measurements and impairment
losses to be recognised by management
These would all be acceptable to an auditor
if management have

applied the valuation models correctly


used appropriate data
made appropriate assumptions
acted in a consistent manner

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Main income and capital


measurement systems
The historic cost accounting system
current cost accounting

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Historic cost accounting

Separation of ownership and control


information asymmetry

Most critical objective of accounting is


accountability - stewardship (conservatism)
The income statement is paramount

transaction based
revenue recognition
matching
profit measurement

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Arguments for historic cost


accounting

Relevant in making economic decisions


Based on actual, not merely possible,
transactions
Data have been concept of profit
Must guard data against internal
modificationsfound to be useful
The best understood
Profit based on alternatives may not be useful
Market prices can be supplementary data
Insufficient evidence to reject it

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Criticisms of Historical
Cost
Objective of accounting
Information for decision making
Basis of historic cost
Matching
Notions of investor
needs

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Objective of current cost


accounting

CCA values assets at their current market buying price


and profit is determined using matching expense
allocations based on the current cost to buy
Profit is more precisely defined as the change in
capital over the accounting period
Managers are better able to evaluate their past
decisions and better use the firms resources to
maximise future profits
Shareholders, investors and others are able to make
better allocations of their resources
Managers will examine

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Arguments for and against


current cost

Recognition principle
violates the conservatism principle - but actual
phenomena
are holding gains profits or revaluation
adjustments?

Objectivity of current cost


lacks objectivity

Technological change
appears to ignore technological advances

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International accounting
standards and current costs

IASB/FASB have agreed that fair value is


the best measurement basis (2004)
the amount for which an asset could be
exchanged, or a liability settled, between
knowledgeable, willing parties in an arms
length transaction

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A mixed measurement system


and international standards
Market values - exit prices - are implied in
the fair value approach in international
financial reporting standards
A lack of a theoretical concept of valuation,
capital maintenance and profit measure,
has resulted in a still mixed measurement
system and a lack of consistency

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Issues for auditors

The mixed measurement model creates


misstatement so that auditors struggle to
meet one of their primary objectives
determining whether the financial statements
present a true and fair view

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Auditor Liability

Will a measurement approach reduce auditor


liability?
Perhaps, if investors subject to limited attention

Auditor can claim that the financial statements proper


anticipated value changes

But, current values may be subject to


manager bias if no market value available
Then, may be hard to resist manager bias

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Auditor Liability and


Conservative Accounting

Example: conditional conservatism

A change in asset value has already occurred


Assume investor is risk averse
Investor opportunity loss of expected utility if a
decline in asset value is not recorded = 1.02
Investor loss if an increase in asset value not
recorded = .52
Investor more likely to sue auditor if a decline in
asset value not recorded.
Auditor reaction: conservative accounting, to
reduce likelihood of lawsuit
Continued
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Auditor Liability and Conservative


Accounting (continued)

Example: unconditional conservatism


Asset value = $10,000 at financial statement date,
but value may change in future
If asset declines in value, investor loses utility of 1.02
If asset increases in value, investor loses utility of .54

How should auditor value asset at statement date?


If asset valued at $10,000 (current value), investor
expected utility = 39.93
If asset valued at $9,400 (conservative valuation),
investor expected utility = 40.00

This suggests an investor demand for


conservatism
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Conclusions

Assuming reasonable reliability, current value


accounting can increase decision usefulness
relative to information perspective
Increased use of current value accounting in
financial reporting
Reasons

Markets not fully efficient


Low explanatory power of net income for share returns
Ohlsn clean surplus theory
Auditor liability

Decision usefulness for investors may be


further increased by conservative accounting
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Education Canada