Godfrey Summary Accounting Theory Chapter 5 Measurement [PDF]

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SUMMARY ACCOUNTING THEORY (SUBJECT CODE: ECAU601401) Chapter 5 Measurement Theory (Godfrey et.al. Accounting Theory 7th Ed) Lecturer: Mrs. Siti Nuryanah, S.E., M.S.M., M.Bus.Acc., Ph.D.



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Group Member Eggie Auliya Husna 1706105246 Fendhi Birowo 1706105290 M. Avisena 1406612275 Yolanda Tamara 1506736064



SALEMBA EXTENSION CLASS ACCOUNTING PROGRAM FACULTY OF ECONOMICS AND BUSINESS UNIVERSITY OF INDONESIA YEAR 2018



MIND MAP FOR CHAPTER 5



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CHAPTER 5 MEASUREMENT THEORY THE IMPORTANCE OF MEASUREMENT Definition of measurement  Campbell  the assignment of numerals to represent properties of material system other than numbers, in virtue of the laws governing these properties.  Stevens  the assignment of numerals to objects or events according to rules. The distinction between those theories are the “systems” and the “properties of those systems”. The systems in Campbell‟s definition are what Stevens calls “object or events”. These could include houses, tables, people, assets, or distance travelled. Properties are the specific aspects or characteristics of the systems, such as weight, length, width or colour. Under this view, the measurement process is similar to the approach to theory formulation and testing. A statement, expressed mathematically, is advanced. Semantic rules (operations) are devised to connect the symbols of the statement to particular objects or events. When it is demonstrated that the relationship in the mathematical statement correlate with the relationships of the objects or events, then measurement of the given aspect of the objects or events has been made. In accounting we measure profit by first assigning a value to capital abd then calculating profit as the change in capital over the period after accounting for all economic events that affect the wealth of the firm. THE NOMINAL, ORDINAL, INTERVAL, AND RATIO SCALES OF MEASUREMENT A scale is created when a semantic rule is used to relate the mathematical statement to objects or events. The scale shows what information the number represent, thus giving meaning to the numbers. The type of scale created depends on semantic rules used. According to Stevens, scales can be described in general terms as a nominal, ordinal, interval, or ratio. These classifications were arrived at by examining the mathematical group structure of scales. The mathematical structure is determined by considering the kind of transformation that leaves the structure of the scale invariant, i.e. unchanged. Nominal scale In the nominal scale, number are used only as labels. Torgerson states that in measurement, as we use the term, the number assigned refers to the relative amount or degree of a property possessed by the object, and not to the object itself, whereas, in the different nominal scales, the numbers refer to the objects or classes of objects: it is the object that is named or classified. The nominal scale simply represents classification, which is not what measurement is considered to be in the ordinary usage of the term. As Torgerson points out, measurements refers to properties of objects, whereas in the nominal scale the numbers often denote the objects themselves, such as numbering or naming players in sporting teams. The major property the numbers have is to identify players or objects. In the accounting system, the closest we have to the nominal scale is the classification of assets and liabilities into different classes. 3



Ordinal scale An ordinal scale is created when an operation ranks the objects in question with respect to a given property. For example, investment instrument ranking 1,2,3 according to their net present values, the highest ranked as 1 and the lowest as 3. The operation (calculation of net present value) gives rise to an ordinal scale, which is the set of numbers referring to the investment alternatives. The numbers indicate the order of the size of the net present value of the options and, therefore, their profitability. A weakness of the ordinal scale is that the intervals between the numbers (1 to 2, 2 to 3, 3 to 4) do not tell us anything about the differences in the quantity of the property they represent. They are maybe very close each other. Another weakness is that the numbers do not signify “how much” of the attribute the objects possess. The natural zero point could be a neutral point where in one direction are all the expected profitable alternatives and in the other direction are all the expected profitable alternatives and in the other direction are the expected unprofitable ones. The numbers assigned to the options on one side of the zero point would have positive signs and, on the other, negative signs. Interval scale The interval scale imparts more information than the ordinal scale. Not only is the ranking of the objects known with respect to the given property, but the distance between the interval on the scale is equal and known. A selected zero point also exist on the scale. An example is Celcius scale of temperature. The weakness of interval scale is that the zero point is arbitrarily established. Mattessich mentions standard cost accounting as one example where the interval scale is used in accounting. The standard may be based on theoretical, average, practical, or normal performance. Because the choice is more or less arbitrary, the calculation of standards and variances generates an interval scales. If the variance is zero, this signifies neutrality, but this point is arbitrarily selected. Ratio scale A ratio scale is one where:  The rank order of the objects or events with respect to a given property is known  The intervals between the objects are equal and are known  A unique origin, a natural zero point, exist where the distance from it for at least one object is known. The ratio scale conveys the most information. An example of the ratio scale is the measurmeent of length, and an example in accounting is the use of dollars to represent cost and value. THE PERMISSIBLE OPERATION OF SCALES The ratio scale allows for all the fundamental arithmetical operations. A ratio scale remains invariant (fixed) over all transformations when multiplied by a constant. For example, consider the following: X’=Cx



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If X represents all the points of a given scale, and each point is multiplied by a constant c, the resulting scale X’ will also be a ratio scale. The reason is that the structure of the scale is left invariant, that is:  The rank order of the point is uncharged  The ratios of the points are unchanged  The zero point is unchanged Invariance of the scale means that, regardless of the measured used, 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, as different systems are variant to each other. Income measured under one system will lead to different decisions from income measured under another system. The systems won‟t provide the same information.  Nominal and ordinal scales  no arithmetic operations  Interval scales  addition and subtraction  Ratio scales  all arithmetic operations THE DIFFERENCE BETWEEN FUNDAMENTAL, DERIVIED, AND FIAT MEASUREMENT Fundamental measurement A fundamental measurement is one where the numbers can be assigned to the property by reference to natural laws and which does not depend on the measurement of any other variable. Properties such as length, electrical resistance, number and volume are fundamentally measurable. A ratio scale can be formulated for each of these properties on the basis of laws relating the different measures (quantities) of the given property. The interpretation of the numbers depends on the confirmed empirical theory that governs the measurments operation. As it turns out, the fundamental properties are additive. Because of this it is simple to find physical parallels to the operations of arithmetic. Derivied measurement According to Campbell, a derivied measurement is one that depends on measurement of two or more other quantities. Derivied measurement operations depend on known relationships to fundamental properties. They are based on a confirmed empirical theory relating the given property to other properties. Mathematical operations can be performed on the numbers from derivied measurements because of the parallel mathematical and physical operations on the fundamental properties. For example:  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 Fiat measurement Fiat measurement (means decree, edict, by Torgerson) would encompass other measurements based on arbitrary definitions (e.g. the measurement of profit in accounting). However, Torgerson points out that the major problem with measurement by fiat, because it is not based on confirmed theory, is the numerous ways in which the scales can be constructed. In accounting, for example, the various accounting standards boards determine accounting scale by fiat, not by 5



reference to confirmed measurement theories. Therefore, there are many measurement alternative so confidence in any particular scale may be low. WHAT IS MEANT BY RELIABILITY AND ACCURACY IN MEASUREMENT Source of error  Measurement operations stated imprecisely  Measurer  Instrument  Environment  Atribute unclear  Risk and uncertainty Reliable measurement Reliability refers to the proven consistency of either an operation to produce satisfactory results or the results (the numbers) themselves for a particular use. In statistics, reliability demands that measurements be repeatable or reproducible, thereby demonstrating their consistency. The notion of reliability incorporates two aspects: the accuracy and certainty of measurement, and the representative faithfulness of disclosures in relation to the underlying economic transactions and events. The measurement aspect concerns the precision of measurement. Accurate measurement Consistency of results, precision and reliability do not necessarily lead to accuracy. The reason is that accuracy has to do with how close the measurement is to the „true value‟ of the attribute measure, the „bullseye‟, so to speak. Fundamental properties, such as the length of an object, can be determined to be accurate by comparing the object with a standard that represents true value. The problem is that for many measurements the true value is not known. In order to determine accuracy in accounting, we need to know what attribute we should measure to achieve the purpose of the measurement. Accuracy measurement relates to the pragmatic notion of usefulness, but accountants are not in agreement as to what the specific, quantitative standards are that are implied. For example, we can calculate the cost of the inventory by FIFO and repeat the calculations a thousand times but it cannot ensure the answer is accurate. Instead of using the term „accuracy‟ which is so often to mean arithmetical precision, it may be prudent to use the term of the social scientists, „validity‟. MEASUREMENT IN ACCOUNTING Measurement in accounting falls into the category of derivied measurement for both capital and profit. Capital is derivied from transactions and revaluations that occur in financial markets, and profit can be derivied from the matching of expenses with revenue or the change in capital over the period. Capital can be defined and derivied in various way, including historical cost, operating, financial, or „fair value‟.



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History shows us that the concepts of capital and profit have changed and evolved overtime so that there are a number of concepts of fundamental measurements. Here is the timeline:  In the first thousand years AD, the economic structure was represented by decentralised, selfcontained fiefdoms.  After the crusades to the Holy Land in the eleventh century, the opening up of the Middle Eastern and Asian trade routes created a demand for tradeable goods (silk, spices, carpets). The Italian trading cities played a major role transporting crusaders to the Holy Land and returning with goods.  The eighteenth century in England saw the development of joint stock companies with limited liability, a separate management class, and transferability of shares.  In 1940, Paton and Littleton produced the first definitive statement on the concepts of capital and profit.  The normative period of the 1960s saw a number of challenges to the historical principle valuation and hence capital maintenance. This era is the forerunner of the „fair value‟ approach to derivied accounting measurement. Consequently, we were left with a number of accounting measurement systems. These different perspectives reflects various boundaries of accounting and lack of agreement on measurement principles, but with the historical cost allocation system as the conventional and dominant model. This has resulted in two notable developments in international accounting standards such as IAS 39/AASB 139 Financial Instruments: Recognition and Measurement and the IASB/FASB joint project on reporting financial performance – (1) that profit measurement and revenue recognition should be linked to timely recognition, and (2) that the „fair value‟ approach should be adopted as a working measurement principle. MEASUREMENT ISSUES FOR AUDITORS There are several issues for auditors:  The existence of alternative valuation methods for some assets, for example, measuring profit by assessing changes in fair value of net assets is addressed by accounting standard IAS 36/AASB 136.  The problem caused by variability in the level of reliability and accuracy of measurement of historical costs. For example, the issues in auditing historical cost, such as standard inventory cost, where the costs are precisely stated, but based on assumptions about engineering processes that are influenced by changing conditions



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