Measurement & Valuation Principles

In finance and accounting, the measurement and valuation of assets, liabilities, income, and expenses are vital in maintaining the accuracy and transparency, as well as the ability to compare statements and financial records. The measurement and principles of valuation are used in the development of the basic principles of accounting, such as IFRS and GAAP. 

Every student in commerce, finance, and business needs to be able to understand these principles for the sake of analyzing business performance. This post will focus on the definition, types of principles, their measurement, and the practical valuation, along with their real-world applications. 

What are the Principles of Measurement and Valuation?

In accounting, measuring assets, liabilities, equity, income, and expenses, and while doing so quantifying them in monetary terms, is referred to as measurement. A measurement equally comes with a basis and standard, and that is what is referred to as the valuation.

All these principles provide a business with the ability to answer the most important questions it has.

• What is the value we shall record for an asset?
• Are liabilities to be measured at cost or the value of the equity present?
• How does a business reflect inflation or a change in market conditions in its financial reporting?

As with the construction standards, these principles provide answers to the set accounting and financial principles, which in turn guide the construction of financial statements in a manner that enhances their reliability and ability to be compared through time and across different organizations.

Key Measurement and Valuation Bases

Although methodologies for measurement and assessment improve financial reporting, these principles should be followed uniformly. Too many changes for a single measurement basis may mislead stakeholders and diminish comparability. Hence, accounting principles, like IFRS and Ind AS, provide rules specifying when and how these rules should be applied.

1. Cost Principle

• An entity's assets and liabilities are recorded at the monetary outflow that was incurred at the time of acquisition.
• For example, if machinery is purchased for ₹10,00,000, it will be recorded at that value, irrespective of any future fluctuations and changes in its market value.

• Pros: Objectivity, verifiable data. 
• Cons: Ignores inflation and changes in market value.

2. Fair Value Principle

• An entity’s assets and liabilities are assessed at the amount they would be sold for in the entity’s relevant market.
• Example: Investments in shares are often valued at their marketable value rather than the purchase price.

• Pros: More relevant and reflects true economic value.
• Cons: Volatile and somewhat subjective.

3. Realizable Value 

• An entity’s assets are assumed to be sold and valued at the amount that would be the result of the sale, while the liabilities are determined at the amount needed to be paid to settle them. 
• Example: Inventory is valued at the lower of cost and the net realizable value (NRV).

4. Principle of Present Value

• Recording is done according to expected future cash flows that have been discounted.
• This was recorded in numerous instances for long-term liabilities, like pension obligations or bonds. 
• Example: A company does not record its loan liability solely at the face value, but does so at the expectation of the future payments, which is rather at the present value of them 5. Current Cost Principle

Current Cost Principle 

• Assets are said to have a cost when they can be bought brand new.
• Example: The current cost principle would be used if the cost of machinery exceeds the replacement cost.

Key Application In Financial Statements

The principles of measurement and valuation underpin financial reporting. Thus, it is indispensable for employed individuals as well as students to internalize these principles to evaluate financial accounts and statements, develop sound business strategies, and appreciate the narratives portrayed through business numerology.

• Balance Sheet: Financial assets like cash and receivables are generally kept at market value, while land and buildings are kept at cost.

• • Profit & Loss Statement: Expenditures are recorded when cash and other assets of the firm are paid at the marketable value, while the revenue is recognized at the fair value of the goods or the services rendered.

• Inventory: It is often kept at a value lower than cost or net realizable value as a prudent measure.

• Long-duration Debts: They are often recorded at the present value of the cash outflows expected.

See Also 

• What is Blockchain?
• What is VAT?
• ITR Filing
• What is GST?

 

Did you know?  After the 2008 global financial crisis, the concept of fair value accounting became more important when it was understood that the historical cost accounting system concealed the financial position of companies and the risks borne, especially by the banks.

FAQs on Measurement Valuation Principles 

Why are different principles of valuation used in accounting?

Different principles are used in valuation and measurement to achieve a balance between reliability and relevance.

Which is better, historical cost or fair value?

Neither is better. Historical cost is stable and objective, whereas fair value is more relevant to the current market conditions. A mixed approach is more common.

In what ways does measurement affect investors?

Investors are influenced by measurement principles that determine the declarable profits and net worth. These also influence the former’s decision to purchase, hold, or dispose of the shares.