In this topic 8 sections
- 15A basis answers what; a technique answers how
- 16Compare cost and current values thoughtfully
- 17Fair value: use the inputs hierarchy correctly
- 18Draw the timeline before using a formula
- 19Effective interest: separate the rate from the coupon
- 20Choose the rate required by the standard
- 21Calculation checks
- 22Sources and further reading
A basis answers what; a technique answers how
Recognition asks whether an item belongs in the statements. Measurement asks what amount to report, both initially and afterwards. IFRS uses a mixed measurement model: different assets and liabilities can be measured differently under their applicable standards.
| Basis or measure | What the amount represents | Important distinction |
|---|---|---|
| Historical cost | Transaction-based cost, updated for consumption, impairment and other required adjustments | Not necessarily an unchanged original price |
| Amortised cost | An amount rolled forward using effective interest, cash flows and applicable impairment | Coupon cash and interest expense can differ |
| Fair value | A current market-participant exit price in an orderly transaction | Not a forced-sale price or management's preferred value |
| Current cost | The current entry amount for an equivalent asset or liability | Replacing service capacity need not mean buying an identical old item |
| Value in use | Discounted entity-specific benefits from use and ultimate disposal | Used in impairment assessment under IAS 36 |
| Fulfilment value | Discounted resources the entity expects to transfer in fulfilling an obligation | Differs from the market price of transferring the obligation |
| Net realisable value | Expected ordinary-course selling proceeds less completion and necessary selling costs | Inventory-specific and entity-specific |
| Fair value less costs of disposal | Fair value after directly attributable disposal costs | One component of recoverable amount |
Present value is a technique. It can support amortised cost, fair value, value in use or another specified measure. A discounted number is not automatically fair value: the cash flows and rate must reflect the assumptions of the required measurement basis.
Connect the measures to their rules. Inventory is generally measured at the lower of cost and net realisable value under IAS 2. Under IAS 36, recoverable amount is the higher of value in use and fair value less costs of disposal. An impairment loss arises when carrying amount exceeds recoverable amount. These comparisons serve different purposes; do not interchange their higher/lower tests.
Compare cost and current values thoughtfully
Historical cost often starts with verifiable transaction evidence and can be inexpensive to obtain. Over time, however, it may be less informative about current prices, and combining costs from different years can hinder comparison. Cost also involves judgement when allocating costs or assessing recoverability.
Current values can provide more up-to-date information but may depend heavily on estimates where observable market evidence is scarce. Fair value is not automatically unreliable, and cost is not automatically faithful: assess the evidence and method. An entity's intention to hold an asset does not override a standard requiring fair value.
Fair value: use the inputs hierarchy correctly
| Level | Nature of inputs | Example of the distinction |
|---|---|---|
| 1 | Unadjusted quoted prices for identical items in an active market accessible at the measurement date | A quoted price for the exact listed share |
| 2 | Other observable inputs, directly or indirectly | A valuation using observable yields for sufficiently comparable instruments |
| 3 | Significant unobservable inputs | A valuation substantially dependent on unobservable cash-flow or risk assumptions |
The level reflects the lowest-level input significant to the entire measurement. Using a model does not automatically mean Level 3, and having some observable inputs does not automatically mean Level 2. IFRS 13 explains how to measure fair value when another standard requires or permits it; it does not require every asset to be revalued.
Draw the timeline before using a formula
Let r be the rate per period, n the number of periods and C a cash payment. Use consistent periods throughout.
| Cash-flow pattern | Present value formula |
|---|---|
| One future amount F at time n | F / (1 + r)^n |
| Different cash flows over time | Sum of each cash flow divided by (1 + r)^its timing |
| Equal payments C at each period end | C × [1 - (1 + r)^(-n)] / r |
| Equal payments C starting immediately | Ordinary-annuity present value × (1 + r) |
At a zero rate, the annuity is simply C × n; do not divide by zero. A payment now has no discounting. For an annual effective rate and monthly cash flows, use a consistent equivalent monthly rate when appropriate; dividing an effective annual rate by 12 is not exactly equivalent.
Effective interest: separate the rate from the coupon
A fictional two-year note has a face amount of $10,000 and pays a $600 coupon at each year end. Its issue yield is 8%. Ignore transaction costs and credit losses. The initial amount is $600 / 1.08 + $10,600 / 1.08² = $9,643.35. The coupon rate is 6%; the effective rate is 8%.
| Year | Opening liability | Interest at 8% | Coupon paid | Closing liability before principal |
|---|---|---|---|---|
| 1 | 9,643.35 | 771.47 | (600.00) | 9,814.81 |
| 2 | 9,814.81 | 785.19 | (600.00) | 10,000.00 |
Use unrounded calculations and round displayed figures; a final cent adjustment may be needed. At issue, debit cash and credit the note liability $9,643.35. In Year 1 debit finance expense $771.47, credit cash $600 and credit the liability $171.47. At maturity, paying $10,000 removes the remaining principal. The coupon is not the total interest expense when the instrument was issued at a discount.
Choose the rate required by the standard
| Application | Rate focus |
|---|---|
| Fixed-rate amortised-cost instrument | Original effective interest rate, subject to applicable modification and other requirements |
| Initial lessee lease liability | Rate implicit in the lease if readily determinable; otherwise lessee's incremental borrowing rate |
| Long-term employee benefit obligation | Reporting-date high-quality corporate bond yields with matching currency and term; government bond yields where that currency lacks a deep corporate market |
| Value in use | Current pre-tax rate reflecting time value and relevant risks not already adjusted in cash flows |
| Discounted provision | Current pre-tax assessment of time value and liability-specific risk, avoiding double counting |
Historical and current rates answer different measurement questions. Do not update a fixed-rate amortised-cost loan to today's market yield merely because rates changed. Conversely, do not assume a long-term employee benefit obligation retains its original discount rate forever.
Risk can be reflected in cash flows or the discount rate as permitted by the relevant standard. Including the same risk in both distorts measurement. Systematic risk concerns market-wide factors; diversifiable risk relates to an individual investment. These finance concepts help explain valuation, but the applicable accounting standard determines the required measurement.
Calculation checks
Check the cash-flow dates, signs, rate period, compounding and whether a residual or balloon payment exists. For an ordinary annuity, the first payment is at the end of period 1. For an advance payment, the first cash flow is at time 0. Do not count it twice.
CHECK: A year-end $5,000 payment is due annually for three years. Should the initial value equal $15,000 when the discount rate is positive?
ANSWER: No. Each future payment has a present value below its nominal amount. The total should therefore be below $15,000. This reasonableness check helps catch the use of a future-value formula by mistake.
Sources and further reading
Study guide: CPA Australia, Financial Reporting study guide, sixth edition, October 2022, Module 1, section 1.5, printed pages 27–38. Download the present-value and effective-interest sheet and the present- and future-value factor tables. The factor tables include single amounts and ordinary annuities, rates of 1%–16% and 20%, and 1–25 periods, calculated independently for Accounting Ahead.
Concept sources: AASB Conceptual Framework, December 2021 compilation, chapter 6; AASB 13, March 2020 compilation, paragraphs 9, 15–26 and 72–90; AASB 9, December 2021 compilation, Appendix A, amortised cost and effective interest; AASB 102, March 2020 compilation, paragraph 9; AASB 136, March 2020 compilation, paragraphs 18, 55–60; AASB 137, March 2020 compilation, paragraphs 45–47; AASB 16, December 2021 compilation, paragraph 26; AASB 119, December 2021 compilation, paragraph 83. Formulas and numerical examples are original applications of the guide's measurement principles.