1.4 Recognition and measurement concepts

Recognition and measurement concepts form the backbone of financial accounting. They provide a framework for recording transactions and valuing assets, liabilities, revenues, and expenses in financial statements. These principles ensure consistency and reliability in financial reporting.

Key concepts include recognition criteria, initial and subsequent measurement, impairment testing, and revenue recognition. Understanding these principles is crucial for accurately reflecting an entity's financial position and performance, and for making informed business decisions based on financial information.

Recognition and measurement principles

• Fundamental concepts in financial accounting that determine when and how items are recorded and valued in financial statements
• Provide a consistent framework for preparers and users of financial statements to understand how transactions and events are reflected in the financial position and performance of an entity

Recognition criteria

Probable future economic benefits

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• An item must have a high likelihood of generating future economic benefits for the entity, such as cash inflows or cost savings
• Probability is assessed based on available evidence and professional judgment
• Examples include expected sales from inventory or future cost savings from a new production process

Reliable measurement of cost or value

• The cost or value of the item must be measurable with a sufficient degree of reliability and objectivity
• Measurement should be based on verifiable and supportable data, such as invoices, contracts, or market prices
• Estimates may be used when precise measurement is not possible, but they should be reasonable and based on the best available information

Initial measurement

Historical cost basis

• Assets are initially recorded at their acquisition cost, which includes the purchase price and any directly attributable costs (transaction costs, installation costs)
• Liabilities are initially recorded at the amount of the obligation incurred or the fair value of the consideration received
• Provides a reliable and objective basis for initial measurement, as it is based on actual transactions

Fair value basis

• In some cases, assets or liabilities may be initially measured at their fair value, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants
• Fair value measurement is required or permitted for certain types of assets (financial instruments, investment properties) or in specific circumstances (business combinations, share-based payments)
• Provides a more relevant and current value, but may involve estimates and assumptions

Subsequent measurement

Cost model

• After initial recognition, assets are carried at their historical cost less accumulated depreciation or amortization and any accumulated impairment losses
• Depreciation or amortization is allocated systematically over the asset's useful life to reflect the pattern of consumption of the asset's future economic benefits
• Provides a consistent and reliable basis for measuring the cost of the asset over time

Revaluation model

• For certain classes of assets (property, plant, and equipment, intangible assets), an entity may choose to subsequently measure them at their fair value less any subsequent accumulated depreciation or amortization and impairment losses
• Revaluations should be performed regularly to ensure that the carrying amount does not differ materially from the fair value at the reporting date
• Revaluation increases are recognized in other comprehensive income and accumulated in equity (revaluation surplus), while decreases are recognized in profit or loss

Value in use vs fair value less costs to sell

• When determining the recoverable amount of an asset for impairment testing, the higher of the asset's value in use and its fair value less costs to sell is used
• Value in use is the present value of the future cash flows expected to be derived from the asset's continuing use and ultimate disposal, based on management's estimates and assumptions
• Fair value less costs to sell is the price that would be received to sell the asset in an orderly transaction between market participants, less the incremental costs directly attributable to the disposal

Impairment of assets

Identifying impairment indicators

• At each reporting date, an entity should assess whether there are any indications that an asset may be impaired, such as declining market prices, technological obsolescence, or changes in the economic or legal environment
• If any impairment indicators are present, the entity should estimate the asset's recoverable amount to determine if an impairment loss needs to be recognized

Measuring recoverable amount

• The recoverable amount is the higher of an asset's value in use and its fair value less costs to sell
• Value in use is calculated by discounting the estimated future cash flows from the asset's continuing use and ultimate disposal using an appropriate discount rate
• Fair value less costs to sell is determined based on market prices or other valuation techniques

Recognizing impairment losses

• If the recoverable amount of an asset is less than its carrying amount, an impairment loss is recognized in profit or loss
• The carrying amount of the asset is reduced to its recoverable amount
• Impairment losses recognized in prior periods may be reversed if there is an indication that the impairment has decreased or no longer exists, subject to certain limitations

Derecognition of assets

Disposal or retirement of assets

• When an asset is sold, scrapped, or otherwise disposed of, it should be derecognized from the financial statements
• The difference between the net disposal proceeds (if any) and the carrying amount of the asset is recognized as a gain or loss in profit or loss

Derecognition criteria and timing

• An asset should be derecognized when the entity loses control over the asset, which typically occurs when the significant risks and rewards of ownership are transferred to the buyer
• In some cases, derecognition may be triggered by other events, such as the expiration of the entity's rights to the asset or the fulfillment of specific derecognition criteria (for financial assets)
• The timing of derecognition should reflect the substance of the transaction and the transfer of control, rather than merely the legal form

Revenue recognition

Performance obligations

• Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer
• A performance obligation is a distinct promise to transfer a good or service, which can be explicitly stated in the contract or implied by the entity's customary business practices
• Performance obligations are identified at contract inception and can be satisfied at a point in time (delivery of goods) or over time (rendering of services)

Transaction price allocation

• The transaction price, which is the amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services, is allocated to the identified performance obligations based on their relative standalone selling prices
• Standalone selling prices are estimated using observable prices, adjusted market prices, or cost-plus-margin approaches, depending on the available information
• Discounts, variable consideration, and non-cash consideration are allocated to the performance obligations proportionately or based on their specific terms

Timing of revenue recognition

• Revenue is recognized when (or as) the entity satisfies a performance obligation by transferring control of the promised good or service to the customer
• For performance obligations satisfied at a point in time, revenue is recognized when control is transferred, which typically occurs upon delivery or acceptance by the customer
• For performance obligations satisfied over time, revenue is recognized based on the progress towards complete satisfaction of the obligation, using input methods (costs incurred) or output methods (units delivered, milestones reached)

Expense recognition

Matching principle

• Expenses are recognized in the same period as the related revenues they help generate, to ensure a proper matching of costs and benefits
• Costs that are directly related to specific revenues (cost of goods sold, sales commissions) are expensed when the corresponding revenue is recognized
• Costs that have a longer-term benefit (property, plant, and equipment, intangible assets) are capitalized and expensed over their useful lives through depreciation or amortization

Immediate expensing vs capitalization

• Costs that do not have a future economic benefit beyond the current period (office supplies, utilities) are expensed immediately in the period incurred
• Costs that generate future economic benefits (purchase of equipment, development of software) are capitalized as assets and expensed over their useful lives through depreciation or amortization
• The decision to expense or capitalize a cost depends on its nature, the expected duration of the benefits, and the materiality of the amount

Accrual basis vs cash basis accounting

• Under the accrual basis of accounting, transactions are recorded when they occur, regardless of when cash is received or paid
• Revenues are recognized when earned and expenses are recognized when incurred, even if the related cash flows occur in a different period
• Accrual accounting provides a more complete and accurate picture of an entity's financial performance and position, as it matches revenues and expenses in the appropriate periods
• Cash basis accounting, in contrast, records transactions only when cash is received or paid, which may distort the timing and recognition of revenues and expenses

Materiality concept in recognition and measurement

• Materiality is a fundamental concept in financial reporting that allows for the omission or misstatement of information that is not significant enough to influence the decisions of users
• An item is considered material if its omission, misstatement, or non-disclosure could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements
• Materiality is a matter of professional judgment and depends on the size, nature, and context of the item in relation to the financial statements as a whole
• The concept of materiality applies to both the recognition and measurement of items in the financial statements, as well as to the level of disclosure provided in the notes