The Recognition and Measurement of Liabilities in IFRS

Working Paper October 2011

Richard Barker
r.barker@jbs.cam.ac.uk
Judge Business School
Cambridge University
Anne McGeachin
anne.mcgeachin@abdn.ac.uk
University of Aberdeen Business School

The authors are grateful for comments from seminar participants at Aberdeen, Cambridge,
Edinburgh, ICAS, Oxford and the ASBs Academic Panel.

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Electronic copy available at: http://ssrn.com/abstract=1952739

The Recognition and Measurement of Liabilities in IFRS

Abstract
An important application for financial accounting theory is in accounting standards, for
which clarity of conceptual foundation can be viewed as essential in addressing the practical
complexities of determining financial position and financial performance. Viewed from this
perspective, the recognition and measurement of liabilities in IFRS is inadequately theorised:
there is an absence of coherent and consistently-applied theory in both the conceptual
framework for financial reporting and in accounting standards themselves. Moreover, this
absence does not result simply from a failure to apply theory that is well-established in the
literature. Instead, potentially relevant contributions from the literature are few in number,
largely disconnected from one another, and at best only indirectly focused on the challenge
at hand. In this paper, we focus on measurement theory, which has come to play an
increasingly important role in IFRS, but to an extent that we argue takes it beyond the
boundaries of practical applicability. In contrast, yet for related reasons, a theory of
conservatism has been downplayed in IFRS, in spite of its relevance as a complement to
measurement theory under conditions of uncertainty. Our analysis has implications both for
accounting theory with respect to recognition and measurement and for the application of
that theory in accounting standards.

Keywords
Liabilities; Recognition; Measurement; Conservatism; Conceptual Framework; IFRS.

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Electronic copy available at: http://ssrn.com/abstract=1952739

The Recognition and Measurement of Liabilities in IFRS

1. Introduction
The purpose of this paper is to contribute to accounting theory and financial reporting
practice with respect to the recognition and measurement of liabilities. Our research is
motivated by the observation that IFRS is inadequately theoretically grounded in this area.
Without formal explanation or justification, IFRS standards and proposals contain multiple
different methods of recognising and measuring liabilities, with inconsistencies among these
methods and with no two standards or proposals adopting the same method.
We question why such diversity exists. Does it imply inappropriate application by the IASB
of established theory, or inadequately developed theory? We do not find answers to either of
these questions in the literature. Indeed, potentially relevant contributions from the literature
are few in number, largely disconnected from one another, and at best only indirectly focused
on the challenge at hand.
The paper is structured as follows. In the next section, we set out our research motivation,
data and method. Our paper is both theoretical and (qualitatively) empirical. The paper is
empirical in so far as we treat the text of IFRS as qualitative data, against which we test the
IASBs application of measurement theory. The paper is theoretical in so far as we seek to
analyse and develop recognition and measurement theory and to identify normative
implications.
Drawing upon the literature, we set out in Section 3 an analysis of theory concerning the
recognition and measurement of liabilities. We focus on a specific interpretation of

measurement theory, the primary insights of which, for the purposes of our paper, can be
summarised as follows.
The process of measurement requires the existence of a currently observable measurement
attribute. The future cannot be observed directly, and therefore it is not possible to measure
directly attributes that are expected to exist in the future. In particular, future cash flows are
not currently measurable. What can be measured is a currently-held expectation of a future
cash flow, as for example captured in a market price. In this case, while a currently
observable measurement attribute does exist, the measurement is of current expectations, not
future cash flows. Viewing measurement in this way, and noting that expectations are
inherently subjective, an important question is whether (and if so in what way) it is
appropriate to base the balance sheet valuation of liabilities upon expectations.
In Sections 4 and 5, we apply our analysis to, respectively, the theoretical position that is
stated in the IASBs conceptual framework (IASB, 2010; hereafter Framework)1 and to
IFRS standards and proposals. The IASBs approach can be characterised as one of
presuming measurability for all liabilities. We argue that the distinction between the
measurable and the immeasurable noted above provides insight into the limitations of this
approach.2 In particular, there exist categories of liabilities which, for good informational
reasons, are recognised in IFRS, yet for which measurement theory provides no support.
Accordingly, we set out in Section 6 implications for extending accounting theory with
respect to the recognition and measurement of liabilities. In particular, we identify that a
theory of conservatism has been downplayed in IFRS, in spite of its relevance as a
complement to measurement theory under conditions of uncertainty. We conclude the paper
in Section 7, identifying potential avenues for revisions to IFRS and for further research.

2. Research Method
Our motivation for this paper arises from the IASBs inconsistent approach to liability
recognition and measurement. The evidence for this inconsistency is found in our source
data, which comprise all accounting standards, exposure drafts and discussion papers issued
(or revised) by the IASB concerning the recognition and measurement of liabilities, coupled
with all public-record comment letters sent to the IASB in response to these pronouncements.
These data are summarised in Table 1.3 Taken together, these documents comprise a rich
source of information. They contain not only the formal requirements of IFRS, but also the
IASBs formal explanations for these requirements. Through the issues raised by each
document, the changes made from previous documents, and the responses of stakeholders,
these documents also help to reveal areas of tension and challenge, together with the reasons
why these challenging situations are perceived to exist, and the extent to which they are either
similar or different in nature across accounting standards.
** Insert Table 1 here **
At first sight, it is surprising that the IASB, with the benefit of extensive stakeholder
engagement, is knowingly inconsistent4 in the development of IFRS. To understand how this
has happened on such a widespread basis, we sought to analyse the theoretical foundations of
recognition and measurement in IFRS. This process initially involved considerable iteration
between our source data and the literature, as we sought to develop a theoretical framework
with which to address the inconsistency that we observed in practice (Van de Ven, 2007). As
will be explored in Sections 3, 4 and 5, we found that we were able to achieve traction on our
research question by focusing on measurement theory. Specifically, we first test
measurement theory against IFRS data, which leads us to conclude, as will be argued in
Sections 4 and 5, that the application of this theory in IFRS is flawed.5 We then argue that a
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direct implication of this conclusion is a need for new theory to complement that which is
already evident in IFRS. In seeking to contribute to theory development in this way, our
analysis of measurement theory suggested a natural path to follow. We argue that the limited
applicability of measurement theory is manifest for liabilities to a greater degree than for
assets, and that conservatism in accounting is the underlying reason for this. Yet the IASBs
application of measurement theory has led it to reject conservatism as being nothing more
than biased measurement, instead of adopting theory to rationalise the presence of
conservatism. We will argue in Section 6 that, under conditions of measurement uncertainty,
a theory of conservatism is required. We also argue that this position finds support in the
literature.
Our paper therefore focuses on two theories in accounting: measurement and conservatism.
We argue that the former is used incorrectly in IFRS and is not applicable to all liabilities,
while the need for the latter is unacknowledged in IFRS. While these conclusions help to
explain the extant inconsistencies in IFRS, they do not in themselves lead to comprehensive,
normative prescriptions for liability recognition and measurement in IFRS.
Acknowledgement of the limitations of measurement theory implies a need for an alternative
theory, which is provided only partially by extant theory concerning conservatism.
The paper now proceeds as follows. Drawing upon the academic literature, Section 3
provides a summary of relevant aspects of recognition and measurement theory, with a
particular focus on contrasting a measurement perspective with an informational perspective.
Sections 4 and 5 then apply this analysis of theory to, respectively, an evaluation of the
Framework, and to the requirements or proposals issued by the IASB. We argue that our
analysis contributes considerably to understanding extant inconsistencies in IFRS. In Section
6, we then discuss the implications of our analysis for conservatism in accounting. Section 7
concludes the paper.
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3. Extant Recognition and Measurement Theory

The literature contains many theoretical papers and other contributions, published over
several decades, relating primarily to the recognition and measurement of assets (for
example, Edwards and Bell, 1961; Sterling, 1970). Relatively little has been published
specifically addressing liabilities.6 There are perhaps two reasons for this. First, when
addressing value attributes, it is natural and intuitive to think first of assets. Second, if a
liability is conceptualised as the opposite of an asset, then an analysis of assets can simply be
viewed in the mirror for the purpose of analysing liabilities. We will argue later in the paper
that this reasoning is insufficient for the theoretical analysis of liabilities. In this section,
however, we are concerned with summarising the extant literature, and so our analysis views
liabilities as the mirror-image of assets.
The mirror-like relationship between assets and liabilities is perhaps most straightforward in
the case of a simple, fixed-rate bank loan, which, as an asset (liability) in a banks
(borrowers) accounts, is a right to receive (obligation to transfer) economic benefits: the
liability mirrors the asset, and the accounting for each counterparty can be expected to be
identical. 7 Moreover, and as set out in Table 2, for any measurement attribute of an asset,
there is an analogue for a liability (see also Baxter, 1975; Nobes, 2001; Lennard, 2002;
Horton et al., 2011). Taking, for example, the first two cases in Table 2, the exit value for an
asset is likely to differ depending upon whether it derives value from being held (value-inuse) rather than through exchange with a market participant (fair value). Analogously, the
exit value for a loan held as a liability is either, respectively, the present value of contractual
payments (cost of performance) or the amount for which the loan could be exchanged in the
capital market (fair value). The third case in Table 2 (cost of release) is also an exit value
attribute, being the amount that the counterparty is contractually obliged to accept, at the
balance sheet date, in full settlement of the outstanding balance.8 The fourth case, in contrast
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to the first three, is an entry cost. For a bank loan held as an asset, the analogue here is the
amount that the entity would expect to receive if it chose to replace an existing loan. This
amount can be termed current equivalent proceeds. Cases five and six in Table 2 are hybrids
of the above (Macve, 2010).
** Insert Table 2 here **
This theoretical consistency holds in spite of data limitations that may exist in practice. For
many liabilities, for example, a cost of transfer may not exist. Such a case might arise in
practice for liabilities where inflows occur in advance of performance, for example
performance obligations arising from revenue contracts with customers (Samuelson, 1993).
The difference here from the earlier case of the bank loan is that, while there is an inflow of
economic benefits, the liability is in the form of a performance obligation (an expected
outflow of goods or services), rather than a contractual future cash outflow.9 Such
obligations typically have unique, entity-specific attributes, and there may be no readily
available way of transferring the liability, and hence no cost of transfer. For other liabilities,
there is no cost of release. This is often the case of with provisions,10 which typically have
either no underlying contract (e.g. lawsuits) or else a contract with effectively no current exit
option (e.g. pension obligations in most jurisdictions). Moreover, provisions can in general
be viewed as liabilities for which the debit entry on initial recognition is not an asset with an
observable value, such as cash.11 Hence there is no observable entry value. Indeed, in a case
such as a lawsuit, there is arguably no entry value at all, because there is no inflow of
resource; so the only applicable measurement attribute is exit value.
In principle, these observations concerning the data limitations for liabilities could also be
said to hold for some assets. This is illustrated in Table 3, which summarises the four
possible cases concerning the availability of entry and/or exit prices. The case of the bank
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loan is the simplest, where both entry and exit values are observable. For many fixed assets,
there is likely to be an observable entry value without an observable exit value, where value
is derived in use. In contrast, the example of an asset generated by (some) share-based
compensation illustrates the case of an exit value that is observable with an entry value is not
observable. Finally, the case where neither value is observable is possible for certain
intangible assets, such as internally-generated brands. Overall, therefore, there is not an inprinciple difference in the four categories in Table 3 between assets and liabilities.
** Insert Table 3 here **
Further, in practice, for both assets and liabilities, and where only the entry value is
observable, a typical, implicit assumption is that of an exchange of equal value. This means
that the (unknown) value of the asset or liability can be set equal to the (known) value of the
corresponding side of the double entry: assets are valued at the cost of resources sacrificed
and liabilities are valued at the value of resources received. This approach of indirect, proxy
measurement can be argued to provide the prevailing logic of historical cost accounting
(Paton, 1922; Sterling, 1970). Equally, if an observable exit value exists but there is no
observable entry value, the exit value can act as a proxy for the entry value. The assumption
of an exchange of equal value does not, however, provide an answer for the final case in
Table 3, which is when neither the entry value nor the exit value is currently observable. In
principle, recognition in this case would require that the value of the asset or the liability
must, in some way, be estimated. This creates a problem. As will now be discussed, on the
interpretation of measurement theory presented in this paper, such values are not actually
measurable but are instead estimates based only on forecasts. This is a point of considerable
importance for this paper, and so the remainder of this section is devoted to exploring it
further.12

There is no universally accepted definition of measurement. A standard reference is Stevens

(1946), who defines measurement as any process of the assignment of numerals to objects or
events according to rules. This definition has been criticised for being too loose, because it
allows more or less any assignment of numbers to categories to be defined as measurement,
even if the underlying method of assignment is inherently arbitrary (Lord, 1953). On this
basis, any number reported in a financial statement is by definition a measure, based as it is
upon the application of a rule, in the form of an accounting standard. If the concept of
measurement is to have any analytical traction, something more is required.
Deeper insight comes from considering the process of measurement, which can be broken
down into three stages: definition of the attribute to be measured, determination of the
quantum (or measurement scale) and application of a measurement instrument to the item in
question (Vehmanen, 2007). It is only the third of these stages that is empirical. While the
measurement attribute and the measurement scale can be determined in principle, the
application of a measurement instrument can only be done in practice, and it requires the
existence of a currently observable measurement attribute. This is an essential point.
Measurement is straightforward in certain cases, such as cash, or assets and liabilities with
observable market values in active markets, or where there exist certain contractual
commitments at the balance sheet date.13 Yet if, for example, the attribute to be measured is
the cost of performance, and the quantum is money, then a fundamental problem arises,
which is that a measurement instrument cannot be applied. This is because future cash flows
are not currently observable. The cost of performance therefore cannot, in the sense
described here, be measured: the future does not currently exist, and so future cash flows are
immeasurable (Chambers, 1998; Rosenfield, 2003).
The concept of measurement error is likewise inapplicable to the (non-existent) future. While
there is likely to be estimation error in practice for the measurement of any currently
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observable item, the item is nevertheless in principle measurable (Morgenstern, 1950). This
measurement is also in principle verifiable and it can therefore be considered to be objective
(McKernan, 2007). In contrast, forecast error is not measurement error; it is instead the
difference between a current forecast and a future realisation that does not yet exist. And to
the extent that any given forecast is a matter of individual opinion about something that is
unobservable, it is subjective and cannot be verified.14 Moreover, while measurement can be
viewed, in the simplest case, as relating to a single, measurable amount, forecasts can be
conceptualised as a probability distribution, making the perceived economic value of the
asset or liability equal to expected value. The values determined by measurement and by
forecasting are therefore different in nature.
It is essential here not to confuse the data in a forecasting model, with which a cost of
performance can be determined, and future data themselves, which do not currently exist
(Winston, 1988). It is possible to use a model to determine the expected value of future cash
flows, and while the future cash flows themselves do not exist, the currently-held
expectations do, and so they are in principle measurable. Sterling (1970) cautions that these
expected values, based upon forecasts, are not a measurement of wealth unless one defines
wealth as a state of mind, and an important question is therefore whether (and if so in what
way) it is appropriate to base the balance sheet valuation of liabilities upon measures of
expectations.15
It is in this context that the market mechanism comes into play as a measurement instrument,
because market prices provide observable and verifiable evidence of currently-held
expectations. In effect, the market transforms subjective expectations about the future into
currently observable amounts. In contrast, certain other types of expectation, such as those
underpinning managements forecast of the cost of performance, are not directly observable

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in practice, meaning that they cannot be measured, and that they are subjective and nonverifiable (Nagel, 1986).16
A further consideration is that measurement can be of different types. Stevens (1946) noted
the existence of different kinds of scales and different kinds of measurement, not all of equal
power and usefulness. He proposed a classification of these scales into four types: nominal,
ordinal, interval and ratio. Chambers (1964, 1965) noted that the secondary metrics common
in accounting, such as net assets, leverage and return on equity, are conceptually valid only if
there is ratio measurement, which is the most demanding category in Stevens typology.
Moreover, for this purpose, there must be only a single measurement attribute used for all
assets and liabilities, because core properties of additivity and ratio measurement would
otherwise not hold (Chambers, 1998; Barth, 2006).
This strict measurement perspective can be contrasted with an informational perspective
(Christensen, 2010a). While not tightly defined, an informational perspective views
accounting information as part of a broader information set, providing one source of input to
users economic decision-making. Proponents of this perspective would argue that, given the
inherent practical difficulties of a strict measurement perspective under conditions of
imperfect and incomplete markets, it is inappropriate to rule out of consideration value
attributes that are not strictly measurable (Beaver and Demski, 1974; Beaver, 1989), nor to
automatically disallow mixed measurement. In particular, an informational perspective
would suggest reporting information relevant to the sustainable economic performance of the
entity, as opposed to a stricter statement of financial position at the balance sheet date,
especially where that statement does not capture the economic choice that is likely to be
undertaken by the entity (Macve, 2010; Whittington, 2010). An informational perspective
would in principle allow the recognition of assets and liabilities that are not strictly
measurable, for example because recognition of such items is necessary for the timely
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recognition of unrealised gains and losses, an important part of accruals accounting (Ball and
Shivakumar 2005).17
In summary, it has been argued here that liabilities are in principle direct analogues for assets,
even though the practical context for recognition and measurement may differ. (We discuss
the implications of that practical context in Section 6.) We argue that an important
conceptual distinction can be made between a measurement perspective and an informational
perspective. It is only in the former domain that the language and method of measurement
can be used without reservation or contention. The implication is that measurability cannot
be universally presumed to exist. Assets or liabilities may nevertheless be deemed to exist
even if their values cannot be measured, and information pertaining to them may be useful
even though it is inevitably subjective.
The next sections of this paper apply the analysis from this section to the current
requirements or proposals concerning the recognition and measurement of liabilities in IFRS.
Our aim is to test whether there is valid application of measurement theory in IFRS. We
present our analysis in two parts, which are the theoretical foundations of liability
measurement in the Framework (Section 4) and theory and practice in accounting standards
themselves (Section 5).

4. Recognition and Measurement Theory in the Conceptual Framework

It is striking, and perhaps revealing with respect to theoretical foundations, that the IASBs
Framework provides remarkably little guidance on recognition and measurement, even
though it is clear on the importance of both factors for effective financial reporting. To the

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extent that the Framework does reveal the IASBs position, the communication is often
implicit.
A liability is defined in the IASBs Framework as a present obligation of the entity arising
from past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. The Framework also states that a liability is
recognised in the balance sheet when it is probable that an outflow of resources embodying
economic benefits will result from the settlement of a present obligation and the amount at
which settlement will take place can be measured reliably (italics added). There are
therefore two recognition thresholds in the Framework: first, that an outflow of resources is
probable and, second, that measurement of the settlement amount is reliable.
While a liability is defined in the Framework as an expected outflow of resources, the
probable outflow recognition threshold constrains the practical applicability of this definition.
It does so by excluding outflows that are unlikely to happen. This exclusion is not precise, in
that probable is not defined, although an interpretation such as more likely than not is
consistent with both the Framework (Botosan et al, 2005) and with the binary nature of
recognition (an item is either recognised or it is not).
Viewed in terms of the analysis in Section 3, the concept of probable is explicitly concerned
with unobservable future cash flows, and therefore with the absence of strict measurability at
the balance sheet date, and yet the definition also calls for reliable measurement. There is a
prima facie conflict here. It is possible, for example in the case of a liability that is a
derivative financial instrument, to have a currently observable market price, and so objective
measurement, yet for it to be probable that there will not be an outflow of resources. It is also
possible, for example in the case of a provision, for the liability to not be reliably measurable
and yet for it to be (subjectively) determined that there is a probable cash outflow. The point
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is that the probability threshold is relevant when there is not reliable measurement, and vice
versa.
To illustrate, consider Table 4. In the case of the simple bank loan, both recognition
thresholds are crossed and recognition is unambiguous. Likewise, for a contingent liability,
neither is crossed, and non-recognition is unambiguous.18 The interesting cases are when one
threshold is crossed and the other is not, which ought to lead to non-recognition under the
Framework, but where the opposite conclusion seems to be the more tenable (indeed, and as
will be discussed in Section 4, it is the opposite conclusion that is reached in practice in
IFRS; Murray, 2010). These cases are the derivative with an improbable outflow and the
provision with no observable measure. In the former case, if a currently observable, reliably
measurable liability exists at the balance sheet date, it is difficult to argue that it should not be
recognised. In the latter case, if the definition of a liability is met, and there is the
expectation of an outflow of resource, then it is difficult to argue that the aims of financial
reporting are best met by non-recognition.
** Insert Table 4 here **
The problem is that probable outflow and reliable measurability are both treated by the
Framework as necessary conditions for recognition, when either could be sufficient in itself.
This is made clear in Figure 1, which is proposed as an alternative to the current recognition
thresholds in the Framework. Consistent with the Framework, a prerequisite for recognition
is meeting the definition of a liability. The first filter thereafter is whether there is a probable
outflow, and if there is then the liability is recognised. Critically, this filter is only necessary
when the recognised liability is a subjective forecast of future cash flows, as in the case of a
provision. If, in contrast, the market mechanism has transformed uncertain future cash flows
into quantified risk and thereby created an observable measure, then the probable outflow
15

threshold is not needed. The second filter is reliable measurability, with the effect that all
reliably measurable liabilities are recognised. If Figure 1 is applied, three of the four
categories in Table 4 now lead to recognition, as opposed to only one under the Framework.
All probable outflows are recognised (not just those that are reliably measurable) and all
reliably measurable liabilities are recognised (not just those with a probable outflow).
Contingent liabilities that cannot be measured reliably and do not have a probable outflow
continue to remain unrecognised, and the imprecise nature of probable outflows remains as
a pragmatic recognition threshold for immeasurable liabilities. The imprecision is an
unavoidable corollary of immeasurability: while recognition is desirable, precision is in
principle unobtainable.
** Insert Figure 1 here **
A possible difficulty with this approach is the inclusion of probable outflows that are not
observable and therefore not reliably measurable, which conflicts with the traditional
emphasis on reliability in financial accounting. The analysis of measurement theory in
Section 3 suggests that this difficulty is unavoidable if forecasts are to be recognised in
financial statements. In its revision to the Framework, however, the IASB has adopted an
approach of attempting to avoid the unavoidable, by effectively broadening its definition of
reliable measurement to encompass subjective forecasts. Specifically, the 2010 Framework
revision replaces reliability with faithful representation, the components of which are
completeness (representation is not partial), neutrality (there is no intended bias) and freedom
from error (the item portrayed is the economic phenomenon in question). As the following
extract makes clear, faithful representation is considered to be applicable even when
observable measurement is not possible.

16

Faithful representation does not mean accurate in all respects ... For example, an
estimate of an unobservable price or value cannot be determined to be accurate or
inaccurate. However, a representation of that estimate can be faithful if the amount is
described clearly and accurately as being an estimate, the nature and limitations of
the estimating process are explained, and no errors have been made in selecting and
applying an appropriate process for developing the estimate.
There is confusion here between faithful representation of the process of determining an
estimate, and faithful representation of the balance sheet item itself. The absence of an
unobservable price or value means that the amount in question cannot in principle be
verifiably complete, neutral or free from error, no matter what process is applied in its
determination. Curiously, the IASB even appears to have acknowledged this point in the
above quotation but nevertheless to have persisted in disconnecting faithful representation
from observability. The Discussion Paper that preceded the revised Framework had included
the notion of verifiability, but then dropped it, as explained in BC3.36: some respondents (to
the DP) pointed out that including verifiability as an aspect of faithful representation could
result in excluding information that is not readily verifiable ... (which) would make the
financial reports much less useful. The Board agreed and repositioned verifiability as an
enhancing qualitative characteristic, very desirable but not necessarily required.
Yet verifiability is the essence of objectivity, because it is the basis on which independent
observers can reach the same measurement (Sterling, 1970; Nagel, 1986). In relegating the
requirement for verifiability, the applicability of the IASBs concept of faithful representation
is broadened, while its meaning is weakened. Viewed in terms of Table 4, the approach fails
to make the distinction between items that are reliably measurable and those that are not, but
instead creates a concept that embraces both categories.19 If the concept of faithful
representation is, in this way, allowed to embrace both objective, verifiable measurement and
17

subjective forecasts, then it cannot in principle be tightly defined. This is, in effect, an
informational perspective, not a measurement perspective.20
The IASBs approach to faithful representation is not inconsistent with its own definition of
measurement, but this is only because that definition is similarly loose. The Framework states
that Measurement is the process of determining the monetary amounts at which the elements
of the financial statements are to be recognized and carried in the balance sheet and income
statement. (para. 99) Under this definition, anything that ends up being recognised in the
financial statements has been though some (undefined) process of measurement. Equally, a
numerical depiction can be deemed to be faithfully representational even if it cannot in
principle be verifiably complete, neutral or free from error. In short, these definitions
broaden, and so weaken, the definition of measurement to the extent that it loses any effective
meaning.
Elsewhere in the Framework also, the distinction made in Section 3 between the measurable
and the immeasurable is conspicuous by its absence. The Frameworks definitions of
measurement and measurement attributes suggest that little consideration was given (in the
1989 text, still extant) to the concept of measurement, and that the measurement as
numerical depiction approach was pervasive.
The Framework (implicitly) defines the measurement attribute as the settlement amount. Yet
the notion of settlement is ambiguous because it could be interpreted either as settlement at
the balance sheet date or settlement in due course of business. This is a distinction analogous
to that between value-in-exchange and value-in-use, as applied to assets. The Framework
appears to endorse both interpretations, because it describes measurement bases applicable to
each. Specifically, settlement at the balance sheet date is implied by current cost, which is
described as follows: Liabilities are carried at the undiscounted amount of cash or cash
18

equivalents that would be required to settle the obligation currently. For settlement in due
course, there are two measurement bases, one undiscounted and the other discounted. The
former, somewhat confusingly, is settlement value and is described as follows: the
undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities
in the normal course of business. The latter, present value, is the present discounted value
of the future net cash outflows that are expected to be required to settle the liabilities in the
normal course of business. Finally, the Framework includes a further measurement attribute,
which fits the criteria of strict measurability, yet is not current. This is historical cost, which
is described as follows: liabilities are recorded at the amounts of proceeds received in
exchange for the obligation, or in some circumstances (for example income taxes), at the
amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal
course of business.
A single measurement attribute could in practice be measured directly or indirectly, making
the application of more than one method of measurement conceptually acceptable, as is
explicit in IFRS 13 (Fair Value Measurement).21 There is no evidence, however, that such a
perspective is intended in the Framework. A more plausible interpretation is that the
Framework offers neither a single, unambiguous measurement attribute, nor a relationship
between such an attribute and applicable methods of measurement. Moreover, the Framework
contains only a limited discussion of measurement methods. It is silent on: first, whether a
liability is initially recognised at an amount identified in an exchange transaction or else as a
forecast of future cash flows; second, whether the carrying amount is revised as expected
cash flows change; third, whether a liability is valued at the most likely settlement amount or
instead the expected value of future cash flows; fourth, whether there is discounting at any
specific rate; fifth, whether there is an adjustment for risk.

19

In conclusion, we cannot reconcile the IASBs approach in the Framework with the analysis
of measurement theory outlined in Section 3. If liabilities are to be recognised in cases where
the desired measurement attribute is not observable, which suggests a latent informational
perspective, then one of two approaches is possible. The first is that adopted by the IASB,
which is to adopt a notion of faithful representation that is broad enough to encompass both
amounts that are measurable and amounts that are not. Such an approach has been argued
here to be inadequate, because it does not allow analytically coherent distinctions to be made.
The second approach is to apply the notion of faithful representation only when it is
theoretically valid to do so, meaning that immeasurable items are excluded. This leaves open
the question of how to account for these items, for which the theory of measurement cannot
be a sufficient foundation. We will return to this theme in Section 6. We first address, in the
next section, the application of measurement theory in accounting standards themselves.

5. Consistency of IFRS Requirements with Underlying Theory

While the Framework can be viewed as an expression of the theoretical foundations of IFRS,
it has three limitations in this respect. First, while partially revised in 2010, much of the
extant text is over twenty years old, dating from 1989. Second, the Framework exists only to
provide general guidance, and it does not have the authoritative status for financial reporting
practice of accounting standards themselves. Third, the Framework is a fairly short
document, without the richness and depth of accounting standards. In this section, we
therefore extend our testing of measurement theory to the IASBs requirements in standards
for liability recognition and measurement, including proposals for new standards. The
recognition and measurement requirements of all of these IASB pronouncements is
summarised in Table 5. In line with the structure of that table, the subsections below discuss
20

recognition first, followed by measurement. The analysis of measurement considers first the
objective of measurement, followed by the existence of observable measures and then the
approach taken by the IASB when the measurement attribute is unobservable.
** Insert Table 5 here **
Probability recognition threshold
The first issue we consider is that of a probability recognition threshold. As discussed above,
such a threshold is included in the Framework. Yet it is present in only one IASB
pronouncement other than the Framework (column 1 in Table 5), in IAS 37. Moreover, the
EDs of amendments to IAS 37 (2005 and 2010) propose removing the threshold, which, if
enacted, would result in the Framework being the sole outlier.22 In this context, the IASB has
stated The IASB regards aligning IAS 37 with other IFRSs - so that all liabilities are
recognised - as more important than preserving consistency with all aspects of the existing
20-year-old Framework (IASB, 2010).
The IASBs stance is rooted in the belief that all liabilities can be measured, and hence
should be recognised. Under this view, a probability recognition threshold is just an
arbitrary barrier. This is illustrated in the explanation in that applying such a threshold would
result in the flawed conclusion that a performance obligation arising from a guarantee, a
warranty or an insurance contract should not be recognised until it is probable that a claim
will arise (IASB, 2006). Here the IASB is rightly saying that a probability threshold is not
needed when there is an observable measurement (an entry value in these cases). However,
the IASB also claims that a probability threshold would be inconsistent with a measurement
based on the probability-weighted average of expected cash flows (IASB, 2006), a claim that
fails to recognise that, in the sense described in Section 3, there can be no strict measurement

21

based on estimates of expected future cash flows and that it is precisely in such cases that a
probability threshold has a role to play.
The difficulty here seems to have been recognised instinctively by respondents to the 2005
ED, albeit without clearly articulating the source of the problem. In contrast to the IASBs
clear wish to remove the threshold (except for leases), many respondents to the IAS 37 EDs
opposed its removal, particularly in the context of single liabilities not held in a portfolio of
similar liabilities. Their consensus view was that the probability recognition criterion is a
useful screen to exclude items from the balance sheet when it is uncertain whether a present
obligation exists, or for liabilities for which there is only a low or remote likelihood of a
future cash outflow from the statement of financial position.
The analysis here suggests an absence of theory concerning liabilities that are not strictly
measurable. The IASBs response has been to assert, incorrectly, the applicability of
measurement theory in this context. The IASBs stakeholders have instinctively opposed this
approach. While not explicitly theoretically grounded, the stakeholders viewpoint is
consistent with the implications for financial reporting of the analysis of measurement theory
in this paper.
Reliable measurement threshold
As with the probability threshold, despite the fact that a reliable measurement threshold exists
in the Framework, it is rare in standards on liabilities (column 2 in Table 5). The criterion
that the liability is capable of reliable measurement is explicit only in IAS 37 and in specific
parts of IAS 19.23 Elsewhere, it is assumed to be met. IAS 37 mirrors the Framework, both in
requiring a liability to be recognised only if the obligation can be estimated reliably, and also
in noting that the use of estimates is an essential part of the preparation of financial
statements and does not undermine their reliability. It goes on to state that this is especially
22

true of provisions, even though by nature they are more uncertain than most other items in the
statement of financial position. It concludes that, except in extremely rare cases, an entity
will be able to determine a range of possible outcomes and can therefore make an estimate of
the obligation that is sufficiently reliable to use in recognising a provision. In short,
measurability is typically presumed.
This contrasts with the requirements for assets in IAS 38, where it is acknowledged that for
internally-generated goodwill and some internally-generated intangible assets, it is not
possible to determine reliably either an entry value (cost) or an exit value. Such assets are
thereby not recognised. The IASB does not explain why it believes that liabilities such as
provisions can be measured more reliably than assets such as internally-generated goodwill.
Moreover, the IASB does not make a distinction between estimates and forecasts, where the
former are in principle measurable while the latter are not.
Again, the evidence here is that of inadequate theoretical foundations: measurability is
assumed inappropriately for certain liabilities, and also, without explanation, measurability is
assumed to differ between assets and liabilities.
Specified measurement objective
As noted in Section 3, the Framework is ambiguous with respect to whether the objective of
measurement concerns settlement currently or in due course, and four measurement bases for
liabilities - historical cost, current cost, settlement value and present value - are duly offered
that support either interpretation.
In the accounting standards themselves, there is not always a specified measurement
objective. Indeed, it is remarkable that, whenever an objective is stated, it is in each case
different from any objective stated elsewhere (column 3 of Table 5). Further, none of these

23

objectives is described in the same terms as any of the measurement bases described in the
Framework. This appears to suggest an extraordinary lack of conceptual clarity.
Although the stated objectives in the standards, exposure drafts and discussion papers are all
different in some way, they fall into three groups: fair value, cost (subsequently amortised
cost), and the amount the entity would rationally pay at the end of the reporting period to be
relieved of the present obligation (or similar wording). The first, fair value, is an observable
measure if there are active markets. However, the IASB also requires fair value in situations
where there are no active markets, at which point it ceases to be observable. The second,
cost, is an observable measure on initial recognition, but amortised cost in subsequent periods
need not be. The third group, the amount the entity would rationally pay at the end of the
reporting period to be relieved of the present obligation, is the definition that the IASB has
developed for liabilities for which it wishes to recognise a cost of performance. Establishing
such a definition goes some way towards the appearance of an observable measure, because it
transforms expectations about future cash flows into a current attribute. However, as with
fair value, only the existence of an active market can transform those subjective expectations
into an observable measure.
The third group of objectives, based as they are on attributes that are not observable, have in
general not been supported by IASB constituents, who have been on the whole unconvinced
by the IASBs definition of cost of performance. For example, IAS 37 (1998) gives a
measurement objective of the best estimate of expenditure required to settle the present
obligation at the end of the reporting period. It states that this is the amount that an entity
would rationally pay to settle the obligation at the end of the reporting period or to transfer it
to a third party at that time. In the 2005 ED of amendments to IAS 37, the objective was
clarified as being the amount the entity would rationally pay at the end of the reporting period
to be relieved of the present obligation (Rees, 2006). Although the IASB regarded this as a
24

clarification of the original measurement objective, many respondents disagreed. They argued
that existing IAS 37 does not require the use of a transfer amount and that an amount that the
entity would pay to transfer or settle the liability at the reporting date is not a relevant
measure for a liability that is almost certainly going to be discharged when it falls due. In
other words, they instinctively opposed the attempt to transform cost of performance from an
estimate of future cash flows into a current attribute. Nonetheless, in the 2010 ED of
amendments to IAS 37, the IASB continued to aim for a strict measurement perspective,
proposing that an entity should measure a liability at the amount that it would rationally pay
at the end of the reporting period to be relieved of the present obligation. Again, the strict
adherence here to the language of measurement, and the presumed generalisability of
measurement, contrasts sharply with stakeholders practical instincts and concerns, with the
latter being explicable in terms of the theoretical analysis in Section 3.
Link to transaction amount
One aspect of liability measurement that is not discussed in the Framework, but that has a
strong influence in the IASBs standards and proposals, is whether the amount initially
recognised should be linked to an amount observed in a transaction. There is an obvious
difference between those liabilities where initial recognition is at an amount identified in an
exchange transaction, as opposed to cases where determination of an amount to be recognised
relies on estimates of future cash flows (column 4 in Table 5).
Liabilities for which an initial measure can be identified in an exchange transaction are
covered by IFRS 9, the insurance contracts ED and the revenue recognition ED. In all these
cases, the initial measurement of the liability is linked to the amount identified in the
exchange transaction (albeit only after substantial debate in the insurance project). In terms
of measurement theory, these proposals could be characterised as a preference for an
observable measure over a forecast of future cash flows.
25

Using an observable transaction price, when one exists, does not solve the problem of what to
do when one does not exist, or if it is thought desirable to remeasure the liability subsequent
to initial recognition. In these cases, and in the absence of active markets, there is no
observable measure. Nonetheless, the IASB has shown little inclination to take a pure
measurement approach by thereby not recognising a liability. Rather, as discussed above, it
has tried to extend a measurement approach to the cost of performance by defining it as a
current attribute. In the absence of active markets or specific transactions, however, the cost
of performance is not an observable measure. This lack of observability leads to problems
for the IASB in specifying how the amount it wishes to be recognised should be determined.
We discuss these problems next.
Cash flows
If cost of performance could be observed, there would be no need to consider what cash
flows should be included in its measurement. Because it cannot be observed, the IASB has
specified that the probability-weighted average of all possible cash flows (expected value)
should be used (column 5 of Table 5), arguing that this is necessary to meet the measurement
objective of an amount that the entity would pay to transfer or settle the liability at the
reporting date (for example, 2005 and 2010 EDs of amendments to IAS 37). This approach
has been generally accepted when there is a portfolio of similar liabilities to be measured.
However, in relation to single liabilities, respondents to the IAS 37 EDs disagreed with use of
expected value and the proposed measurement objective, arguing that that the most relevant
information is given by the best estimate of what the cash flows ultimately will be.
The debate over expected value illustrates clearly the IASBs confusion over measurement.
The IASB has repeatedly argued that expected value is necessary to arrive at a meaningful
measure, whereas under a strict measurement perspective the question would never arise. In
turn, the IASBs constituents are not persuaded by the IASBs desire to follow its perceived
26

principle of measurement. Ironically, many of them regard this approach as too driven by
theoretical but impractical concepts.
Discount rate
As with cash flows, if cost of performance could be observed, there would be no need to
consider what discount rate to use. However, because it cannot, this has become a major
issue in the measurement of liabilities. IFRSs, EDs and DPs are uniform in their
requirements and proposals that all measures that are based on estimates of future cash flows
should be discounted, whenever the impact of discounting is material (except for IAS 12).24
There are differences, however, on which discount rate to use to reflect the time value of
money (column 6 of Table 5).
There is one (almost) universal feature, which is that all the discount rates being considered
by the IASB are current rates. The only exception to this is the rate proposed in the leases
ED.25 However, even having established an almost common approach to including the time
value of money, further questions arise as to how this should be done. For example the
insurance contracts DP and ED raise the issue of the liquidity characteristics of the liability
and propose that the discount rate should reflect the liquidity characteristics of the item being
measured. All other IFRS, EDs and DPs are silent on this issue.
So the question of the discount rate illustrates another aspect of the problems facing the IASB
when there is no observable measure. Even if there is consensus on the principle, how much
guidance is needed on how the amount to be recognised should be determined?
Risk adjustment
The final set of problems relate to adjustments for risk. There are differences in IFRS on
whether to include a risk-adjustment for the uncertainties surrounding the cash flows and, if a

27

risk-adjustment is included, what the objective of the risk-adjustment is, how to treat
diversifiable risk, and how to treat credit risk (column 7 of Table 5).
As with the cash flows and discount rate, the question of the effect of risk would not need to
be considered if cost of performance were an observable measure. But as with the previous
issues the IASB has had to consider the effect of risk in trying to extend measurement theory
to the cost of performance. It has been a particular issue in the IAS 37 and insurance
contracts projects, both of which require/propose an adjustment for risk, but only after
significant debate and disagreement over its objective and the impact of diversifiable risk
(IAS 37 2010 ED, Insurance Contracts ED). The IASBs arguments are all expressed in
terms of achieving the stated measurement objective (IAS 37 2010 ED). In contrast,
respondents to the proposals both in the IAS 37 project and the insurance project are
generally much more concerned with the practical aspects of how such an adjustment should
be made, and whether it can be determined in a reliable and comparable way. In doing so,
they are implicitly acknowledging the difficulties that arise because the measurement
objective is not an observable measure.
Finally, the inclusion of own credit risk in the measurement of a liability is a controversial
subject. IAS 37 is silent on the matter. The insurance DP (2007) argued that credit
characteristics should be included in the measurement of an insurance contract liability. In
2009, IASB issued a staff-developed DP on the subject that set out some common views on
credit risk. The responses to the DP demonstrated clearly that most respondents took an
informational approach to the issue. The responses indicated that, broadly, constituents
wanted to include credit risk when a liability was assumed in an exchange transaction with an
observed price, yet did not want to include it in the measurement of a liability if its effects
had to be estimated rather than included in an observed price. Consistency of measurement

28

across different liabilities was not an overriding concern; indeed, it was down the list of
priorities.
As a result of these responses, the IASB decided not to continue with a standalone project on
own credit risk. Instead it decided to consider credit risk in the conceptual framework
measurement project and on a standard-by-standard basis. In 2010, it issued the ED of
amendments to IAS 37 that remained silent on credit risk, and the insurance contracts ED that
includes it only in the residual margin that calibrates the liability measurement to the
transaction price.26
A general conclusion here is that while the IASBs thinking can be characterised by
adherence to a presumed generalisability of measurement, the concerns of stakeholders arise
when the boundaries of the applicability of measurement theory are reached. While certain
aspects of financial reporting practice are adequately theorised from a measurement
perspective, others require adoption of an informational perspective, from which theorising is
notable for its absence. In the next section, we therefore turn to the need for new theory to
complement that which is already evident in IFRS. We note that this need for new theory is
greater for liabilities than for assets, primarily because the practice of conservatism has
greater consequence for liabilities in terms of the applicability of measurement theory.

6. The Need for Additional Theory

The analysis in Sections 4 and 5 has applied measurement theory to identify areas of tension
and inconsistency in IFRS. It was argued in Section 4 that a probable outflow recognition
threshold is not needed when recognition is restricted to items that are reliably measurable,
but that it has a role to play when strict measurement is not possible. The IASB has in effect
avoided this issue by means of a broad definition and interpretation of measurement, and
29

thereby a presumption of measurability for all recognised items. The consequences of this
position, as discussed in Section 5, have included disagreement with stakeholders over both
the probable outflow recognition threshold and the boundaries of measurement. The IASBs
position has also generated confusion through the conflation of measurement objectives that
are in practice measurable (fair value when active markets exist or cost) with those that are
not (the amount that an entity would rationally pay to be relieved of the liability). While the
IASB describes all three of these objectives as measurable, the third is an amount based on
forecasts rather than on observable measurement, and it therefore introduces the subjective
complexities of probability distributions of expected cash flows, discount rates and risk
adjustments.
If recognition was in practice restricted to items that are observable, and so in principle
reliably measurable, these tensions and inconsistencies would not arise. In other words, the
central problem is that IFRS requires items to be recognised even though they cannot be
reliably measured. A central question, therefore, which we address in this section of the
paper, is why such recognition is required in the first place.
This question is particularly important for liabilities. This is in part for practical reasons. An
important difference between assets and liabilities is that entry values are more likely to be
observable for assets, because their acquisition is usually associated with the sacrifice of
monetary resource.27 This makes both entry valuation and indirect exit valuation relatively
difficult to attain for liabilities than for assets. The recognition of a provision, for example, is
not triggered by a transaction stated in monetary terms. In other words, while (as argued in
Section 3) measurability may be no different in principle between assets and liabilities, it is
likely to be more problematic in practice for liabilities.28

30

There is also an important theoretical reason for the required recognition of immeasurable
liabilities, but not of immeasurable assets. We have so far argued, in Section 3, that
measurement attributes for assets are in principle the mirror-image of those for liabilities, and
that while the theoretical literature has focused mainly on assets, this is understandable in the
absence of anything conceptually distinctive about liabilities. Sections 4 and 5 have shown,
however, that recognition is in practice required for liabilities that cannot strictly be
measured, and for which theoretical support therefore needs to come elsewhere than from
measurement theory. We will now argue that this theoretical foundation concerns
conservatism, the implications of which are different for liabilities than for assets.
Conservatism is the differential verifiability required for the recognition of gains and losses,
whereby expected losses are recognised with less verification than expected gains (Basu,
1997; Watts, 2003a). Hence, while conservatism makes it possible to argue against
recognising asset values that are based upon forecasts, the same need not apply to liabilities.
Rather, conservatism would encourage their recognition. Referring back to Table 3, if, in
practice, entry values and exit values are unavailable, the principle of conservatism is
conventionally applied. In the case of a lawsuit, for example, a liability of uncertain amount
is typically recognised in the accounts of the defendant, while, even with no difference at all
in either the amount under consideration or the associated uncertainty, an asset is typically
not recognised in the accounts of the plaintiff. Consistent with this reasoning, it was argued
in Section 4, using Table 4, that the Frameworks recognition criteria for liabilities would be
conceptually more coherent if there was recognition when an outflow of resources is probable
(as well as for all measurable liabilities, see Figure 1). In contrast, the practice of
conservatism for assets means that a probable inflow recognition threshold would not be
needed, thereby simplifying the algorithm in Figure 1 to the questions of definition (does an
asset exist?) and measurement (can the asset be measured reliably?). In summary,
31

conservatism creates a challenge that is specific to liabilities, because, in contrast with assets,
it leads to their recognition even when they cannot strictly be measured. This distinction
between assets and liabilities is based upon verifiability, which makes the application of
conservatism inseparable from issues of measurability.
To some extent, conservatism has been viewed in the academic literature as evidence of
tradition and convention, rather than as a practice that can be justified conceptually (Sterling,
1970). In contrast, a more recent strand in the literature has provided theoretical support for
conservatism. In particular, a contracting explanation (Watts, 2003a) identifies a need for
conservatism as a means of addressing the moral hazard that arises when management and
investors have asymmetric information and asymmetric payoffs. Central to this explanation is
the role of verifiability, because it is optimal for contractual metrics to have a higher standard
of verifiability for assets than for liabilities. Empirical evidence supports both the existence
of conservatism and the contracting explanation (Basu, 1997; Watts, 2003b; Ryan, 2006;
LaFond and Watts, 2008; LaFond and Roychowdhury, 2008; Giner et al, 2011).
The IASB has explicitly rejected conservatism, however, through its use in the Framework of
the language of measurement, by which anything that is deemed to be representationally
faithful is treated conceptually as a measure. In evaluating conservatism as a candidate for
an aspect of faithful representation, the Framework (BC3.27) argues that its inclusion in this
regard would be inconsistent with neutrality. Yet the Framework defines neutral
information as without bias, which has little practical meaning when applied to unverifiable
subjective estimates. In explicitly ruling out conservatism in this way, the Framework argues
from a position that is tenable only when there is reliable measurement, and yet the theory of
conservatism outlined above applies only when there is not reliable measurement.29 The
Framework therefore dismisses conservatism on inappropriate grounds, misinterpreting it as a
deliberate process of biased measurement, rather than (in the context of liabilities) as a
32

justification, based upon asymmetry of information and payoffs, for recognising probable
outflows in the absence of observable measurement.30
Conservatism is also not used to support IASB proposals for requirements in standards, even
when it would be a natural argument to use. For example, in terms of conservatism, not
having a probability recognition threshold for liabilities is more conservative than having
one. But the IASB does not use conservatism as a justification for the proposed removal of
the threshold from IAS 37. All its arguments are based on the view that liabilities can be
measured, and therefore should be recognised. Conservatism also could be used as an
argument in discussions of credit risk. The IASB is aiming for a measurement attribute of the
amount that an entity would pay to transfer or settle the liability at the reporting date. This
would include the effect of its creditworthiness. However, conservatism would argue against
recognition of a liability at the smaller amount caused by including the effect of credit risk
and recognition of a gain when an entitys creditworthiness decreases. Although the IASB
seems willing to accept its constituents dislike of the inclusion of credit risk (which is surely
in part derived from a desire for conservatism), it does not use conservatism to justify this
departure from its stated measurement objective.
It is only in the insurance and revenue recognition projects that conservatism is
acknowledged as a desirable attribute, albeit not by name. The basis for conclusions to the
insurance contract DP argued that the observed price for the transaction with the
policyholder, although useful as a reasonableness check on the initial measurement of the
insurance liability, should not override an unbiased estimate of the amount another party
would require to take over the insurers contractual rights and obligations. The justification
for the IASBs change from this approach in the insurance ED was the desire to avoid day
one gains, consistent with the revenue recognition project.

33

While conservatism does not find theoretical endorsement in IFRS, it is nevertheless

prevalent in accounting standards themselves, and it is therefore in practice consistent with
the theory outlined above from the literature. A simple need, therefore, is to embed a theory
of conservatism from the literature into IFRS. Where the literature falls short in this regard,
however, is that it is insufficiently normative. Empirical evidence points to the existence of
conservatism in practice, and underlying theory explains this practice in terms of economic
benefits. This is a positive approach, describing and attempting to explain behaviours that
have evolved in practice. Yet standard setting is a normative activity. It exists as a market
intervention, as a mechanism of policy with the explicit aim of creating outcomes that the
market itself would not be expected to generate. Viewed in this light, the literature leaves
several questions unanswered. There are therefore implications for future research, as will be
discussed in the final section of the paper.
In conclusion, the argument here is that there is a role for conservatism, both in the theory of
recognition and measurement, and also in practice in IFRS, yet this role is denied by the
Framework and elsewhere in IFRS. While the literature provides some insight into a theory
of conservatism, there is a need for further normative contributions to inform the
implementation of conservatism in accounting standards.

7. Conclusions
We set out to understand why IFRS contains multiple and inconsistent recognition and
measurement requirements for liabilities. We apply measurement theory to extant and
proposed IFRS, identifying where the theory can be said to hold and where it cannot. We
argue that, while measurement attributes for liabilities are conceptually analogous to those for
assets, measurement is relatively problematic for liabilities in practice, primarily because
34

conservatism encourages the recognition of liabilities that have no observable measure.

However, the IASB does not acknowledge either the limitations of measurability or the
existence of conservatism. This leads the IASB to seek all its answers within the context of
measurement, thereby missing the opportunity to adopt insights resulting from a theory of
conservatism. In contrast, conservatism has become increasingly important in the literature,
in particular in positive empirical studies. The literature does not, however, offer a
sufficiently normative theory of conservatism, and it therefore falls short from the perspective
of adoption by the IASB in the Framework and in accounting standards. Our paper therefore
has implications for both revisions to IFRS and for further research.
The implications for revising IFRS are as follows. First, measurement should be defined
more tightly in the Framework, in line with the analysis in Sections 3 and 4. This tightening
would make verifiability a necessary requirement for reliable measurement, in contrast with
the present state where verifiability is desirable but not necessarily required. The tightening
would also clarify that the notion of faithful representation relates uniquely to observable
amounts, and cannot in principle relate, as in the present Framework, to the faithful
description of the process of forecasting an unobservable amount. Second, the recognition
thresholds in the Framework should be re-defined in line with Figure 1 and the associated
analysis in Section 4. Accordingly, all measurable amounts would be recognised, with the
probable outflow recognition threshold being reserved for immeasurable amounts. Third, the
probable outflow recognition threshold should be justified conceptually in the Framework.
Such justification cannot in principle be based upon measurement theory, for the reasons
argued in Section 4. Instead, and as argued in Section 6, a theory of conservatism is required
in IFRS, for which the literature provides a foundation. Fourth, and in line with the analysis
in Section 5, individual accounting standards should make a clear distinction between
amounts that are measures and those that are forecasts.
35

Beyond these proposed changes to IFRS, there is also scope for further improvement, yet for
this to be possible there is a need for a normative theory of conservatism. Meeting this need
is an implication of the paper for further research. The potential for research in this area can
be illustrated with two examples.
The first example concerns the degree of differential verifiability that IFRS should require for
the recognition of gains and losses, and the extent to which this should vary in different
applications. For practical purposes, accounting standards need to specify not just whether
conservatism should be applied, but also to what degree. This requires understanding the
informational value of conservatism in different settings, for example where asymmetries of
incentives and information are likely to arise and why. One possible line of enquiry, which
addresses the underlying behavioural aspects of conservatism, is suggested by decision
theory. The concept of Choquet expected utility concerns decisions that are made in the
absence of a known distribution, where a decision-makers utility is a function of his or her
degree of ambiguity aversion, which in turn determines the desired level of conservatism
(Gilboa and Schmeidler, 1989). In this setting, which can be modelled analytically and/or
tested experimentally, the level of ambiguity can be determined endogenously by the gametheoretic actions of other players, and so it enables analysis not just of information
asymmetry but also of incentive asymmetry.
The second example concerns financial statement presentation, in particular whether amounts
recognised conservatively should be presented differently from amounts that can be
interpreted as unbiased measures. On this question, a normative approach would seek to
develop financial statement presentation in a way that is currently not required. In this
context, an implication of the IASBs presumption of measurability is the effective denial of
the role of forecast error in balance sheet valuation, because errors are presumed to arise from
measurement alone (Christensen, 2010b). Viewed from this perspective, the probable
36

outflow recognition criterion appears unacceptably imprecise and arbitrary. Indeed, it is not
needed if all liabilities are viewed as measurable. Yet if the concept of forecast error is
acknowledged, amounts recognised on the basis of an estimated probable outflow provide
useful information, albeit of a different nature than measurable amounts. Managements
willingness and ability to forecast future outcomes provide information both ex ante, at the
time of the forecast, and ex post, in comparing the outcome that was forecasted with that
which ultimately arose. Acknowledgement of the role of forecasting error, and of a
distinction in financial statement presentation between measures and forecasts, and between
ex ante forecasts and ex post forecast revisions, would enhance the informational usefulness
of the financial statements (Barker, 2004; Glover et al, 2005).
In conclusion, our paper is motivated by extant and important conceptual inconsistencies in
IFRS, for which the literature offers limited directly relevant analysis. We seek to apply
measurement theory in order to explain these conceptual inconsistencies, which leads to three
conclusions: first is the need to revise the treatment of recognition and measurement in IFRS,
in order to make it consistent with measurement theory; second is the need to introduce a
theory of conservatism in IFRS, in order to justify financial reporting practice than cannot be
explained by measurement theory; and third is the need to develop a normative theory of
conservatism in the literature, in order to enable and justify a greater impact on policy and
practice.

37

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40

Figure 1: Recognition Algorithm (Liabilities)

Does the item meet

the definition of a
liability?

No

Do not recognise

Yes

Is an outflow
probable?

Yes

Recognise

No

Is the item
reliably
measurable?

No

Do not recognise

Yes

Recognise

41

Table 1: IFRS Sources on Liability Recognition and Measurement

Date

Comment letters

End of comment
period

Framework

1989

31

N/A

N/A

IAS 12 Income Taxes

1996

32

N/A

N/A

IAS 17 Leases

1997

N/A

N/A

IAS 19 Employee Benefits

1998

N/A

N/A

IAS 37 Provisions, contingent liabilities

and contingent assets

1998

N/A

N/A

IFRS 2 Share-based payments

2004

N/A

N/A

IFRS 4 Insurance contracts

2004

N/A

N/A

IAS 37 ED

June 2005

123

Oct 2005

Insurance contract DP

May 2007

162

Nov 2007

Revenue recognition DP

December 2008

211 [July 2009

Board paper]

June 2009

Pensions DP (for contribution-based

promises)

March 2009

150

Sept 2009

Leases DP

March 2009

302

July 2009

Credit risk DP

June 2009

123

Sept 2009

IAS 37 ED/Working draft of revised

standard

January 2010

211

May 2010

Revenue recognition ED

June 2010

973

Oct 2010

Insurance contracts ED

July 2010

248

Nov 2010

Leases ED

August 2010

760

Dec 2010

IFRS 9 Financial Instruments

October 2010
(liabilities)

N/A

N/A

42

Table 2: Assets vs Liabilities - Measurement Attribute Analogues

Measurement Attribute

Assets

Liabilities

1. Current holding
value

Value-in-use

Cost of performance

(Entity-specific present value

of expected economic
benefits)

(Entity-specific present value

of economic benefits
expected to be consumed in
settlement of the liability)

2. Current market exit

value

Fair value

Cost of transfer (fair value)

(The price that would be

received to sell an asset in an
orderly transaction between
market participants at the
measurement date.)

(The price that would be paid

to transfer a liability in an
orderly transaction between
market participants at the
measurement date.)

3. Current contractual
exit value

Cost of liquidation

Cost of release

(The amount that the entity is

currently, contractually
obliged to accept to liquidate
the asset.)

(The amount that the entity is

currently, contractually
entitled to pay in full
settlement of the liability.)

4. Current entry value

Replacement cost

Current equivalent
proceeds

(The outflow of economic

benefits that would be
required to replace the
service potential of the
existing asset).

(The inflow of economic

benefits corresponding to the
current replacement of the
liability).

5. Mixed
measurement: exit
value

Recoverable amount

Settlement amount

(Higher of value-in-use and

value-in-exchange)

(Higher of cost of
performance or cost of
release)

6. Mixed
measurement: entry
and exit value

Deprival value

Relief value

(Lower of replacement cost

or recoverable amount)

(Lower of current equivalent

proceeds of settlement
amount)

43

Table 3: Measurement Attributes on Initial Recognition33

Is an exit value observable?

Yes
Is an entry value
observable?

Yes

No

No

Asset:
Bank loan

Asset:
Some intangible assets and
specialised PPE

Liability:
Bank loan

Liability:
Performance Obligation

Asset:
Donated assets

Asset:
Some intangible assets

Liability:
Some shared-based
payments

Liability:
Provisions

44

Table 4: Recognition Thresholds

Is the liability reliably measurable?

Is an outflow of
resource probable?

Yes

No

Yes

Bank loan

Provision

No

Derivative financial
liability with market
price but improbable
outflow34

Contingent
Liability

45