copyright © 2009 by pearson education canada 7 - 1 chapter 7 measurement applications

Copyright © 2009 by Pearson Education Canada7 - 1

Chapter 7Measurement Applications

Copyright © 2009 by Pearson Education Canada7 - 2

Chapter 7 Measurement Applications

Copyright © 2009 by Pearson Education Canada 7 - 3

Two Bases of Current Value Measurement• Value-in-use

– Discounted present value of future receipts– Relevance: high– Reliability: management may change intended use

• Fair value– Exit price: measures opportunity cost of retaining

asset/liability in firm, hence stewardship oriented– Relevance: high if well-working market value available– Reliability: high if well-working market value available– Fair value is the measurement basis of SFAS 157


7.2.1, 7.2.3 Longstanding Measurement Examples• Accounts receivable and payable

– Approximates value-in-use if time is short

• Cash flows fixed by contract– Capital leases– Long-term debt

• Unless interest rate changes


7.2.3 Lower-of-Cost-or-Market Rule• A partial application of measurement

– Inventory– Ceiling tests

• A vehicle for conservative accounting


7.2.4 Revaluation Option

• IAS 16– Allows property, plant and equipment to be

written up to fair value– Requires reasonable reliability– Fair values must be kept up to date– Not presently available under U.S.

accounting standards


7.2.5 Ceiling Test for Property, Plant and Equipment• IAS 36

– Applies if revaluation option not selected– Recognize impairment loss in current earnings if book

value greater than recoverable amount– Impairment losses can be reversed, but not to more than

book value if no impairment loss had been recorded

• SFAS 144– 2-step procedure

• Determine if impaired (no discounting)• If impaired, write down to fair value• No reversal


7.2.6 Post-Employment Benefits

• Pensions– Projected benefit obligation (PBO)

• Total pension liability (discounted), including for expected increases in compensation

– SFAS 87, 158• SFAS 159 requires PBO, net of fair value of pension plan

assets, to be included on balance sheet• Pension gains and losses (e.g. changes in benefits, interest

rates) included in other comprehensive income (OCI)– Amortized into net income over time

» Continued


7.2.6 Post-Employment Benefits (continued)

• Other post-employment benefits (e.g., health care, insurance)– Accumulated benefit obligation (ABO)

• Similar to PBO but excluding expected increases in compensation

– SFAS 106, 158 require ABO to be included on balance sheet


7.3.1 Financial Instruments

• Definition– A contract that creates a financial asset of one firm

and a financial liability or equity instrument of another firm

• Note broad definition of financial assets and liabilities


Why Fair Value Financial Instruments?• To increase decision usefulness

– Many financial instruments traded on well-working markets → reasonable reliability

• To control gains trading


7.3.2 IAS 39• Applies to debt and equity securities• Four financial asset categories

– Available-for-sale• Fair valued, gains/losses in OCI

– Loans & receivables• Valued at cost, subject to impairment test• May be written up again if fair value rises

– Held-to-maturity • Valued similarly to loans & receivables

– Trading • Fair valued, gains/losses in net income

» Continued


7.3.2 IAS 39 (continued)• Two financial liabilities categories

– Trading, valued at fair value• E.g., a financial institution issues 30-day financial paper• Accounts payable

– If longer-term, they may bear interest at a fixed rate. If so, their fair value varies with interest rates

– Other, valued at cost• E.g., bonds outstanding, demand deposits

» Continued


7.3.2 IAS 39 (continued)

• Why not simply value all financial instruments at fair value, rather than the complex mixture of valuations under IAS 39?– Reliability

• Demand deposits difficult to fair value due to core deposit intangibles

• No market value may be available– Some financial instruments thinly traded, others not traded at

all

– To control excess earnings volatility• Unrealized gains/losses on available-for-sale included in OCI• Loans & receivables and held-to maturity valued at cost

(subject to ceiling test)


7.3.4 Derivative Financial Instruments

• Derivatives are financial instruments • Definition

– A contract, the value of which depends on some underlying…

– May not require an initial cash outlay– Generally settled in cash, not in kind

• Derivatives valued at fair value under IAS 39 and SFAS 133– Gains and losses included in net income, except

certain hedging contracts


7.3.5 Hedge Accounting• Fair Value Hedges

– Gains and losses on the hedging instrument included in net income• Fair valuing the hedged item offsets effect on net

income

• Cash Flow Hedges– Gains and losses on the hedging instrument

included in OCI, until the future transaction affects net income

» Continued


7.3.5 Hedge Accounting (continued)• Benefits of Hedge Accounting

– Reduces earnings volatility• Offset gains/losses by fair valuing hedged item (fair

value hedge)• Delay gain/loss recognition by including in OCI until

realized (cash flow hedge)• Hedging may avoid the ceiling test

– Theory in Practice 7.2

» Continued


7.3.5 Hedge Accounting (continued)

• To Obtain Benefits of Hedge Accounting– Hedges must qualify

• Must be highly effective– Negative correlation with hedged item

– Hedges must be designated• To reduce temptation to speculate• Requires elaborate procedure and

documentation• Macro hedging allowed under IAS 39 to simplify


The Firm’s Real Volatility• Volatility of firm’s environment

– Depends on states of nature

• Less– Natural hedging– Hedging with derivatives

• Equals real volatility of the firm– As chosen by management


Should Financial Statements Reflect Real Volatility?

• Seems reasonable– Investors sensitive to risk– Real firm risk should not be covered up?– Fair value accounting for all assets and liabilities

(including derivatives) reflects real volatility– Historical cost accounting hides real volatility,

and can result in little warning of financial distress & legal liability

– Partial fair value accounting (i.e., the mixed measurement model) can overstate real volatility

• This is the problem of mismatch


A Mismatch Example • Firm has long-term debt outstanding

– Accounted for at historical cost

• Firm has created a natural hedge by acquiring interest-bearing securities– Accounted for at fair value, changes in fair

value included in net income (e.g., available-for-sale)

» Continued


A Mismatch Example (continued) • Then, changes in fair value of debt are not

included in net income, but the opposite changes in fair value of the interest-bearing securities are included in net income

• Net income overstates the real volatility of the firm; that is, a mismatch

» Continued


A Mismatch Example (continued) • The fair value option

– Allows firms to voluntarily fair value assets/liabilities

– IAS 39 restricts fair value option to reducing mismatch

• In this example, firm could fair value long-term debt to eliminate excess income volatility

– SFAS 159 does not restrict fair value option to reducing mismatch

• Theory in Practice 7.1, re: Blackstone Group


Use of Fair Value Option Following a Debt Downgrade• Suppose that a credit downgrade reduces

fair value of a firm’s debt– No writedown under historical cost accounting– Firm may use fair value option to write debt

down• Results in a gain to net income. Strange?

– Presumably, this is a reason IAS 39 restricts fair value option to mismatch situations

– But can argue the gain represents the lenders’ portion of the loss in fair value of debt—not borne by shareholders

– SFAS 159 would allow, IAS 39 would not


7.4 Accounting for Intangibles• Purchased intangibles

– Goodwill arising from an acquisition (IFRS 3, SFAS 142)

• Accounted for at cost• No amortization• Subject to ceiling test

– Can lead to major writedowns, e.g., JDS Uniphase, 2001 Annual Report. See Theory in Practice 7.3

– Management devices to work around goodwill and related writedowns

• “Pro-forma income,” e.g., TD Bank, 2000 Annual Report. See Theory in Practice 7.3

» Continued


7.4 Accounting for Intangibles (continued)• Self-developed intangibles

– Self-developed goodwill, e.g., from R&D• Hard to reliably determine fair value• Costs written off as incurred

– Recognition lag: goodwill value shows up over time on income statement

• Recognition lag responsible for low ability of net income to explain stock returns?

– Lev & Zarowin (1999) argue yes


7.4.3 Lev & Zarowin, “The Boundaries of Financial Reporting…”• Their study documents a decreasing

usefulness of earnings information– Usefulness evaluated by ability of earnings to

explain abnormal share return• Low R2

– And falling?• Low ERCs• Especially for research-intensive firms

» Continued


7.4.3 Lev & Zarowin (continued)

• Conclusion– Accounting for intangibles is

inadequate

» Continued


7.4.3 Lev & Zarowin (continued)• Suggestion to improve usefulness

– Capitalize successful intangibles after a “trigger point” is attained

• Amortize over useful life• Like successful efforts accounting in oil and gas • Amounts capitalized and amortized may reveal

inside information to investors, since it is management that has best knowledge of R&D value


7.5.2 Risk Management• Risk controlled by natural hedging +

hedging with derivatives• Some reasons for managing firm-

specific risk, even though investors can diversify it away– Reduce investor estimation risk– Cash availability for planned capital

expenditures– Control speculation– Reduce likelihood of major losses, leading to

lawsuits


Reporting on risk• Beta risk

– Relevant to rational, diversified investor• Beta an input into investment decisions

– Accounting variables correlated with beta• May help investors to estimate beta

– Beaver, Kettler, and Scholes (1970)

• Reasons why reporting on other (firm-specific) risks also relevant to investors– Investors may not act according to rational decision

theory model– Risk information may reduce estimation risk– Risk reporting may control speculation


7.5.4 A Measurement Perspective on Risk Reporting• Narrative, in MD&A

– Canadian Tire Corp. 2006 Annual report • Text, Section 4.8.2

• Sensitivities Analysis– Suncor Energy Inc., 2006 Annual Report

• Table 7.2

• Value at Risk– Microsoft Corp., 2006 Annual Report


Conclusions• Standard setters continue to increase

current value measurements in financial statements– Some measurements are one-sided

• Lower-of-cost-or-market, ceiling tests• IASB standards more likely than FASB to allow

writeups

• Accountants are recognizing an increased obligation to measure and report on firm risk

The End

Thank you

copyright © 2009 by pearson education canada 7 - 1 chapter 7 measurement applications

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