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Chapter 7

Chapter 7. Measurement Applications. Chapter 7 Measurement Applications. 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

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Chapter 7

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  1. Chapter 7 Measurement Applications

  2. Chapter 7Measurement Applications

  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

  4. 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

  5. 7.2.3 Lower-of-Cost-or-Market Rule • A partial application of measurement • Inventory • Ceiling tests • A vehicle for conservative accounting

  6. 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. 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

  8. 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

  9. 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

  10. 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

  11. Why Fair Value Financial Instruments? • To increase decision usefulness • Many financial instruments traded on well-working markets → reasonable reliability • To control gains trading

  12. 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

  13. 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

  14. 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)

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 7.4.3 Lev & Zarowin (continued) • Conclusion • Accounting for intangibles is inadequate • Continued

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

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