1.
Strictly speaking, the answer is “yes,” since post-revenue-recognition assets, such
as accounts receivable, are valued at the net amount expected to be received. This
amount approximates present value if we accept that the time to collection is
sufficiently short that discounting is not needed. Present value (i.e., value-in-use)
is a version of current value, consistent with a valuation approach, not a cost
approach. Complete historical cost accounting for accounts receivable would
require them to be valued at the cost of the inventory or services sold, until cash is
received.
A “no” answer can also be argued if we accept that the historical cost basis of
accounting only holds up to the point in the firm’s operating cycle at which
revenue is regarded as earned, usually the point of sale. Financial assets generated
subsequent to this point can be valued at current value without violating the
historical cost basis of accounting.
2.
a.
Under the current IFRS 15 and ASC 606 standards, the company appears
to be prematurely recognizing revenue on the computer program component of
the contract. It is unlikely to have satisfied its obligation for this component upon
contract signing. Under the current standards, an account receivable should not be
set up and revenue should not be recognized until the program is installed and
operating satisfactorily.
Also, the 80% allocation of contract price to the computer program may be
arbitrary. Under the current standards, allocation should be on the basis of standalone prices for the two contract components, or an estimate thereof.
Deferred revenue would not be recorded under the current standards. Instead,
revenue should be recognized only as the maintenance obligation is satisfied. This
assumes that progress can be reasonably measured. If not, no revenue would be
recognized until the maintenance obligation is completed.
b.
The approach of the current standards is more relevant than the company’s
approach since revenues from both contract components are recognized consistent
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with the services provided during the period (i.e. successful installation of the
program and maintenance services provided during the periods). Under the
company’s chosen accounting policies, an account receivable and associated
revenue seem to be recorded prematurely. Also, deferred revenue is recognized
(i.e. amortized) in accordance with the firm’s chosen amortization policy, in this
case evenly over three years. This policy need not conform with the time pattern
of maintenance services actually rendered over the life of the contract.
The approach of the current standard is less reliable than the company’s approach.
Under the company’s policy, allocation of deferred maintenance revenues equally
over three years is a straightforward calculation, whereas, under the current
standards, an estimate of progress to date on the maintenance obligation is subject
to estimation error and possible bias.
3.
Perhaps the main reason is cost. Since hedging transactions are costly, the firm
may feel that the optimal cost-benefit trade-off is not risk-free.
Also, the firm may be at least partially protected by natural hedging.
Another cost-related reason is that investors can diversify firm-specific risk
themselves. Investors may feel they can manage firm-specific risk more cheaply
through diversification than the firm can through costly hedging and natural
hedging. As a result, they would object if management engaged in excessive riskavoidance through hedging transactions.
Perfect hedges are not always available. It may be difficult or impossible to find a
hedging instrument that has a perfect negative correlation with the value of the
item to be hedged. As a result, firms must bear some basis risk.
The firm may not be planning any costly internally financed capital projects, so
that it does not anticipate a need to ensure a large amount of cash will be
available. Consequently, the firm may feel less need to hedge its future cash flows
than it would otherwise.
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Investors and, on their behalf, the firm’s Board of Directors, may be concerned
that excessive hedging may slip into speculation, which places more risk, rather
than less, on the firm. As a result, the Board may limit, or at least closely monitor,
the extent of the firm’s hedging.
4.
a.
High operating leverage in a firm’s cost structure means a high sensitivity
of earnings to changes in revenues, as illustrated in the case of Yahoo Inc. Since
stock prices are sensitive to earnings, high operating leverage means high stock
price variability when revenue changes.
b.
Momentum is a product of self-attribution bias, whereby good investment
outcomes reinforce an investor’s confidence, leading to the purchase of more
shares. This drives share price higher than it would be if all investors were
rational. A stock market bubble is an extreme case of momentum trading. Over
time, however, share prices revert toward their efficient market levels, as it
becomes apparent that prices are too high. In the case of a bubble, the reversion
can be very swift. The combination of stock prices that are too high (driven by
momentum) and subsequent reversion produces high stock price volatility.
c.
The presence of rational investors will likely increase, not decrease, the volatility.
Self-attribution biased investors may overreact to earnings and price volatility,
Then, some rational investors may “jump on the bandwagon” (Section 6.2.4) to
exploit the resulting share price runup or rundown while it lasts, further increasing
volatility. Even if rational investors do not jump on the bandwagon, Verardo
(Section 6.2.4) found a significant positive relationship between the extent of
belief dispersion and momentum, driven by different prior beliefs and different
information processing abilities.
5.
a.
Yes, Inco should have recognized an impairment loss. The undiscounted
cash flows from the mine were below book value for most of the time prior to
2002. Undiscounted cash flows were greater than book value for a brief period
around the end of 2000. However, if Inco had written down the mine earlier, as it
should have, this was not enough to write the asset back up. Accounting standards
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at the time regarded a written-down value as the new cost, so that, once written
down, assets could not have been written up again.
Under the current IASB standards (IAS 36), the mine should have been written
down to its recoverable amount as soon as this value fell below book value. If the
recoverable amount later increased, the mine could have been written up, but not
to a value above its original cost. If the recoverable amount fell further after the
first write-down, further impairment should be recognized.
Note: An alternative answer, equally acceptable:
Under IAS 16, property, plant, and equipment can be valued at fair value if this
option is chosen, providing fair value can be determined reliably. Here, the
tracking stock provides a reliable fair value. Thus, under this option, write-downs
would be required whenever the value of the tracking stock fell below book value.
If the value of the tracking stock should increase subsequently, the mine could be
written up to this new fair value.
b.
No, delaying a write-down would not have been acceptable under the
Samuelson theory. If the nickel and stock markets work well, the value of the
tracking stock is the best estimate of future market value of the asset, hence, of its
future cash flows. Management may have felt justified in delaying a write-down
under IAS 36 if it was confident nickel prices would increase. For example,
management may have had inside information that justified a value-in-use high
enough to avoid a write-down. However, given the Samuelson theory, increasing
value-in-use above the value of the tracking stock would not be defensible.
If Inco had chosen the fair value option under IAS 16, delaying a write-down
would not have been acceptable since if the stock market works well, the tracking
stock provides the best available evidence of fair value.
c.
Prospect theory predicts loss aversion, under which individuals dislike
losses and tend to hold assets rather than sell them and realize the loss. In the case
of Inco, the prospect of reporting an impairment loss is analogous to recognizing a
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loss, and delaying recognition is analogous to holding. Thus, management delays
the impairment charge.
It should be noted, however, that prospect theory is not sufficient justification to
violate GAAP.
6.
a.
The three policies are increasing in relevance. IAS 39 was lowest in
relevance. Under IAS 39, loans were valued at their discounted expected future
receipts before any provision for credit losses. Credit losses were recognized as
loans become impaired. Since the essence of relevance is to predict future cash
flows, a delay in recognizing impairment until it has taken place reduces
relevance relative to policies that attempt to anticipate future credit losses even if
the loan is not currently impaired.
The 2009 IASB proposal is next in relevance. It proposes recording of writedowns, even if a loan is not impaired, by creating a loan loss allowance at the end
of each period based on expected future credit losses. It anticipates expected
future loan losses sooner than IAS 39.
The Basel Committee’s suggested policy is the most relevant of all, since it
predicts cash flows over the business cycle, rather than over the term of the loan
as in the 2009 IASB proposal. In effect, the Basel Committee’s proposal predicts
cash flows over a longer period than the IASB proposal.
b.
The three policies are decreasing in reliability. As the period over which
credit losses are predicted lengthens, the potential for errors of estimation and bias
in projecting future loan losses and discount rates increases.
c.
Fair value accounting for loans would require valuing them at their market
value (Level 1) or at an estimate of market value (Levels 2 and 3). Under Level 3,
market value could perhaps be approximated by valuing loans at present values
discounted at a current interest rate rather than at the effective rate established at
loan acquisition.
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If a Level 1 valuation (and to a lesser extent Level 2) is feasible, valuing loans at
market value would be most consistent with the valuation perspective (i.e., at fair
value) since market value would include the market’s expectations of future credit
losses, and should be reasonably reliable. Level 3 valuations would be less
reliable since expected future receipts and discount rates are subject to error and
possible bias. Only if the increase in relevance of Level 3 valuations exceeded the
decrease in reliability should fair value accounting be applied.
A reasonable conclusion is that fair value should not be adopted for all loans,
since most loans are unlikely to have a market value and the resulting need to
apply Level 3 introduces considerable unreliability.
7.
a.
One reason is as a form of credit enhancement. By retaining an interest,
hence bearing some risk, the company demonstrated its commitment to the quality
of its mortgage lending procedures.
Another reason is that the company would earn interest income (i.e., accretion of
discount) on the retained interests, thereby bolstering its income statement.
Third, since retained interests were valued at fair value, and since no secondary
market existed for these retained interests, they were valued on a discounted
present value basis. The resulting need for estimates gave New Century
considerable latitude in the discounted present value calculations. The company
may have used this latitude to bias current value estimates, thereby increasing or
smoothing reported net income.
b.
Again, this was a form of credit enhancement. New Century would receive
a higher price for mortgages transferred. The company probably believed that
house prices would continue to rise, so that mortgage delinquencies would be
rare.
c.
Under IFRS 9, derecognition is allowed when the firm transfers
substantially all of the risks and rewards of ownership of the mortgages sold. The
question then is, does a one-year commitment to buy back troubled mortgages
violate transferring all the risks? Undoubtedly, some risk remains for New
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Century. However, due to buoyant expectations about the future of the housing
market at the time, New Century could argue that the risk of buying back was low
and, if a mortgage was bought back, the loan could be sold or refinanced with
little loss. Thus, treating the mortgages transferred as sales and providing for
expected credit losses on mortgages bought back would seem to have been
feasible under IFRS 9.
However, IFRS 7 requires disclosure of assets that have been derecognized but in
which the firm has a continuing involvement. IFRS 12 requires disclosure of
interests in and risks arising from joint arrangements with others. It thus seems
that the market would have been aware of New Century’s one-year buyback
commitments and its revenue recognition policies. Whether this information
would have led to an increase in investor risk assessments, reduction of leverage,
and higher cost of capital sufficient to reduce the extent of New Century’s
activities to the point that it would have avoided bankruptcy is difficult to say.
Also, much of New Century’s early revenue recognition from retained interests
and servicing rights would have to be reversed as mortgages collapsed. This
would have led to large reported losses regardless of whether or not it
derecognized its securitized mortgages, further increasing the likelihood of share
price collapse and bankruptcy.
Given the buoyant expectations at the time regarding the future of the housing
market, a reasonable conclusion is that the new standards would not have
prevented New Century’s bankruptcy.
8.
Reasons to agree with Mr. Fink:

If markets work well, current asset price is the best estimate of prices in all
future periods. This “more accurate appraisal” should help investors to
predict future cash flows. That is, fair values are high in relevance.

To the extent that fair value accounting increases transparency (i.e., higher
earnings quality), investors benefit through lower estimation risk. Mr. Fink
may feel that fair values are more transparent in the sense that fair values
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may increase the ability of investors to predict future firm performance
relative to other bases of valuation such as historical cost. Also, if markets
work well, fair values are reliable, particularly in the sense of lowering
estimation risk due to less ability of the manager to bias the valuation.

A dictionary definition of granularity is “composed of small compact
particles.” This seems to imply that fair value accounting increases the
ability of investors to see inside the business. Mr. Fink may feel that by
marking to market individual assets, investors can see which assets have
increased in value and which have decreased. This may help them to
evaluate risk and trends in firm performance.

Since market values tend to be volatile, Mr Fink is correct in expecting
that this will cause managers and investors to be concerned about quarterly
results. This diverts managers’ attentions from longer term activities,
which may be of greater long-term benefit to investors. Also, to lower
short-term volatility, managers may engage in costly hedging, or may
engage in earnings management, for example, by manipulating loan loss
provisions, to smooth out earnings.
Reason to disagree with Mr. Fink:

Mr. Fink ignores reliability when he suggests that fair value accounting is
good for investors. To the extent that fair values are not derived from
markets that work well, they are subject to possible error and manager bias
(e.g., Level 3 and, to a lesser extent, Level 2). If reliability is sufficiently
low, this would wipe out the benefits to investors of greater relevance.

By, in effect, charging managers with the opportunity cost of firm assets
and liabilities, fair value accounting will encourage stewardship; if the
manager cannot earn at least cost of capital on opportunity cost, the firm
should be reorganized or sold. Thus, fair value accounting can motivate
improved manager performance to the investors’ longer-term benefit.
9.
a.
According to IFRS 9, Barclays must transfer substantially all the risks and
rewards of ownership of the securities in question in order to derecognize them.
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It seems from the information available that the rewards of the securities have
been transferred, since increases in fair value accrue to C12. However, it is not
clear that the risks have been transferred, since almost all of the selling price is
financed by a loan from Barclays Capital. Should the transferred securities decline
in value, it is unclear how the loan would be repaid by C12. A reasonable
conclusion is that this deal would not qualify as a sale under IFRS 9.
Since the IFRS derecognition standard has been converged with U.S. GAAP, this
conclusion would also be consistent with FASB standards.
b.
Under IFRS 10, consolidation is required when one entity controls
another. Control exists when one firm (Barclays) has power to direct the activities
and shares in the risks of another (C12). Since Barclays Capital pays an annual fee
of $40 million to C12 for management of the transferred securities, it seems that
control has been transferred to C12. However, as pointed out in a., if the cash
flow from the transferred securities becomes insufficient to meet loan repayments,
Barclays would likely have to absorb the loss, in which case it could be deemed to
share in losses (i.e., bear risk) of C12.
A reasonable conclusion is that Barclays would be required to consolidate C12
under IFRS 10.
c.
The return on the market (FTSE 100) on September 16 was 82/(5,124.10 –
82) = 0.0163. According to the market model (Section 4.5), with αj = Rf(1 – βj) =
0 and RMt = 0.0163, we expect Barclays’ share return on September 16 to be
Rjt = 0 + 2.1568 × 0.0163 = 0.0352
Abnormal return is actual minus expected return:
ARjt = 0.0290 - 0.0352. = -0.0062
Since abnormal return is negative, it seems that the market disapproved of the
deal.
10.
Arguments against fair valuing long-term debt:
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
Market value of debt falls following a credit downgrade. It may seem
strange to many persons that the firm records a gain following a credit
downgrade.

The reduction or increase in fair value of debt, from changes in market
interest rates or credit downgrades, or both, creates a wealth transfer from
debtholders to shareholders. Under the equity view of financial reporting
(Section 3.7.1), a wealth transfer such as this is not a gain or loss to the
entity. Thus, no gain or loss should be recognized.
 Many firm assets, such as self-developed goodwill, patents, R&D, are not
valued on the balance sheet. Downgrades or increases in the credit rating of
debt is frequently due to changes in the value of these assets. Yet, such
changes are not recognized in current earnings, while if debt is fair valued,
changes in fair value are included. This creates a mismatch situation that
increases the volatility of reported earnings.
Arguments in favour of fair valuing long-term debt:
 To the extent firm assets are fair valued on the balance sheet, and changes
in fair value contribute to changes in the firm’s credit rating, failure to fair
value debt creates a mismatch. If so, firms should be required to fair value
their debt, so as to reduce mismatch.
 If the proprietorship view of financial reporting (Section 3.7.1) is accepted,
changes in the fair value of debt represent a gain to shareholders, which
should be reflected in earnings.
 To the extent that the balance sheet is the primary financial statement, assets
and liabilities should be fair valued, subject to reasonable reliability.
Inability to fair value certain assets, such as intangibles, should not be used
as a reason not to fair value liabilities.
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