MEASUREMENT
APPLICATIONS
David Chu
Richard Persaud
Jeffrey Rousset
Stephen Storey
Overview
• Current Value Accounting
• Financial Instruments
• 2007-2008 Market Meltdown
• Derivative Instruments
• Reporting on Risk
• Accounting for Intangibles
Current Value Accounting
• Value-in-Use
• Business Model
• Fair Value
• Exit price (opportunity cost)
• 3 Levels
Accounts Receivable & Payable
• Current accounts receivable
• Net of allowance for doubtful accounts
• Accounts payable
• Approximates present value
• Discount factor ignored
Cash Flows Fixed by Contract
• Effective interest rate
• Amortized cost accounting
• Finance lease contract
• Lower of fair value leased payments or present value of
minimum lease payments
Lower of Cost or Market Rule
• Usefulness
• Conservatism
Revaluation Option for Property, Plant,
and Equipment
• IAS 16
• Allows for revaluation option
• Must keep updated
Ceiling Test for Property, Plant, and
Equipment
• Impairment loss is recognized if Book Value is
less than the Recoverable amount
Differences:
• IAS 36
• FASB
Pensions and other Post-Employment
Benefits
• Defined pension plans (IAS 19)
• Pension expense arising current period employee
service to include the change in the discounted present
value of expected future pension payments, including
for any future compensation increases.
• Implications for measurement approach
Financial Instruments
• Financial instruments are defined as follows:
• A financial instrument is a contract that creates a financial asset of
one firm and a liability or equity instrument of another firm.
• Financial Instruments include:
• Cash
• An equity instrument of another firm
• A contractual right to:
• Receive cash or another financial instrument from another firm,
or
• Exchange financial instruments with another firm
• A contractual obligation to:
• Deliver cash or another financial asset to another firm, or
• Exchange financial instruments with another firm
IAS 39 Classification of Financial Assets
• Available-for-Sale
• Non-derivative instruments, valued at fair value. Most unrealized
gains and losses included in OCI until the asset is disposed of.
• Loans and Receivables
• Non-derivative instruments, valued at amortized cost and are
subject to an impairment test. Examples include bank loans.
• Held-to-Maturity
• Non-derivative instruments, valued at amortized cost and are
subject to an impairment test. Firms intent is to hold until maturity.
• Financial Assets at Fair Value through Profit and Loss
• Includes all derivatives not held for hedging and non-derivative
financial assets held for trading. These are investments in assets
for the short term, with gains and losses included in net income.
IAS 39 – Fair Value Option
• The ability to designate instruments at fair value is permitted
under IAS 39, called the Fair Value Option.
• The Option gives firms the right, but not the obligation, to value
financial assets and liabilities at fair value.
• Once designated under this option however, the firm must
continue to fair-value the instrument in future periods.
• IAS 39 recognizes two categories for financial liabilities:
1.
Financial Liabilities at fair value through profit and loss
• Includes financial liabilities held for trading and other liabilities
that the firm has designated to belong to this category
2.
Other Financial Liabilities
• Valued at cost or amortized cost. Examples include bonds
outstanding
Switching between Asset Classes
• Firms can have strong incentives to switch between
held-to-maturity and held-for-trading categories
• Firms can immediately increase net income if the asset value
has appreciated from its book value.
• IAS 39 provides strong disincentives for this behavior
• If a firm sells or reclassifies a significant amount of held-tomaturity securities, the firm is prevented from using the heldto-maturity category for at least two years.
• This eliminates a firms ability to value instruments at
amortized cost over that period of time.
Why Not Always Use Fair Value?
• Issue #1: If reliable measurements cannot be attained,
then fair value is likely not going to be decision useful,
despite being more relevant.
• Issue #2: Other Financial items can also be difficult to
value reliably. Financial institutions, specifically, face
issues when valuing demand deposits, and their resulting
intangibles, at fair value. This issue is in regards to core
deposit intangibles.
Issues Arising from Fair Value
• Earnings Mismatch defined as:
• Earnings volatility in excess of the real volatility facing a firm
• Some firms utilize a natural hedge, where they hold
financial assets and liabilities of similar duration and other
characteristics to offset their impact on the firm
• From a business perspective, an increase in interest rates
decreases the fair value of a company’s interest bearing assets, but
also decreases the fair value of the debt
• The financial statements will only show the loss on the assets, and
therefore makes earnings more volatile than the true value of the
company
• IAS 39 lets liabilities be fair valued only if it reduces this mismatch
Fair Value Accounting in the U.S.
• In the U.S., ASC 825-10-15 allows for fair-valuing
liabilities, but does not restrict this option to only reducing
mismatch situations
• A company that has its debt downgraded by a credit
agency will report a gain on its Income Statement
• Implies that a loss by debt holders results in a more profitable firm
as a whole.
• Credit risk is a function of the business environment facing the firm
and the fair value of its assets. As several balance sheet assets are
recorded at cost, another mismatch situation occurs as these
assets are not written-down to correlate with the downgrade.
2007-2008 Market Crash
• Following the market meltdown, several firms reported
huge fair value write-downs of their assets due to
illiquidity issues and the increased cost of insurance
through Credit Default Swaps.
• Managers and Regulators felt that the accounting policies
at the time were excessive and forced down the value of
even unaffected investments.
• In the face of this difficulty, standard setters (IASB and
FASB) introduced two modifications in 2008
• Firms could determine fair value based on their own cash flow
estimates and risk-adjusted discount rate
• Firms could reclassify certain assets in “rare circumstances”
IFRS 9 Replaces IAS 39
• Effective January 1, 2013, IFRS 9 will permanently
replace IAS 39 which was a temporary measure
• All financial assets are to be recorded at fair value at acquisition,
and may be subsequently converted to the amortized cost basis if
the objective of the firm is to collect the interest and principal. This
reduces the number of possible accounting methods to two
• Gains and losses on financial assets are generally recorded in net
income
• Assets that were originally held to collect interest and principal and
were sold prior to maturity, may be recognized through profit and
loss unless transactions of this nature occur too often, in which
case the company will have to use fair value accounting
• Ultimately IFRS 9 backs off from its harsh stance on fair
value accounting for financial instruments
Derecognition and Consolidation
• Off-balance sheet financing concealed much of the risk
borne by financial institutions leading to the ’07-’08 crash
• Derecognition – Financial institutions engage in
securitization to lower the leverage on their Balance Sheet
• Consolidation – The extensive use of Special Purpose
Entities (SPEs) blurred the boundary between what should
be consolidated on the financial statements and what you
be left off
Derivative Instruments
• Derivative Instruments rely on some underlying
price, interest rate, etc…
• Derivatives allow for high amounts of leverage as
minimal initial cash outflow
• Manage Risk
• Speculate
• Industry has moved from historical cost method to
fair value method
Option Fair Value Pricing
• Use expected value to determine fair value
• Black/Scholes pricing formula
• Current market price of shares
• Variability of return of the share
• Exercise price of the share
• Time to Expiration
• Risk free rate
Derivative Instruments
• Derivatives used to protect against risks
• Fair value hedges used as a hedge against an
asset or liability
• Cash flow hedges to hedge anticipated
transactions
Why firms manage risk
1. CAPM model does not include estimation risk
2. Ensure cash is available when needed
3. Derivatives used to speculate
4. Hedging may prevent large losses
Firm risks
• Interest rate risks for financial institutions
• Greater volatility of full fair value income negatively
related to hare price
• Sensitivity analysis of risk
• Value at Risk
Accounting for Intangibles
• Intangible assets are capital assets that do not have
•
•
•
•
physical substance – ex: patents, trademarks
If purchased or self-developed, intangibles may be treated
like property, plant & equipment and are valued at cost
and amortized over useful life
If acquired through business combination, cost is equal to
fair value and subject to the ceiling test
Costs of developing a product resulting from research
may be capitalized if the results of the research are
technically and commercially feasible and costs can be
measured reliably
Due to recognition lag, intangibles appear through the
income statement
Purchased Goodwill
• Goodwill is the difference between the fair value
of the tangible and identifiable intangible assets
and the liabilities of the acquired company, and
the purchase price paid by the acquiring
company for consolidated financial statements
purposes
Purchased Goodwill example
A Ltd.
Balance Sheet
As at January 1, 2011
Capital Assets
$500
___
$500
Liabilities
Equity
$100
400
$500
Purchased Goodwill example cont’d
Z Ltd.
Balance Sheet
As at January 1, 2011
Capital Assets
$300
___
$300
Liabilities
Equity
$140
160
$300
Purchased Goodwill example cont’d
A Ltd.
Balance Sheet (Post-Acquisition)
As at January 1, 2011
Capital Assets,
excluding Z Ltd.
Investment in Z
$500
400
$900
Liabilities
$100
Equity
800
$900
A Ltd. purchases all 160 shares of Z Ltd. in exchange for
40 shares of A’s stock valued at $10/share
Purchased Goodwill example cont’d
A Ltd. and Subsidiary
Consolidated Balance Sheet
As at January 1, 2011
Capital Assets,
exclude goodwill $840
Goodwill
200
$1040
Liabilities
Equity
$240
800
$1040
Assume Z. Ltd.’s capital assets fair value were $340 and
its liabilities were $140. Goodwill is purchase price ($400)
less the fair value of net assets ($200)
Self-Developed Goodwill
• No readily identifiable transactions exist to determine the
cost of self-developed goodwill
• Lev and Zarowin (1999), suggest capitalizing the
accumulated costs of R&D projects if it can be tested
through working models or successful clinical trials
• Standard setters are reluctant due to concerns about
reliability
• Clean Surplus Model (chapter 6) may be used to
determine expected present value of future abnormal
returns
Accounting for Goodwill
• New governance and accounting rules place attention on
•
•
•
•
the fair value of balance sheet intangibles
GAAP no longer requires goodwill to be amortized
Fair value of goodwill and useful life of other intangibles
need to be assessed yearly to an annual impairment test
Companies may get independent valuation specialists to
review management’s reports
Should lead to more credible financial reporting and
realistic pricing practices
Question
What are the two bases of current value
measurement?
Answer
Value-in-Use and Fair Value
Question
What are the challenges for the measurement
approach?
a) Estimates
b) Reliability
c) None of the above
d) A and B
Answer
d) A and B
Question
• Which of the following classifications of financial
assets is not allowed in Canada, under the
current IAS 39.
• Available-for-Sale
• Loans and Receivables
• Held-to-Maturity
• Financial Assets at Fair Value through Profit and
Loss
• Mark-to-Market
Answer
• Mark-to-Market
Question
• What is a natural hedge?
Answer
• Some firms utilize a natural hedge, where they
hold financial assets and liabilities of similar
duration and other characteristics to offset their
impact on the firm
• From a business perspective, an increase in interest
rates decreases the fair value of a company’s interest
bearing assets, but also decreases the fair value of the
debt
Question
• Why cant standard setters demand that financial
assets are always measured at fair value?
Answer
• Fair value may not be reliable for certain
securities for which there is little or no market.
Issues also arise in regards to how intangibles
should be fair valued when valuing deposits at
financial institutions.
Question
• What are the two types of goodwill?
Answer
• Purchased
• Self-Developed
Question
• Is goodwill amortized?
Answer
• No, it is subject to the annual impairment test