AK0040

ACCOUNTING THEORY
Measurement Applications

ACCOUNTING PROGRAM
Contents
• Overview
• Current Value Accounting
• Longstanding Measurement Examples
• Financial Instrumen Defined
• Primary Financial Instruments
• Fair Value VS Historical Cost
• Liquidity Risk and Financial Reporting Quality
• Derecognition and Consolidation
• Derivative Financial Instruments
• Accounting for Intangible
• Reporting on Risk
Overview
Despite the presures for a measurement approach, the
movement of accounting practise in this direction
encounters some formidable obstacles.
1. Reability – the decision usefulness of current value-based
financial statements will be compromised if too much
reliability is sacrificed for greater relevance.
2. Management’s skepticism about reserve recognition
aacounting carries over to current value accounting in
general, particulary since the measuremet approach
implies that current values, and the volatility that
accompanies them, are incorporated into the financial
statements proper.
3. Managers, investors, and auditors may prefer conservative
to current value accounting in some circumstances.
Current Value Accounting
Two versions of current value accounting:
1. Value in Use
2. Fair Value
Current Value Accounting
Two versions of current value accounting:
1. Value in Use
Value in use can be measured by the discounted
present value of cash expected to be received of
paid with respect to the use of the asset or
liability.
Value in use also suffer from probles of reliability,
since future cash flows have to be estimated. This
exposes the estimates to error and possible
manager bias.
Current Value Accounting
Two versions of current value accounting:
2. Fair Value
Fair value accounting is currently governed by
IFRS 13 (effective in 2013). This standard is
substantially the same as accounting standards in
the United States (SFAS 157, effective 2007, now
ASC 820-10)
Fair Value is the price that would be received to
sell an asset or paid to transfer a liability in an
orderly transaction between market participants
at the measurement date.
Current Value Accounting
Current Value Accounting and the Income Statement
• We can also consider current value accounting from a
revenue recognition poit of view.
• Value in use recognizes revenue before they are realized,
since anticipated future cash flows are capitalized into
asset values.
• Fair value accounting recognizes gais and losses as
changes in fair value occur.
• In effect, fair value accounting, as viewed by standard
setters, represents an attempt to increase the forward-
looking nature of the income statement, thereby
reducing recognition lag and increasing decision
usefulness for investors.
Current Value Accounting
Current Value Accounting and the Income Statement
• Fair value accounting changes the nature of the income
statement.
• Under historical cost accounting, net income is the result
of the machting of cost and revenue, with revenue
recognizes when it is considered to be realized.
• Under fair value, the bacance sheet assumes greater
importance, and, consistent with our discussion of the
conceptual framework, net income is regarded as an
explanations of the changes for the period in balace sheet
fair values, to help forward-looking invstors assess the
prospects of future cash flows.
• Fair value accounting also improves the ability of net
income to report on manager stewardship.
Longstanding Measurement Examples
Even though financial statements are based on a mixed
measurement model, they contain a substantial current
value component.
To preface a discussion of more recent measurement-
oriented standards, we will review some common,
longstanding instances of current value-based
measurement.
• Account Recivable and Payable
• Cash Flows Fixed by Contract
• The Lower-of-Cost-or-Market Rule
• Revaluation Option for Property, Plant, and Equipment
• Impairment Test for Property, Plant, and Equipment
Financial Instrument Defined
A financial instrument is defined as follows:
“a financial instrument is a contract that
creates a financial asset of one firm and a
financial liability or equity instrument of
another firm”
Financial Instrument Defined
Financial assets and liabilities are difined quite broadly
A financial asset is:
• Cash
• An equity instrument of another firm
• A contractual right
To receive cash or another financial asset from
another firm
To exchange financial instruments with another firm
under conditions that are potentially favourable
Financial Instrument Defined
Similarly, a financial liability is any liability that is:
A contractual obligation
To deliver cash or another financial asset to another
firm, or
To exchange financial assets or financial liabilities
with another firm under conditions that are
potentially unfavourable.
Thus, financial assets and liabilities include item such as
accounts and notes receivable and payable, debt and
equity securities held by firm, and bonds aoutstanding.
This are reffered to as primary instruments.
Primary Financial Instruments
Standard Setters Back Down Somewhat on Fire
Value Accounting
Longer-Run Changes to Fair Value Accounting
The Fair Value Option
Loan Loss Provisioning
Primary Financial Instruments
Standard Setters Back Down Somewhat on Fire Value
Accounting
• Following the 2007-2008, many firms reported fair
value writedowns of their financial assets.
• Since valuations based on market values that suffered
from liquidity pricing were obviosly very low,
writedowns were huge.
• Since spreads on credit default swaps were wide,
attempts to infer market values based on the cost of
insurance also produced valuations. These writedowns
were severely citicized by management, who viewed
them as axcessive.
 Primary Financial Instruments
Standard Setters Back Down Somewhat on Fire Value
Accounting
• Standard setters were thus caught in the position that their standards
imposed fair value accounting under an assumption that markets
worked well, but markets were clearly not working well.
• In the face of this difficulty, they introduced some modification in
2008:
The IASB and FASB issued similar guidance on how to determine
fair value when markets are inactive. The guidance was that
when market values did not exist and could not be reliably
inferred from values of similar items, firm could determine fair
value by using their own assumptions of future cash flows from
the assets and liabilities, discounted at a risk-adjusted interest
rate.
The IASB allowed reclassification of certain financial assets to
allow greater consistency with FASB standards, which allowed
relaxation of fair value in”rare circumstance”. The market
meltdowns were deemed such as a circumstance.
Primary Financial Instruments
Longer-Run Changes to Fair Value Accounting
FASB rules for valuations of debt and equity securities are
some what different. ASC 320-10 imposes a three-part
classification for financial assets:
• Trading – These securities are acquired with the intention
of reselling. They are valued at fair value, with unrealized
gains and losses included in net income.
• Held to Maturity – These securities are acquired with the
intention that they be held to maturity. They are valued at
amortized cost. If their fair value falls below their amortized
cost, the securities are written down to their fair value.
• Available for Sale – These securities are valued at fair value,
with unrealized gains and losses included in other
comprehensive income.
Primary Financial Instruments
The Fair Value Option
• At acquisition, the firm can irrevocably designate
financial assets and/or financial liabilities that
would normally be valued at amortized cost into
the fair value category if this reduces a mismatch,
where a mismatch is earnings volatility in excess of
the real volatility facing the firm.
• Changes in fair value of assets and liabilities
designated under the fair value option are included
in net income.
Primary Financial Instruments
The Fair Value Option
• Mismatch arises when some assets or liabilities are
fair valued but related liabilities or assets are not.
• To reduce the potential for mismatch, the firm
could adopt the fair value option for its long-term
debt so that “both sides” of the natural hedge are
fair-valued, with gains and losses on both included
in net income, use of the fair value option is
restricted. One restriction is that this option is used
to reduce a mismatch such as the one just
described.
Primary Financial Instruments
Loan Loss Provisioning
A second outcome of the IASB project to replace IAS
39 is a proposal to revise the rules for recognizing
impairment of financial assets valued at amortized
cost, such as loasns receivable.
The proposal is to include expected credit losses in the
calculation of expected future cash flows for loans
receivable, a process called loan loss provisioning.
Fair Value Versus Historical Cost
• Some accountants argue that historical cost
accounting is more useful to investors than current
value.
• In this regard, several theoretical models evaluate
the relative merits of fair value and historical cost
accounting for financial instruments.
Liquidity Risk and Financial
Reporting Quality
• Concern about the tranparency of ABSs and of financial
reporting itself due to lack of reporting of off balance
sheet risk were important contributors to the lack of
liquidity, since, as investors concern grew they reduced
buying activity and even left the market.
• Consequently, costs of buying and selling securities rose
dramatically, since the very act of buying and selling on
an illiquid market affects the security price.
• We conclude that liquidity risk can be a significant
contributor to cost of capital, perticularly in times of
serve market downturns, and that quality financial
reporting, by reducing liquidity risk, can help to reduce
the adverse effects of liquidity risk on the cost of capital.
Derecognition and Consolidation
• Derecognition and consolidation are at the heart of the
accounting issues that contributed to the 2007-2008
market meltdowns outlines.
• Off balance sheet financing, which concealed much of
the risk borne by financial institutions, would not be
possible without asset derecognition and subsequent
failure to consolidate the off balance sheet entities that
held many of the sponsors’ derecognized assets.
• Standard setters have responded to these issues with
new rules that attempt to control off balance sheet
financing and bring it out into the open.
Derecognition and Consolidation
• Accountant have debated the question of asset
derecognition for many years. That is, when can an
asset be removed from the balance sheet and
revenue recognized on the resulting sale?
• The usual criterion for derecognitionis point of sale.
• For example, inventory sold is derecognized and
revenue is recognized based on the sale proceeds.
Any risks of resulting accounts receivable are
provided for through estimates of credit losses.
Other obligation, such as warranties arising from
the sale, are also provided for.
Derecognition and Consolidation
• The alternative to derecognition is to retain transferred
assets on the balance sheet and treat the proceeds
received as a secure borrowing.
• This treatment is appropriate if the transfer is
accompanied by so many risks and future obligations
that the risks and rewards of ownership have not really
been transfereed to the buyer.
• The implication of these additional derecognition,
consolidation, and disclosure standards is that prior to
the market meltdown, investors did not have enough
information to fully evaluate off balance sheet
activities.
Derivative Financial Instruments
Characteristics of Derivatives
• Derivative instruments are contracts, the value of
which depends on some undelying price, interest
rate, foreign exchange rate, or other variable.
• A characteristic of derivative instruments is that
they generally require or permit settlement in cash
– delivery of the assets associated with the
underlying need not take place.
• Derivative instruments may or may not require an
initial net investment.
Derivative Financial Instruments
Hedge Accounting
• Natural hedging also provides risk protection, so that
there is less need for the protection provided by
derivatives.
• There are different types of hedge. Derivative
instruments designated as hedges of recognized assets
and liabilities are called fair value hedge.
• The essence of a fair value hedge is that if a firm owns,
say, a risky asset or liability, it can hedge this risk by
aquiring a hedging istrument – some other asset or
liability whose value moves in the direction opposite to
thet of the hedge item.
Accounting for Intangibles
• Intangible assets are capital assets that do not have
physical substance, such as patents, trademarks,
franchises, good workforce, location,
restructurings, information technology, internet site
names, and more generally, goodwill.
• Some intangibles are accounted for much like
property, plant, and equipment. If they are
purchased or self-developed with reasonable
certainty of future net benefits, they are valued at
cost and amortized over their useful lives.
Accounting for Intangibles
• If they are acquired in a business combination and fair
value can be determined reliably, their cost is equal to
their fair value aquisition.
• However, it is important to realize that intangible are
“there” even if they are not on the balance sheet.
Instead, due to recognition lag, the appear through the
income statement.
• That is, since historical cost accounting waits untuk
value is realized as sales and earnings, the income
statement contains the current “installment” of hte
value of intangibles.
• If these installments are positive, the firm has goodwill.
Reporting on Risk
• Information about firm risk, in addition to beta, is
valued by the stock market, particularly for
financial institutions.
• This is documented by the reaction of share and
bond returns of these institutions to risk exposures
and to the impact of hedging on these risks.
• Financial reporting has responded to the need for
risk disclosure by increased discussion of risks and
how they are managed, and by suplementary
disclosure of financial instrument information.
Reporting on Risk
• This enables investors to better evaluate the
amounts, timing, and uncertainty of returns on
their invesments.
• Financial reporting also requires the providing to
investors of quantitative risk information, such as
sensitivity analyses and value at risk.
• Despite methodological challenges, these represent
important steps in moving risk disclosure toward a
measurement approach.
Questions and Answers