Financial accounting theory 5e scot ch07

Chapter 7

Measurement Applications

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Chapter 7
Measurement Applications

Copyright © 2009 by Pearson Education Canada

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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

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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

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7.2.3 Lower-of-Cost-or-Market Rule
• A partial application of measurement
– Inventory
– Ceiling tests

• A vehicle for conservative accounting

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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

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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

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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

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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

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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

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Why Fair Value Financial
Instruments?
• To increase decision usefulness
– Many financial instruments traded on well-working
markets → reasonable reliability

• To control gains trading

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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

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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

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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)

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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

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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

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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

»

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Continued

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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

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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

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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

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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

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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

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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

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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

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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

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