Introduction to Teaching Fair Value in Accounting Earl K. Stice PricewaterhouseCoopers Professor of...

Introduction to Teaching

Fair Valuein Accounting

Earl K. SticePricewaterhouseCoopers Professor of Accounting

Brigham Young University

3 August 2008

Key Points

1.Teach the use of basic valuation models.

2.Teach where fair value numbers are used in financial reporting.

3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157.

4.Instructors, and then their students, must learn more about the basics of derivatives.

Table of ContentsOverview and Questions to Consider............................................................................2 Introductory Financial Accounting...............................................................................5

Example A – At What Amount Should Land Be Recorded? Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Example C – Valuing Buildings With Market Multiples Example D – Valuing of Bonds Held as Investment Securities

Introductory Managerial Accounting .........................................................................13

Capital Budgeting Spreadsheet Assignment Intermediate Financial Accounting.............................................................................19

Cash Flow Projection Models Introduction to Derivatives The Fair Value Option Fair Value Disclosures

Questions to Consider(page 2)

a.Should accounting professors teach FAIR VALUE, or should we subcontract this to finance professors?

• Current coverage of time value of money is a good model.– Discuss and use in both accounting and

finance.– In accounting classes, come back to it over

and over.

Questions to Consider (page 3)

b. Where can we fit this material in an already-crowded accounting curriculum?

• Sprinkled in various courses where appropriate– Examples are given in your packet.– Yes, some of our favorite old topics are going

to have to be cut back or even eliminated.

Questions to Consider (page 3)

c. Where should accounting students learn about spreadsheet modeling?

• Chicago voting is a good model – early and often.– The practitioners told us that this is extremely

important.

Table of ContentsOverview and Questions to Consider............................................................................2 Introductory Financial Accounting...............................................................................5

Example A – At What Amount Should Land Be Recorded? Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Example C – Valuing Buildings With Market Multiples Example D – Valuing of Bonds Held as Investment Securities

Introductory Managerial Accounting .........................................................................13

Capital Budgeting Spreadsheet Assignment Intermediate Financial Accounting.............................................................................19

Cash Flow Projection Models Introduction to Derivatives The Fair Value Option Fair Value Disclosures

IntroductoryFinancial Accounting

Important to change

• what we teach, and

• the way we teach,

in the very first accounting class.


We have been saying for years that our students need more

• Unstructured problems

• Business focus

Fair value is a perfect setting in which to do this.

Introductory Financial Accounting

Example A (page 5) – At What Amount Should Land Be Recorded?

a. Purchased land for $220,000 one year ago.b. Lorien would have to pay $260,000 to buy an

equivalent piece of land now (but she has special skills).

c. She can sell this land for $310,000 less $20,000 in various fees to finalize the sale.

d. Comparable land sales data• 13,000 square feet• Average sales price = $21.55 per square foot• Low sales price = $20.06 per square foot• High sales price = $24.78 per square foot


Example A – At What Amount Should Land Be Recorded?

Question: Lorien can use only a

single number to report the value of the land in her balance sheet; at how much should Lorien report the land?



Historical cost = $220,000

• very reliable

Replacement cost = $260,000

• reflects the general rise in prices

• updated purchase price (with Lorien’s skill)

• But it is a hypothetical price



Net realizable value = $290,000• Includes a profit• Reflects Lorien’s special skill

Fair value = $280,150 (= $21.55 × 13,000)• Includes a profit• Does NOT reflect Lorien’s special skill• Hypothetical arms’-length price



Yes, but what is the answer?


Example B (page 7) – Does Measuring Asset Amounts Depend on the Type of Asset?

Assets

1.Cash

2.Accounts receivable

3.Inventory

4.Investment securities

5.Land

6.Building


Example B – Does Measuring Asset Amounts Depend on the Type of Asset?

Measurement alternativesa. Historical cost: amount paid to acquire an asset

(adjusted for depreciation)b. Replacement cost: amount that would have to be paid to

acquire the same or an equivalent assetc. Fair value: the price that would be received to sell an

asset in an orderly transaction between market participants

d. Net realizable value: amount of cash into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion



Question: For each of the six assets, state which one of the four measurement alternatives should be used. Explain your choice.



Student insightFor investment securities, FAIR VALUE is

a good measurement when there are active markets because

• the “hypothetical” sales price is not so hypothetical and

• market participants approximate price takers so there isn’t much difference between entry and exit prices.


Example C (page 9) – Valuing Buildings With Market Multiples

CapitalizationSquare Feet Rate

Building 1 15,000 9%Building 2 22,000 10%Building 3 38,000 7%Building 4 41,000 8%Building 5 46,000 10%


Example C – Valuing Buildings With Market Multiples

Selling Price Square Feet

Capitalization Rate 10,000 20,000 30,000 40,000 50,000 7% 700,000 1,425,000 2,000,000 2,500,000 3,000,000 8% 625,000 1,250,000 1,750,000 2,250,000 2,625,000 9% 550,000 1,100,000 1,550,000 2,000,000 2,300,000

10% 500,000 1,000,000 1,400,000 1,800,000 2,100,000



Question: Estimate the fair value of each of the five buildings.



Numerical solution on page 10.

Student insight: These “fair values” are NOT simply pulled out of thin air.


Example D (page 11) – Valuing of Bonds Held as Investment Securities

BondTerm Rating

Bond 1 15 AABond 2 6 BBBBond 3 3 AAABond 4 18 BBBond 5 9 A


Example D – Valuing of Bonds Held as Investment Securities

Bond Prices (% of par) Bond Ratings

Term (in years) AAA AA A BBB BB2 103.85 103.56 102.71 102.37 100.295 103.66 102.53 101.45 100.17 98.50

10 101.64 100.29 99.56 98.54 91.9820 95.66 91.49 90.00 89.31 82.06



Question: Estimate the fair value of each of the five bonds.



Numerical solution on page 12.

Student insight: Some “fair values” are more reliable than others.


We have been saying for years that our students need more

• Unstructured problems• Business focus

Fair value is a perfect setting in which to do this in the very first accounting class.

IntroductoryManagerial Accounting (page 13)

Capital budgeting• special case of discounted cash flow

analysis

• good setting in which to help students hone (or learn) their spreadsheet skills

IntroductoryManagerial Accounting

Capital Budgeting Spreadsheet Assignment

• I show them a completed sample.

• I require them to– make their own spreadsheet using mine as

a model and– do sensitivity analysis using their

spreadsheet.

Introductory Managerial Accounting

Capital Budgeting SpreadsheetPresent

Amount ValueOriginal Cost -100,000 (100,000)

($100,000 now)

Initial Investment in Working Capital -30,000 (30,000)($30,000 now)

Retrieval of Working Capital 30,000 18,628($30,000 in 5 years)

Net Cash Revenues $24,000 90,979([$70,000 - $30,000] per year for 5 years)

$40,000x(1-.4)=$24,00070000 30000

Depreciation Tax Savings: ($20,000x.4=$8,000 per year) $8,000 30,326

20000Overhaul:

Cost: $20,000 after 3 years -20,000 (15,026)Depreciation Tax Savings:

10000 $10,000*.4 after 4 years 4,000 2,73210000 $10,000x.4 after 5 years 4,000 2,484

Salvage Value 6,000 3,72610000 ($10,000 after 5 years)

$10,000*(1-.4)=$6,000(Assumes capital gain tax) ---------

Net Present Value 3,848=====


Capital Budgeting Spreadsheet

YEARS0 1 2 3 4 5

Original Cost -100,000Initial Investment in Working Capital -30,000Retrieval of Working Capital 30,000After-tax Cash Revenues 42,000 42,000 42,000 42,000 42,000After-tax Cash Expenses -18,000 -18,000 -18,000 -18,000 -18,000Depr. Tax Savings, Initial Cost 8,000 8,000 8,000 8,000 8,000Overhaul Cost -20,000Depr. Tax Savings, Overhaul 4,000 4,000After-tax Salvage Value 6,000Net Cash Flow -130,000 32,000 32,000 12,000 36,000 72,000

Present Value of Cash Flows -130,000 29,091 26,446 9,016 24,588 44,706

Net Present Value $3,848Internal Rate of Return 11.005%


Capital Budgeting Spreadsheet

• You have the assignment and the solution on pages 13 through 18.

• We will make the spreadsheet itself available to you.

IntroductoryManagerial Accounting

Capital budgeting• special case of discounted cash flow

analysis

• good setting in which to help students hone (or learn) their spreadsheet skills

Intermediate Financial Accounting

This is where the fair value “heavy lifting” occurs.

It will be a lot easier if students have been prepared with concepts and tools in the introductory courses.


Business Valuation and

Impairment-Related Asset Valuation

Intermediate Financial AccountingCash Flow Projection Models (page 20)

Three important skills

1. Financial statement articulation

2. Spreadsheet modeling

3. Cash flow projection


Home Depot, Inc. Simplified Financial Statements

For Fiscal 1985 (in millions) Cash 10 Receivables 27 Inventory 153 Total Current Assets 190 Gross Property, Plant, and Equipment (PPE) 199 Accumulated Depreciation -9 TOTAL ASSETS 380


4. Cash is expected to increase at the same rate as sales.

5. • Average collection period 14.08 days [Accounts Receivable/ (Sales/365)] • Number of Days' Sales in Inventory 107.6 days [Inventory/ (Cost of Goods Sold/365)] • Fixed Asset Turnover 3.518 times [Sales / Gross PPE]


Cash Flow Projection Models

Pages 23 and 24

Series of questions to be distributed (after they have constructed their spreadsheets) and discussed in class.

Intermediate Financial AccountingCash Flow Projection Models (Question 1)

Cash Flow from Operations 40% 1985 1986 1987 1988 1989 1990 Net Income 8 5 7 10 13 19 Depreciation 5 8 11 16 22 31 (Increase) in Receivables (15) (11) (15) (21) (30) (41) (Increase) in Inventories (68) (61) (86) (120) (168) (235) Increase in A/P 23 30 42 58 82 115

Net Cash from Operations (47) (29) (41) (57) (81) (111)

Intermediate Financial AccountingCash Flow Projection Models (Question 6)

Cash Flow from Operations 40% 1985 1986 1987 1988 1989 1990 Net Income 8 33 50 70 99 138 Depreciation 5 7 10 14 19 27 (Increase) in Receivables (15) 3 (10) (14) (19) (26) (Increase) in Inventories (68) 24 (51) (73) (100) (142) Increase in A/P 23 21 49 58 81 113

Net Cash from Operations (47) 88 48 55 80 110

Intermediate Financial AccountingCash Flow Projection Models

Three important skills

1. Financial statement articulation

2. Spreadsheet modeling

3. Cash flow projection


Introduction to Derivatives (page 25)

From paragraphs A24 and A25

of SFAS No. 157:

• long-dated currency swap

• three-year option on exchange-traded shares

• receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate


Introduction to Derivatives

Pages 25 through 341. Understand what a derivative is and how

derivatives can be used to help manage risk.2. Identify the different types of risk faced by a

business.3. Describe the characteristics of the following types

of derivatives: swaps, forwards, futures, and options.

4. Define hedging, and outline the difference between a fair value hedge and a cash flow hedge.

5. Understand the basics of accounting for derivatives


Introduction to Derivatives (pages 33,34)

Southwest Airlines Years Ended December 31, (In millions) 2006 2005 2004 OPERATING INCOME 934 725 404 Effect of hedging 634 892 455 Operating income without hedging 300 (167) (51)


Introduction to Derivatives

Students completing intermediate financial accounting should know

1. What a derivative is2. The different types of risk faced by a

business3. Characteristics of swaps, forwards, futures,

and options4. What hedging is5. The basics of accounting for derivatives


The Fair Value Option (page 35)

Under SFAS No. 159, a company has the option to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date.

Why? – “Mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.”



Simple balance sheet• One asset, a bond investment• One liability, a bond payable• No equity

Both bonds issued at par and are• $1,000 face value• 20 years• 10% coupon rate



Assets Liabilities and Equity Lusvardi Bond $1,000 Bonds Payable $1,000 Equity $0



With the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $851 Bonds Payable $851 Equity $0 ------------------------------------------------------------------------ WithOUT the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $851 Bonds Payable $1,000 Equity ($149)



With the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $1,196 Bonds Payable $1,196 Equity $0 ------------------------------------------------------------------------ WithOUT the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $1,196 Bonds Payable $1,000 Equity $196


The Fair Value Option

Student insight

In spite of all of the criticism about “fair value accounting,” it looks like the FASB’s ideas aren’t all bad.


Fair Value Disclosures (page 41)

• Level 1 inputs – quoted prices in active markets for identical assets (or liabilities).

• Level 2 inputs – observable inputs other than quoted prices in active markets for identical assets.

• Level 3 inputs – unobservable inputs.


Fair Value Disclosures (page 42)


Fair Value Disclosures

Student insight

After the background exposure to valuation models of all sorts, the division into these three levels makes perfect sense.

Key Points

1.Teach the use of basic valuation models.

2.Teach where fair value numbers are used in financial reporting.

3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157.

4.Instructors, and then their students, must learn more about the basics of derivatives.

[email protected]

Email me if you want soft copies of this material.

Introduction to Teaching Fair Value in Accounting Earl K. Stice PricewaterhouseCoopers Professor of...

Documents

Transcript of Introduction to Teaching Fair Value in Accounting Earl K. Stice PricewaterhouseCoopers Professor of...