Chapter 7

Measurement Applications

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Overview• Introduction (7.1)• Current value accounting (CVA) (7.2)

– Two versions of current values (7.2.1)– Current values and income statement (7.2.2)

• Current value applications– Longstanding examples (7.3)– Financial instruments (7.4-7.10)

• Primary financial instruments (7.5.1-7.5.3)• Related issues(7.6-7.8)* – Slides only

– Intangibles (7.11)

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7.1 Introduction• Measurement approach

– Extensive use of current value concepts in financial statements proper• Two sided: write up and write down• One side: write down only

– Conservative accounting– Reflects the real risk facing the firm

• Recall the Clean Surplus Model– Biased vs. non-biased accounting

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7.2 Current Value Accounting – Two versions (7.2.1)

• Value-in-use– Also called amortized cost– Valued at discounted present value of future receipts– High relevance, limited reliability

• Error and possible bias in estimating• Management may opportunistically change estimates

• Fair value– Also called exit price – 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 (IFRS 13)

– Measures opportunity cost of retaining asset/liability in firm4

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Current Values:

Two Versions of Current Values

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(IFRS 13, “Fair Value Measurements”, effective in 2013)

Why Set Fair Value @ Exit Price?• More objective if well-working market exists

– Tier 1: Market Price of identical assets/liabilities– Tier 2: Market price of the similar items

• If well-working market does not exist– Tier 3 fair value will be used;

• Tier 3: Present value of future cash flows of the item, or any other best available information about how a market participant holding the item would value the item

– In such case, why not value-in-use (VIU)?

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Why Set Fair Value @ Exit Price?

• If tier 3 is used, both exit price and VIU are subject to estimation errors

• However, exit price is believed to be more reliable– Exit price (Tier 3)

• PV of FCF the market would expect – Value in use

• PV of FCF the entity would expect

• Conditioned on adequate disclosures

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Criticism to Exit Price• Exit price is a good proxy in many scenarios to

determine fair value; however– Exit price may not be representative in all scenarios.

For example• Auction sale

– Exit price is the next best bid• New car bought yesterday

– Concern on reliability• Recent study suggests that relevance of exit price outweigh

concerns on reliability (Song, Thomas and Yi, 2010)

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7.2.2 Current values and income statement

• Revenue is recognized as change in asset value• Value-in-use

- Asset value changes with present value changes• Fair value

- Asset value changes with actual asset value changes

• Revenue cognition is sooner under VIU/FV than HC- Under HC, revenue (i.e. change in asset value) is

recognized when realized- Under VIU/FV, revenue is recognized before realized

Reduction of recognition lag in income statement Income statement is more forward-looking, and a better

measurement of management stewardship9

Recognition Lag (p.57, Ch2.5)

• The extent to which the timing of revenue recognition lags behind changes in real economic value– Current value accounting

• Little recognition lag– Historical cost accounting

• Greater recognition lag

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7.3 Longstanding Examples– Discussion

In the measurement of each item belowa. Discuss if current value is appliedb.If yes, which current value (VIU or FV) is used

1. Accounts receivable (and payable)2. Inventory3. PP&E4. Long-term debt5. Finance lease

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A/R & Inventory

• Accounts receivable and payable– Initially measured at the amount to be collected or paid

• Approximates VIU if time is short

– On B/S date, adjusted for estimated uncollectible amount

• Approximates VIU if time is short

• Inventories– B/S date: at the lower-of-cost-or-market (LCM)– What is the “market” value?

• Exit price less cost to sell (i.e. NRV)– LCM is an example of conservatism, also a partial

application of current value accounting12

Property, Plant &Equipment (PP&E)• Two options on B/S date

– Revaluation model vs. cost model• IASB: firms can choose either option • FASB: only cost model is allowed

• Revaluation model– PPE valued at fair value (must pass reliability check)

• Cost model – PPE valued at cost (i.e. book value), adjusted for

impairment• A partial application of current value accounting

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Cash Flows Fixed By Contract• Long-term debt

– Valued at present value of future interest and principal payments, discounted at effective interest rate (i.e. value in use, also called amortized cost)

• Finance lease– Initially valued at the lower of VIU or FV (IAS 17)– B/S date valuation is similar to PP&E• Both are examples of cash flows fixed by

contract

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7.4–7.10 Financial Instruments• A contract that creates a financial asset of

one firm and a financial liability or equity instrument of another firm– Primary financial instruments (7.5)

• 7.5.1 Fair value accounting in 2007-2008 crisis• 7.5.2 Current value use in IFRS 9 “Financial

Instruments” • 7.5.3 The fair value option• 7.5.4. Loan loss provisioning – optional

– Related issues (7.6-7.8)* – Slides only– Derivative financial instruments (7.9) - optional

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Primary Financial Instruments• Cash • All receivables/payables• All passive investments/liabilities

– Equity passive investment• In contrast to equity strategic investment• Measured at FV/NI or FV/OCI

– Debt investment• Note all debt investments are passive

investments• Measured at FV/NI, FV/OCI or VIU

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7.5.1 FVA in 2007-2008 Crisis (self-read)

• Use of fair value assumes market works well. Why?– Only if market works well, exit price can be

determined• What if the market does not work well?

– E.g. 2007-2008 market crisis– IASB/FASB revised standards to relax

requirements on FV• More in 7.6

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7.5.2 IFRS 9 “Financial instruments”• Published in July 2014, effective on Jan 1, 2018• Applies to all types of passive financial instruments• Note FASB went to another direction (i.e. HFT/AFS/HTM)

• At acquisition– Financial instruments recorded at FV

• After acquisition– Most financial assets valued at FV, with unrealized G/L

included in OCI or NI• Some are valued at amortized cost (i.e. VIU), if two conditions

are met: (1) cash flows fixed by contract, AND (2) business model (see next slide)

– Most financial liabilities valued at amortized cost (VIU)18

Concept of Business Model in IFRS 9

• VIU (amortized cost) should be used – Only if when the firm’s business model (instead

of manager’s intention) is hold-to-maturity (HTM)– Purpose is to control management ability to

change intended use• Managers may wish to switch from FV to VIU, for

earnings management purpose

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7.5.3 The Fair Value Option• On B/S date,

– When VIU (amortized cost) should be used to account for financial instrument

– IFRS 9 grants firm an option to choose FV instead– IF such choice reduces mismatch

• The choice must be made at acquisition, not on B/S date, and the decision is irrevocable

• The purpose is to reduce a mismatch – Problem of mismatch (see next slide)

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The problem of mismatch• Mismatch occurs

– When some assets/liabilities are fair-valued but related liabilities/assets are not

• Cannot accomplish natural hedge

• To overcome mismatch problem– Allow firms to choose fair value on both sides

• i.e. Fair value option– Allow some financial assets being valued at VIU– Allow some unrealized G/L being included in OCI

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7.6&7.7 FV vs. HC & Liquidity Pricing* (Slide Only)

• Huge fair value write-downs during financial crisis– When market is down, firms face higher risk of liquidity

pricing (i.e. liquidity risk)– Liquidity pricing drives market value (FV) below VIU– Managers and politician argue HCA is better than FVA in

such case• Standard setters

– Back down to allow firms to use VIU when market is inactive (subject to ceiling test)

– But insist that managers and politicians may have overstated the negative effects of FV liquidity risk

• Given mixed results from academic studies

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7.8 De-recognition and Consolidation* (Slide Only)

• Abuses of loopholes contribute to 2007-2008 crisis– e.g. Off-B/S financing

• Standard setters responded by issuing new standards – Point of de-recognition?

• No de-recognition is control retained

– Scope of consolidation? – how to decide control• Control exists when one firm has power over another and bears

risk of return on its investment (no longer “50% plus 1 share” rule)

– Require more disclosures

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7.11 Accounting for Intangibles• Non-goodwill intangibles

– Valued at carrying cost, adjusted for impairment– Similar to accounting for PP&E

• Goodwill– Purchased goodwill

• Accounted for at cost; no amortization • Subject to ceiling test (i.e. impairment test)

– Self-developed goodwill, e.g., from R&D• Hard to reliably determine fair value• Costs written off as incurred

– Result in recognition lag: goodwill value shows up on income statement when the product is actually sold

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Recognition Lag Revisit• Responsible for low ability of net income to

explain stock returns (Lev & Zarowin,1999)– Accounting for intangibles is inadequate

• Does clean surplus theory provide a way to estimate unrecorded goodwill?– Yes, but subject to reliability

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Conclusions• Examples discussed in this chapter represent only

a partial list of current-value-based measurements in existing GAAP

• They show a considerable amount of current-value-based measurements in the mixed measurement model

• Some current value measurements are one-sided• Standard setters continue to favor current value

measurements in financial statements• Accountants are recognizing an increased

obligation to measure and report on firm risk26