Chapter Measurement Applications Copyright © 2009 by Pearson Education Canada 7-1 Chapter Measurement Applications Copyright © 2009 by Pearson Education Canada 7-2 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 Copyright © 2009 by Pearson 7-3 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 Copyright © 2009 by Pearson 7-4 7.2.3 Lower-of-Cost-or-Market Rule • A partial application of measurement – Inventory – Ceiling tests ã A vehicle for conservative accounting Copyright â 2009 by Pearson 7-5 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 Copyright © 2009 by Pearson 7-6 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 ã No reversal Copyright â 2009 by Pearson 7-7 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 Copyright © 2009 by Pearson 7-8 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 Copyright © 2009 by Pearson 7-9 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 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 Copyright © 2009 by Pearson 7- 7.4 Accounting for Intangibles (continued) • Self-developed intangibles – Self-developed goodwill, e.g., from R&D • Hard to reliably determine fair value • Costs written off as incurred – Recognition lag: goodwill value shows up over time on income statement • Recognition lag responsible for low ability of net income to explain stock returns? – Lev & Zarowin (1999) argue yes Copyright © 2009 by Pearson 7- 7.4.3 Lev & Zarowin, “The Boundaries of Financial Reporting…” • Their study documents a decreasing usefulness of earnings information – Usefulness evaluated by ability of earnings to explain abnormal share return • Low R2 – And falling? • Low ERCs • Especially for research-intensive firms » Continued Copyright © 2009 by Pearson 7- 7.4.3 Lev & Zarowin (continued) • Conclusion – Accounting for intangibles is inadequate » Continued Copyright © 2009 by Pearson 7- 7.4.3 Lev & Zarowin (continued) • Suggestion to improve usefulness – Capitalize successful intangibles after a “trigger point” is attained • Amortize over useful life • Like successful efforts accounting in oil and gas • Amounts capitalized and amortized may reveal inside information to investors, since it is management that has best knowledge of R&D value Copyright © 2009 by Pearson 7- 7.5.2 Risk Management • Risk controlled by natural hedging + hedging with derivatives • Some reasons for managing firm-specific risk, even though investors can diversify it away – – – – Reduce investor estimation risk Cash availability for planned capital expenditures Control speculation Reduce likelihood of major losses, leading to lawsuits Copyright © 2009 by Pearson 7- Reporting on risk • Beta risk – Relevant to rational, diversified investor • Beta an input into investment decisions – Accounting variables correlated with beta • May help investors to estimate beta – Beaver, Kettler, and Scholes (1970) • Reasons why reporting on other (firm-specific) risks also relevant to investors – Investors may not act according to rational decision theory model – Risk information may reduce estimation risk – Risk reporting may control speculation Copyright © 2009 by Pearson 7- 7.5.4 A Measurement Perspective on Risk Reporting • Narrative, in MD&A – Canadian Tire Corp 2006 Annual report • Text, Section 4.8.2 • Sensitivities Analysis – Suncor Energy Inc., 2006 Annual Report • Table 7.2 • Value at Risk – Microsoft Corp., 2006 Annual Report Copyright © 2009 by Pearson 7- Conclusions • Standard setters continue to increase current value measurements in financial statements – Some measurements are one-sided • Lower-of-cost-or-market, ceiling tests • IASB standards more likely than FASB to allow writeups • Accountants are recognizing an increased obligation to measure and report on firm risk Copyright © 2009 by Pearson 7- ... 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. .. Pearson 7- 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... Hedging may avoid the ceiling test – Theory in Practice 7.2 » Copyright © 2009 by Pearson Continued 7- 7.3.5 Hedge Accounting (continued) • To Obtain Benefits of Hedge Accounting – Hedges must qualify