Chapter 7

Measurement Applications

7-1
Copyright © 2009 by Pearson Education Canada
 Chapter 7
Measurement Applications

7-2
Copyright © 2009 by Pearson Education Canada
 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

» 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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 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

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 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

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 7.4.3 Lev & Zarowin (continued)

• Conclusion
– Accounting for intangibles is inadequate

» Continued

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 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

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 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

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 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

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 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

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 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

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