Download Why Fair Value Financial Instruments?

Chapter 7
Measurement Applications
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Chapter 7 Measurement Applications
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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
» 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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The End
Thank you