MEASUREMENT
PERSPECTIVE APPLICATION
Despite
the pressures for a measurement perspective, the movement of accounting
practice in this direction meets two challenges, first, reliability, the
decision usefulness of fair-value-based financial statement will compromised if
it too much reliability is sacrificed for greater relevance. Second,
management’s doubt about RRA (Reserve Recognition Accounting) carries over to
fair value accounting in general, particularly since the measurement
perspective implies that fair values are incorporated in the financial
statement proper.
A. Longstanding Measurement Example
Even though financial statements are conventionally
referred to as based on historical cost they contain a substantial fair value.
Common longstanding instances of market and present-value based valuation.
1. Account
Receivable and Payable
Current account receivable and
payable are valued at the expected amount of cash received or paid because of
the length of time to payment is short so the discount factor is ignored and
this basis of valuation estimates present value.
2. Cash
Flow Fixed by Contract
There are numerous instances where
the cash flow is fixed by contract. The valuation is frequently based on
present value, since the contract often provides reliable estimates of amount
and timing of future cash flow and interest rate. If a firm issues long-term
debt and uses compound interest method to amortize any discount and premium,
the resulting net book value of the debt equals to the present value of the
future interest and principal payments. It should be noted that, if the market
interest change during the life of contract, present value of outstanding debt
or leases are not adjusted, so it still on historical cost basis.
3. The
Lower-Of-Cost-Or-Market (LOCOM)
While assets values are written
down under LOCOM, they are not written up. The written down value become the
new cost. The LOCOM rule is usually in terms of conservatism. It more difficult
to justify in terms of decision usefulness, however, since one would think that
market value information is useful, it would be useful when the value is
greater than the cost as well as when it is less than the cost. Presumably, the
accountants and auditors must feel that their exposure to legal liability is
greater for an assets overstatement than for an equivalent amount of
understatement.
4. Ceiling
Test for Capital Assets
The primary basis of accounting for
capital assets continues to be historical cost, Section 3060 requires a
write-down when the net carrying value of the capital assets exceeds the net
recoverable amount that calculated by the estimation of future net cash flows
from use of the capital assets. The net cash flows are essentially the assets
operating inflows less related cash outflows, including any future removal and
site restoration costs plus residual or salvage value. The estimation of the
net recoverable amount is to be based on the most probable set of economics
condition. The major difference is under the section 3060 the estimated future
cash flow are not discounted in computing net recoverable amount on the grounds
that the purpose of the calculation is to determine cost recovery, not valuation. Another
difference is the asymmetric nature of ceiling test. That is the capital assets
may be written down, but not written up, to net recoverable value. In this
regard, the ceiling test is similar to the LOCOM rule.
5. Push
Down Accounting
The assets and liabilities of the
acquired firm to be comprehensively revaluated, with the resulting values
recorded on the books of the acquired firm. This is called a push down
accounting. The result is that the assets and liabilities are recorded on the
books of the acquired firm at their fair values as established in the
acquisition transaction.
The
main point to realize is that a considerable amount of measurement perspective
is already inherent in financial statements, even though those statements are
regarded primarily historical cost based.
B. More Recent Fair Value Oriented
Standards
1. Pensions
and Other Post Employment Benefits (OPEB)
Pension plan are accounted for on a
present value basis under section 3461. Pension liabilities are based on
expected present value of pension benefits earned by the employee to date,
taking in to account projected compensation to expected retirement.
OPEB liability is based on the
expected present value of benefits to be paid on behalf of current and retired
employees. The important aspect of pension and OPEB accounting is their use of
discounted present value to calculated expense and accumulated liabilities.
Accounting for pension and OPEB on a preset value basis entails a substantial
loss of reliability due to many assumption and estimation that have to be made.
Recall that low reliability is a possible explanation for apparent lack of decision.
2. Impaired
Loans
The standard requires that loans be
written down by the lender to their estimated realizable amount when they
become impaired or restructured. This amount is based on expected future cash
flows to be derived from the loans, discounted at the rate of interest implicit
in the loan transaction. It is latter provision that allow write up if loan
qualities are improve, it is suggesting a movement away from LOCOM.
C. Financial Instruments
A
financial instrument is any contract that gives rise to both a financial asset
of one party and a financial liability or equity instrument of another party.
1. Valuation
of Debt and Equity securities
Investment in debt securities and
investment in equity securities are determinable fair values. Assets are
classified at acquisition into:
a. Held
to maturity : debt securities for which the entity has a positive intent and
ability to hold to maturity
b. Trading
Securities : held for a short time for the purpose of selling them
c. Available
for sale
Two
major problems are:
a. Gains
trading can be employed when the investment portfolios are valued at cost or
amortized cost and when at least some securities have risen in value. Then the
institution can realize a gain by selling securities that have risen and
continuing hold securities that may have fallen in value. Gain trading is not
possible if the securities are valued at fair value. if the changes of fair
value are recorded as they occur, then there is no gain or losses in disposal.
b. Volatility
of reported net income applies only to financial assets. However financial
institution may coordinate the duration and other characteristics of their
financial assets and liabilities in order to create a natural hedge of changes
in value. It then seems reasonable that if financial assets are carried at fair
value so should financial liabilities. Otherwise, the volatility of net income
that result from recognizing unrealized gains and losses from only financial
assets is greater than the real volatility the firm has chosen through its natural
hedging activity.
2. Derivative
Instruments
Derivative instrument are
contracts, the value of which depends on some under lying price, interest rate,
foreign exchange rate and other variable. A characteristic of derivative
instruments in that they require or permit settlement in cash. The accounting
for derivative instruments has been moved substantially towards a measurement
perspective, that all derivatives be measured at fair value for balance sheet
purposes. If derivative is traded, fair value would be measured by its market
value. The five variables of potion pricing formula by black and schools are:
a. Current
market price
b. Variability
of return of the share
c. Exercise
price of option
d. Time
to expiration
e. Risk
free interest rate
3. Hedge
Accounting
For simple, hedging means the
derivative instruments as a way of reducing specifics risk, such as a risk of
interest rate changes on floating rate debt or foreign exchange risk on
anticipated future sales. Natural hedging is viewed as reducing total, or non
specific, firm risk. The essence of hedge is that if a firm owns a risky assets
and it can hedge by hedging instruments. Hedging may not be completely
effective because there may not exist a hedging instrument that will completely
offset the hedged item’s gain or losses. For derivative instrument designed as
hedges of recognized assets and liabilities, called fair value hedge, the gain
or loss on the hedging instrument is include in current earnings.
4. The
Joint Working Group Standard
In 2000, the financial instrument
joint working group of standard setters issued a draft standard, Financial
Instrument and Similar Items. This draft standard proposes fair value
accounting for almost all financial instruments, with gain and losses from
adjusting to market included in net income. JWG points out that fair values are
the most relevant value for financial statement users, and argues that fair
values of derivative can be determined with reasonable reliability.
The draft standards would require
adjustment of the carrying value of financial liabilities resulting from changes in market interest rates. The
draft standard also require that demand deposits bee fair valued, but the value
of core deposit intangibles not be deducted in determining this value. The
draft standard also deals with hedge accounting, however it’s requires that
there unrealized gain and losses be included in net income. The JWG pointing
out that weather the future purchases actually take place depend on the
management’s continuing intent to enter into the transaction. That is an
expected future transaction cannot be used to justify an obligation to use the
gain to offset a future loss.
D. Accounting for Intangible
Accounting
for intangibles is the ultimate test for the measurement perspective. While the
intangible assets (patents, trademarks, franchises, good workforce, location,
etc) are important assets for firms, their fair value are difficult to
establish reliably, particularly when they are self-developed. This is because
the cost of intangibles may be spread over many years, it may not be known
whether they will ever produce future benefits.
1. Accounting
for Purchased Goodwill
When one firm acquires another in a
business combination, the purchase method of accounting for the transaction
requires that the tangible and identifiable intangible assets and the
liabilities of the acquired company be valued at their fair values of the
purposes of the consolidated financial statements. Goodwill is then the
difference between the net amount of these fair values and the total purchase
price paid by the acquiring company.
The identifiable assets and
liabilities of the purchased company must be valued at their fair values for
purposes of preparing a consolidated balance sheet, with any excess of the
purchase price over net fair value reflected as goodwill.
2. Self
Developed Goodwill
Unlike purchase goodwill, no
readily identifiable transaction exist to determine the cost of self developed
goodwill. Based on LZ argument there are two suggestions might be done. First,
for a type of successful efforts accounting for R&D. They purpose that the
cost of R&D be capitalized. Capitalization provides a reasonable tradeoff
between relevance and reliability and reveals inside information about the
success of R&D efforts to the market. The capitalized costs would then be
amortized over their estimated useful life time. The second suggestion is to
restate current and previous financial statement as evidence that past
expenditures on intangibles are paying off become available.
3. The
Clean Surplus Model Revisited
Another approach to valuing
goodwill is to use the clean surplus model. Alternatively the clean surplus
goodwill calculation could possibly serve as a ceiling test for purchased
goodwill.
E. Reporting Risk
1. Beta
Risk
Professional accounting bodies
recognize that investors need risk information. The theory underlying the
suggest that a stock’s beta id the sole firm-specific risk measure for rational
investor’s diversified portfolio. The usual way to estimate beta is by means of
a regression analysis based on the market model. These considerations seems
suggest that there is little role for financial reporting of firm risk. One
reason is the beta and various accounting based risk measure are correlated.
Financial statement based risk measure may indicate the direction and magnitude
of a change in beta sooner than market model which would require several
periods of new data for re-estimation. Under ideal condition, there is a direct
relationship between debt to equity and beta, while Lev (1974) stated that
under ideal condition there is a relationship between operating leverage and beta.
The higher firm’s financial and operating leverage, the more it will benefit.
Since the beta measure how strongly the firm’s share price varies as the market
varies. The greater leverage the higher is beta.
2. Stock
Market Reaction to Other Risks
Over the past few years, standard
setters have been requiring increased risk related information in annual
reports. These include supplementary information about exposures to market and
credit risks and about the forms risk management policies. BBL (Barth, Beaver
and Landsman) and Schrand collectively suggest that the stock market is
sensitive to interest rate risk, over and above its sensitivity to beta.
Furthermore, both the firm’s on balance sheet natural hedging as well as its
off balance sheet derivatives hedging affect the magnitude of the market
response. We would expect that if other sources of risk than beta were to be
useful for investor, it would be for interest rate risk financial institution
3. A
Measurement Perspective on Risk Reporting
The disclosures are primarily
oriented to the information perspective, they involve the communication of
information to enable investor to make their own risk valuation. The risk
disclosure requirements are lain down by Linsermeier and Parson, which can take
the following forms:
a. A
tabular presentation of fair value and contract term sufficient to enable
investors to determine a firm’s future cash flow form financial instruments by
maturity date.
b. A
sensitivity analysis showing the impact on earnings, cash flows or fair values
of financial instruments, resulting from changes in relevant commodity prices,
interest rates, and foreign exchange rates.
c. Value
at risk, being the loss in earnings, cash flows or fair values resulting from
future price changes sufficiently large that they a specified low probability
of occurring.
Referrence:
scott,william. Foundamentals of accounting theory.
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