© 2006 pearson education canada inc.7-1 chapter 7 measurement perspective applications

© 2006 Pearson Education Canada Inc.

7-1

Chapter 7

Measurement Perspective Applications


7-2

Measurement Perspective Examples

• Accounts Receivable and Payable

• Capital Leases• Lower-of-Cost-or-Market Rule

– Inventories– Temporary investments– N.B. No subsequent writeup if

market value improves—partial application


7-3

Examples, Cont’d.• Ceiling Tests

– 2-stage procedure• Impaired?• If so, write down to fair value

– No subsequent writeup if asset value improves—partial application

• Post-Employment Benefits– Expected present value of benefits

earned– Expense reduced by earnings on plan

assets– Reliability of estimates?

• Choice of discount rate


7-4

Examples, Cont’d.

• Impaired Loans– Write down to estimated

realizable value•Discounted at interest rate implicit

in the loan transaction

– An extension of measurement perspective, since may write loan value up if its fair value improves


7-5

Financial Instruments


7-6

Definition

• A Financial Instrument is– A contract…– Cash, or a contractual right to

receive/deliver cash or another financial instrument…

• Note Broad Definition– Cash, receivables, payables,

marketable securities,...


7-7

SFAS 115 (and Section 3855, CICA Handbook)

• Applies to Debt & Equity Securities– Classified at acquisition into

one of 3 categories•Held-to-maturity

– Valued on cost basis

•Trading– Valued at fair value

•Available-for-sale– Valued at fair value


7-8

SFAS 115 (and Section 3855, CICA Handbook), Cont’d.

• Why the 3 Categories?– Core deposit intangibles

• Inability to value reliably precludes including financial liabilities in scope of SFAS 115 (Section 3855 includes some)

– Gains trading• Fair value accounting makes gains trading more

difficult for trading and available-for-sale securities • Elaborate precautions to prevent gains trading for

held-to-maturity securities

– Earnings volatility • Reduced by including unrealized gains on available-

for-sale securities in other comprehensive income (OCI)


7-9

Derivative Financial Instruments

• Definition of Financial Instruments Includes Derivatives

• Definition of Derivatives– A contract, the value of which

depends on some underlying…– May not require an initial cash outlay– Generally settled in cash, not in kind


7-10

SFAS 133 (and Section 3865, CICA Handbook)

• Fair Value Hedges– Gains and losses on the hedging

instrument included in net income•Fair valuing the hedged item may offset

• Cash Flow Hedges– Gains and losses on the hedging

instrument included in OCI, until the future transaction affects net income


7-11

SFAS 133 (and Section 3865, CICA Handbook),

cont’d.• 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•Hedging may avoid the ceiling test


7-12

SFAS 133 (and Section 3865, CICA Handbook), cont’d.

• To Obtain Benefits of Hedge Accounting– Hedges Must Qualify

•Must be highly effective– Negative correlation with hedged item

– Hedges Must be Designated•Requires elaborate procedure and

documentation


7-13

Accounting for Intangibles

• Purchased Intangibles– Goodwill arising from an acquisition

• Accounted for at cost• No amortization• Subject to ceiling test

– Can lead to major writedowns, e.g., JDS Uniphase, 2001 Annual Report. See Problem 9.7

– Management devices to work around goodwill and related writedowns

• “Pro-forma income,” e.g., TD Bank, 2000 Annual Report. See practice and theory vignette, Section 7.4.2


7-14

Accounting for Intangibles, Cont’d

• 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


7-15

Lev & Zarowin, “The Boundaries of Financial

Reporting…”• Their Study Documents a

Decreasing Usefulness Earnings Information– Usefulness evaluated by ability of

earnings to explain abnormal share return• Low R2

– And falling?

• Low ERCs• Especially for research-intensive firms


7-16

Lev & Zarowin, Cont’d

• Conclusion– Accounting for intangibles is

inadequate


7-17

Lev & Zarowin, Cont’d

• Suggestion to Improve Usefulness– Capitalize successful intangibles

after a “trigger point” is attained•Amortize over useful life•Like SE in oil and gas accounting•Amounts capitalized and amortized may

reveal inside information, since it is management that has best knowledge of R&D value


7-18

Risk Management

• Risk Controlled by Natural Hedging + Hedging with Derivatives

• Hedging v. Speculation– A fine line separates the two


7-19

Reporting on risk

• Beta Risk– Relevant to rational, diversified investor– Accounting variables correlated with beta

• Beaver, Kettler, and Scholes (1970)

• Reasons Why Other Risks Also Relevant– Investors may not act according to rational

decision theory model– Risk information may reduce estimation

risk– Risk reporting may control speculation


7-20

A Measurement Perspective on Risk

Reporting• Narrative, in MD&A

– Canadian Tire Corp. Text, Section 4.8.2

• Sensitivities Analysis– Suncor Energy Inc., 2003 Annual

Report

• Value at Risk– Microsoft Corp., 2004 Annual

Report


7-21

Sensitivities Analysis, Suncor Energy Inc.

• 2003 Annual Report– See Table 7.2– Problems of sensitivities

analysis•Net of Hedging?•Linearity Assumption - Relevant

Range•Co-movements (i.e., correlations)

in prices


7-22

Value at Risk, Microsoft Corp.

• 2004 Annual Report– Discloses a 97.5% probability that

a loss in fair value over a 20-day period will not exceed the following amounts (net of hedging):• Interest rate risk: $298 (million)•Currency rate risk: $207•Equity price risk: $773•Total risk: $835

– Correlation of price risks•Note the 3 specific risks do not add to

total

© 2006 pearson education canada inc.7-1 chapter 7 measurement perspective applications

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fair value slide

fair value available

fair value accounting

loan value

asset value

realizable value

financial instruments