Overview

The decision usefulness of current value-based financial statements will be compromised if too much reliability is sacrificed for greater relevance
Management's skepticism in current value accounting, particularly since the measurement approach implies that current values,and the volatility that
accompanies them, are incorporated into the financial statements proper

Conservative accounting results in persistently understatement of assets, earnings, and shareholders' equity relative to their current values
Managers, investors, and auditors may prefer conservative accounting to current value accounting in some circumstances as conservative accounting can
contribute to investor decision-making and reduction of auditor liability

Difficulties with measurement approach

Current Value Accounting
Discounted present value of cash expected to be received or paid with respect to the use of the asset or liability
Informs the investor about the firm's future economic prospects
Value in use may be relevant as it indicates expected cash flows to or from the firm
May be sold instead of written down, and thus realizes a loss which is low persistent
May also declare to hold financial assets/instruments (investments, etc.) to maturity, thereby avoiding a write down
On one qualification: value in use depends on how the item is used, and management might change, often strategically, how it intends to use the asset or
liability

Business model allows certain financial assets to be valued at value in use only if the firm's business model involves holding the assets soas to generate cash
flows from interest and principal payments

Value-in-use: the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful
life

Assets could be put to their next best use, which could be either to sell or redeem them at their exit price
It measures the opportunity cost to the firm of the intended use of its assets and liabilities
The basis of valuation is termed exit price
Can be observed
Level 1: assets and liabilities for which a reasonably well-working market price exists
Can be inferred
Level 2: assets and liabilities for which a market price can be inferred from the market prices of similar items
Cannot observed or inferred
Firm's own expected cashflow could be used as a place to start in estimating fair value
Level 3: assets and liabilities for which a market value cannot be observed or inferred. Then the firm shall use the best available information about how a
market participant holding the asset or liability would value the item

Fair value hierarchy: measurement of Fair Values

Use of FV gives up relevance comparing to value in use because we might not plan on selling the asset
Fair Value: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement
date

Net income is the result of the matching of costs and revenue, with revenue recognized when it is considered to be realized
Historical cost accounting
Value in use recognizes revenues before they are realized, since anticipated future revenues are capitalized into asset values
Net income is simply accretion of discount, plus or minus changes in management's estimates
Value in use
Fair value accounting recognizes gains and losses as changes in fair value occurs
How well did they use the assets in running the company.
Treating management as stewards of the asset and recording on management performance.
Managers are charged with the opportunity cost of net assets used in the business, and, assuming reasonable reliability, his/ her success is measured
by the firm's ability to use these net assets to generate a return over and above their opportunity cost

Net income shifts towards a report on manager stewardship

All gains and losses show up on the income statement. Management is responsible for these gains and losses.
Fair value
Effect on Income Statement
Measurement Examples
Current AR, net of AFDA and AP are valued at the expected amount of cash to be received or paid
Accounts receivables and payable
As long as interest rate (borrowing rate) does not change, book value equals value in use (PV)
Long term debt may be valued at the PV of future interest and principle payments, discounted at the effective interest rate
Expected future contractual cash receipts or payments are discounted at the effective interest rate under the contract, and this rate is retained despite
changes in relevant interest rates and/or the firm's credit rating

As interest rates change, this initial equivalence between current value and book value may be lost over time
Need to be initially valued at the lower of the fair value of the leased asset or the present value of minimum lease payments, using the interest rate
implicit in the lease or the lessee's incremental borrowing rate when the implicit rate is impracticable to determine

Firm often design lease contracts so that they do not qualify as finance leases, then no assets and liability need to be reco rded
Problems
Lease contracts and related leased assets
Amortized cost accounting
Cash flows fixed by contract
LCNRV approach
Can write down to recoverable amount and back up, but cant go above the cost
Conservatism concept
Inventories
Revaluation model, at fair market value
Can write down to recoverable amount and back up, but cant go above the cost
Ceiling test
Property, Plant & Equipment
Discounted PV of expected future pension payments, including for any future compensation increases
Pensions
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Discounted PV of expected future pension payments, including for any future compensation increases
PV of the future pension payments and value pension asset at the FV of the pension asset
Reliability is a major concern, just like all other under current value accounting (although relevancy may be increased)
Financial Instruments
Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity
If financial instrument is measured at historical cost, the financial instrument can be sold when it goes up or down in valueto gain and income instant gain
Gains trading
Non derivative financial assets designated by the firm at acquisition as this category
Valued at fair value, with most unrealized gains and losses included in OCI
Upon disposition, unrealized gains and losses are transferred from other comprehensive income to net income
Available for sale
Fixed or determinable future payments that do not have active market values, such as bank loans
Non derivative financial assets
Valued at amortized cost, subject to an impairment test
If there is impairment (expected future cash flows fall below the amount originally estimated), the asset is written down to its new expected value,
using the effective interest rate established at acquisition, with the unrealized loss included in net income

If the value of a written down asset subsequently increases, it is written up, but not above its current book value if there had been no write down
Loans and receivables
Fixed or determinable payments that the firm intends to hold to maturity such as a portfolio of bond investments
Non derivative financial assets
Valued at amortized cost, subject to an impairment test similar to that for loans and receivables
If the value of written down asset subsequently increases, the write down may be reversed under certain conditions
Held to maturity
Includes all derivatives not held for hedging and non derivative financial assets held for trading
Unrealized gains and losses on financial assets in this category are included in net income
Financial assets at fair value through profit and loss
Four categories of financial assets:
Financial liabilities held for trading and financial liabilities that the firm has designated to belong to this category
Fair value option
Financial liabilities at fair value through profit and loss
Bonds outstanding
Valued at cost or amortized costs
Other financial liabilities
Two categories of financial liabilities:
Fair value option allows firms to opt to value financial assets and liabilities at fair value
Thus, the asset/liability has to be valued at cost
If reliability measurements cannot be attained, fair value is unlikely to be decision useful, despite its relevance
Creates a natural hedge of changes in values
If unrealized gains and losses on these financial assets do not enter into net income, the mismatch that creates excess net i ncome volatility is
again sidestepped

Standards stipulate that certain securities (held to maturity) need not be carried at fair value and that unrealized gains and losses on others
(available for sale) are included in other comprehensive income

Amortized cost can be opt out to prevent accounting mismatch

Adopt fair value option so that both sides of the natural hedge are fair valued
Avoiding mismatch:
Mismatch arises when some assets or liabilities are fair valued but related liabilities or assets are not
Valuation
Despite its relevancy, fair value accounting is unlikely to be reliable
If interest increases and coupon payments remain the same, the discounted PV would be smaller, thus realizing a gain in bond valuation.
Debt go down in value, gain realized not because of how firm performed. Thus doesnt reflect true value to shareholders
For bond, if market interest rate changes
If interest rate rises, the fair value of the interest bearing securities falls
The loss is offset by the decrease in the fair value of the debt
Net income will not reflect this offsetting if it includes unrealized gains and losses from fair valuing the firm's interest bearing securities while excluding
losses and gains on long term debt carried at amortized cost

As a result, the volatility of net income is greater than the real volatility the firm has chosen through its natural hedging activities. Then there is a
mismatch

A firm with debt issued at a fixed interest rate may hold fixed interest bearing securities of similar amount and maturity
Impact of Fair Value Accounting
Derivative Instruments
Arising from changes in interest rates, commodity prices, and foreign exchange rates
Price risk/market risk
Credit risks
Mitigate changes in future cost risks, such as price; mitigate changes in interest rate risks
Manage cash flows by issuing zero coupon debt
Manage their capital structure by means of convertible debt
Derivatives help to reduce market incompleteness, since they enable the firm to purchase protection against risks that would otherwise be difficult to
control

Manage risk
Purpose
Many firms hold financial assets and liabilities with similar duration and other characteristics
If interest rate go up, the fair value of the interest bearing securities fall and the loss is offset by the decrease in the fair value of the debt
Ex., a firm with long-term debt issued at fixed interest rate may hold fixed interest-bearing securities of similar amount and maturity
Liability/debt that was due in USD, then you set up an offsetting investment in USD. Any gains and losses in the exchange rate in your liability is offset by the
corresponding gain/loss on the asset

Natural Hedging
Forward contracts will specify future prices to try to mitigate risks in changing prices
Contracts, the value of which depends on some underlying price, interest rate, foreign exchange rate, or other variable
Derivative instruments convey a benefit to the holder if there is a favorable movement in the underlying
Derivatives
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Derivative instruments convey a benefit to the holder if there is a favorable movement in the underlying
Delivery of the asset associated with the underlying need not take place
Option contract need not involve the holder actually buying the share, but only receiving the value of the option in cash at time of settlement
Generally require or permit settlement in cash
May not require an initial investment
Mitigated through disclosures
Thus, moved substantially towards a measurement approach
The low initial investment characteristic of derivatives is a reason why accountants have found them difficult to deal with under historical cost accounting
Leverage aspect of derivatives - a lot of protection can be acquired at relatively low cost
Change in fair value of derivative instruments are recognized in net income, except for certain hedging contracts
Used when natural hedge is not feasible
The essence of fair value hedge is that if a firm owns a risky asset, it can hedge this risk by acquiring a hedging instrument (some other asset or liability whose
value moves in the direction opposite to that of the hedging item (gain in hedging instrument/loss in hedged items, vice versa)

I.e., hedged item's gain or loss may be greater than that of the hedging instrument. Thus the difference results in a net gain or loss recorded
There may not be a hedging instrument that will completely offset the hedged item's gain or loss
There could be risks due to change in price, exchange rate
The risk resulting from the absence of a perfectly effective hedge is called basis risk
Gain or loss on the hedged item and the loss or gain on the hedging instrument can both be recorded in current net income, which then includes a realized loss
or gain only to the extent the hedge is not completely effective

A firm can avoid the effect on net income of lower of cost or market and ceiling tests and other fair values changes, by appropriate hedging strategy
The gains or losses on the assets/liabilities can be mitigated using derivates, so there is an offsetting gain/loss on the derivative
Fair Value Hedges
Managing risks in changes in future prices
Hedging against anticipated transactions to reduce risk arising from price changes of the firm's future production
Help ensure cash availability for future investment projects, where these are to be financed internally
Cash flow hedge are fair valued, with unrealized gains and losses included in other comprehensive income (OCI) until the transactions affect net income
I.e., an oil and gas producer may wish to hedge next period's sales
Including unrealized gains and losses on cash flow hedges in OCI income reduces net income volatility by delaying their effect on net income until the next period, when the
anticipated cash flows are realized

Cash Flow Hedges

Non derivative instruments are generally prohibited from being hedging instruments
Management designate the instrument as a hedge at the inception of the hedge, identify the hedged item, and document the nature of the risk being hedged
Highly effective essentially means that there is high negative correlation between the fair values of the hedging instrument and the hedged items
The derivative instrument must be highly effective in offsetting changes in the fair value of the hedged item
Eligible to be hedging instrument if:
Deferring loss recognition to other comprehensive income (cash flow hedge)
Offsetting gains or losses on the derivative by fair valuing the hedge item (fair value hedge)
Benefits of hedge accounting:
Hedge accounting standard may reduce mismatch volatility, but accounting standards per se do not reduce the real volatility f aced by the firm
Derivative financial instruments are generally accounted for at fair value
Full disclosure is particularly necessary to protect investors, since firms may also use derivatives to speculate
Other Issues
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 generally valued at their fair value for purpose of the consolidated financial statement

Good will is measured at fair value

However, management strongly complained about goodwill amortization since it forced down consolidated net income following the acquisition, making
it more difficult to convince investors that the acquisition was a successful business strategy

Management has an incentive to demonstrate, through increased reported earnings, its good business judgement in entering into a business combination
Balance sheet items were added together, with no new purchased goodwill recognized. So there was nothing to amortize
Pooling of interest accounting
GAAP income statement itself is not affected
For management to convince investors that goodwill amortization and other selected items do no matter, in the sense that they are not
relevant to the evaluation of the performance of the consolidated entity

Pro-forma income is emphasized in earnings announcements, messages to shareholders, MD&A, etc.

Less discipline for managers to avoid overpaying in business acquisitions
Mislead investors, since there are few rules to determine just what items are excluded from GAAP income
Allowing measurement approach
Goodwill is written down if impaired, but cant be written up if fair value subsequently increased
To respond, new standards were set
Criticism
Pro-forma income (cash income), where pro-forma income is net income before goodwill amortization, restructuring changes, and a variety of other
items selected by management

In response, managers attempted to circumvent/avoid goodwill amortization

Traditionally goodwill is amortized over its useful life, consistent with the matching concept of historical cost accounting
Purchased Goodwill
Investors do not bid up the firm's share price in response to reported R&D as much as under complete reliability
Lack of knowledge of R&D profitability creates estimation risk
No readily identifiable transactions exist to determine the cost of self-developed goodwill
Cost that may create goodwill are mostly written off (R&D)
Goodwill that develops from these costs show up as abnormal earnings in subsequent income statements
Creates mismatch between costs and revenues, and is the root cause of low value relevance of reported earnings
Not on a financial statement due to difficulty in measuring; no reliable measurements
Signal effect: the greater the firm's research potential, the more it will invest in R&D
React positively to the increased expected profits these costs create
The more the firm spends, the higher its potential must be
Therefore, higher is the capitalized R&D cost, the more the market will bid up the price of the firm's shares (an proponent to capitalize R&D costs - to
recognize goodwill, as oppose to expensing them and writing them off)

Positive market reactions to successful R&D costs

Self-Developed Goodwill
CAPM: only beta is the risk measure when explaining share prices
Beta risk
Reporting on Risk
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CAPM: only beta is the risk measure when explaining share prices
Can be mitigated with providing financial statements
Beta is subject to estimation risk
Beta measures how strongly the firm's share price varies as the market varies. The greater the leverage the higher is beta
Accounting based risk measures (dividend payout) may provide timely indications of shifts in beta
By including off balance sheet on the balance sheet, measurement of the debt component of the debt to equity ratio is improved
Certain financial-statement-base risk and bet are related and that these measures can indicate the direction and magnitude of a change in beta sooner
than the market model

Share returns are related to other risk measures

Reporting on firm's risk management strategies may reduce investor concerns about estimation risk resulting from adverse selection
Firms that are planning large capital expenditures may wish to ensure cash is available when needed
Require full disclosure of the firm's risk management strategies, and the fair value of its various derivatives and their unr ealized gains and
losses

May increase risk rather than reduce it as it may be difficult for investors to diversity speculation risk, since losses can be very large and can threaten
the existence of the firm itself

Crucial when managers use derivatives to speculate

Conservative accounting can help reduce legal liability
Use of derivatives to reduce the volatility of manager's compensation
Why do firms manage firm-specific risk?
Risk reporting in MD&A
IAS 39 requires disclosures include supplementary information about exposures to market and credit risks and about the firms risk management policies
Research shown that there is a market reaction to the fair values of banks' loans portfolios, suggesting that the relevance of fair value reporting of these
assets outweighs reliability difficulties in measuring loan value

BBL: a bank in poor financial condition is less likely to be around to realize the unrealized gains and losses on its loan portfolio
Additional volatility of FFV income was negatively related to share price, and positively related to cost of capital, after controlling for other factors
affecting interest rate risk

HHW: comprehensive income contains only a relatively small amount of information about a banks interest rate risk
Evidence of market response to interest rate risk suggests that this risk is not fully hedged by banks and that investors do not, or cannot, fully diversify the
risk that remains

Comprehensive income seems ineffective relative to full fair value income in reporting on interest rate risk, implying that increased adoption of a
measurement approach could convey useful information

Stock market reaction to other risk

$3 drop in prices wouldnt necessarily translate to 3 times the drop in earnings
Sensitivity estimates are subject to relevant range problems
Changes in crude oil is dependent on natural gas
Movement in prices
Investors has to assess these
No probabilities of price changes
Problems
Sensitivity analysis showing the impact on earning, cash flows, or fair values of financial instruments, resulting from changes in relevant commodity
prices, interest rates, and foreign exchange rates

Addresses some problems with sensitivity analysis

The need to assess the joint price distribution, including correlations between the price risks
Problems
Value at risk the loss in earnings, cash flows, or fair values resulting from future price changes sufficiently large that they have a specified low probability
of occurring

A measurement approach to risk reporting

Articles
Whether the accounting rules on FV for financial instruments contributed to the financial crisis
FV accounting does not reflect underlying economics and cash flows held to maturity
The value of security should be carried at historical cost and not written down
How we account for financial instruments was a major factor in the financial crisis
U.K. Lawmakers Defend Fair Value
Banks recognized loan losses too late and didnt have enough reserves set aside under the current "incurred loss" loan model
FV accounting contributed little or nothing to the failures of banks
Expected future losses
Establish a mean of recognizing potential loan losses earlier on the loans underwrite and could incentivize prudent risk management practices
A forward looking instead of backward looking loan loss model would be more appropriate
Could have an reliability issue though
Could lead to the perception of earnings management
By letting credit losses be recognized earlier
Requiring that the measurement of credit losses be informed by reasonable and supportable forecasts of economic conditions in the foreseeable future
To enhance the current incurred loss loan model:
Write-downs during financial crisis using FV was not appropriate
Better Loss Model May Have Prevented Bank Failures: GAO
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