Chapter 7Measurement ApplicationsAccounting for Goodwill Danny, Jesse, Varun, Ali , Irfan, Zeeshan
Current Value Accounting • Movement of accounting practice to current value-based financial statements is pointless if it sacrifices reliability for more relevance. • Why there is skepticism about RRA. • Why managers, investors and auditors prefer conservative accounting as opposed to current value accounting.
Current Value Accounting • 2 bases of current value measurement • Value in use • Measure by discounted present value of cash expected to be received/paid from asset/liability • Relevant info • Informs investor about firm’s future • So value in use is relevant, BUT it depends on how it’s used and management changes • Example: financial instrument that decreases in value Management can declare holding it to maturity, avoiding writedown
Current Value Accounting • 2nd base for current value approach: fair value or exit value • Definition of fair value • Price that would received to sell an asset or paid to transfer liability • Exit price = opportunity cost to firm of the intended use of asset/liability • Due to market inefficiencies, fair value hierarchy is needed.
Current Value Accounting • Fair value hierarchy • Lvl 1: assets/liabilities which well-working market price exists • Lvl 2: assets/liabilities which market price can be inferred from market price of similar items • Lvl 3: assets/liabilities which market value cannot be observed or inferred. Firm would use best available info about how to value them.
Current Value Accounting • Different impacts of types of accounting on income statement • Under historical accounting ,net income is result of costs and revenue, revenue being recognized when incurred. • Under value in use accounting, net income is accretion of discount. • Under fair value accounting, net income depends on management stewardship
Longstanding Measurement Examples • Examples of current value-based measurements in GAAP • Accounts Receivable & Payable • Accounts receivable and payable are measured at expected amount of cash to be received or paid. • Due to short time period, discount factor is neglected. • Cash flows fixed by contract • Long term debt often have fixed interest and principal payments.
Longstanding Measurement Examples • Lower-of-Cost-or-Market Rule • When net realizable value of inventory falls below cost, it’s written down. • When NRV increases, inventory is written up, but not above cost. • Revaluation option for Property, Plant, Equipment • PPE can be valued at fair value, if it can be done reliably. • Once revalued, it must be kept up to date.
Longstanding Measurement Examples • Ceiling Test for Property, Plant, Equipment • Impairment loss for PPE is recognized if book value is greater than recoverable amount • Recoverable amount = great of fair value less costs to sell or value-in-use • Pensions and Other Post-Employment Benefits • For defined benefit pension plans, pension expense arising from current period employee service includes change in the discounted present value of expected future pension payments.
Financial Instruments • a contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm • Can you give an example of a financial instrument?
Financial Instruments • Financial asset is: • cash • equity instrument of another firm • contractual right • to receive cash or another financial asset from another firm • exchange financial instruments with another firm under conditions that are potentially favourable • Financial liability is: • Contractual obligation • deliver cash or another financial asset to another firm • exchange financial assets or financial liabilities with another firm under conditions that are potentially unfavourable
IAS 39 • IAS 39 classifies financial assets into four categories: • available for sale • loans and receivables • held to maturity • financial assets at fair value through profit and loss • IAS 39 classifies financial liabilities into two categories: • financial liabilities at fair value through profit and loss • other financial liabilities
FVO • Fair value option – under this option, the firm can opt to value financial assets and liabilities at fair value, even though fair value is not required. Once chosen, the firm will generally continue to fair-value asset or liability in subsequent periods. • Why would firms have incentive to use the fair value option?
Incentive? • Firms have strong incentives to transfer assets between classes, i.e. a transfer from held to maturity to held for trading categories would trigger an immediate increase in net income if the transferred securities had gained in fair value • However, IAS 39 gives disincentives, should this happen IAS 39 prevents use of the held to maturity category for two years, thereby eliminating the firm’s ability to value the financial instruments at amortized cost for this period.
Fair value? • Why not value all financial instruments at fair value? • Because sometimes reasonably reliable measurements cannot be attained
Deposits • Core deposit intangibles – arise from customers’ acceptance of a lower-than-market rate of interest on their deposits, due to goodwill, habit, location, etc. • Example: supposed a bank pays 1% interest on a customer’s $100 deposit lends the customer’s money at 5%. As long as the customer keeps the deposit, the bank’s deposit liability is accompanied by a core deposit intangible asset that will generate $4 per year
Problems? • IAS 39 does not allow for fair value accounting for demands deposits due to the unreliable nature of measuring intangibles • Mismatch arises when some assets or liabilities are fair-valued but related liabilities or assets are not
Example • Many firms hold financial assets and liabilities with similar duration and other characteristics. These create a natural hedge of changes in values. • Thus, a firm with long term debt issued at a fixed interest rate may hold fixed interest bearing securities of similar amount and maturity. This debts fair value will change with rising or decreasing interest rates
IAS 39 • 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 • Reduce mismatch by adopting fair value option so that “both sides” of the natural hedge are fair-valued
Allen and Carletti (2008) • Model in which banks and insurance firms hold both long-term and short-term financial assets • Can’t pay claims? Liquidate all assets, generating liquidity pricing • Liquidity pricing drives market price below value-in-use
Predictions • The model predicts that historical cost accounting is socially preferred to fair value, since it avoids the possibility of financial contagion from one industry to another when the industries hold similar assets in common
Sapra (2008) • Points out the A and C model does not allow for governments containing contagion • If returns on the long-run asset are correlated over time, fair value accounting can give warning of impending bank failure, giving governments a chance to step in before deterioration
A and C • Helps to show how financial distress can spread across the financial services industry and to understand why financial firms are usually the strongest opponents of fair value accounting. • Model is too strong in its blanket condemnation of fair value accounting
Plantin, Sapra, and Shin (2008)(PSS) • PSS assumes that financial institutions know the value-in-use of their liquid assets. However, if sold, the proceeds will be less than value-in-use, for two seasons: • loans are difficult to value by prospective purchasers in the market, who do not have access to all the value information possessed by the institution • since loan market is so liquid, selling assets lowers their price, similar to liquidity pricing in the AC model.
FAIR VALUE ACCOUNTING • Managements Preference. • If you were management what would you prefer? Fair value or cost accounting
The 2008 Market Melt down Crisis • Post Recession Huge Fair value write downs. • Assets to be written down to market value • If you were management what would you prefer? Fair value or cost accounting $2,000 $10,000
The 2008 Market Melt down Crisis • Standards Severely criticized by Management and Banks. • Economist report Sept 18th 2008 • IASB and FASB rewrite standards • Fair Value when Markets are inactive?
Outcomes • Project to replace IAS 39 • Effective January 1st, 2013 • Fair Value at acquisition • Re-value at acquisition unless firms business model is to hold assets for principle and interest. (Backing off somewhat from Fair Value) • FASB does not allow for business model concept. IFRS 9
Derecognition and Consolidation • Major Contributors to the 2007 – 2008 Financial crisis • Off Balance sheet Financing • Failure to consolidate these entities that held many derecognized assets
Derecognition vs.Securitization • When can an asset be removed from the balance sheet? And the resulting revenue be recognized • Usually this is completed at point of sale • However what happens when we treat transferred assets as secured borrowing? • Derecognition can improve the firms ratios considerably • Niu and Richardson (2006) study, 103 firms • If securitized their transfers instead of derecognizing them • Debt to Equity: 5.97 10.20
Lehman Brothers • 2008 Collapse – used derecognition and consolidation • Repurchase Agreements @ 105% – treated as sales • Allowed under FASB rules at the time • Completed Transaction under U.K. subsidiary’s statements • Led to improvement of parent companies statements when consolidated • SEC filings from Nomura, Santander and Merrill Lynch have all acknowledged the heavy use of off-balance sheet repo-to-maturity transactions. 2011 • More recent – MF Global’s Bankruptcy in October 31st 2011 $1 Billion in equity supporting $40 Billion in Assets
? of Liability • When should a firm be allowed to derecognize a transferred asset? • In 2008: • Under IAS 39 – it was “substantially all” of the risks and rewards of ownership • Under FASB – it was to “surrender control” of the transferred asset. • In 2009: • New exposure draft for amending IAS 39 • States derecognition is allowed when transferring firm no longer has the ability to obtain all future economic benefit of the asset.
Implications • Prior to the Meltdown Investors did not have enough information to fully evaluate off-balance sheet activities • With the additional disclosures required standard setters hoping to avoid allowing companies access to practices that contributed to the meltdown
Derivative Instruments • Derivatives instruments are contracts and their value depends on price, interest rate, foreign exchange rate, or other variables If the market price of the shares go up, what will happen to the value of the option? BUY (call option) 100 shares of common stock for $30 each = $3,000 Characteristic of Derivative instruments is that it requires settlement in cash
Difficulties Accountants Face to Value Derivatives • The low initial investment characteristic of derivatives is a reason why accountants have found them difficult to deal with under historical cost accounting. • It is impossible for investors to figure out firms derivative dealings, that is why accountants have asked for supplemental disclosure • IAS 39 – All derivatives be measured at fair value for balance sheet purposes
How to value derivative? Share Value Option Value • Fair value is measured by its market value • Example: (Call option: 100 shares for $30 each). Current market price of the shares is $28 per share • Assumptions: The option can be exercised at the end of 2 months, Share prices change at the end of each month, share price can go up by $2 with the probability of 50% or go down by $2 with the probability of 50%. Probability 200 0.25 0.50 0 0 0.25
Hedge Accounting • Derivate instruments designated as hedges of recognized assets and liabilities are called fair value hedges. • If a firm owns a risky asset , it can hedge the risk by acquiring a hedging instrument • Hedging instrument: some other asset or liability whose value moves in the direction opposite to that of the hedged item. IAS 39
Difference between hedged item and hedged inventory • Example: During the year, a firm is concerned that selling prices of the inventory will decline, hedges the price risk on its inventory by entering into a forward contract to sell the inventory at its current market price. • Hedged item: inventory • Hedged instrument: forward contract
Cash flow hedges • Firms may hedge anticipated transaction to reduce the risk arising from price change of the firm’s future production • Management must designate the instrument as a hedge, identify the hedged item and document the nature of the risk
Highly effective • There is high negative correlation between the fair values of the hedging instrument and the hedged item • One way of estimating this correlation is the cumulative dollar offset method • Example: firm borrows at a variable interest rate. Hedges its cash flow risk by purchasing a treasury bill. Interest payment increased by $1500 and fair value of the treasury bill is $1300. the ratio of loss to gain is -1500/1400 = -1.15
Accounting for Intangibles • Intangibles are capital assets that do not have physical substance. • Examples??
Intangibles • Most intangibles accounted for like property, plant and equipment • If purchased or self-developed with certainty of future net benefit they are valued at cost and amortized over their useful life. • If acquired with business acquisition then are recorded at a fair value determined reliably or at acquisition cost.
Research Costs – Intangibles • Since intangibles value is spread over many years despite no assurance of future benefits, research costs are not allowed to be amortized. • IAS 38: research costs must be charged to expenses as incurred. • Self developed intangibles are most effected by this rule; do not appear on balance sheet
Goodwill – Intangibles • During an acquisition of a business accounting required value of business be recorded using fair values for: tangible assets, intangibles assets, and Liabilities • Goodwill is the difference between the net amount of fair values and total purchase price paid by acquiring company