ACF3100 – Advanced Financial Accounting
Lecture Four – Measurement and Fair Value
Understand the concept and importance of measurement in financial reporting
Describe the standard setter’s approach to measurement and evaluate benefits and challenges
associated with a mixed measurement approach
Explain and evaluate different measurement alternatives
Define and understand the concept of fair value
Explain the controversial and political nature of measurement, particularly fair value accounting
Explain how fair value can be determined
Conceptual Framework
The process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement
May involve calculation, estimation and/or apportionment
Impacts quality and therefore usefulness
Makes financial statements decision useful o
Gives meaning to the items included
Allows users of accounting information to: o
Assess an entity’s fina ncial performance and position
o
Compare the entity’s performance and position over time
o
Compare entities
The conceptual framework does not provide guidance as to which measurement bases should be used
In reality a range of bases are used
Historical cost remains dominant
Steady shift towards fair value
IASBs use a mixed measurement model o
Different measurement bases are employed to different degrees and in varying combinations during the preparation of the financial statements
o
Variation across and within items
Refer examples from Pacific Brands http://www.pacificbrands.com.au/assets/Documents/ResultsReports2014/Pacific%2 0Brands%20Annual%20Report_HR%20(PBG%20website%20Final)%20Reduced.pdf
o
This leaves a large amount of flexibility and choice within par ticular standards
Example– MixedMeasurementApproach MixedMeasurementApproach
Refer Pacific Brands 2014 Annual Re port Note 1 – Significant Accounting Policies for some examples. K. Inventories: lower of COST and NET REALISABLE VALUE M. PPE. COST less accumulated depreciation and accumu lated impairment losses N. Intangible Assets. COST less accumulated amortisation and impairment R. Long term employee benefits. PRESENT VALUE
ACF3100 – Advanced Financial Accounting
W. Derivative financial instruments. FAIR VALUE
ACF3100 – Advanced Financial Accounting
Little or no agreement on what measures should be used The inherent flexibility and the nature of a mixed measurement appr oach reducescomparability Measurement can be quite subjective With flexibility comes opportunisticaccountingchoices The current approach results in the additivityproblem
Defined in the Conceptual Framework as: Assets are recorded at the amount of cash or cash equivalents paid or the fai r value of consideration given to acquire them at the time of their acqu isition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy th e liability in the normal course of business
HistoricalCostandtheQualityofAccounting
Relevance Low: especially as time passes o Faithful Representation High: measures an objective transaction o Understandability High: concept well known and understood o Comparability Medium: purchasing power of money changes over time o
Defined in the Conceptual Framework as: Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired curr ently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.
CurrentCostandtheQualityofAccountingInformation
Relevance High: indicative of future potential o Faithful Representation High: determined by reference to actual costs o Understandability Low: can be subjective, depends o Comparability Medium: can be subjective, depends o
Defined in the Conceptual Framework as: Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash out flows that are expected to be required to settle liabilities in the normal course o business
PresentValueandtheQualityofAccountingInformation
Relevance High: indicative of future potential o Faithful Representation Low: can be very subjective o Understandability Medium: assumptions used can be complex o Comparability
ACF3100 – Advanced Financial Accounting
o
Medium: involves many different assumptions
FairValueandtheQualityofAccountingInformation:ArgumentsForFairValue
Relevance Focuses on future potential o Faithful Representation Determined using objective market prices o Understandability Simple representation of current market value o Comparability Focus on market value not individual entity o
FairValueandtheQualityofAccountingInformation:ArgumentsAgainstFairValue
Relevance Hypothetical and not relevant to specific entity o Faithful Representation If no objective market prices then highly subjective o Understandability Often based on complex assumptions and calculation o Comparability Different models lead to very different results o
Significant influences include: Accounting standards Potential users of the financial statements What will provide the most decision useful information, eg: creditors – liquidity – fair value o Practical considerations Is it possible to calculate? o Cost versus benefit o Managements motivations and objectives Short-term versus long-term o Impact on incentives o Reputational impact o
Different interest groups may favour different accounting measurement approaches – variability and subjectivity in practice – impact on financial performance and position Fair value has been particular focus during the GFC May have made economic crisis worse o May not be reliable o May have hidden problems o
ACF3100 – Advanced Financial Accounting
o
May be difficult to regulate
A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either: A) in the principalmarket for the asset or liability; or B) in the absence of a principal market, in the mostadvantageousmarket for the asset or liability
But the entity must have access to the market: Market participants The fair value of the asset or liability shall b e measured using the assumptions that market o participants would use in pricing the asset or liability developed using current information In developing those assumptions, an entity need not identify specific market participants o
An exit price embodies expectations about the future cash inflows and outflows associated with the asset or liability from the perspective of market participants at the measurement date. It is current and specific.
Remember we’re using an exit price model
Assume entry = exist unless: Related party transaction o Duress o Complex transaction o Different markets (retail vs. wholesale) o If different (unless another standard does not allow it) the item is recognised at fair value and the gain or loss is recorded through pr ofit and loss
Is the market really inactive? Assume a market is active, burden of proof on the accountant to show it is inactive o If it is inactive Make adjustments (possibly substantial) o Use an alternative valuation technique o
An inactive market would be characterised by: a) Few recent transactions b) Price quotations are not developed using current information c) Price quotations vary substantially d) Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated e) The market has gone toxic f) There is a wide bid-ask spread g) There is a significant decline in the activity h) Little information is publicly available
ObservableInputs are those values that can be obtained independently from available market data, possibly
with some adjustment for the specific asset, which would be used by market participants when valuing an asset or liability. UnobservableInputs are based on information that is not available to the market but must be inferred or
estimated based on the best information available.
ACF3100 – Advanced Financial Accounting
Quiz
Level 1 Inputs Quoted prices (unadjusted) in active markets for identical assets or liabilities o Level 2 Inputs Inputs other than quoted prices included within Level 1 that are observable o Level 3 Inputs Inputs that are not based on observable market data (unobservable inputs) o
ACF3100 – Advanced Financial Accounting
A fair value measurement of a non- financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use As determined by: Physically possible Legally permissible Financially feasible
A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value an entity shall take into account the characteristics of th e asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following: The condition and location of the asset; and Restrictions, if any, on the sale or us e of the asset
How to deal with transaction costs: Although transaction costs are considered when d etermining the most advantageous market, the price used to measure the fair value of the ass et or liability shall not be adjusted for t hose costs Exception: transportation costs are considered (as a negative) in the v alue of an asset
Example– DealingwithTransactionCosts
Measuring a widget machine: There is no principal market but we have identified two markets where almost identical machines are being actively traded In Market A, the price that would be received is $30,000 incurring transport costs of $2,000 to deliver the machine to that market and would incur $1,000 of advertising costs In Market B, the price that would be received is $28,000 and transport costs of $3,000
Market A: $30,000 - $2,000 - $1,000 = $27,000 Market B: $28,000 - $3,000 = $25,000 Most advantageous market Market A Fair Value = $30,000 - $2,000 = $28,000
Fair value measurement assumes that a financial or non-financial liability or an entity’s own equity instrument (eg: equity interest issued as consideration in a business combination) is transferred to a market participant at the measurement date. Liabilities can be valued based on the corresponding asset.
When public prices are not available for the debt or equity the entity should, where possible, ‘measure
the fair value of the liability or equity instrument fr om the perspective of a market participant that holds the identical item as an asset at the measurement date’
ACF3100 – Advanced Financial Accounting
If no corresponding asset exists: When using a present value techniq ue to measure the fair value of a liability that is not held by another party as an asset, an entity s hall, among other things, estimate the future cash outflows th at market participants would expect to incur in fulfilling the obligation
An entity shall disclose information that helps u sers of its financial statements assess both of the following: For assets and liabilities that are measured at fair v alue on a recurring or non-recurring b asis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements For recurring fair value measurements using significant unobserv able inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period
