Chapter 7

Measurement Applications

Overview
Introduction (7.1)
Current value accounting (CVA) (7.2)
Two versions of current values (7.2.1)
Current values and income statement (7.2.2)

Current value applications

Longstanding examples (7.3)
Financial instruments (7.4-7.10)
Primary financial instruments (7.5.1-7.5.3)
Related issues(7.6-7.8)* Slides only
Intangibles (7.11)
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7.1 Introduction
Measurement approach
Extensive use of current value concepts in
financial statements proper
Two sided: write up and write down
One side: write down only
Conservative accounting

Reflects the real risk facing the firm

Recall the Clean Surplus Model
Biased vs. non-biased accounting
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7.2 Current Value Accounting

Two versions (7.2.1)
Value-in-use
Also called amortized cost
Valued at discounted present value of future receipts
High relevance, limited reliability
Error and possible bias in estimating
Management may opportunistically change estimates

Fair value
Also called exit price
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 (IFRS 13)
Measures opportunity cost of retaining asset/liability in firm
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Two Versions of Current Values

Current Values:

(IFRS 13, Fair Value Measurements, effective in 2013)

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Why Set Fair Value @ Exit Price?

More objective if well-working market exists
Tier 1: Market Price of identical assets/liabilities
Tier 2: Market price of the similar items

If well-working market does not exist

Tier 3 fair value will be used;
Tier 3: Present value of future cash flows of the item, or
any other best available information about how a
market participant holding the item would value the
item

In such case, why not value-in-use (VIU)?

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Why Set Fair Value @ Exit Price?

If tier 3 is used, both exit price and VIU are
subject to estimation errors
However, exit price is believed to be more
reliable
Exit price (Tier 3)
PV of FCF the market would expect

Value in use
PV of FCF the entity would expect

Conditioned on adequate disclosures

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Criticism to Exit Price

Exit price is a good proxy in many scenarios to
determine fair value; however
Exit price may not be representative in all scenarios.
For example
Auction sale
Exit price is the next best bid

New car bought yesterday

Concern on reliability
Recent study suggests that relevance of exit price outweigh
concerns on reliability (Song, Thomas and Yi, 2010)

7.2.2 Current values and income

statement
Revenue is recognized as change in asset value
Value-in-use
- Asset value changes with present value changes

Fair value
- Asset value changes with actual asset value changes

Revenue cognition is sooner under VIU/FV than HC

- Under HC, revenue (i.e. change in asset value) is
recognized when realized
- Under VIU/FV, revenue is recognized before realized
Reduction of recognition lag in income statement
Income statement is more forward-looking, and a better
measurement of management stewardship

Recognition Lag (p.57, Ch2.5)

The extent to which the timing of revenue
recognition lags behind changes in real
economic value
Current value accounting
Little recognition lag

Historical cost accounting

Greater recognition lag

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7.3 Longstanding Examples

Discussion
In the measurement of each item below
a. Discuss if current value is applied
b.If yes, which current value (VIU or FV) is used
1.
2.
3.
4.
5.

Accounts receivable (and payable)

Inventory
PP&E
Long-term debt
Finance lease
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A/R & Inventory

Accounts receivable and payable
Initially measured at the amount to be collected or paid
Approximates VIU if time is short

On B/S date, adjusted for estimated uncollectible

amount
Approximates VIU if time is short

Inventories
B/S date: at the lower-of-cost-or-market (LCM)
What is the market value?
Exit price less cost to sell (i.e. NRV)
LCM is an example of conservatism, also a partial
application of current value accounting

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Property, Plant &Equipment (PP&E)

Two options on B/S date
Revaluation model vs. cost model
IASB: firms can choose either option
FASB: only cost model is allowed

Revaluation model
PPE valued at fair value (must pass reliability check)

Cost model
PPE valued at cost (i.e. book value), adjusted for
impairment
A partial application of current value accounting
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Cash Flows Fixed By Contract

Long-term debt
Valued at present value of future interest and principal
payments, discounted at effective interest rate (i.e.
value in use, also called amortized cost)

Finance lease
Initially valued at the lower of VIU or FV (IAS 17)
B/S date valuation is similar to PP&E

Both are examples of cash flows fixed by

contract

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7.47.10 Financial Instruments

A contract that creates a financial asset of
one firm and a financial liability or equity
instrument of another firm
Primary financial instruments (7.5)
7.5.1 Fair value accounting in 2007-2008 crisis
7.5.2 Current value use in IFRS 9 Financial
Instruments
7.5.3 The fair value option
7.5.4. Loan loss provisioning optional

Related issues (7.6-7.8)* Slides only

Derivative financial instruments (7.9) - optional
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Primary Financial Instruments

Cash
All receivables/payables
All passive investments/liabilities
Equity passive investment
In contrast to equity strategic investment
Measured at FV/NI or FV/OCI

Debt investment
Note all debt investments are passive
investments
Measured at FV/NI, FV/OCI or VIU
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7.5.1 FVA in 2007-2008 Crisis

(self-read)
Use of fair value assumes market works
well. Why?
Only if market works well, exit price can be
determined

What if the market does not work well?

E.g. 2007-2008 market crisis
IASB/FASB revised standards to relax
requirements on FV
More in 7.6
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7.5.2 IFRS 9 Financial instruments

Published in July 2014, effective on Jan 1, 2018

Applies to all types of passive financial instruments
Note FASB went to another direction (i.e. HFT/AFS/HTM)
At acquisition
Financial instruments recorded at FV

After acquisition
Most financial assets valued at FV, with unrealized G/L
included in OCI or NI
Some are valued at amortized cost (i.e. VIU), if two conditions
are met: (1) cash flows fixed by contract, AND (2) business
model (see next slide)

Most financial liabilities valued at amortized cost (VIU)

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Concept of Business Model in IFRS 9

VIU (amortized cost) should be used
Only if when the firms business model (instead
of managers intention) is hold-to-maturity (HTM)
Purpose is to control management ability to
change intended use
Managers may wish to switch from FV to VIU, for
earnings management purpose

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7.5.3 The Fair Value Option

On B/S date,
When VIU (amortized cost) should be used to
account for financial instrument
IFRS 9 grants firm an option to choose FV instead
IF such choice reduces mismatch

The choice must be made at acquisition, not on

B/S date, and the decision is irrevocable
The purpose is to reduce a mismatch
Problem of mismatch (see next slide)

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The problem of mismatch

Mismatch occurs
When some assets/liabilities are fair-valued but
related liabilities/assets are not
Cannot accomplish natural hedge

To overcome mismatch problem

Allow firms to choose fair value on both sides
i.e. Fair value option

Allow some financial assets being valued at VIU

Allow some unrealized G/L being included in OCI

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7.6&7.7 FV vs. HC & Liquidity

Pricing* (Slide Only)
Huge fair value write-downs during financial crisis
When market is down, firms face higher risk of liquidity
pricing (i.e. liquidity risk)
Liquidity pricing drives market value (FV) below VIU
Managers and politician argue HCA is better than FVA in
such case

Standard setters
Back down to allow firms to use VIU when market is
inactive (subject to ceiling test)
But insist that managers and politicians may have
overstated the negative effects of FV liquidity risk
Given mixed results from academic studies
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7.8 De-recognition and

Consolidation* (Slide Only)
Abuses of loopholes contribute to 2007-2008 crisis
e.g. Off-B/S financing

Standard setters responded by issuing new

standards
Point of de-recognition?
No de-recognition is control retained

Scope of consolidation? how to decide control

Control exists when one firm has power over another and bears
risk of return on its investment (no longer 50% plus 1 share rule)

Require more disclosures

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7.11 Accounting for Intangibles

Non-goodwill intangibles
Valued at carrying cost, adjusted for impairment
Similar to accounting for PP&E

Goodwill
Purchased goodwill
Accounted for at cost; no amortization
Subject to ceiling test (i.e. impairment test)

Self-developed goodwill, e.g., from R&D

Hard to reliably determine fair value
Costs written off as incurred
Result in recognition lag: goodwill value shows up on
income statement when the product is actually sold
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Recognition Lag Revisit

Responsible for low ability of net income to
explain stock returns (Lev & Zarowin,1999)
Accounting for intangibles is inadequate

Does clean surplus theory provide a way to

estimate unrecorded goodwill?
Yes, but subject to reliability

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Conclusions
Examples discussed in this chapter represent only
a partial list of current-value-based
measurements in existing GAAP
They show a considerable amount of currentvalue-based measurements in the mixed
measurement model
Some current value measurements are one-sided
Standard setters continue to favor current value
measurements in financial statements
Accountants are recognizing an increased
obligation to measure and report on firm risk
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