#20: present value & fair value

Question 0

Present Value and Annuities: Present Value and Future Value of $1

Answer 0

Present value of $1 – the amount that must be invested now at a specific interest rate so that one dollar can be paid or received in the future

The future value of $1 – the amount that would accumulate at a future point in time if one dollar were invested now

Question 1

Present Values and Annuities: Important Applications

Answer 1

1. Leases,
2. Pensions
3. Bonds
4. Long-term Debt

Question 2

Present Value and Annuities: Annuities Defined

Answer 2

Ordinary Annuity (Annuity in arrears) = Payments made at the end of each period
– Number of interest periods = number of payments

Annuity due (Annuity in advance) = Payments made at the beginning of the period
– Number of interest periods = number of payments – 1

Question 3

Present Value and Annuities: Present Value and Future Value of an Ordinary Annuity

Answer 3

Present value of an ordinary annuity – the current worth of a series of identical periodic payments to be made in the future

Future value of an ordinary annuity – the sum, to be received at some point in the future, of identical periodic payments from the present until that future point

Question 4

Present Value and Annuities: Present Value and Future Value of an Annuity Due

Answer 4

The only difference in the calculations of an annuity due and an ordinary annuity is the timing of payments.

Therefore,
PV of $1 annuity due for n + 1 periods at x%
= $1 + PV of ordinary annuity for n periods at x%

E.g. if PV of $1 ordinary annuity at 6% for 2 periods = 1.833, the PV of $1 annuity due at 6% for 3 periods = 1.833 + 1 = 2.833

Also,
FV of $1 annuity due for n + 1 periods at y%
= (1 + y%) x FV of $1 ordinary annuity for n periods

Question 5

Fair Value Measurements

Answer 5

Standard definition of fair value and framework for its measurements established by US GAAP and IFRS except for the following items
– Share-based compensation
– Vendor-specific objective evidence of fair value
– Lease classification or measurement

Question 6

Fair Value Measurement –Fair Value Defined

Answer 6

Fair value = price that would be received to sell an asset or paid to transfer a liability in an an ORDERLY TRANSACTION between market participants in the PRINCIPAL (or MOST ADVANTAGEOUS) market at the measurement date under current market conditions

Question 7

Fair Value Measurement –Fair Value Defined, cont.

Answer 7

1. Fair value is measured for specific assets liabilities , or the entity’s owns equity instrument
2. Fair value is a market-based measure
3. Fair value is measured in the principal market, or the most advantageous market
4. Fair value is an exit price (price to sell an asset to transfer a liability) not an entry price (price to azure an asset or or assume a liability)
5. Fair value reflects all assumptions used in pricing the asset or liability, including assumptions about risk
6. Fair value does not include transactions costs. May include transportation costs if location is an attribute of the asset or liability
7. Fair value of non financial asset assumes highest and best use of asset
8. Fair value of liability should include liability’s nonperformance risk
9. Fair value of entity’s own equity instrument should be measured from the perspective of a market participant
10. Fair value assumes that the liability or equity instrument is transferred to the market participant on the measurement date and continues to remain outstanding on that date.

Question 8

Fair Value Measurement –Fair Value Defined: Market participants

Answer 8

Market participants = independent buyers and sellers, knowledgeable about the asset or liability, willing and able to transact for the asset or liability

Question 9

Fair Value Measurement –Fair Value Defined: Orderly Transaction

Answer 9

Orderly Transaction = asset or liability is exposed to market for period before measurement date that is long enough to allow marketing activities that are usual and customary for transactions involving such assets and liabilities

Question 10

Fair Value Measurement –Fair Value Defined: Best and Highest Use

Answer 10

Fair value of non financial asset assumes highest and best use of asset

A reporting entity’s current use of a non financial asset is presumed to be its highest and best use unless market or other factors suggest otherwise

Highest and best use concept does not apply to liabilities and financial assets

Question 11

Fair Value Measurement –Fair Value Defined: Principal and Most Advantageous Market

Answer 11

Principal market = market with greatest volume or activity for the asset or liabilities

If there is a principal market, the price in that market will be the fair value, even if there is amore advantageous price in a different market

Most Advantageous market = market with the best price for the asset or liability, after considering transaction costs
–Price in this market is used only if there is not principal market

Question 12

Fair Value Measurement –Framework

Answer 12

Fair Value Measurement Framework:

1. Valuation Techniques
2. Hierarchy of inputs into the valuation techniques

Question 13

Fair Value Measurement –Framework: Hierarchy of Inputs ››› Level 1

Answer 13

Level 1 = highest priority
– Most reliable measures of fair value

Includes:
– quoted prices in active markets for identical assets or liabilities
– quoted prices for identical liabilities when traded as assets if no adjustments to the quoted market prices of the assets are required

Question 14

Fair Value Measurement –Framework: Hierarchy of Inputs ››› Level 2

Answer 14

Level 2 = Inputs other than quoted market prices that are directly of indirectly observable for the asset or liability

Includes
– quoted prices for similar assets or liabilities in active markets
– quoted prices for identical or similar assets in markets that are not active
– quoted prices for identical liabilities when traded as assets, if adjustments to the quoted market prices of the assets are required
– quoted prices for similar liabilities when traded as assets
– inputs other than quoted prices that are observable of the asset or liability
– inputs derived from or corroborated by observable market data

Question 15

Fair Value Measurement –Framework: Hierarchy of Inputs ››› Level 3

Answer 15

Level 3 = lowest priority
–Least reliable measure of fair value

Level 3 = unobservable inputs for the asset or liability i.e. they reflect reporting entity’s assumptions
– Base on the best available information

Use Level 3 inputs only when there are no Level 1 or 2 inputs, or if cost/benefit not there for Level 1 or 2 inputs.

Question 16

Fair Value Measurement –Framework: Valuation Techniques

Answer 16

1. Market approach
   – Uses prices and other information from market transactions involving identical or comparable assets or liabilities
2. Income approach
   – Converts future amounts, including cash flows or earnings, to a single discounted amount to measure fair value of assets or liabilities
3. Cost approach
   – Uses current replacement cost to measure fair value of assets
   – Not applicable to liabilities

A change in valuation technique or its application is accounted for as a change in accounting estimate
– Accounted for prospectively