areaIII E. Fair value measurement Flashcards
Fair value is 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. The valuation techniques broadly fall into three categories: Market Approach, Cost Approach, and Income Approach
The Market Approach uses
prices and other relevant information
generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities.
Key Points
● Comparable: Look at prices from actual market transactions or market data (e.g., selling prices of similar assets).
● Adjustments: May require adjustments for differences in condition, location, or terms.
Example
Stock prices listed on a major stock exchange
Relies on the ‘principle of substitution’, implying that a market participant would not pay more for an asset than the cost to acquire a substitute asset of comparable
utility.
The Cost Approach is based on
the amount that would be required to replace the service capacity of an asset (replacement cost).
Key Points
● Current Replacement Cost: Estimate the cost to acquire or construct a substitute asset with similar utility.
● Depreciation and Obsolescence: Deduct for physical deterioration, functional obsolescence, and economic obsolescence.
Example
Estimating the fair value of a piece of machinery by calculating the current cost to acquire a similar new machine and then
subtracting depreciation.
Reflects the amount a market participant would pay to acquire or construct a substitute asset of comparable utility, adjusting for obsolescence and physical deterioration
The Income Approach converts
future amounts (e.g., cash flows or earnings) to a single present (discounted) amount.
Key Points
● Discount Rate: Use a rate that reflects the risk associated with the cash flows.
● Projection of Future Cash Flows: Estimate the future economic benefits associated with the asset.
Example
Valuing a bond based on the present value of its future interest payments and redemption value, discounted at the market rate of interest
Suitable for valuing assets that generate predictable cash flows. The discount rate reflects current market conditions and the specific risks of the asset
Key Assumptions in Fair Value Measurement
● Highest and Best Use:
● Market Participant Assumptions:
● Unit of Account:
Key Assumptions in Fair Value Measurement
● Highest and Best Use:
○ Refers to the use of an asset that maximizes its potential and is physically possible, legally permissible, and financially feasible.
○ This concept applies primarily to non-financial assets.
● Market Participant Assumptions:
○ Assumes that fair value is determined based on the perspective of market participants, not the specific entity.
○ Considers characteristics that market participants would value in a transaction.
● Unit of Account:
○ Refers to the level at which an asset or liability is aggregated or disaggregated for recognition and measurement.
○ Determines how assets and liabilities are grouped or separated in a fair value measurement
The fair value hierarchy categorizes the inputs used in valuation techniques into three broad levels:
Level 1: Observable Inputs
Level 2: Observable Inputs (Other than Level 1)
Level 3: Unobservable Inputs
Level 1: Observable Inputs:
● Definition: Quoted prices for identical assets or liabilities in active markets.
● Example: A publicly traded stock with a quoted market price on the New York Stock Exchange.
● Journal Entry (for purchasing a stock):
(Debit) Investment in Stock XX
(Credit) Cash XX
Level 2: Observable Inputs (Other than Level 1):
● Definition: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.
● Example: A corporate bond not actively traded, but its price can be derived from observable market data like interest
rates and yield curves.
● Journal Entry (for purchasing a bond)
(Debit) Investment in Bonds (at derived
price) XX
(Credit) Cash XX
Level 3: Unobservable Inputs:
● Definition: Unobservable inputs for the asset or liability, reflecting the entity’s own assumptions about market
participant assumptions.
● Example: A privately-held company’s stock or a custom-built machine with no active market. Valuation might be based on
discounted cash flows or earnings multiples.
● Journal Entry (for recording an asset valued with DCF):
(Credit) Asset (at DCF value) XX
(Debit) Cash or Payable (depending on the
purchase) XX
FAR3C10016
When a not-for-profit entity receives a multi-year unconditional promise to give, how should the present value of the promise be recorded?
A. At the full value of the promised amount
B. At the present value of the future cash flows
C. As a deferred revenue over the period of the promise
D. At the fair value of the assets promised
B. At the present value of the future cash flows
A multi-year unconditional promise to give is recorded at the present value of the future cash flows expected to be received.
FAR2B10023
What additional information is needed to prepare a rollforward if the company uses the direct write-off method for bad debts?
A) The total amount of sales returns
B) The amount of receivables written off during the period
C) The change in allowance for doubtful accounts
D) The interest rate applied to overdue receivables
B) The amount of receivables written off during the period
Under the direct write-off method, actual bad debts written off are directly deducted from the receivables balance. Information about the allowance for doubtful accounts or interest on receivables is not relevant for this method.
FAR1B20016
When preparing a statement of activities, how should ‘Endowment Contributions’ be recorded if they are permanently restricted?
A) As an expense
B) As unrestricted revenue
C) As temporarily restricted revenue
D) As permanently restricted revenue
D) As permanently restricted revenue
‘Endowment Contributions’ that are permanently restricted should be recorded as permanently restricted revenue, reflecting the donor’s restrictions on the funds.
FAR1A60003
In the context of consolidated financial statements, the ‘minority interest’ refers to:
A. The portion of the profits belonging to the parent company
B. The portion of the subsidiary’s equity not owned by the parent company
C. The interest expenses of the subsidiary
D. The portion of the parent company’s equity owned by external investors
B. The portion of the subsidiary’s equity not owned by the parent company
‘Minority interest’ (or non-controlling interest) refers to the share of equity in a subsidiary that is not owned by the parent company. This represents the interests of minority shareholders in the subsidiary’s net assets and must be presented separately in consolidated financial statements.
A is incorrect as it refers to the parent company’s share, not the minority interest.
C is incorrect because minority interest is about equity, not debt.
D is incorrect as it pertains to the parent company’s equity, not the subsidiary’s.
FAR2E10010
For which type of investment is fair value accounting most likely not applicable?
A) Short-term investments in treasury bills.
B) Investments in private equity funds.
C) Long-term holdings of preferred shares.
D) Investment in a joint venture under joint control.
D) Investment in a joint venture under joint control.
Investments in joint ventures under joint control are usually accounted for using the equity method or proportionate consolidation, not at fair value.
FAR3C10014
How should a not-for-profit entity classify an unconditional promise to give that is expected to be collected in more than one year?
A. As a current asset
B. As a long-term liability
C. As a deferred revenue
D. As a long-term receivable
D. As a long-term receivable
An unconditional promise to give expected to be collected in more than one year is classified as a long-term receivable in the entity’s financial statements.
FAR3F10005
How does a significant residual value guarantee affect a lessee’s lease liability?
A. Increases the lease liability.
B. No effect on lease liability.
C. Reduces the lease liability.
D. Recognized as a separate asset.
A. Increases the lease liability.
A significant residual value guarantee increases the lease liability, as it represents an additional obligation of the lessee at the end of the lease term.
FAR3C10058
If a not-for-profit entity receives construction services for free, which are normally capitalized, how should it record the contribution?
A. Debit Building (Asset); Credit Contributed Services Revenue
B. Debit Contributed Services Revenue; Credit Building (Asset)
C. Debit Expense; Credit Contributed Services Revenue
D. Debit Cash; Credit Contributed Services Revenue
A. Debit Building (Asset); Credit Contributed Services Revenue
Free construction services that are normally capitalized are recorded as Debit Building (or a similar asset account) and Credit Contributed Services Revenue, reflecting the increase in asset value due to the donated service.
FAR2B10029
If a company uses the aging method for its allowance for doubtful accounts, how would this impact its rollforward analysis of trade receivables?
A) It increases the trade receivables balance
B) It decreases the trade receivables balance
C) It is included as a separate line item in the rollforward
D) It has no direct impact on the trade receivables rollforward
D) It has no direct impact on the trade receivables rollforward
The aging method affects the allowance for doubtful accounts and the net realizable value of receivables but does not directly change the gross trade receivables balance in a rollforward analysis.
