Chapter 7 - measurement applications

Question 1

What is the concept of Business model in IFRS 9

Answer 1

• May value certain financial assets at value in use if firm’s business model is to hold the assets to generate future cash flows from interest and principal
• Restricts management ability to change intended use.

Question 2

What is fairvalue?

Answer 2

Exit price (opportunity cost): ideally market value but market incompleteness complicates this.

Question 3

Describe the fairvalue hierarchy

Answer 3

Level 1: reasonably well working market exists
Level 2: price inferred from market price similar items
Level 3: estimate how much prospective buyer would pay
–> reliability decreases as move from level 1 to 3

Question 4

What does exit price measure?

Answer 4

the opportunity cost of retaining asset/liability in firm

Question 5

What is exposure draft?

Answer 5

expanded supplementary disclosures so outside parties can see how fair value has been arrived at

Question 6

Name some longstanding measurement examples

Answer 6

1) Accounts receivable and payable approximates value in use if time is short (Discount factor is negligible).
2) Amortized cost: present value using effective interest rate (i.e. long-term debt)
3) Lower of cost or market rule: Inventory may be written up but not above cost (represents conservatism and a partial application of current value accounting)
4) PP&E: option to value at fair value if can be done reliably (FV must be kept to date. not avail under FASB)
5) Ceiling test: value at recoverable amount if less than book value (protect auditor against liab)
6) Post-employment benefits: valued at present value.

Question 7

What’s recoverable amount?

Answer 7

The greater of 1) FV less costs to sell and 2) value in use/

Question 8

Can impairment losses be reversed?

Answer 8

Yes but not above original BV.

Question 9

What’s a financial instrument

Answer 9

A contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm

Question 10

Why FV financial statements?

Answer 10

1) increase usefulness (relevance)
2) many financial instruments traded on well-working markets (reasonably reliable)
3) control gains trading

Question 11

IAS 39 (Assets)

Answer 11

Applies to debt and equity
4 financial asset categories:
1) AFS: Fair valued, fains/losses in OCI (transferred to NI on disposition)
2) Loans & Reeivables (no active market values): Valued at cost, subject to impairment test (written down, impairment loss in NI). May be written up again to Book value of fairvalue rises
3) HTM: Valued similar to loans and receivables.
4) Trading (and derivatives no held for hedging): fair valued, gain/losses in net income.

Question 12

ASC 325-10

Answer 12

IN US. No reversal of writedown.

Question 13

IAS 39 (liabilities)

Answer 13

1) trading: valued at fair value

2) Other: Valued at cost or amortized cost. (Bond outstanding or demand deposits)

Question 14

What happens if firm sells/reclassifies HTM seurities?

Answer 14

The use of HTM category prohibited for 2 years.

Question 15

Why not simply value all Financial instruments at fair value?

Answer 15

Reliability: Demand deposits difficult to value due to core deposit intangibles.

• No market value may be available (some are thinly traded or not traded at all)
• hard to reliably estimate timing of withdrawals

Question 16

Core deposit intangible

Answer 16

arises form customers’ acceptance of lower than market rate of interest due to goodwill, habits, and etc.

Question 17

What’s the major problem with mixed measurement model (some financial instruments FVed and some not)?

Answer 17

mismatch may lead to the problem of excess financial statement volatility. financial statement volatility may exceed real volatility.

Question 18

How can the excess volatility from a mixed measurement model be controlled?

Answer 18

1) fair value option (choose to fair value long term debt to match)
2) include some unrealized gains/losses in OCI
3) some financial items (loans & receivables and HTM) can be valued at cost (subject to ceiling test)

Question 19

Should a firm’s long-term debt be revalued following a credit downgrade, thereby reporting a gain?

Answer 19

credit downgrade means that the FV of the firm’s debt falls.
-if firm debt is downgraded, some firm assets must have declined in value. These assets may be valued at cost or not valued at all: then recording a gain creates mismatch.

This also represents a wealth transfer: shareholders gain because of lower value of firm debt but debtholder lose because of higher risk.

Question 20

Why did the 2007/2008 market meltdowns generate serious complaints about fair value accounting?

Answer 20

1) Banks had to writedown longterm assets to liquidity price and volated legal capital requirement. In this situation, historical costing is socially preferred since it avoids financial contagion.
2) if value in use is low (bad economic condition), historical cost preferred, if high, fair value preferred by shareholders.

Question 21

Describe IFRS 9

Answer 21

replaced IAS 39

1) Financial assets are recorded at FV on acquisition.
2) Subsequent valuation on amortized cost if objective is to hold asset (business model)
3) Proposed new standards for Derecognition, consolidation and increased disclosure

Question 22

Derecognition (IFRS 9)

Answer 22

(of assets or liabilities form balance sheet). i.e. if Accounts receivables were securitized and sold to off balance sheet entities.
–> Allowed to derecognize if transferring firm retains NO future benefit OR obligation.

Question 23

Consolidation (IFRS 9)

Answer 23

Power and risk ( consolidate if owns shares and shares entity's profit and loss) 
Regard SPEs (little equity capital and formed for special purpose) as consistent with CONTROL.

Question 24

Derivative

Answer 24

A contract whose value depends on some underlying. May not require initial cash outlay and is generally settled in cash.

• -> little or no cost means that all or part of contract is off balance sheet (require supplemental disclosure.
• -> A lot of protection or speculation can be acquired with little cost.

Question 25

How are derivatives recorded?

Answer 25

IAS 39 require derivatives to be valued at fair value. Unrealized gains and losses included in net income except for hedging contracts.

Question 26

Fair value hedges

Answer 26

acquiring a hedging instrument whose value moves in the opposite direction of the hedged risky asset.
Gains and losses on instrument are included in net income. (if more than 1 year, write down inventory and recognize gain on hedge)

Question 27

Cash flow hedges

Answer 27

Used to anticipate transactions (i.e reduce risk arising form price changes of the firms future production)
Gains and losses on hedging instrument included in OCI until future transaction affects net income.

Question 28

what is basis risk

Answer 28

risk resulting from the absence of a perfectly effectively hedge.,

Question 29

An instrument must meet certain criteria to be eligible for hedge accounting. Describe these

Answer 29

Non-derivative instruments are generally prohibited from being eligible.
For instruments that are eligible, managers must designate the instrument as a hedge at the inception of the hedge, identify the hedged item, and document the nature of the risk being hedged. reported net income would lose reliability if managers can change the purpose of hedge instruments. Hedge must also be highly effective (negative correlation with hedged item)

Question 30

Benefits of hedge accounting

Answer 30

reduce earnings volatility by:

1) offset gains/losses by fair valuing hedged item (fair value hedge)
2) delay gain/loss recognition by including OCI until realized (CF hedge)
3) Hedging may avoid the ceiling test

Question 31

How to account for purchased intangibles?

Answer 31

Good will is diference between net amount of fair value and purchase price.
Good will is accounted for at cost. No amortization unless there is evidence of impairment. Subject to ceiling tests and can lead to large write offs

Question 32

how to account for self-developed intagibles. (R&D)

Answer 32

expensed as incurred because it is hard to reliably determine fair value. Good will shows up over time as abnormal earnings (recognition lag).
Costs of developing a produvct or process resulting from research may be capitalized if results of the research are technically/commercially feasible and costs can be measured reliably.

Question 33

what is R&D recognition lag responsible for?

Answer 33

low ability of net income to explain stock returns. Efficient market will not penalize firm for increase in R&D. maybe even reward it with higher share price.

Question 34

How to improve usefulness of earnings with regards to intagibles?

Answer 34

capitalize successful intangibles after a trigger point is obtained (project passes feasibility test)

• amortize over useful life
• creates a problem of low reliability.

Question 35

how does lack of complete reliability mitigate risk that management will overinvest

Answer 35

estimation risk causes investors not to bid up share price in response to reported R&D as much. management incentive to overinvest is reduce.

Question 36

2 ways to manage risk/

Answer 36

natural hedging (match assets and liab) and hedging with derivatives

Question 37

reasons for managing firm specific risk even though investors can diversify it away.

Answer 37

1) reduce investor estimation risk (adverse selection)
2) cash availability for planned capiital expenditures
3) control speculation (full disclosure of risk management strategies)
4) reduce likelihood of major losses leading to lawsuits
5) reduce volatility of management compensation if tied to earnings.

Question 38

what are the 2 forms of quant risk assessments performed by firm?

Answer 38

1) sensitivities analysis

2) value at risk