© 2006 Pearson Education Canada Inc.7-1 Chapter 7 Measurement Perspective Applications.
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© 2006 Pearson Education Canada Inc.
7-1
Chapter 7
Measurement Perspective Applications
© 2006 Pearson Education Canada Inc.
7-2
Measurement Perspective Examples
• Accounts Receivable and Payable
• Capital Leases• Lower-of-Cost-or-Market Rule
– Inventories– Temporary investments– N.B. No subsequent writeup if
market value improves—partial application
© 2006 Pearson Education Canada Inc.
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Examples, Cont’d.• Ceiling Tests
– 2-stage procedure• Impaired?• If so, write down to fair value
– No subsequent writeup if asset value improves—partial application
• Post-Employment Benefits– Expected present value of benefits
earned– Expense reduced by earnings on plan
assets– Reliability of estimates?
• Choice of discount rate
© 2006 Pearson Education Canada Inc.
7-4
Examples, Cont’d.
• Impaired Loans– Write down to estimated
realizable value•Discounted at interest rate implicit
in the loan transaction
– An extension of measurement perspective, since may write loan value up if its fair value improves
© 2006 Pearson Education Canada Inc.
7-5
Financial Instruments
© 2006 Pearson Education Canada Inc.
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Definition
• A Financial Instrument is– A contract…– Cash, or a contractual right to
receive/deliver cash or another financial instrument…
• Note Broad Definition– Cash, receivables, payables,
marketable securities,...
© 2006 Pearson Education Canada Inc.
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SFAS 115 (and Section 3855, CICA Handbook)
• Applies to Debt & Equity Securities– Classified at acquisition into
one of 3 categories•Held-to-maturity
– Valued on cost basis
•Trading– Valued at fair value
•Available-for-sale– Valued at fair value
© 2006 Pearson Education Canada Inc.
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SFAS 115 (and Section 3855, CICA Handbook), Cont’d.
• Why the 3 Categories?– Core deposit intangibles
• Inability to value reliably precludes including financial liabilities in scope of SFAS 115 (Section 3855 includes some)
– Gains trading• Fair value accounting makes gains trading more
difficult for trading and available-for-sale securities • Elaborate precautions to prevent gains trading for
held-to-maturity securities
– Earnings volatility • Reduced by including unrealized gains on available-
for-sale securities in other comprehensive income (OCI)
© 2006 Pearson Education Canada Inc.
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Derivative Financial Instruments
• Definition of Financial Instruments Includes Derivatives
• Definition of Derivatives– A contract, the value of which
depends on some underlying…– May not require an initial cash outlay– Generally settled in cash, not in kind
© 2006 Pearson Education Canada Inc.
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SFAS 133 (and Section 3865, CICA Handbook)
• Fair Value Hedges– Gains and losses on the hedging
instrument included in net income•Fair valuing the hedged item may offset
• Cash Flow Hedges– Gains and losses on the hedging
instrument included in OCI, until the future transaction affects net income
© 2006 Pearson Education Canada Inc.
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SFAS 133 (and Section 3865, CICA Handbook),
cont’d.• Benefits of Hedge Accounting
– Reduces earnings volatility•Offset gains/losses by fair valuing
hedged item (fair value hedge)•Delay gain/loss recognition by
including in OCI until realized•Hedging may avoid the ceiling test
© 2006 Pearson Education Canada Inc.
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SFAS 133 (and Section 3865, CICA Handbook), cont’d.
• To Obtain Benefits of Hedge Accounting– Hedges Must Qualify
•Must be highly effective– Negative correlation with hedged item
– Hedges Must be Designated•Requires elaborate procedure and
documentation
© 2006 Pearson Education Canada Inc.
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Accounting for Intangibles
• Purchased Intangibles– Goodwill arising from an acquisition
• Accounted for at cost• No amortization• Subject to ceiling test
– Can lead to major writedowns, e.g., JDS Uniphase, 2001 Annual Report. See Problem 9.7
– Management devices to work around goodwill and related writedowns
• “Pro-forma income,” e.g., TD Bank, 2000 Annual Report. See practice and theory vignette, Section 7.4.2
© 2006 Pearson Education Canada Inc.
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Accounting for Intangibles, Cont’d
• Self-Developed Intangibles– Self-developed goodwill, e.g., from
R&D•Hard to reliably determine fair value•Costs written off as incurred
– Recognition lag: goodwill value shows up over time on income statement
•Recognition lag responsible for low ability of net income to explain stock returns?
– Lev & Zarowin (1999) argue yes
© 2006 Pearson Education Canada Inc.
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Lev & Zarowin, “The Boundaries of Financial
Reporting…”• Their Study Documents a
Decreasing Usefulness Earnings Information– Usefulness evaluated by ability of
earnings to explain abnormal share return• Low R2
– And falling?
• Low ERCs• Especially for research-intensive firms
© 2006 Pearson Education Canada Inc.
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Lev & Zarowin, Cont’d
• Conclusion– Accounting for intangibles is
inadequate
© 2006 Pearson Education Canada Inc.
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Lev & Zarowin, Cont’d
• Suggestion to Improve Usefulness– Capitalize successful intangibles
after a “trigger point” is attained•Amortize over useful life•Like SE in oil and gas accounting•Amounts capitalized and amortized may
reveal inside information, since it is management that has best knowledge of R&D value
© 2006 Pearson Education Canada Inc.
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Risk Management
• Risk Controlled by Natural Hedging + Hedging with Derivatives
• Hedging v. Speculation– A fine line separates the two
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Reporting on risk
• Beta Risk– Relevant to rational, diversified investor– Accounting variables correlated with beta
• Beaver, Kettler, and Scholes (1970)
• Reasons Why Other Risks Also Relevant– Investors may not act according to rational
decision theory model– Risk information may reduce estimation
risk– Risk reporting may control speculation
© 2006 Pearson Education Canada Inc.
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A Measurement Perspective on Risk
Reporting• Narrative, in MD&A
– Canadian Tire Corp. Text, Section 4.8.2
• Sensitivities Analysis– Suncor Energy Inc., 2003 Annual
Report
• Value at Risk– Microsoft Corp., 2004 Annual
Report
© 2006 Pearson Education Canada Inc.
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Sensitivities Analysis, Suncor Energy Inc.
• 2003 Annual Report– See Table 7.2– Problems of sensitivities
analysis•Net of Hedging?•Linearity Assumption - Relevant
Range•Co-movements (i.e., correlations)
in prices
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Value at Risk, Microsoft Corp.
• 2004 Annual Report– Discloses a 97.5% probability that
a loss in fair value over a 20-day period will not exceed the following amounts (net of hedging):• Interest rate risk: $298 (million)•Currency rate risk: $207•Equity price risk: $773•Total risk: $835
– Correlation of price risks•Note the 3 specific risks do not add to
total
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