CHAPTER 18 Accounting values and reporting. Contents Accounting values Measurement focus ...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 18Accounting values and reporting


Contents Accounting values Measurement focus Expanding the boundaries of the

accounting model Fair value measurement The IASB’s mixed-attribute model Comprehensive income Efficient market hypothesis


Accounting values Different value perspectives

1) Entry value2) Exit value3) Value in use

Entry and exit values are market values Market buying price and market selling

price of an item Value in use is an entity-specific value

Specific to the company that uses the item Incorporates management intentions


Value in use

Value in use is the incremental firm value from continuing use of the item Estimate the future net cash flows

expected to arise from the continuing use and ultimate disposal of the item and discount these to present value

More subjective and unique to the item


Values in the accounting model

Entry values are basic to the historical cost model (initial measurement) Replacement cost as a (potential) revised

entry cost for subsequent measurement Exit values are used both as a control

and as a measurement base for subsequent measurement Net realizable value Fair value remeasurement


Values in the accounting model (cont.)

Value in use is used as a control measure only Threshold value to arrive at an

estimate of the recoverable amount of an asset

IAS 36 Impairment of Assets


Deprival value

Deprival value rests on a comparison of a current entry value (replacement cost) and the recoverable amount

Value to the business - what the loss to the business would be if it were obliged to forfeit the asset in question


Fig. 18.1 Deprival value

= lower of

Replacement cost

Higher of Net realizable value or

Value in use

Deprival value


Measurement focus

The income statement articulates with the balance sheet: the values in both statements are not derived independently of each other

Balance sheet focus: measure balance sheet values independently on different dates and the changes will determine profit or loss of the intervening period


Measurement focus (cont.)

Income statement focus: measure income with the balance sheet representing unabsorbed costs (assets) and anticipated expenditure (current liabilities) and financing

The IASB’s view tends to a mixed focus


Expanding the boundaries of the accounting model

Standard setters tend to give more emphasis on representing the current economic status of the company’s assets and liabilities in addition to its completed transactions

Drive towards earlier recognition of (changes in) assets and liabilities than takes place under the completed transaction approach

General issue of recognising changes in economic value


Executory contracts Executory contracts are binding contracts

where the company has entered into an agreement but fulfilment of the terms has not been completed

Steps to bring executory contracts within the boundaries of the financial accounting model Treatment of onerous contracts (IAS 37) Recognising assets and liabilities from executory

contracts that are financial instruments (IAS 39)


Fair value measurement

Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction

Fair value has been introduced in IFRS as A means of putting a value on an incomplete

transaction A measurement attribute for subsequent

measurement in a number of significant standards


Fair value measurement

Fair value is a market-based measurement and as such not affected by factors specific to a particular company

If available, an observable market price in an active market is the best evidence of fair value

But what if a) there is more than one market price, b) the market is illiquid, c) there are no recent prices, and d) there is no market for the specific item to be measured ?


Fair value measurement hierarchy

Need for a formal hierarchy which recognizes different market circumstances in how a fair value is derived

Bottom layer = fair value entirely derived using a model and company data with no market inputs

Reliability concerns


The IASB’s mixed-attribute model

In IFRS, fair value accounting has come to complement historical cost accounting in several domains

Main fair value requirements: IFRS 3 Business Combinations IAS 36 Impairment of Assets IAS 37 Provisions, Contingent Liabilities and

Contingent Assets IAS 39 Financial Instruments: Recognition and

Measurement IAS 40 Investment Property IAS 41 Agriculture


Financial instruments

Financial instruments include cash, receivables, payables, equity and debt instruments as well as derivatives and some commodity contracts

IAS 39 Financial Instruments: Recognition and Measurement establishes principles for recognizing and measuring financial instruments


Derivative financial instruments

Derivatives are defined as financial instruments exhibiting three characteristics:

1. Their value changes in response to a change in some market-related underlying variable

2. It requires no or relatively small initial investment

3. It is settled at a future date The potentially significant future cash flow

consequences of these risky contracts bring them within the scope of the definition of assets and liabilities with fair value as the most relevant measurement attribute


Four categories of financial instrument (IAS 39)

A financial asset or liability at fair value through profit or loss (includes financial instruments held with a view to short-term profit taking and derivatives)

Held-to-maturity investments and liabilities

Loans and receivables Available-for-sale assets


IAS 39 measurement rules The four different categories of financial

instruments (financial assets and financial liabilities) are measured and reported (treatment of fair value changes) differently after initial recognition

Fair value option: a company has the option to designate a qualified financial instrument on initial recognition as one to be measured at fair value with fair value changes in profit or loss


Fig. 18.2 IAS 39 – Measurement bases of financial assets

Measurementof

financial assets

General:Fair value

Specific:Amortised cost(historical cost)

Exception:Hedge Accounting

Held-to-maturity investments

Loans and receivables

If no reliable fair value estimate determinable


Fig. 18.3 IAS 39 – Measurement bases of financial liabilities

Measurementof

financial liabilities

General:Amortised cost(historical cost)

Specific:Fair value

Exception:Hedge Accounting

Held for trading liabilities(including

derivatives)

Those designated using

the fair value option


Hedge accounting

Hedge accounting rules apply if a financial instrument (usually a derivative) qualifys as an effective hedging instrument

Hedge accounting will try to match any gain or loss that arises due to movements in the hedged item (the result of the hedged risk) with corresponding (but opposite) movements in the hedging instrument


Fig. 18.4 IAS 39 – Accounting for changes in fair value of financial

instrumentsRemeasurement gains or losses

on financial instruments

(Changes in fair value)

Held for trading (including

derivatives)Fair value option

Available-for-sale Special treatment

Hedge Accounting

Profit or loss of period in which fair value changes occur

Directly in equity(through Statement of

Changes in Equity)

Recycling of cumulative gain or loss to profit or loss on disposal or

impairment


IAS 40 Investment property

IAS 40 covers tangible fixed assets of property which are held as an investment for the purpose of earning rental or for capital appreciation

Choice between an historical cost model and a fair value model (with changes recognized in the income statement)


IAS 41 Agriculture IAS 41 covers valuation of biological

assets and agricultural produce at the point of harvest

Required measurement at fair value less estimated point-of-sale costs from initial recognition up to the point of harvest, with changes in fair value to be include in profit or loss


Comprehensive income

Comprehensive income encompasses all recognized changes in assets and liabilities from transactions or other events except those related to transactions with shareholders in their capacity as owners


Comprehensive income (cont.)

It includes net income (as traditionally defined) and other comprehensive income

Other comprehensive income (OCI) is the result of remeasurements that are accounted for directly in equity Recycling of other comprehensive

income at transaction completion needed?


Fig. 18.5 Comprehensive income

Changes in equity

• Share issue• Dividends• Retirement of shares…

Net profit or lossOther

comprehensive income

Retained profit Reserves

Share capitalShare premium

Accumulated OCI

Transactions with shareholders

Transactions with others than

shareholders

recycling


Extended measurement of income income

Traditional transaction-based (historical cost realized)

profit

+ economic gains and losses (remeasurements)

= Comprehensive income


Efficient market hypothesis

A strongly efficient financial market is one where the price of a security compounds all public information about the security

In such a context taking the market price without research would be an efficient way to invest

Challenges the benefits of financial statement analysis

CHAPTER 18 Accounting values and reporting. Contents Accounting values Measurement focus ...

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