SOLUTION: Fair value measurement | My Assignment Tutor

1-1Welcome toFinancialAccounting andReportingWednesday 8.30am – 11.30amUBSS Sydney CBD CampusLevel 10 & 11 233 Castlereagh StreetSydney NSW20001-2Financial Accountingand ReportingFair value measurementand Choice ofaccounting methods(chapter 4 & 5)Assistant Professor Dr Nilima PaulLecture 3 Copyright ©2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –9781442561175/Henderson/Issues In Financial Accounting/16e1-3A Standard on fair value measurement In September 2011 AASB 13 Fair Value Measurement was issued AASB 13 is a new standard which provides a consistent definition of fairvalue to be applied across all other accounting standards. Prior to the introduction of AASB 13 different standards had their owndefinition of fair value. The main objectives of AASB 13 are:1. To define fair value2. To establish a framework for measuring fair value3. To require disclosures about fair value measurement1-4Definition of a fair value Prior to the release of AASB 13 the OLD definition of fair value was:“…The amount for which an asset could be exchanged, or a liabilitysettled, between knowledgeable, willing parties in an arm’s lengthtransaction.” The NEW definition of fair value in AASB 13 is as follows:“…the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants at themeasurement date.”1-5Elements in the definitionExit price The exit price is defined as:“…The price that would be received to sell an asset or paid to transfer aliability” The exit price is based on the perspective of the holder The exit price is based on expectations about future cash flows that will begenerated by the asset/liability subsequent to the sale/transfer This is the case even where the holder intends on holding theasset/liability1-6Elements in the definitionOrderly transactions Refers to transactions made under normal market conditions Excludes sales made under liquidation or “fire sale” conditions Excludes non-arms length salesMarket participants Must be independent from each other Must be knowledgeable about the asset or liability Must have the ability to enter into the transaction Must not be forced or compelled1-7Application of AASB 13AASB 13 applies to: Non-financial assets; and Liabilities and equity.Four step process in making a FV measurement:1.Determine the asset or liability that is the subject of themeasurement.2.Determine the valuation premise that is appropriate.3.Determine the principal or most advantageous market.4.Determine the appropriate valuation technique.1-81.Determine the asset or liability that is thesubject of the measurement. This step involves considering characteristics that market participantswould take into account when pricing an asset or liability. Relevant questions to consider include:● What is the location of the asset?● What is the condition of the asset?● Are there any restrictions on sale or use of the asset?● Is the asset or liability a stand-alone asset or it is a group of assets?1-92. Determine the valuation premise that isappropriate. Fair value is measured by considering the highest and best use of an asset.“…the use of a non-financial asset by market participants that would maximise the value of the asset or the group of assets andliabilities (eg a business) within which the asset would be used.” These uses must be physically possible, legally permissible and financially feasible. The highest and best use is from the perspective of the market participant, not the holder – eg land on which a factory currently standscould be used for residential housing development.In combination valuation premise FV is determined under this premise where market participants would obtain maximum benefit principally through usingthe asset in combination with other assets and liabilities as a group. The asset will be sold as an individual asset, not as a group, but the asset will be used by the market participant inconjunction with other assets.Stand-alone valuation premise FV is determined under this premise where market participants would obtain maximum benefit principally through usingthe asset on a stand-alone basis.1-103. Determine the principal or most advantageousmarket. The objective of the valuation technique selected is to estimate the price at which an orderly transactions would take place betweenmarket participants under current market conditions. Three possible valuation techniques exist:1. The market approach2. The cost approach3. The income approach Judgement is required to select the most appropriate technique for the situationInputs When applying a technique the use of observable inputs needs to be maximised and unobservable inputs minimised. Observable inputs are developed using market data, such as publicly available information. Unobservable inputs are those where market data is not available and are developed using the best informationavailable To achieve consistency and comparability AASB 13 provides a hierarchy of inputs.1-114. Determine the appropriate valuationtechnique.‘Increases in economic benefits during the accounting period in the form ofinflows or enhancements of assets or decreases of liabilities that result inincreases in equity, other than those relating to contributions from equitypartners.’ Essential characteristics according to Framework 2010:● It is a flow► That takes the form of an increase in assets or a decrease inliabilities, and► Results in an increase in equity1-12DisclosureAASB 13 requires an entity to disclose information that enables users toassess both of the following:a)for assets and liabilities that are measured at fair value on a recurring ornon-recurring basis in the statement of financial position after initialrecognition, the valuation techniques and inputs used to develop thosemeasurements.b)for recurring fair value measurements using significant unobservableinputs (Level 3), the effect of the measurements on profit or loss or othercomprehensive income for the period.1-13Chapter 5: The choice of accounting methods.Choice by accounting standard setters●Choice of accounting policy is critical because it determines accounting practice● The process of choice can be broken into four periods:1. The ad hoc period2. The conceptual framework period3. The harmonisation period4. The convergence period1-14The harmonisation period: The harmonisation period:● In mid-1990s, there was support for the ‘harmonisation’ of Australianaccounting standards with International Accounting Standards fromthree sources:1. IASC2. ASX3. ‘Big business’● Australian standard setters adopted a program to:► Revise all existing Australian accounting standards so thatcompliance with those standards automatically ensuredcompliance with International Accounting Standards1-15The convergence period: The convergence period:● In June 2002:► The FRC announced that AASB standards would be ‘converged’with IASB standards from 1 January 2005● In effect, Australia has adopted IASB accounting standards:► Essential features unchanged► Amended for consistency with local environment1-16The availability of choiceThere are three reasons statement preparers need to make choices aboutaccounting policies:1. Some aspects of financial reporting are still not covered by specificaccounting standards2. Even where there are accounting standards, they may containalternative policies3. Accountants are required to make judgements on various estimates;e.g. the useful life and residual value of depreciable non-currentassets1-17Creative accountingWhere the choice of accounting policy is made to ensure the publishedfinancial statements present the impression desired by the statementpreparers• Four ways in which accountants may be ‘creative’ in preparing andpresenting financial statements are:1. Choice of accounting policies2. Estimates or predictions of future events3. Disclosure of transactions or events4. Timing of transactions1-18Choice of accounting policies Accountants may be creative in:►Their choice of accounting policies; or►By making changes to accounting policies AASB 108 requires the disclosure of:►Accounting policies and the financial effects of changes inaccounting policies This type of creativity results in:►An inter-period allocation of amounts rather than a permanentchange in financial performance and position1-19Estimates or predictions of future eventsSome accounting policies rely on estimates or predictions of future events,e.g.:►Calculation of depreciation requiring estimates of useful lives andresidual values►Calculation of long service leave expense requiring estimates ofprobability of employees taking long service leaveThis type of creativity also involves inter-period allocation of amounts1-20Disclosure of transactions or events• Preparers of financial statements may use materiality toconceal items that the preparers prefer not to disclose• Form and content of financial statements have beenemployed to distract attention from some items andattract attention to others1-21Timing of transactionsPreparers of financial statements may change the appearance of an entity’sfinancial performance and position by the timing of transactions• Examples:• Deferral of major items of expenditure• Anticipation of income1-22Explanations for choices madeSpeculation about the reasons why particular accounting policies arepreferred in certain circumstances:● Income-smoothing motivations● Capital market motivations● Contractual motivations1-23The income-smoothing hypothesisGordon (1964) suggested that in selecting accounting policies:● Managers were concerned with maximising their own welfare whichdepended on shareholder satisfaction● Managers’ welfare increased by diminishing marginal amounts withan increase in shareholders’ satisfaction● Shareholders’ satisfaction with management increases with theaverage rate of growth and the stability of the firm’s reported profitIt follows that managers should, within accounting rules:● First, smooth reported profit● Secondly, smooth the rate of growth in profit1-24Capital markets motivationsAccounting information is used by investors and analysts to value shares:►There is an incentive for managers to manipulate profit to influencethe share priceResearch on managers’ incentives to meet earnings benchmarks hasconsidered:►Avoiding losses (reporting positive profits)►Sustaining last year’s performance►Meeting analysts’ forecasts1-25The relationship between owners and managersConflicting economic incentives may exist between the principal and agentA contract between the parties may reduce potential opportunisticbehaviour of the manager Agency costs:● Costs incurred to reduce opportunistic behaviour; and● Costs of opportunistic behaviour that are not economic to eliminateManagers may also choose accounting policies that maximise the value ofthe business; i.e.● ‘Efficiency’ motive for accounting policy choice