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CHAPTER 7
MEASUREMENT APPLICATIONS
7.1 Overview
7.2 Current Value Accounting
7.2.1 Two Versions of Current Value Accounting
7.2.2 Current Value Accounting and the Income Statement
7.2.3 Summary
7.3 Longstanding Measurement Examples
7.3.1 Accounts Receivable and Payable
7.3.2 Cash Flows Fixed by Contract
7.3.3 The Lower–of–Cost–or–Market Rule
7.3.4 Revaluation Option for Property, Plant, and Equipment
7.3.5 Impairment Test for Property, Plant, and Equipment
7.3.6 Summary
7.4 Financial Instruments Defined
7.5 Primary Financial Instruments
7.5.1 Standard Setters Back Down Somewhat on Fair Value Accounting
7.5.2 Longer–Run Changes to Fair Value Accounting
7.5.3 The Fair Value Option
7.5.4 Loan Loss Provisioning*
7.5.5 Summary and Conclusion
7.6 Fair Value versus Historical Cost*
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7.7 Liquidity Risk and Financial Reporting Quality*
7.8 Derecognition and Consolidation
7.9 Derivative Instruments
7.9.1 Characteristics of Derivatives
7.9.2 Hedge Accounting
7.10 Conclusions on Accounting for Financial Instruments
7.11 Accounting for Intangibles
7.11.1 Introduction
7.11.2 Accounting for Purchased Goodwill
7.11.3 Self–Developed Goodwill
7.11.4 The Clean Surplus Model Revisited
7.11.5 Summary
7.12 Reporting on Risk
7.12.1 Beta Risk
7.12.2 Why Do Firms Manage Firm–Specific Risk?
7.12.3 Stock Market Reaction to Other Risks
7.12.4 A Measurement Approach to Risk Reporting
7.12.5 Summary
7.13 Conclusions on Measurement Applications
LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
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1. To Introduce the Major Financial Instrument Accounting Standards
My purpose in covering the accounting for financial instruments is twofold. First,
consistent with the main purpose of this chapter, I use these standards as a way to
explore the extent to which standard setters are adopting a measurement perspective
for financial instruments. Second, I hope to give senior undergraduate accounting
students exposure, at a fairly general level, to the contents and reasoning of the main
financial instruments standards’ they will be facing when they enter practice or industry.
Nevertheless, instructors may wish to pick and choose the topics they cover. There are
two optional sections. Section 7.5.4 deals with loan loss provisioning, where it appears
that a new standard will be some time coming.
Section 7.6 outlines some analytical work on fair value versus historical cost accounting.
While I feel that some of the implications of this analytical work are worth noting, they
may be of only peripheral interest to some students and instructors.
Other sections that could be dropped with little loss of continuity include Section 7.7 re
market liquidity, although the recent market meltdowns have heightened interest in
liquidity, at least in the lack of it. Section 7.5.1 re the stopgap changes in standards
resulting from the severe criticisms of fair value accounting during the recent market
meltdowns will lose interest over time. Section 7.5.3, dealing with mismatch and the fair
value option may be perceived as too esoteric by some, although I feel that students
who are planning a career in accounting should be exposed to these concepts,
particularly since they relate to reporting on risk. Section 7.8 dealing with new standards
for derecognition and consolidation is subject to the same comment.
2. The Distinction between Fair Value and Value–In–Use
This distinction is important since recent IASB accounting standards, such as IFRS 9,
exhibit some backing off from fair value towards amortized cost, a version of value-in-
use but using the discount rate established at acquisition.
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Points to bring out include:
• The fair value hierarchy, including trade–offs between relevance and reliability.
• The concept of amortized cost.
• The opportunity cost interpretation of fair value. This moves the income
statement in a stewardship direction since we can interpret measuring assets at
fair value as charging management with the opening opportunity cost of the
assets entrusted to it. The income statement can then be interpreted as a report
on the ability of management to earn more than cost of capital on assets used in
the business. If not, the firm would be better off to sell the assets (or dismiss the
manager).
3. To Review Long–Standing Examples of Current Cost Accounting
Section 7.3 is a mainly descriptive section designed to review common examples of
measurement. The concept of impairment tests is important since it pervades fair value
accounting, particularly for financial instruments.
This text treats impairment tests, including lower–of-cost-or–market, as partial
applications of current cost accounting. This is appropriate, I feel, when we are talking
about impairment tests from the standpoint of investors. Under contract theory,
discussed in Chapter 8, impairment has a somewhat different rationale.
4. To Introduce the Accounting for Financial Assets and Liabilities
This is a complex topic, and one which is undergoing considerable change. The IASB is
currently in the process of replacing IAS 39, with a view to simplifying the accounting for
financial instruments. IFRS 9, Financial Instruments is the first result of this process,
although it is not effective until January 1, 2015. Instructors should be alert for possible
changes in this standard by that date, particularly with respect to the business model
concept, since the accounting for financial instruments is not yet converged with the
FASB.
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I feel it is important not to get bogged down in this topic. Suggestions for points that
can be usefully discussed are:
• The concept of business model. This is a clever way to operationalize value–in–
use accounting. It, hopefully, controls the possibility that management may
change its intended use of an asset so as to influence the accounting valuation.
• The concept of mismatch, leading to the IASB version of the fair value option.
Theory in Practice 7.2 re Morgan Stanley could be used as a basis for
discussion, although it relates to the U.S. version, which does not restrict to
mismatch. Theory in Practice 7.4 re Blackstone illustrates another U.S.
implementation of the fair value option, in a derivatives context.
• The new standards on derecognition and consolidation can be used as a basis
for discussion of the standard setters response to some of the accounting
problems with off–balance sheet entities leading up to the 2007–2008 market
meltdowns. An important question for discussion is whether these new standards
will prevent these accounting problems from recurring. Theory in Practice 7.3 re
Repo 105s illustrates some of the complexities surrounding derecognition and
how it has been abused.
5. To Introduce Accounting for Derivative Financial Instruments
Students should be aware of the need for firms to manage risks. Also, I have noted that
students often bring little or no prior understanding of derivatives. Points that could be
emphasized include:
• The concept of a natural hedge.
• What is a derivative financial instrument?
• Managing risks versus speculation as reasons for dealing in derivatives. Perhaps
the best way to approach this topic is to discuss one of the “horror stories”
resulting from derivatives speculation—see Note 18 of this chapter.
• The distinction between fair value hedges and cash flow hedges.
• Basic accounting for both types of hedges.
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6. To Evaluate a Measurement Perspective on Intangibles
In Example 7.1, the text gives a simple example of purchase accounting for subsidiary
acquisition. This leads to purchased goodwill. The text briefly discusses pro–forma net
income, which in large measure was managements’ response to the amortization of
purchased goodwill. Theory in Practice 7.5 illustrates extreme cases of pro–forma
reporting.
Problems of reliability are particularly serious in the accounting for self–developed
goodwill. Yet, according to Lev & Zarowin (1999), this is the reason for the low and
decreasing R2 of net income in explaining share return variability. Their suggestion for
capitalizing R&D costs once a research project passes a critical “hurdle” seems a
reasonable compromise between relevance and reliability, and is an extension of R&D
accounting in IASB standards, where development costs may be capitalized. The Lev
and Zarowin paper is quite readable, and could be assigned as reading by instructors
who wish to spend more time on accounting for R&D and goodwill from a measurement
perspective. If a clean surplus valuation project, as suggested in Chapter 6 (Chapter 6,
Problem 12), has been assigned, the question of using the clean surplus approach to
measuring self–developed goodwill (or badwill) can also be discussed.
7. Reporting on Risk
Reporting on risk is an increasingly important component of financial reporting. For
example, the standards on derecognition, consolidation, and disclosure (Section 7.8)
require risk assessments and disclosure.
Reporting on risk immediately raises the question of whether it is consistent with the
principle of portfolio diversification and CAPM, which implies that a stock’s beta is the
only relevant risk measure. However, the text suggests several reasons why firm–
specific risk is relevant to investors. The most important reason, at least from a
theoretical perspective, is estimation risk. Investors are concerned about estimation risk
since it results from concerns about insider exploitation about their information
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advantage (i.e., adverse selection). To the extent the firm employs astute risk
management strategies, and investors know what these strategies are, estimation risk is
reduced because there is less risk that insiders will be able to exploit advance
knowledge of bad, or good, state realizations. For whatever reason, empirical evidence
outlined in Section 7.5.3 suggests that investors are sensitive to firm-specific risk
information, at least for financial institutions.
Also, from an ex post perspective, material realizations of downside risk, such as from
unfortunate dealings in derivatives, seem to draw auditors into the lawsuits that follow. It
seems doubtful that an argument based on diversification (i.e., that diversified investors
should offset their losses from the shares in question in the lawsuit with favourable
realizations of their other investments), is a convincing defence in a court of law.
A question for discussion is whether narrative risk disclosures in MD&A, as illustrated in
Section 3.6.3 for Canadian Tire Corp., can provide adequate risk information or whether
they should be supplemented with quantitative risk measures such as those described
in Section 7.12.4
SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. Strictly speaking the answer is yes, since post–revenue–realization assets such
as accounts receivable are valued at the net amount expected to be received.
This amount approximates present value if we accept that the time to collection is
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c. The approach suggested in b is more relevant than the matching
approach since it measures expected future cash flows. Under historical cost
3. Perhaps the main reason is cost. Since hedging transactions are costly,
the firm may feel that the optimal cost–benefit trade–off is not at zero risk.
Also, the firm may be at least partially protected by natural hedging.
Another cost–related reason is that investors can diversify firm–specific risk
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d. No, they are not mutually exclusive. There is no reason why non–stationarity of
beta, momentum and bubbles cannot exist in the presence of high operating
Note: An alternative argument can be made that high operating leverage and
6.5.1 )optional section0. Biased self–attribution is not consistent with rationality. If
5. The three policies are increasing in relevance. IAS 39 was lowest in relevance.
Under IAS 39, loans were valued at their discounted expected future receipts
b. The three policies are decreasing in reliability. As the period over which
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c. Fair value accounting for loans would require valuing them at their market
value (Level 1) or at an estimate of market value (Levels 2 and 3). Under Level 3,
6. a. One reason is as a form of credit enhancement. By retaining an interest,
hence bearing some risk, the company demonstrated its commitment to the
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b. Again, this was a form of credit enhancement. New Century would receive
c. Under IFRS 9, derecognition is allowed when the firm transfers
substantially all of the risks and rewards of ownership of the mortgages sold. The
question then is, does a one year commitment to buy back troubled mortgages
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7. Reasons to agree with Mr. Fink:
• If markets work well, current asset price is the best estimate of prices in all
future periods. This “more accurate appraisal” should help investors to
predict future cash flows. That is, fair values are high in relevance.
• To the extent that fair value accounting increases transparency (i.e.,
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Reason to disagree with Mr. Fink:
• Mr. Fink ignores reliability when he suggests that fair value accounting is
good for investors. To the extent that fair values are not derived from
• Fair value accounting, by, in effect, charging managers with the
benefit.
8. a. According to IFRS 9, Barclays must transfer substantially all the risks and
rewards of ownership of the securities in question in order to derecognize.
It seems from the information available that the rewards of the securities have
been transferred, since increases in fair value accrue to C12. However, it is not
clear that the risks have been transferred, since almost all of the selling price is
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10. No. If the inventory has fallen in value, the value of the forward contract has
11. a. The increase in Ballard’s share price implies a low R2 and ERC. There
was a positive firm–specific (i.e., abnormal) return on Ballard’s shares in
b. LZ suggest capitalization of accumulated R&D costs once they pass a
hurdle that suggests a successful research project. The higher the hurdle, the
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and how long it takes Manulife to more fully hedge against future changes in
investment returns. If low returns persist, and if investment returns are not fully
hedged, its persistent earnings calculation will overstate future earnings
performance, particularly since hedging is costly.
A reasonable conclusion is that while Manulife’s persistent earnings may be of
some usefulness to investors, the degree of usefulness is reduced to the extent