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Solution Manualto accompanyContemporary Issues inAccountingMichaela Rankin, Patricia Stanton,Susan McGowan, Kimberly Ferlauto& Matt TillingPREPARED BY:Matthew TillingJohn Wiley & Sons Australia, Ltd 2012Chapter 10: Fair value accountingCHAPTER 10FAIR VALUE ACCOUNTINGContemporary Issu...

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Matthew Tilling

John Wiley & Sons Australia, Ltd 2012

Solution manual to accompany: Contemporary Issues in Accounting

CHAPTER 10 FAIR VALUE ACCOUNTING

Contemporary Issue 10.1 How to conjure up billions

1.

What is the relationship between liabilities and the recording of goodwill? (K)K

GM recorded some of its liabilities at amounts that exceeded fair value, primarily related to employee benefits. The difference between those liabilities’ carrying amounts and fair values gave rise to goodwill as the identifiable net assets were reduced creating a difference with equity value that was ‘filled’ with goodwill. The bigger the difference, the more goodwill GM booked. In other instances, GM said it recorded certain tax assets at less than their fair value, which also resulted in goodwill. On the liabilities side, for example, GM said the fair values were lower than the carrying amounts on its balance sheet because it used higher discount rates to calculate the fair value figures. The higher discount rates took GM’s risk of default into account, driving fair values lower.

2.

Explain how GM can argue that because it has a higher risk of default the fair value of the liabilities would be lower than their carrying amount. (J, K)

This is a direct result of the requirement that liabilities be carried at their market value. Remember that the IASB in the Basis for Conclusions paragraph BC88–BC89 to IFRS 13 states that “the fair value of a liability equals the fair value of a properly defined corresponding asset”. Someone holding GMs debt would reduce its value to account for a higher default risk. This translates into a lower liability value, as the companies on credit risk must be included in the calculation. JK 3. Discuss what would be most relevant to the users of GM’s financial statements with regards to the valuation of the liabilities. (J, K, AS) This is an interesting issue. Surely the expected amount to be paid is most relevant. In fact it could be argued that by taking into account the entity’s own credit risk the principles of going concern have been violated. Contemporary Issue 10.2 Serial floats and patent porkies 1.

Describe the three acceptable valuation techniques and how they could be used the fair value of the patent in this scenario. (K) a)

The market approach is based on the ability to identify a market for an identical or comparable asset or liability.

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Chapter 10: Fair value accounting

This would require a similar patent to be identified and then a market price established. In reality it is very unlikely that a similar enough patent will be found as patents by their nature are meant to be unique. Also there is not a well-established or active market.

2.

b)

The income approach is based on converting future cash flows or income and expense into a single present value. This would require the use of cash flow budgets and significant estimates of future performance.

c)

The cost approach is based on an estimate of the cost of replacing the ‘service capacity’ of the asset under consideration. This would focus simply on the cost incurred to date in securing and developing the patent.

Provide examples of the inputs you could use to establish the fair value of the patent and to what level those inputs would be assigned. (J, K, AS)

There are a range of potential inputs to any model employed to value a patent. The majority, other than costs, are going rely heavily on unobservable assumptions and are therefore going to be level 3 inputs. 3.

Given that the valuation of the patent did involve a sales transaction would this indicate that the market approach was the appropriate one to use in this case? What weight can be placed on the ‘independent valuation’? (J, K)

It would appear that the sale was not a market transaction as it involved related parties and therefore does not represent a market approach, therefore it is not appropriate to use in this case. The independent valuation is worrying, though it is difficult to tell from the article whether it was the patent that was valued or the transaction. IT could be perfectly true that 24 million was “paid” for the patent and this is what has been verified. It is also possible that the “transactions” are not inappropriate, the question is the recording in the accounts.

© John Wiley and Sons Australia, Ltd 2012

10.2

Solution manual to accompany: Contemporary Issues in Accounting

Review Questions 1. Why has the IASB decided to release a standard on ‘fair value’, given that it is a general term, rather than a specific accounting issue? Because it is seen as such a key concept in accounting and is used across so many standards the IASB clearly feels it is important to crystallise all the relevant material in a single standard. It will be interesting to see how this standard integrates with the Conceptual Framework as the measurement concepts are developed and expanded in the coming months and years. 2. What alternative measures are used in the accounting to value items? Provide specific examples. As discussed in Chapter 4 Measurement accounting uses a mix measurement model. Traditionally historic cost has been the predominant measure in accounting. It focuses on the actual amount paid for an item though adjustments may be made over time to account for changes in the asset. This approach is used for many items including intangibles, property plant and equipment, and inventory. Current replacement cost is the amount that would be paid at the current time to purchase an identical item. It can be used to measure inventory when current cost represents net realisable value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It can be used to measure property plant and equipment under the revaluation model. Present value is the present discounted value of the future net cash flows associated with the item. It can be used to measure the value of biological assets. 3. What are the main arguments against the old definition (i.e. the one presented in Appendix A of AASB 3) of fair value? IFRS 3/AASB 3Business Combinations Appendix A defined fair value as: The amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arms-length transaction.

The use of the word ‘exchanged’ is problematic. In this hypothetical transaction, is the asset being measured from the point of view of the buyer or the seller? Applying the definition to liabilities is a little confusing. First, what do we mean by settle a liability. In reality, a liability isn’t settled with knowledgeable and willing parties, but rather a creditor who has a right to receive the money. The definition does not make it clear on which date this exchange should be valued. What does it mean to be a ‘willing’ party? An organisation may be in distress and in urgent need of cash and therefore willing to sell an asset at a deep discount for rapid reimbursement. 4. Identify and discuss the objectives of the fair value standard. The fair value standard has the following objectives:

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Chapter 10: Fair value accounting

(a) to establish a single source of guidance for all fair value measurements required or permitted by IFRSs to reduce complexity and improve consistency in their application; (b) to clarify the definition of fair value and related guidance in order to communicate the measurement objective more clearly; and (c) to enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used and to inform them about the inputs used to derive those fair values. These certainly appear to justify the need for an authoritative standard on fair value. The first is focussed on accounting information producers, while the second is focussed on users. The third objective is the most significant in some ways. While the IASB stated they did not want to significantly change accounting practice around fair value simply clarify, the enhanced disclosure has brought with it significant additional requirements for reporting entities and accountants. 5. What is the new definition of fair value? Explain the key parts to this definition. The definition of fair value in paragraph 9 of IFRS 13 Fair Value Measurement is: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Key parts of this definition are: Price - it is based on an exchange value. Would – it can be a hypothetical transaction. Received to sell – it is an exit price Paid to transfer – again an exit price. Orderly transaction – Market has time to operate and no duress. Market participants – Arms-length transaction Measurement date – the date the transaction would be assumed to occur. 6. Why has the IASB chosen to use exit price as the primary measure of fair value? The use of an exit price offers a number of advantages. First, it is current. It allows users to focus on a value today, not some historic price that may or may not be relevant under today’s conditions. Second, it is specific. It focuses on the asset or liability at hand, rather than the price to purchase a generic equivalent item. Third, it has a level of independence by introducing, if only hypothetically, an external party into the transaction. The value is based on its estimate of value, not the price the entity was, or is, prepared to pay for the item. 7. Assuming an entity does not want to sell an asset, how is exit price useful to the users of that entity’s financial statements? Exit price is seen to capture more than just the price of an asset but more intrinsically its value in use. As discussed in the text we can put up an economic rationalist argument that ultimately concludes that the exit price must closely approximate the expected future benefit contained in the asset. The same logic can also be applied to liabilities. The point where a sale will occur is therefore constrained by the minimum the current owner will accept and the maximum the potential buyer will pay and both are determined with

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Solution manual to accompany: Contemporary Issues in Accounting

reference to the expected future benefit to be received from the asset. There may be some difference in opinion or potential benefit or risk tolerance based on access to skills or markets, but in a reasonably efficient market these differences will not be significant. Therefore, the sales price of an asset can be taken as a fair estimate of its future value, or the expected future economic benefit to be realised, which is a fundamental part of the definition of an asset. And this expected future economic benefit is also assumed to be useful information to the users of the entity’s financial statements. 8. The existence of a market is very important to determining fair value. What factors would indicate an appropriate market exists? Appendix B to the standard, which contains the application guidance, devotes considerable discussion to how to identify when a market is not to be considered active, and therefore not amendable to an orderly transaction and so not an appropriate basis for assigning a fair value. Based on the factors identified in paragraph B37 we can conclude an active market DOES exist when: (a) There are sufficient recent transactions. (b) Price quotations are developed using current information. (c) Price quotations don not vary substantially either over time. (d) There exist Indices that are highly correlated with the fair values of the asset or liability. (e) There are low implied liquidity risk premiums, yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices. (f) There is a narrow bid-ask spread or at least a steady bid-ask spread. (g) There is a market for new issues (i.e. a primary market) for the asset or liability or similar assets or liabilities. (h) Information is publicly available. 9. If it is determined that markets for the item under consideration are inactive, does that mean they cannot be fair valued? Discuss. Under IFRS 13, if it is determined that the market is not active, then an entity may determine that significant adjustments are needed to quoted prices to accurately reflect estimated fair value, or in fact market prices may not be used at all. Instead, an alternative valuation technique (or techniques) may be used if deemed appropriate. The standard does not describe a method for making these adjustments should they be deemed necessary. This creates some interesting issues. So the obvious answer is yes, you can still fair value. But is it still a fair value in accordance with the definition if it is not based on market valuations? Probably not. A number of respondents to the exposure draft suggest that if a market does not form the basis of the valuation then it should not be called a ‘fair value’ but something else. The IASB decided this would be too confusing and did not introduce a separate terminology. Second, does this create a dangerous precedent that may encourage accountants to declare a falling market (which is often accompanied by some of the indications of an ‘inactive’ market as described in paragraph B37) to be inactive. They can then make adjustments up to artificially increase the value of an asset? 10. While fair values are based on market prices, the standard also states that fair values are based on the specific item being valued. What does this mean

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Chapter 10: Fair value accounting

when considering the valuation of a share in company? A large piece of mining equipment? The valuation of a share in a company should be a relatively straight forward undertaking. Assuming the share is publically traded, and we are talking about a common class of share, there is a market and each share in the market is identical (having the same rights). So no adjustment should need to be taken to account for the fact it is a ‘different’ share that we are valuing. The mining equipment will need adjustment. Even if there is an active market for the mining equipment we are fair valuing because each individual piece of equipment will have specific characteristics that will impact on the amount buyers are willing to pay. This could be condition, age, location, use based. So even in an active market consideration will need to be given to the value attached to the specific item being valued. 11. What are the limitations on determining the highest and best use for an asset when establishing fair value? Paragraph 28 of IFRS 13 imposes three limitations to keep the estimates realistic and focused on the specific asset to be valued: (1) the use must be physically possible, taking into account, for example, the location or condition of the asset; (2) it must be legally permissible, considering for example zoning regulations; and (3) it must be financially feasible, meaning that even if physically and legally possible, it would be fiscally sensible to put the asset to the nominated best use. 12. Identify and discuss the hierarchy for fair valuing liabilities. The standard sets out a hierarchy for valuing liabilities and equity. In the first instance, if there is an active market for the debt or equity, then this market will provide a fair value for the debt or equity. When public prices aren’t available for the debt or equity, according to paragraph 37 of IFRS 13 the entity should, where possible, ‘measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date’. Should no corresponding asset exist for a liability or equity then the entity needs to use a valuation technique based on the assumptions that would be used by market participants. The first level is most consistent with the fair value ideal, but relatively uncommon for liabilities. The second level is interesting from an economic theory perspective. Also note that this is not the case under the leases standard for many types of finance lease, where often the lease liability does not equal the lease asset (note of course leases are excluded from the fair value standard). The third level is the most contentious and has the potential to significantly impact on firms that have liabilities for restoration. 13. Describe the valuation techniques that can be used to fair value an asset, which method is preferred? Paragraph 62 states that there are three widely used techniques that can be used to fair value an asset and that the entity ‘shall use valuation techniques consistent with one or more of those approaches to measure fair value’. The techniques are outlined in some detail in Appendix B to IFRS 13.

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Solution manual to accompany: Contemporary Issues in Accounting

The market approach is based on the ability to identify a market for an identical or comparable asset or liability. This approach is theoretically most directly related to the intention of the standard. Depending on the nature of the market, adjustments may need to be made to take existing transactions and best approximate the price that would be relevant to the specific item under consideration. The income approach is based on converting future cash flows or income and expense into a single present value. Usually this would mean using discounted cash flow models, but could alternatively use much more complex models such as a Black–Scholes– Mertons options pricing approach. The cost approach is based on an estimate of the cost of replacing the ‘service capacity’ of the asset under consideration. This is what is known as the current replacement cost in accounting theory. The cost is calculated not based on a new asset, rather an asset that would substitute to derive comparable benefit, taking into account the ‘obsolescence’ of the current asset. The technique chosen is a matter for professional judgment however, paragraph 67 of IFRS 13 requires that the accountant maximise relevant observable inputs and minimise unobservable inputs. In practice this would mean that the market approach is most likely to be preferred. However, this also means that where a market is inactive, as previously discussed, alternative valuation methods are available to an entity. 14. Describe the 3 levels of inputs that can be used in valuing an item under AASB 13/IFRS 13. How is the valuation level ultimately determined? Appendix A of IFRS 13 defines inputs as: The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following: the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model); and the risk inherent in the inputs to the valuation technique.

Inputs may be observable or unobservable. Observable inputs are split into two levels, those that do not need to be adjusted, that is, they are based on active markets for identical assets or liabilities, these inputs are termed Level 1 inputs. Other observable inputs require adjustment to reflect quantitative or qualitative differences between the item under consideration and the market observed, these inputs are termed Level 2 inputs. Level 3 inputs are based on unobservable inputs that require estimation and inference by the entit...