Tut 5 Solutions - HOMEWORK HELPS PDF

Preview

Summary

Tutorial 5 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 f...

Description

Tutorial 5 1. 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. 2. 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. 3. 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. 4. 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? 5. 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. 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. 6.

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 entity. In establishing the fair value of an item the entity will most likely have to use a range of inputs. Paragraph 73 of IFRS 13 is clear: The fair value measurement is categorised in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.

‘Significant’ requires professional judgement to interpret. 7. In light of the Conceptual Framework for Financial Reporting what are the broad arguments for and against the use of fair value and modified historic cost in accounting? The argument over which is better, modified historic cost or fair value has traditionally formed around the terms relevance and reliability. Historic cost is argued to be more reliable while fair value has been argued to be more relevant. Generally the concept of prudence has been called upon to support reliability and therefore historic cost. The recent rewriting of the conceptual framework, which has exchanged reliability for faithful representation, coupled with the preferencing of relevance have signalled a shift towards fair value. The framework also emphasises that faithful representation requires a lack of bias, both positive or negative, invalidating arguments in favour of prudence.

8. 10 years ago your organisation bought a block of land on the Perth foreshore for $500 000. Over the next two years an apartment block was constructed on the site at a cost of $5 000 000. The apartments are currently owned by your organisation and sublet to tenants on a variety of leases not longer than five years. You want to establish the fair value of the property using AASB 13/IFRS 13. You have ascertained the following information for your assessment: I.

Two separate expert valuations have been received. One valuer said the property was worth around $9 000 000 ($1 000 000 for the land and $8 000 000 for the building). The other valuer said it was worth

$6 000 000 ($750 000 land value and $5 250 000 building value). Both valuers acknowledge that valuing the building in the current economic climate is difficult as there have been few sales of comparable buildings recently. They have used their experience of prior markets to estimate the values. II.

The current cost of replacing the building has been established as $7 500 000, determined based on the current design with today’s construction costs, including labour, materials and overhead.

III.

Present value of future cash flows: Average net cash inflows over next 20 years is estimated to be $650 000 per year, based on projected cash flows from rent, tax savings and expenditures. It is assumed after 20 years the building will need to be replaced, and the land will be worth $1 000 000. The current borrowing rate for the entity is 12%.

IV.

Depreciation is currently being charged on a straight-line basis using the same assumptions presented in part III.

(a) Discuss each of the above four values as a basis for establishing fair value. In accordance with AASB 13/IFRS 13 which methodology do you believe is most appropriate? What additional information would you like to obtain to make a better estimate? Valuation A is superficially based on a market valuation. While this is ideal any many circumstances, the evidence here would strongly suggest there is an inactive market. And therefore significant adjustments may need to be made to the valuations. Using this valuation would quickly introduce a number of level 3 inputs. In addition the significant variations in value presented would suggest that this just simply isn’t an appropriate base. One thing that is clear from the standard, simply collecting a number of valuations and averaging them is not an appropriate approach. Valuation B is a cost approach. This may be appropriate in this situation. Adjustments may need to be made to account for the current condition of the building, and a way still needs to be found to value the land. But this may introduce the least number of unobservable inputs. Valuation C is an income approach. In an ideal world the income approach gives the most relevant information about the value of an asset. However in the real world it often relies on the most number of assumptions and is subject to the potential for significant manipulation. In this case, given the time frames involved and the associated uncertainties of the building rental market it would seem unlikely that this provides an appropriately reliable basis for valuation. The figures given appear insufficiently detailed and considered. Is it likely that the net cash inflow will remain steady for 20 years? How was the value for the land established? Substantial though would need to be put into the appropriate discount rate, accounting for a range of factors specific to the project.

Valuation D is not a fair value but simply and application of the modified historic cost which is an acceptable alternative to fair value. Given the limited information available the most appropriate approach to fair value the asset would appear to be based on approach B current replacement cost. It is possible that with further refinement an appropriate income approach could be established, but it would require significant additional work and possibly a number of level 3 inputs. 9. Why has the Global Financial Crisis created intense discussion about accounting for fair values? The Global financial crisis refers to the problems in the equity and debt markets around the world, including falling share prices and difficulties facing companies wishing to borrow. Prior to the GFC, there was a rapid and dramatic growth in lending (mainly in the US, but including other countries) for the purchase of houses to borrowers with lower levels of documentation and security (subprime mortgages). These loans were securitised and sold on the financial markets to institutional investors. It is claimed that the securities were sold with incomplete information about their risk, or without regard to their default risk because it was believed that the mortgaged properties could be sold easily to repay the debts. As borrowers defaulted on their repayments, the value of these securities fell and banks faced considerable difficulty selling the houses for their estimated values. Mark to market, or fair value accounting, requires the securities and the associated financial instruments to be shown on the institutions’ balance sheets at fair values (where they were not held off balance sheet through various complex arrangements). As the problems spread, there was greater uncertainty about the asset values and more entities faced difficulties caused by either the loss of value of the subprime mortgages, or the loss in value of institutions that owned the securities. The chain reaction in write-downs caused loss of faith in fair value accounting. Many opponents of fair value accounting claim that it has made problems worse. Sound companies are unable to borrow because either their own balance sheets are affected adversely by write-downs, or because banks are suffering and so reducing their lending to all companies. The supporters of fair value accounting claim that it has simply made the existing problems more transparent, increasing the likelihood of a speedy resolution. Ignoring fair values would mean that reality is being ignored, and problems loans would continue to be made....