6.1 Overview
This chapter is a continuation of the previous chapters however the focus here is on the role of the measurement perspective on decision usefulness as opposed to the information perspective. The textbook defines measurement perspective as:
The measurement perspective on financial reporting is an approach under which accountants undertake a responsibility to incorporate fair values into the financial statements proper, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict future firm performance.[1]
In the past, there has been a significant amount of financial reporting based on historical cost measurement but the trend now is to report financial performance on a fair value basis thus allowing investors to value investment alternatives.
6.2Reasons for increased attention to Measurement
6.2.1Introduction
In recent years there has been considerable doubt about the relevance of historical-based accounting. For instance net income only explains a small part of the variation of security prices. Therefore, there is a need for a perspective that will help investors assess the probabilities of future earnings and returns more effectively than historical cost accounting. Also, there is increasing pressure in support of a measurement perspective from financial institutions that have been increasingly involved in lawsuits due to conflicts over valuation.
6.2.2The Explanatory Power of Net Income
As mentioned in the previous section most of the variability of security returns is due to factors other than the change of earnings. It is unrealistic, however, to expect net income to explain all of a security’s abnormal return. Even the information perspective recognizes that there are many other competing information sources out there and that accounting information cannot explain all of abnormal return variability. It has been argued that the lack of timeliness of historical-cost-based-earnings is the reason for the poor earnings quality. This quality can be improved by incorporating the measurement perspective into financial statements.
6.2.3Ohlson’s Clean Surplus Theory
The Ohlson’s Clean Surplus Theory (based on the F&O version) shows how the market value of the firm can be expressed in terms of balance sheet and income sheet components. The market value of a firm can be expressed by the formula:
PAt = bvt + gt
Where bvt is the net book value of the firms assets per the balance sheet and gt is the expected present value of future abnormal earnings, also called goodwill (the difference between actual and expected earnings). We need both of these figures to estimate share value. The Clean Surplus Theory leads to the measurement perspective because the more fair values the accountant incorporates into the bvt the less the need to predict abnormal earnings. When the firm’s goodwill is equal to zero this implies that abnormal earnings do not persist and that all of firm value appears on the balance sheet. The F&O model also introduces the concept of earnings persistence. This deals with the persistence of state realizations beyond the current year. For example, if a bad state realization occurs in a given year the economic effects are likely to persist into the future. According to the Clean Surplus Theory the greater the persistence, the greater the impact of the income statement on firm value.
6.2.4Auditor’s Legal Liability
The main source in favour of the measurement perspective comes from financial institutions. Auditors are facing increasing legal liability and are having difficulty defending themselves from lawsuits in connection with business failure. For instance, if the recordings of asset values are overstated this could result in litigation against the accountant because the accounting information was misleading to investors.
6.3Longstanding Measurement Examples
6.3.1Accounts Receivable and Payable
Accounts receivable and payable are valued at the expected amount of cash to be received or paid. This basis of valuation approximates present value.
6.3.2Cash Flows Fixed by Contract
Cash flows fixed by contract are valued at present value. For instance, capital lease contracts are to be valued at the present value of minimum lease payments, using the lower of interest rate implicit in the lease and the lessee’s borrowing rate. However, if market rates change during the life of the lease the present value of the lease is not adjusted. Therefore, this would require partial application of the measurement perspective.
6.3.3The Lower-of-Cost-or-Market Rule
The lower-of-cost-or-market rule is also an example of a measurement perspective. When asset (temporary investment, inventory) market values fall below their carrying value, a write-down is required to market value. Once an asset value is written down it is not written up again.
6.3.4Ceiling Test for Capital Assets
Section 3060 imposes a ceiling test for capital assets and it requires a write-down when the net carrying value of the capital assets exceeds the net recoverable amount. The net recoverable amount requires an estimation of future net cash flows from the capital asset based on the most probable set of economic conditions. The catch is that the estimated cash flows are not discounted. In comparison to the lower-of-cost-or-market rule capital assets may be written down, but not written up, to net recoverable value.
6.3.5Push Down Accounting
Push down accounting occurs when one firm acquires another and the assets and liabilities of the acquired firm are re-valued. The result is that the balance sheet components are recorded on the books of the acquired firm at their fair values as established in the acquisition transaction.
6.4More Recent Fair-Value-Oriented Standards
6.4.1 Pension and other Post-Employment Benefits
Pension benefits and other post-employment benefits are accounted for using the present value of future benefit, while pension fund assets are accounted for using a fair value approach. We account for these items in such manners in order to match current revenues with future expenses. When accounting for pension and other post-employment benefits using the present value approach, we sacrifice a lot of reliability for increased relevance.
6.4.2 Impaired Loans
Impaired loans are to be accounted for using estimated realizable amount. This estimate may be revised for subsequent changes, which are shown on the income statement.
6.5 Financial Instruments
6.5.1 Introduction
Firstly, financial instruments are those that create an asset for one party and a liability or equity for another party. Secondly, Accounting for these instruments is predominantly measurement-based.
6.5.2 Valuation of Debt and Equity Securities
Investments in debt or equity securities must be classified as “held-to-maturity”, “trading”, or “available for sale”; the former being valued at amortized cost, the latter two being valued at fair value. The problem with accounting for these securities is that people will only sell the securities if there is a gain in their value, and will not sell the securities that have lost value (i.e. they classify them as “held-to-maturity” until their value rises so that they can be transferred out of this classification). Accounting standards attempt to prevent this by placing strict rules on what can and cannot be traded into and out of “held-to-maturity” securities. The standards also aim to prevent increasing volatility of net income measures.
6.5.3 Derivative Instruments
The value of derivative instruments is based on some underlying: price, interest rate, foreign exchange rate, etc. These instruments require or permit net settlement, and there is usually little or no cost to account for. Supplementary disclosure is needed for these instruments because of this. Accounting for dividends is tending towards a measurement perspective
6.5.4 Hedge Accounting
Firms avoid risky financial situations by using a hedging instrument to move in the opposite direction from price risks. Finding an ideal hedged item is very difficult because of the uncertainty associated with it and the financial world. Basis risk is the risk occurring because we rarely have a perfectly efficient hedge. In hedge accounting, unrealized gains and losses can be deferred. These gains and losses are shown on the income statement once a deferral is not necessary.
6.1Reporting on Risk
6.6.1 Beta Risk
There is a direct relationship between beta and financial-statement-based risks (i.e. dividend payout, leverage, and earnings variability). For instance, the higher the dividend payout, the lower the beta.
6.6.2 Stock Market Reaction to Other Risks
Investors and standard setters both want and require increased risk-related information in annual reports. For example, investors have often been affected by fair-value disclosure on the market value of equity. Also, the market responds the firm’s on-balance sheet natural hedging as well as its off-balance-sheet derivatives hedging.
6.6.3A Measurement Perspective on Risk Reporting
Quantitative price risk disclosures are taking the following forms: a disclosure of fair values and contract terms, a disclosure of a sensitivity analysis on the potential changes that may affect financial position, and a disclosure of the value that would be at risk if a certain low-probability event occurred.
Chapter Six – Quiz
Part I - Multiple Choice
1)According to Lev, what percent of change in security price is due to an earnings announcement?
a)2 – 5%
b)5 – 8%
c)95 – 98%
d)92 – 95%
2)The Ohlson clean surplus theory provides a framework consistent with the measurement perspective by showing how the market value of the firm can be expressed in terms of:
a)Value-relevant information
b)Security Price
c)Balance Sheet and Income Statement components
d)The Measurement Perspective
3)Earnings Persistence is related to:
a)β
b)ωoxt-1a
c)ERC
d)PA1
4)Due to increased legal liability, Auditors are pushing for:
a)The Historical-cost perspective
b)The Measurement perspective
c)The Information perspective
d)The Persistence perspective
5)Of the following, the one whose discount factor will be the smallest
a)Short-term investments
b)Long-term debt
c)Accounts Payable
d)Cash
6)The lower-of-cost-or-market rule is usually justified in terms of:
a)Conservatism
b)Reliability
c)Relevance
d)Usefulness
7)The calculation of the net recoverable amount requires the estimation of:
a)The market value of the asset less transaction costs
b)Future value of the cash outflows
c)Present value of related cash inflows
d)Future net cash flows
8)Which of the following is not an example of a recent fair-value-orientation standard?
a)Pensions and other post-employment benefits
b)Impaired loans
c)R.R.A.
d)Ceiling Test for Capital Assets
9)Of the following, which is Derivative instruments not dependant on:
a)Underlying price
b)Interest rate
c)Foreign exchange rate
d)Utility rate
10)One way of estimating the correlation between the fair values of a hedging instrument and the hedged item is:
a)Cumulative dollar offset
b)Variable interest rate liability
c)Comprehensive forecasted transactions
d)Cash flow hedges
Part II – Short Answer
1)Explain the measurement perspective on financial reporting.
2)Explain why financial reporting is moving more towards the measurement perspective.
[1] Page 175 Scott, William R. Financial Accounting Theory, 2nd edition