1. © 2006 Pearson Education Canada Inc.7-1 Chapter 7 Measurement Perspective Applications

2. © 2006 Pearson Education Canada Inc.7-2 Measurement Perspective Examples Accounts Receivable and Payable Capital Leases Lower-of-Cost-or-Market Rule –Inventories –Temporary investments –N.B. No subsequent writeup if market value improves—partial application

3. © 2006 Pearson Education Canada Inc.7-3 Examples, Cont’d. Ceiling Tests –2-stage procedure Impaired? If so, write down to fair value –No subsequent writeup if asset value improves— partial application Post-Employment Benefits –Expected present value of benefits earned –Expense reduced by earnings on plan assets –Reliability of estimates? Choice of discount rate

4. © 2006 Pearson Education Canada Inc.7-4 Examples, Cont’d. Impaired Loans –Write down to estimated realizable value Discounted at interest rate implicit in the loan transaction –An extension of measurement perspective, since may write loan value up if its fair value improves

5. © 2006 Pearson Education Canada Inc.7-5 Financial Instruments

6. © 2006 Pearson Education Canada Inc.7-6 Definition A Financial Instrument is –A contract… –Cash, or a contractual right to receive/deliver cash or another financial instrument… Note Broad Definition –Cash, receivables, payables, marketable securities,...

7. © 2006 Pearson Education Canada Inc.7-7 SFAS 115 (and Section 3855, CICA Handbook) Applies to Debt & Equity Securities –Classified at acquisition into one of 3 categories Held-to-maturity –Valued on cost basis Trading –Valued at fair value Available-for-sale –Valued at fair value

8. © 2006 Pearson Education Canada Inc.7-8 SFAS 115 (and Section 3855, CICA Handbook), Cont’d. Why the 3 Categories? –Core deposit intangibles Inability to value reliably precludes including financial liabilities in scope of SFAS 115 (Section 3855 includes some) –Gains trading Fair value accounting makes gains trading more difficult for trading and available-for-sale securities Elaborate precautions to prevent gains trading for held-to- maturity securities –Earnings volatility Reduced by including unrealized gains on available-for-sale securities in other comprehensive income (OCI)

9. © 2006 Pearson Education Canada Inc.7-9 Derivative Financial Instruments Definition of Financial Instruments Includes Derivatives Definition of Derivatives –A contract, the value of which depends on some underlying… –May not require an initial cash outlay –Generally settled in cash, not in kind

10. © 2006 Pearson Education Canada Inc.7-10 SFAS 133 ( and Section 3865, CICA Handbook) Fair Value Hedges –Gains and losses on the hedging instrument included in net income Fair valuing the hedged item may offset Cash Flow Hedges –Gains and losses on the hedging instrument included in OCI, until the future transaction affects net income

11. © 2006 Pearson Education Canada Inc.7-11 SFAS 133 ( and Section 3865, CICA Handbook), cont’d. Benefits of Hedge Accounting –Reduces earnings volatility Offset gains/losses by fair valuing hedged item (fair value hedge) Delay gain/loss recognition by including in OCI until realized Hedging may avoid the ceiling test

12. © 2006 Pearson Education Canada Inc.7-12 SFAS 133 ( and Section 3865, CICA Handbook), cont’d. To Obtain Benefits of Hedge Accounting –Hedges Must Qualify Must be highly effective –Negative correlation with hedged item –Hedges Must be Designated Requires elaborate procedure and documentation

13. © 2006 Pearson Education Canada Inc.7-13 Accounting for Intangibles Purchased Intangibles –Goodwill arising from an acquisition Accounted for at cost No amortization Subject to ceiling test –Can lead to major writedowns, e.g., JDS Uniphase, 2001 Annual Report. See Problem 9.7 –Management devices to work around goodwill and related writedowns “Pro-forma income,” e.g., TD Bank, 2000 Annual Report. See practice and theory vignette, Section 7.4.2

14. © 2006 Pearson Education Canada Inc.7-14 Accounting for Intangibles, Cont’d Self-Developed Intangibles –Self-developed goodwill, e.g., from R&D Hard to reliably determine fair value Costs written off as incurred –Recognition lag: goodwill value shows up over time on income statement Recognition lag responsible for low ability of net income to explain stock returns? –Lev & Zarowin (1999) argue yes

15. © 2006 Pearson Education Canada Inc.7-15 Lev & Zarowin, “The Boundaries of Financial Reporting…” Their Study Documents a Decreasing Usefulness Earnings Information –Usefulness evaluated by ability of earnings to explain abnormal share return Low R 2 –And falling? Low ERCs Especially for research-intensive firms

16. © 2006 Pearson Education Canada Inc.7-16 Lev & Zarowin, Cont’d Conclusion –Accounting for intangibles is inadequate

17. © 2006 Pearson Education Canada Inc.7-17 Lev & Zarowin, Cont’d Suggestion to Improve Usefulness –Capitalize successful intangibles after a “trigger point” is attained Amortize over useful life Like SE in oil and gas accounting Amounts capitalized and amortized may reveal inside information, since it is management that has best knowledge of R&D value

18. © 2006 Pearson Education Canada Inc.7-18 Risk Management Risk Controlled by Natural Hedging + Hedging with Derivatives Hedging v. Speculation –A fine line separates the two

19. © 2006 Pearson Education Canada Inc.7-19 Reporting on risk Beta Risk –Relevant to rational, diversified investor –Accounting variables correlated with beta Beaver, Kettler, and Scholes (1970) Reasons Why Other Risks Also Relevant –Investors may not act according to rational decision theory model –Risk information may reduce estimation risk –Risk reporting may control speculation

20. © 2006 Pearson Education Canada Inc.7-20 A Measurement Perspective on Risk Reporting Narrative, in MD&A –Canadian Tire Corp. Text, Section 4.8.2 Sensitivities Analysis –Suncor Energy Inc., 2003 Annual Report Value at Risk –Microsoft Corp., 2004 Annual Report

21. © 2006 Pearson Education Canada Inc.7-21 Sensitivities Analysis, Suncor Energy Inc. 2003 Annual Report –See Table 7.2 –Problems of sensitivities analysis Net of Hedging? Linearity Assumption - Relevant Range Co-movements (i.e., correlations) in prices

22. © 2006 Pearson Education Canada Inc.7-22 Value at Risk, Microsoft Corp. 2004 Annual Report –Discloses a 97.5% probability that a loss in fair value over a 20-day period will not exceed the following amounts (net of hedging): Interest rate risk: $298 (million) Currency rate risk: $207 Equity price risk: $773 Total risk: $835 –Correlation of price risks Note the 3 specific risks do not add to total