ch05_sm_leo_10e.docx

Solutions Manual to accompany

Company Accounting 10e prepared by

Ken Leo John Hoggett John Sweeting Jeffrey Knapp Sue McGowan

© John Wiley & Sons Australia, Ltd 2015

Chapter 5: Fair value measurement

Chapter 5 – Fair Fair value measurement measurement REVIEW QUESTIONS

1.

Name three three current current accounting standards that permit permit or require require the use of fair values.

AASB 3 Business combinations para 32 AASB 9 Financial instruments para 4.1 AASB 116 Property, plant and equipment , para 31 AASB 138 Intangibles para 33, 75 AASB 140 Investment property para 30 AASB 141 Agriculture para 13

2.

What are the main objectives of AASB 13?

The main objectives are: - to define fair value - to establish a framework for measuring fair value - to require disclosures about fair value measurement (AASB 13, para 1)

3. What are the key elements of the definition of “fair value”?

- current exit price: to sell an asset or paid to transfer a liability - in an orderly transaction - between market participants participa nts - at the measurement date

4.

How does the proposed proposed definition of fair value differ from that used used in current accounting standards?

The definitions are the same in terms of: - assumes an hypothetical transaction - the transaction is orderly - market participants is the same as knowledgeable willing parties in an arm’s leng th transaction The new definition: - specifies that an entity is selling the asset, not buying - clarifies that a liability is to be transferred - specifies the need for a measurement date


Chapter 5 – Fair Fair value measurement measurement REVIEW QUESTIONS

1.

Name three three current current accounting standards that permit permit or require require the use of fair values.

AASB 3 Business combinations para 32 AASB 9 Financial instruments para 4.1 AASB 116 Property, plant and equipment , para 31 AASB 138 Intangibles para 33, 75 AASB 140 Investment property para 30 AASB 141 Agriculture para 13

2.

What are the main objectives of AASB 13?

The main objectives are: - to define fair value - to establish a framework for measuring fair value - to require disclosures about fair value measurement (AASB 13, para 1)

3. What are the key elements of the definition of “fair value”?

- current exit price: to sell an asset or paid to transfer a liability - in an orderly transaction - between market participants participa nts - at the measurement date

4.

How does the proposed proposed definition of fair value differ from that used used in current accounting standards?

The definitions are the same in terms of: - assumes an hypothetical transaction - the transaction is orderly - market participants is the same as knowledgeable willing parties in an arm’s leng th transaction The new definition: - specifies that an entity is selling the asset, not buying - clarifies that a liability is to be transferred - specifies the need for a measurement date

Solution Manual to accompany Company Accounting 10e

5.

How does entry price differ from exit price?

An entry price is one that would be paid to buy an asset or received to incur a liability. An exit price is one that would be received to sell an asset or paid to transfer a liability. They are expected to be the same IF they relate to the same asset or liability on the same date in the same form in the same market. This is probably only true in an active market.

6. Is the reporting reporting entity a market participant?

No. Assumptions made by market participants particip ants are not those made by b y the entity itself. The fair value is not entity-specific.

7.

Does the measurement measurement of fair value take take into account transport costs and transaction costs? Explain.

Transaction costs are the incremental direct costs to sell an asset or transfer a liability, while costs are the costs necessarily incurred to transfer an asset to its most advantageous transport costs market.

The measurement of fair value requires both costs to be taken into consideration in the determination of the most advantageous market. However, only transport costs are used in the calculation of the fair value number. Transaction costs are entity-specific, transport costs are not; they relate to the asset itself. See Illustrative example 5.1.

8.

What are are the key steps in determining determining a fair value measure?

An entity has to determine: 1. the particular asset or liability that is the subject of the measurement (consistent with its unit of account). 2. for a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use). 3. the principal (or most advantageous market) for the asset or liability. 4. the valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use in pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorised.


9.

Explain the difference between the current use of an asset and the highest and best use of that asset.

The current use is how the reporting entity is currently using an asset. The highest and best use is based on how market participants will use the asset. An example of where the two may differ is where land is currently used as a site for a factory, but the land could be used for residential purposes. The current use is industrial while the highest and best use could be either industrial or residential.

10. Explain the difference between the in-combination valuation premise and the standalone valuation premise.

The valuation premise is established by the highest and best use of the asset. In-combination valuation premise is discussed in AASB 13, para 31(a) which states that the highest value of an asset may be:

“through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and li abilities (e.g. a business)”.

In these circumstances, the fair value will be the price received in a current sales transaction, assuming the asset will be used with other assets and/or liabilities that are also available to market participants. If the asset is to be used with a business and include liabilities, the nature of the associated liabilities are only those used to fund working capital, not liabilities used to fund assets that are outside the group of assets in the current transaction. Stand-alone valuation premise is essentially when the asset is being considered as a single (stand-alone) asset, and not in combination with other assets or liabilities. In these circumstances, “the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a stand-alone basis”. (AASB 13 para. 31(b))

11. What is the difference between an entity’s principal market and its most advantageous market?

Appendix A to AASB 13 contains the following definitions: Most advantageous market: The market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Principal market: The market with the greatest volume and level of activity for the asset or liability.


Because there may be buyers and sellers who are willing to pay high prices and deal outside the principal market, the most advantageous market may not be the principal market. However, an entity may assume that the principal market is the most advantageous market provided that the entity can access the principal market.


12. What valuation techniques are available to measure fair value?

-

the market approach: prices generated by market transaction the cost approach: prices based on amounts required to replace the service capacity of an asset. the income approach: prices generated by considering future cash flows or future income and expenses

13. Explain the fair value hierarchy.

The fair value hierarchy is a hierarchy of inputs into the fair value measurement. The inputs are the assumptions that market participants make when using a valuation technique in pricing an asset or liability. The inputs are classified as observable or unobservable. The fair value hierarchy gives the highest priority to observable inputs and the lowest to unobservable inputs. The hierarchy does NOT prioritise the valuation techniques, just the inputs to those techniques. The fair value hierarchy prioritises inputs into 3 levels – Level 1, 2 and 3 – see the answer to RQ 14 for information on these levels. The hierarchy is also used in the disclosure process as a fair value measure is classified in its entirety based on the lowest level input that is significant to the entire measurement.

14. Explain the different levels of fair value inputs. Level 1 inputs are quoted prices in active markets for identical assets or liabilities.

The inputs are observable. The markets must be active. The assets/liabilities must be identical. Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly as prices or indirectly as derived from prices.

The inputs are observable. The inputs are based on market prices or other market data such as interest rate curves. Level 3 inputs are inputs for the asset or liability that are not based on observable market data.

The inputs are unobservable. The information may include entity-specific data.


15. How does the measurement of the fair value of a liability differ from that of an asset?

The highest and best use does not apply to liabilities. There will generally be no observable price for the transfer of a liability. The measurement of the liability is based on the same methodology that the counterparty would use to measure the fair value of the corresponding asset. Non-performance risk is taken into consideration in the measurement of the fair value of a liability.


CASE STUDIES Case Study 1

Valuation premise for measurement of fair value

Snapper Ltd conducts a business that makes women’s shoes. It operates a factory in an inner suburb of Perth. The factory contains a large amount of equipment that is used in the manufacture of shoes. Snapper Ltd owns both the factory and the land on which the factory stands. The land was acquired in 2007 for $200 000 and the factory was built in that year at a cost of $520 000. Both assets are recorded at cost, with the factory having a carrying amount at 30 June 2016 of $260 000. In recent years there has been a property boom in Perth with residential house prices doubling such that the average price of a house is approximately $500 000. A recent valuation of the land on which the factory stands as performed by a property valuation group and based on recent sales of land in the area has the land at a value of $1 000 000. The land is now considered prime residential property given its closeness to the city and, with its superb river views, its suitability for building executive apartments. It would cost $100 000 to demolish the factory to make way for these apartments to be built. It is estimated that to build a new factory on the current site would cost around $780 000. The directors of Snapper Ltd want to measure both the factory and the land at fair value as at 30 June 2016. Required Discuss how you would measure these fair values.

1. Determine the asset or liability that is the subject of measurement: In this case, there are 2 assets that could be measured at fair value, namely land and factory. An alternative would be to consider the land and the factory as a single asset. 2. Determine the valuation premise consistent with the highest and best use The land could be sold for residential purposes for an estimated $1m. Given the cost to demolish the existing factory of $100 000, the land could be sold for residential purposes for $900 000. Measuring fair value in this fashion assumes a specific use and is based on an in-exchange valuation premise as the land is considered on a stand-alone basis.

The land and factory could also be sold as a package for use by market participants in conjunction with other assets. The factory has been depreciated by the reporting entity to half its original cost. Given the cost to build a new factory is $780 000, a depreciated replacement cost of the existing factory could be said to be $390 000. However as the factory could presumably be viably built on a cheaper block of land ie one not usable for residential purposes, it is unlikely that there is a market for the land and the factory on an in-use basis. A market participant would be forced to pay the $900 000 for the factory and the land given the alternative use of the land for residential purposes. 3. Determine the most advantageous market for the assets The most advantageous market would appear to be the selling of the property for residential purposes. 4. Determine the valuation technique


The market approach would be the appropriate valuation technique given that there are observable market inputs in relation to the selling prices of similar properties. The land has a fair value based on market prices for similar properties of $900 000. The factory has a zero fair value as a separate asset. Example 2 of the Illustrative Examples considers a similar situation to this case. The highest and best use of the land is determined by comparing: (i) the value of the land as a vacant block for residential purposes which would include the factory at a zero fair value, and (ii) the value of the land as currently developed for industrial use which would include the factory as an ongoing asset. The highest and best use is the higher of these two values. If (i) is chosen, then the factory has a zero fair value and no subsequent depreciation would be determined. If (ii) is chosen, then it would be necessary to determine the fair value of the land separate from the fair value of the factory in order to depreciate the factory. It could be argued that that the fair value of the factory equals the difference between the fair value of the land for residential purposes and the fair value of the combined assets.


Case Study 2

Highest and best use

Bream Ltd is in the business of bottling wine, particularly for small wineries that cannot afford sophisticated technical equipment and want to concentrate on the growing of the grapes themselves. One of the key features of the bottles that are used by Bream Ltd is that, for the bottles used for white wine and champagne, they have an in -built insulation device that is successful in keeping the contents of the bottle cold, with the temperature being unaffected by the bottle being held in the hand. In January 2016, Solar-Blue, a company experimenting with energy sources useful in combating climate change, produced a device which, when attached to the outside of a container, could display the actual temperature of the liquid inside. The temperature was displayed by the highlighting of certain colours on the device. Exactly how this device could be attached to wine bottles had yet to be specifically determined. However, Bream Ltd believed that its employees had the skills that would enable the company to determine the feasibility of such a project. Whether the costs of attaching the device to wine bottles would be prohibitive was also unknown. As Bream Ltd was concerned that competing wine bottling companies may acquire the device from Solar-Blue, it paid $100 000 for the exclusive rights to use the device with bottles. The accountant wants to measure the fair value of the asset acquired. Required Discuss the process of determining this fair value.

1.

Determine the asset or liability that is the subject of measurement: In this case, the asset is the right to use the temperature-revealing device.

2. Determine the valuation premise consistent with the highest and best use To measure the fair value of the asset at initial recognition, the highest and best use of the asset is determined on the basis of its use by market participants. There are a number of possible uses for the asset: (a) Bream Ltd could continue to develop the device for use with bottles - how the device could be used with wine bottles has yet to be specifically determined. Bream Ltd believes its employees have the skills to be able to investigate this possibility. The fair value measured would then be based on an in-use valuation premise and would be based on the price that would be received in a current transaction to sell the device to market participants, assuming that there are other wine makers, or even soft drink companies that would be able to use the device in conjunction with their bottling activities. (b) Bream Ltd could decide to cease development of the device in relation to its applicability to use with bottles. In valuing the asset, the assumption is then that other market participants would also lock up the device based upon a defensive competitive strategy, reducing the risk that competitors could achieve a significant marketing edge and so substantially increase market share. The appropriate assumption is then an inuse valuation premise. (c) Bream Ltd could consider that the highest and best use of the asset is to cease development of the project as other market participants would also cease development if they acquired the asset. This may be the case where market participants do not consider that the device will eventually be able to be used with bottles and so the device will not provide a market rate of return if completed. The fair value would be


measured using an in-exchange valuation premise in this scenario. The fair value would be determined by considering what market participants would pay for the rights to use the device for bottles if Bream Ltd sold this asset to them. 3. Determine the principal (or most advantageous market) for the assets The most advantageous market would be determined by considering the three scenarios in part 2 above, and taking into account the transport and transaction costs. 4. Determine the valuation technique This asset is a unique asset. There are no similar assets on the market. Hence a market valuation approach is not applicable. An income valuation approach could be used based on the expected extra cash flows that could be derived from sales once the device has proved to be successful. Given that the device still has to be proved to be useful in relation to bottles, this requires a great deal of judgement. The cost approach would require the determination of the costs required to develop a similar device and have the rights to its use. This would be difficult for Bream Ltd to be able to calculate with any reliability. It is expected that the income valuation approach would be the most applicable method. In deciding to pay Solar-Blue $100 000 for the rights to use the device, it is assumed that Bream Ltd would have investigated the possible effects on its profits and market share if its competitors had acquired the device from Solar-Blue.


Case Study 3

‘In-combination’ valuation premise

Herring Ltd acquired a business that used a large number of assets that worked in combination to produce a product saleable in offshore markets. One feature of the assets of the business is that it includes a computer program that enables the inputs to the manufacturing process to be transferred in a predetermined routine to the assets that work together to produce the output. In measuring the fair value of the computer program, management of Herring Ltd determined that the valuation premise was ‘in -combination’ as the program worked together with other assets in the business. Required Discuss how the various valuation approaches may be applied in the determination of the fair value of the computer program.

The computer program would provide the best value to market participants through its use with other assets as the program works with other assets in the manufacturing process. Hence, the in-use valuation premise is appropriate for this asset while the highest and best use for the asset is its current use within the manufacturing process. The market valuation approach would not be applicable if the software program is unique. Use of the market valuation approach would require the existence of comparable software assets. The income approach could be applied with a present value technique being used. The cash flows used in this technique would be based on the income stream expected to result from the use of the computer program over its economic life. This may be determined by considering what market participants would pay as a licence fee to be able to use the computer program in their businesses. The cost approach could also be used. This approach would require the estimation of what it would cost currently to construct a substitute computer program that would perform the same tasks as the program being valued. A difficulty in this process could arise if some of the components of the program are unique and difficult to replicate by another market participant.


Case Study 4

Characteristics of an asset

Mr Merman owned a large house on a sizeable piece of land in Brisbane. The property had been in his family since around 1889. Mr Merman was 92 years old and was incapable of taking care of the large property. He wanted to move into a retirement village and so sold his property to the MedSea Group which was an association of doctors. The doctors wanted to use the house for their medical practice as it was centrally situated, had many rooms and had an ‘old -world’ atmosphere that would make patients feel comfortable. The house was surrounded by a large group of trees that had been planted by the Merman family over the years. The trees covered a large portion of the land. MedSea did not want to make large alterations to the house as it was suitable for a doctors’ surgery. Only minor alterations to the inside of the house and some maintenance to the exterior were required. However, MedSea wanted to divide the land and sell the portion adjacent to the house; this portion currently being covered in trees. The property sold would be very suitable for up-market apartment blocks. One of the conditions of the sale of the property to MedSea was that, while Mr Merman remained alive, the trees on the property could not be cut down as it would have caused him great distress to see such alterations to the family home. This clause in the contract would restrict the building of the apartment blocks. However, this restriction would not be enforceable on subsequent buyers of the property if MedSea wanted to sell the property in the future. A further issue affecting the building of the apartment blocks was that across one corner of the block there was a gas pipeline that was a part of the city infrastructure for the supply of gas facilities to Brisbane residents. Required Outline any provisions in AASB 13 that relate to consideration of restrictions on the measurement of fair values of assets, and how in the situation described above the restrictions would affect the measurement of the fair value of the property by MedSea.

The relevant paragraphs of AASB 13 are: -

-

Para 11: Fair value measurement shall consider the characteristics of an asset or liability eg condition, location and restrictions on sale or use. Para 20: although an entity must have access to the market at the measurement date, it does not need to be able to sell the particular asset or transfer the liability on that date if there are restrictions on the sale of the asset. Para 28(b): Highest and best use must be a legally permissable use, taking into account any legal restrictions on the use of the asset.

Para BC46 states that restrictions on the sale or use of an asset affect its fair value if market participants would take the restrictions into account when pricing the asset at the measurement date. Para BC100 states that restrictions on the transfer of an asset relate to the marketability of an asset. The inclusion of a restriction preventing the sale of an asset typically results in a lower fair value for the restricted asset than for the non-restricted asset, all other factors being equal.


Note that the adjustment for a restriction is not a level 1 input, and if the adjustment is significant, the fair value measure would be categorised at a lower level of the fair value hierarchy. The asset considered in this case is the house and the land. There are no restrictions on the house but there are restrictions on the land. There are 2 restrictions on the land: - the trees cannot be cut down until Mr Merman dies; and - there is a gas pipeline across one corner of the land. The restriction on the cutting down of the trees is enforceable on MedSea but not on any subsequent buyers of the property. Because the restriction is specific to MedSea and not to other market participants the restriction is not considered in measuring the fair value of the property – fair value measurement is not entity-specific. Therefore the fair value of the land is based on the higher of its fair value as the grounds of the current property, ie on an in-use valuation premise – and its fair value in exchange to market participants ie on an in-exchange valuation premise, considering the use of the property as a residential building site. The restriction on the property in relation to the felling of the trees is not a consideration in this measurement process. The restriction in relation to the gas pipeline is a condition specific to the asset itself in the same way as the condition or location of an asset is specific to an asset. This restriction is transferred to subsequent buyers of the property, the market participants. Measurement of the fair value of the property must then take into consideration the existence of the restriction and the effect on the valuation of the property. For example, if a building cannot be built over the pipeline as the gas authorities may need access to the pipeline, then this restricts the size of any building that could be built on the property. This affects the value of the land regardless of whether an in-use or an in-exchange valuation premise is applied.


PRACTICE QUESTIONS Question 5.1

Requirement for a standard

Measurement at fair value has been available in accounting standards for a long period of time. However, it was only in 2011 that the AASB issued AASB 13 F air V alue , providing an accounting standard in relation to fair value measurement. Measurement Required Discuss why such a standard was considered necessary.

The definition of fair value prior to the issue of AASB 13 was as follows: Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction.

Paragraph BC30 provides three reasons for the change in the definition: 1. the current definition does not specify whether an entity is buying or selling the asset. It is then uncertain whether fair value is an exit [selling] price or an entry [buying] price. The proposed definition requires the use of an exit price. 2. in the current definition, it is unclear what is meant by “settling” a liability. Who are the knowledgeable parties? Does this mean the creditor, or other parties? The proposed definition requires measurement by reference to the transfer of a liability to a party who may not be the creditor. 3. there is no explicit statement in the current definition whether the exchange or settlement takes place at the measurement date or at some other date. The proposed definition specifies that the fair value is the price at the measurement date.

Question 5.2

Definition of fair value

AASB 13 provides a definition of ‘fair value’. Required Outline the key characteristics of this definition and explain the effects of the inclusion of each characteristic in the definition.

The key characteristics are: 1. a current exit price :

The price is based on expectations about the future cash flows to be generated by an asset or used to pay or transfer a liability. The cash flows for an asset can be generated from use of the asset or sale of the asset. The price may be different from an entry price.


The effect of this characteristic, for an asset, is that the price is a selling price not a buying price. 2. an orderly transaction :

An orderly transaction is defined in Appendix A as: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (eg a forced liquidation or distress sale).

The transaction is a hypothetical one. The transaction occurs in current markets, in particular in markets where orderly transactions occur. Market transactions in cases of liquidation sales or fire sales are not relevant markets. This characteristic affects the choice of markets to be observed. 3. between market participants :

A definition of market participants is given in Appendix A: Buyers and sellers in the principal (or most advantageous market) for the asset or liability that have all the following characteristics: a) They are independent of each other, ie they are not related parties as defined in AASB 124 Related Party Disclosures …. b) They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary; c) They are able to enter into a transaction for the asset or liability; d) They are willing to enter into a transaction for the asset or liability, ie they are motivated but not forced or otherwise compelled to do so.

The phrase “knowledgeable, willing parties in an arm’s length transaction” has the same meaning. The assumptions made in the valuation process are those made by the market participants, not those made by the reporting entity. There is no need to identify specific market participants – the emphasis is on the characteristics of the participants. The fair value measure is not entity-specific. The market participants are assumed to have the other assets to combine with the asset being valued where an in-use valuation premise is applied. 4. at the measurement date :

Fair value is measured at a specific point of time taking into consideration the conditions and restrictions in relation to an asset and a liability at that date.


Question 5.3

Assets without an active market

Emily Chasan (2008) reported: ‘It’s ridiculous to apply fair value accounting to assets that have no market,’ said Christopher Whalen, managing director of risk research firm Institutional Risk Analytics. ‘All this volatility we now have in financial reporting and disclosure, it’s just absolute madness.’ ‘Investors as a group have to get a better understanding of what the volatility means,’ said Ed Nusbaum, chief executive of accounting firm Grant Thornton. ‘They want to live in a perfect world. They’d like complete transparency and no surprises. But I think it’s unlikely that the big write-downs that we’ve seen will reverse.’

Required Discuss the issues associated with fair value accounting for assets without an active market.

Paragraph 62 of AASB 13 proposes 3 possible valuation techniques: - the market approach - the cost approach, and - the income approach In using these techniques the reporting entity will make assumptions or provide inputs into the valuation model. The inputs are classified as being one of two types: - observable, and - unobservable These inputs are prioritised into 3 levels: Levels 1, 2 and 3. Only Level 1 and level 2 inputs relate to information obtained from markets. Level 3 inputs are not based on observable market data. In the quotation from Chasan the question is whether fair values based on unobservable inputs should be allowed. Questions relate to: - the reliability of the fair value numbers - the cost of generating such numbers - the relevance and understandability of these numbers: will users of financial reports treat all fair values the same regardless of the level of inputs? Past experience with entities such as Enron do not inspire confidence in the use of fair value numbers based on unobservable inputs. The quotation from Nusbaum states that investors have to get used to an imperfect world. The standard-setters have tried to get users used to such a world by requiring entities to disclose the assumptions underlying the fair values disclosed. Whether this will allow users to be able to deal with volatility and to assess the effects of unobservable inputs is yet unknown.


Question 5.4

Unit of account

Recognition and disclosure of assets and liabilities depends on determining the ‘unit of account’. Required A. What is meant by ‘unit of account’? B. Provide some examples of the application of unit of account in Australian Accounting Standards. C. What unit of account is adopted in AASB 13 for fair value measurement and disclosure?

(A)

The phrase “unit of account” refers to the level at which the accounting for an asset or a liability occurs. For example, with a vehicle, is the unit of account the whole car or parts of the car? Appendix A defines “unit of account” as: “The level at which an asset or a liability is aggregated or d isaggregated in a Standard for recognition purposes”.

(B)

AASB 116 para 44: depreciation of PPE is often calculated on the parts of a larger asset, for example, an aeroplane may be broken down into parts such as seating, engine, electronics etc. for depreciation purposes. AASB 136 para 80 requires goodwill to be allocated to individual CGUs, if possible, for purposes of impairment testing. The allowance for doubtful debts may be determined for each customer or be based on a grouping of customers perhaps classified on risk levels.

(C)

According to para 14 of AASB 13, whether the asset or liability is a stand-alone asset or liability, a group of assets or a group of liabilities, or a group of assets and liabilities, recognition and disclosure depends on a determination of the unit of account. The unit of account for an asset or a liability is determined in accordance with the Standard that requires or permits the fair value measurement , unless AASB 13 determines otherwise. In other words, reference must be made back to other AASBs such as AASB 116 and AASB 136. If another AASB requires that a single asset be used then this is the unit of account for fair value measurement. If another AASB requires a grouping of assets to be used, then fair value is applied to such a group. Note para 32 of AASB 13: the fair value measurement of a non-financial asset assumes that the asset is sold consistently with the unit of account. So for example, in relation to the aeroplane example, the fittings of an aeroplane would be replaced in a stand-alone transaction as would the engines, giving rise to different assets for depreciation purposes. Note para 39(b) of AASB 13: The unit of account for the asset is not the same as for the liability or equity instrument.


Question 5.5

Exit prices as fair value

Benston (2008) issued the following statement: Although the FASB has specified that fair values should be exit prices, many of the illustrative examples involve calculations of value-in-use or entrance values. This inconsistent application of the prescription of FAS 157 appears due to two factors. One is that the price another firm might pay for an asset depends on the value of the asset to that firm, its value in use. The other is perhaps the realization that when there is no potential purchaser, exit values would be zero or even negative if the firm would have to pay to dispose of an asset. The balance sheet would be decimated.

Required Discuss whether Benston’s criticisms of FAS 157 are applicable to AASB 13.

Benston raises 2 issues: 1. Although fair value is defined as an exit price, use of entry prices in level 2 inputs and determination of values using level 3 inputs will mean that fair values are not always really exit prices.

Where the valuation relies on an in-use valuation premise, the fair value may be determined by calculating the cost of constructing an item of plant and equipment. Also if an income valuation approach is used, there may be no market measures at all as the NPV calculation could be based on unobservable market data. This also raises questions in terms of the fair value being entity-specific versus that of market participants. Where unobservable data such as income stream is used, the numbers used in that calculation will generally be based on those coming from an entity’s own data. This is firstly because a reporting entity has no access to other entity’s internal data, and secondly because the asset being valued may not currently be being used by other entities. 2. In some cases, the exit price will be zero. Does this affect relevance of information?

A classic case of this is the land on which there is currently a factory but, because of rising residential prices, the highest and best use of the land is for residential purposes. For unique assets, those that are special tools for the entity, are there circumstances where there are no other market participants. Or must the valuer assume that other market participants have the relevant other assets to use with the asset being valued? This seems to stretch the hypothetical transaction very thinly,


Question 5.6

Orderly transactions

The definition of fair value requires that an asset or a liability be transferred in an ‘orderly transaction’. Required A. What is an orderly transaction? B. In order to be classified as an orderly transaction, how long must a transaction be exposed to a market? C. Can orderly transactions occur in a distressed market?

(A)

What is an orderly transaction? Appendix A defines an “orderly transaction” as follows: “A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). Note the words: exposure to the market before measurement date; usual and customary; not forced. Some examples of transactions being potentially non-orderly include: - The seller focussed on a single market participant during the marketing period. - The seller has filed for bankruptcy or has been placed in receivership. - Regulatory or legal requirements forced a sales transaction. - The selling price falls outside the normal range for similar transactions.

(B)

In order to be classified as an orderly transaction, how long must a transaction be exposed to a market? There is no specific period set in AASB 116. Obviously, the longer the period that a transaction is exposed to the market, the better for categorising as an orderly transaction. In determining whether a transaction is orderly, observation must be made of the market in which the transaction occurred to determine relative lengths of exposure. For example, in relation to equity instruments which are sold on a stock exchange such as the ASX, the time period may be measured in minutes if trading via electronic means is considered a normal transaction. Transactions involving specific forms of real estate such as port facilities may require exposure to a market for several months.

(C)

Can orderly transactions occur in a distressed market? It may be necessary to distinguish between a distressed market and a distressed sale. In current economic times where there seems to be a constant global financial crisis, certain markets may be generally regarded as distressed. eg properties in Greece. Determination of whether a market is stressed requires judgement. A sale in a distressed market is not necessarily a distressed sale.


Question 5.7

Exit prices as fair value for classes of assets

In its response to the IASB Exposure Draft, the G100 stated: The G100 does not believe that an exit price based measure of fair value is appropriate for all classes of assets. While such a measure may be appropriate for financial instruments we do not believe that an exit price based measure provides useful information for certain classes of non-financial assets such as property, plant and equipment where an entity-specific measure may be more appropriate.

Required Discuss the use of entity-specific information in the generation of fair value numbers under AASB 13.

The measurement of fair values under AASB 13 is based on a hypothetical transaction between the reporting entity and market participants. The assumptions used as inputs into the valuation process are those made by the market participants, not those made by the entity itself. Hence the fair value under AASB 13 is not an entity-specific measure. However, even though this is the intent of the standard-setters, the question is whether in practice fair value measures will not be based on entity-specific information: - a reporting entity is not required to identify specific market participants, so any assumptions made will not relate to the circumstances facing any entity currently operating in practice. - In an endeavour to make the inputs more reliable, an entity may rely on information generated within itself rather than less reliable, hypothetical information concerning some non-existent market participant. - If the market participant buyer steps into the shoes of the entity that holds those specialised assets, then potentially the market participant is assumed to be the same as the reporting entity and entity-specific factors are used in the valuation. - Where an income valuation approach is used, and a net present value method applied, it is hard to see that entities will not insert the entity-specific information into the present value calculations. - Similarly where level 3 unobservable inputs are used, non-market data is not readily available for in-use assets carried by other entities. - Simple cost-benefit considerations will encourage an entity to use in-house data rather than model what a market participant might hypothetically do.


Question 5.8

Entry and exit values

The accounting literature contains many debates over whether fair value should be based on what the owner would receive upon selling an asset or what it would pay to acquire a new one. The oft quoted example is that of a specialised machine such as a large blast furnace operated by a large mining company that once installed would never be removed except for scrap. This asset is purchased at a high price but once installed can be sold for scrap value only. The argument by the opponents of exit values is that the acquisition of such an asset would require the buyer to record an immediate loss. The argument of the opponents of replacement cost or entry price is that use of such a measure conceals the risk inherent in the specialisation strategy adopted by the company on acquisition of such an asset. Required Discuss how AASB 13 resolves this debate.

The definition of “fair value” in AASB 13 requires that an exit price be used in the measurement of fair value – fair value is the price that would be received to sell an asset.

However note paragraph 27: “A fair value measurement of a non -financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.” The highest and best use establishes the valuation premise which may use the asset in combination with other assets as a group. In such a case the fair value is the price received in a current transaction to sell the asset assuming that the asset would be used with other assets and that those other assets would be available to market participants. (Alternatively of course, the highest and best use could be to sell the asset on a stand-alone basis.) Applying this to the situation of the mining company’s blast furnace this blast furnace is not used as a stand-alone asset. It is used in conjunction with the whole process of melting ore to produce, for example, iron and steel products. Traditional arguments about measurement were based on either a replacement cost approach or an exit (selling) amount approach: - AASB 13 does not use an entry price approach, rather it uses an exit price approach. This is because the market that the entity faces is the exit market. Replacement costs only apply when the entity enters into a replacement of asset transaction. - AASB 13, although it applies an exit value approach, it adopts a different exit value approach from that argued for in the traditional accounting literature. In that literature the exit price was purely considered in selling the asset as a stand-alone asset. In such a case, upon acquisition of the blast furnace, the entity would experience a loss equal to the difference between the cost price of the furnace and the scrap value of the furnace. Under AASB 13, the exit price would be measured using the highest and best use approach and be measured using the assumption that the furnace is used in combination with the other assets of the mining company. Note that this approach by AASB 13 solves similar debates involving assets such as specialised tools where an entity may make its own tools to be used in its manufacturing


process. There is then no organised market for such tools. Under AASB 13 it is assumed that other market participants would have such tools available.

Question 5.9

Measurement of fair value

Ernst & Young (2005, p. 8) made the following statement: Nevertheless, the path the standard-setters have chosen is one where big swings in balance sheet and income statement numbers are inevitable. As a consequence, users of financial reports will need clear distinctions to be made between objective and subjective figures, between realised gains and losses, gains and losses based on real market process, and gains and losses based on hypothetical calculations.

Required Discuss how AASB 13 attempts to overcome these issues when providing information to users of financial reports.

Paragraph 91 of AASB 13 states that the key principle of disclosure is that an entity will disclose information that enables users of the financial statements to assess the methods and inputs to develop these measurements as well as to enable users to see the effect on profit or loss or other comprehensive income where unobservable inputs are used. If fair values are only used in a small number of cases, then it is possible that users of financial statements may be able to see what is occurring. However if a large number of an entity’s assets are measured at fair value, the extent of the detail may be such as to make the information not understandable. Para 93(e) specifically addresses disclosures where level 3 inputs are used in the measurement of fair value. In particular the effects on comprehensive income are addressed. Disclosure of information concerning valuation methods and inputs – such as required by paragraph 93(d) should assist in understanding the level of objective and subjective information. As the measurement of fair value is based on a hypothetical transaction, there is always going to be information based on “hypothetical calculations”. What are “real” market processes? As the measures of fair value are based on hypothetical transactions, no measures of fair value are based on real market transactions. However, the methods used and the inputs used have differing market measures in them. By disclosing the methods and inputs used, users of financial reports are made aware of these differences and can then assess for themselves the reliability and relevance of the information to them in making their decisions.

The distinction between realised and unrealised gains is not based on AASB 13 but rather on the underlying standard that is applied in the measurement of specific assets. For example, with property, plant and equipment, under the valuation model where fair value is measured, the application of AASB 116 requires the valuation increment to be recognised in other comprehensive income (an unrealised gain) rather than in profit or loss (only for realised


gains). However for financial assets, some movements in fair value, although unrealised, may be recognised in profit or loss.

Question 5.10

Determination of fair value

Trout Ltd holds an asset that is traded in three different markets, namely Market A, Market B, and Market C. Trout Ltd normally trades in Market C. Some information gathered in relation to these three markets is as follows: Market A

Annual volume Price Transport costs Possible fair value

Transaction costs Net proceeds

Market b

Market C

60 000

24 000

12 000

100

96

106

6

6

8

94

90

98

2

4

4

92

86

94

Required Using the above information, explain how Trout Ltd should measure the fair value of the asset it holds.

The principal market in this example is Market A as it has the highest volume and level of activity. The most advantageous market in this example is Market C as it has the highest net proceeds. Note that both transaction and transport costs are considered in determining which market is the most advantageous market. However transaction costs are not used in the measurement of the fair value. Paragraph 16 of AASB 13 requires that a fair value measurement assumes that the transaction to sell an asset takes place in either: (a) the principal market or (b) in the absence of a principal market, the most advantageous market. In determining the fair value of this asset held by Trout Ltd: IF the information about volume and activity in each market is available to Trout Ltd then the fair value must be measured using the principal market. In this case, the fair value is $92. IF the information about all the markets is not reasonably available or if Trout Ltd does not have access to all markets, then Trout Ltd would use Market C to measure fair value. The fair value is then $94.


Question 5.11

Fair value of work-in-progress

In relation to fair value measurement, the following statement was made by Benston (2008): Since the exit price of raw materials will almost always be less than the price at which they were purchased and the exit value of partially finished goods probably is zero or negative, companies using the . . . definition of fair value would have to record a substantial expense . . . The situation is likely to be more drastic for fixed assets, particularly for special-purpose assets that have no value to other parties.

Required Discuss the statement made by Benston.

The comment that “the exit price of raw materials will almost always be less than the price at which they were purchased and the exit value of partially finished goods probably is zero or negative” is not true.

This comment assumes that an in-exchange valuation premise is used. If that were the case then the current selling price of such items may be small. However, where an in-use valuation premise is used, the exit value is determined based on what a market participant would pay for these items assuming the items are used by that participant in conjunction with other assets held by the market participant. The exit price for raw material would then not be significantly different from what the reporting entity paid, assuming no market changes in the short term. Similarly with the special purpose non-current assets such as a large blast furnace used by a smelting company. This asset may not be able to be removed once placed into the reporting entity’s factory. As such its disposable – or in-exchange – value would be scrap value only. However, assuming a market participant had the same combination of other assets and requires a blast furnace to complete the grouping of assets to get a factory into operation, the fair value is not zero. The fair value would be based on the cost of obtaining such a blast furnace for incorporation into the factory’s operations.


Question 5.12

Management bias on fair value measurement

One of the concerns associated with fair value measurement is that management bias may affect the reliability of the information. AASB 13 requires that fair values be based on market-based assumptions rather than entity-specific assumptions in order to overcome this issue. Required Compare the potential for management bias when making market-based or entityspecific assumptions.

The measurement of fair values under AASB 13 is based on a hypothetical transaction between the reporting entity and market participants. Being hypothetical this allows management to decide the constraints and the determinants of that transaction. The assumptions used as inputs into the valuation process are those made by the market participants, not those made by the entity itself. Hence the fair value under AASB 13 is not supposed to be an entity-specific measure. However, even though this is the intent of the standard-setters, the question is whether in practice fair value measures will not be based on entity-specific information: - a reporting entity is not required to identify specific market participants, so any assumptions made will not relate to the circumstances facing any entity currently operating in practice. - In an endeavour to make the inputs more reliable, an entity may rely on information generated within itself rather than less reliable, hypothetical information concerning some non-existent market participant. - If the market participant buyer steps into the shoes of the entity that holds those specialised assets, then potentially the market participant is assumed to be the same as the reporting entity and entity-specific factors are used in the valuation. - Where an income valuation approach is used, and a net present value method applied, it is hard to see that entities will not insert the entity-specific information into the present value calculations. - Similarly where level 3 unobservable inputs are used, non-market data is not readily available for in-use assets carried by other entities. - Simple cost-benefit considerations will encourage an entity to use in-house data rather than model what a market participant might hypothetically do. Under these circumstances, management bias could potentially enter into the determination of the fair value.


Question 5.13

Liabilities

Cod Ltd holds a number of liabilities that it wants to measure at fair value. The accountant of Cod Ltd is unsure of how to apply AASB 13 in relation to liabilities. Required A. Under what circumstances are liabilities measured at fair value? B. When measuring the fair value of a liability, is it true that the price to transfer the liability is the same as the price to settle the liability? C. Should the credit risk of an entity be taken into account in measuring the fair value of a liability?

(A) Under AASB 137 para 36, when measuring a provision, the amount recognised should be the best estimate of the consideration required to settle the present obligation at the end of the reporting period. This is often expressed as the amount an entity would pay to settle the present obligation or to provide consideration to a third party to assume it. Under AASB 13, for a liability, fair value is the amount paid to transfer a liability rather than the amount to settle a liability. Note para 34(a) of AASB 13: a liability would remain outstanding and the market participant transferee would be required to fulfil the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date. However, the IASB in para BC 82 of the Basis for Conclusions to IAS 13 argued that the fair value of a liability from the perspective of market participants who owe the liability is the same regardless of whether it is settled or transferred. This is because both settlement and transfer of a liability reflect all costs incurred, whether direct or indirect, and the entity faces the same risks as a market participant transferee. Similar thought processes are used in estimating both the amount to settle a liability and to transfer a liability. Hence many provisions may be measured at fair value under AASB 137. Other circumstances where a liability is measured initially at fair value are: Recognition of an asset retirement obligation; Recognition of a restructuring liability; Recognition of liabilities assumed in a business combination; and In applying an impairment test to goodwill when it is necessary to measure the fair value of the entity itself. In measuring the fair value of the non-controlling interest in a subsidiary when the full goodwill method is used. Under AASB 139, on initial recognition, financial liabilities must be measured at fair value as per AASB 13. Subsequent measurement may also be at fair value.    





(B) No. The price to transfer a liability assumes that the liability continues whereas the price to settle a liability assumes the liability is extinguished – see (a) above. The result may however be the same. (C) According to para 42 of AASB 13 the fair value of a liability reflects the effect of non performance risk- defined in Appendix A as “the risk that an entity will not fulfil an obligation. Non-performance risk includes, but may not be limited to, the entity’s own credit risk.”


Note Illustrative example 5.10 in the text to the different measures of fair value when two entities have different credit ratings. The use of fair values may also result in an entity recording a gain when there is a decline in the credit rating of an entity. In such a case the decline in credit rating causes an increase in the interest rate at which an entity can borrow.

Question 5.14

Fair value hierarchy

AASB 13 proposes a fair value hierarchy. Required Discuss the differences between the various levels in the hierarchy and whether prices produced under all levels should be described as ‘fair values’.

There are 3 valuation approaches into which inputs or assumptions are made. The inputs are classified as observable and unobservable. The inputs are placed in a fair value hierarchy [note that the valuation techniques are not put into a hierarchy, just the inputs to those techniques]. Note: 1. The inputs are prioritised into 3 levels – Levels 1,2 and 3. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Note the references to active markets and the need for identical items. Level 2 inputs are inputs other than quoted market prices in level 1 that are observable for the asset or liability, either directly as prices or indirectly being derived from prices. These inputs are observable and may be inputs from information other than prices such as interest rate curves. Adjustments may have to be made to these prices based on condition of the assets. Level 3 inputs are not based on observable market data. These are unobservable inputs. This information may sometimes be based on entity-specific data adjusted for factors concerning market participants.

2. The fair value hierarchy gives the highest priority to quoted market prices in active markets for identical assets and liabilities [level 1] and lowest priority to unobservable inputs [level 3]. 3. The availability of inputs and their relative subjectivity affect the selection of the valuation technique. 4. The fair value measure is categorised in its entirety at the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.


Questions about whether prices determined using level 3 inputs should be called fair values are based on issues about - the reliability of the fair value numbers - the cost of generating such numbers - the relevance and understandability of these numbers: will users of financial reports treat all fair values the same regardless of the level of inputs? Past experience with entities such as Enron do not inspire confidence in the use of fair value numbers based on unobservable inputs. Whether disclosure will assist in overcoming these problems is an issue on which there is still on-going debate. The standard-setters believe that disclosure will assist in the interpretation of the fair value numbers.

Question 5.15

Disclosures relating to fair values

Disclosures in relation to fair value measurement depend on whether the fair value measurement is recurring or nonrecurring. Explain the difference between these terms and give examples of differences in the disclosures required under the two circumstances.

Recurring and non-recurring bases

Note para 91 of AASB 13 for use of the terms “recurring” and “non-recurring”. Note para 93 (a) for definitions of these terms. “Recurring” fair value measures are those that other AASB accounting standards require or permit in the statement of financial position at balance date. “Non-recurring” fair value measures are those that some AASB accounting standards require or permit in specific circumstances eg in relation to non-current assets held for sale. Disclosures required

Para 91 sets out the objective of the disclosures required under AASB13. In para 91 (a) for both measurement on a recurring and non-recurring basis, the valuation techniques and inputs to develop those measurements must be disclosed. In para 91 (b), for recurring measurements only, where Level 3 inputs are used, the effect of the measurement on profit or loss or other comprehensive income must be disclosed. Note para 93: (a) for recurring and non-recurring (b) for recurring and non-recurring (c) for recurring only: the amounts of any transfers between level 1 and level 2 of the fair value hierarchy, the reasons for the transfers and the entity’s policy for determining when transfers between levels are deemed to have occurred. (d) for recurring and non-recurring


(e) for recurring only when the measures are categorised within Level 3 of the fair value hierarchy – a reconciliation between opening and closing balances disclosing also certain specified changes during the period (f) for recurring only where fair value measures are categorised within Level 3 of the hierarchy (g) for recurring and non-recurring (h) for recurring only where measures are categorised within Level 3 (i) for recurring and non-recurring measures

Question 5.16

Highest and best use

Royal Dutch Shell (2009) stated: 5.2 In practical terms, however, we doubt that an asset measured on any other basis than its intended use will provide more useful information to readers . . . the fact that, say, a site used for production would have a higher market value if it were redeveloped for retail purposes, is not relevant if the entity is not engaged in retail or, more obviously, needs the site in order to carry out its production operations. 5.3 The risk here is that the fair value measure, as redefined, results in irrelevant information.

Required Discuss the issues associated with measuring the fair value of a site currently used for production but which also can be redeveloped for retail purposes.

This quotation raises questions about the utility of fair value information about assets that are held for use rather than exchange. With AASB 13 the standard-setters have been concerned with how to measure fair value rather than when to require fair value measures. As noted in section 5.8.5 of the text, a number of respondents to the IASB questioned whether the measurement of fair value should be prescribed before the measurement section of the Framework has been determined. Potentially the way in which users want to use fair values to make decisions may have an effect on how fair value is determined. The analysis in the section 5.8.5 referring to Whittington’s two schools of thought in relation to measurement shows large differences in the purpose of information and its determination. In the example of the land on which a factory is built but for which there is a higher and better use in terms of residential property, the question of whether the factory should have a fair value of zero may be of concern. It could be argued that measuring the factory at zero would not provide decision-useful information when an entity is using that factory in its operations. In particular users may want to see a depreciation component determined so that they could assess the economic resources consumed in the generation of cash flows process. In other words, it could be argued that the use of fair value in this circumstance does not provide the most decision-useful information. However on the other hand, recording the factory at a zero amount alerts the users of the report that there are alternative uses for the land and factory.

ch05_sm_leo_10e.docx

Recommend Documents