ก ก ก Mark-to-Market Accounting 30 ก

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1 ก ก ก ก Mark-to-Market Accounting ก กก ก. 30 ก ก

2 Fair Value Accounting & Business Decisions. 1 ก 2

3 IFRS 13 Fair Value Measurement 3 Measurement Bases Historical Cost Accounting Fair Value Accounting 4

4 Needs for Accounting Information A C C O U N T I N G I N F O R M A T I O N Valuation: Shareholders use accounting information in equity valuation. Stewardship: Shareholders use accounting information to assess efficiency of management in making investment and conducting operations to add value for shareholders. 5 The issue of debate is which measurement basis should be applied to determine the summary, bottom-line numbers, earnings and book value on which investors and analysts focus. Question of the Day: Is Fair Value fair? 6 Economist Brian Wesbury represented the views of that group when he declared, Markto-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value.

5 The Conceptual Framework for Financial Reporting 7 Measurement of the elements of financial statements Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement. Measurement bases (a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. 8 (b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

6 (c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. 9 (d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. Historical Cost and Its Importance 10 The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realizable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.

7 Shift to Fair Value Valuation 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. Willing parties are presumed to be market participants representing independent buyers and sellers that are: a. knowledgeable, having a common level of understanding about factors relevant to the asset or liability and the transaction, and b. Willing and able to transact in the same market, having the legal and financial ability to do so. 11 The aim of a fair value measurement is to measure an estimated exchange price for the asset or liability without having to enter into real transaction (Elena,20XX). The fair value estimate is made under conditions of uncertainty. An estimate that excludes compensation for bearing risk would not faithfully represent fair value. IASB -- Moving Towards Fair Value Recently, IASB has adopted the fair value as the primary basis of asset/liability measurement. A substantial potion of a reporting entity s assets and liabilities are stated in the Statement of Financial Position at fair value e.g. financial assets/liabilities (including derivative), pension assets/liabilities, tangible and intangible assets acquired from business combinations, noncurrent assets held for resale, etc. 12

8 Accounting Choices S&L Crisis 1980 s Hamburger Crisis 2008 Historical Cost Accounting Fair Value Accounting 13 The basis premise underlying the FASB s decision is that fair value of financial assets and liabilities better enables investors, creditors, and other users of financial statements to assess the consequences of an entity s investment and financial strategies (Dumitru and Giorgiana, 20XX). Measurement Bases Applied Statement of Financial Position Assets: 14 Cash Investment in Marketable Securities Fair value Accounts receivable Net realizable value Inventory Lower of cost or net realizable value Property, Plant, and Equipment Cost (or revalued amount) less accumulated depreciation and impairment Other assets Mixed Valuation Approaches

9 Measurement of inventories: Inventories shall be measured at the lower of costand net realizable value. Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. 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. 15 Net realizable value refers to the net amount that an entity expects to realize from the sale of inventory in the ordinary course of business. Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific value; the latter is not. Net realizable value for inventories may not equal fair value less costs to sell. Measurement of Property, Plant, & Equipment: Measurement at recognition Measurement after recognition An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost. Cost model: After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. Revaluation model: After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined 16 using fair value at the end of the reporting period.

10 Costis the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognized in accordance with the specific requirements of other IFRSs. Entity-specific value is the present value of the cash flows an entity expects to arise from the continuing use of an asset and from its disposal at the end of its useful life or expects to incur when settling a liability. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm s length transaction. An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. Recoverable amount is the higher of an asset s fair value less costs to sell and its value in use. 17 The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. Impairment of Assets Recoverable Amount VS Carrying Amount The higher of 18 VIU: Value in use NSP: Fair value less costs to sell

11 Matrix Presentation Measurement Bases Identified Assets: Cash Statement of Financial Position Historical Cost Fair Value Investment in Marketable Securities Accounts receivable Inventory Property, Plant, and Equipment 19 Other assets Modification vs. Paradigm Shift 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. Modification to Historical Cost Accounting Fair value variously applied in a mixed attribute model (e.g. Impairment, Cost Allocations) Fair value continually applied as entry value (e.g. Asset revaluation) Fair Value: (a) Market-based rather than entity-based value measurement, and (b) (b) Exit price rather than entry price (Jaggiet al., 2010) Fair value continually applied as exit value (e.g. Mark-tomarket Accounting) Paradigm Shift from Historical Cost Accounting to Fair Value Accounting 3

12 IFRS 9 Financial Instruments Initial measurement of financial instruments: All financial instruments are initially measured at fair value plus or minus, in case of a financial asset or financial liability not at fair value through profit or loss, transaction costs. Initial measurement Subsequent measurement 21 Subsequent measurement of financial assets IFRS 9 divides all financial assets into 2 classifications those measured at amortized cost and those measured at fair value. Classification is made at the time the financial asset is initially recognized. Subsequent Measurement of Financial Assets: Debt Instruments A debt instrument that meets the following 2 conditions can be measured at amortized cost (net of any writedownfor impairment): Fair value option is available. Business model test The objective of the entity s business model is to hold the financial asset to collect the contractual cash flows (rather than to sell the instrument prior to its contractual maturity to realize its fair value changes). Cash flow characteristic test The contractual terms of the financial asset give rise on specified date to cash flows that are solely payments of principal and interest on the principal outstanding. 22 All other debt instruments must be measured at fair value through profit or loss (FVTPL).

13 Subsequent Measurement of Financial Assets: Equity Instruments All equity investments are to be measured at fair value in the statement of financial position, with value changes recognized in profit or loss, except for those equity instruments for which the entity has elected to report value changes in other comprehensive income. If an equity investment is not held for trading, an entity can make an irrevocable election at initial recognition to measure it at fair value through other comprehensive income(fvtoci) with only dividend income recognized in profit or loss. 23 Subsequent Measurement of Financial Liabilities Two measurement categories continue to exist: Fair value through profit or loss (FVTPL) and amortized cost. Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are measured at amortized cost unless the fair value option is applied. Fair value option: IFRS 9 contains an option to designate a financial liability as measured at FVTPL. 24 IFRS 9 requires gains and loss on financial liabilities designated as at fair value through profit or loss to be split into the amount of changes in the fair value that is attributable to changes in the credit risk of the liability, which shall be presented in other comprehensive income, and the remaining amount of the change in fair value of the liability which shall be presented in profit or loss. Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss, the entity may only transfer the cumulative gain or loss within equity.

14 FVTPL Reclassification For financial assets, reclassification is required between FVTPL and amortized cost, or vice versa, if and only if the entity s business model objective for its financial assets changes so its previous model assessment would no longer apply. If reclassification is appropriate, it must be done prospectively from the reclassification date. An entity does not restate any previously recognized gains, losses, or interest. Amortized Cost 25 IFRS 9 does not allow reclassification where: The other comprehensive income option has been exercised for a financial asset, or The fair value option has been exercised in any circumstance for a financial assets or financial liability. Empirical Evidence on Fair Value Option Guthrie et al. (2011) suggest that earnings management is a plausible explanation for only a small number of individual firms electing the fair value option for financial instruments. Current and future earnings management are only marginal factor in determining whether fair value option should be adopted. 26 Fiechter, 2011 stated that the fair value option reduces accounting mismatches which results in lower volatility in earnings.

15 IFRS 13 Fair Value Measurement The fair value hierarchy categorizes the inputs used in valuation techniques into 3 levels. The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure fair value are categorized into different levels of the fair value hierarchy, the fair value measurement is categorized in its entirety in the level of the lowest level input that is significant to the entire measurement. 27 Fair Value Hierarchy: Level 1, 2, &3 Inputs Level 1 inputs Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 inputs Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs 28 Level 3 inputs are unobservable inputs for the asset or liability.

16 Fair Value Hierarchy: Level 1 Inputs Level 1 inputs Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 inputs A quoted market price in active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value Level 2 inputs whenever are inputs available, other with than limited quoted exceptions. market prices included within Level 1 that are observable for the asset or If an liability, entity holds either a directly position or in a indirectly. single asset or liability and the asset or liability is traded in an active market, the fair value of the asset or liability is Level measured 3 inputs within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity, even if the market s Level 3 inputs normal are daily unobservable trading volume inputs is not for sufficient the asset to absorb the liability. quantify held and placing orders to sell the position. 29 Level 2 inputs Fair Value Hierarchy: Level 2 Inputs Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. 30 Level 2 inputs include: Quoted prices for similar assets or liabilities in active markets. Quoted prices for identical or similar assets or liabilities in markets that are not active. Inputs other than quoted prices that are observable for the asset or liability, for example Interest rates and yield curves observable at commonly quoted intervals Implied volatilities Credit spreads Inputs that are derived principally from or corroborated by observable market data by correlation or other means ( market-corroborated inputs )

17 Level 3 inputs Fair Value Hierarchy: Level 3 Inputs Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity s own data, taking into account all information about market participant assumptions that is reasonably available. 31 Fair Value Hierarchy IFRS IAS39 (proposed version before IFRS 13) Level 1 = Quoted prices in an active markets US GAAP FAS 157 Level 1 = Market prices Level 2 = More recent quoted price Level 3 = Estimation of fair value by reference to similar financial instruments Level 4 = Valuation techniques incorporating a maximum of observable data Level 5 = Valuation techniques incorporating non-observable data Level 2 = Model prices with observable inputs Level 3 = Model prices with no observable inputs 32 IASB later adopted the view similar to that of FASB.

18 Fair Value Measurement Approach A fair value measurement requires an entity to determine all of the followings: The particular asset or liability that is the subject of the measurement (consistently with its unit of account). For a non-financial asset, the valuation premise that is appropriate for measurement (consistently with its highest and best use). The principal (or most advantageous) market for the asset or liability. 33 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 when pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorized. Guidance on Measurement An entity takes into account the characteristics of the asset or liability being measured that a market participant would take into account when pricing the asset or liability. Fair value measurement assumes an orderly transaction between market participants at the measurement date under the current market condition. Fair value measurement assumes a transaction taking place in the principal market or liability, or in absence of a principal market, the most advantageous market for the asset or liability. A fair value measurement of a non-financial asset takes into account its highest and best use. 34 A fair value of measurement of a financial or non-financial liability or an entity s own equity instruments assumes it is transferred to a market participant at the measurement date, without settlement, extinguishment, or cancellation at the measurement date.

19 Valuation Techniques Objective of Valuation Techniques The objective of using a valuation techniques is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants and the measurement date under current market conditions. 35 Market approach 36 Uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business) Cost approach Reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost). Income approach Converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.

20 Disclosure IFRS 13 requires an entity to disclose information that helps users of its financial statements assess both of the followings: For assets and liabilities that are measure at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements. For fair value measurement using significant unobservable inputs ((Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period. 37 Key definitions: IFRS13 Fair Value Measurement Fair value 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. Active market A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. Exit price The price that would be received to sell an asset or paid to transfer a liability. Highest and best use The use of a non-financial asset by market participants that would maximize the value of asset or the group of assets and liabilities (e.g. business) within which the asset would be used. Most advantageous market The market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transport cost. Principal market The market with the greatest volume and level of activity for the asset and liability. 38

21 Empirical Evidence on Value Relevance of Fair Value 39 Landsman, 2007 suggests that the fair value information is informative to investors. However, the level of informativeness depends on the amount of measurement error and source of the estimates management or external appraisers. Hitz, 2007 determines the decision usefulness of fair value information under valuation perspective and information perspective and yields mixed results. Song et al., 2010 suggest that the value relevance of Level 1 and Level 2 fair values is greater than that of Level 3 fair values. Moreover, the value relevance of Level 3 fair values is greater for the firms with strong corporate governance mechanism. 40

22 One-to-one Condition for Fair Value: +++ Fair Value Fair value is appropriate when value to shareholders is determined solely by exposure to market price; that is, shareholder value is one-to-one with market prices. One-to-one condition for fair value applies: 41 Investments in securities in trading portfolio and derivatives instruments Pension assets Investments by insurance company Real estates held for speculation Options that give counter party the call rights. A marketable bond in which a firm invests its excess cash is exposed to changes in market price that determines the amount of cash on liquidation, and shareholder welfare is tied to the market price, one-forone. This is appropriate for trading portfolio where the investor gets return from the changes in the market price (Penman, 2007). 42

23 One-to-one Condition for Fair Value: --- Fair Value Fair values are a minus when the firm arbitrages market prices, i.e. fair value is not appropriate when the firm adds value (for shareholders) by buying at (input) market prices and selling at (output) market prices. One-to-one condition for fair value does not apply: 43 Inventory Investment in subsidiary, associate, jointly controlled entity Performance obligations Receivables allowances and warranty liabilities Property, plant, & equipment Raw materials used in manufacturing does not get its value from a change in its exit price, but as an input into a process that adds value to its market price by producing a product and selling it to customers. The change in the shareholder value is not one-to-one with changes in the market price of raw materials, but for adding value from buying inputs favorably and selling it to customers with mark-ups (Penman, 2007). 44

24 Fair Value Accounting Statement of financial position becomes the primary source of information to shareholders. Assets and liabilities are stated at fair value, book value of equity reports value of equity. Statement of income reports economic income since it is the changes in value over a period. Volatility in earnings is informative for value at risk. Income reports the value added to shareholders wealth. 45 SFP provides information on valuation. SCI provides information on risk exposure and performance. Historical Cost Accounting Statement of income is a main vehicle for conveying message about value to investors. Earnings report how well the firm has performed in arbitraging prices in input (supplier) markets and output (customer) markets. Historical cost earnings report the value added buying inputs at one price, and selling them at another price. Current earnings can be used to forecast future earnings. Earnings measure the stewardship of management in arbitraging input and output markets (in adding value to shareholders). 46 SCI focuses on matching of revenues (value received from transactional exit prices) with costs (value surrendered in transactional input prices). SFP is a by-product of matching concept.

25 47 48

26 Enron made extensive use of what it called mark-to-market accounting. Enron s mark-to-market actually, mark-to-estimate practices would have fallen into the income approach for valuation using unobservable, i.e., Level 3, inputs under SFAS Chief economist Brian S. Wesburyand his colleague Bob Steinat First Trust Portfolios of Chicago estimate the impact of the "mark-tomarket" accounting rule on the current crisis as follows: "It is true that the root of this crisis is bad mortgage loans, but probably 70% of the real crisis that we face today is caused by markto-market accounting in an illiquid market. What's most fascinating is that the Treasury is selling its plan as a way to put a bottom in mortgage pool prices, tipping its hat to the problem of mark-to-market accounting without acknowledging it. It is a real shame that there is so little discussion of this reality." (Emphasis added.)

27 Fair Value and Financial Crisis Financial Crisis Assets value of financial institutions were significantly declined due to the mark-tomarket requirements. 51 Mortgage-backed securities (MBS) were affected negatively, which resulted in further decline in market values. Fair Value & Business Cycle -- Upturns Increase in liquidity High market demand In good times (adopted from Matherat, 2008) Increase unrealized gains Increase in asset value Macroeconomic impact increase in leverage in creation of bubbles. 52 Increase balance sheet The upward revaluation of assets reflects in profits may lead to pressure on management to distribute dividends. The price bubbles may be started by excess liquidity in the markets, which leads to procyclicaland self-extending write-ups (Caruana and PazarbasioGlu, 2008).

28 Fair Value & Business Cycle -- Downturns Decrease in liquidity Forced sales In bad times (adopted from Matherat, 2008) Downward pressure on deleveraging effect Decline in asset value Macroeconomic impact forced deleveraging through recapitalization and credit crunch 53 Impact in balance sheet The downturn revaluation of assets may be rapid and severe. The use of fair value accounting from the beginning of the cycle could itself exacerbate the overshooting of prices on the upside and therefore lead to a shaper fall during the downturn (Caruanaand PazarbasioGlu, 2008). Pluses Arguments for Fair Value (Penman, 2007 and Jaggi, et al., 2010) 54 Investors are concerned with value, not cost, so report fair values. With the passage of time, historical prices become irrelevant in assessing an entity s current financial position. Prices provide upto-date information about the value of assets. Fair value accounting reports assets and liabilities in the way that an economist would look at them; fair values reflect true economic substance. Fair value accounting reports economic income: in accordance with the widely accepted Hicksiandefinition of income as a change in wealth, the change in fair value of net assets on the balance sheet yields income. Fair value accounting is a solution to the accountant s problem of income measurement, and is to be preferred to the hundreds of rules underlying historical cost income. Fair value is a market-based measure that is not affected by factors specific to a particular entity; accordingly it represents an unbiased measurement that is consistent from period to period and across entities.

29 Minuses Arguments for Fair Value (Penman, 2007 and Jaggi, et al., 2010) Fair values are not appropriate when they replace historical cost accounting from which fair value is assessed. Fair values bring price bubbles (inefficient price) into financial statements. Mismatch problem may create excess volatility in earnings. The fair value accounting exacerbated the financial crisis by reducing the values of assets. Fair value accounting lead to procyclicaltrends, which could potentially increase systematic risk in financial markets. The reliability of fair value estimation is an issue of concern. 55 Modifications to Fair Value Requirements after Financial Crisis Possible modifications are made in authoritative guidance on fair value measurement during the economic downturns. Orderly transactions FASB provides a process for determination of fair value when the volume and level of activity for the assets and liabilities are significantly lower than the normal market activity. 56 Guidance is provided in the case that debt securities are otherthan-temporarily impaired.

30 in extreme cases, mark-to to-model degenerates into what I would call mark-to to-myth myth (Buffett, 2003). 57 References Caruana, J. and C. Pazarbasioglu Revisiting Valuation Practices Throughout the Business Cycle: Some Symmetry is needed. Financial Stability Review, 12: Dumitru, M. and B. C. Giorgiana. 20XX. Searching for the Fair Story Behind Fair Value for Financial Instruments. Economic Science Series: Elena, N. M. 20XX. Issues Regarding Valuation in Accounting: From Historical Cost Towards Fair Value. Economic Science Series: Fiechter, P The Effects of the Fair Value Option under IAS 39 on the Volatility of Bank Earnings. Journal of International Accounting Research, 10(1): Guthrie, K., J. H. Irving, and J. Sokolowsky Accounting Choice and the Fair Value Option. Accounting Horizons, 25(3): Hitz, J-M The Decision Usefulness of Fair Value Accounting A Theoretical Perspective. European Accounting Review, 16(2):

31 References Landsman, W. R Is Fair Value Accounting Information Relevant and Reliable? Evidence from Capital Market Research. Accounting and Business Research, Special Issue: International Accounting Policy Forum: Lins, K. V., H. Servaes, and A. Tamayo Does Fair Value Reporting Affect Risk Management? International Survey Evidence. Financial Management, Fall: Matherat, S Fair Value Accounting and Financial Stability: Challenges and Dynamics. Financial Stability Review, 12: Penman, S. H Financial Reporting Quality: Is Fair Value a Plus or a Minus?. Accounting and Business Research, Special Issue: International Accounting Policy Forum: Song, C. J., W. B. Thomas, and H. Yi Value Relevance of FAS No. 157 Fair Value Hierarchy Information and the Impact of Corporate Governance Mechanism. The Accounting Review, 85(4):