moodle.najah.edumoodle.najah.edu/.../content/0/ch10_sm_rankin.docxWeb viewSolution Manual. to accompany. Contemporary Issues in Accounting. Michaela Rankin, Patricia Stanton, Susan

Solution Manual

to accompany

Contemporary Issues in Accounting

Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto

& Matt Tilling

PREPARED BY:

Matthew Tilling

John Wiley & Sons Australia, Ltd 2012

Solution manual to accompany: Contemporary Issues in Accounting

CHAPTER 10

FAIR VALUE ACCOUNTING

Contemporary Issue 10.1 How to conjure up billions

1. What is the relationship between liabilities and the recording of goodwill? (K)K GM recorded some of its liabilities at amounts that exceeded fair value, primarily related to employee benefits. The difference between those liabilities’ carrying amounts and fair values gave rise to goodwill as the identifiable net assets were reduced creating a difference with equity value that was ‘filled’ with goodwill. The bigger the difference, the more goodwill GM booked. In other instances, GM said it recorded certain tax assets at less than their fair value, which also resulted in goodwill.On the liabilities side, for example, GM said the fair values were lower than the carrying amounts on its balance sheet because it used higher discount rates to calculate the fair value figures. The higher discount rates took GM’s risk of default into account, driving fair values lower. 2. Explain how GM can argue that because it has a higher risk of default the fair

value of the liabilities would be lower than their carrying amount. (J, K) This is a direct result of the requirement that liabilities be carried at their market value. Remember that the IASB in the Basis for Conclusions paragraph BC88–BC89 to IFRS 13 states that “the fair value of a liability equals the fair value of a properly defined corresponding asset”. Someone holding GMs debt would reduce its value to account for a higher default risk. This translates into a lower liability value, as the companies on credit risk must be included in the calculation. J K3. Discuss what would be most relevant to the users of GM’s financial statements with

regards to the valuation of the liabilities. (J, K, AS) This is an interesting issue. Surely the expected amount to be paid is most relevant. In fact it could be argued that by taking into account the entity’s own credit risk the principles of going concern have been violated. Contemporary Issue 10.2 Serial floats and patent porkies 1. Describe the three acceptable valuation techniques and how they could be used the

fair value of the patent in this scenario. (K)

a) The market approach is based on the ability to identify a market for an identical or comparable asset or liability.

© John Wiley and Sons Australia, Ltd 2012 10.1

Chapter 10: Fair value accounting

This would require a similar patent to be identified and then a market price established. In reality it is very unlikely that a similar enough patent will be found as patents by their nature are meant to be unique. Also there is not a well-established or active market.

b) The income approach is based on converting future cash flows or income and

expense into a single present value.This would require the use of cash flow budgets and significant estimates of future performance.

c) The cost approach is based on an estimate of the cost of replacing the ‘service

capacity’ of the asset under consideration.This would focus simply on the cost incurred to date in securing and developing the patent.

2. Provide examples of the inputs you could use to establish the fair value of the patent

and to what level those inputs would be assigned. (J, K, AS) There are a range of potential inputs to any model employed to value a patent. The majority, other than costs, are going rely heavily on unobservable assumptions and are therefore going to be level 3 inputs. 3. Given that the valuation of the patent did involve a sales transaction would this

indicate that the market approach was the appropriate one to use in this case? What weight can be placed on the ‘independent valuation’? (J, K)

It would appear that the sale was not a market transaction as it involved related parties and therefore does not represent a market approach, therefore it is not appropriate to use in this case. The independent valuation is worrying, though it is difficult to tell from the article whether it was the patent that was valued or the transaction. IT could be perfectly true that 24 million was “paid” for the patent and this is what has been verified. It is also possible that the “transactions” are not inappropriate, the question is the recording in the accounts.



Review Questions

1. Why has the IASB decided to release a standard on ‘fair value’, given that it is a general term, rather than a specific accounting issue?

Because it is seen as such a key concept in accounting and is used across so many standards the IASB clearly feels it is important to crystallise all the relevant material in a single standard. It will be interesting to see how this standard integrates with the Conceptual Framework as the measurement concepts are developed and expanded in the coming months and years.

2. What alternative measures are used in the accounting to value items? Provide specific examples.

As discussed in Chapter 4 Measurement accounting uses a mix measurement model. Traditionally historic cost has been the predominant measure in accounting. It focuses on the actual amount paid for an item though adjustments may be made over time to account for changes in the asset. This approach is used for many items including intangibles, property plant and equipment, and inventory. Current replacement cost is the amount that would be paid at the current time to purchase an identical item. It can be used to measure inventory when current cost represents net realisable value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It can be used to measure property plant and equipment under the revaluation model. Present value is the present discounted value of the future net cash flows associated with the item. It can be used to measure the value of biological assets.

3. What are the main arguments against the old definition (i.e. the one presented in Appendix A of AASB 3) of fair value?

IFRS 3/AASB 3Business Combinations Appendix A defined fair value as:

The amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arms-length transaction.

The use of the word ‘exchanged’ is problematic. In this hypothetical transaction, is the asset being measured from the point of view of the buyer or the seller? Applying the definition to liabilities is a little confusing. First, what do we mean by settle a liability. In reality, a liability isn’t settled with knowledgeable and willing parties, but rather a creditor who has a right to receive the money.The definition does not make it clear on which date this exchange should be valued.What does it mean to be a ‘willing’ party? An organisation may be in distress and in urgent need of cash and therefore willing to sell an asset at a deep discount for rapid reimbursement.

4. Identify and discuss the objectives of the fair value standard.

The fair value standard has the following objectives:



(a) to establish a single source of guidance for all fair value measurements required or permitted by IFRSs to reduce complexity and improve consistency in their application;(b) to clarify the definition of fair value and related guidance in order to communicate the measurement objective more clearly; and(c) to enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used and to inform them about the inputs used to derive those fair values.

These certainly appear to justify the need for an authoritative standard on fair value. The first is focussed on accounting information producers, while the second is focussed on users. The third objective is the most significant in some ways. While the IASB stated they did not want to significantly change accounting practice around fair value simply clarify, the enhanced disclosure has brought with it significant additional requirements for reporting entities and accountants.

5. What is the new definition of fair value? Explain the key parts to this definition.

The definition of fair value in paragraph 9 of IFRS 13 Fair Value Measurement 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.

Key parts of this definition are: Price - it is based on an exchange value.Would – it can be a hypothetical transaction.Received to sell – it is an exit pricePaid to transfer – again an exit price.Orderly transaction – Market has time to operate and no duress.Market participants – Arms-length transactionMeasurement date – the date the transaction would be assumed to occur.

6. Why has the IASB chosen to use exit price as the primary measure of fair value?

The use of an exit price offers a number of advantages. First, it is current. It allows users to focus on a value today, not some historic price that may or may not be relevant under today’s conditions. Second, it is specific. It focuses on the asset or liability at hand, rather than the price to purchase a generic equivalent item. Third, it has a level of independence by introducing, if only hypothetically, an external party into the transaction. The value is based on its estimate of value, not the price the entity was, or is, prepared to pay for the item.

7. Assuming an entity does not want to sell an asset, how is exit price useful to the users of that entity’s financial statements?

Exit price is seen to capture more than just the price of an asset but more intrinsically its value in use. As discussed in the text we can put up an economic rationalist argument that ultimately concludes that the exit price must closely approximate the expected future benefit contained in the asset. The same logic can also be applied to liabilities.The point where a sale will occur is therefore constrained by the minimum the current owner will accept and the maximum the potential buyer will pay and both are determined with



reference to the expected future benefit to be received from the asset. There may be some difference in opinion or potential benefit or risk tolerance based on access to skills or markets, but in a reasonably efficient market these differences will not be significant. Therefore, the sales price of an asset can be taken as a fair estimate of its future value, or the expected future economic benefit to be realised, which is a fundamental part of the definition of an asset.And this expected future economic benefit is also assumed to be useful information to the users of the entity’s financial statements.

8. The existence of a market is very important to determining fair value. What factors would indicate an appropriate market exists?

Appendix B to the standard, which contains the application guidance, devotes considerable discussion to how to identify when a market is not to be considered active, and therefore not amendable to an orderly transaction and so not an appropriate basis for assigning a fair value. Based on the factors identified in paragraph B37 we can conclude an active market DOES exist when:(a) There are sufficient recent transactions.(b) Price quotations are developed using current information.(c) Price quotations don not vary substantially either over time.(d) There exist Indices that are highly correlated with the fair values of the asset or liability.(e) There are low implied liquidity risk premiums, yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices.(f) There is a narrow bid-ask spread or at least a steady bid-ask spread.(g) There is a market for new issues (i.e. a primary market) for the asset or liability or similar assets or liabilities.(h) Information is publicly available.

9. If it is determined that markets for the item under consideration are inactive, does that mean they cannot be fair valued? Discuss.

Under IFRS 13, if it is determined that the market is not active, then an entity may determine that significant adjustments are needed to quoted prices to accurately reflect estimated fair value, or in fact market prices may not be used at all. Instead, an alternative valuation technique (or techniques) may be used if deemed appropriate. The standard does not describe a method for making these adjustments should they be deemed necessary.This creates some interesting issues.So the obvious answer is yes, you can still fair value. But is it still a fair value in accordance with the definition if it is not based on market valuations? Probably not. A number of respondents to the exposure draft suggest that if a market does not form the basis of the valuation then it should not be called a ‘fair value’ but something else. The IASB decided this would be too confusing and did not introduce a separate terminology. Second, does this create a dangerous precedent that may encourage accountants to declare a falling market (which is often accompanied by some of the indications of an ‘inactive’ market as described in paragraph B37) to be inactive. They can then make adjustments up to artificially increase the value of an asset?

10. While fair values are based on market prices, the standard also states that fair values are based on the specific item being valued. What does this mean



when considering the valuation of a share in company? A large piece of mining equipment?

The valuation of a share in a company should be a relatively straight forward undertaking. Assuming the share is publically traded, and we are talking about a common class of share, there is a market and each share in the market is identical (having the same rights). So no adjustment should need to be taken to account for the fact it is a ‘different’ share that we are valuing.The mining equipment will need adjustment. Even if there is an active market for the mining equipment we are fair valuing because each individual piece of equipment will have specific characteristics that will impact on the amount buyers are willing to pay. This could be condition, age, location, use based. So even in an active market consideration will need to be given to the value attached to the specific item being valued.

11. What are the limitations on determining the highest and best use for an asset when establishing fair value?

Paragraph 28 of IFRS 13 imposes three limitations to keep the estimates realistic and focused on the specific asset to be valued:

(1) the use must be physically possible, taking into account, for example, the location or condition of the asset; (2) it must be legally permissible, considering for example zoning regulations; and (3) it must be financially feasible, meaning that even if physically and legally possible, it would be fiscally sensible to put the asset to the nominated best use.

12. Identify and discuss the hierarchy for fair valuing liabilities.

The standard sets out a hierarchy for valuing liabilities and equity. In the first instance, if there is an active market for the debt or equity, then this market will provide a fair value for the debt or equity. When public prices aren’t available for the debt or equity, according to paragraph 37 of IFRS 13 the entity should, where possible, ‘measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date’. Should no corresponding asset exist for a liability or equity then the entity needs to use a valuation technique based on the assumptions that would be used by market participants.The first level is most consistent with the fair value ideal, but relatively uncommon for liabilities. The second level is interesting from an economic theory perspective. Also note that this is not the case under the leases standard for many types of finance lease, where often the lease liability does not equal the lease asset (note of course leases are excluded from the fair value standard). The third level is the most contentious and has the potential to significantly impact on firms that have liabilities for restoration.

13. Describe the valuation techniques that can be used to fair value an asset, which method is preferred?

Paragraph 62 states that there are three widely used techniques that can be used to fair value an asset and that the entity ‘shall use valuation techniques consistent with one or more of those approaches to measure fair value’. The techniques are outlined in some detail in Appendix B to IFRS 13.



The market approach is based on the ability to identify a market for an identical or comparable asset or liability. This approach is theoretically most directly related to the intention of the standard. Depending on the nature of the market, adjustments may need to be made to take existing transactions and best approximate the price that would be relevant to the specific item under consideration. The income approach is based on converting future cash flows or income and expense into a single present value. Usually this would mean using discounted cash flow models, but could alternatively use much more complex models such as a Black–Scholes– Mertons options pricing approach.The cost approach is based on an estimate of the cost of replacing the ‘service capacity’ of the asset under consideration. This is what is known as the current replacement cost in accounting theory. The cost is calculated not based on a new asset, rather an asset that would substitute to derive comparable benefit, taking into account the ‘obsolescence’ of the current asset. The technique chosen is a matter for professional judgment however, paragraph 67 of IFRS 13 requires that the accountant maximise relevant observable inputs and minimise unobservable inputs. In practice this would mean that the market approach is most likely to be preferred. However, this also means that where a market is inactive, as previously discussed, alternative valuation methods are available to an entity.

14. Describe the 3 levels of inputs that can be used in valuing an item under AASB 13/IFRS 13. How is the valuation level ultimately determined?

Appendix A of IFRS 13 defines inputs as:

The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following: the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model); and the risk inherent in the inputs to the valuation technique.

Inputs may be observable or unobservable. Observable inputs are split into two levels, those that do not need to be adjusted, that is, they are based on active markets for identical assets or liabilities, these inputs are termed Level 1 inputs. Other observable inputs require adjustment to reflect quantitative or qualitative differences between the item under consideration and the market observed, these inputs are termed Level 2 inputs. Level 3 inputs are based on unobservable inputs that require estimation and inference by the entity.In establishing the fair value of an item the entity will most likely have to use a range of inputs. Paragraph 73 of IFRS 13 is clear:

The fair value measurement is categorised in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.

‘Significant’ requires professional judgement to interpret.

15. What information must be disclosed when an item in the balance sheet is measured at fair value? How are the disclosures different depending on the level of input?

The principles for disclosure are set out in paragraph 91 of IFRS 13:



An entity shall disclose information that helps users of its financial statements assess both of the following:(a) for assets and liabilities that are measured at fair value on a recurring or nonrecurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements.(b) for recurring fair value measurements using significant unobservable inputs (Level-3), the effect of the measurements on profit or loss or other comprehensive income for the period.

The actual disclosures required are comprehensive, as indicated in paragraph 93 of IFRS 13,

and are outlined in the text. As the level of measurement moves from level 1 through to level

3 the amount and nature of the disclosure becomes increasingly comprehensive.



Application questions

10.1 In light of the Conceptual Framework for Financial Reporting what are the broad arguments for and against the use of fair value and modified historic cost in accounting? [J,K]

The argument over which is better, modified historic cost or fair value has traditionally formed around the terms relevance and reliability. Historic cost is argued to be more reliable while fair value has been argued to be more relevant. Generally the concept of prudence has been called upon to support reliability and therefore historic cost. The recent rewriting of the conceptual framework, which has exchanged reliability for faithful representation, coupled with the preferencing of relevance have signalled a shift towards fair value. The framework also emphasises that faithful representation requires a lack of bias, both positive or negative, invalidating arguments in favour of prudence.

10.2 The fair valuing of liabilities has proved problematic for the IASB. Discuss the old definition and contrast with new definition. Have the problems been satisfactorily dealt with, are there other issues to consider? [K,J]

The old definition focused on the “settlement of a liability”. The concept of settlement was difficult to define and could be very specific to the firm and tended to lead to a focus on future events. The new definition shifts the focus to a market, what would it cost to pay someone else to take the liability off the firm’s hands. This creates a focus on the current condition and terms of the liability and introduces the market into its valuation. It has solved many of the associated confusion, but is still problematic. It may be that the current organisation is uniquely positioned or advantaged in settling the liability and therefore could argue that a market valuation will lead to an over estimate of the eventual cost. Also some liabilities are difficult to shift and therefore very difficult to secure an appropriate market valuation.

10.3 As noted in the chapter, potential valuation bases were considered when deciding how to measure fair value. Describe each and, where appropriate, give examples of how these are already used in accounting. [K]

Past entry priceUnmodified historic cost. Generally used for inventory valuation.

Past exit price Immediate resale value when purchased.

Modified past amountModified historic cost. Often used for plant and equipment.

Current entry priceCurrent purchase price.

Current exit priceCurrent selling price. Basis for fair value.

Current equilibrium priceThe intersection of entry and exit price. An economic ideal.

Value in useDiscounted value of future cash flows. Probably the most useful measure of value, sometimes used to achieve a fair value.

Future entry priceValue asset could be purchased for in the future.



Future exit price.Value asset could be sold for in the future.

10.4 Paragraph 16 of AASB 13/IFRS 13 indicates that fair value should be based on the principal or most advantageous market for an item. What do these terms mean and how does this relate to the value of the item to the entity itself? [K]

The Principal Market is the market with the greatest volume and level of activity for the asset or liability. The Most Advantageous Market is 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 taking into account transaction costs and transport costs. It has been argued that because they do not relate to the current use of the asset they provide an inappropriate basis on which to value an asset or liability. However the IASB argues that an entity should be aware of these markets and that they would sell the item into them if their current use did not entail at least an equivalent amount of value. Hence these markets are indicative of the base value of an item to the entity and therefore provide useful information.

10.5 XYZ Ltd owns a land based drilling rig. It is in near perfect condition and unmodified. The company wishes to establish a fair value for the rig and identified two markets where near identical rigs are being actively traded. In Market A, the price that would be received is $27 000, there will be a commission payable to a selling agent of 10% and it will cost $3,000 to transport the rig to that market. In Market B, the price that would be received is $26 000, there are no commissions to pay and the costs to transport the asset to that market are $3000. What fair value would be placed on the asset based on this information? Show workings and explain. [K, AS]

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

Most advantageous marketMarket A: $27 000 – 2700 – 3000 = $21 300Market B: $26 000 – 3000 = $230 000

Therefore Market B is the most advantageous and the fair value of the asset is $23,000 as this only takes into account transportation costs. If there had been commissions or other transaction costs these would have been excluded once the most advantageous market was identified.

10.6 An entity wants to fair value some of its motor vehicle asset, which consist of approximately 20 motor vehicles of various, but common, commuter type cars. How would the entity go about fair valuing those motor vehicles and what factors would it need to consider? [J, K, AS]

The decision to fair value must be applied at the class level. So if some motor vehicles are to be valued, then all motor vehicles must be fair valued unless it is possible to argue that there are distinct groups of motor vehicles with very difference uses within the organisation. Having established which vehicles are to be fair valued a process would have to be undertaken. Given these are common, commuter type cars it would seem that a market based approach is most appropriate. Appropriate adjustments would need to be made based on market factors that participants would consider in



valuing the assets. Presumable make and model of the vehicle, kilometres driven, condition of the vehicles.

10.7 The concept of highest and best use to value an asset has been criticised by a number of respondents to the fair value exposure draft. They argued that it may not reflect the actual use of the asset by the entity and therefore provides a misleading valuation for the asset under consideration. Why did the IASB proposed this definition and how is it justified in situations where the use is clearly different. [J, K]

The arguments used by the IASB assume a relatively efficient market and economic rationalism. The efficient market argument assumes the entity is reasonable aware of the value the asset has to them, and the value they could get from other markets. Economic rationalism assumes that the entity will take options that maximise profit and return to shareholders. Therefore entities with assets would sell the item into the most advantageous or principal market if their current use did not entail at least an equivalent amount of value. Hence these markets are indicative of the base value of an item to the entity and therefore provide useful information.

10.8 10 years ago your organisation bought a block of land on the Perth foreshore for $500 000. Over the next two years an apartment block was constructed on the site at a cost of $5 000 000. The apartments are currently owned by your organisation and sublet to tenants on a variety of leases not longer than five years. You want to establish the fair value of the property using AASB 13/IFRS 13. You have ascertained the following information for your assessment: [J, K, AS]

I. Two separate expert valuations have been received. One valuer said the property was worth around $9 000 000 ($1 000 000 for the land and $8 000 000 for the building). The other valuer said it was worth $6 000 000 ($750 000 land value and $5 250 000 building value). Both valuers acknowledge that valuing the building in the current economic climate is difficult as there have been few sales of comparable buildings recently. They have used their experience of prior markets to estimate the values.

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

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

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



(a) Discuss each of the above four values as a basis for establishing fair value. In accordance with AASB 13/IFRS 13 which methodology do you believe is most appropriate? What additional information would you like to obtain to make a better estimate?

Valuation A is superficially based on a market valuation. While this is ideal any many circumstances, the evidence here would strongly suggest there is an inactive market. And therefore significant adjustments may need to be made to the valuations. Using this valuation would quickly introduce a number of level 3 inputs. In addition the significant variations in value presented would suggest that this just simply isn’t an appropriate base. One thing that is clear from the standard, simply collecting a number of valuations and averaging them is not an appropriate approach.

Valuation B is a cost approach. This may be appropriate in this situation. Adjustments may need to be made to account for the current condition of the building, and a way still needs to be found to value the land. But this may introduce the least number of unobservable inputs.Valuation C is an income approach. In an ideal world the income approach gives the most relevant information about the value of an asset. However in the real world it often relies on the most number of assumptions and is subject to the potential for significant manipulation. In this case, given the time frames involved and the associated uncertainties of the building rental market it would seem unlikely that this provides an appropriately reliable basis for valuation. The figures given appear insufficiently detailed and considered. Is it likely that the net cash inflow will remain steady for 20 years? How was the value for the land established? Substantial though would need to be put into the appropriate discount rate, accounting for a range of factors specific to the project.Valuation D is not a fair value but simply and application of the modified historic cost which is an acceptable alternative to fair value.Given the limited information available the most appropriate approach to fair value the asset would appear to be based on approach B current replacement cost. It is possible that with further refinement an appropriate income approach could be established, but it would require significant additional work and possibly a number of level 3 inputs.



Case Study questions

Case study 1 Former FDIC Chief: fair value caused the crisis

1. A number of observers suggest that fair valuing of CDOs under the old definition caused the global financial crisis of 2008. What do you think of this argument? [J, AS]

2. What indications were there that the market was not working properly? [J, AS]3. Under AASB 13/IFRS 13, how would these financial instruments been valued? [J, AS]

There has also been significant academic research on this question and a review of the literature will turn up more recent discussion. However in short there are two camps, as so often seems to be the case. One side tends to argue that failure to use fair value allowed the CDOs to be carried at an inflated price for too long that actually made the crisis worse. Proponents of this view argue that this is exactly why fair value should be used. Opponents of fair value argue that because market values had to be used, and this was especially true under previous applications of the fair value rule to financial instruments, when a market goes ‘toxic’ that is trades falls to below rational expectations, these values are required to be used in the financial statements even though the holder does not intend to sell. CDOs had a market value of zero and therefore had to be recorded as such even though the holders believed there was intrinsic value in the instruments. The market panicked confusing market value with actual value and this lead to the potential for a ‘run on the bank’.There were clear indications that the market had gone toxic, liquidity had left the market, trade volumes were non-existent and the market values that were present were substantially below a rational valuation of the instruments. Under IFRS 13 adjustments can be made to market prices when there is clear indication that the market is not working properly.This addresses some of the concerns raised by users about the implementation of fair value. However it raises other concerns. It is acknowledged that not only do there exist times when markets are toxic but also when they are irrational exuberant. The new standards allows financial report prepares to uncritically accept and use inflated market prices and then potentially turn around and argue, when prices are falling, that the market has become inactive and therefore attempt to avoid recording declines in value.



Case study 2

Required1. Identify the three valuation techniques that could have been used for establishing fair

value and discuss their appropriateness in this situation. [K]2. There are two present value approaches outlined in AASB 13/ IFRS 13. How are they

different and how would it have changed your approach to establishing fair value in this case study? [J, K]

3. Calculate the expected present value of the liability in accordance with AASB 13/IFRS 13. [AS]

4. How would your value have differed if you had simply calculated the valuation based on the entities expected discounted cash flow? [J, AS]

5. How is this difference in valuation, which has caused concern in the mining industry, justified by the IASB? [J, K]

6. What is non-performance risk and why is it included in the calculation? [K]

1. The standard states that there are 3 widely used techniques and that the entity must “use valuation techniques consistent with one or more of those approaches to measure fair value”. The techniques are then outlined in some detail in Appendix B to IFRS 13.

2. The market approach is based on the ability to identify a market for an identical or comparable asset or liability. This approach is theoretically most directly related to the intention of the standard. Depending on the nature of the market, adjustments may need to be made to take existing transactions and best approximate the price that would be relevant to the specific item under consideration.

The income approach is based on converting future cash flows or income and expense into a single present value. Usually this would mean discounted cash flow models familiar from finance, but could alternatively be much more complex models such as a Black-Scholes-Mertons options pricing approach.

The cost approach is based on an estimate of the cost of replacing the “service capacity” of the asset under consideration. This is what is known as the current replacement cost in accounting theory.

3. Expected “Settlement Value” (Old definition):

Expected Labour Costs in 10 Years: $250 000 (weighted average)Overhead: $200 000Total: $450 000Inflation factor (4% for 10 years) 1.4802Expected Cash Flow $666 090

Discount Rate: 5%

Present Value = $666 090/ (1 + 0.05)^10 = $408 921



Expected Exchange Value (Current definition):

Expected Labour Costs in 10 Years: $250 000 (weighted average)Overhead: $200 000Contractors Mark Up $90 000Total: $540 000Inflation factor (4% for 10 years) 1.4802Expected Cash Flow $799 308

Market Risk Premium (add 5%) $39 965

Risk Adjusted Expected Cash Flow $839 273

Discount Rate: 8.5% (includes non-performance risk)

Present Value = $839 273/ (1 + 0.085)^10 = $371 198

4. The technique chosen is clearly a matter for professional judgment and will depend on the circumstances and information available to the accountant attempting to make the valuation. However the standard, in paragraph 67, requires that the accountant maximise relevant observable inputs and minimise unobservable inputs. In practice this would mean that the market approach is most likely to be preferred. However this also means that where a market is inactive, as previously discussed, alternative valuation methods are available to an entity.

5. In this case the only option available that makes sense is an income approach. 6. Non-performance risk 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.



Additional Readings

Gwilliam, D., & Jackson, R. H. G. (2008). Fair value in financial reporting: Problems and pitfalls in practice A case study analysis of the use of fair valuation at Enron. Accounting Forum, 93947600(02), 240-259.

Rayman, R. (2007). Fair value accounting and the present value fallacy: The need for an alternative conceptual framework. The British Accounting Review, 39(3), 211-225. Retrieved from http://www.sciencedirect.com/science/article/B6WC3-4P0NC17-1/2/3ee78d96a90a3b01e5e797a70d663b4e

Ronen, J. (2008). To Fair Value or Not to Fair Value: A Broader Perspective. Abacus, 44(2), 181-208. doi:doi:10.1111/j.1467-6281.2008.00257.x

Whittington, G. (2008). Fair Value and the IASB/FASB Conceptual Framework Project: An Alternative View. Abacus, 44(2), 139-168. doi:doi:10.1111/j.1467-6281.2008.00255.x


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moodle.najah.edumoodle.najah.edu/.../content/0/ch10_sm_rankin.docxWeb viewSolution Manual. to accompany. Contemporary Issues in Accounting. Michaela Rankin, Patricia Stanton, Susan