Changes In Fair Value Research Articles

The Matrix Format Income Statement: A Case Study about Earnings Management and Reporting Financial Performance

The Matrix Format Income Statement case study allows you to explore the issue of earnings management and its impact on the transparency and understandability of reported financial results. Part A of the case demonstrates the impact of a commonly used accounting treatment for available-for-sale investments (presentation in the statement of changes in equity and recycling of fair value changes) on users' ability to extract decision-useful information. Part B investigates the effect on transparency and understandability of the same financial information when a different presentation and measurement approach, known as the matrix format income statement, is used.

Fair value accounting and the present value fallacy: The need for an alternative conceptual framework

The major functions of company accounting identified by the IASB and the FASB are (1) reporting on ‘the custody and safekeeping’ of the company's resources and (2) reporting on ‘their efficient and profitable use’. The joint IASB/FASB project for improving the conceptual framework for financial reporting is directed towards better performance of both functions within the conventional ‘accrual’ system of accounting through the use of ‘fair value’. Although the disclosure of fair values is a development to be welcomed, the requirement that changes in fair value should be reported as ‘gains’ or ‘losses’ appears to rely on the ‘Hicksian’ concept of income as a theoretical ideal. The object of the present paper is to establish that this concept is fundamentally flawed by what may be called the ‘present value fallacy’. Even in an economic utopia of perfectly competitive markets (with no discrepancies between objective market values and subjective present values), the concept of income or profit as value growth can be seriously misleading. If the prevailing Hicksian conceptual framework is discarded in favour of an alternative based on Fisher's theory of income, the two major, but incompatible, functions of financial reporting can be carried out independently and without compromise. The conventional ‘hybrid’ system of accrual accounting, in which backward-looking measures of volume and forward-looking measures of value are mixed together, would be replaced by a ‘segregated’ system in which they are kept strictly apart. A logical extension of Fisher's theory suggests the disclosure by agent/managers of the return on investment that they are planning to deliver to their principal/owners. This type of ‘decision-useful information’ is vital for the efficient operation of capital markets and for removing the accounting incentive to short-termism.

Including Credit Standing in Measuring the Fair Value of Liabilities—Let's Pass This One to the Shareholders

Measuring and reporting liabilities at fair value is part of the FASB's overall project on fair value measurement and reporting. The FASB has taken the position that in measuring and reporting the fair value of a liability, such as a debt financial instrument, the fair value measure should reflect the credit standing of the issuer. Furthermore, changes in fair value, including the effect of changes in the issuer's credit standing, should be reported as gains and losses on the issuer's income statement. Whether liabilities should be reported at fair value and whether the fair value measure should incorporate credit standing and changes in credit standing are controversial issues. The primary controversy centers on the counterintuitive results of an entity's recording of a loss if its credit standing improves or a gain if its credit standing deteriorates. In this paper, we advocate an alternative position. We propose that liabilities be measured and reported using risk-free rates. This proposed approach recognizes the default risk portion of a debt's fair value as a distribution to shareholders when the liability is incurred. Our proposal supports the FASB's position that an entity's cost of borrowing, that is, interest expense on the entity's income statement, should reflect its credit standing and changes in its credit standing. We believe that our approach to accounting for liabilities is a viable alternative that warrants consideration. It avoids counterintuitive results, is consistent with the theories underlying the pricing of debt securities, and is more consistent with a going-concern assumption that an entity is expected to fulfill its debt obligations.

Performance Measurement for Equity Analysis and Valuation1

This paper comments on the IASB/FASB project on financial statement presentation. It suggests that the basic approach of cohesiveness between statements is worthwhile and the split between operating, financing and investing is useful to investors. However it proposes different valuation and presentation approaches for different activities, and underlines the importance of earnings for forecasting comprehensive income. It suggests a conceptual approach to defining earnings and explores ways of avoiding recycling while identifying fair value changes for some assets and liabilities.

New FASB Statement Requires Initial Fair Value Treatment for Servicing Assets and Liabilities - Look for Increases in Gain on Sale Revenues at Mortgage Companies

The Financial Accounting Standards Board (FASB) recently issued Statement No. 156 - Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140 (SFAS 156) which requires, if servicing assets and liabilities are separately recognized, their initial measurement at fair value. Subsequent measurement may be at the lower of cost or market (accounting method required under old guidance) or at fair value, with changes in fair value recognized in the income statement. The fair value election for subsequent measurement is irrevocable and may be made on a class-by-class basis. This standard may be adopted currently (early adoption is as of January 1, 2006) and must be adopted for 2007. Moody's believes the standard will both positively and negatively affect the quality of the financial information creditors and fixed income investors use in their decision making. The financial statements of mortgage companies, especially the mono-line mortgage companies, are likely to be significantly impacted by the new standard due to the change to fair value measurement at initial recognition for their mortgage servicing rights (MSRs). Recent disclosures support our belief that the large mortgage companies are the most likely candidates to elect fair value treatment for subsequent measurement of servicing assets and liabilities under the new standard.

The Impact of International Accounting Standard 41 'Agriculture' in the Wine Industry

The increasing relevance of fair value as measurement adversely to historical cost put on the agenda of the main accounting standard setting bodies the determination of it is value and afterly its register. This has been shown by recent standard's amendments and issues that enable or even demand the valorisation of certain fair value's elements. The scarce importance given by normalization entities to the agricultural activity lead to the increasingly demanding harmonization of this sector. Aware of this situation, the IASB issued IAS 41, which specifically addresses the fair value measurement of biological assets and agricultural goods. In this paper we will talk about the wine industry. We have chosen this specific industry based on its relevance compared to other agriculture industries. We analyse the impact of IAS 41 and its development, given particular emphasis to the perspective of some of the main players in the standard draft. Finally, this paper comprises an empirical study based on an inquiry sent to a set of companies that are classified as wine industry (CAE 15931). In an empirical level, the methodology used varies accordingly to the different issues pretended. In this way to evaluate the impact of IAS 41 and of fair value changes we used a set of non-parametric tests, such as the test of signs and the Wilcoxon test. The application of these methodologies allowed us to conclude that the adoption of fair value would result in a positive impact on earnings. This will lead to a rise in the companies' gains, since standardization establishes that fair value's fluctuations shall be included on the result of operations over the period in which it arises. In order to understand which relevant factors in standard's application are, we adopt the descriptive, factor, principal components, clusters and discriminant analysis. Although, the study's limitations, we have analysed the results, which allowed us to conclude that the inquired gave more relevancy to the variables related to the applicability of the standard and the experience and knowledge of this and other standards, this is, they consider the applicability of the standard relevant for the sector.

Relative Value Relevance of Alternative Accounting Treatments for Unrealized Gains: Implications for the IASB

AbstractWe investigate the relative value relevance of the alternative accounting methods for unrealized gains on investment properties in New Zealand (NZ). Using both the Likelihood‐ratio test and the F‐test, we find that, while preferred by the NZ standard setter, recognition of unrealized gains in the income statement is not superior to (or significantly different from) recognition of unrealized gains in revaluation reserve in terms of their value relevance. The results are robust to the different research methods we used. Our results have implications for the International Accounting Standards Board in terms of: (i) recognizing changes in fair values of investment properties in the income statement under the revised IAS 40: Investment Property in countries where “realization” refers to net income available for distribution; (ii) its intent to issue a standard on a single statement of comprehensive income; and (iii) its initiative to reduce or eliminate alternative accounting treatments for similar fact situations in its standards.

International accounting standard (IAS) 41: What are the implications for reporting forest assets?

This paper investigates the implications of International Accounting Standard 41 (IAS 41) for European Union (EU) entities reporting on material holdings of forest assets. To all intents and purposes, Australia has been a test for IAS 41 because of the close similarities between IAS 41 and the relevant Australian regulation on forestry that has been operational for the last four years. The Australian reporting experience is used to identify potential implications for EU reporting entities. Evidence suggests that constituents’ key concerns with IAS 41 relate to the measurement of biological assets at fair value and the inclusion in income of unrealised gains or losses from measuring these assets at fair value. These concerns are borne out by the Australian experiences. Evidence is presented that suggests that compliance with IAS 41 will allow statement preparers a choice of methods to determine the fair value of timber assets. Additionally, it seem likely that the recognition of unrealised gains and losses from timber assets from changes in fair value and the harvest of agricultural produce will markedly affect income statements, introducing greater volatility into reported income. The impact has been greater for government departments. The median timber gain expressed as a percentage of net profit ranged from 44.5% to 79.9% in individual years. An unresolved issue has been identified — do such accounting procedures reflect the nature of investment in forestry?

Fair Value Accounting for All Financial Instruments: Perceptions from Managers of Australian Financial Institutions

The Joint Working Group (JWG) proposal for the measurement of all financial instruments at fair value and the recognition of changes in fair value in the income statement met with criticism from the Joint Working Group of Banking Associations QWGBA). This research study investigates the extent to which chief financial officers in Australian financial institutions agree with the JWGBA. Findings indicated respondents tended to agree, albeit to a lesser extent, with the JWGBA. Conversely, they also agree with the JWG, as they believe fair-value information is not commercially sensitive and could be reliably determined.

Fair Values, Income Measurement, and Bank Analysts' Risk and Valuation Judgments

We examine how fair-value-income measurement affects commercial bank equity analysts' risk and value judgments. Normatively, holding information and other underlying economics constant, bank analysts' risk and valuation assessments should distinguish between banks with different risks, but should not depend on how banks measure income. In our experiment, we vary income measurement—full-fair-value (all fair-value changes recognized in income) versus piecemeal-fair-value (some fair-value changes recognized in income, others disclosed in the notes). We also vary interest-rate-risk exposure (exposed versus hedged). We find that bank analysts' risk and value judgments distinguish banks' exposure to interest-rate risk only under full-fair-value-income measurement. Our evidence contributes to research concerned with financial performance reporting, risk, and fair-value accounting by demonstrating that differences in income measurement affect fundamental judgments of specialist analysts. Our findings are striking because they: (1) point toward an important role for measurement and recognition of fair-value gains and losses in income, and (2) suggest that note disclosure is not a substitute for financial-statement recognition (even for professional analysts specializing in banks and working in a context that involves assessment of core operations of a bank). These results should be of interest to accounting standard setters as they evaluate whether to require full-fair-value-income measurement.

Reporting Fair Value Interest and Value Changes on Financial Instruments

AAA Financial Accounting Standards Committee INTRODUCTION The Joint Working Group of Standard Setters' (JWG 2000) Recommendations on Accounting for Financial Instruments and Similar Items (hereafter the Proposal) requires that all changes in the fair value of financial instruments be reported in the income statement, except those associated with certain foreign exchange transactions. The Proposal also requires that the interest and the gain or loss components of these changes in fair value be separately classified on the income statement, and it provides some guidance for calculating these components. Specifically, firms must record interest on a yield to maturity basis, with interest revenue (expense) on a financial asset (liability) being calculated as the current interest rate times the fair value of the instrument during the period. This approach differs from the current amortized cost accounting for interest. Assuming that the total changes in the fair value of financial instruments during the period are recognized in some fashion on the income statem ent, this difference in interest results in exactly the opposite difference in unrealized gains and losses. This commentary summarizes the position of the Financial Accounting Standards Committee of the American Accounting Association (hereafter the Committee) on the Proposal's fair value interest approach. (1) In particular, we compare the relative merits of the fair value and amortized cost approaches to interest. Our discussion assumes that the total changes in the fair value of financial instruments are recognized in some fashion on the income statement each period, so that the only issue is the classification of the components of those changes in fair value. The Committee is not aware of any empirical research that relates specifically to the relative desirability of the fair value and amortized cost approaches to measuring interest. However, empirical evidence supports the importance of reporting items separately with different sustainability and different certainty. By sustainability, we mean that an item persists over time, on average. A sustainable item could be uncertain, however, in that ex post its persistence may be higher or lower than expected. This evidence suggests that the preferred income statement reporting of the total periodic return to a financial instrument is to aggregate income components with similar sustainability and certainty. (2) Conceptually, the periodic returns to financial instruments can be separated into three components with distinct sustainability or certainty. The first two components- amortized cost interest and the difference between fair value interest and amortized cost interest--sum to fair value interest. It is useful to distinguish these two components of fair value interest because amortized cost interest is both sustainable and certain, whereas the difference between fair value interest and amortized cost interest is sustainable but uncertain. The difference between fair value interest and amortized cost interest is sustainable because unexpected changes in interest rates and the resulting unexpected changes in fair values affect fair value interest calculations throughout the remaining lives of financial instruments. For example, an unexpected gain on a financial asset due to a decrease in interest rates in the current period reduces expected fair value interest revenue on the asset throughout its remaining life. T he third component of the periodic returns to financial instruments is the unexpected change in their fair values during the period. Unexpected changes in the fair values of financial instruments are both unsustainable and uncertain. (3) The amortized cost interest method separately reports the first component--amortized cost interest--but combines the second and third components-the difference between fair value interest and amortized cost interest and the unexpected gain or loss. …

Alternative Approaches to Testing Hedge Effectiveness under SFAS No. 133

INTRODUCTION Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities--An Amendment of FASH Statement No. 133, prescribes comprehensive new rules for accounting for derivative instruments (FASB 1998,2000). SFAS No. 133 (para. 3) standardizes the accounting treatment for derivative instruments by requiring all entities to report their derivatives as assets and liabilities on the balance sheet and to measure them at fair value. Reporting changes in the fair value of a derivative in earnings each quarter could create a matching problem. If the derivative is being used as an economic hedge, changes in the value of the derivative might increase (or decrease) reported earnings one period while the opposite change in the value of the hedged item affects earnings in a later period. To avoid distorting earnings, SFAS No. 133 (paras. 3, 20, and 28) permits firms to match the timing of the gains and losses of hedged items and their hedging derivatives, provided the derivative qualifies as a hedge. For a fair-value hedge, SFAS No. 133 (para. 22) permits the hedger to record the change in the fair value of the hedged item concurrently with the gain or loss on the hedging derivative. In the case of a cash-flow hedge, the effective portion of any changes in the hedging derivative's fair value is recorded in other comprehensive income until the change in the value of the hedged item is recognized in earnings (SFAS No. 133, para . 30). (1) In principle, a hedge is highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent. Hedged item refers to an asset or a liability or a prospective cash inflow or outflow. Derivative refers to any derivative or combination of derivatives used to hedge changes in fair value or cash flow. Hedged position refers to the combined hedged item and derivative. The hedged item can be a designated portion of an asset or liability or a designated expected future cash flow that is attributable to a particular risk (SFAS No. 133, paras. 21 and 28, and Derivatives Implementation Group [DIG] Issue E10 [FASB 2000]). To qualify a derivative position for hedge accounting, the hedging entity must specify the hedged item, identify the hedging strategy and the derivative, and document by statistical or other means the basis for expecting the hedge to be in offsetting the designated risk exposure. The documentation step is c alled prospective testing, and it must be done before entering into the hedge and on an ongoing basis to justify continuing hedge accounting. The hedger must also regularly perform retrospective testing to determine how effective the hedging relationship has been in actually achieving offsetting fair values or cash flows. This article examines the test choices that firms must make. Section 2 of Appendix A of SFAS No. 133 requires the use of statistical or other numerical tests for hedge effectiveness, unless a specific exception applies, but SFAS No. 133 does not endorse any specific testing methodology. The hedger must select the methodology, such as regression analysis, choose the measurement period, and specify an appropriate test statistic like adjusted [R.sup.2] along with the critical value to distinguish a hedge from one that is not, for example, an adjusted [R.sup.2] above 0.8. The article describes four existing methods of testing hedge effectiveness: (1) the Dollar-Offset Method, (2) the Relative-Difference Method, (3) the Variability-Reduction Method, and (4) the Regression Method. We refine the Variability-Reduction Method and the Regression Method to correct their potential to accept poorly performing hedges. …

Fair Values, Comprehensive Income Reporting, and Bank Analysts' Risk and Valuation Judgments

We investigate whether the measurement and reporting of comprehensive income in financial statements systematically affects commercial bank equity analysts' investment risk assessments and valuation judgments. In an experiment in which 80 buy side analysts specializing in banking and financial institutions participated, we vary whether a bank is exposed to or hedged against interest rate risk across three different comprehensive income accounting regimes - piecemeal fair value accounting with comprehensive income reported in the statement of changes in equity, piecemeal fair value accounting with comprehensive income reported in a separate statement of performance, and full fair value accounting with comprehensive income reported in a separate statement of performance. When fair value changes are measured and reported on a piecemeal basis, we find no investment risk or valuation judgment differences across CI reporting regimes. Although we find that the analysts' investment risk judgments are influenced by the banks' risk management strategies, their valuation judgments are not. Only when fair value changes are measured completely and reported transparently (i.e., full fair value accounting) do analysts' valuation judgments distinguish between banks with different levels of risk. The study contributes to three avenues of literature concerned with financial-reporting transparency, risk, and fair value accounting. First, our ex ante evidence informs accounting standard setters as they evaluate whether to move to full fair value accounting for all financial instruments, and assess the degree to which differences in comprehensive income measurement and reporting affect the information analysts obtain from financial statements. Second, the study adds to the experimental accounting literature that examines comprehensive income reporting format effects and valuation judgments. Third, we add to archival accounting research on the information in comprehensive income by testing market participants' judgments under different comprehensive income reporting regimes, which cannot be directly investigated with archival data.

Agency Problems, Auditing, and the Theory of the Firm: Some Evidence

Agency Problems, Auditing, and the Theory of the Firm: Some EvidenceAuthor(s): Ross L. Watts and Jerold L. ZimmermanSource: Journal of Law and Economics, Vol. 26, No. 3, (Oct., 1983), pp. 613-633Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/725039Accessed: 29/06/2008 23:14