Accounting Theory

Session 4
Problem Set 6
Chapter 7
Measurement Applications

Adapted from Scott,

Financial Accounting Theory

Prof. Garen Markarian, PhD 1

 Problem Set 6
Question 1
1) Accounts receivable are usually valued on the balance sheet at
current value, namely the amount owing from customers less an
allowance for uncollectible accounts. Does this violate the historical
cost basis of accounting? Explain.
Note: A good answer will consider the point in the operating cycle
at which revenue is realized.

Prof. Garen Markarian, PhD 2

 Problem Set 6
Solution 1 (1)
1) Does this violate the historical cost basis of accounting? Explain.
Strictly speaking the answer is yes: post-revenue-realization assets such as
accounts receivable are valued at the net amount expected to be received.
This amount approximates present value if we accept that the time to
collection is sufficiently short that discounting is not needed. Present value
(i.e.: value-in-use) is a version of current value, consistent with a
measurement approach, not a cost approach.
Complete historical cost accounting for accounts receivable would require
them to be valued at cost of the inventory or services sold until cash is
received.

Prof. Garen Markarian, PhD 3

 Problem Set 6
Solution 1 (2)
1) Does this violate the historical cost basis of accounting? Explain.
A no answer can also be argued if we accept that the historical cost basis of
accounting only holds up to the point in the firm’s operating cycle at which
revenue is regarded as earned, usually the point of sale. Financial assets
generated subsequent to this point can be valued at current value without
violating the historical cost basis of accounting.

Prof. Garen Markarian, PhD 4

 Problem Set 6
Question 2 (1)
2) A technology company sells a complex computer program. It
promises customers that it will provide updates and virus
protection for three years from date of sale. The company
recognizes 80% of the proceeds of selling the program as revenue,
and records the remaining 20% as a liability to be extinguished
over three years. The company tentatively plans to recognize one-
third of the 20% liability as revenue each year, on grounds that this
produces the best matching of costs and revenues.
However, it consults you before finalizing its policy.

Prof. Garen Markarian, PhD 5

 Problem Set 6
Question 2 (2)
2) You point out that accounting standards are now primarily based
on a measurement approach, and that matching of costs and
revenues is not consistent with this approach. Instead, you
recommend that the liability be measured at the amount the firm
would rationally pay to be relieved of the obligation.

Required:
a. Explain why matching of costs and revenues is not consistent with a
measurement approach.
b. Suggest one or more ways to determine the amount the firm would
rationally pay to be relieved of the obligation.
c. Compare the relevance and reliability of your suggested approach(es) with
the matching approach of writing the obligation off over three years.
Prof. Garen Markarian, PhD 6
 Problem Set 6
Solution 2 a
2) Required:
a. Explain why matching of costs and revenues is not consistent with a
measurement approach.
Under historical cost accounting, the income statement is the primary
financial statement. Net income for a period represents the difference
between revenue recognized during the period and the historical costs of
earning that revenue. When revenue is received in advance, it is deferred to
future periods when it will be matched with the costs of earning that
revenue: it is not viewed as a liability, as it would be under a measurement
perspective, but rather as revenue that is not yet earned.
Similarly, asset values on the balance sheet are not intended to represent
their value, but rather the costs of those assets that will be matched with
revenues in future periods.
Prof. Garen Markarian, PhD 7
 Problem Set 6
Solution 2 b
2) Required:
b. Suggest one or more ways to determine the amount the firm would
rationally pay to be relieved of the obligation.
The firm would normally calculate the discounted present value of the costs
expected to meet its contractual liability. This is the amount the company
would be rationally willing to pay to be relieved of this obligation.
However, if there is a market for the required services, and if the market
value of the services is less than the company’s cost estimate, the obligation
would be valued at the lower amount. This is now the amount that the
company would rationally pay to be relieved of the obligation.
The liability would be remeasured at each period end over the three years,
to show the expected cash outflows remaining.
Prof. Garen Markarian, PhD 8
 Problem Set 6
Solution 2 c
2) Required:
c. Compare the relevance and reliability of your suggested approach(es) with
the matching approach of writing the obligation off over three years.
The approach suggested in b. is more relevant than the matching approach
since it measures expected future cash flows. Under historical cost
accounting, the balance sheet measure of the liability does not measure
future cash flows but rather the portion of the deferred revenue remaining
to be allocated to future periods.
The approach suggested in b. is less reliable than the matching approach.
Allocation over three years is a straightforward calculation, whereas an
estimate of discounted future expected cash flows is subject to estimation
error and possible bias.
Prof. Garen Markarian, PhD 9
 Problem Set 6
Question 3 (1)
3) Under current accounting standards, such as IAS 39, loans are
valued at amortized cost. That is, valuation is based on expected
future receipts from the loan discounted at the effective rate of
interest established at loan acquisition. If the loan becomes
impaired (i.e.: expected future receipts fall), the loan is written
down to its new expected value, discounted at the original effective
rate.

Prof. Garen Markarian, PhD 10

 Problem Set 6
Question 3 (2)
3) During the 2007-2008 market meltdowns, these write-downs were
criticized for waiting “too long”. That is, write-downs were delayed
until the financial institution holding the loan decided that
impairment had occurred. This often generated huge write-downs,
particularly if the impairment had been building up over some
considerable period of time prior to the impairment recognition.
In 2009, the IASB proposed to record write-downs sooner.
Specifically, the expected future cash flows used to determine the
effective interest rate would now include expected credit losses over
the life of the loan.

Prof. Garen Markarian, PhD 11

 Problem Set 6
Question 3 (3)
3) This proposal did not satisfy the Basel Committee on Banking
Supervision, a group of central bankers and financial supervisors
from major world economies. The Committee proposed that the
IASB should consider providing for credit losses through the
business cycle (dynamic provisioning). That is, in periods of high
economic activity, loan lenders should provide greater-than-
expected credit losses when calculating expected present value of
future loan receipts. This would create an excess allowance that
could be used to absorb greater-than-expected credit losses in
periods of low economic activity. The result would be to bolster
banks’ loans loss protection and smooth reported earnings over the
business cycle.

Prof. Garen Markarian, PhD 12

 Problem Set 6
Question 3 (4)
3) Required:
a. Evaluate the relevance of each of the three loan loss policies outlined
above.
b. Evaluate the reliability of each policy.
c. Why not require fair value accounting for loans, rather than amortized
cost accounting?

Prof. Garen Markarian, PhD 13

 Problem Set 6
Solution 3 a (1)
3) Required:
a. Evaluate the relevance of each of the three loan loss policies outlined
above.
The three policies are increasing in relevance. Under IAS 39, loans are
valued at their discounted expected future receipts before any provision for
credit losses. Credit losses are recognized as loans become impaired. Since
the essence of relevance is to predict future cash flows, a delay in
recognizing impairment until it takes place reduces relevance relative to
inclusion of expected future credit losses in the original loan valuation,
which is the policy under the 2009 IASB proposal.

Prof. Garen Markarian, PhD 14

 Problem Set 6
Solution 3 a (2)
3) Required:
a. Evaluate the relevance of each of the three loan loss policies outlined
above.
The Basel Committee’s suggested policy is the most relevant of all, since it
predicts cash flows over the business cycle, rather than over the term of the
loan as in the 2009 IASB proposal. In effect, the Basel Committee’s
proposal predicts cash flows over a longer period than the IASB proposal.

Prof. Garen Markarian, PhD 15

 Problem Set 6
Solution 3 b
3) Required:
b. Evaluate the reliability of each policy.
The three policies are decreasing in reliability. As the period over which
credit losses are predicted lengthens, the potential for changes in interest
rates, errors of estimation, and bias increases.

Prof. Garen Markarian, PhD 16

 Problem Set 6
Solution 3 c (1)
3) Required:
c. Why not require fair value accounting for loans, rather than amortized
cost accounting?
Fair value accounting for loans would require valuing them at their market
value or, if a reasonably well-working market did not exist, at their present
values discounted at a current interest rate rather than at the effective rate
established at loan acquisition. This rate is subject to change as interest
rates in the economy, and the firm’s cost of capital, varies over time.

Prof. Garen Markarian, PhD 17

 Problem Set 6
Solution 3 c (2)
3) Required:
c. Why not require fair value accounting for loans, rather than amortized
cost accounting?
If such a market exists, valuing loans at market value would be most
consistent with the measurement perspective (i.e.: at fair value), and should
be reasonably reliable. If a market does not exist, valuation at discounted
expected value using a current interest rate should approximate fair value
(e.g.: level 3 valuation), but would be low in reliability. Only if the increase
in relevance of this valuation exceeded the decrease in reliability should
fair value accounting be applied.

Prof. Garen Markarian, PhD 18

 Problem Set 6
Solution 3 c (3)
3) Required:
c. Why not require fair value accounting for loans, rather than amortized
cost accounting?
However, the most likely reason for amortized cost accounting rather than
fair value is political. Fair value accounting for loans increases earnings
volatility, and possible liquidity pricing during a severe recession. This
results in severe pressure from management, who object to fair valuation of
loans when their intent is to hold them to maturity.

Prof. Garen Markarian, PhD 19

 Problem Set 6
Question 4
4) Should firms be required to fair value their long-term debt, even in
the absence of a mismatch? Explain.

Prof. Garen Markarian, PhD 20

 Problem Set 6
Solution 4 (1)
4) Should firms be required to fair value their long-term debt, even in
the absence of a mismatch? Explain.
This question does not have a clear answer, and is currently being debated
by the IASB.

Prof. Garen Markarian, PhD 21

 Problem Set 6
Solution 4 (2)
4) Should firms be required to fair value their long-term debt, even in
the absence of a mismatch? Explain.
Arguments against fair valuing long-term debt:
• Market value of debt falls following a credit downgrade. It may seem strange to
many persons that the firm record a gain following a credit downgrade.
• The reduction or increase in fair value of debt creates a wealth transfer from debt
holders to shareholders. Under the equity view of financial reporting, such a wealth
transfer is not a gain or loss to the entity. Thus, no gain or loss should be recognized.
• Many firm assets, such as self-developed goodwill, patents, R&D, are not valued on
the balance sheet. Downgrades or increases in the credit rating of debt is frequently
due to changes in the value of these assets. Yet, such changes are not recognized in
current earnings, while if debt is fair valued, changes in fair value are included. This
creates a mismatch situation that increases the volatility of reported earnings.
Prof. Garen Markarian, PhD 22
 Problem Set 6
Solution 4 (3)
4) Should firms be required to fair value their long-term debt, even in
the absence of a mismatch? Explain.
Arguments in favor of fair valuing long-term debt:
• To the extent firm assets are fair valued on the balance sheet, and changes in fair
value contribute to changes in the firm’s credit rating, failure to fair value debt
creates a mismatch. If so, firms should be required to fair value their debt, so as to
reduce mismatch.
• If the proprietorship view of financial reporting is accepted, changes in the fair value
of debt represent a gain to shareholders, which should be reflected in earnings.
• To the extent that the balance sheet is the primary financial statement, assets and
liabilities should be fair valued, subject to reasonable reliability. Inability to fair
value certain assets, such as intangibles, should not be used as a reason not to fair
value liabilities.
Prof. Garen Markarian, PhD 23
 Problem Set 6
Question 5
5) A firm buys, and designates, an effective forward contract to hedge
the price risk of its current stock of inventory. Suppose that the
inventory is still on hand at period end, and that its market value
has fallen. Will application of the lower-of-cost-or-market rule
create a loss on inventory on the firm’s income statement? Explain
why or why not.

Prof. Garen Markarian, PhD 24

 Problem Set 6
Solution 5
5) (…) Will application of the lower-of-cost-or-market rule create a
loss on inventory on the firm’s income statement? Explain why or
why not.
No: if the inventory has fallen in value, the value of the forward contract
has risen. Any write-down of inventory under the lower-of-cost-or-market
rule will be offset by a gain from valuing the hedging instrument at fair
value.

Prof. Garen Markarian, PhD 25

 Problem Set 6
Question 6 (1)
6) An economist suggests that the best measure of a firm’s income is
the change in the market value of that firm’s shares over the period
(adjusted for capital transactions). Furthermore, he argues, such a
measure would avoid the reliability problems of attempting to fair
value individual assets and liabilities, particularly intangibles such
as goodwill. In effect, he asks, why not fair value the whole firm?

Prof. Garen Markarian, PhD 26

 Problem Set 6
Question 6 (2)
6) Required:
a. How much information would net income calculated this way add to what
the market already knows about the firm?
b. Note that measuring income as the change in the firm’s market value is
equivalent to fair valuing all its assets and liabilities, including self-
developed intangibles. Given that standard setters are attempting to
extend fair value accounting to additional assets and liabilities, how far
should fair value accounting be extended while still providing useful
information to investors? In your answer, consider whether fair valuation
of self-developed goodwill would be decision useful. Could valuing self-
developed goodwill at current value be decision useful? Why or why not?

Prof. Garen Markarian, PhD 27

 Problem Set 6
Solution 6 a
6) Required:
a. How much information would net income calculated this way add to what
the market already knows about the firm?
Net income calculated this way would add nothing to what the market
already knows.

Prof. Garen Markarian, PhD 28

 Problem Set 6
Solution 6 b (1)
6) Required:
b. (…) how far should fair value accounting be extended while still providing
useful information to investors? In your answer, consider whether fair
valuation of self-developed goodwill would be decision useful. Could
valuing self-developed goodwill at current value be decision useful? Why
or why not?
This suggests a limit to the extension of fair value accounting. While fair
valuation of individual assets and liabilities may be decision useful, fair
valuation of all of them would not be decision useful, as per a..
In particular, fair valuing self-developed goodwill is not decision useful,
since the fair value of self-developed goodwill incorporates what the
market already knows about firm value.

Prof. Garen Markarian, PhD 29

 Problem Set 6
Solution 6 b (2)
6) Required:
b. (…) how far should fair value accounting be extended while still providing
useful information to investors? In your answer, consider whether fair
valuation of self-developed goodwill would be decision useful. Could
valuing self-developed goodwill at current value be decision useful? Why
or why not?
However, current value of self-developed goodwill would be decision
useful if relevance outweighed problems of reliability, since current value
would reveal inside information about management’s expectations of future
firm performance.

Prof. Garen Markarian, PhD 30