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Introduction to Teaching
Fair Valuein Accounting
Earl K. SticePricewaterhouseCoopers Professor of Accounting
Brigham Young University
3 August 2008
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Key Points
1.Teach the use of basic valuation models.
2.Teach where fair value numbers are used in financial reporting.
3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157.
4.Instructors, and then their students, must learn more about the basics of derivatives.
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Table of ContentsOverview and Questions to Consider............................................................................2 Introductory Financial Accounting...............................................................................5
Example A – At What Amount Should Land Be Recorded? Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Example C – Valuing Buildings With Market Multiples Example D – Valuing of Bonds Held as Investment Securities
Introductory Managerial Accounting .........................................................................13
Capital Budgeting Spreadsheet Assignment Intermediate Financial Accounting.............................................................................19
Cash Flow Projection Models Introduction to Derivatives The Fair Value Option Fair Value Disclosures
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Questions to Consider(page 2)
a.Should accounting professors teach FAIR VALUE, or should we subcontract this to finance professors?
• Current coverage of time value of money is a good model.– Discuss and use in both accounting and
finance.– In accounting classes, come back to it over
and over.
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Questions to Consider (page 3)
b. Where can we fit this material in an already-crowded accounting curriculum?
• Sprinkled in various courses where appropriate– Examples are given in your packet.– Yes, some of our favorite old topics are going
to have to be cut back or even eliminated.
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Questions to Consider (page 3)
c. Where should accounting students learn about spreadsheet modeling?
• Chicago voting is a good model – early and often.– The practitioners told us that this is extremely
important.
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Table of ContentsOverview and Questions to Consider............................................................................2 Introductory Financial Accounting...............................................................................5
Example A – At What Amount Should Land Be Recorded? Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Example C – Valuing Buildings With Market Multiples Example D – Valuing of Bonds Held as Investment Securities
Introductory Managerial Accounting .........................................................................13
Capital Budgeting Spreadsheet Assignment Intermediate Financial Accounting.............................................................................19
Cash Flow Projection Models Introduction to Derivatives The Fair Value Option Fair Value Disclosures
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IntroductoryFinancial Accounting
Important to change
• what we teach, and
• the way we teach,
in the very first accounting class.
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IntroductoryFinancial Accounting
We have been saying for years that our students need more
• Unstructured problems
• Business focus
Fair value is a perfect setting in which to do this.
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Introductory Financial Accounting
Example A (page 5) – At What Amount Should Land Be Recorded?
a. Purchased land for $220,000 one year ago.b. Lorien would have to pay $260,000 to buy an
equivalent piece of land now (but she has special skills).
c. She can sell this land for $310,000 less $20,000 in various fees to finalize the sale.
d. Comparable land sales data• 13,000 square feet• Average sales price = $21.55 per square foot• Low sales price = $20.06 per square foot• High sales price = $24.78 per square foot
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Introductory Financial Accounting
Example A – At What Amount Should Land Be Recorded?
Question: Lorien can use only a
single number to report the value of the land in her balance sheet; at how much should Lorien report the land?
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Introductory Financial Accounting
Example A – At What Amount Should Land Be Recorded?
Historical cost = $220,000
• very reliable
Replacement cost = $260,000
• reflects the general rise in prices
• updated purchase price (with Lorien’s skill)
• But it is a hypothetical price
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Introductory Financial Accounting
Example A – At What Amount Should Land Be Recorded?
Net realizable value = $290,000• Includes a profit• Reflects Lorien’s special skill
Fair value = $280,150 (= $21.55 × 13,000)• Includes a profit• Does NOT reflect Lorien’s special skill• Hypothetical arms’-length price
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Introductory Financial Accounting
Example A – At What Amount Should Land Be Recorded?
Yes, but what is the answer?
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Introductory Financial Accounting
Example B (page 7) – Does Measuring Asset Amounts Depend on the Type of Asset?
Assets
1.Cash
2.Accounts receivable
3.Inventory
4.Investment securities
5.Land
6.Building
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Introductory Financial Accounting
Example B – Does Measuring Asset Amounts Depend on the Type of Asset?
Measurement alternativesa. Historical cost: amount paid to acquire an asset
(adjusted for depreciation)b. Replacement cost: amount that would have to be paid to
acquire the same or an equivalent assetc. Fair value: the price that would be received to sell an
asset in an orderly transaction between market participants
d. Net realizable value: amount of cash into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion
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Introductory Financial Accounting
Example B – Does Measuring Asset Amounts Depend on the Type of Asset?
Question: For each of the six assets, state which one of the four measurement alternatives should be used. Explain your choice.
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Introductory Financial Accounting
Example B – Does Measuring Asset Amounts Depend on the Type of Asset?
Student insightFor investment securities, FAIR VALUE is
a good measurement when there are active markets because
• the “hypothetical” sales price is not so hypothetical and
• market participants approximate price takers so there isn’t much difference between entry and exit prices.
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Introductory Financial Accounting
Example C (page 9) – Valuing Buildings With Market Multiples
CapitalizationSquare Feet Rate
Building 1 15,000 9%Building 2 22,000 10%Building 3 38,000 7%Building 4 41,000 8%Building 5 46,000 10%
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Introductory Financial Accounting
Example C – Valuing Buildings With Market Multiples
Selling Price Square Feet
Capitalization Rate 10,000 20,000 30,000 40,000 50,000 7% 700,000 1,425,000 2,000,000 2,500,000 3,000,000 8% 625,000 1,250,000 1,750,000 2,250,000 2,625,000 9% 550,000 1,100,000 1,550,000 2,000,000 2,300,000
10% 500,000 1,000,000 1,400,000 1,800,000 2,100,000
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Introductory Financial Accounting
Example C – Valuing Buildings With Market Multiples
Question: Estimate the fair value of each of the five buildings.
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Introductory Financial Accounting
Example C – Valuing Buildings With Market Multiples
Numerical solution on page 10.
Student insight: These “fair values” are NOT simply pulled out of thin air.
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Introductory Financial Accounting
Example D (page 11) – Valuing of Bonds Held as Investment Securities
BondTerm Rating
Bond 1 15 AABond 2 6 BBBBond 3 3 AAABond 4 18 BBBond 5 9 A
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Introductory Financial Accounting
Example D – Valuing of Bonds Held as Investment Securities
Bond Prices (% of par) Bond Ratings
Term (in years) AAA AA A BBB BB2 103.85 103.56 102.71 102.37 100.295 103.66 102.53 101.45 100.17 98.50
10 101.64 100.29 99.56 98.54 91.9820 95.66 91.49 90.00 89.31 82.06
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Introductory Financial Accounting
Example D – Valuing of Bonds Held as Investment Securities
Question: Estimate the fair value of each of the five bonds.
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Introductory Financial Accounting
Example D – Valuing of Bonds Held as Investment Securities
Numerical solution on page 12.
Student insight: Some “fair values” are more reliable than others.
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IntroductoryFinancial Accounting
We have been saying for years that our students need more
• Unstructured problems• Business focus
Fair value is a perfect setting in which to do this in the very first accounting class.
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IntroductoryManagerial Accounting (page 13)
Capital budgeting• special case of discounted cash flow
analysis
• good setting in which to help students hone (or learn) their spreadsheet skills
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IntroductoryManagerial Accounting
Capital Budgeting Spreadsheet Assignment
• I show them a completed sample.
• I require them to– make their own spreadsheet using mine as
a model and– do sensitivity analysis using their
spreadsheet.
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Introductory Managerial Accounting
Capital Budgeting SpreadsheetPresent
Amount ValueOriginal Cost -100,000 (100,000)
($100,000 now)
Initial Investment in Working Capital -30,000 (30,000)($30,000 now)
Retrieval of Working Capital 30,000 18,628($30,000 in 5 years)
Net Cash Revenues $24,000 90,979([$70,000 - $30,000] per year for 5 years)
$40,000x(1-.4)=$24,00070000 30000
Depreciation Tax Savings: ($20,000x.4=$8,000 per year) $8,000 30,326
20000Overhaul:
Cost: $20,000 after 3 years -20,000 (15,026)Depreciation Tax Savings:
10000 $10,000*.4 after 4 years 4,000 2,73210000 $10,000x.4 after 5 years 4,000 2,484
Salvage Value 6,000 3,72610000 ($10,000 after 5 years)
$10,000*(1-.4)=$6,000(Assumes capital gain tax) ---------
Net Present Value 3,848=====
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Introductory Managerial Accounting
Capital Budgeting Spreadsheet
YEARS0 1 2 3 4 5
Original Cost -100,000Initial Investment in Working Capital -30,000Retrieval of Working Capital 30,000After-tax Cash Revenues 42,000 42,000 42,000 42,000 42,000After-tax Cash Expenses -18,000 -18,000 -18,000 -18,000 -18,000Depr. Tax Savings, Initial Cost 8,000 8,000 8,000 8,000 8,000Overhaul Cost -20,000Depr. Tax Savings, Overhaul 4,000 4,000After-tax Salvage Value 6,000Net Cash Flow -130,000 32,000 32,000 12,000 36,000 72,000
Present Value of Cash Flows -130,000 29,091 26,446 9,016 24,588 44,706
Net Present Value $3,848Internal Rate of Return 11.005%
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Introductory Managerial Accounting
Capital Budgeting Spreadsheet
• You have the assignment and the solution on pages 13 through 18.
• We will make the spreadsheet itself available to you.
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IntroductoryManagerial Accounting
Capital budgeting• special case of discounted cash flow
analysis
• good setting in which to help students hone (or learn) their spreadsheet skills
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Intermediate Financial Accounting
This is where the fair value “heavy lifting” occurs.
It will be a lot easier if students have been prepared with concepts and tools in the introductory courses.
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Intermediate Financial Accounting
Business Valuation and
Impairment-Related Asset Valuation
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Intermediate Financial AccountingCash Flow Projection Models (page 20)
Three important skills
1. Financial statement articulation
2. Spreadsheet modeling
3. Cash flow projection
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Intermediate Financial AccountingCash Flow Projection Models (page 21)
Home Depot, Inc. Simplified Financial Statements
For Fiscal 1985 (in millions) Cash 10 Receivables 27 Inventory 153 Total Current Assets 190 Gross Property, Plant, and Equipment (PPE) 199 Accumulated Depreciation -9 TOTAL ASSETS 380
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Intermediate Financial AccountingCash Flow Projection Models (page 22)
4. Cash is expected to increase at the same rate as sales.
5. • Average collection period 14.08 days [Accounts Receivable/ (Sales/365)] • Number of Days' Sales in Inventory 107.6 days [Inventory/ (Cost of Goods Sold/365)] • Fixed Asset Turnover 3.518 times [Sales / Gross PPE]
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Intermediate Financial Accounting
Cash Flow Projection Models
Pages 23 and 24
Series of questions to be distributed (after they have constructed their spreadsheets) and discussed in class.
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Intermediate Financial AccountingCash Flow Projection Models (Question 1)
Cash Flow from Operations 40% 1985 1986 1987 1988 1989 1990 Net Income 8 5 7 10 13 19 Depreciation 5 8 11 16 22 31 (Increase) in Receivables (15) (11) (15) (21) (30) (41) (Increase) in Inventories (68) (61) (86) (120) (168) (235) Increase in A/P 23 30 42 58 82 115
Net Cash from Operations (47) (29) (41) (57) (81) (111)
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Intermediate Financial AccountingCash Flow Projection Models (Question 6)
Cash Flow from Operations 40% 1985 1986 1987 1988 1989 1990 Net Income 8 33 50 70 99 138 Depreciation 5 7 10 14 19 27 (Increase) in Receivables (15) 3 (10) (14) (19) (26) (Increase) in Inventories (68) 24 (51) (73) (100) (142) Increase in A/P 23 21 49 58 81 113
Net Cash from Operations (47) 88 48 55 80 110
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Intermediate Financial AccountingCash Flow Projection Models
Three important skills
1. Financial statement articulation
2. Spreadsheet modeling
3. Cash flow projection
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Intermediate Financial Accounting
Introduction to Derivatives (page 25)
From paragraphs A24 and A25
of SFAS No. 157:
• long-dated currency swap
• three-year option on exchange-traded shares
• receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate
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Intermediate Financial Accounting
Introduction to Derivatives
Pages 25 through 341. Understand what a derivative is and how
derivatives can be used to help manage risk.2. Identify the different types of risk faced by a
business.3. Describe the characteristics of the following types
of derivatives: swaps, forwards, futures, and options.
4. Define hedging, and outline the difference between a fair value hedge and a cash flow hedge.
5. Understand the basics of accounting for derivatives
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Intermediate Financial Accounting
Introduction to Derivatives (pages 33,34)
Southwest Airlines Years Ended December 31, (In millions) 2006 2005 2004 OPERATING INCOME 934 725 404 Effect of hedging 634 892 455 Operating income without hedging 300 (167) (51)
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Intermediate Financial Accounting
Introduction to Derivatives
Students completing intermediate financial accounting should know
1. What a derivative is2. The different types of risk faced by a
business3. Characteristics of swaps, forwards, futures,
and options4. What hedging is5. The basics of accounting for derivatives
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Intermediate Financial Accounting
The Fair Value Option (page 35)
Under SFAS No. 159, a company has the option to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date.
Why? – “Mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.”
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Intermediate Financial Accounting
The Fair Value Option (page 35)
Simple balance sheet• One asset, a bond investment• One liability, a bond payable• No equity
Both bonds issued at par and are• $1,000 face value• 20 years• 10% coupon rate
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Intermediate Financial Accounting
The Fair Value Option (page 35)
Assets Liabilities and Equity Lusvardi Bond $1,000 Bonds Payable $1,000 Equity $0
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Intermediate Financial Accounting
The Fair Value Option (page 36)
With the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $851 Bonds Payable $851 Equity $0 ------------------------------------------------------------------------ WithOUT the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $851 Bonds Payable $1,000 Equity ($149)
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Intermediate Financial Accounting
The Fair Value Option (page 37)
With the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $1,196 Bonds Payable $1,196 Equity $0 ------------------------------------------------------------------------ WithOUT the Fair Value Option Assets Liabilities and Equity Lusvardi Bond $1,196 Bonds Payable $1,000 Equity $196
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Intermediate Financial Accounting
The Fair Value Option
Student insight
In spite of all of the criticism about “fair value accounting,” it looks like the FASB’s ideas aren’t all bad.
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Intermediate Financial Accounting
Fair Value Disclosures (page 41)
• Level 1 inputs – quoted prices in active markets for identical assets (or liabilities).
• Level 2 inputs – observable inputs other than quoted prices in active markets for identical assets.
• Level 3 inputs – unobservable inputs.
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Intermediate Financial Accounting
Fair Value Disclosures (page 42)
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Intermediate Financial Accounting
Fair Value Disclosures
Student insight
After the background exposure to valuation models of all sorts, the division into these three levels makes perfect sense.
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Key Points
1.Teach the use of basic valuation models.
2.Teach where fair value numbers are used in financial reporting.
3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157.
4.Instructors, and then their students, must learn more about the basics of derivatives.