AC2101 – Accounting

Recognition and Measurement

Seminar 2
Accounting Measurement and Income
Concepts

Semester 1, AY2017/2018

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 Seminar 2 Agenda
▪ Recap from Seminar 1: Gap in Statement of Financial
Position. This seminar,
▪ How to close this gap?
▪ Understanding FRS 113 Fair Value Measurement

▪ Measurement of income under ideal conditions vs.

accounting practice
▪ Time value of money and present value computation

▪ Income: Economic perspective versus Accounting

perspective

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 Recall Diagram from Seminar 1

“GAP” in the
Statement of
Financial Position Current
P/B price to
Ratio book ratio
is about 7

1980s 2000
Year
3
 Close the GAP in the Statement of
Financial Position

▪ Seminar Question 1 – Linsmeier (2011)

▪ Lessons learnt from the crises?

▪ Research studies?

▪ Increasing Use of Fair Value – FRS 113

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FRS 113 – Fair Value Measurement

▪ Effective for annual periods beginning on or after 1

January 2013 or earlier

▪ Reasons to issue FRS 113

▪ Discuss Seminar Question 2

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FRS 113 – Fair Value Measurement
▪ Objective
▪ Defines FV
▪ Sets out a framework for measuring FV in a single
FRS
▪ Requires FV measurement disclosures
▪ Measurement and disclosure requirements of FRS 113
do not apply to the following:
▪ Share-based payment transactions under FRS 102
▪ Leasing transactions under FRS 17
▪ Measurements that have some similarities to fair
value but are not fair value, e.g. NRV in FRS 2

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 FRS 113 – Fair Value Measurement

An exit price An exit price

▪ Definition of fair value
…the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date Market-based transaction
(i.e., not entity-specific)

Current price
Not a liquidation or forced
sale. Assumes that the
transaction takes place in
either the principal market
/most advantageous
market

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 FRS 113 – Fair Value Measurement

▪ Framework for measuring fair value (From FRS 113 para

IN9, para B2)
▪ Determine the particular asset or liability being measured
▪ For a non-financial asset, determine the highest and best
use of the asset (either in combination with other assets or
on a stand-alone basis)
▪ Determine the market in which an orderly transaction would
take place for the asset or liability
▪ Determine the appropriate valuation technique to use
▪ Maximise the use of relevant observable inputs and
minimise unobservable inputs.

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 FRS 113 – Fair Value Measurement

▪ A fair value measurement of a non-financial asset takes into

account a market participant’s ability to generate economic
benefits by using the asset in its highest and best use or by
selling it to another market participant that would use the asset
in its highest and best use, taking into account the use of the
asset that is:

▪ Physically possible – FRS 113 para 28(a)

▪ Legally permissable – FRS 113 para 28(b)
▪ Financially feasible – FRS 113 para 28(c)

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 FRS 113 – Fair Value Measurement

▪ Highest and best use is determined from the perspective of

market participants, even if the entity intends a different use.

▪ However, an entity’s current use of a non-financial asset is

presumed to be its highest and best use;
▪ Unless market or other factors suggest that a different use by
market participants would maximise the value of the asset.

FRS 113, para 29

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 FRS 113 – Fair Value Measurement
▪ Principal Market versus Most Advantageous Market
▪ Principal Market has the greatest volume and activity level
▪ Example adapted from FRS 113 Illustrative Example 6 - Assume
firm owns an asset that can be traded in the following markets:

Market A B
Number of Trades 30 12
Price 26 25
Transport Cost (2) (2)
Possible Fair Value 24 23
Transaction Cost (3) (1)
Net Proceeds 21 22

▪ Which is the Principal Market?

▪ What is the fair value in this case? Hint: price is adjusted for
transportation costs but not transaction costs (FRS 113 paras 25-
26)
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 FRS 113 – Fair Value Measurement
▪ Principal Market versus Most Advantageous Market
▪ Most advantageous market maximizes amount received/paid net
of transaction & transport costs.
▪ Example adapted from FRS 113 Illustrative Example 6 - Assume
firm owns an asset that can be traded in the following markets:
Market A B
Number of Trades 30 12
Price 26 25
Transport Cost (2) (2)
Possible Fair Value 24 23
Transaction Cost (3) (1)
Net Proceeds 21 22
▪ Which is the Most Advantageous Market?
▪ What is the fair value in this case? Hint: price is adjusted for
transportation costs but not transaction costs (FRS 113 paras 25-
26)
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 FRS 113 – Fair Value Measurement
▪ Valuation Techniques
• Price can be directly observable or estimated using
valuation technique but valuation technique should
maximize (minimize) use of relevant observable
(unobservable) inputs
• 3 widely-used valuation techniques are:
• Market approach
• uses prices and other relevant information generated by market
transactions involving identical or comparable (i.e. similar) assets, liabilities
or a group of assets and liabilities, such as a business.
• Cost approach
• reflects the amount that would be required currently to replace the service
capacity of an asset (often referred to as current replacement cost).
• Income approach
• converts future amounts (e.g. cash flows or income and expenses) to a
single current (i.e. discounted) amount.
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 FRS 113 – Fair Value Measurement

▪ Inputs to Valuation Techniques

• Inputs to valuation techniques are categorized into 3
levels known as the FAIR VALUE HIERARCHY:
➢Level 1 inputs = unadjusted quoted prices in
accessible active markets for identical assets/liabilities
➢Level 2 inputs = inputs other than Level 1 that are
directly/indirectly observable
➢Level 3 inputs = unobservable inputs

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 FRS 113 – Fair Value Measurement

▪ Valuation Techniques
• Disclose information to users for assessing
➢The valuation techniques and inputs to
valuation techniques used to develop FV
measurements
➢For recurring FV measurements using Level 3
inputs significantly, their effect on P/L or OCI

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FRS 113 – Fair Value Measurement
▪ Objective
▪ Defines FV
▪ Sets out a framework for measuring FV in a single
FRS
▪ Requires FV measurement disclosures

FRS 113 paras

91-99

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Is the transaction price always
equal to fair value then?
1. Yes
2. No

0% 0%

1 2

17
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Up till this point, we’ve been covering
the GAP in the STATEMENT OF
FINANCIAL POSITION…

▪ Is there also a GAP in the INCOME

STATEMENT?
▪ Understand Accounting Income and Economic
Income
▪ But before that…time value of money (i.e.,
computation of present value)

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 Time Value of Money
The time value of money means that all things being equal,
it is better to have money now rather than later.

Rationale: Like other commodities, money is a scarce

resource. Receiving the same amount of money later
rather than now involves forgoing interest income that
could have been earned during the intervening period.

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 Time Value of Money
Given the time value of money, a dollar is worth more today
than it would be worth tomorrow given its capacity to earn
interest.

Discounting is the method used to figure out how much future

payments are worth today (i.e., their present value).
0 1 2 3 4 5
Time
$1 $1 Interest rate
$0.75 = 10%

$0.62

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 Present Value (PV) of a Single Sum

PV of a single sum represents the value today of a single sum

to be received or paid at a future time.

Formula: PV (Single sum) = Future $

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Present Value (PV) of an Annuity

An annuity is a series of payments of equal amounts.

PV of an annuity:
▪ sometimes called PV of an ordinary annuity, to be
differentiated from PV of an annuity due.

▪ PV (Ordinary annuity)= Annuity $

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 For AC2101 purposes…

▪ Must know how to compute PV-related computations

using the financial calculator (Recommended: Texas BA
II Plus)

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Seminar Q3: Preferred payout is…
1. Lump sum of $1m today
2. Lump sum of $1m 10 years from
now
3. Ordinary annuity of $100K for 10
years
4. Annuity due of $100K for 10 years
25% 25% 25% 25%

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1 2 3 4
Why are we learning PV?

▪ To help us compute economic income…

(later, we will also use PV for leases, bonds etc)

▪ So what is economic income?

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Concept of (net) income in
economics: Solomons (1961)
▪ Hick’s definition
– (Net) Income = the maximum amount a man can
consume in a period and still be as well off at the end of
the period as he was at the beginning
▪ Extending to a business entity…
– (Net) Income = the amount by which an entity’s net worth
has increased during a period, due allowance being
made for any new capital contributed by its owners or for
any distributions made by the entity to its owners

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In other words, net
(economic) income of an
business entity…
V0=Value (Net V1=Value (Net
Worth) of the Firm Worth) of the
at time T0 Firm at time T1

T0 T1

Economic Income = V1-V0

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Concept of (net) income in
economics: Solomons (1961)
▪ But what is the value/net worth (i.e, V0 and V1) of
the firm?
▪ Solomons (1961, pp 376) states “…the Hicksian
income demands that in evaluating net worth we
capitalize expected future net receipts…”
▪ Discuss: Do we capitalise expected future net
receipts for inventory under FRS 2?
▪ Let’s turn to an ideal world situation where we do
“capitalize expected future net receipts”

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Measurement of (Economic) Net
Income under Ideal Conditions with
Certainty
Assumptions (per Scott)

▪ Future cash flows and interest rate are known publicly

with certainty

➢ Known publicly: No information asymmetry

➢ With certainty: Ex ante prediction = Ex post realization

➢ Relevant attribute: NPV of future cash flows

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In other words, net (economic)
income …

PV0 PV1

T0 T1

Economic Income = PV1-PV0

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 Seminar Question 4

▪ Discuss Seminar Question 4 on Economic

Income

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 (Economic) Income measurement
under ideal conditions with certainty
Implications
▪ Total economic income equals total accounting income over the
entity’s entire life but they are not necessarily equal in the interim
periods.
▪ Statement of Financial Position (SFP) reflects 100% of the entity’s
market value
▪ Asset’s NPV = Asset’s market value
▪ SFP is completely relevant and faithfully represented
▪ SFP has all the relevant info and Income Statement has no additional
info (i.e., income is simply the change in financial position between an
accounting period)
▪ Financial reporting is simplified
▪ No recognition/measurement/disclosure problems

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