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AC2101 PRESENTATION QUESTION MEASUREMENT & INCOME Seminar Group 1 Project Team 1 • Gary Chong • Michelle Tan • Brenda Kwong • Yeoh Keong Yee • Chua Yan Ting
AC2101 PRESENTATION QUESTION
MEASUREMENT & INCOME
Seminar Group 1 Project Team 1•Gary Chong•Michelle Tan•Brenda Kwong•Yeoh Keong Yee•Chua Yan Ting
2 Part 1Gary Chong
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Part 1 AAA Ltd purchased 2 equipment items on 1 January 20x1. Equipment 1 has a 2-year useful life (salvage value is zero
with zero disposal cost) and will generate cash flows of $500 at the end of each year.
Equipment 2 has a 5-year useful life and will generate cash flows of $250 each at the end of each of the last 4 years.
AAA Ltd operates in ideal conditions under certainty. The interest rate is constant at 5% per annum All cash flows from operations in one period are paid out as
dividend on the first day of the following period (assuming that dividends can be paid of share capital as well)
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1. How much did AAA Ltd pay, to the nearest dollar, to acquire the two equipment items on January 1, 20x1?
Value of Equipment 1: + = $929.7052
Value of Equipment 2: + + + = $844.2739
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500 $500Equipment 2 $250 $250 $250 $250
I=5%
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1. How much did AAA Ltd pay, to the nearest dollar, to acquire the two equipment items on January 1, 20x1?
Total Value: Value of Equipment 1 + Value of Equipment 2= $929.7052 + $844.2739= $1,773.9791= $1,774 (Nearest Dollar)
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2. What is the total economic depreciation, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x1?Recall that Economic Depreciation = Value of Asset at START of the year – Value of Asset at END of the year
Total Value of Equipment 1 & 2 at start of 20x1 = $1,773.9791
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2. What is the total economic depreciation, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x1?
Total Value of Equipment 1 & 2 at end of 20x1= + + + = $1,362.6781
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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2. What is the total economic depreciation, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x1?
Economic Depreciation= $1,773.9791 - $1,362.6781= $411.3010= $411 (Nearest Dollar)
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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Approach #1
Economic Income = Revenue – Economic Depreciation
Economic Depreciation = $1,362.6781 – ( + + )= $1,362.6781 - $680.8120= $681.8661
3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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Approach #1
Economic Income = Revenue – Economic Depreciation= $750 – $681.8661= $68.1339= $68 (Nearest Dollar)
3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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Approach #2Hick’s definition of Economic Income:PV of the firm at the end of the year – PV of the firm at the start of the year
PV of the firm at the start of 20x2 = Cash + Value of Machine= 0 + + + + = $1,362.6781
3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?
Approach #2
PV of the firm at the end of 20x2 = Cash + Value of Machine= $750 + + + = $1,430.8120
20x1 20x2 20x3 20x4 20x5
Equipment 1 $500Equipment 2 $250 $250 $250 $250
I=5%
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3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?Approach #2
Total Economic Income= $1,430.8120 - $1,362.6781= $68.1339= $68 (Nearest Dollar)
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3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?Approach #3
Total Economic Income = Interest Rate * PV of the net asset at the start of the year= 0.05 x $1,362.6781= $68.1339= $68 (Nearest Dollar)
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4. How will your answers above change if no dividends are paid out by AAA Ltd?
If dividends are not given out, interest on cash generated by machine will be
earned.
4. How will your answers above change if no dividends are paid out by AAA Ltd?There will be no changes to Question 1.
The interest earned from the cash flow will not affect the valuation of the two equipment.
4. How will your answers above change if no dividends are paid out by AAA Ltd?There will be no changes to Question 2.
No interest is earned yet at December 20x1 because cash is only first generated at December 20x1.
4. How will your answers above change if no dividends are paid out by AAA Ltd?There will be changes to Question 3.
Interest will be earned at December 20x2 from the cash flow of $500 generated from Equipment 1.
Hick’s definition of Economic Income:PV of the firm at the end of the year – PV of the firm at the start of the year
Approach #1PV of the firm at the start of 20x2= Cash + Value of Machine
= $1,362.6781
PV of the firm at the end of 20x2= Cash + Value of Machine
= $1,455.8120
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3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?
Total Economic Income= $1,455.8120 - $1,362.6781= $93.1339= $93 (Nearest Dollar)
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3. What is the total economic income, to the nearest dollar, of AAA Ltd for the annual period ending December 31, 20x2?Approach #2
Total Economic Income= $68 + (0.05 x $500)= $68 + $25= $93
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Part 2 – Michelle TanExplain clearly why each of the following statements is TRUE or FALSE
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A. Financial information need not be a prediction or forecast to have predictive value
True A piece of financial information can be said to have predictive value if it allows users to predict future outcomes, so as to make good financial decisions or evaluate future events.
Financial information need not be a prediction or forecast itself to have predictive value. Users employ financial information with predictive value as a tool in making their own predictions.
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B. Financial information has confirmatory value if it provides feedback about previous evaluations
True Information with confirmatory value should be such that it confirms or changes previous evaluations, therefore being capable of making a difference in its users’ decisions.
E.g. A piece of information that allows users to confirm a previously estimated outcome has confirmatory value.
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C. Neutral information does not mean information with no purpose or no influence on behaviour
True A piece of information is neutral when it is not biasedly selected or presented in order to increase the probability that it will be received more favourably or unfavourably by users.
Such information can still be relevant and useful in influencing users’ decisions.
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D. Faithful representation does not mean accurate in all respects True Faithful representation = Complete, neutral, free from error
Free from error Completely accurate Free from error No errors or omissions in the description of the phenomenon, and process to produce reported information has been selected and applied with no errors
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D. Faithful representation does not mean accurate in all respects Estimate of an unobservable price/value cannot be determined to be accurate or inaccurate.
However, the information would be free from error and faithfully represented as long as… - it is specified clearly and accurately that it is an estimate
- the nature and limitations of the estimation process are explained
- no errors have been made in selecting and applying the process for coming up with the estimate
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E. Verification of data must be done only by direct means/observation to ensure verifiability
False Verification of data can be done by direct or indirect means
Direct means/observation Verifying an amount or other representation through direct observation.
E.g. Counting cash
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E. Verification of data must be done only by direct means/observation to ensure verifiability
Indirect means/observation Checking inputs to a model, formula or other technique and recalculating the outputs using the same methodology.
e.g. Verifying the carrying amount of inventory by checking the inputs and recalculating the ending inventory using the same cost flow assumption
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Part 3 – Brenda KwongFair Value Measurement of Asset
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QuestionCCC Ltd owns an asset that can be traded in five differently located markets. CCC Ltd does not have access to the market at location 3.
What is the fair value of the asset?
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Data in QuestionMarket at location
1 2 3 4 5
Number of trades
38 35 34 33 30
Price of the asset
$30 $28 $27 $25 $32
Transport Cost
$3 $4 $1 $1 $2
Transaction Cost
$4 $3 $2 $3 $2
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Definition of Fair Value
… fair value as 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.
(FRS 113 para 9)
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Characteristics of Asset A fair value measurement is for a particular asset or liability…take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:
(a) the condition and location of the asset; and (b) restrictions, if any, on the sale or use of the asset
(FRS 113 para 11)
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Definition of Market A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:
(a) in the principal market for the asset or liability; or
(b) in the absence of a principal market, in the most advantageous market for the asset or liability.
(FRS 113 para 16)
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Access The entity must have access to the principal (or most advantageous) market at the measurement date.
(FRS 113 para 19) Since CCC Ltd does not have access to the market at Location 3, we do not consider location 3 when determining Principal/Most Advantageous market.
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Principal Market The market with the greatest volume and level of activity for the asset or liability.
(FRS 113 Appendix A)
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Applying Principal MarketMarket at location
1 2 3 4 5
Number of trades
38 35 34 33 30
Price of the asset
$30 $28 $27 $25 $32
Transport Cost
($3) ($4) ($1) ($1) ($2)
Possible Fair Value
$27 $24 $24 $30
Transaction Cost
$4 $3 $2 $3 $2
Market at Location 1 has the highest number of trades Principal Market
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Fair Value in Principal Market Location is a characteristic of the asset Fair value of the asset would be measured using the price that would be received in that market, after taking into account transport costs
Fair Value = Price of asset – Transport cost = $30 - $3
= $27
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Transaction Costs? No adjustment for transaction costs of $4 Transaction costs are not a characteristic of an asset or a liability; rather, they are specific to a transaction and will differ depending on how an entity enters into a transaction for the asset or liability
(FRS 113 para 25)
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Extension: Most Advantageous Market 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
(FRS 113 Appendix A)
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Applying Most Advantageous Market
Market at location
1 2 3 4 5
Number of trades
38 35 34 33 30
Price of the asset
$30 $28 $27 $25 $32
Transport Cost ($3) ($4) ($1) ($1) ($2)Possible Fair
Value$27 $24 $24 $30
Transaction Cost
($4) ($3) ($2) ($3) ($2)
Net Proceeds $23 $21 $21 $28Market at Location 5 has the highest net proceeds Most Advantageous Market
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Fair Value in Most Advantageous Market Fair Value = Price of asset – Transport cost
= $32 - $2= $30
Price adjusted for transport cost but not transaction costs
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ConclusionHowever, since CCC Ltd has access to principal market (Market at Location 1), fair value measurement would be for the transaction taking place at principal market.
Thus, Fair Value of Asset = $27
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Part 4 – Yeoh Keong YeeExplain clearly why each of the following statements is TRUE or FALSE
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A. An entity must determine the highest and best use for a financial asset before it can measure its fair value under FRS 113. False FRS 113: 28 “The highest and best use of a non-financial asset…”
E.g. PPE have multiple uses and need to determine highest and best use for FV
FRS 113 also applicable to Financial Assets, but FV already reflected in the financial market, no need to determine Highest and Best use.
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B. Fair value measurement of an asset shall generally take into account the condition and location of the asset and restrictions, if any, on the sale or use of the asset under FRS 113 True
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B. Continued FRS 113: 11 :A fair value measurement is for a particular asset or liability. Therefore, when measuring fair value an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:
(a) the condition and location of the asset; and (b) restrictions, if any, on the sale or use of the asset.
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B. Continued E.g. If the asset is located at a remote part, more cost would be incurred to bring from the current location to the market.
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C: Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date True
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C. Continued FRS 113:76 : “Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.”
i.e. It is the most reliable evidence of fair value and thus should go unadjusted, except for conditions fulfilled in Para 79.
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D. For recurring fair value measurements using significant unobservable Level 3 inputs, the entity shall disclose the effect of such measurements on profit or loss or other comprehensive income for the period True
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D. Continued FRS 113: 91(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.”
Eg. May have too many unrealized gains, resulting in suspicions for it, thus need to disclose effects of it to users in the P/L and OCI.
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E. Linsmeier(2010) suggests that the historical amortized cost models delay recognition of losses on loans and debt securities, which in turn delay recognition of underlying economic problems True
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E. Continued The paper mainly emphasizes bank’s Amortized cost model for financial instruments.
Also slow to recognize impairment losses because it will effect their bottom-line (P/L).
Thus severely overstated the value Increased exposure to credit & interest rate risk affected their economic viability
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Part 5 – Chua Yan TingAnkara, a public limited company, is reviewing the fair valuation of certain assets and liabilities
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Data Relating to Asset Asian Market European Market Australasian
Market
Volume of market - units 4,000,000 2,000,000 1,000,000
Price $19 $16 $22
Costs of entering market ($2) ($2) -
Possible Fair Value $17 $14 $22
Transaction costs ($1) ($2) ($2)
Net Proceeds $16 $12 $20
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Data Relating to Asset Asian Market European Market Australasian
Market
Volume of market - units 4,000,000 2,000,000 1,000,000
Price $19 $16 $22
Costs of entering market ($2) ($2) -
Possible Fair Value $17 $14 $22
Transaction costs ($1) ($2) ($2)
Net Proceeds $16 $12 $20
Note: For Ankara, there is
no need to adjust for costs of entering the market as they
are already trading in the
market.
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FRS 113 – Fair Value Measurement
“A fair value measurement of a non-financial asset takes into account… 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…”
“Highest and best use”: Principal Market VS Most Advantageous Market
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Principal Market: Greatest Volume and Activity level Asian Market European Market Australasian
Market
Volume of market - units 4,000,000 2,000,000 1,000,000
Price $19 $16 $22
Costs of entering market ($2) ($2) -
Possible Fair Value $17 $14 $22
Transaction costs ($1) ($2) ($2)
Net Proceeds $16 $12 $20
Note: Price is adjusted for
transportation costs, but not transaction
costs. Hence Fair Value is $17.
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Fair Value of Asset Principal Market in this case will clearly be the Asian
market, with the highest volume and activity level at 4,000,000 units, which in the case, would make the fair value of the asset $17.
Note that it is only in the absence of a principal market then do we consider the most advantageous market, i.e. gives the most net proceeds [Australasian market]
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Fair Value of Asset However, it is to be noted that if Asian market does
indeed have the highest volume and activity level, why is Ankara not trading in that market already? Do they not have access to the Asian market? If so, Asian market cannot be considered a principal market
[FRS113:19]
We would then have to consider the next market, and so forth. In considering the Fair Value of this asset, there has to be much consideration as to what markets Ankara has access to.
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Data Relating to LiabilitiesInput AmountLabour and material cost $2 millionOverhead 30% of labour and material
costThird party mark-up – industry average
20%
Annual inflation rate 5%Risk adjustment – uncertainty relating to cash flows
6%
Risk-free rate of government bonds
4%
Entity’s non-performance risk
2%
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Fair Value of Decommissioning Liability Entity has legal obligation to remove the mine On the basis of paragraphs B23–B30 of FRS 113, Ankara should use the expected present value technique to measure the fair value of the decommissioning liability
You can refer to FRS 113 Illustrative Example 37 [@ ASC]
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Expected Cash Flows (31 Dec 2013/ 1
Jan 2014)$
Labour and material cost 2,000,000Overhead (0.3 × 2,000,000) 600,000Third party mark-up (0.2 × (2,000,000 + 600,000))
520,000
Expected cash flows before inflation adjustment
3,120,000
Inflation factor (5% over 3 yrs) (1.053)
1.157625
Expected cash flows adjusted for inflation
3,611,790
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Fair Value of Decommissioning Liability
Expected Cash Flows (31 Dec 2013/ 1 Jan 2014)
$Expected cash flows adjusted for inflation
3,611,790
Uncertainty relating to cash flows (0.06 × 3,611,790)
216,707.40
Expected cash flows adjusted for market risk
3,828,497.40
Expected present value using discount rate of 6% for 3 years
3,214,480.24
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Discount Rate Risk-free rate of interest for a 3-year maturity on 1 January 2014 is 4%
Entity adjusts that rate by 2% to reflect its non-performance risk (i.e. the risk that it will not fulfill the obligation)
Discount rate used to compute present value of cash flows is 4% + 2% = 6%
