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1. How are assets and liabilities measure under IAS 39?

According to IAS 39, Financial Instruments: Recognition and Measurement,

financial instrument are to be stated at their fair value- defined as the amount
for which and asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm;s length transaction.

If the market for a financial instrument is not active, an entity establishes a fair
value by using valuation technique, (including) discounted cashflow analysis and
option pricing models, says IAS 39.

A gain or loss on a financial asset or financial liability classified as at fair value

through profit or loss shall be recognized in profit or loss.

2. What impact according to the author, will fair value accounting have on the
balance sheet and income statement?

As far as financial instruments are concerned, fair value accounting is notable for
its closeness to the long-cherished academic ideal of income as present value
growth. The possible objection can there be to fair value accounting. IAS 39
looks like a passport to the promised land of truth and fairness of view.

Using fair value accounting make reporting the financial statement in the real
condition even it was had a great impact of the economic condition such as the
financial position of a company who had the impact of national inflation. In
accounting we still need to present all the financial position based on the
economic reality so all the stake holders as a user of the financial statement can
knew exactly the real condition of a company.

So, accounting as current economic reality is balance sheet and income

statement should be based on a valuation basis that is more reflective of
economic reality rather than historical costs. Focus on current and future prices.

3. What measurement requirement of historical cost accounting is violated?

 Historical cost accounting values can relate to transactions that could be a year
old or 10 years old. So, the acquisition value may be out of date and thus
balance sheet represents out of date values.

Historical cost accounting is only interested in cost allocation and not in the value
of an asset. So, it discloses the acquisition cost of an asset and its depreciation
in the following year, but ignores the possibility that the current market value of
the asset may be higher or lower than the disclosed amount.

Historical cost accounting has also flaw in terms of inflation. It is based on the
assumption that the purchasing power remains same over a period of time. But in
reality, an asset purchased at the current point of time may be more expensive in
future due to inflation. Historical cost financial statements are unadjusted for this
inflation. As a result, in the time of high inflation, profits are inflated and thus the
tax bill tends to increase.

When an entitys financial instruments are concerned, historical cost prices

reflect both an old interest rate and an outdated assessment of the amouts,
timing & uncertainty of future cash flows.

Intangible assets acquired outside of business combination (internally generated)

are not reported in historical financial statements. Reliable forecast of the future
income effects of a financial instrument is unlikely to be possible from the simple
extrapolation of past gain and losses based on historical cost.

4. Is a change in asset value an increase in wealth or income? Are they the

same?

It can be wealth and income, but both of them are in different way. When
company sells excess capital markets in exchange for an asset, it is a way of
storing wealth, and hopefully of generating income as well. The asset is your
investmenta use of your liquidity. Some assets are more liquid than others. For
example, you can probably sell your car more quickly than you can sell your
house. As an investor, you assume that when you want your liquidity back, you
can sell the asset. This assumes that it has some liquidity and market value
(some use and value to someone else) and that it trades in a reasonably efficient
market. Otherwise, the asset is not an investment, but merely a possession,
which may bring great happiness but will not serve as a store of wealth. Assets
may be used to store wealth, create income, and reduce future expenses.

Assets Store Wealth

If the asset is worth when it is resold than it was when it was bought, then you
have earned a capital gain. Wealth created when an asset is sold for more than
the original investment. The investment has not only stored wealth but also
increased it.

Assets create income

Some assets not only store wealth but also create income. For example, an
investment in a share of stock stores wealth and also perhaps creates dividend
income. A deposit in a savings account stores wealth and created interest
income. Some investors care more about increasing asset value than about
income. For example, an in a share of corporate stock may produce a dividend,
which is a share of the corporation profit, or the company may keep all its profit
rather than pay dividend to shareholders. Reinvesting that profit in the company
may help the company to increase in value. If the company increases in value,
the stock increases in value, increasing investors wealth.

Further, increases in wealth through capital gains are taxed differently than
income, making capital gains more valuable than an increase in income for some
investors. On the other hand, other investors care more about receiving income
from their investments. For example, retirees who no longer have employment
income may be relying on investments to provide income for living expenses.
Being older and having a shorter horizon, retirees may be less concerned with
growing wealth than with creating income.
 5. What do you think fundamental value in accounting should be? Refer to the
debate regarding value in use and value in exchange outlined in this
chapter when answering this question.

One criterion used to assets the usefulness of accounting numbers is their ability
to reflect the fundamental value of firm. Such value is typically defined as the
present value of the firms expected future dividends based on all currently
available information. Assessing the relationship between a firms accounting
numbers and its fundamental value is thus of interest to both researchers and
practitioners.

CASE STUDIES

Case Study 6.1 Fair value or false accounting

1. How are the assets and liabilities measured under IAS 39?

They are to be stated at their fair value defined as the amount for which an asset could
be exchanged or a liability settled between knowledgeable willing parties at arms
length. In an active market financial instruments would be measured at their exchange
price (buying and selling prices having small margins). If the market is not active, then
they are valued at the discounted present value or via an option pricing model.

2. What impact according to the author, will fair value accounting have on the
balance sheet and income statement?

Any gain or loss is recognised in the income statement and the financial instrument is
valued at fair value in the balance sheet.

3. What measurement requirement of historic cost accounting is violated?

The measurement requirement is that profit is only measured when an external
transaction is realised. Departure from the realisation principle is covered in the criticism
section. The problems are:
liquidation vs. going concern concept
recognition before confirmation by sale
definition of profit and meaningful profit
problems of obtaining selling prices
value in use concept of an asset.

Raymon pays particular attention to the concept of realisation. Comments such as the
relevance of a value change being a measure of financial performance is the result of a
fallacy deeply entrenched in the conventional academic wisdom, and the fundamental
mistake is to report value change as a gain or loss; summarise his position.

4. Is a change in asset value an increase in wealth or income? Are they the

same?

Of course this is a debate that has occurred amongst financial accounting theorists for
nearly a century. Rayman uses the return on investment argument and no adaptive
behaviour to support his case. That is if interest rates fall and investors do not realise
the capital gain, then they are no better off. This is true as the rate of return has
dropped to 5.5% from 8% and no realisation has occurred. However, the opportunity is
there to realise the investment and adapt the investment to other classes of assets
which will benefit from a fall in interest rates (e.g. stock market, housing). Is unrealised
income an increase in wealth or income or not is answered by economists who define
increases in wealth as income. Not all accountants agree. What does the general public
think? Using the illustration of the recent housing boom can provide a case study.
Certainly most people saw the increased prices as an increase in wealth and either
realised the value or else used their greater equity to borrow and consume, thus fuelling
recent consumer spending. Other case studies can be used by the instructor in this
debate.
5. What do you think fundamental value in accounting should be? Refer to the
debate regarding value in use and value in exchange in this chapter when
answering this question.

A difficult question. See the answer to case study 1, question 5 above which addresses
the question of the fundamental value of assets and the above section in the text. If the
firm has assets that are mixed financial, operating, intangible then valuation would
require the utilisation of different fundamental value concepts. This appears to be the
way that standard setting bodies are headed. However, the problem is that the
conceptual nature of the system becomes more and more complex and the solution
more vague. Moreover, any standard that attempts to address the problem gives the
impression that the output is a result of compromise rather than being driven by one
conceptual general model. Moreover, users must be sophisticated enough to
understand that different components of fundamental value and because the solution
may be a mixed system, the additive principle may be questioned.