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day 12 fair value accounting 2009 spring v3

day 12 fair value accounting 2009 spring v3 -...

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Fair Value Accounting Dr. James Gong
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Agenda Review of what we have learned so far Why fair value accounting? What’s fair value and fair value accounting? Group exercise: Fair value accounting in topics we have  covered History of fair value accounting Group discussion: fair value accounting and financial crisis Practice problem: fair value accounting of a simple revenue  recognition problem Future of fair value accounting Mid-term exam feedback
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Review Objectives of accounting Characteristics of useful accounting information Measurement method Phenomena and attributes in accounting Estimation  Relevant metrics Assets Historical cost vs. fair value Trade off between relevance (for valuation vs.  feedback value) and faithful representation
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Higher relevance Increase the consistency and comparability of  fair value measurements  Eliminate accounting arbitrage Consistency with IFRS Consistency with what FASB has done with  regard to financial instruments and certain  financial assets and liabilities Potential Advantages
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Potential Disadvantages Difficulty in measuring fair value Greater use of estimation  Reliance on subjective estimation Volatility in earnings Cost of measuring and auditing fair value Unintended or unexpected consequences Credit quality declines => fair value declines => gains Banks’ positions look worse and worse in the downward  market
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“an estimate of the price that could be received  for an asset or paid to settle a liability in a current  transaction between marketplace participants in  the reference market for the asset and liability.”   (FASB) “the amount for which an asset could be  exchanged, or a liability settled, between  knowledgeable, willing parties in an arm’s length   transaction.”  (IASB) What Is Fair Value (1)
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Short working definition The market value, if a sufficiently active market exists,  OR An estimated market value, otherwise Estimated market value is  present value  of  future expected cash flows, adjusted for: Risk Market imperfections “Similar factors if market-based information is  available to estimate those adjustments”  What Is Fair Value (2)
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Need not be based on an actual transaction  No requirement that a market exists  Current transaction  => fair value measurement is  not intended to capture the most likely settlement  amount  Example :  An arrangement will settle for 100 with probability .30  and for 0 with probability .70.  The most likely settlement amount  is 0.  A current transaction would reflect the  dispersion of  outcomes:  .30 x 100 + .70 x 0 => 30.
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