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ACCOUNTING THEORY & CONTEMPORARY ISSUES (AT I)

MODULE FIVE MEASURMENT APPROCH ON DECISION USEFULNESS

Slide 2 PART 1 - The Measurement Approach PART 2 - Increased Attention to Measurement PART 3 - Ohlsons Clean Surplus Theory PART 4 - Measurement Approach Applications PART 5 - Financial Instruments Section I Section II PART 6 - Reporting on Risk Lecture by: Dr. A. L. Dartnell, FCGA Year 2009 - 2010

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Slide 3 Handout

MODULE FIVE

The Measurement Approach

PART 1 Major Points Objective The Measurement Approach Slide 4 Objective The module relates to the measurement approach which is an attempt to put as much fair value material as is possible into the financial statements. Providing this can be done with reliability of the data. Topics relate to the measurement approach; the reasons why more attention is being paid to this approach; anomalies existing in the current market situations; the use of the clean surplus theory for firm evaluation; the measurement oriented standards in GAAP; reference to financial instruments and recent releases in respect of such instruments regarding fair value measurement; accounting for intangible assets; and reporting on risk. Slide 5 What is fair value? Fair value is the amount at which parties dealing at arms length would be willing to buy or sell an asset or liability. For the course the term current value is used when referring generally to asset and liability valuations that depart from historical cost. The term fair value is used to refer specifically to measurements based on market value. Value-in-use refers to valuations based on discounted present value. The text notes that fair value and value-in-use need not be the same when ideal conditions do not exist. Note to measure fair value we can use present value, as we did in Module 1, the market value, or the value provided by a model. This was under ideal conditions. More recently the measurement approach in financial reporting has increased

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Our objective is to examine measurement changes in standards in recent years and to consider other relevant points regarding the measurement approach. Slide 6 The Measurement Approach. This module moves from the information approach of Module 4, which is associated with historical cost accounting, to the measurement approach, which is associated with the inclusion fair value material in the financial statements. Note: the main difference is that historical cost statements are based fully on past transactions and they depend much more on the notes in the financial statements for disclosure of information. The fair value approach will include unrealized changes in fair values in income. Up-to-date information is included in the statements. To be decision useful, however, current values should not be too unreliable. This is a potential problem with the measurement approach and important to note. Under topic 5.1 of the notes it refers to the use of fair value. Slide 7 It is unlikely the full measurement approach will replace historical cost. What it really comes down to is that it is a matter of degree how much each is included in the financial statements. There is fair value in various components of the financial statements at the present time. Set amounts - cash, accounts receivable, accounts payable, mortgages, loans, etc. There have been a number of new releases, such as pensions, leases, capital assets, the marking-to-market concept, pushdown accounting, stock options Slide 8 Firms want best evaluation of their assets but it can become complex. More recently there are many questions re including more measurement approach into financial statements - including more market-based & present value material, without sacrificing reliability. There seems to be a view among accountants that the trade off between relevance and reliability may have changed. Possibly they are willing to give up some reliability in favour of more relevance to the real world, more so than in historical cost.

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Slide 9 PART 2

Increased Attention to Measurement

Major points Behavioural Finance Prospect Theory Is Beta dead? Stock Market Volatility The Efficient Securities Markets Anomalies

- Post-announcement Drift - Market Efficiency and Non-Earnings Information - Market Response to Accruals

Slide 10 Increased attention to the measurement approach What are the reasons for the increased interest in Measurement? The first question is: Are securities market efficient? Behavioural Finance Page 178 deals with investors behaviour, that is, the rationality of their behaviour. Investors become overconfident and sometimes overreact to a firms possibilities. One characteristic is self-attribution which takes the position that a gain is due to their abilities and yet when a loss occurs it is related to state realizations of something else rather than their own actions. Another characteristic is that an investor assigns too much weight to evidence, for example growth in a firm and they do not look at the base from which it comes. The growth may not be sustainable in the long run. This is referred to as representativeness. Another characteristic is momentum. It feeds on itself. People see the market rising and they buy more. Momentum increases. This whole study of investor behaviour which is related to market inefficiencies is referred to behavioural finance.

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Slide 11 This part refers to some market anomalies that have been observed. These have tended to bring attention to the question of the efficient market. Prospect Theory First the prospect theory. Briefly this theory states that investors considering a risky investment (a prospect) will look at gains and losses from a separate point of view. The loss prospect is considered to be greater than the gain prospect. A small loss will be taken very seriously by investors. From a weight point of view, the loss prospect tends to be overweighted. On the other hand investors tend to take the gain prospect with scepticism and the gain is underweighted Slide 12 Considering these gains and losses on different levels can lead to irrational behaviour, such as staying out of the market even though the prospects for gains are good, and holding on when bad news arrives. There is an imbalance in the views. Slide 13 While there seems to be a good deal of truth in this theory by Shefrin and Statman, the results are inconclusive. Study is also carried out on the theory by Burgstahler and Dichev. You can see additional material in the text. However, the results of these latter researchers are also not at all clear. Nevertheless, if enough investors act like this, it can cause anomalous reaction and work against the efficient market theory Slide 14 Beta Is Beta Dead? Second, we spoke about Beta earlier and stated it measures the systematic risk in a companys share. There has been some question about beta being dead as in some cases the measurement of returns has not been as satisfactory as expected. However, as your text points out, Beta may change over time, and, if so, and these changes are taken into consideration, it may still be explaining the returns very well.

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Slide 15 The other suggestion is that there are two classes of investors the rational type and the overconfident type. When taken together and mixed in the market, beta still seems to be a good risk measure but also an accounting-based measure is important in considering the matter, such as the debt/equity ratio. A number of studies would question beta. Read them. While there may be some validity in them, it is concluded that beta changes over time and, if this is the case, it is still a good measure of the volatility of the security. Slide 16 Stock Market Volatility Another area of question regarding market efficiency is the volatility of the stock market, in the extreme case of volatility, the bubble. The tremendous run-up of technology shares in the late 1990s and 2000 was a bubble in the market and the bubble burst. These types of actions are the result of overconfidence, getting on the band wagon and irrational exuberance, as stated in the text. Slide 17 Considering market efficiency, it would not be expected the market would act like a bubble. The growth would be slower and would depend on returns. Some of the technology companies had not returned a dollar of revenue and their shares were rising at a fast rate. Firm value under normal circumstances would be more evenly spread out over time. In this respect the evidence to be found regarding excess volatility is a mixed finding but still something to consider in the whole mix of market efficiency. Slide 18 Efficient Securities Market Anomalies Post-announcement Drift Market Efficiency and Non-Earnings Information Market Response to Accruals Slide 19 What is an anomaly in the market place?

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Those situations which appear to contradict the theory of the efficient market, that markets are not totally efficient in impounding information. Slide 20 Post-announcement Drift Our first consideration is the post-announcement drift. If the market is efficient, once an announcement is made concerning net income, the news should be incorporated into the price and that is the end of it. This is not what happens. Slide 21 On good news the market can drift upwards for 60 days following the announcement. The same takes place on bad news releases. This is referred to as the post-announcement drift. Significance of the drift - people should be able to make arbitrage profits by buying good news shares at the announcement date and selling short on bad news shares. (Selling short is the process of selling more shares than one has and when the price falls, buying shares at the lower price to fill the sell order executed earlier.) Slide 22 Do investors do this? If they did the arbitrage profits would be eliminated quickly but they are not. It is an anomaly. In 1989, the period 1974-1986 was studied by Bernard and Thomas. They set out to explain the post-announcement drift. One suggestion is that possibly the risk of a firm changes after the announcement but points made say this was not too solid. Slide 23 Another point advanced was the transaction costs, that is, that the profits to be made really only covered these costs, and it would eliminate most possible profits. This does not seem too solid as 18% could be made in arbitrage profits and transaction costs certainly did not equal this.

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Slide 24 - A third point was that investors are not able to or do not, whatever it may be, relate the current earnings with the future earnings. Studies indicate that there is a tandem effect in respect of earnings, that is, if earnings are up this quarter, the next quarter is likely to be up over last year. People take time to "figure it all out." To quote from your notes: "They underestimate the diagonal probabilities." Slide 25 Risk and transactions are consistent with market efficiency - recognizing future earnings is not. It is a challenge to our belief that the market is very efficient. Slide 26 Market Efficiency and Non-earnings Information Net income is not the only information available. There is a good deal of information in the balance sheet and also supplementary information. (But we saw that RRA was weak when it came to decision-usefulness.) It is difficult to prove. But why does the investor not use this non-earnings information? The analysts always state that the notes to the statements are very important. Slide 27 There is a good deal of information available which indicates future earnings. For example, the ratios, accruals, and other points which can help understand the earnings. This information can help beat the market. But investors do not beat the market. Even the mutual funds and others such as value line, an investing information device, find it difficult to the beat the market. Slide 28 A very interesting study by Ou and Penman - This couple derived 68 ratios and used 16 of them for the period l965 to 1972, and applied them to a large sample of U.S. firms.

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They used a regression model with a number of variables and made predictions for the period 1973 to 1983. With these predictions they devised their investment strategy for each firm, for each year, buying, and selling short, on the basis of their finding for the firms. The results were that they earned a return of 14.53% over two years, in excess of the market return. They beat the market. This should not have happened under efficient market theory. The information available to Ou and Penman was available to all investors. Your guess. Did investors look at it closely? The market apparently did not digest all the information. It adjusted only after announcements were made and it did not anticipate future earnings. Slide 29 Market Response to Accruals Sloan over 30-year period analyzed over 40,000 earnings announcements. In net income there are cash flows and accruals, the latter being such things as allowance for doubtful accounts, allowance for warranties, etc. He separated them according to each aspect it would be Net Income = operating cash flows + or net accruals. This would include receivables, allowance for doubtful accounts, amortization expense, etc., Sloan pointed out that a dollar of cash flow should mean more to good news than accruals, the reason is that cash flow is likely to be more persistent than accruals, as accruals reverse in the future. Slide 30 Thus the market should fine tune and give more weight to the cash flow aspect than accruals. It does not seem to. Sloans study was extensive and he designed a strategy which exploited high and low accrual situations. He made a return of 10.4% over the market return by taking account of high and low accruals. This would raise some question as to market efficiency as the market had not impounded this information. However, remember the market is only as strong as the people who act in it.

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Slide 31 Summary In the face of these various situations the text concludes in Section 6.2.9 that securities markets are not fully efficient. If they were fully efficient, you would not observe the anomalies. However, it also concludes that markets are close enough to full efficiency that the implications of efficiency for financial reporting as laid out by Beaver (Topic 3.2) remain. This conclusion is largely based on the impressive evidence consistent with efficiency described in text, Chapter 5 and Topic 4.3. In other words, efficient market theory is still the best available theory to help accountants understand the decision needs of investors, and hence to prepare useful financial reports The text also concludes that it is an open question whether average investor behaviour is better described by rational or behavioural theories. However, from an accounting standpoint, this may not matter since fair value information in the financial statements proper should improve decision making regardless. Slide 32 The Explanatory Power of Net Income There is just one more aspect that needs to be commented upon. We established in Module Four that the market prices do respond to net income prepared on an historical-cost basis. However, Lev, an accounting research writer, contends that the market response to good or bad news is not great. In fact he believes that it is accountable for only 2 to 5% of the variation in abnormal earnings, and the balance is not explainable. He states this would include a three- or four-day period around releases As your text states, there is a difference between statistical significance and practical significance. A small difference in a statistic such as the earnings response coefficient can be significant while in practical terms it does not seem very much. Slide 33 Nevertheless, while we would not expect net income to explain the whole change, as there are other factors involved, the suggested change of 2 to 5% is small. Lev thinks it is "poor earnings quality" which is responsible. In other words, more value-related numbers should be included.

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Our aim should be to make net income as relevant for the real world as possible. Thus we should be endeavouring to place more measurement data in our financial accounting presentations. You have no doubt heard of severe criticisms of fair value accounting by financial institutions who were forced to take huge writedowns following the recent market meltdowns (if not, reread the account of them in Topic 1.2). In effect, these institutions argued that fair value accounting was too conservative, since they viewed the huge writedowns following the 2007-2008 market meltdowns as excessive. The Canadian Standards Board and the International Group did relax a little in this respect. This is referred to later in my comments.

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Slide 34

PART 3

Ohlsons Clean Surplus Theory Major Points The Clean Surplus Theory Abnormal Earnings Example re Share Price evaluation. Auditors Legal Liability Slide 35 The Clean Surplus Theory The clean surplus theory shows how the balance sheet and income statement correlate to the give firms value. This allows the investor to calculate share price. The theory is as follows: From the income statement: 1. Actual earnings are based on the clean surplus calculated by ensuring that all gains and losses go through the income statement. 2. Goodwill is calculated as the difference between actual and expected earnings. From the balance sheet: 3. Expected earnings are calculated by multiplying the opening shareholders equity by the firms cost of capital. 4. Take the net worth of the firm and add the calculated estimate of the firms goodwill to arrive at the firms value. 5. Then take the number of shares outstanding and divide it into the firms value to arrive at an estimated share price.

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The calculated share price is then compared to actual market price to determine how close the market value is to the calculated value. Slide 36 Abnormal Earnings I want to say a few words about abnormal earnings. From a theoretical point of view there are no abnormal earnings Slide 37 It is shown in the text that from a theoretical point of view, under ideal conditions, the present value under uncertainty and dividend irrelevancy, it is theoretically correct that there are no abnormal earnings over the life of the firm. You will note on page 198 of the text that the writer uses the Example 2.2. Slide 38 You will also note that the calculations are for a poor one year and a good second year. Given dividend irrelevancy, the present values market value can be expressed in terms of future cash flows $100 and $200, respectively, which gives a present value of $236.36, which would be the market value of the firm. Slide 39 The market value can also be compressed into BV and Goodwill, which is the net book value at any time and goodwill being the present value of abnormal earnings. For this to hold, all items of gain and loss must go through the income statement the clean surplus concept. Slide 40 Recall that abnormal earnings were the difference between actual and expected earnings. The course writer goes on to calculate the theoretical loss of year 1 (bad state) and the theoretical gain of year 2 (good state). Thus the abnormal earnings offset each other then the goodwill is zero. Thus there would be no persistence of abnormal earnings and good will would be zero. This is referred to as unbiased accounting, (under an ideal situation.)

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Slide 41 This would hold for any firm using historical cost accounting. If the historical cost accounting is downward relative to the market value then there is unrecorded goodwill. Then the firm in the long run will pick up this goodwill. Slide 42 The author then deals with persistence of earnings which can continue from one period to another. Using the example of interest rates, the bad state can continue but after a while the effect will die out. In a more general tone forces of competition will eventually eliminate positive and negative goodwill, that is, abnormal earnings. It does not conflict with anything in decision theory and investors will want information on persistence. Slide 43 The author again refers to Example 2-2, page 201 concerning persistence. He points out the topic of persistence of earnings is important and the example has two implications all the action is not involved with the balance sheet, the income statement is also important, and investors will want more information on persistence of earnings. Slide 44 Example re Share Price evaluation. Note: The second example relates to determining share value by the financial statement material. It indicates the share price in the market may be high but the theory can be useful in the measurement process. Lets look at the Canadian Tire, page 204

Canadian Tire - Estimating Common Shares Facts: 2006 Annual Report Net income 2006 - $357 million Book value 2005 - $2,511.1 million, 2006, $2,785.2million Return on Equity (ROE) 0.14 (arbitrarily will continue for 7 years after which return will equal the cost of capital. ) Dividends for 2006, $53.8 million Dividend payout 0.15 - $53.8/357 Cost of capital according to CAPM - Er = Rf(1-) + (Mr) Risk free rate 6.00% - the bank rate Add 4% for market risk 10% Estimated beta 0.68

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Cost of Capital 9%. This will stay constant Next we want to evaluate Canadian Tire unrecorded Goodwill Book value (2007) = Book value (2006) + Net Income (2007) Dividends (2007) Or Book value (2007) = Book value(2006) + (1 K) Net Income(2007) (K is the dividend payout ratio) From 2006 Annual Report: BV (2007) = BV (06) (1 + (1 k)ROE = 2,785.2(1 + (0.85 x 0.14)) (dividend payout and return on equity) = 2.785.2 x 1.12 .15 .14 = $3,119 million BV (08) $3,494; (09) $3,913; (10) $4,382; (11) $4,908; (12) $5,497 Estimating Canadian Tire cost of capital : Er = Rf (1 ) + E(Rm) Assume: Rf = 0.06; b = 0.68; Market = 0.10 Er = 0.6(1 0.68) + 0.68(0.10) = 0.02 + 0.07 = .09 or 9% Cost of capital 9% stays constant for 7 years. Estimating Firms Goodwill Clean Surplus Abnormal earnings are difference between actual earnings and accretion of discount: Accretion of Discount = Cost of Capital x Opening Book Value Actual earnings projected as ROE x Opening BV Expected abnormal earnings 2007 Expected abnormal earnings 2007 = (ROE E(R)) BV2006 = (.0.14 - 0.09) 2,785.2 = $139 million Similar calculations will be made for all years and discounted by cost of capital to get present value. Goodwill 2007 2013 = 139/1.09 + 156/1.092 + 175/1.093 + 196/1.094 + 219/1.095 + 245/1.096 + 275/1.097 = $972 Million Then add BV06 and Expected PV and divide by 81,575,556 million shares $2,785.2 + 972 = $3,757.2 / 81,575,556 = $46.06 per share

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Actual share price $74 - Market expectation may be higher than justified. However, some discussion occurs on pp 206-207 re the difference. You will note one study thinks this method can be good for two or three years and it is suggested in your text that the calculation could be on track as the market may be overvaluing the Canadian Tire shares. Some points suggested: 1. The share may be affected by momentum behaviour as described in the text. 2.The Return on Equity used was 14%. The market may be expecting more. Maybe analysts are expecting higher returns. 3.There may be some recognition lag. For example, with R&D the market may see through to the future and feel the returns will be higher. 4.Market expectations for Canadian Tire opportunities may be high and it expands. 5. The persistence of abnormal earnings could be different than that above of 5%. That is 14% less cost of capital 9%. However, even for well established firms competitive pressures tend to reduce growth rates and eliminate abnormal earnings. This is quite evident for a number of large firms in recent years. Slide 45 Summary Probably that while the estimate of Canadian Tire share was on track, it may not have exploited all the information in the financial statements and analyst information part of which is noted above. This led to a discussion in the text of three types of studies on the clean surplus theory. Go over them to see what is said. Slide 46 It is summed up in that the clean surplus theory has shown that financial statement information can be used for earnings prediction. Also, the clean surplus theory includes the measurement perspective in the mix and reduces the factor of unrecorded goodwill, (which can occur under historical cost accounting), making for the reduction in the possibility of mistakes on the part of investors in predicting for the future. This, of course, will improve decision-making, with the result of a better operation in the securities market. Slide 47 As noted above the clean surplus theory supports a measurement approach. There are two interrelated reasons for this:

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First, by demonstrating an equivalence between financial statement variables and market value, financial statements are shown to be firmly grounded in the theory of value. Second, the more fair values that are included on the balance sheet, the "less" abnormal earnings need to be predicted, leading to more accurate predictions and hence more useful financial statements. The reason why is there is less to predict is that current share value is based, directly or indirectly, on the markets expectations of the present value of the firms expected future cash receipts. Under the measurement approach, expected future cash receipts are capitalized on the balance sheet (either directly, as in value-in-use accounting, or via market value as in fair value accounting), rather than having to be projected and included in goodwill as the text does for Canadian Tire Slide 48 Auditors' Legal Liability Perhaps auditors are as interested in the measurement approach as much as any one. Companies show a good going concern approach today and tomorrow they are bankrupt. We have had a number of situations like this. Confederation Life was an example, as well as, more recently, a number of high tech companies. The big question asked is why the statements did not show more explicitly the state of the company? It is difficult for auditors to defend themselves in such situations. Slide 49 Consider one point - firms are more and more facing environmental costs, which may have a significant effect on the statements. Your course writer thinks that one way auditors and accountants can protect themselves in this respect is by more valuation in the accounts. Say, more marking-to-market. The present value or valuation approach would point out for the future that things are not what they appear to be. This would require more estimates and judgment but because of the legal liability, encountered every day, the tradeoff between relevance and reliability may have changed. Slide 50 Summary Despite problems the course writer and others will continue to accept the security market efficiency concept and historical cost. It is unlikely that historical cost will be

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displaced as the accounting base. However, how much valuation can be added gets closer to the target. Can we help by more valuation inclusions in financial statements?

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Slide 51 PART 4

Measurement Approach Applications

Major Points GAAP Valuations Post-revenue Realization Assets and Liabilities Long-term investments Leases Slide 52 Pension Obligations and Other Post-Employment Benefits The Lower-of-Cost-or-Market Rule Ceiling Tests for Capital Assets Push-down Accounting Impaired Loans Share Options Slide 53 GAAP Valuations (Measurements) With this question in mind we will move to the current situation and mention some of the major situations currently in GAAP. Post-revenue Realization Assets and Liabilities Post-revenue realization accounts - cash and accounts receivable, allowance for doubtful accounts, accounts payable, and similar accounts can be considered as present value. Slide 54 Cash Flows Fixed by Contract Long-term investments

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Section 3051, which deals with long-term investments, recommends that discount or premium on bonds be amortized over the remaining life of the bond. An example of both: Bond Premium First, we have to have the price of the bond. Assume a 10-year bond is issued at $50,000, at an interest rate of 10%. Assume, however, it is sold at a premium where the yield is 9%. This means the price of the bond will be: P.V. = ? i = 9% Coupons P.V. = 5,000 [ 1 - 1.09-10 ] n = 10 [ 0.09 ] R = $5,000 F.V. = $50,000

P.V. = 5,000(6.41766) = $32,088.29 Maturity P.V. = 50,000(0.42241) = 21,120.54 (1/1.09-10 = 0.42241) $53,208.83 Thus, we have a premium of $53,208.83 - $50,000 = $3,208.83 This is amortized over ten years either by straight-line or effective interest method. Straight-line would be $320.88 a year. The effective interest method, however, would be: Year One: New present value of the bond after one year: P.V. = 5,000 [ 1 - 1.09-9] = 5,000(5.99525) = $29,976.23 [0.09] 50,000(1.09)-9 = 50,000(0.46043) = 23,021.39

$52,997.62 Amount of premium to be amortized for year one: $53,208.83 - 52,997.62 = $2ll.21

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End of year one - Journal Entry Interest expense - $4,788.79 Bond Premium on bond payable - 211.21 Cash $5,000 Interest payable $50,000 x .10 = $5,000 Partial long-term liability of Statement of Financial Position Bonds Payable $50,000.00 Unamortized premium on bonds payable 2,997.62 Net book value of bonds payable $52,997.62 There are a few points which should be made: - This assumes the bond will be held to maturity - That the discount rate will be unchanged - That the organization will be able to pay off the bond at maturity. The straight-line method can be considered as approximating the present value method providing we accept it as an approximation of the theoretically correct interest method. Bond Discount Let's assume the bond was sold at a discount and the yield was more than 10%. Say, 11%. Original price: 5,000 (5.88923) = $29,446.16 50,000 (1.11)-10 or 0.35218 = 17,609.22 $47,055.38 Price after one year would be 5,000 (5.53705) = $27,685.25 50,000 (1.11)-9 or 0.39092 = 19,546.24 $47,231.49 Bond discount $50,000 47,231.49 = $ 2,768.51

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Amount of discount to be amortized for year one: $47,231.49 - 47,055.38 = $176.11 End of year one journal entry Interest expense - $5,176.11 Bond Discount on bond payable - 176.11 Cash $5,000.00 Interest payable $50,000 x .10 = $5,000.00 Partial long-term liability of Statement of Financial Position Bonds Payable $50,000.00 Unamortized discount on bonds payable 2,768.51 Net book value of bonds payable $47,231.49 By the time the tenth year is reached this would be $50,000. A typical examination question XYZ Co. issued a $100,000 par value bonds on December 31, 2001, to yield an effective rate of interest of 8% per year. The coupon rate is 10% per year. The bonds mature on December 31, 2004. Coupon payments are made on December 31 each year. You purchase all the bonds. Required: a) Calculate the present value of the future receipts from the bond. Answer Cash flow each year $100,000 x .10 = $10,000 P.V. = ($10,000/1.08) + ($10,000/1.082) + $110,000/1.083) = $105,154.34 Question b) Show on December 31, 2002, that the book value of the bonds under the effective interest method of amortization equals the present value of the bonds on that date. State the assumptions under which this holds.

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Answer One year Interest income for the bondholder - $105,154.34 x .08 = $ 8,412.35 Cash received by bondholder - $10,000 Amortization for year - $10,000.00 - $8,412.35 = $ 1,587.65 Bond book (carrying) value $105,154.34 1,587.65 = $103,566.69 To calculate the cash flows for two years: P.V. of Bond cash flows ($10,000/1.08) + (110,000/1.082) = $103,566.53 A few items to note about this: First, the bond was sold at a premium as the yield was only 8% while the coupon rate was 10%. Thus, there will be an amortization of the premium of $5,154.34 over the life of the bond. The first years amortization is $1,587.65. The remaining premium to be amortized over the two years would be $3,566.69. This premium reduces the interest cost over the life of the bond. The book value was $105,154.34 at the first of the year and it would be reduced by the amortization for the year, leaving $103,566.69 as book value, and as stated above, the $3,566.69 is amortized over the remaining life of the bond. Fit this in with the premium example above. Note that if they had a yield of 10% there would be no amortization. The Present value would have been $100,000 and interest income would be $10,000. Cash received would have been $10,000, amortization would be zero. When making this 8% assumption for this calculation, we are making assuming that the book value will equal the present value for the next two years, that is, the discount rate of 8% will not change in the next two years and the bond issuer will be able to meet the payments of interest and principal. If there is a change, the resulting figures will change. Remember the above is the effective interest method for amortization. The straight line method would have been 1/3 each year of $5,154.34 ($1,718.11) would have been amortized.

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Slide 55 Leases Section 3065 covers leases. As you know by now, the present value approach is recommended for capital leases and related obligations. Valuation is at the present value of the discounted lease payments, which uses the discount rate involved with the lease. Slide 56 Pension Obligations and Other Post-Employment Benefits Section 3460 covers pension obligations The release states that in the case of defined benefit plans, where a stated number of years of service are credited for time worked, at a certain percentage a year, the present value of the accrued benefits must be disclosed. Section 3461 covers other post-employment benefits, such as life, dental and health benefits for retired employees. You will note that from an accounting point of view they are treated in the same manner as are the pension benefits. Firms are required by CICA to accrue the costs of such benefits over the life of the employees working years. These would be shown as liabilities but written off to equity. Slide 57 The accounting for pensions and OPEBs represents a major application of, and challenge for, the measurement approach. The text, Section 7.2.6, describes United States pension standards, since these are more advanced towards measurement than standards in Canada and internationally. The most advanced standard is used here since the purpose is to describe the measurement approach in action. Also, it is likely that international and Canadian pension standards will converge to similarity with the FASB standard, possibly by the time IASB standards are adopted in Canada. Note the definition of the projected benefit obligation (PBO) in text, page 233. This is the discounted expected value of future expected pension payments, including for expected compensation increases (i.e., value-in-use). SFAS 158, effective in 2006, requires this liability to be shown on the balance sheet. Prior to SFAS 158, and still under Canadian and international standards, pension gains and losses such as actuarial adjustments due to changing lifespans, changes in interest rates, and changes in plan benefits, could be offbalance sheet reporting. By bringing the PBO onto the balance sheet, SFAS 158 represents a major application of the measurement approach. However, as the text points out on page 234, the application is not complete since some pension gains and losses are included in other comprehensive income and amortized into net income over several years. The

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reason, presumably, is to avoid extreme volatility of reported net income, since pension gains and losses can be large and of low persistence. Carefully read the module notes on this topic

Slide 58 .

The Lower-of-Cost-or-Market Rule This rule, with which you are very familiar, is really a partial application of the valuation principle. Assets are to be written down if the market value is less than cost but they cannot be written up from the cost. You are aware that this rule applies to inventory and marketable securities. You can see quite readily it is only a partial application. If a firm buys an investment in shares of ABC Pacific for $20.00 a share, and it declines to $17.00, the share must be carried at $17.00. However, if the share rises to $23.00, it must be carried at $20.00. This is done in the cause of conservatism. It is very questionable; it shows the value on one side only. Slide 59 As you read the text and the Handbook sections, notice the various characteristics of these measurement situations. For example, the lower-of-cost-or-market rule, described in text Section 7.2.3, is a one-sided or asymmetric version of the measurement approach. Traditionally, asset values subject to this rule are written down, but are not written up if current value rises above cost. However, note that IAS 2 allows subsequent writeup of previously written down inventory, but not to above original cost. Subsequent writeup is also permitted for inventories under section 3031 of CICA Handbook. Under United States standards, subsequent writeup is not allowed. Sections 3051.17-22 incl. of CICA Handbook, which should now be read, require investments to be valued at cost, subject to writedown if a decline in value is other than temporary. However, unlike for inventories, section 3051.19 specifically prohibits subsequent writeup.

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Slide 60 Ceiling Tests for Capital Assets Section 3063, issued in 1990, requires that the basic recording of capital assets be historical cost, this section requires writedowns when the net carrying amount of the capital asset exceeds the net recoverable amount. The approach is somewhat of an attempt to apply more value. Slide 61 Text Section 7.2.5 describes the ceiling test. Under international standards, IAS 36 requires a writedown for property, plant, and equipment (and various other long-lived assets, including intangibles to be discussed in Topic 5.6) when the recoverable amount (fair value less costs to sell or value-in-use, whichever is greater) is less than book value. Note that writedowns can be reversed (but not to above book value) if recoverable value subsequently increases. Section 7.2.5 also describes the two-step ceiling test under United States standards. This version of the ceiling test is also used in Canada (CICA Handbook, section 3063) pending adoption of IASB standards in 2011. First, it is determined if capital assets are impaired. This is the case if the book value of the asset exceeds the sum of its undiscounted expected direct cash flows. If the asset is deemed impaired, the second step is to determine its fair value. Fair value can be measured by means of quoted market prices, if available. Otherwise, fair value can be measured as the discounted expected present value of the assets direct future cash flows. The ceiling test, however, is still one-sided. That is, assets are not written up if fair value is greater than book value. Furthermore, subsequent write-up of impaired assets is not allowed if fair value rises (paragraph .06). Slide 62 Notice in Section 3063, the two techniques suggested to measure expected present value. The first, in sections A11-A13, is similar to that used for RRA (Section 2.4 of the text). Here, if future cash flows from the asset are uncertain, the firm estimates annual future expected cash flows and discounts them using a risk adjusted interest rate. (Recall that RRA uses 10%. For ceiling tests, a specific risky rate is not specified.)

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Increasing the interest rate for risk, of course, lowers the expected value. The adjustment for risk arises because financial statement users are assumed risk averse (paragraph A22). The second technique, in sections A14-A18, is similar in concept to the present value calculations illustrated in Example 2.2 on pages 29-33 of the text. Here, for each year, each possible cash flow (which may be adjusted downwards for risk to reflect the assumption that users are risk averse) is multiplied by its (subjective) probability to arrive at expected cash flow for that year. These expected amounts are then discounted at a risk-free rate of interest, since the adjustment for risk is already built into the expected cash flows themselves. Either technique is acceptable, but the preference in section 3463 is for the second one (the expected present value approach) when the determination of fair value is "complex" (see paragraph A13). Slide 63 Push-down Accounting A point covered in Section 1625.06, issued in 1993, relates to acquisition of other firms, in arm's length transactions. It allows the acquired firm to be comprehensively revalued, and the resulting value recorded on the acquired firm's books. The assets and liabilities are recorded at market value. This is referred to as push-down accounting. Also revaluation is required in a reorganization if such is significant. Slide 64 Impaired Loans Section 3025 relates to impaired loans. This requires that loans be written down by the lending organization to their estimated realizable amount when they become impaired or restructured. (As you can understand the amounts are based on expected cash flows to be received from the loans, discounted at the appropriate rate related to the loan.) Any writedown is to be included in the current income. One can see where this is coming from with the mergers, acquisitions, takeovers, and bankruptcies. So often one reads about the impaired loans with bankrupt financial institutions.

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Share Options This release was added in 2002 and requires the cost of share options to be recorded in the income statement. More will be referred to in Module 6. These are clear moves to the measurement approach.

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Slide 65 PART 5

Financial Instruments

Section I

Major Topics New Releases Valuation of debt and equity securities IAS 39 U.S. Standard Slide 66 New Releases There is a wide variety of instruments ranging from bonds to derivative instruments such as options and interest rate swaps. The purpose of the section is to enhance the users' understanding and make it more decision useful.

The AcSB adopted three Handbook standards, with the effective date of October 1, 2006. These are sections 1530, 3855, and 3865, titled Comprehensive Income, Financial Instruments Recognition and Measurement, and Hedges, respectively.

Slide 67 Financial assets and liabilities are defined on pages 235-236 of the text. Notice that the definitions are rather broad. Briefly Definition of a financial instrument: A financial asset is a contract that creates a financial asset of one firm and a financial liability or equity instrument of another firm. Examples of a financial asset are cash, an equity instruments of another firm, a contractual right, such as, to receive cash or another financial asset from another firm, or to exchange financial instruments with another firm under favourable conditions. Examples of a financial obligation are to deliver cash or another financial asset to antoher firm; to exchange financial assets or financial liabilities with another firm under unfavourable conditions.

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Slide 68 Valuation of debt and equity securities The classification of debt and equity securities under Section 3855 is: Held-for-trading ; Held-to-maturity investments; Loans and receivables, or, Available-for-sale assets. Slide 69 Held for trading any financial asset or liability may be so designated, when first recognized. All derivatives, except those that are designated and effective hedge instruments, are classified as held for trading, as are any the entity intends to liquidate prior to maturity. Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold. If there are significant sales prior to maturity, an entity may have to reclassify these financial assets to the available for sale category. Loans and receivables are non-derivative financial assets resulting from loans and receivables other than debt securities. May be designated held for trading. They do not include debt securities. Trade accounts receivable and loans receivables from consumer, commercial, or real estate lending activities are debt securities only if they have been securitized. Investments in debt securities are classified as financial assets held for trading, held-to-maturity, or available-for-sale, as appropriate. Available for sale financial assets are either non-derivative financial assets that are designated as available for sale or non-derivative financial assets not classified as held for trading, held to maturity, or loans and receivables. Investments in equity instruments are to be classified either as Held-for-Trading or Available-for-Sale. Slide 70 Financial assets and liabilities are initially measured at the fair value of the consideration given or received when the entity becomes a part to the contract creating the item.

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If the instrument is constructed such that it confers an apparent benefit on one of the parties, fair value is to be determined with reference to fair value prices for the risks involved. Slide 71 If held for trading, gain or loss is put in net income, if available for sale, gain or loss is in other comprehensive income, if held to maturity, amortized cost. Subsequent to initial recognition, financial assets are measured at fair value, except for loans and receivables and held-to-maturity, which are measured at amortized cost, using the effective interest method and investments in equity instruments that do not have a quoted market price in an active market, which are measured at cost (as long as they are not classified as held for trading. Subsequent to initial recognition, an entity qualifying under Section 1300, may elect to measure available for sale financial assets, that would otherwise be measured at fair value, may measure at cost or amortized cost, except for active instruments in a market where price is easy to obtain or the assets are designated hedging instruments. Slide 72 For most financial instruments, calculation of fair value will require identification of a reliable current price or rate. When a current price in an active market is not available, future cash flows are to be discounted using appropriate discount rates for the term of each cash flow. A gain or loss from a change in the fair value of a financial asset or liability that is not part of a hedging relationship, and that is Held-for-Trading, is recognized in net income in the period in which it arises. A gain or loss from a change in the fair value of a financial asset or liability that is not part of a hedging relationship, and that is Available-for-Sale, is recognized in other comprehensive income until the financial asset is derecognized or becomes impaired, at which time the cumulative gain or loss previously recognized in accumulated other comprehensive income is recognized in income for the period. (Note: other comprehensive income includes adjustments to fair value of available-for-sale securities, foreign currency translation, and other types of unrealized gains and losses. As they are realized they are transferred to net income. (U.S. similar release is SFAS 130.) .

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Slide 73 IAS 39 The text discussion of financial instruments is primarily oriented to IAS 39. This is the main focus. Canadian standards dealing with financial instruments are for the most part consistent with IAS 39. You should be familiar with IAS 39 categories for financial assets. Pages 236-237 of the text. Also see page 2 of your module notes. Your notes emphasizes this. Slide 74 While related Canadian accounting standards are basically the same as international standards there are some differences. Three such differences are: The accounting for impaired loans is governed by section 3025 of CICA Handbook, not section 3855 directly. However, as mentioned, section 3025 is similar to the loans and receivables category of IAS 39. Noteworthy among these similarities is the writing back up of impaired loans that had previously been written down. This represents a major extension of the measurement approach into Canadian standards, and a departure from lower-of-cost-or-market and ceiling test thinking, which generally do not allow subsequent writeups. IAS 39 restricts the fair value option to reducing a mismatch. Section 3855 does not restrict the fair value option to mismatch reduction. As a result, consider a Canadian firm with long-term debt outstanding that has received a credit downgrade. In other words, the fair value of the debt has fallen. Suppose the firm has no related natural hedge of this liability; there is no mismatch situation. Nevertheless, the firm could apply the fair value option to this debt, and record a gain in net income equal to the reduction in the fair value of the debt. In this regard, the situation is similar to that described on text page 238-239 under U.S. standards. SFAS 159 does not impose a mismatch restriction either. While recording a gain following a credit downgrade may seem counter-intuitive, it does have a rationale from the common shareholders perspective, as explained on page 239. IAS 39 allows equity financial assets to be valued at cost if fair value is not available. However, a fair value may be available even if a quoted market price is not available (for example, fair value may be reliably estimated by other means). If so, IAS 39 requires that the asset be fair valued. Undersection 3855 of CICA Handbook, an equity asset is valued at cost if a quoted market value is not available, regardless of whether fair value can be estimated by other means. In this instance, section 3855 is slightly less measurement oriented that IAS 39.

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Slide 75 U. S. Standards SFAS 115 issued by FASB applies to investments in both debt and equity securities, which have readily determinable values. Originally SFAS 115 provided a good deal of information to help us. It was introduced to prevent gains trading. Note the U.S. SFAS 115 requires that assets be classified at acquisition into one of the following three categories: Trading, Held-to-Maturity and Available-for-Sale. It does not include Loans and Receivables. Slide 76 Two Points should be made re SFAS 115 It was designed to do away with gains trading or cherry picking a practice financial institutions were suspected of using as a way to influence reported earnings. Referred to below. The second point is that it applies only to financial assets but not to financial liabilities. It seems reasonable that if financial assets are carried at fair value so should financial liabilities. This would form a natural hedge of changes of value. The problem is, for example, what is a deposit worth with the situation of reserve banking? However, see page 237 regarding valuation in U.S. Without the balance there could be an increase in the volatility of income. Possibly this is why some securities are exempt from the fair value rule. Slide 77 Gains Trading The textbook (page 237) describes the problem of gains trading, or "cherry picking," outlines the stringent provisions in SFAS 115 to prevent this. Briefly, gains trading is selling investments which have risen and reporting gains and holding poor performing investments and showing them at cost. No loss is shown on the latter investments as it would be contended they were being held to maturity. If they were valued at fair value, a loss would be shown and gains trading would be eliminated. While SFAS 115 was intended to eliminate gains trading, it is possible to reclassify securities from held-to-maturity to trading and thus gains can be made and a sale is not necessary.

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Slide 78 Disclosure Section 3861

The disclosure provisions of Section 3861 remain. You should be familiar with paragraphs 3861.01-.09 that provide a general overview and helpful definitions and paragraphs 3861.78-.94 that require the fair values of each class of financial instrument, both primary and derivative, to be disclosed provided fair value can be determined with reasonable reliability.

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Slide 79 Part 5

Financial Instruments

Section II Major Items Derivative Instruments Hedge Accounting Accounting for Intangibles Slide 80 Sections 7.3.4 and 7.3.5 of the text describe another important component of financial instrument accounting, the accounting for derivatives. Derivative instruments are contracts, the value of which depends on some underlying price, interest rate, foreign exchange or other such variable. IAS 39 and SFAS 133 use a similar approach to derivatives; there are some minor differences with Canadian standards. These are the main points to note about accounting for derivatives As you probably know, the "option" is a derivative financial instrument, because its value derives from the value and characteristics of the underlying asset. An example: a person might have an option to buy 100 shares at a given price of $20.00, and their option may cost $2.00 each. Thus, if the share goes up they can still purchase the share at $20.00. A deposit on a house is an option. This is brought into the course because "option" pricing models provide a good and convenient way to value derivative securities, particularly when reliable market values are not available. This enables marking-to-market for derivatives which all helps in the valuation approach. Slide 81 If fair value is not readily available the Black-Scholes model as well as other models may be used to determine a fair value. The Black-Scholes "option" pricing formula is the function of five variables - the current market price, the variability of return, the exercise price, time of expiration and the existing risk-free rate in the economy.

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Slide 82 A Brief Summary From a measurement point of view RRA has not proven too successful, while other aspects have proven to be much better - bonds, leases and similar items based on present value and proposed financial assets would be marked-to-market. If ideal conditions hold, situations governed by contract seem to work out well. Slide 83 While cash flows for RRA have not proven to be too acceptable the same process is being followed for capital assets, i.e., judging cash flows; but future cash flows are not discounted, as mentioned previously. Also, capital assets may be written down but not up. This approach is a partial acceptance of the valuation approach. Slide 84 Question Question: Why present value or direct valuation in one case and market values or indirect valuation in another case? As you surmise by now, market value breaks down if ideal conditions are not met. The major problem is information asymmetry. Even if one does not have a problem with information asymmetry, markets can be thin, such as a market for ships. As your notes point out market value can be suitable for the likes of inventories, marketable securities, and push-down accounting. Slide 85 Hedge Accounting Hedging is used to protect against changes in interest rates, commodity prices and foreign exchange rates.

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Although Hedging has been around for a long time, in more recent years various instruments have been made available for firms to manage risk and uncertainties to which they are exposed. Slide 86 Incidentally, natural hedging is the responsibility of management, that is, there is a natural hedge if assets available move in the opposite direction of, for example, long-term liabilities. The accounting for formal hedges involves difficult issues of valuation and revenue recognition, which are being now recognized by standard-setting bodies. Slide 87 Business people often purchase "futures contracts" as an investment or to offset the risk of future price changes. A futures contract, which is a forecasted situation, is a contract between a buyer and seller of a commodity or financial instrument and the clearinghouse of a futures exchange, such as the Chicago Clearinghouse. It is called a futures contract when it is traded on an exchange. For a purchaser of a futures contract the price of the commodity, interest rate or foreign exchange is guaranteed at the maturity date. Slide 88 These can vary but they have three common characteristics: - They obligate the buyer or seller to accept or make delivery of a commodity or financial instrument at a specified time, and cash can be accepted rather than delivery of the commodity or instrument. For example, if there is a hedge concerning wheat, it is not necessary to deliver the wheat, cash will be acceptable. Slide 89 They can be effectively cancelled before their time by entering into an offsetting contract for the same commodity or instrument. All changes in the market value of open contracts are settled on a regular basis, usually daily.

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Slide 90 Previously to Section 3865, we did not have an accounting release on hedging in Canada but a section is included in Section 3860.92 - .95. Briefly sets out disclosure. Slide 91 Section 3865 covering Hedges will move accounting for financial instruments in Canada into substantial agreement with that of the United States and the International Group. . There are two basic types of hedges: Fair value hedges. These are hedges of some asset owned by the firm. If the hedge is outstanding at year-end, it is valued at fair value. To reduce excess net income volatility, the hedged item is also fair valued. See text, pages 244-245 for further discussion. Cash flow hedges. These are hedges of price risk of the firms products. Their purpose is to lock in a price for product not yet produced. Cash flow hedges are valued at fair value at period-end. To reduce excess net income volatility, unrealized gains and losses on cash flow hedges are included in other comprehensive income. Next period, as the hedged product is produced and sold, the unrealized hedging gains or losses are transferred from other comprehensive income to net income, where they offset decreases or increases in product selling prices. As a result, the firm receives net proceeds for its hedged product equal to the price it locked in when the fair value hedge was acquired. Slide 92 Hedges must qualify if they are to receive the benefits of hedge accounting. See your notes to see how they qualify. Differences between SFAS 133 and section 3865 Section 3865 of the CICA Handbook is substantially converged with IAS 39 (and with SFAS 133). However, two differences of IAS 39 and Section 3865 from SFAS 133 are worthy of note. First, under IAS 39 and Section 3865, hedging instruments (also called hedging items) may include non-derivative financial assets and liabilities when designated as a hedge of a foreign currency risk exposure. Under SFAS 133, only derivatives can be designated as hedges. For example, a Canadian financial firm may use securities (that is, non-derivative financial assets) to hedge the risk of changing foreign exchange rates on liabilities payable in that foreign currency. The reason for allowing this more generous treatment, according to the AcSB, is that when derivative markets are less liquid than those in the

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United States, it could be quite costly for firms to hedge such risks using derivatives. To the extent that higher hedging costs reduce the extent of hedging, reported net income without this provision would be more volatile for Canadian and foreign firms than for similar U.S. firms. Slide 93 Second, both standards require that to be eligible for hedge accounting, hedges must be "highly effective." SFAS 133 does not lay down rules to determine effectiveness. The second difference, however, is that IAS 39 and section 3865 specifically mentions that effectiveness can be demonstrated by (IAS 39) or requires (section 3855) high correlation, consistent with the texts discussion on pages 245-246. To understand how derivative instruments work to reduce risk, read the two articles, "Controlling Financial Risk Readings 5-2 and 5-3. Slide 94 Accounting for Intangibles Previously there were two methods of accounting for acquisitions the purchase method and pooling of interest method. The pooling method has been eliminated and the accounting for goodwill has been changed. First, purchased goodwill, under Historical Cost and prior to 2001, was amortized over it useful life, up to 40 years. However, since 2001, purchased goodwill remains on the balance sheet and is only written down on impairment of the asset, as are long-lived intangibles with indefinite lives. In other words, this is the measurement perspective. Other intangibles, with specified lives, such as patents, or fairly close to specification, are generally written down on the straight line approach, applying the writedown to the asset value. Second, self-developed goodwill is actually written off in expense. For example, if one undertakes R and D and writes it off, they are actually writing off any goodwill that might accrue on a self-developed basis. The results will be in net income in later years. It must become commercially viable for consideration of capitalizing and amortizing. The criteria for recognition of an internally generated intangible asset are essentially the same as those for the deferral of development costs (see paragraph 3450.21). Recognizing internally generated goodwill is allowed under Section 3064.40, under very strict conditions. However, it is not required.

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Slide 95 A typical examination question Question Globally, decisions regarding hedging are becoming increasingly important for businesses Required: a) Define a natural hedge Briefly describe how natural hedges can reduce risk. Answer A natural hedge is the process of matching or equating the financial assets and liabilities of a company. If a firm owns risky assets as well as risky liabilities, losses (or gains) in assets are offset by gains (or losses) in risky liabilities. This process results in reduced risk for the company. Question b) Explain the difference between price risk and basis risk Answer Price risks are uncertainties in the value of shares (that is, the firms value) arising from possible changes in interest rates, commodity prices, and foreign exchange rates. Basis risk arises when gains and losses on hedging items do not exactly equal the gains and losses on hedging instruments. Question c) Section 1650.54 of the Handbook requires that for a hedge that is a non-monetary item, any exchange gain or loss on the foreign currency denominated monetary item should be deferred until the settlement date of that monetary item. Define a monetary asset. Provide a rationale for the deferrals cited.

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Answer A monetary asset is money or a claim to money, the value of which is fixed by contract or otherwise. The deferrals are consistent with the matching principle. Those deferrals ensure that gains and losses from the hedged items and from their related hedging instruments are recognized during the same accounting period. The reason for the deferral is that the net amount received from the hedged item is not known until the amount ultimately received from the hedging instrument is known.

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Slide 96 PART 6

Reporting on Risk

Major Items Risk Reporting Beta Risk - Estimating Beta Risk Study Stock Market Reaction to Other Risks Section 3861 Sensitivity Tables Economic Value Added Slide 97 Risk Reporting The accounting bodies recognize that investors need risk information. It has been suggested earlier that beta is the sole indicator of risk of a share. The usual way to estimate beta is by regression analysis based on the market model. Firm-specific risk can be diversified away. Slide 98 Beta Risk - Estimating Beta It might be suggested there is little room for financial statements to report risk. This is not correct. One good reason is that beta and some financial items correlate very well. This is significant as financial data may indicate a change and the extent of a change in beta, without which several periods of new data may be required to estimate beta. Slide 99 How useful is financial statement information in evaluating portfolio risk? Can it be a check on beta? Portfolio risk depends mainly on the betas of the portfolio's securities. Thus financial statement information must be useful in estimating betas.

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The best way to estimate beta is to obtain past data on the relationship between a security's return and the return of the market portfolio. We can estimate beta by the formula we used previously, CAPM. Rjt = Rfj (1 Bj) + jRmt + jt So data are obtained for Rjt, the firm's return on its security, Rmt, the market return, and abnormal returns. Then from the above formula Bj can be determined. Your notes describe the process of using least-squares regression to arrive at a value. In other words they get the correlation between the beta of the portfolio (the stock beta) and various financial statement items. We will look at a study based on this approach Slide 100 Risk Study In a very interesting study of 307 New York Stock Exchange firms, regression was used to obtain stock beta's for two periods. It was noted that the relationship between beta and accounting risk measures was fairly high. Three risk measures from the financial statements were then calculated: Dividend payout Leverage Earnings variability From these they devised 61 portfolios and they calculated the correlation coefficients between the accounting-based measures of portfolio risk and the betas. Correlation Coefficients Period 1 Period 2 Dividend payout (note negative) -0.79 -0.50 Leverage 0.41 0.48 Earnings variability 0.90 0.82 The correlations are interesting. For example, the higher the dividend payout the lower the risk, as shown by the negative correlations Leverage is not too high, but,

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Earnings variability is very high. The conclusion was that risk based on financial statements can be useful in predicting beta. A typical short question: Question Name three financial statement-based risk measures which have been found to be correlated with security beta. What is the likely reason why accounting-based risk measures and security betas are correlated? Answer Leverage, earnings variability, and dividend payout. The most likely reason is that both accounting risk measures and security betas are correlated with the underlying operating and financial riskiness of the firms. Slide101 Why do Firms Manage Firm-specific Risk? From an investor perspective, reducing estimation risk by reporting on risk management strategies, and enabling the detection of speculation, are important reasons why even diversified investors would support risk management and reporting. Stock Market Reaction to Other Risks Studies indicate that the stock market is sensitive to interest rate risk of financial institutions, as well as beta. Thus more information on interest risk may be of benefit to investors. Also it was found that some firms are sensitive to price changes and foreign currency change. Slide 102 The Securities and Exchange Commission in the U.S. has three disclosure requirements regarding risk. They are: - A tabular presentation of fair values and contract terms sufficient to enable investors to determine a firms future cash flows from financial instruments by maturity date;

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Slide 103 - A sensitivity analysis showing the impact on earnings, cash flows or fair value of financial instruments, resulting from commodity prices, interest rates, and foreign exchange rates; - Value at risk, the loss in earnings, cash flows or fair values resulting from future price changes. Slide 104 Section 3861 Section 3861 requires substantial risk disclosure see a general outline which includes managements discussion re risk management, including hedging strategies. Also read paragraphs CICA Handbook, paragraphs 3861.36-.38, .41-.45, .49, and .58 Our discussion of MD&A in Topic 3.7 shows that MD&A is an important vehicle for reporting on risk, applying to public companies across Canada. Indeed, MD&A reporting requirements now extend to quarterly reports, review by the audit committee, and approval by the board of directors. In addition, many Canadian firms provide measurement approach-oriented risk reports as part of MD&A, such as the sensitivity analysis of Suncor Energy Inc. illustrated on text page 261. With respect to financial instruments, section 3862 of the CICA Handbook requires considerably expanded risk information, including information about different types of risk, including credit risk. At this point, read section 3862.31-.42 of the Handbook. Note in particular that quantitative risk disclosure is now required (paragraph 3862.34), consistent with a measurement approach. Slide 105 Sensitivity Tables There is shown in the text on page 261 a sensitivity analysis. These are used to show the expected results of change and, thus, the risk involved. You should note very carefully that such tables are very sensitive to ranges. For example, take the first line, if oil were to change by $1US a barrel, according to the table, earnings would change by $55 Million. However, multiples of that are not likely to be in proportion. It is unlikely that a $3 change would result in three times $55 million, it may be more or may be less. For example, volume would be involved and costs per unit may not be as high if demand increased. Go over the section carefully.

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Slide 106 Economic Value Added Economic value added is a method used to determine what additional value was added to the firm in the given period. The formula is: EVA = Net Operating Profit after Tax minus Capital Charges.* * Capital Employed x Cost of Capital for the firm ( the weighted average cost of capital.) The difference between the NOPAT and Capital Charge is the economic value that has been added during the year. It could be a negative figure just as easily as a positive figure. You should be able to calculate EVA. There is an example shown in your text on page 218.. Slide 107 Another question which is of interest This question relates to an article re the DaimlerChrysler corporation. It refers to the Daimler Corporation suffering large reductions in operating profit as a result of the Chrysler and Mitsubishi losses, which involved a merger with Daimler. This is a question on persistence of earnings. Required: a) This part of the question related to a calculation of figures from the article. For the sake of space I am not repeating the article, which is in the June 2002 examination. However, it asks that based on the information provided in the article, compute DaimlerChrysler AGs expected income (loss) after one-time charges for 2001. Answer a) DaimlerChrysler income before restructuring charges for 2001 is about 2 billion euros. The restructuring charges are likely to be 3.5 billion euros. Thus, the expected loss after one-time charges is about 1.5 billion euros. Question b) Explain why it is advisable to report the amount of operating income and the amount of one-time charges separately, as in followed the article. Relate your answer to the

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ERCs and the three types of earnings or earnings components as propounded by Ramkrishnan and Thomas. Answer Ramkrishnan and Thomas distinguish three components of earnings that have different persistence, namely: permanent, transitory, and price-irrelevant components. The persistence value of these three components of earnings are: 1 + 1/Rt, 1, and, zero. (Thus permanent earnings would have the first persistence of 1 + 1/Rt, the transitory or passing earnings would have an ERC of 1 and the price-irrelevant components would be zero. Note the permanent earnings are treated like a perpetuity in financial terms. The return would go on indefinitely. Operating income is likely to have more permanent components than the one-time restructuring charges, which would have more or most all low-persistence components. Thus operating earnings and one-time charges have different earnings response coefficients (ERCs.) Also, persistence from higher-quality earnings is positively related to ERCs. If operating income and one-time charges are reported separately it helps investors form their own estimates of a companys earnings persistence, which is useful for making investment decisions. Question c) Identify and briefly describe the signal that adds credibility to Chairman Juergen Schrempps statement about future earnings. (He said he was going to provide a detailed forecast for the company and Chrysler at the news conference to be held that day.) Answer Voluntary forecasts about the companys difficulties add credibility to Mr. Schrempps statement in the press. The voluntary forecast is a signal. By making such an announcement, he voluntarily puts his forecasts under the gun. (Signalling will be covered in Module 9.)