The Application Of Income Approach In The Measurement Of The Bond’s Fair Value

At the beginning of 2014, C hina’s Ministry of Finance formally issued the thirty-ninth account ing standa rd for enterprises called the measurement of fair value, and required a ll enterprises complied with accounting standards to implement the new accounting standard since July 1st, 2014. The new accounting standard accords to international fina ncial repor ting standa rds, keeping the same with international financial reporting standards. The implementation of new accounting standard puts forward new requirements to measure the fair va lue of fina ncial assets or liabilities.Fair value is 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. The assumptions used by the market participa nts are inputs, which are divided into observable inputs and unobservable input values. Enterprises should divide the inputs used to measure the fair value into three levels, in priority of utilizing the prices from active marke ts for identical assets or liabilities, which is the first level. In add ition, the use of unobservable inputs is the third level. Accordingly, the fair value hierarchy depends on inputs used for valuation techni que, rather than the valuation technique itself. The fair va lue of the first level utilizes the prices from active markets for identical assets or liabilities without any adjustment. The fair value of the second level utilizes valuation technique, and observable inputs used for valuation technique are directly or indirectly from active marke ts for identical assets or liabilities, such as interest rate, exchange rate, market multiplier and cash flow. The fair value of the third level utilizes valuation technique and unob servable inputs which can’t be obtained from active marke ts. In C hinese listed enterprises, Bank of C hina(BOC), Industrial and Commercial Bank o f China(ICBC), Agricultural Bank o f C hina(ABC) and China Construction Bank(CCB) are the largest state-owned listed banks, called the Big Four Banks. The author analyzes and sorts out the data of the four banks’ annual financial reports in 2014, and discovers that the main assets measured by fair value are bo nds. With the implementation of new accounting standard, the measurement of fina ncial assets or liabilities’ fair va lue has a clear regulation and basis. It is difficult to obtain the price of the bond from an active market without any adj ustment, so the bo nd’s fair value is concentrated in the second level and its fair value is estimated by the valuation technique through observable inputs. In this case, how to measure the fair value of the bond and provide useful information for market participants becomes a question. Therefore, this essay attempts to employ the income approach to measure the fair value of the four state-owned banks’ bonds.Because China Construction Bank(CCB) doesn’t provide the contractual cash flow of the bo nds in its 2014 annual financial report, this paper has to measure the fair value of three ot her ba nks ’bonds in 2014 by inc ome approach. Because the bo nds that four major state-ow ned banks holdare issued by the government and financial institutions,the risk of the bonds is low and the bo nds have stable future cash flows.The bo nds’ contractual cash flows are supposed to be the future cash flows, so discount rate adjustment method is usedin the measurement of the bo nds’ fair value.The observablerate of return of the AAA rated bond is usedasthe adjusted discount rate. It is very possible that four state-owned banks employ income approach to calculate the fair value of their bonds. The amount discounted by the bo nds’ contractual cash flows disclosed in the annual financial reports of the three state-owned ba nks is ba sically consistent with the bonds’ fair value. The author compares the fair value of the bo nds calculated by income approachwiththe amount discounted by the bo nds ’ contractual cash flows disclosed in the annual financial reports of the three state-owned banks, findsthat the adjusted discount rate used by three banks is high. C urrently the pressure of the economic decline becomes greater, so the three banks concernthe risk and put forward higher requirement on the risk premium. The adjusted discount rate used by the three banks is higher than the similar bond’s rate of return observed in the active market,so the fair value of the bo nds disclosed in the financial reports is lower. The aut hor hopes this paper provides some reference abo utthe application of income approach and the measurement of the bo nds’ fair value to the other companies.