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Chapter 2 Accounting

Under Ideal Conditions


Nic Festarini, Alex Leon, Ben McRae, Matt Spark

2.1 Overview

Present

Value Model

- Under certainty and uncertainty


Reserve

Recognition Accounting

Historical
The
A

Cost Accounting

Non-Existence of True Net Income

Matter of Principles by Al Rosen

CICA

Handbook: Section 1100

Overview

2.2 The Present Value


Model Under Certainty

Widely

used in Economics, Finance and


Accounting

Provides

relevant information to financial


statement users

Determines

firms future prospects and


aids in investment decisions

The Present Value Model

Consider

P.V. Ltd. is a one asset company


with no liabilities. Assume the asset will
generate end of year cash flows of $150 in
both year 1 & 2, and then have a zero
value after that. Assume the economic
interest rate is 10%. Determine the
present value of the firms cash flows and
balance sheets at year 0 and year 1.

Example of the Present Value


Model Under Certainty


Cash

flow
= $150 each yr for 2 yrs
Interest rate = 10%
Present Value at year 0 = PA0
PA0

=
PA0 = 136.36 + 123.97
PA0 = $260.33
Balance Sheet As at Time 0
Capital Asset,
at expected PV

$260.33

Shareholders
Equity

$260.33

Example of the Present Value


Model Under Certainty

Net

revenues are capitalized into asset value

Similar

to a savings account

Net

Income
PA0 = 260.33 * 0.1
PA0 = $26.03
Accretion

of discount

Example of the Present Value Model


Under Certainty

Present

value at the end of year 1

PA1

=
PA1 = 136.36
Balance Sheet at the End of Year 1
Assets

Shareholders Equity

Cash

$150

Opening Value $260.33

Capital Asset,
at PV

$136.36

Net Income

$286.36

$ 26.03
$286.36

Example of the Present Value


Model Under Certainty

Dividends
Net

book value = Present value

Relevant
Arbitrage
Net

and Reliable
Profits

income plays no role in firm valuation

Important Points

2.3 The Present Value


Model Under Uncertainty
Illustrative example with concepts carrying over from 2.1

States

of Nature: Uncertain future events


such as the state of the economy.

States

of nature are a conceptual device to


model uncertain/uncontrollable future events
whose realizations affect cash flows of a firm

Example

State 1: Economy is bad (probability 0.5)


State 2: Economy is good (probability 0.5)
Note: No one can control which of the states is realized;
hence they are called states of nature

States of Nature (States)

At

time 0, no one knows which state will


occur and we assume that the set of possible
states is publicly known and complete.

Assume

that the state probabilities are


objective and publicly known
Ex: If we imagine a long-run sequence of
repetitions of our two-state economy, the bad state
will occur with relative frequency of 0.5.
Note: The implication of an objective probability here is that

any particular outcome tells us nothing about what the state


probabilities are.

States of Nature Continued

Ideal

conditions under uncertainty are


characterized by:
1. A given, fixed interest rate at which the
firms future cash flows are discounted
2. A completely and publicly known set states
of nature
3. State probabilities objective and publicly
known
4. State realization publicly observable

Ideal Conditions

Taking

into account that the economy can


be in a bad state or a good state
during each year. If it is in a bad state,
cash flows will be $100 for the year. If it is
in the good state, however, cash flows will
be $200 for the year. Assume that during
each year the bad state and the good
state each occur with probability 0.5.

Example

Calculation

of expected present value at

time 0:
PV0 = 0.5 () + 0.5 (
PV0 = (0.5 * $272.73) + (0.5 * $247.93)
PV0 = $136.36 + $123.97
PV0 = $260.33
Balance Sheet As at Time 0
Capital Asset,
at expected PV

$260.33

Shareholders
Equity

Example Continued

$260.33

Investors

may be averse to risk

Expected

value of the firm at the end of


year 1 will be $236.36 or $336.36
depending on whether the bad state or
the good state happens in that year
See calculations on subsequent slides

Example Continued

Accretion

year 1

Calculated

of discount is based on expected net income for


as: 0.10 * $260.33 = $26.03

Income Statement for Year 1 (Bad State)


Accretion of Discount

$26.03

Less: Abnormal earnings:


Expected Cash Flow (0.5 *
$100 + 0.5 * $200)

$150

Actual Cash Flow

$100

Net Loss
Under

($50.00)
($23.97)

uncertainty, net income consists of expected net


income plus or minus abnormal (unexpected) earnings for
the year

Example Continued

At

the end of year 1, expected present


value of the remaining cash flows:
PV1 = 0.5 = $136.36
Balance Sheet As at End of Year 1 (Bad State)
Financial Asset

Cash

Shareholders
Equity
$100.00

Opening Value

$260.33

$136.36

Net Loss

($23.97)

Capital Asset
End of Year Value

$236.36

Example Continued

$236.36

Accretion

of discount is based on expected


net income for year 1

Calculated

as: 0.10 * $260.33 = $26.03

Income Statement for Year 1 (Good State)


Accretion of Discount

$26.03

Add: Abnormal Earnings


Expected Cash Flow (0.5 *
$100 + 0.5 * $200)

$150

Actual Cash Flow

$200

Net Income

Example Continued

$50.00
$76.03

Balance Sheet As at End of Year 1 (Good State)


Financial Asset
Cash

Shareholders
Equity
$200.00

Opening Value

$260.33

$136.36

Net Income

$76.03

Capital Asset
End of Year Value

$336.36

This

$336.36

chapter ignores the complication of risk


averse investors by assuming investors are risk
neutral. That is, they are indifferent between the
sure thing and the 50/50 gamble. As such, the
firms market value will be $260.33 at time 0.

Example Continued

Financial

statement reliability and


volatility are different concepts. While PV
calculations are reliable under ideal
conditions, net income and balance sheet
values are volatile since end-of-period PV
depend on which state is realized.
Volatility is demonstrated by abnormal
earnings in our example, where net
income varied from ($23.97) to $76.03
under bad and good state realizations.

Points to Consider

The

income statement has no information


content when abnormal earnings do not
persist. Investors have sufficient
information to calculate for themselves
what realized net income will be, once
they know the current years state
realization.
Net income is predictable conditional on the
state of nature

Points to Consider Continued

Subjective

Probabilities (formally
introduced in chapter 3): Individuals must
assess state of nature probabilities for
themselves, using whatever information is
available.
A more reasonable assumption than objective
probabilities because the future performance of
a business entity is much more complex and
difficult to predict than a simple two state
illustration.

Looking Ahead

2.4 Reserve
Recognition Accounting
An Example of RRA with Husky Energy Inc.

Reserve

Recognition Accounting (RRA) is a


current value standard for oil and gas
companies.
In 1982, the FASB issued SFAS 69 which
required supplemental disclosure of certain
information about the operations of publicly
traded oil and gas companies
SFAS 69 requires disclosure of the estimated
PV of future receipts from a companys
proven oil and gas reserves
Intended to provide investors with more
relevant information

Reserve Recognition Accounting

When

estimating future cash flows, SFAS 69


requires that the PV calculations use year-end oil
and gas prices (as opposed to prices expected to
be in effect when the reserves are lifted and
sold). SFAS 69 does not require disclosure of
states and nature and their probabilities, only the
end results of the expectation calculation.
SFAS 69 requires a mandated 10% discount rate
to be used, presumable for comparability across
firms.
The figures apply only to proved reserves

RRA Continued

RRA

is more relevant that historical costs


of reserves, however it is by no means
completely relevant
RRA is not a complete representation since
it applied only to proved reserves
Concept itself is a matter of judgement, since
proved essentially means reasonably certain
of recovery under current economy and
operating conditions. This definition is thus
subject to bias, and estimates are subject to
error as shown by substantial adjustments to
previous estimates.

RRA Continued

Oil

company managers tend to regard


RRA with suspicion. As an example,
Huskys management states in its SFAS 69
disclosures that its RRA information is not
a reliable performance measure and
should not solely be relied upon in
evaluation company performance.
Why use RRA?
May want to appeal to a broader spectrum of
investors as many multinational oil companies
report RRA information.

RRA Continued

The

basic problem is that Husky does not


operate under ideal conditions.
1. Interest rates in the economy are not fixed,
although FSAS 69 deals with this by requiring a fixed,
given rate of 10% for discounting.
2. The set of states of nature affecting the amounts,
prices, and timing of future production is much larger
than the simple two-state example shown previously.
3. Objective state probabilities of proved reserve
amounts are not available.
It is difficult to apply PV accounting when the ideal
conditions it requires does not hold.

Basic Problems of RRA

The complex environment in which oil


companies operate renders it effectively
impossible to prepare estimates that are
completely accurate and unaffected by
subsequent events. Thus estimates become
subject to errors and possible bias that
threaten reliability to the point where the
benefit of increased relevance is
threatened.

..Basic Problems of RRA Continued

2.5 Historical Cost


Accounting

Present-day

accounting practice can be


considered as a mixed measurement model
It can be argued that Historical Cost
accounting is more useful than Current Value
Accounting (Dichev and Tang 2008)
Past performance is the best indicator of
future performance
Statement of Earning is primary F/S

Comparison of Different
Measurement Bases

Current

Value accounting includes volatility


and reliability concerns
Firms operate in an constantly changing
environment
Samuelson (1965), who demonstrated that
when markets work well, market prices
fluctuate randomly
Balance Sheet is of greater importance
However, volatility impacts F/S as volatility
reflects the firms environment

Comparison of Different
Measurement Bases

It

is necessary to trade them off

Different measurements bases imply different


tradeoffs
Historical

Cost

Relevance Low
Reliability High
Current

Value

Relevance High
Reliability Low

Characteristics: Relevance vs.


Reliability

Current

Value implies earlier Revenue


Recognition than under Historical Cost
Current value accounting values assets &
liabilities as changes constantly occur in current
value
Recognition as changes in current value occur

Historical cost accounting values inventories at


cost and A/R at selling price
Recognition as inventory is sold

Characteristics: Revenue
Recognition

Recognition

Lag refers to the timing of


revenue recognition lags behind changes
in economic value
Current Value Low Recognition Lag
Changes in economic value occur as recognized
Historical

Value High Recognition Lag

Changes in economic value occur through


realization

Characteristics: Recognition Lag

Historical

Cost

Matching is primarily used as net income is


accomplished through the use of accruals
Accruals

Result of the matching of realized revenues


with the associated costs
Accruals smooth out cash flows to allocate
them over related periods

Characteristics: Matching of Costs


& Revenues

Matching

is reasonably reliable yet


vagueness is present
Consider Amortization of Capital Assets:
IAS 16, amortization should be charged
systematically over the assets useful life and
reflect the pattern of benefit consumption
However, useful life and benefit consumption
are largely subjective estimates

Characteristics: Matching of Costs


& Revenues

Current

Value

Matching is not required, as net income is an


explanation of changes in current value
Values of assets & liabilities is driven by:
Market Forces
The firms response to these forces

Characteristics: Matching of Costs


& Revenues

2.6 The Non-Existence


of True Net Income

Current

Value accounting F/S require that


all the firms assets and liabilities be
prepared based on the current value
Net income is the change in the firms current
value during the period

However

under real world conditions Net


income does not exist as a well-defined
economic construct
Lack of objective state probabilities

The Non-Existence of True Net


Income

Presence

of Incomplete Markets market


values need not exist for all firm assets
and liabilities
Ready market values is not available, results in
an impossible income measure Income is not
well defined when markets are incomplete
(Beaver & Demski 1979)

However,

net income is not information


impact when conditions are ideal

The Non-Existence of True Net


Income

Frustrating

difficulty of agreeing on
accounting policies
Different users will desire tradeoffs between
relevance and reliability
Several different accounting policies

Fascinating

lack of well-defined concepts


of net income
Judgment is critical in the process of asset
valuation and income measurement
Provides the basis of the accounting profession

Concept of Net Income

Additional Reading:
A Matter of Principles
Al Rosen

Difficult

to interpret

Do investors require education to understand a


companies financial statements?
Several

alternatives for reporting

Various methods can lead to misunderstandings


amongst investors
Depreciation policies
Inventory costing

Financial Statements in Canada

Not

familiar with Canadian GAAP


Inability to explain GAAPs impact on the
financial statements
EPS and EBITDA figures are being
misinterpreted

Current Problems Investor Perspective

Old

text books can become misleading


extremely quickly with the fast changing
principles in accounting
Principles once deemed useful and
current, can quickly become outdated in
Canadian GAAP

Accounting Text Books

CICA Handbook:
Section 1100
Generally Accepted Accounting Principles

This

section describes what constitutes GAAP


principles for private enterprises
Provides guidance on sources to consult when
selecting accounting policies and determining
appropriate disclosures
The primary sources of GAAP in descending order
of authority:
Sections 1400-3870
Accounting Guidelines

CICA HB: S1100

Accounting

guidelines set out how existing


sections shall be applied in specific cases
Sections and accounting guidelines
sometimes have illustrative material such
as examples and decision trees
Part 1 of the handbook may be an
important source to consult on matters
not covered by Part 2

CICA HB: S1100

Consistent

accounting policies used for


similar transactions unless GAAP requires
or permits categorization of items for
which different policies may be
appropriate
Specific GAAP recommendations from the
primary sources override the concepts in
section 1000

CICA HB: S1100

Jeopardy