Chapter 2 Accounting Under Ideal Conditions

Group AStephanie CenedeseNicholas FergusonElisa MartoneJohn severinMarcus Traynor

Chapter 2 Accounting Under Ideal Conditions

AGENDAPresent Value Model under CertaintyPresent Value Model under UncertaintyReserve Recognition Accounting (RRA)Historical Cost AccountingNon-existence of True Net IncomeArticle: A Matter of Principles

Present Value ModelProvides most relevant information to users of financial statements information about a firms future economic prospects (dividends, cash flows, profitability)Relevant financial statements need to be reliable information that faithfully represents the firms financial position and results of operationsPresent Value Model under CertaintyCertainty: future cash flows of a firm and the economys interest rate are publicly known which can also referred to as ideal conditions

Example: One asset firm that generates $150 per year for two years with no liabilities and has a value of $0 at the end of the two years.

Interest rate = 10%

Present Value Model under CertaintyNet income for the year: $260.33 x 10% = $26.03 Balance Sheet As at Time 0 Capital asset, PV $260.33Shareholders equity $260.33Income Statement For Year 1Accretion of discount $26.03Present Value Model under Certainty

*Note: assuming there is no dividends to be paid Recall: At time 0, PA0= $260.33 For year 1, accretion of discount = $26.03 Balance Sheet As at End of Year 1Financial Asset $150.00Cash 136.36Capital asset, PV $286.36Shareholders equity $260.33Opening Value 26.03 $286.36Present Value Model under CertaintyNOTES

1. NBV of capital asset at any year-end = PV

2. Accretion of discount is also referred to as ex ante or expected net income Since all conditions are certain, expected net income = ex post or realized net income Present Value Model under CertaintyNOTES3. Relevant financial statement information gives information about the firms future economic prospects Future dividends = payoff to investors

Dividend irrelevancy: under ideal conditions, the timing of dividends will not affect the PV. Cash flows are also relevant

Therefore, the prior financial statements = relevant

Present Value Model under CertaintyNOTES4. Net income does not play a role in firm valuation under ideal conditions

Future cash flows are known

Net income (accretion of discount) is predictable

Balance sheet contains all the relevant information Present Value Model under Certainty5. Information that represents what it intends to represent is reliable

Financial statements are reliable under ideal conditions since cash flows and interest rate are known with certainty

Any calculation errors would immediately be discovered NOTES

Present Value Model under Certainty6. Under ideal conditions, PV of asset/liability = market value

Arbitrage: making profits in one market and selling in another market with identical goods and services NOTES

Example: Present Value Model under CertaintyInterest rate = 10%

Owner would not sell asset for less than $260.33No one would be willing to pay more than $260.33

Recall: PV of asset at time 0 = $260.33Present Value Model under Certainty7. Market value of the firm = sum of financial assets and PV of joint future receipts from its capital assets + intangibles PV of liabilities

Total market value of previous example = $260.33NOTESPresent Value Model under Uncertainty

Important to consider the potential for different states of nature of the economy and how they affect cash flows

Ex: weather, government policies, strikes by suppliers, etc.

These states are objective, publicly known, and observablePresent Value Model under Uncertainty

Concept of ideal conditions is extended

Characterized by:

1. Given, fixed interest rate2. Complete and publicly known sets of nature3. State probabilities objective and publicly known4. State realization publicly observable Example: Present Value Model Under UncertaintyABC Company, a one-asset firm with no liabilities, has the opportunity to generate either $100 or $200 each year for two years and will then have 0 value. Assume an interest rate in the economy of 10%. There are equal opportunities for each outcome (probability of 0.5).

Example: Expected Present ValuePA0 = (100/1.10 + 200/1.10) + (100/1.102 + 200/1.102)PA0 = (*272.73) + (*247.93)PA0 = 136.36 + 123.97PA0 = $260.33

Example: Effect on Income Statement

Insert Marcus updated tableABC CompanyIncome Statement(bad economy)For Year 1Accretion of Discount (10*260.33) $26.03Less: Abnormal Earnings Expected Cash Flows (.5*$100 +.5*$200) $150.00 Actual Cash Flows $100.00 -$50.00 Net Loss $23.97The negative $50 of unexpected cash flows results in a $50 shock to earnings for the year. This shock is call abnormal earnings, or unexpected earnings

End of Year 1 Expected Present Value of Cash Flows:PA1 = 0.5*($100/1.10 + $200/1.10) = $136.36Example: Effect on Balance SheetABC CompanyBalance Sheet (bad economy)For Year 1Financial AssetCash $100Capital AssetEnd of Year Value $136.36 $236.36

Shareholders equity Opening Value $260.33Net Loss $ 23.97 $236.36Rework the Income Statement and Balance Sheet of ABC Company assuming that the good economy state has occurred.

Example: Effect on I/S and B/S Good EconomyABC CompanyIncome Statement(good economy)For Year 1Accretion of Discount (10*260.33) $26.03Less: Abnormal Earnings Expected Cash Flows $150.00 Actual Cash Flows $200.00 $50.00 Net Income $76.03ABC CompanyBalance Sheet (good economy)For Year 1Financial AssetCash $200.00Capital AssetEnd of Year Value $136.36 $336.36

Shareholders equity Opening Value $260.33Net Loss $ 76.03 $336.36Present Value Model under Uncertainty

1. Financial Statement information is still completely relevant and reliable. Relevant: Balance Sheet values are based on expected future cash flows, and dividend irrelevancy holdsReliable: ideal conditions ensure that present value calculations faithfully represent firms expected future cash flows

2. Two ways of calculating balance sheet current valuesValue in use Fair Value

Present Value Model under Uncertainty3. Income statement lacks information content when abnormal earnings do not existInvestors have sufficient information to calculate realized net incomeNet income is predictable conditional on the state of nature

4. Consider all state probabilities to be objective at this point in timeSubjective probabilities eliminate the existence of ready-made probabilities No guarantee of equivalent frequencies of potential states in two-period economy with subjective probabilitiesRevenue Recognition Accounting (RRA)Current value model when ideal conditions do not exist

SFAS 69 applies to publicly traded oil and gas companiesRequires management judgment in determining proved reservesRevenue recognized when reserves are determined to be provedSet discount rate of 10%Adjustments to estimates in present value calculation are required

Revenue Recognition AccountingNational Instrument 51-101Canadian reserve recognition accounting standardRequires a report by an independent Qualified Reserves Evaluator or AuditorRequires (constant and forecast) price disclosureRevenue Recognition AccountingRelevance vs. reliability

Which reporting method is more relevant?

Which reporting method is more reliable?Historical Cost AccountingPrivate companies often have financial records that contain personal expenses and/or one-time unique expenses that dont contribute to generating revenue. A companys financial statements should be cleansed of these expenses in order for a buyer to understand a companys true profit-generating ability. This should be done on a historical basis, reconciled to the actual financial statements, and be consistently applied in any financial projection.

- Financial Post, July 20/2011, John Jazwinski and Matt HurlbertSPEAKING POINTS:

27Current Value AccountingHistorical Cost Accounting History does not repeat itself exactly

Current value of assets/liabilities = best indicator of future prospects

Income statement explains the changes in assets/liabilities

Balance Sheet assumes greater importancePast performance is the best indicator of future performance

Accomplished revenues represent solid foundation for future earning

Statement of Earnings is the most important

Balance Sheet used to report asset costs matched against revenues it generatedWhich is better for investors?Relevance vs. reliability

Revenue recognition

Recognition lag

Matching of costs and revenuesCharacteristics of Historical Cost Accounting

RELEVANCE VS. RELIABILITYNecessary to have TRADEOFFS

Historical Cost

High reliabilityLow relevanceREVENUE RECOGNITIONRevenue is recognized when inventory is soldRECOGNITION LAGMINIMALSince changes in economic value are realized as they occurCurrent Value Accounting Revenue is recognized as changes in value occurHistorical Cost AccountingGREATRevenue is not recognized until increases in inventory value are validated (i.e. sales)MATCHING OF COSTS AND REVENUESHistorical Cost Accounting:Net income is a result of matching realized revenues with the expenses associated to earning themFor example: AMORTIZATION

IAS 16 says amortization should be charged : Over the useful life of the asset; and Reflect consumption patterns

Current Value Accounting:Net income is simply an explanation of the change in current values in the periodSUBJECTIVE =Reduced reliabilityDiscussion Question:Which method of accounting is better for investors and why:

Historical Cost Accounting

OR

Current Value AccountingThe Non-Existence of True Net IncomeCLAIM: Net income does not exist as a well-defined economic construct

ARGUMENT:

Net income has no information content when conditions are ideal

Incomplete markets happen when market values do not exist for all assets and liabilitiesIMPLICATIONS:

Judgement is required to estimate net income and asset valuation

Judgement is the basis for the accounting profession!Article: A Matter of PrinciplesRosen argues accounting principles are continuously changing:

Historical cost principle Conservatism principle Matching principle

Shift from Income Statement to Balance Sheet

- Investors are unfamiliar with changing policiesRecent Accounting Changes IFRS

ASPE transition balance sheet and reconciliation of retained earnings

New IAS 19 pension plans

Discussion Question:Onus on Investors or Accounting Authorities?Group AStephanie CenedeseNicholas FergusonElisa MartoneJohn severinMarcus Traynor

Chapter 2 Accounting Under Ideal Conditions

WORKS CITED Alciatore, M. L. (1993). New Evidence on SFAS No. 69 and the Components of the Change in Reserve Value. The Accounting Review , 68 (3), 639-656. Deloitte. "IAS 19 Employee Benefits." Summaries of International Financial Reporting Standards. 2010. Web. 6 Jan. 2012. . Elliott, D. C. (2009). Discussion Paper: UNFC, User Manuals, and Working Groups. Alberta Securities Commission. Jazwinski, John, and Matt Hurlburt. "Enhancing Value before You Sell." Financial Post. 20 July 2011. Web. 06 Jan. 2012. . Libby, Robert, Patricia A. Libby, Daniel G. Short, George Kanaan, and Maureen Gowing. Financial Accounting. Boston: McGraw-Hill/Irwin, 2008. Print. NATIONAL INSTRUMENT 51-101 - Standards of Disclosure for Oil and Gas Activities. (n.d.). Retrieved 01 07, 2012, from Canadian Council of Professional Geoscientists (CCPG): http://www.ccpg.ca/profprac/en/Standards%20Disclosure%20for%20Oli%20and%20Gas%20Activities_51-101-2236.pdf Rosen, Al. "A Matter of Principles." Print. Rpt. in ProQuest. By Canadian Business. Vol. 77. Toronto, 2004. 19. Print. Iss. 2. Scott, William R. "Chapter 2: Accounting Under Ideal Conditions." Financial Accounting Theory. 6th ed. Toronto: Pearson, 2012. 34-55. Print.