Chapter 2 Accounting Under Ideal Conditions GROUP A STEPHANIE CENEDESE NICHOLAS FERGUSON ELISA MARTONE JOHN SEVERIN M A R C U S T R AY N O R AGENDA Present Value Model under Certainty Present Value Model under Uncertainty Reserve Recognition Accounting (RRA) Historical Cost Accounting Non-existence of True Net Income Article: A Matter of Principles Present Value Model Provides most relevant information to users of financial statements “information about a firm’s future economic prospects (dividends, cash flows, profitability)” • Relevant financial statements need to be reliable “information that faithfully represents the firm’s financial position and results of operations” Present Value Model under Certainty Certainty: future cash flows of a firm and the economy’s 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 Certainty Balance Sheet As at Time 0 Capital asset, PV $260.33 Shareholder’s equity $260.33 Income Statement For Year 1 Accretion of discount $26.03 Net income for the year: $260.33 x 10% = $26.03 Present Value Model under Certainty Balance Sheet As at End of Year 1 Financial Asset Cash Capital asset, PV $150.00 136.36 $286.36 Shareholder’s equity Opening Value $260.33 26.03 $286.36 *Note: assuming there is no dividends to be paid Recall: At time 0, PA0= $260.33 For year 1, accretion of discount = $26.03 Present Value Model under Certainty NOTES 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 Certainty NOTES 3. Relevant financial statement information gives information about the firm’s 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 Certainty NOTES 4. 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 Certainty NOTES 5. 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 Present Value Model under Certainty NOTES 6. 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 Example: Present Value Model under Certainty Interest rate = 10% Owner would not sell asset for less than $260.33 No one would be willing to pay more than $260.33 Recall: PV of asset at time 0 = $260.33 Present Value Model under Certainty NOTES 7. 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 = $260.33 Present 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 observable Present Value Model under Uncertainty Concept of ideal conditions is extended Characterized by: 1. Given, fixed interest rate 2. Complete and publicly known sets of nature 3. State probabilities objective and publicly known 4. State realization publicly observable Example: Present Value Model Under Uncertainty ABC 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 Value PA0 = ½(100/1.10 + 200/1.10) + ½(100/1.102 + 200/1.102) PA0 = (½*272.73) + (½*247.93) PA0 = 136.36 + 123.97 PA0 = $260.33 ABC Company Balance Sheet As at Time 0 Capital Asset, at EPV $260.33 Shareholder's Equity $260.33 Example: Effect on Income Statement ABC Company Income Statement Insert Marcus’ updated (bad tableeconomy) For Year 1 Accretion of Discount (10*260.33) $26.03 Less: Abnormal Earnings Expected Cash Flows (.5*$100 +.5*$200) $150.00 Actual Cash Flows $100.00 -$50.00 Net Loss $23.97 The 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) = $136.36 Example: Effect on Balance Sheet ABC Company Balance Sheet (bad economy) For Year 1 Financial Asset Cash Capital Asset End of Year Value $100 $136.36 $236.36 Shareholder’s equity Opening Value Net Loss $260.33 $ 23.97 $236.36 Rework 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 Economy ABC Company Income Statement (good economy) For Year 1 Accretion of Discount (10*260.33) Less: Abnormal Earnings Expected Cash Flows $150.00 Actual Cash Flows $200.00 Net Income $26.03 $50.00 $76.03 ABC Company Balance Sheet (good economy) For Year 1 Financial Asset Cash $200.00 Capital Asset End of Year Value $136.36 $336.36 Shareholder’s equity Opening Value Net Loss $260.33 $ 76.03 $336.36 Present 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 holds Reliable: ideal conditions ensure that present value calculations faithfully represent firm’s expected future cash flows 2. Two ways of calculating balance sheet current values • Value in use • Fair Value Present Value Model under Uncertainty 3. Income statement lacks information content when abnormal earnings do not exist • Investors have sufficient information to calculate realized net income Net income is predictable conditional on the state of nature 4. Consider all state probabilities to be objective at this point in time • Subjective probabilities eliminate the existence of “ready-made” probabilities • No guarantee of equivalent frequencies of potential states in twoperiod economy with subjective probabilities Revenue Recognition Accounting (RRA) Current value model when ideal conditions do not exist SFAS 69 – applies to publicly traded oil and gas companies Requires management judgment in determining proved reserves Revenue recognized when reserves are determined to be proved Set discount rate of 10% Adjustments to estimates in present value calculation are required Revenue Recognition Accounting National Instrument 51-101 Canadian reserve recognition accounting standard Requires a report by an independent Qualified Reserves Evaluator or Auditor Requires (constant and forecast) price disclosure Revenue Recognition Accounting Relevance vs. reliability Which reporting method is more relevant? Which reporting method is more reliable? Historical Cost Accounting “Private companies often have financial records that contain personal expenses and/or one-time unique expenses that don’t contribute to generating revenue. A company’s financial statements should be cleansed of these expenses in order for a buyer to understand a company’s 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 Hurlbert Which is better for investors? Historical Cost Accounting Current Value Accounting History does not repeat itself exactly Current value of assets/liabilities = Past performance is the best indicator of future performance Accomplished revenues represent best indicator of future prospects solid foundation for future earning Income statement explains the changes in assets/liabilities Statement of Earnings is the most Balance Sheet assumes greater importance important Balance Sheet used to report asset costs matched against revenues it generated Characteristics of Historical Cost Accounting RELEVANCE VS. RELIABILITY REVENUE RECOGNITION RECOGNITION LAG MATCHING OF COSTS AND REVENUES RELEVANCE VS. RELIABILITY Necessary to have TRADEOFFS Historical Cost High reliability Low relevance REVENUE RECOGNITION Current Value Accounting Historical Cost Accounting Revenue is recognized as changes in value occur Revenue is recognized when inventory is sold RECOGNITION LAG MINIMAL Since changes in economic value are realized as they occur GREAT Revenue is not recognized until increases in inventory value are validated (i.e. sales) MATCHING OF COSTS AND REVENUES Historical Cost Accounting: Net income is a result of matching realized revenues with the expenses associated to earning them For 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 period Discussion Question: Which method of accounting is better for investors and why: Historical Cost Accounting OR Current Value Accounting The Non-Existence of True Net Income CLAIM: 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 liabilities IMPLICATIONS: • Judgement is required to estimate net income and asset valuation • Judgement is the basis for the accounting profession! Article: A Matter of Principles Rosen 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 policies Recent 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? Chapter 2 Accounting Under Ideal Conditions GROUP A STEPHANIE CENEDESE NICHOLAS FERGUSON ELISA MARTONE JOHN SEVERIN M A R C U S T R AY N O R 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. <http://www.iasplus.com/standard/ias19.htm#1004ed>. • 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. <http://business.financialpost.com/2011/07/20/marketing-feature-enhancing-value-before-yousell/>. • 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_51-1012236.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.