GROUP A STEPHANIE CENEDESE NICHOLAS FERGUSON ELISA MARTONE JOHN SEVERIN MARCUS TRAYNOR Chapter 2 Accounting Under Ideal Conditions Chapter 2 Accounting.

GROUP ASTEPHANIE CENEDESENICHOLAS FERGUSON

ELI SA MARTONEJOHN SEVERIN

MARCUS TRAYNOR

Chapter 2 Accounting Under Ideal Conditions

AGENDA

Present Value Model under Certainty

Present Value Model under Uncertainty

Reserve Recognition Accounting (RRA)

Historical Cost AccountingNon-existence of True Net

IncomeArticle: 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

Net income for the year: $260.33 x 10% = $26.03

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

Present 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 1

Financial Asset $150.00Cash 136.36Capital asset, PV $286.36

Shareholder’s equity $260.33Opening Value 26.03 $286.36

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

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

NOTES

Present Value Model under Certainty

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

NOTES

Example: Present Value Model under Certainty

Interest 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 = $260.33

Present Value Model under Certainty

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

NOTES

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 rate2. Complete and publicly known sets of nature3. State probabilities objective and publicly known4. 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 + 123.97PA0 = $260.33

Example: Effect on Income Statement

Insert Marcus’ updated table

ABC CompanyIncome Statement

(bad economy)For Year 1

Accretion 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 $23.97

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 CompanyBalance Sheet (bad economy)

For Year 1Financial AssetCash $100Capital AssetEnd of Year Value $136.36 $236.36

Shareholder’s equity Opening Value $260.33Net Loss $ 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 CompanyIncome Statement(good economy)

For Year 1

Accretion of Discount (10*260.33) $26.03Less: Abnormal Earnings Expected Cash Flows $150.00 Actual Cash Flows $200.00 $50.00 Net Income $76.03

ABC CompanyBalance Sheet

(good economy)For Year 1

Financial AssetCash $200.00Capital AssetEnd of Year Value $136.36 $336.36

Shareholder’s equity Opening Value $260.33Net Loss $ 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 holdsReliable: 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

incomeNet 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

two-period 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

Current Value Accounting Historical 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 importance

Past 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 generated

Which is better for investors?

RELEVANCE VS. RELIABILITY

REVENUE RECOGNITION

RECOGNITION LAG

MATCHING OF COSTS AND REVENUES

Characteristics of Historical Cost Accounting

RELEVANCE VS. RELIABILITY

Necessary to have TRADEOFFS

Historical Cost

High reliabilityLow relevance

REVENUE RECOGNITION

Revenue is recognized when inventory is sold

RECOGNITION LAG

MINIMALSince changes in economic

value are realized as they

occur

Current Value Accounting

Revenue is recognized as changes in value

occur

Historical Cost

Accounting

GREATRevenue 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

SUBJECTIVE =

Reduced

reliability

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 constructARGUMENT:

• 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?

GROUP AS T E P H A N I E C E N E D E S EN I C H O L A S F E R G U S O N

E L I S A M A R T O N EJ O H N S E V E R I N

M A R C U S T R AY N O R

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. <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-you-sell/>.• 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.