Chapter 2 – Accounting Under Ideal Conditions

Nic Festarini, Alex Leon, Ben McRae, Matt Spark

2.1 Overview

Overview

Present Value Model

◦- Under certainty and uncertainty

Reserve Recognition Accounting

Historical Cost Accounting

The Non-Existence of True Net Income

A Matter of Principles by Al Rosen

CICA Handbook: Section 1100

2.2 The Present Value Model Under Certainty

The Present Value Model

Widely used in Economics, Finance and Accounting

Provides relevant information to financial statement users

Determines firms future prospects and aids in investment decisions

Example of the Present Value Model Under Certainty

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 yrsInterest rate = 10%Present Value at year 0 = PA0

PA0 = PA0 = 136.36 + 123.97PA0 = $260.33

Balance Sheet As at Time 0

Capital Asset, at expected PV

$260.33 Shareholder’s Equity

$260.33

Example of the Present Value Model Under Certainty

Net revenues are capitalized into asset value

Similar to a savings account

Net IncomePA0 = 260.33 * 0.1PA0 = $26.03

Accretion of discount

Example of the Present Value Model Under Certainty

Present value at the end of year 1PA1 = PA1 = 136.36

Balance Sheet at the End of Year 1

Assets Shareholder’s Equity

Cash $150 Opening Value $260.33

Capital Asset, at PV

$136.36 Net Income $ 26.03

$286.36 $286.36

Important Points

Dividends

Net book value = Present value

Relevant and Reliable

Arbitrage Profits

Net income plays no role in firm valuation

2.3 The Present Value Model Under UncertaintyIllustrative example with concepts carrying over from 2.1

States of Nature (States)

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 Continued

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.

Ideal Conditions

Ideal conditions under uncertainty are characterized by:

◦1. A given, fixed interest rate at which the firm’s 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

Example

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 Continued

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 Shareholder’s Equity

$260.33

…Example Continued

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 of discount is based on expected net income for year 1 Calculated as: 0.10 * $260.33 = $26.03

Under uncertainty, net income consists of expected net income plus or minus abnormal (unexpected) earnings for the year

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 ($50.00)

Net Loss ($23.97)

…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 Shareholder’s Equity

Cash $100.00 Opening Value $260.33

Capital Asset

End of Year Value $136.36 Net Loss ($23.97)

$236.36 $236.36

…Example Continued

Accretion of discount is based on expected net income for year 1Calculated 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 $50.00

Net Income $76.03

…Example Continued

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

Financial Asset Shareholder’s Equity

Cash $200.00 Opening Value $260.33

Capital Asset

End of Year Value $136.36 Net Income $76.03

$336.36 $336.36

This 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 firm’s market value will be $260.33 at time 0.

Points to Consider

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 Continued

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 year’s state realization. ◦Net income is predictable conditional on the

state of nature

Looking Ahead

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.

2.4 Reserve Recognition Accounting

An Example of RRA with Husky Energy Inc.

Reserve Recognition Accounting

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 company’s proven oil and gas reserves

Intended to provide investors with more relevant information

…RRA Continued

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, Husky’s 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.

Basic Problems of RRA

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 Continued

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.

2.5 Historical Cost Accounting

Comparison of Different Measurement Bases

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 firm’s environment

Characteristics: Relevance vs. Reliability

It is necessary to trade them off◦Different measurements bases imply different

tradeoffsHistorical Cost

◦Relevance – Low◦Reliability – High

Current Value◦Relevance – High◦Reliability – Low

Characteristics: Revenue Recognition

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: Recognition Lag

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: Matching of Costs & Revenues

Historical Cost◦Matching is primarily used as net income is

accomplished through the use of accrualsAccruals

◦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 asset’s 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 firm’s response to these forces

2.6 The Non-Existence of True Net Income

The Non-Existence of True Net Income

Current Value accounting F/S require that all the firm’s assets and liabilities be prepared based on the current value◦Net income is the change in the firm’s current

value during the periodHowever 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

Concept of 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

Additional Reading:A Matter of Principles

Al Rosen

Financial Statements in Canada

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

Current Problems – Investor Perspective

Not familiar with Canadian GAAPInability to explain GAAP’s impact on the

financial statementsEPS and EBITDA figures are being

misinterpreted

Accounting Text Books

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

CICA Handbook: Section 1100

Generally Accepted Accounting Principles

CICA HB: S1100

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

Jeopardy