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Chapter 2

Chapter 2. Accounting Under Ideal Conditions . Julie Wong Ifrah Zubaid -Ahmad Decheng Feng. Agenda . Ideal conditions Present value under certainty Present value under uncertainty Non-ideal conditions Reserve recognition accounting Mixed measurement model. Ideal Conditions .

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Chapter 2

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  1. Chapter 2 Accounting Under Ideal Conditions Julie Wong IfrahZubaid-Ahmad DechengFeng

  2. Agenda • Ideal conditions • Present value under certainty • Present value under uncertainty • Non-ideal conditions • Reserve recognition accounting • Mixed measurement model

  3. Ideal Conditions

  4. Ideal Conditions

  5. The Present Value Model Under Certainty Accretion of discount = Expected net income = Realized net income Ex: You invest $100 in a bank. The interest rate in the economy is 10%. At the end of year one, how much interest do you expected to earn from the bank? Answer: $10 (Accretion of discount)

  6. The Present Value Model Under Certainty Ex: Firm with assets but no liabilities, is generating cash flow of $110 at the end-of-year for two years (after 2 years asset will have zero value). The interest rate in the economy is 10%. If you sell your firm today, how much will your firm be worth?

  7. The Present Value Model Under Certainty

  8. Accretion of Discount At time 0, Capital asset present value = $190.91 For year 1, accretion of discount = $190.91*10% = $19.09 At time 1, capital asset present value = $100 [cash flow year 2 present value 110/1.1] For year 2, accretion of discount = $100*10% = $10 CHECK: $110+$110= $220 (undiscounted) Present value = $190.91 (discounted) $220-$190.91 = $29.09 (total accretion)

  9. Balance Sheet As at time 0 Capital asset, at present value $190.91 Shareholders' equity $190.91 Income Statement For Year 1 Accretion of discount $19.09

  10. Balance Sheet As at End of Year 1 Financial Asset Cash Capital Asset, at present value $110.00 $100.00* $210.00 Shareholders’ Equity Opening value Net Income $190.91 $19.09 $210.00 *Present value of future cash flows = $110/1.1 = $100 Note: Net income not used to value firm

  11. Relevancy • Pay offs to investors, PV establish firm’s value • Dividend Irrelevancy under ideal conditions • Only one risk-free interest rate in economy Reliability • Faithful representation • Inputs 100% publicly known and true

  12. Market Value • Present value of asset/liability = market value • No arbitrage • Cash flows and interest rate are known • Market value of firm = sum of financial assets and PV of future cash flows from capital asset

  13. The Present Value Model Under Uncertainty

  14. Expected Present Value, Time 0 PA0 = 0.5($100/1.10 + $120/1.10) + 0.5($100/1.102 + $120/1.102) = $100 + $90.91 = $190.91

  15. The Present Value Model Under Uncertainty Expected Net Income ≠ Realized (Actual) Net income Because of… Abnormal Earnings / Unexpected Earnings

  16. Abnormal Earnings – Bad Economy Abnormal Earnings = $100 – $110 = ($10)

  17. Income Statement (Bad Economy) For Year 1 Accretion of discount (0.10*$190.91) $19.09 Less: Abnormal earnings, as a result of bad-state realization Expected cash flows $110 Actual cash flows 100 10.00 Net Income (Actual/Realized) $9.09

  18. Balance Sheet (Bad Economy) As at End of Year 1 Financial Asset Cash $100.00 Capital Asset, end of year value 100.00* $200.00 Shareholders’ Equity Opening value $190.91 Net Income$9.09 $200.00 *0.5(100/1.1) + 0.5(120/1.1) = 100 (present value for year 2 cash flows) Note: State realizations are independent

  19. Abnormal Earnings – Good Economy Abnormal Earnings = $120 – $110 = $10

  20. Income Statement (Good Economy) For Year 1 Accretion of discount (0.10*$190.91) $19.09 Add: Abnormal earnings, as a result of good-state realization Actual cash flows $120 Expected cash flows 110 10.00 Net Income (Actual/Realized) $29.09

  21. Balance Sheet (Good Economy) As at End of Year 1 Financial Asset Cash $120.00 Capital Asset, end of year value $100.00 $220.00 Shareholders’ Equity Opening value $190.91 Net Income$29.09 $220.00

  22. Relevant • Based on expected future cash flows • Dividend irrelevancy (a given, fixed interest rate) • Reliable – present values of future cash flows • No arbitrage – inputs are publicly known • Abnormal earnings do not persist • Net income is predictable conditional on the state of nature

  23. When is Net Income Informative? • Subjective probability • No ready-made state probabilities • Different frequencies • Investors assess probabilities • Limited knowledge • Income statement = information source

  24. Ideal Conditions

  25. Non-Ideal Conditions

  26. Non-Ideal Conditions

  27. Why are Non-Ideal Conditions Important? • This is why we need accountants • Difficulty agreeing on on accounting policies • Different users want different trade offs between reliability and relevancy • Different ways to value assets and measure income • “A Matter of Principals” article

  28. Reserve Recognition Accounting (RRA) • Financial Accounting Standard Board (FASB) • Issued Statements of Financial Accounting Standards(SFAS) 69 • Oil and Gas Reserve

  29. Husky Energy Inc. 2008 Expected net income- accretion of discount $2,098 Abnormal earnings Net present value of additional reserves added during the year 1,590 Unexpected items- changes in estimates Net changes in sales and transfer prices (10,852) Revisions of quantity estimates 119 Changes in timing of net future cash flows 182 Changes in estimated future development costs (1,588) Net changes in income taxes 3,719 (8,420) Net Income (loss) from proved oil and gas reserves $4,732

  30. Why isn’t RRA Reliable? • Interest rate is not fixed- 10% • There are more than 2 stages in the economy (good vs. bad) => value at year-end prices • Subjective state probabilities

  31. Historical Cost • Relevant Vs. Reliable • Revenue Recognition • Recognition Lag • Matching of costs and Revenues

  32. Different Measurement Bases • Historical cost • Past performance predicts future performance • Importance of income statement • Current value accounting • Changing environment • Current values predict future performance • Importance of balance sheet

  33. Thank you for listening and participating

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