1. Chapter 2 Accounting Under Ideal Conditions
Group A
Stephanie Cenedese
Nicholas Ferguson
Elisa Martone
John severin
Marcus Traynor

2. 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

4. Present Value Model Relevant financial statements need to be reliable
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”

5. 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%

6. 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: $ x 10% = $26.03

7. Present Value Model under Certainty
Balance Sheet
As at End of Year 1
Financial Asset $150.00
Cash
Capital asset, PV $286.36
Shareholder’s equity $260.33
Opening Value
$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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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).

18. Example: Expected Present Value
PA0 = ½(100/ /1.10) + ½(100/ /1.102)
PA0 = (½*272.73) + (½*247.93)
PA0 =
PA0 = $260.33

19. Example: Effect on Income Statement
ABC Company
Income Statement
(bad economy)
For Year 1
Accretion of Discount (10*260.33) $26.03
Less: Abnormal Earnings
Expected Cash Flows (.5*$ *$200) $150.00
Actual Cash Flows $ $50.00
Net Loss $23.97
Insert Marcus’ updated table
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/ $200/1.10) = $136.36

20. Example: Effect on Balance Sheet
ABC Company
Balance Sheet
(bad economy)
For Year 1
Financial Asset
Cash $100
Capital Asset
End of Year Value $136.36
$236.36
Shareholder’s equity
Opening Value $260.33
Net Loss $ 23.97
Rework the Income Statement and Balance Sheet of ABC Company assuming that the good economy state has occurred.

21. 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) $26.03
Less: Abnormal Earnings
Expected Cash Flows $150.00
Actual Cash Flows $ $50.00
Net Income $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 $260.33
Net Loss $

22. 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

23. 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 two-period economy with subjective probabilities

24. 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

25. Revenue Recognition Accounting
National Instrument
Canadian reserve recognition accounting standard
Requires a report by an independent Qualified Reserves Evaluator or Auditor
Requires (constant and forecast) price disclosure

26. Revenue Recognition Accounting
Relevance vs. reliability
Which reporting method is more relevant?
Which reporting method is more reliable?

27. 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
SPEAKING POINTS:

28. Which is better for investors?
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

29. Characteristics of Historical Cost Accounting
Relevance vs. reliability
Revenue recognition
Recognition lag
Matching of costs and revenues

30. RELEVANCE VS. RELIABILITY
Necessary to have TRADEOFFS
Historical Cost
High reliability
Low relevance

31. Historical Cost Accounting
REVENUE
RECOGNITION
RECOGNITION
LAG
MINIMAL
Since changes in economic value are realized as they occur
Current Value
Accounting
Revenue is recognized as changes in value occur
GREAT
Revenue is not recognized until increases in inventory value are validated (i.e. sales)
Historical Cost Accounting
Revenue is recognized when inventory is sold

32. 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

33. Discussion Question:
Which method of accounting is better for investors and why:
Historical Cost Accounting OR
Current Value Accounting

34. 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!

35. 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

36. Recent Accounting Changes
IFRS
ASPE transition balance sheet and reconciliation of retained earnings
New IAS 19 pension plans

37. Onus on Investors or Accounting Authorities?
Discussion Question:
Onus on Investors or Accounting Authorities?

38. Chapter 2 Accounting Under Ideal Conditions
Group A
Stephanie Cenedese
Nicholas Ferguson
Elisa Martone
John severin
Marcus Traynor

39. 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),
Deloitte. "IAS 19 Employee Benefits." Summaries of International Financial Reporting Standards Web. 6 Jan <
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 Web. 06 Jan <
Libby, Robert, Patricia A. Libby, Daniel G. Short, George Kanaan, and Maureen Gowing. Financial Accounting. Boston: McGraw-Hill/Irwin, Print.
NATIONAL INSTRUMENT Standards of Disclosure for Oil and Gas Activities. (n.d.). Retrieved 01 07, 2012, from Canadian Council of Professional Geoscientists (CCPG):
Rosen, Al. "A Matter of Principles." Print. Rpt. in ProQuest. By Canadian Business. Vol. 77. Toronto, Print. Iss. 2.
Scott, William R. "Chapter 2: Accounting Under Ideal Conditions." Financial Accounting Theory. 6th ed. Toronto: Pearson, Print.