Presentation on theme: "Chapter 2 Accounting Under Ideal Conditions"— Presentation transcript:
1 Chapter 2 Accounting Under Ideal Conditions Group AStephanie CenedeseNicholas FergusonElisa MartoneJohn severinMarcus Traynor
2 AGENDAPresent 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’sfinancial 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 conditionsExample: 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 SheetAs at Time 0Capital asset, PV $260.33Shareholder’s equity $260.33Income StatementFor Year 1Accretion of discount $26.03Net income for the year: $ x 10% = $26.03
7 Present Value Model under Certainty Balance SheetAs at End of Year 1Financial Asset $150.00CashCapital asset, PV $286.36Shareholder’s equity $260.33Opening Value$286.36*Note: assuming there is no dividends to be paidRecall: At time 0, PA0= $260.33For year 1, accretion of discount = $26.03
8 Present Value Model under Certainty NOTES1. NBV of capital asset at any year-end = PV2. Accretion of discount is also referred to asex ante or expected net incomeSince all conditions are certain,expected net income = ex post or realized net income
9 Present Value Model under Certainty NOTES3. Relevant financial statement information gives information about the firm’s future economic prospectsFuture dividends = payoff to investorsDividend irrelevancy: under ideal conditions, the timing of dividends will not affect the PV. Cash flows are also relevantTherefore, the prior financial statements = relevant
10 Present Value Model under Certainty NOTES4. Net income does not play a role in firm valuation under ideal conditionsFuture cash flows are knownNet income (accretion of discount) is predictableBalance sheet contains all the relevant information
11 Present Value Model under Certainty NOTES5. Information that represents what it intends to represent is reliableFinancial statements are reliable under ideal conditions since cash flows and interest rate are known with certaintyAny calculation errors would immediately be discovered
12 Present Value Model under Certainty NOTES6. Under ideal conditions,PV of asset/liability = market valueArbitrage: 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 $260.33No one would be willing to pay more than $260.33Recall: PV of asset at time 0 = $260.33
14 Present Value Model under Certainty NOTES7. Market value of the firm = sum of financial assets and PV of joint future receipts from its capital assets + intangibles – PV of liabilitiesTotal 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 flowsEx: 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 extendedCharacterized by:1. Given, fixed interest rate2. Complete and publicly known sets of nature3. State probabilities objective and publicly known4. 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).
19 Example: Effect on Income Statement ABC CompanyIncome Statement(bad economy)For Year 1Accretion of Discount (10*260.33) $26.03Less: Abnormal EarningsExpected Cash Flows (.5*$ *$200) $150.00Actual Cash Flows $ $50.00Net Loss $23.97Insert Marcus’ updated tableThe negative $50 of unexpected cash flows results in a $50 shock to earnings for the year. This shock is call abnormal earnings, or unexpected earningsEnd 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 CompanyBalance Sheet(bad economy)For Year 1Financial AssetCash $100Capital AssetEnd of Year Value $136.36$236.36Shareholder’s equityOpening Value $260.33Net Loss $ 23.97Rework 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 CompanyIncome Statement(good economy)For Year 1Accretion of Discount (10*260.33) $26.03Less: Abnormal EarningsExpected Cash Flows $150.00Actual Cash Flows $ $50.00Net Income $76.03ABC CompanyBalance Sheet(good economy)For Year 1Financial AssetCash $200.00Capital AssetEnd of Year Value $136.36$336.36Shareholder’s equityOpening Value $260.33Net 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 holdsReliable: ideal conditions ensure that present value calculations faithfully represent firm’s expected future cash flows2. Two ways of calculating balance sheet current valuesValue in useFair Value
23 Present Value Model under Uncertainty 3. Income statement lacks information content when abnormal earnings do not existInvestors have sufficient information to calculate realized net incomeNet income is predictable conditional on the state of nature4. Consider all state probabilities to be objective at this point in timeSubjective probabilities eliminate the existence of “ready-made” probabilitiesNo 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 existSFAS 69 – applies to publicly traded oil and gas companiesRequires management judgment in determining proved reservesRevenue recognized when reserves are determined to be provedSet discount rate of 10%Adjustments to estimates in present value calculation are required
25 Revenue Recognition Accounting National InstrumentCanadian reserve recognition accounting standardRequires a report by an independent Qualified Reserves Evaluator or AuditorRequires (constant and forecast) price disclosure
26 Revenue Recognition Accounting Relevance vs. reliabilityWhich 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 HurlbertSPEAKING POINTS:
28 Which is better for investors? Current Value AccountingHistorical Cost AccountingHistory does not repeat itself exactlyCurrent value of assets/liabilities = best indicator of future prospectsIncome statement explains the changes in assets/liabilitiesBalance Sheet assumes greater importancePast performance is the best indicator of future performanceAccomplished revenues represent solid foundation for future earningStatement of Earnings is the most importantBalance Sheet used to report asset costs matched against revenues it generated
29 Characteristics of Historical Cost Accounting Relevance vs. reliabilityRevenue recognitionRecognition lagMatching of costs and revenues
30 RELEVANCE VS. RELIABILITY Necessary to have TRADEOFFSHistorical CostHigh reliabilityLow relevance
31 Historical Cost Accounting REVENUERECOGNITIONRECOGNITIONLAGMINIMALSince changes in economic value are realized as they occurCurrent ValueAccountingRevenue is recognized as changes in value occurGREATRevenue is not recognized until increases in inventory value are validated (i.e. sales)Historical Cost AccountingRevenue 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 themFor example: AMORTIZATIONIAS 16 says amortization should be charged :Over the useful life of the asset; andReflect consumption patternsCurrent Value Accounting:Net income is simply an explanation of the change in current values in the periodSUBJECTIVE =Reduced reliability
33 Discussion Question:Which method of accounting is better for investors and why:Historical Cost AccountingORCurrent Value Accounting
34 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 idealIncomplete markets happen when market values do not exist for all assets and liabilitiesIMPLICATIONS:Judgement is required to estimate net income and asset valuationJudgement is the basis for the accounting profession!
35 Article: A Matter of Principles Rosen argues accounting principles are continuously changing:Historical cost principleConservatism principleMatching principleShift from Income Statement to Balance Sheet- Investors are unfamiliar with changing policies
36 Recent Accounting Changes IFRSASPE transition balance sheet and reconciliation of retained earningsNew 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 AStephanie CenedeseNicholas FergusonElisa MartoneJohn severinMarcus Traynor
39 WORKS CITEDAlciatore, 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 <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 Web. 06 Jan <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, 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.