Chapter 2

Accounting Under Ideal Conditions

Julie WongIfrah 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

Ideal Conditions

The Present Value Model Under Certainty

Accretion of discount= Expected net income= Realized net incomeEx: 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)

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?

Year 1 Year 2 Today (at Time 0)

$110 $110 110/1.1+110/1.12

=100+90.91=$190.91

The Present Value Model Under Certainty

Accretion of Discount Year 1 Year 2 Total

$19.09 $10.00 $29.09

At time 0, Capital asset present value = $190.91For 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)

Balance Sheet As at time 0

Capital asset, at present value $190.91 Shareholders' equity $190.91

Income StatementFor Year 1

Accretion of discount $19.09

Balance Sheet

As at End of Year 1

Financial Asset

CashCapital 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

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

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

The Present Value Model Under Uncertainty

States Cash flows

Good Economy

Bad Economy

$120

$100

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

The Present Value Model Under Uncertainty

Expected Net Income ≠ Realized (Actual) Net income

Because of…

Abnormal Earnings / Unexpected Earnings

Abnormal Earnings – Bad Economy States Cash flows Expected Cash

flow(Time 1)

Good Economy

Bad Economy

$120

$100

0.5 X $120 + 0.5X$100

=$110

Abnormal Earnings = $100 – $110 = ($10)

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

Income Statement(Bad Economy)

For Year 1

Balance Sheet (Bad Economy)

As at End of Year 1

Financial Asset Cash $100.00Capital Asset, end of year value 100.00* $200.00

Shareholders’ EquityOpening value $190.91Net 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

Abnormal Earnings – Good Economy States Cash flows Expected Cash

flow(Time 1)

Good Economy

Bad Economy

$120

$100

0.5 X $120 + 0.5X$100

=$110

Abnormal Earnings = $120 – $110 = $10

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

Income Statement (Good Economy)

For Year 1

Balance Sheet (Good Economy)

As at End of Year 1

Financial Asset Cash $120.00Capital Asset, end of year value $100.00 $220.00

Shareholders’ EquityOpening value $190.91Net Income $29.09 $220.00

• 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

When is Net Income Informative?

• Subjective probability• No ready-made state probabilities• Different frequencies• Investors assess probabilities– Limited knowledge

• Income statement = information source

Ideal Conditions

Non-Ideal Conditions

Non-Ideal Conditions

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 relevancyDifferent ways to value assets and measure

income • “A Matter of Principals” article

Reserve Recognition Accounting (RRA)

• Financial Accounting Standard Board (FASB)– Issued Statements of Financial Accounting

Standards (SFAS) 69– Oil and Gas Reserve

Husky Energy Inc. 2008Expected 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 estimatesNet changes in sales and transfer prices (10,852)Revisions of quantity estimates

119Changes in timing of net future cash flows 182Changes 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

Why isn’t RRA Reliable?

1. Interest rate is not fixed- 10%2. There are more than 2 stages in the economy

(good vs. bad) => value at year-end prices3. Subjective state probabilities

Historical Cost

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

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

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