Chapter 2 – Accounting
Under Ideal Conditions
Nic Festarini, Alex Leon, Ben McRae, Matt Spark
2.1 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
Overview
2.2 The Present Value
Model Under Certainty

Widely used in Economics, Finance and
Accounting

Provides relevant information to financial
statement users

Determines firms future prospects and
aids in investment decisions
The Present Value Model

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 yrs
Interest rate = 10%
Present Value at year 0 = PA0
$150
1.10
$150
1.102

PA0 =

PA0 = 136.36 + 123.97
PA0 = $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 Income
PA0 = 260.33 * 0.1
PA0 = $26.03

Accretion of discount

Example of the Present Value
Model Under Certainty

Present value at the end of year 1
$150
1.10

PA1 =

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
$286.36
$ 26.03
$286.36
Example of the Present Value
Model Under Certainty

Dividends

Net book value = Present value

Relevant and Reliable

Arbitrage Profits

Net income plays no role in firm valuation
Important Points
2.3 The Present Value
Model Under Uncertainty
Illustrative example with concepts carrying over from 2.1

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 (States)

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.
…States of Nature Continued

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
Ideal Conditions

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

Calculation of expected present value at
time 0:
PV0 = 0.5
$100
(
1.10
+
$200
)
1.10
+ 0.5
$100
( 2
1.10
+
$200
2)
1.10
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
…Example Continued
$260.33

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
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
Net Loss

($50.00)
($23.97)
Under uncertainty, net income consists of
expected net income plus or minus abnormal
(unexpected) earnings for the year
…Example Continued

At the end of year 1, expected present
value of the remaining cash flows:
PV1 = 0.5
$100
(
1.10
+
$200
1.10
) = $136.36
Balance Sheet As at End of Year 1 (Bad State)
Financial Asset
Cash
Shareholder’s
Equity
$100.00
Opening Value
$260.33
$136.36
Net Loss
($23.97)
Capital Asset
End of Year Value
$236.36
…Example Continued
$236.36

Accretion of discount is based on expected
net income for year 1

Calculated 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
Net Income
…Example Continued
$50.00
$76.03
Balance Sheet As at End of Year 1 (Good State)
Financial Asset
Cash
Shareholder’s
Equity
$200.00
Opening Value
$260.33
$136.36
Net Income
$76.03
Capital Asset
End of Year Value
$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.
…Example Continued

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

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
…Points to Consider Continued

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.
Looking Ahead
2.4 Reserve
Recognition Accounting
An Example of RRA with Husky Energy Inc.
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

Reserve Recognition Accounting



When estimating future cash flows, SFAS 69
requires that the PV calculations use yearend 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.
…RRA Continued

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
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.
..Basic Problems of RRA Continued
2.5 Historical Cost
Accounting


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
Comparison of Different
Measurement Bases

It is necessary to trade them off
◦ Different measurements bases imply different
tradeoffs

Historical Cost
◦ Relevance – Low
◦ Reliability – High

Current Value
◦ Relevance – High
◦ Reliability – Low
Characteristics: Relevance vs.
Reliability

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: Revenue
Recognition
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: Recognition Lag

Historical Cost
◦ Matching is primarily used as net income is
accomplished through the use of accruals

Accruals
◦ 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
Characteristics: Matching of Costs
& Revenues
2.6 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 period

However under real world conditions –
Net income does not exist as a welldefined 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
The Non-Existence of True 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
Concept of Net Income
Additional Reading:
A Matter of Principles
Al Rosen

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
Financial Statements in Canada
Not familiar with Canadian GAAP
 Inability to explain GAAP’s impact on the
financial statements
 EPS and EBITDA figures are being
misinterpreted

Current Problems – Investor
Perspective
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

Accounting Text Books
CICA Handbook:
Section 1100
Generally Accepted Accounting Principles



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

CICA HB: S1100
Jeopardy