Accounting Under Ideal Conditions
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Accounting Under Ideal Conditions Financial Accounting Theory: Chapter 2 Cathy Phung Jaspreet Sidhu Neil Ganatra Yashar Davarpanah 1 • Present Value Model Under Certainty 2 • Present Value Model Under Uncertainty 3 • Reserve Recognition Accounting 4 • Historical Cost Accounting & True Net Income Present Value Model Under Certainty PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Overview The study of Financial Accounting Theory starts with the Present Value Model Financial statement Relevance Dividends, Cash Flow, Profitability Financial statement Reliability Financial Position, Results of Operations PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Present Value Model Under Certainty Certainty = Complete Relevance and Reliability IDEAL CONDITIONS = Future cash flows and interest rate in the economy are publicly known with certainty PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Present Value Model Under Certainty Example Consider Company A: One asset firm with no liabilities Asset will generate end-of-year cash flows of $150 each year for two years Economy interest rate is 10% PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Example – Present Value Model Under Certainty Present Value Opening Balances PVO = 150/(1.10) + 150/(1/1.10)^2 = $260.33 Balance Sheet Accounts – Time 0 Capital Assets, at present value = $260.33 Shareholders’ equity = $260.33 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Example – Present Value Model Under Certainty Income Statement for Year 1 Ended Net Income = $260.33 x 10% = $26.03 Accretion of Discount Opening present value multiplied by the interest rate Expected Net Income = Realized Net Income PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Example – Present Value Model Under Certainty Balance Sheet – As at End of Year 1 Assets Shareholders Equity Cash $150.00 Opening Value $260.33 Capital Asset 136.36 Net Income 26.03 Total $286.36 Total $286.36 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Example – Present Value Model Under Certainty Dividend Irrelevancy Dividend Policy will not affect firm value under Ideal Conditions As long as investors can invest dividends they receive at the same rate of return as the firm earns on cash flows not paid in dividends, PV of an investors overall interest in the firm is independent of the timing of dividends. Dividend Paying Ability PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Example – Present Value Model Under Certainty Net Income Able to determine value from Opening Balance Sheet Accounts Perfectly Predictable Plays no role in firm valuation PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Principal of Arbitrage At 10%, no one would be willing to pay more than $260.33 for asset at time 0 – would be earning less than 10%. At 10%, owner would not sell asset for less than $260.33 – would rather hold onto the asset and earn 10%. Therefore: Only possible equilibrium market price is $260.33 PV of Asset = Market Value PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Review Questions Question 1 – MDL Doors opening present value is $250, what is the Accretion of Discount for the year given a 10% economy interest rate? a) $32 b) $25 $0 $2.50 c) d) PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Review Questions Question 1 – MDL Doors opening present value is $250, what is the Accretion of Discount for the year given a 10% economy interest rate? a) $32 b) $25 $0 $2.50 c) d) PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Present Value Model Under Uncertainty PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary States of Nature Definition: Uncertain future events that affect cash flows Examples: Weather Government policies Strikes by suppliers Equipment breakdowns PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary States of Nature – Example 1 State 1 : Economy is Bad State 2 : Economy is Good State 1: $100/Year State 2: $200/Year PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Assumptions – Example 1 1. 2. 3. 4. 5. PV under Certainty Two year cash flows Probability of occurrence of each state = 50 % Set of possible states is publicly known and complete State realization is publicly observable State probabilities are objective and publicly known PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Summary – Ideal Conditions Under Uncertainty 1. 2. 3. 4. A given, fixed interest rate A complete and publicly known set of states of nature State probabilities objective and publicly known State realization publicly observable PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Calculate Expected Present Value – Example 1 State 1 : Economy is Bad State 2 : Economy is Good State 1: $100/Year State 2: $200/Year Interest: 10% Assumptions: 1. Two year cash flows 2. Probability of occurrence of each state = 50 % PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Possible Answers $260.33 B. $300.00 C. $100.00 D. $200.33 A. PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Answer PA0 = o.5 ( ( $100 / 1.10) + ( $200 /1.10) ) + 0.5 ( ( $100/1.10 2 ) + ( $200/1.10 2 ) ) = $260.33 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Balance Sheet at Time 0 Capital Asset, at Expected Present Value $260.33 Shareholders’ Equity $260.33 In this Chapter we will ignore the 50/50 gamble We assume investors are risk-neutral Firm’s market value will be $260.33 at time 0 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Accretion of Discount – Year 1 (Bad Economy) Based on Expected Net Income for Year 1 Interest x Present value at time 0 0.10 x $260.33 = $26.03 Assume actual cash flows for year 1 = $100 Expected cash flows = $ 150 (0.5x100+0.5x200) Therefore Abnormal Earnings Bad State Realization = $50 Net Income: $26.03 - $50 = (23.97) PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Expected Present Value of Remaining Cash Flows PA 1 = 0.5 ( ($100 / 1.10) + ($200/1.10)) = $136.36 Balance Sheet Financial Assets: Cash Capital Assets: End of Year Value Shareholders’ Equity Opening Value Net Loss PV under Certainty PV under Uncertainty $100.00 136.36 $236.36 $260.33 23.97 $236.36 Revenue Recognition Accounting Historical Cost Accounting Summary Notes – Example 1 Completely Relevant and Reliable - Financial statement information is both completely relevant and reliable. Relevance because balance sheet values are based on expected future cash flows and dividend irrelevancy holds. Reliable because ideal conditions ensure that present value calculations faithfully represent the firm’s expected future cash flows. Volatility - Net Income and Balance Sheet values are volatile since end of year period present values depend on which state is realized 2 Way of Calculating Balance Sheet Current Values - Expected Present Values or Market Values Predictability - Net Income is predictable conditional on the state of nature PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Reserve Recognition Accounting PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary What is Reserve Recognition Accounting (RRA)? Present value accounting applied to oil and gas reserves PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Accounting Standards United States Financial Accounting Standards Board (FASB) issued SFAS 69 PV under Certainty PV under Uncertainty Canada Canadian Standards Association (CSA) issued National Instrument (NI) 51101 Revenue Recognition Accounting Historical Cost Accounting Summary Financial Accounting Standards Board FASB issued SFAS 69 in 1982 Publicly traded oil and gas companies are required to disclose supplementary information PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary SFAF Summary Proved oil and gas reserve quantities Capitalized costs relating to oil and gas producing activities Costs incurred in oil and gas property acquisition, exploration, and development activities Results of operations for oil and gas producing activities A standardized measure of discounted future net cash flows relating to proved oil and gas reserve quantities PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Canadian Standards Association National Instrument (NI) 51-101 requires similar present value disclosures but considerably expanded Option to apply for exemption and report under U.S. reserve recognition rules PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Why were these standards issued? Provides investors with relevant information about future cash flows that historical cost-based financial statements don’t provide PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary A standardized measure of discounted future net cash flows Future Cash Inflows: requires computations using year-end oil and gas prices Future production and development costs: estimated expenditures incurred in developing and producing proved oil and gas reserves Future Income Taxes: Computed by applying appropriate year-ends tax rates Discount: 10% rate is mandated by SFAS 69 for comparability across firms PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Husky Energy Inc. - 2008 Future Cash Inflows Future Production Costs Future Development Costs Future income Taxes Future Net Cash Flows 29,918 11,695 4,020 3,715 10,488 Annual 10% Discount factor 4,129 Future Net Cash Flows $6,359 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Husky Energy Inc. - 2008 Changes in standardized measures of discounted future net cash flows Beginning Balance: Present value at January 1st, 2008 +/- Adjusts for changes in quantities, prices, timings, costs and income taxes = Present Value at December 31st, 2008 PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Ideal conditions vs. “real world” environment Two components of changes in estimates: 1) Changes in estimates of cash flow amounts Under ideal conditions, there are no errors of estimates 2) volatility of earnings depending on the state realized PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Husky Energy Inc. – Income Statement Method 1 Expected net income Abnormal earnings Additional reserves Changes in estimate 2,098 Net loss (4,732) PV under Certainty PV under Uncertainty Revenue Recognition Accounting 1,590 (8,420) Historical Cost Accounting Summary Husky Energy Inc. – Income Statement Method 2 Cash Flow from Operations Development costs Amortization Expense 6,197 (2,455) (8,474) Net Loss (4,732) PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Problem 2012 Statement of Changes in Standardized Measure Present value January 1, 2012 224,533 Sales of oil & gas, net of production costs (102,732) Net change in prices and production costs 710,398 Extension and discoveries of proved reserves, net 224,214 Development costs incurred during the period 27,828 Revisions to quantity estimates 87,934 Accretion of discount 22,453 Net change in income taxes (330,636) Change in estimates future development costs (39,238) Present value December 31, 2012 PV under Certainty PV under Uncertainty $824,754 Revenue Recognition Accounting Historical Cost Accounting Summary Problem Expected Net Income Abnormal earnings NPV of Additional reserves Changes in estimates Net changes in price & production costs Revision of previous qty estimates Net change in income taxes Change in estimated in future development Costs Total changes in estimates 22,453 224,214 710,398 87,934 (330,636) (39,238) 428,458 Net income from proved oil & gas reserves PV under Certainty PV under Uncertainty Revenue Recognition Accounting 675,125 Historical Cost Accounting Summary Reliability & Relevance High PV under Certainty relevancy but low reliability PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Reliability Proved reserves: “reasonable certainty” of recovery under current economic and operating conditions Do not operate under ideal conditions PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Problem: Lack of ideal conditions 1) 2) 3) Interest rates in the economy are not fixed – SFAS mandates a 10% rate States of nature are more complex than the “good” and “bad” states Subjective state probabilities PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Reliability – Husky Example Its RRA information is not a reliable performance measure and should not solely be relied upon in evaluating company performance, is not a representation of the value of the company’s reserves, and is not used to internal decision-making PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Relevance Information must affect a decision made by decision makers in order for it to be relevant Highly relevant: present values of future receipts predict future cash flow Conveys more useful information to investors than historical cost accounting Relevance: RRA vs. Historical RRA Historical Revenue, gains and losses are recorded using year-end prices – resulting in revenue being recognized sooner Revenue, gains and losses are recorded as reserves are lifted and sold Oil and gas assets are valued at expected present value Oil and gas assets are valued at historical cost PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Important Note Complete relevance and reliability is not possible without ideal conditions, there must be a trade off! More relevant information requires more estimates, reducing reliability Historical Cost Accounting PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Recap from Chapter 1... • Different systems of accounting valuation include: 1. 2. Historical cost accounting Current cost accounting PV under Certainty Value-in-use discounted PV of future cash flows Fair value (aka exit price) the amount that would be received or paid should the firm dispose of the asset or liability PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Historical Cost vs. Current Cost Accounting Relevance vs. Reliability • There is always a tradeoff between the two! Historical Cost Accounting Current Cost Accounting MORE RELIABLE, LESS RELEVANT MORE RELEVANT, LESS RELIABLE •Verifiable number •Less subject to bias •But values change over time PV under Certainty PV under Uncertainty •Provides more accurate picture of company’s worth •Requires greater estimation •More prone to error/subject to manipulation Revenue Recognition Accounting Historical Cost Accounting Summary Historical Cost vs. Current Cost Accounting Revenue Recognition Historical Cost Accounting Current Cost Accounting LATER REVENUE RECOGNITION •Revenue recognition when objective evidence of realization is available (eg: deferred revenue) PV under Certainty PV under Uncertainty EARLIER REVENUE RECOGNITION •Revenue recognition changes as changes in current value occur Revenue Recognition Accounting Historical Cost Accounting Summary Historical Cost vs. Current Cost Accounting Recognition Lag Historical Cost Accounting Current Cost Accounting LONGER RECOGNITION LAG SHORTER RECOGNITION LAG •Revenue is not recognized until it can be validated •Changes in economic value are recognized as they occur Recognition lag the extent to which the timing of revenue recognition lags behind changes in real economic value PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Historical Cost vs. Current Cost Accounting Matching of Costs and Revenues Historical Cost Accounting Current Cost Accounting BASIS OF HISTORICAL COST ACC’T LITTLE MATCHING •Accomplished through accruals •They "smooth out" cash flow so as to allocate them over the periods to which they relate PV under Certainty PV under Uncertainty •Value changes in assets/liabilities driven by market forces Revenue Recognition Accounting Historical Cost Accounting Summary Accountants still debate over whether historical cost or current value accounting is more useful for investors in making decisions.... PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary The Non-Existence of True Net Income A fundamental problem is the lack of objective state probabilities In the real world, we have incomplete markets So why bother calculating something that doesn’t exist? This is the basis of the accounting profession! If ideal conditions existed, net income could be calculated by all, eliminating the need for accountants. PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary Summary 1 Present Value Model Under Certainty 2 Present Value Model Under Uncertainty 3 Reserve Recognition Accounting 4 Historical Cost Accounting & True Net Income PV under Certainty PV under Uncertainty Revenue Recognition Accounting Historical Cost Accounting Summary
