Chapter 2
Accounting Under Ideal Conditions
Julie Wong
Ifrah 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 income
Ex: 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?
The Present Value Model Under Certainty
Year 1
Year 2
Today (at Time 0)
$110
$110
110/1.1+110/1.12
=100+90.91
=$190.91
Accretion of Discount
Year 1
Year 2
Total
$19.09
$10.00
$29.09
At time 0, Capital asset present value = $190.91
For 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 Statement
For Year 1
Accretion of discount
$19.09
Balance Sheet
As at End of Year 1
Financial Asset
Cash
Capital 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
$120
Bad Economy
$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
$120
Bad Economy
$100
0.5 X $120 +
0.5X$100
=$110
Abnormal Earnings = $100 – $110 = ($10)
Income Statement
(Bad Economy)
For Year 1
Accretion of discount (0.10*$190.91)
Less: Abnormal earnings, as a result of bad-state realization
Expected cash flows
Actual cash flows
Net Income (Actual/Realized)
$19.09
$110
100
10.00
$9.09
Balance Sheet
(Bad Economy)
As at End of Year 1
Financial Asset
Cash
Capital Asset, end of year value
Shareholders’ Equity
Opening value
Net Income
$100.00
100.00*
$200.00
$190.91
$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
$120
Bad Economy
$100
0.5 X $120 +
0.5X$100
=$110
Abnormal Earnings = $120 – $110 = $10
Income Statement
(Good Economy)
For Year 1
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
Balance Sheet
(Good Economy)
As at End of Year 1
Financial Asset
Cash
Capital Asset, end of year value
Shareholders’ Equity
Opening value
Net Income
$120.00
$100.00
$220.00
$190.91
$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 relevancy
Different 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. 2008
Expected net income- accretion of discount
Abnormal earnings
Net present value of additional
reserves added during the year
Unexpected items- changes in estimates
Net changes in sales and transfer prices
(10,852)
Revisions of quantity estimates
119
Changes in timing of net future cash flows
182
Changes in estimated future development costs (1,588)
Net changes in income taxes
3,719
Net Income (loss) from proved oil and gas reserves
$2,098
1,590
(8,420)
$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 prices
3. 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
Thank you for listening and participating