Chapter 2
Accounting Under Ideal Conditions
GROUP A
STEPHANIE CENEDESE
NICHOLAS FERGUSON
ELISA MARTONE
JOHN SEVERIN
M A R C U S T R AY N O R
AGENDA
Present 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
Present Value Model
 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’s
financial position and results of operations”
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 conditions
Example: 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%
Present Value Model under Certainty
Balance Sheet
As at Time 0
Capital asset, PV
$260.33
Shareholder’s equity
$260.33
Income Statement
For Year 1
Accretion of discount
$26.03
Net income for the year: $260.33 x 10% = $26.03
Present Value Model under Certainty
Balance Sheet
As at End of Year 1
Financial Asset
Cash
Capital asset, PV
$150.00
136.36
$286.36
Shareholder’s equity
Opening Value
$260.33
26.03
$286.36
*Note: assuming there is no dividends to be paid
Recall:
At time 0, PA0= $260.33
For year 1, accretion of discount = $26.03
Present Value Model under Certainty
NOTES
1.
NBV of capital asset at any year-end = PV
2.
Accretion of discount is also referred to as
ex ante or expected net income
Since all conditions are certain,
expected net income = ex post or realized net income
Present Value Model under Certainty
NOTES
3. Relevant financial statement information gives
information about the firm’s future economic prospects
Future dividends = payoff to investors
Dividend irrelevancy: under ideal conditions, the
timing of dividends will not affect the PV. Cash flows
are also relevant
Therefore, the prior financial statements = relevant
Present Value Model under Certainty
NOTES
4. Net income does not play a role in firm valuation
under ideal conditions
• Future cash flows are known
• Net income (accretion of discount) is predictable
• Balance sheet contains all the relevant information
Present Value Model under Certainty
NOTES
5. Information that represents what it intends to
represent is reliable
• Financial statements are reliable under ideal
conditions since cash flows and interest rate are
known with certainty
• Any calculation errors would immediately be
discovered
Present Value Model under Certainty
NOTES
6. Under ideal conditions,
PV of asset/liability = market value
Arbitrage: making profits in one market and
selling in another market with identical goods
and services
Example: Present Value Model under Certainty
Interest rate = 10%
Owner would not sell asset for less than $260.33
No one would be willing to pay more than $260.33
Recall: PV of asset at time 0 = $260.33
Present Value Model under Certainty
NOTES
7. Market value of the firm = sum of financial assets
and PV of joint future receipts from its capital assets +
intangibles – PV of liabilities
Total market value of previous example = $260.33
Present Value Model under Uncertainty
Important to consider the potential for different
states of nature of the economy and how they affect
cash flows
Ex: weather, government policies, strikes by
suppliers, etc.
These states are objective, publicly known, and
observable
Present Value Model under Uncertainty
Concept of ideal conditions is extended
Characterized by:
1. Given, fixed interest rate
2. Complete and publicly known sets of nature
3. State probabilities objective and publicly known
4. State realization publicly observable
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).
Example: Expected Present Value
PA0 = ½(100/1.10 + 200/1.10) + ½(100/1.102 + 200/1.102)
PA0 = (½*272.73) + (½*247.93)
PA0 = 136.36 + 123.97
PA0 = $260.33
ABC Company
Balance Sheet
As at Time 0
Capital Asset, at EPV
$260.33
Shareholder's Equity
$260.33
Example: Effect on Income Statement
ABC Company
Income Statement
Insert Marcus’ updated (bad
tableeconomy)
For Year 1
Accretion of Discount (10*260.33)
$26.03
Less: Abnormal Earnings
Expected Cash Flows (.5*$100 +.5*$200) $150.00
Actual Cash Flows
$100.00 -$50.00
Net Loss
$23.97
The negative $50 of unexpected cash flows results in a $50 shock to earnings
for the year. This shock is call abnormal earnings, or unexpected earnings
End of Year 1 Expected Present Value of Cash Flows:
PA1 = 0.5*($100/1.10 + $200/1.10) = $136.36
Example: Effect on Balance Sheet
ABC Company
Balance Sheet
(bad economy)
For Year 1
Financial Asset
Cash
Capital Asset
End of Year Value
$100
$136.36
$236.36
Shareholder’s equity
Opening Value
Net Loss
$260.33
$ 23.97
$236.36
Rework the Income Statement and Balance Sheet of ABC
Company assuming that the good economy state has occurred.
Example: Effect on I/S and B/S – Good Economy
ABC Company
Income Statement
(good economy)
For Year 1
Accretion of Discount (10*260.33)
Less: Abnormal Earnings
Expected Cash Flows $150.00
Actual Cash Flows
$200.00
Net Income
$26.03
$50.00
$76.03
ABC Company
Balance Sheet
(good economy)
For Year 1
Financial Asset
Cash
$200.00
Capital Asset
End of Year Value $136.36
$336.36
Shareholder’s equity
Opening Value
Net Loss
$260.33
$ 76.03
$336.36
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 holds
Reliable: ideal conditions ensure that present value calculations faithfully
represent firm’s expected future cash flows
2. Two ways of calculating balance sheet current values
• Value in use
• Fair Value
Present Value Model under Uncertainty
3. Income statement lacks information content when abnormal earnings do
not exist
• Investors have sufficient information to calculate realized net income
Net income is predictable conditional on the state of nature
4. Consider all state probabilities to be objective at this point in time
• Subjective probabilities eliminate the existence of “ready-made”
probabilities
• No guarantee of equivalent frequencies of potential states in twoperiod economy with subjective probabilities
Revenue Recognition Accounting (RRA)
 Current value model when ideal conditions do not exist
 SFAS 69 – applies to publicly traded oil and gas companies




Requires management judgment in determining proved reserves
Revenue recognized when reserves are determined to be proved
Set discount rate of 10%
Adjustments to estimates in present value calculation are required
Revenue Recognition Accounting
 National Instrument 51-101
 Canadian reserve recognition accounting
standard
 Requires a report by an independent Qualified
Reserves Evaluator or Auditor
 Requires (constant and forecast) price disclosure
Revenue Recognition Accounting
Relevance vs. reliability
Which reporting method is more relevant?
Which reporting method is more reliable?
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 Hurlbert
Which is better for investors?
Historical Cost Accounting
Current Value Accounting

History does not repeat itself
exactly
 Current value of assets/liabilities =
 Past performance is the best
indicator of future performance
 Accomplished revenues represent
best indicator of future prospects


solid foundation for future earning
Income statement explains the
changes in assets/liabilities
 Statement of Earnings is the most
Balance Sheet assumes greater
importance

important
Balance Sheet used to report asset
costs matched against revenues it
generated
Characteristics of
Historical Cost Accounting
RELEVANCE VS. RELIABILITY
REVENUE RECOGNITION
RECOGNITION LAG
MATCHING OF COSTS AND REVENUES
RELEVANCE VS. RELIABILITY
Necessary to have TRADEOFFS
Historical Cost
High reliability
Low relevance
REVENUE
RECOGNITION
Current Value
Accounting
Historical Cost
Accounting
Revenue is recognized as
changes in value occur
Revenue is recognized
when inventory is sold
RECOGNITION
LAG
MINIMAL
Since changes in
economic value
are realized as
they occur
GREAT
Revenue is not
recognized until
increases in inventory
value are validated
(i.e. sales)
MATCHING OF COSTS AND REVENUES
Historical Cost Accounting:
Net income is a result of matching realized revenues with the
expenses associated to earning them
For example: AMORTIZATION
IAS 16 says amortization should be charged :
- Over the useful life of the asset; and
- Reflect consumption patterns
Current Value Accounting:
Net income is simply an explanation of the change in current
values in the period
Discussion Question:
Which method of accounting is better for
investors and why:
Historical Cost Accounting
OR
Current Value Accounting
The Non-Existence of True Net Income
CLAIM: Net income does not exist as a well-defined economic construct
ARGUMENT:
• Net income has no information content when conditions are ideal
• Incomplete markets happen when market values do not exist for all
assets and liabilities
IMPLICATIONS:
•
Judgement is required to estimate net income and asset valuation
• Judgement is the basis for the accounting profession!
Article: A Matter of Principles
Rosen argues accounting principles are continuously changing:
• Historical cost principle
• Conservatism principle
• Matching principle
- Shift from Income Statement to Balance Sheet
- Investors are unfamiliar with changing policies
Recent Accounting Changes
• IFRS
• ASPE transition balance sheet and reconciliation of
retained earnings
• New IAS 19 pension plans
Discussion Question:
Onus on Investors or Accounting Authorities?
Chapter 2
Accounting Under Ideal Conditions
GROUP A
STEPHANIE CENEDESE
NICHOLAS FERGUSON
ELISA MARTONE
JOHN SEVERIN
M A R C U S T R AY N O R
WORKS CITED
• Alciatore, M. L. (1993). New Evidence on SFAS No. 69 and the Components of the Change in Reserve Value. The
Accounting Review , 68 (3), 639-656.
• Deloitte. "IAS 19 Employee Benefits." Summaries of International Financial Reporting Standards. 2010. Web.
6 Jan. 2012. <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 2011. Web. 06
Jan. 2012. <http://business.financialpost.com/2011/07/20/marketing-feature-enhancing-value-before-yousell/>.
• Libby, Robert, Patricia A. Libby, Daniel G. Short, George Kanaan, and Maureen Gowing. Financial Accounting.
Boston: McGraw-Hill/Irwin, 2008. Print.
• NATIONAL INSTRUMENT 51-101 - Standards of Disclosure for Oil and Gas Activities. (n.d.). Retrieved 01 07,
2012, from Canadian Council of Professional Geoscientists (CCPG):
http://www.ccpg.ca/profprac/en/Standards%20Disclosure%20for%20Oli%20and%20Gas%20Activities_51-1012236.pdf
• Rosen, Al. "A Matter of Principles." Print. Rpt. in ProQuest. By Canadian Business. Vol. 77. Toronto, 2004. 19.
Print. Iss. 2.
• Scott, William R. "Chapter 2: Accounting Under Ideal Conditions." Financial Accounting Theory. 6th ed.
Toronto: Pearson, 2012. 34-55. Print.