Accounting Theory & Contemporary Issues
AT1
Lecture and Handouts by:
Dr. A. L. Dartnell, FCGA
Year 2007 - 2008
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Module I
ACCOUNTING UNDER IDEAL
CONDITIONS
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Module 1
Part 1 - Foundation items re the course
Part 2 - Present value accounting under certainty
Part 3 - Present value accounting under
uncertainty
Part 4 - Reserve recognition accounting
Part 5 - Examination question examples
Part 6 - Historical cost accounting
Comment re the audio and my script
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1
Part 1:
Foundation Items
Three points:
1.
AT1 deals with standard setting of accounting
policies;
2.
Why do we need an accounting theory course?
3. Why does the course writer refer so much to
shares, the stock market and related matters
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Foundation Items (con’t)
Objective
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AT1 revolves around setting of standards for release
of information for investors and creditors.
Standards can be set by various regulatory bodies –
CICA, Securities Commissions, Stock Exchanges,
etc.
Our objective is to provide the best information
possible for the readers of the reports.
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Foundation Items (con’t)
History and research
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See pages 1 - 7 in textbook for background.
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Foundation Items (con’t)
Information asymmetry:
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Occurs when one party is more informed than the
other(s).
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It comes in two forms:
• Adverse selection
• Moral hazard
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Foundation Items (con’t)
Adverse selection
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Relates to the possession of greater information by
one party over the other
In the securities market, stems from insider trading
and selective release of inside information.
Antidote is full disclosure.
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Foundation Items (con’t)
Moral hazard
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Relates to shirking on the part of managers, or any
situation where a person cannot be observed by
the employing party.
Participation in the fruits of the operations, (for
example, profit sharing) is an antidote.
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Foundation Items (con’t)
Present Value Accounting
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What did Professor Hicks says
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Change in economics of the firm equals the
difference between net assets at the beginning of
the period and at the end of the period
- Increase in assets = increase in wealth (profit)
- Decrease in assets = decrease in wealth (loss)
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Foundation Items (con’t)
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How do we measure this “well-offness”
The present value system:
Best way of measuring the change in the value
of assets
Comes closer to the valuation of the market value
than do other systems
Present value accounting is a theoretical ideal not
fully attainable, but a target
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Foundation Items (con’t)
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Present value calculations:
See examples in the Appendix for refresher
Present value limitations:
Difficult to precisely relate present value to
market value, due to need for ideal conditions:
• a definite cash flow situation
• a definite discount rate - what we would term a
riskless rate
• a definite time period
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Foundation Items (con’t)
Relevance and Reliability
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Aim to make statements as relevant and reliable as
possible
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Relevance: statements must give users
information on future cash flows - shows what
the assets are worth in the future, predictive
value
Reliability: statements should be precise and as
free from bias as possible
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Foundation Items (con’t)
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Relevance and Reliability generally work against
each other
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Present value: more relevance but less reliability
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Historical cost: more reliability but less relevance
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Foundation Items (con’t)
Dividend irrelevancy
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Theoretical concept - if conditions are certain,
present value equals market value.
Dividend irrelevancy - situation where it is presumed
whether dividends are paid to the shareholders or
retained for reinvestment, they will earn the same
return.
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Foundation Items (con’t)
Arbitrage
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What is arbitrage? It makes for market equilibrium
Arbitrage will bring the market back into equilibrium
(under ideal conditions).
Buying in one market and selling in another for a
higher price, thus, making a profit.
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Foundation Items (con’t)
Arbitrage example
Buy a share in the Toronto market
$60.00
Sell it in the New York market
(above commissions and FX)
$61.00
Profit per share =
$ 1.00
• Profit potential exists because there is imperfect
information (information asymmetry).
• If market is working well, there is no possibility for
arbitrage.
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Foundation Items (con’t)
Arbitrage example (cont’d)
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From an economic theory viewpoint how does
arbitrage work in an ideal situation?
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If I buy in the Toronto market, share price will rise
and sell in the New York market, share price will
fall.
The supply/demand relationship will erase
difference.
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Part 2
Present Value - Certainty
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Follow the Handout - Page 7
Present Value under Certainty
Example
Description and Required
What is the Answer
Steps – year zero
Balance sheet
Steps – end of first year
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Present Value - Certainty (con’t)
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Income statement – first year
Balance sheet – first year
Steps – end of second year
Income statement – second year
Balance sheet second year
Summary of present value under certainty
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Description of Question
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Cash flows - $300 year 1, $400 year 2
Salvage value $100
Current market yield interest rate is 9%
Loan $150 at 8%
Bond issue $120 at coupon rate of 10%
Provision for $100 working capital
Interest payable each year 9%
Dividends of $20 each year
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Description of Question
(con’t)
• Balance of financing by common shares
• Common shares will increase by $100 at the end of
second year
• Required – prepare a balance sheet at year zero and
income statements and balance sheets at the end of
year one and year two.
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Answer
Year Zero
• Steps – year zero
Obtain present value of asset
Financing –principle and interest
Make provision for $100
Deduct present value of loan and bond
to arrive at common shares
• Balance sheet - total assets $796.11
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First Year Results
• Steps end of first year
Set up income statement
Set up balance sheet for year 1
Cash paid out
Determine remaining balance capital asset
Obtain liabilities – p.v. of loan and bond
Obtain retained earnings
• Income statement – net income $47.37
• Balance sheet – assets $823.71
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Second Year Results
• Steps year 2
Set up income statement
Show interest received on bank balance
Calculate amortization
Obtain interest expense
Set up balance sheet
Set up cash account – 7 items – total $583.85
Capital asset = $100.00
Set up liabilities and shareholders’ equity
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Second Year Results (con’t)
• Steps (con’t)
Shareholders’ equity will be original balance
plus $100
Net income will be $49.86
Total assets will be $683.85
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Part 3
Present Value - Uncertainty
Follow the Handout – Page 13
• Present Value under Uncertainty – what is it?
• Example
• Description and Required
• Answer
• Steps – year zero
• Balance sheet
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Present value – Uncertainty
(con’t)
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Income statement – year 1
Balance sheet – end of year 1
Alternate income statement – year 1
Income statement – year 2
Balance sheet – end of year 2
Summary of present value to Accounting
A typical short answer exam question
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Description of Question
• Still under ideal conditions
• Jane’s new company
• Cash flows $250 for each of 2 years if economy is
good and $120 for each year
if economy is poor.
• Probabilities 50/50 – good/poor years
• Jane obtains loan of $200 @ 9%
• Going yield rate is 8%
• States of nature and cash flows are given
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Year Zero
Year Zero
• Steps
Balance sheet year zero
Determine Capital asset $329.91
Determine loan present value
Determine shareholders’ equity
Asset value $329.91
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First Year Results
• First year results
• Steps
Set up income statement
Determine amortization
Determine interest on loan
Net income $75.10
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First Year Results (con’t)
• Set up Balance Sheet
Steps
Determine cash
Obtain present value of capital
Calculate present value of loan
Determine shareholders’ equity
Assets are $403.30
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First Year Results (con’t)
• Alternative income statement
• Steps
Need accretion of discount
Actual cash flows
Expected cash flow
• Abnormal Profit $65.00
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Second Year Results
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Assume a poor year for year 2
Steps for Income Statement
Sales
Interest received on cash account
Interest paid on loan
Amortization – no salvage
Income for the year will be a loss
of $(48.90)
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Second Year Results (con’t)
Steps
Set up Balance sheet
• 1. Determine Cash
• 2. Calculate Capital Assets to zero
• 3. Extinguish Loan
• 4. Show Shareholders’ Equity
• 5. Determine Retained Earnings
6. Assets should be $152.56
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Summary of Present Value - Accounting
• Ideal present value statements are relevant
and reliable
• Relevant as they are based on future cash
flows
• Reliable because their values reflect for sure
future cash flows
• Can present value material be applied in practice –
some cases yes, some difficult
• A typical short exam question
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Part 4
Reserve Recognition Accounting
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What is Reserve Recognition Accounting
The Purpose of RRA
Theoretical and Practical RRA
What is the Standard Measure - $2,710 m
Changed in the Measure during the year
Accretion of discount
Sales statement and alternate format $(684)
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Reserve Recognition Accounting (con’t)
• An exam question
• Exxon Corporation - supplemental information $5,277
• Exxon Income statement - $(1,249)
• Exxon Alternative Income statement
• Comparison of theoretical model
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Reserve Recognition Accounting
(con’t)
• Summary
• Major problems
Many estimates
Changing interest rates
Changing states of nature
Cannot determine complete cash flows
• Canadian Requirements Similar to SFAS 69
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Part 5
Examination Question Examples
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Follow the Handout – Page 26
Question 1 - Description
Answer
Amortization - $450,000
Income statement - $150,000
Balance sheet - $1,600,000
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Examination Questions Examples (con’t)
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Follow Handout at Page 25
Question No 2 - explanation
Required
Answer
Capital Asset each year Total $3,993.00
Non-interest bearing note – Total $1,500.00
Book value each year – Total $620.57
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Examination Questions Examples (con’t)
• Part a
Income statement – net income $187.30
Balance sheet – assets $3,300.00
• Part b
Income statement – net income $206.03
Balance sheet – assets $3,630.00
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Examination Questions Examples (con’t)
• Part c
Income statement – net income $226.64
Balance sheet – assets $2,493.00
• Part d
Expected net income second year - $206.03
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Part 6
Historical Cost Accounting
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Topics
Why present value accounting
Major problems with historical cost
Examples
Amortization
Future Income tax liability
Full cost versus successful efforts
• Conclusion
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Why Present Value Accounting
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Why Present Value Accounting
First, it is a balance sheet approach
Referred to as the Measurement Perspective
Increases in assets and liabilities are recognized
Future cash flows are discounted and capitalized
on the balance sheet
• Income is actually the net change in present
values for the period.
• Whether changes are realized or not they are
recognized in the balance sheet
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Historical Cost Accounting
Comments:
• Income statement approach
• Some increases and decreases are not recognized
in the balance sheet
• Net income lags behind economic performance
• Thus, accountants must wait for validation
of changes in cash flows, which comes to a
matching of revenues and costs.
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Historical Cost Accounting
• Major Problems
• It does not equate in large measure with present
value accounting
• It does not present complete relevant and reliable
statements
• Difficult to solve many problems with historical costs
statements, must use other ways, e.g., present value
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Amortization
• Necessary to amortize wearing out of assets to meet
matching principle
• Historical cost rules do not direct how much
must be amortized each year
• States method must be consistent with time
pattern of asset expiration
• A variety of methods are used
• Present value only one method to be used
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Future Income Tax Liability
• History of tax since 1953
• Deferred method put in in 1963
• Underlying problem – number of methods being
used under historical cost
• Generally the method used was different than the tax
method
• Deferrals have grown into large amounts as firms
have grown.
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Future Income Tax Liability (con’t)
• Change introduced in 1997, as tax postponements
were to be assets and liabilities rather than deferrals.
• Timing differences from January 1, 2000, to appear
as liabilities rather than deferrals
• If tax rate does not change no difference
• If tax rate changes liabilities have to be
revalued at new tax rates
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Future Income Tax Liability (con’t)
• Basic problem – various methods still being
used
• With present value only one method would be
used
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Full Cost vs Successful Efforts
in Oil and Gas
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Full cost approach
Successful efforts approach
CICA allows both methods
Under present value one method would be used
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Conclusion
• Under Historical Cost Accounting net income does
not exist as a well-defined economic concept
• The matching principle allows for different ways to
be followed.
• Many such situations, for example, inventories
• Accounting challenge – how can we improve
historical cost statement?
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Appendix
Present Value Calculations
Present Value Annuities
• Present value annuity with even payments
• Present value annuity with uneven payments
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