Transcript Accounting Under Ideal Conditions

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