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

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?

Year 1Year 2Today (at Time 0) $ / /1.1 2 = =$ The Present Value Model Under Certainty

Accretion of Discount Year 1Year 2Total $19.09$10.00$29.09 At time 0, Capital asset present value = $ 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 = $ (discounted) $220-$ = $29.09 (total accretion)

Balance Sheet As at time 0 Capital asset, at present value $190.91Shareholders' equity $ 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 $ $100.00* $ Shareholders’ Equity Opening value Net Income $ $19.09 $ *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 StatesCash flows Good Economy Bad Economy $120 $100

Expected Present Value, Time 0 PA 0 = 0.5($100/ $120/1.10) + 0.5($100/ $120/ ) = $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 StatesCash flowsExpected Cash flow (Time 1) Good Economy Bad Economy $120 $ X $ X$100 =$110 Abnormal Earnings = $100 – $110 = ($10)

Accretion of discount (0.10*$190.91) $19.09 Less: Abnormal earnings, as a result of bad-state realization Expected cash flows $110 Actual cash flows Net Income (Actual/Realized) $9.09 Income Statement (Bad Economy) For Year 1

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 $9.09 $ *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 StatesCash flowsExpected Cash flow (Time 1) Good Economy Bad Economy $120 $ X $ X$100 =$110 Abnormal Earnings = $120 – $110 = $10

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 Net Income (Actual/Realized) $29.09 Income Statement (Good Economy) For Year 1

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 $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

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 Expected net income- accretion of discount $2,098 Abnormal earnings Net present value of additional reserves added during the year 1,590 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 flows182 Changes in estimated future development costs (1,588) Net changes in income taxes 3,719(8,420) Net Income (loss) from proved oil and gas reserves $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