Chapter 2 – Accounting Under Ideal Conditions Nic Festarini, Alex Leon, Ben McRae, Matt Spark

2.1 Overview

Overview Present Value Model Reserve Recognition Accounting - Under certainty and uncertainty Reserve Recognition Accounting Historical Cost Accounting The Non-Existence of True Net Income A Matter of Principles by Al Rosen CICA Handbook: Section 1100 Overview

2.2 The Present Value Model Under Certainty

The Present Value Model Widely used in Economics, Finance and Accounting Provides relevant information to financial statement users Determines firms future prospects and aids in investment decisions The Present Value Model

Example of the Present Value Model Under Certainty Consider P.V. Ltd. is a one asset company with no liabilities. Assume the asset will generate end of year cash flows of $150 in both year 1 & 2, and then have a zero value after that. Assume the economic interest rate is 10%. Determine the present value of the firms cash flows and balance sheets at year 0 and year 1. Example of the Present Value Model Under Certainty

Example of the Present Value Model Under Certainty Cash flow = $150 each yr for 2 yrs Interest rate = 10% Present Value at year 0 = PA0 PA0 = $150 1.10 + $150 1.102 PA0 = 136.36 + 123.97 PA0 = $260.33 Balance Sheet As at Time 0 Capital Asset, at expected PV $260.33 Shareholder’s Equity Example of the Present Value Model Under Certainty

Example of the Present Value Model Under Certainty Net revenues are capitalized into asset value Similar to a savings account Net Income PA0 = 260.33 * 0.1 PA0 = $26.03 Accretion of discount Example of the Present Value Model Under Certainty

Example of the Present Value Model Under Certainty Present value at the end of year 1 PA1 = $150 1.10 PA1 = 136.36 Balance Sheet at the End of Year 1 Assets Shareholder’s Equity Cash $150 Opening Value $260.33 Capital Asset, at PV $136.36 Net Income $ 26.03 $286.36 Example of the Present Value Model Under Certainty

Important Points Dividends Net book value = Present value Relevant and Reliable Arbitrage Profits Net income plays no role in firm valuation Important Points

2.3 The Present Value Model Under Uncertainty Illustrative example with concepts carrying over from 2.1

States of Nature (States) States of Nature: Uncertain future events such as the state of the economy. States of nature are a conceptual device to model uncertain/uncontrollable future events whose realizations affect cash flows of a firm Example State 1: Economy is bad (probability 0.5) State 2: Economy is good (probability 0.5) Note: No one can control which of the states is realized; hence they are called states of nature States of Nature (States)

…States of Nature Continued At time 0, no one knows which state will occur and we assume that the set of possible states is publicly known and complete. Assume that the state probabilities are objective and publicly known Ex: If we imagine a long-run sequence of repetitions of our two-state economy, the bad state will occur with relative frequency of 0.5. Note: The implication of an objective probability here is that any particular outcome tells us nothing about what the state probabilities are. …States of Nature Continued

Ideal conditions under uncertainty are characterized by: 1. A given, fixed interest rate at which the firm’s future cash flows are discounted 2. A completely and publicly known set states of nature 3. State probabilities objective and publicly known 4. State realization publicly observable Ideal Conditions

Taking into account that the economy can be in a “bad” state or a “good” state during each year. If it is in a bad state, cash flows will be $100 for the year. If it is in the good state, however, cash flows will be $200 for the year. Assume that during each year the bad state and the good state each occur with probability 0.5. Example

Balance Sheet As at Time 0 Calculation of expected present value at time 0: PV0 = 0.5 ( $100 1.10 + $200 1.10 ) + 0.5 ( $100 1.102 + $200 1.102 ) PV0 = (0.5 * $272.73) + (0.5 * $247.93) PV0 = $136.36 + $123.97 PV0 = $260.33 Balance Sheet As at Time 0 Capital Asset, at expected PV $260.33 Shareholder’s Equity …Example Continued

…Example Continued Investors may be averse to risk Expected value of the firm at the end of year 1 will be $236.36 or $336.36 depending on whether the bad state or the good state happens in that year See calculations on subsequent slides …Example Continued

Income Statement for Year 1 (Bad State) Accretion of discount is based on expected net income for year 1 Calculated as: 0.10 * $260.33 = $26.03 Under uncertainty, net income consists of expected net income plus or minus abnormal (unexpected) earnings for the year Income Statement for Year 1 (Bad State) Accretion of Discount $26.03 Less: Abnormal earnings: Expected Cash Flow (0.5 * $100 + 0.5 * $200) $150 Actual Cash Flow $100 ($50.00) Net Loss ($23.97) …Example Continued

Balance Sheet As at End of Year 1 (Bad State) At the end of year 1, expected present value of the remaining cash flows: PV1 = 0.5 ( $100 1.10 + $200 1.10 ) = $136.36 Balance Sheet As at End of Year 1 (Bad State) Financial Asset Shareholder’s Equity Cash $100.00 Opening Value $260.33 Capital Asset End of Year Value $136.36 Net Loss ($23.97) $236.36 …Example Continued

Income Statement for Year 1 (Good State) Accretion of discount is based on expected net income for year 1 Calculated as: 0.10 * $260.33 = $26.03 Income Statement for Year 1 (Good State) Accretion of Discount $26.03 Add: Abnormal Earnings Expected Cash Flow (0.5 * $100 + 0.5 * $200) $150 Actual Cash Flow $200 $50.00 Net Income $76.03 …Example Continued

Balance Sheet As at End of Year 1 (Good State) This chapter ignores the complication of risk averse investors by assuming investors are risk neutral. That is, they are indifferent between the sure thing and the 50/50 gamble. As such, the firm’s market value will be $260.33 at time 0. Balance Sheet As at End of Year 1 (Good State) Financial Asset Shareholder’s Equity Cash $200.00 Opening Value $260.33 Capital Asset End of Year Value $136.36 Net Income $76.03 $336.36 …Example Continued

Financial statement reliability and volatility are different concepts Financial statement reliability and volatility are different concepts. While PV calculations are reliable under ideal conditions, net income and balance sheet values are volatile since end-of-period PV depend on which state is realized. Volatility is demonstrated by abnormal earnings in our example, where net income varied from ($23.97) to $76.03 under bad and good state realizations. Points to Consider

…Points to Consider Continued The income statement has no information content when abnormal earnings do not persist. Investors have sufficient information to calculate for themselves what realized net income will be, once they know the current year’s state realization. Net income is predictable conditional on the state of nature …Points to Consider Continued

Subjective Probabilities (formally introduced in chapter 3): Individuals must assess state of nature probabilities for themselves, using whatever information is available. A more reasonable assumption than objective probabilities because the future performance of a business entity is much more complex and difficult to predict than a simple two state illustration. Looking Ahead

2.4 Reserve Recognition Accounting An Example of RRA with Husky Energy Inc.

Reserve Recognition Accounting Reserve Recognition Accounting (RRA) is a current value standard for oil and gas companies. In 1982, the FASB issued SFAS 69 which required supplemental disclosure of certain information about the operations of publicly traded oil and gas companies SFAS 69 requires disclosure of the estimated PV of future receipts from a company’s proven oil and gas reserves Intended to provide investors with more relevant information Reserve Recognition Accounting

When estimating future cash flows, SFAS 69 requires that the PV calculations use year- end oil and gas prices (as opposed to prices expected to be in effect when the reserves are lifted and sold). SFAS 69 does not require disclosure of states and nature and their probabilities, only the end results of the expectation calculation. SFAS 69 requires a mandated 10% discount rate to be used, presumable for comparability across firms. The figures apply only to “proved” reserves …RRA Continued

RRA is more relevant that historical costs of reserves, however it is by no means completely relevant RRA is not a complete representation since it applied only to “proved” reserves Concept itself is a matter of judgement, since “proved” essentially means reasonably certain of recovery under current economy and operating conditions. This definition is thus subject to bias, and estimates are subject to error as shown by substantial adjustments to previous estimates. …RRA Continued

Oil company managers tend to regard RRA with suspicion Oil company managers tend to regard RRA with suspicion. As an example, Husky’s management states in its SFAS 69 disclosures that its RRA information is not a reliable performance measure and should not solely be relied upon in evaluation company performance. Why use RRA? May want to appeal to a broader spectrum of investors as many multinational oil companies report RRA information. …RRA Continued

The basic problem is that Husky does not operate under ideal conditions. 1. Interest rates in the economy are not fixed, although FSAS 69 deals with this by requiring a fixed, given rate of 10% for discounting. 2. The set of states of nature affecting the amounts, prices, and timing of future production is much larger than the simple two-state example shown previously. 3. Objective state probabilities of proved reserve amounts are not available. It is difficult to apply PV accounting when the ideal conditions it requires does not hold. Basic Problems of RRA

..Basic Problems of RRA Continued The complex environment in which oil companies operate renders it effectively impossible to prepare estimates that are completely accurate and unaffected by subsequent events. Thus estimates become subject to errors and possible bias that threaten reliability to the point where the benefit of increased relevance is threatened. ..Basic Problems of RRA Continued

2.5 Historical Cost Accounting

Comparison of Different Measurement Bases Present-day accounting practice can be considered as a mixed measurement model It can be argued that Historical Cost accounting is more useful than Current Value Accounting (Dichev and Tang 2008) Past performance is the best indicator of future performance Statement of Earning is primary F/S Comparison of Different Measurement Bases

Comparison of Different Measurement Bases Current Value accounting includes volatility and reliability concerns Firms operate in an constantly changing environment Samuelson (1965), who demonstrated that when markets work well, market prices fluctuate randomly Balance Sheet is of greater importance However, volatility impacts F/S as volatility reflects the firm’s environment Comparison of Different Measurement Bases

Characteristics: Relevance vs. Reliability It is necessary to trade them off Different measurements bases imply different tradeoffs Historical Cost Relevance – Low Reliability – High Current Value Relevance – High Reliability – Low Characteristics: Relevance vs. Reliability

Characteristics: Revenue Recognition Current Value implies earlier Revenue Recognition than under Historical Cost Current value accounting values assets & liabilities as changes constantly occur in current value Recognition as changes in current value occur Historical cost accounting values inventories at cost and A/R at selling price Recognition as inventory is sold Characteristics: Revenue Recognition

Characteristics: Recognition Lag Recognition Lag refers to the timing of revenue recognition lags behind changes in economic value Current Value – Low Recognition Lag Changes in economic value occur as recognized Historical Value – High Recognition Lag Changes in economic value occur through realization Characteristics: Recognition Lag

Characteristics: Matching of Costs & Revenues Historical Cost Matching is primarily used as net income is accomplished through the use of accruals Accruals Result of the matching of realized revenues with the associated costs Accruals “smooth out” cash flows to allocate them over related periods Characteristics: Matching of Costs & Revenues

Characteristics: Matching of Costs & Revenues Matching is reasonably reliable – yet vagueness is present Consider Amortization of Capital Assets: IAS 16, amortization should be charged systematically over the asset’s useful life and reflect the pattern of benefit consumption However, useful life and benefit consumption are largely subjective estimates Characteristics: Matching of Costs & Revenues

Characteristics: Matching of Costs & Revenues Current Value Matching is not required, as net income is an explanation of changes in current value Values of assets & liabilities is driven by: Market Forces The firm’s response to these forces Characteristics: Matching of Costs & Revenues

2.6 The Non-Existence of True Net Income

The Non-Existence of True Net Income Current Value accounting F/S require that all the firm’s assets and liabilities be prepared based on the current value Net income is the change in the firm’s current value during the period However under real world conditions – Net income does not exist as a well- defined economic construct Lack of objective state probabilities The Non-Existence of True Net Income

The Non-Existence of True Net Income Presence of Incomplete Markets – market values need not exist for all firm assets and liabilities Ready market values is not available, results in an impossible income measure – Income is not well defined when markets are incomplete (Beaver & Demski 1979) However, net income is not information impact when conditions are ideal The Non-Existence of True Net Income

Frustrating – difficulty of agreeing on accounting policies Different users will desire tradeoffs between relevance and reliability Several different accounting policies Fascinating – lack of well-defined concepts of net income Judgment is critical in the process of asset valuation and income measurement Provides the basis of the accounting profession Concept of Net Income

Additional Reading: A Matter of Principles Al Rosen

Financial Statements in Canada Difficult to interpret Do investors require education to understand a companies financial statements? Several alternatives for reporting Various methods can lead to misunderstandings amongst investors Depreciation policies Inventory costing Financial Statements in Canada

Current Problems – Investor Perspective Not familiar with Canadian GAAP Inability to explain GAAP’s impact on the financial statements EPS and EBITDA figures are being misinterpreted Current Problems – Investor Perspective

Old text books can become misleading extremely quickly with the fast changing principles in accounting Principles once deemed useful and current, can quickly become outdated in Canadian GAAP Accounting Text Books

CICA Handbook: Section 1100 Generally Accepted Accounting Principles

This section describes what constitutes GAAP principles for private enterprises Provides guidance on sources to consult when selecting accounting policies and determining appropriate disclosures The primary sources of GAAP in descending order of authority: Sections 1400-3870 Accounting Guidelines CICA HB: S1100

Accounting guidelines set out how existing sections shall be applied in specific cases Sections and accounting guidelines sometimes have illustrative material such as examples and decision trees Part 1 of the handbook may be an important source to consult on matters not covered by Part 2 CICA HB: S1100

Consistent accounting policies used for similar transactions unless GAAP requires or permits categorization of items for which different policies may be appropriate Specific GAAP recommendations from the primary sources override the concepts in section 1000 CICA HB: S1100

Jeopardy