1. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Chapter 4 Economic valuation concepts

2. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Contents Introduction The basic equation Income and capital Wealth and value An array of value concepts Economic value Capital maintenance Criteria for appraising alternative valuation concepts Fisher and physic income Hicks and capital maintenance Calculation of economic income Income ex ante and income ex post

3. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Learning objectives Provide an overview and context of the asset valuation debate Explain definitions and interrelationships of income, capital and value Describe the variety of alternatives that need to be explored within the parameters of the valuation debate Outline the concepts of income developed by Fisher (1930) and Hicks (1946) Contrast ex ante and ex post economic income Outline the scope of economic thinking in this area.

4. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA The basic equation Balance sheet balances since it is defined that it must balance Capital is balancing figure and defined as the liability of the business entity to the ownership entity Business owns net assets (= assets minus borrowings) Thus, capital = net assets

5. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA The basic equation (cont’d) Profit is the positive difference between revenues and expenses Profit increases net assets or capital Dividends (drawings) reduce net assets or capital So: W 1 + P – D = W 2 W 1 = Opening net assets P = Profit for the period D = Dividends (drawings) W 2 = Closing net assets

6. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income and capital Definition of income and capital: –Different meanings –Clear definition is difficult –Many accounting texts evade the difficulties by talking in purely bookkeeping terms Possibility: –Capital is a stock of wealth that generates income –Income is the enjoyment from the use of capital Definitions circular and inadequate Capital is a stock of assets capable of generating future services (e.g. field) Value of capital is dependent on the value of those future services (e.g. value of crops grown on the field)

7. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Wealth and value Need for evaluation by attaching a monetary value on it: 4 approaches of monetary value: –Historic costs –Replacement costs –Net realizable value –Net present value or economic value 2 assumptions: –Monetary terms –Money is a perfectly acceptable measuring unit Both assumptions need critical consideration!

8. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA An array of value concepts 3 dimensions: –The form (and place) of the thing being valued –The date of the price used in valuation –The market from which the price is obtained

9. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA An array of value concepts (cont’d) Form and place of asset Value date, marketInitial inputsPresent formUltimate form Past, entryHistoric costsDiscarded alternatives Irrelevant Past, exitDiscarded alternatives Irrelevant Current, entryCurrent costsPresent costsIrrelevant Current, exitIrrelevantOpportunity costsCurrent values Future, entryPossible replacement costs Irrelevant Future exitIrrelevantPossible selling values Expected values

10. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA An array of value concepts (cont’d) Edwards and Bell’s useful valuation possibilities: Exit values –Expected values (ultimate, future, exit): values expected to be received in the future for output sold according to the firm’s planned course of action –Current values (ultimate, current, exit): values actually realized during the current period for goods or services sold –Opportunity costs (present, current, exist): values that could currently be realized if assets were sold outside the firm at best prices immediately obtained

11. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA An array of value concepts (cont’d) Entry values –Present costs (present, current, entry): the cost currently of acquiring the asset being valued –Current costs (initial, current, entry): the cost currently of acquiring the inputs which the firm used to produce the asset being valued –Historic costs (initial, present, entry): the cost at time of acquisition of the inputs which the firm in fact used to produce the asset being valued

12. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Economic value Edwards and Bell exposition of the array of value concepts excludes economic value possibility

13. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Capital maintenance Profit = increase in capital; or Profit = increase in closing capital after having maintained the original capital Every income concept also has a definable capital maintenance concept Important element in the IASB framework

14. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Criteria for appraising alternative valuation concepts Accounting communicates useful information for decision making Different users face different decisions Many valuation bases useful, but for different purposes No best overall valuation concept; it depends on question/decision

15. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Fisher and psychic income People do things because of the satisfaction they derive Satisfaction is a mental occurrence and cannot be measured directly or objectively Fisher (1930) proposes approximations for satisfaction or enjoyment income: 1)Real income: physical events and material things, measurable but with no common denominator 2)Cost of living: money paid to obtain real income 3)Money income: all money received and readily available and intended to be used for spending money

16. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Fisher and psychic income (cont’d) However, satisfaction still most important So Fisher distinguished three successive stages of a person’s income: –Enjoyment or psychic income –Real income measured as cost of living –Money income, consisting of the money received by someone for meeting their costs of living Accounting: real income is the most practical since it is closer to ultimate reality Fisher’s definition of income does not involve a concept of capital maintenance. It is a measure of consumption and distinguishes from the mainstream accounting thinking

17. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Hicks and capital maintenance Hicks (1946) adopts a forward-looking approach to valuation and income measurement Approximations: 1)Income is the maximum amount which can be spent during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts 2)Income is the maximum amount the individual can spend this week, and still expect to be able to spend the same amount in each ensuing week 3)Income is the maximum amount of money which the individual can spend this week, and still expect to be able to spend the same amount in real terms in each ensuing week

18. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Hicks and capital maintenance (cont’d) Hicks, as Fisher, is concerned with consumption, but is also concerned with capital maintenance or the capacity to consume Long run concept

19. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Calculation of economic income Fisher: Income = Consumption Hicks: Income = Consumption + Saving Saving = difference between the value of capital at the end and at the start of the period So: Y = C + (K e – K s ) In business, C is redefined as the realized cash flows of the period

20. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Calculation of economic income (cont’d) Example: An investment on 1 January year 1 has expected receipts on 31 December each year of €1000 for 3 years. The discount rate to reflect the time value of money is 10%. So the capital as at 1 January for each of year 1, 2 and 3: Year 1: 2486 (1000/1.1 + 1000/(1.1) 2 + 1000/(1.1) 3 ) Year 2: 1735 (1000/1.1 + 1000/(1.1) 2 ) Year 3: 909 (1000/1.1)

21. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA YearCKeKe KsKs YRICum. RI Total RI Income from RI Total EI 0024860000 00 1100017352486249751 24860249 2100090917351748261577248675249 310000909919092486 158249 4000002486 249 Calculation of economic income (cont’d)

22. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income ex ante and income ex post Income ex ante (before the event): Y = C 1 + (K e 1 – K s ) C 1 = expected realized cash flow for the period anticipated at the beginning of the period K e 1 = the closing capital as measured (estimated) at the beginning of the period K s = the capital at the beginning of the period as measured (estimated) at the beginning of the period

23. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income ex ante and income ex post (cont’d) Example: Suppose: the expected return from the investment in Year 3 increases to € 1100 Effect on: Year 1 : no change Year 2 : no change Year 3 : K s = €1000 (1100/1.1) instead of €909 So, windfall gain of €91

24. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income ex ante and income ex post (cont’d) Income ex post (after the event): Y = C + (K e – K s 1 ) C = the actual realized cash flow of the period K e = the closing capital measured (estimated) at the end of the period K s 1 = the opening capital measured (estimated) at the end of the period.

25. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income ex ante and income ex post (cont’d) Example: Suppose: the expected return from the investment in Year 2 increases to € 1100 Effect on: Year 1 :no change Year 2 : K s = €1818 (1000/1.1 + 1100/(1.1) 2 ) instead of €1735 So, windfall gain of €83

26. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Income ex ante and income ex post (cont’d) Remarks: Income ex post is still based on expectations of the future and therefore as subjective as economic income ex ante The windfall gain only becomes realized as the cash flow is actually received Not clear cut whether the windfall gain is income or capital as it depends on where we consider our starting point to be

27. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Summary Income, capital and value are interrelated concepts Value can be defined in variety of ways The economic ideas in this chapter are –theoretically sound and logically sensible –highly subjective in application as regards size of future cash flows timing of future cash flows discount rate to apply to future cash flows –problematic as regards windfall gains and losses –and therefore, as far as accounting is concerned, they probably represent an unattainable ideal.