Chapter 2

Accounting Under Ideal Conditions

GROUP A
STEPHANIE CENEDESE
NICHOLAS FERGUSON
ELISA MARTONE
JOHN SEVERIN
M A R C U S T R AY N O R

AGENDA

Present Value Model under

Certainty
Present Value Model under
Uncertainty
Reserve Recognition Accounting
(RRA)
Historical Cost Accounting
Non-existence of True Net
Income

Present Value Model

Provides most relevant information to users of financial

statements
information about a firms future economic prospects
(dividends, cash flows, profitability)

Relevant financial statements need to be

reliable
information that faithfully represents the firms
financial position and results of operations

Present Value Model under Certainty

Certainty: future cash flows of a firm and the economys interest rate are
publicly known which can also referred to as ideal conditions
Example: One asset firm that generates $150 per year for two years with no
liabilities and has a value of $0 at the end of the two years.
Interest rate = 10%

Present Value Model under Certainty

Balance Sheet
As at Time 0
Capital asset, PV
$260.33

Shareholders equity
$260.33
Income Statement
For Year 1

Accretion of discount

$26.03

Net income for the year: $260.33 x 10% = $26.03

Present Value Model under Certainty

Balance Sheet
As at End of Year 1
Shareholders equity
$260.33
Opening Value
26.03

Financial Asset
$150.00
Cash
136.36
Capital
asset, PV
*Note: assuming
there is no dividends to be paid
$286.36
$286.36
Recall: At time 0, PA0= $260.33
For year 1, accretion of discount = $26.03

Present Value Model under Certainty

NOTES

1.

NBV of capital asset at any year-end = PV

2.

Accretion of discount is also referred to as

ex ante or expected net income
Since all conditions are certain,
expected net income = ex post or realized net income

Present Value Model under Certainty

NOTES

3. Relevant financial statement information gives

information about the firms future economic prospects

Future dividends = payoff to investors

Dividend irrelevancy: under ideal conditions, the

timing of dividends will not affect the PV. Cash flows
are also relevant
Therefore, the prior financial statements = relevant

Present Value Model under Certainty

NOTES

4. Net income does not play a role in firm valuation

under ideal conditions
Future cash flows are known
Net income (accretion of discount) is predictable
Balance sheet contains all the relevant information

Present Value Model under Certainty

NOTES

5. Information that represents what it intends to

represent is reliable
Financial statements are reliable under ideal
conditions since cash flows and interest rate are
known with certainty
Any calculation errors would immediately be
discovered

Present Value Model under Certainty

NOTES

6. Under ideal conditions,

PV of asset/liability = market value
Arbitrage: making profits in one market and
selling in another market with identical goods
and services

Example: Present Value Model under Certainty

Interest rate = 10%

Owner would not sell asset for less than $260.33
No one would be willing to pay more than $260.33
Recall: PV of asset at time 0 = $260.33

Present Value Model under Certainty

NOTES

7. Market value of the firm = sum of financial assets

and PV of joint future receipts from its capital assets +
intangibles PV of liabilities
Total market value of previous example = $260.33

Present Value Model under

Uncertainty

Important to consider the potential for different

states of nature of the economy and how they affect
cash flows
Ex: weather, government policies, strikes by
suppliers, etc.
These states are objective, publicly known, and
observable

Present Value Model under

Uncertainty

Concept of ideal conditions is extended

Characterized by:
1. Given, fixed interest rate
2. Complete and publicly known sets of nature
3. State probabilities objective and publicly known
4. State realization publicly observable

Example: Present Value Model Under

Uncertainty
ABC Company, a one-asset firm with no liabilities, has the
opportunity to generate either $100 or $200 each year for two
years and will then have 0 value. Assume an interest rate in the
economy of 10%. There are equal opportunities for each
outcome (probability of 0.5).

Example: Expected Present Value

PA0 = (100/1.10 + 200/1.10) + (100/1.102 + 200/1.102)

PA0 = (*272.73) + (*247.93)
PA0 = 136.36 + 123.97
PA0 = $260.33
ABCCompany
Balance Sheet
Asat Time 0
Capital Asset, at EPV

$260.33

Shareholder'sEquity

$260.33

Example: Effect on Income Statement

ABC Company
Income Statement
(bad economy)
Insert Marcus updated table
For Year 1
Accretion of Discount (10*260.33)
$26.03
Less: Abnormal Earnings
Expected Cash Flows (.5*$100 +.5*$200) $150.00
Actual Cash Flows
$100.00 $50.00
Net Loss
$23.97
The
negative $50 of unexpected cash flows results in a $50 shock to earnings

for the year. This shock is call abnormal earnings, or unexpected earnings
End of Year 1 Expected Present Value of Cash Flows:
PA1 = 0.5*($100/1.10 + $200/1.10) = $136.36

Example: Effect on Balance Sheet

ABC Company
Balance Sheet
(bad economy)
For Year 1
Financial Asset
Cash
$100
Capital Asset
End of Year Value
$136.36

Shareholders equity
Opening Value
$260.33
Net Loss
23.97

$236.36

$236.36

Rework the Income Statement and Balance Sheet of ABC

Company assuming that the good economy state has occurred.

Example: Effect on I/S and B/S Good Economy

ABC Company
Income Statement
(good economy)
For Year 1
Accretion of Discount (10*260.33)
$26.03
Less: Abnormal Earnings
Expected Cash Flows $150.00
Actual Cash Flows
$200.00
$50.00
Net Income
$76.03
ABC Company
Balance Sheet
(good economy)
For Year 1
Financial Asset
Cash
$200.00
Capital Asset
End of Year Value
$136.36

Shareholders equity
Opening Value
$260.33
Net Loss
76.03

$336.36
$336.36

Present Value Model under

Uncertainty

1. Financial Statement information is still completely

relevant and reliable.
Relevant: Balance Sheet values are based on expected
future cash flows, and dividend irrelevancy holds
Reliable: ideal conditions ensure that present value
calculations faithfully represent firms expected future
cash flows
2. Two ways of calculating balance sheet current values
Value in use
Fair Value

Present Value Model under Uncertainty

3. Income statement lacks information content when abnormal earnings do

not exist
Investors have sufficient information to calculate realized net income
Net income is predictable conditional on the state of nature
4. Consider all state probabilities to be objective at this point in time
Subjective probabilities eliminate the existence of ready-made
probabilities
No guarantee of equivalent frequencies of potential states in twoperiod economy with subjective probabilities

Revenue Recognition Accounting (RRA)

Current value model when ideal conditions do

not exist
SFAS 69 applies to publicly traded oil and

gas companies

Requires management judgment in determining proved

reserves
Revenue recognized when reserves are determined to be
proved
Set discount rate of 10%
Adjustments to estimates in present value calculation are
required

Revenue Recognition Accounting

National Instrument 51-101

Canadian reserve recognition accounting

standard
Requires a report by an independent Qualified
Reserves Evaluator or Auditor
Requires (constant and forecast) price disclosure

Revenue Recognition Accounting

Relevance vs. reliability

Which reporting method is more relevant?
Which reporting method is more reliable?

Historical Cost Accounting

Private companies often have financial records that contain personal

expenses and/or one-time unique expenses that dont contribute to
generating revenue. A companys financial statements should be
cleansed of these expenses in order for a buyer to understand a
companys true profit-generating ability. This should be done on a
historical basis, reconciled to the actual financial statements, and be
consistently applied in any financial projection.
- Financial Post, July 20/2011, John Jazwinski and Matt Hurlbert

Which is better for investors?

Current Value Accounting
History does not repeat itself

exactly
Current value of assets/liabilities =

best indicator of future prospects

Income statement explains the

changes in assets/liabilities
Balance Sheet assumes greater

importance

Historical Cost Accounting

Past performance is the best

indicator of future performance

Accomplished revenues represent

solid foundation for future earning

Statement of Earnings is the most

important
Balance Sheet used to report asset

costs matched against revenues it

generated

Characteristics of
Historical Cost Accounting

RELEVANCE VS. RELIABILITY

REVENUE RECOGNITION
RECOGNITION LAG
MATCHING OF COSTS AND REVENUES

RELEVANCE VS. RELIABILITY

Necessary to have TRADEOFFS
Historical Cost
High reliability
Low relevance

REVENUE
RECOGNITION

Current Value
Accounting

Historical Cost
Accounting

Revenue is recognized as
changes in value occur

Revenue is recognized
when inventory is sold

RECOGNITION
LAG
MINIMAL
Since changes in
economic value
are realized as
they occur
GREAT
Revenue is not
recognized until
increases in inventory
value are validated (i.e.
sales)

MATCHING OF COSTS AND REVENUES

Historical Cost Accounting:
Net income is a result of matching realized revenues with the
expenses associated to earning them
For example: AMORTIZATION

IVE =
T
C
E
J
B
SU
bility
a
i
l
e
r
d
e
Reduc

IAS 16 says amortization should be charged :

- Over the useful life of the asset; and
- Reflect consumption patterns

Current Value Accounting:

Net income is simply an explanation of the change in current
values in the period

Discussion Question:
Which method of accounting is
better for investors and why:
Historical Cost Accounting
OR
Current Value Accounting

The Non-Existence of True Net

Income
CLAIM: Net income does not exist as a well-defined economic construct
ARGUMENT:
Net income has no information content when conditions are ideal

Incomplete markets happen when market values do not exist for all
assets and liabilities

IMPLICATIONS:

Judgement is required to estimate net income and asset valuation

Judgement is the basis for the accounting profession!

Article: A Matter of Principles

Rosen argues accounting principles are

continuously changing:
Historical cost principle
Conservatism principle
Matching principle
- Shift from Income Statement to Balance Sheet
- Investors are unfamiliar with changing policies

Recent Accounting Changes

IFRS
ASPE transition balance sheet and
reconciliation of retained earnings
New IAS 19 pension plans

Discussion Question:

Onus on Investors or Accounting

Authorities?

Chapter 2

Accounting Under Ideal Conditions

GROUP A
STEPHANIE CENEDESE
NICHOLAS FERGUSON
ELISA MARTONE
JOHN SEVERIN
M A R C U S T R AY NO R

WORKS CITED
Alciatore, M. L. (1993). New Evidence on SFAS No. 69 and the Components of the Change in Reserve Value. The
Accounting Review , 68 (3), 639-656.
Deloitte. "IAS 19 Employee Benefits." Summaries of International Financial Reporting Standards. 2010. Web.
6 Jan. 2012. <http://www.iasplus.com/standard/ias19.htm#1004ed>.
Elliott, D. C. (2009). Discussion Paper: UNFC, User Manuals, and Working Groups. Alberta Securities
Commission.
Jazwinski, John, and Matt Hurlburt. "Enhancing Value before You Sell." Financial Post. 20 July 2011. Web. 06
Jan. 2012. <http://business.financialpost.com/2011/07/20/marketing-feature-enhancing-value-before-yousell/>.
Libby, Robert, Patricia A. Libby, Daniel G. Short, George Kanaan, and Maureen Gowing. Financial Accounting.
Boston: McGraw-Hill/Irwin, 2008. Print.
NATIONAL INSTRUMENT 51-101 - Standards of Disclosure for Oil and Gas Activities. (n.d.). Retrieved 01 07,
2012, from Canadian Council of Professional Geoscientists (CCPG):
http://www.ccpg.ca/profprac/en/Standards%20Disclosure%20for%20Oli%20and%20Gas%20Activities_51-101-2
236.pdf
Rosen, Al. "A Matter of Principles." Print. Rpt. in ProQuest. By Canadian Business. Vol. 77. Toronto, 2004. 19.
Print. Iss. 2.
Scott, William R. "Chapter 2: Accounting Under Ideal Conditions." Financial Accounting Theory. 6th ed.
Toronto: Pearson, 2012. 34-55. Print.