Accounting under ideal condition

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

2.1 Overview

Present Value Model

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◦ - Under certainty and uncertainty

Resere Reco!nition Accountin!

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"istorical #ost Accountin!

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$%e Non-&xistence o' $rue Net (nco)e

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 A Matter of of Principles *y Al Rosen

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#(#A "and*ook+ Section 

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Overview

2.2 The Present Value Model Under Certaint

.idely used in &cono)ics, Finance and Accountin!

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Proides releant in'or)ation to 'inancial state)ent users

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/eter)ines 'ir)s 'uture prospects and aids in inest)ent decisions

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The Present Value Model

#onsider P0V0 Ltd0 is a one asset co)pany 1it% no lia*ilities0 Assu)e t%e asset 1ill !enerate end o' year cas% 'lo1s o' 23 in *ot% year  4 5, and t%en %ae a 6ero alue a'ter t%at0 Assu)e t%e econo)ic interest rate is 70 Determine the  present value of the firms cash flows and balance sheets at year 0 and year 1.

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!"a#ple o$ the Present Value Model Under Certaint

#as% 'lo1 8 23 eac% yr 'or 5 yrs  (nterest rate 8 7  Present Value at year  8 PA  

PA- 8  PA  8 9:09: ; 590s proen oil and !as reseres (ntended to proide inestors 1it% )ore releant in'or)ation 

6eserve 6ecognition Accounting

.%en esti)atin! 'uture cas% 'lo1s, SFAS :< re?uires t%at t%e PV calculations use year-end oil and !as prices Das opposed to prices expected to *e in e''ect 1%en t%e reseres are li'ted and soldE0 SFAS :< does not re?uire disclosure o' states and nature and t%eir pro*a*ilities, only t%e end results o' t%e expectation calculation0 SFAS :< re?uires a )andated 7 discount rate to *e used, presu)a*le 'or co)para*ility across 'ir)s0 $%e 'i!ures apply only to IproedJ reseres 

-66A Continued

RRA is )ore releant t%at %istorical costs o' reseres, %o1eer it is *y no )eans co)pletely releant RRA is not a co)plete representation since it applied only to IproedJ reseres 

◦ #oncept itsel' is a )atter o' Gud!e)ent, since  IproedJ essentially )eans reasona*ly certain o' recoery under current econo)y and operatin! conditions0 $%is de'inition is t%us su*Gect to *ias, and esti)ates are su*Gect to error as s%o1n *y su*stantial adGust)ents to preious esti)ates0

-66A Continued

il co)pany )ana!ers tend to re!ard RRA 1it% suspicion0 As an exa)ple, "usky>s )ana!e)ent states in its SFAS :< disclosures t%at its RRA in'or)ation is not a relia*le per'or)ance )easure and s%ould not solely *e relied upon in ealuation co)pany per'or)ance0 .%y use RRA 

◦ May 1ant to appeal to a *roader spectru) o' inestors as )any )ultinational oil co)panies report RRA in'or)ation0

-66A Continued

$%e *asic pro*le) is t%at "usky does not operate under ideal conditions0

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◦ 0 (nterest rates in t%e econo)y are not 'ixed, alt%ou!% FSAS :< deals 1it% t%is *y re?uirin! a 'ixed, !ien rate o' 7 'or discountin!0 ◦ 50 $%e set o' states o' nature a''ectin! t%e a)ounts, prices, and ti)in! o' 'uture production is )uc% lar!er t%an t%e si)ple t1o-state exa)ple s%o1n preiously0 ◦ 90 *Gectie state pro*a*ilities o' proed resere a)ounts are not aaila*le0 

(t is di''icult to apply PV accountin! 1%en t%e ideal conditions it re?uires does not %old0

%asic Pro7le#s o$ 66A

$%e co)plex eniron)ent in 1%ic% oil co)panies operate renders it e''ectiely i)possi*le to prepare esti)ates t%at are co)pletely accurate and una''ected *y su*se?uent eents0 $%us esti)ates *eco)e su*Gect to errors and possi*le *ias t%at t%reaten relia*ility to t%e point 1%ere t%e *ene'it o' increased releance is t%reatened0

..%asic Pro7le#s o$ 66A Continued

2.8 9istorical Cost Accounting

Present-day accountin! practice can *e considered as a )ixed )easure)ent )odel (t can *e ar!ued t%at "istorical #ost accountin! is )ore use'ul t%an #urrent Value Accountin! D/ic%e and $an! 5E ◦ Past per'or)ance is t%e *est indicator o' 'uture per'or)ance ◦ State)ent o' &arnin! is pri)ary FCS 

Co#parison o$ :i$$erent Measure#ent %ases

#urrent Value accountin! includes olatility and relia*ility concerns Fir)s operate in an constantly c%an!in! eniron)ent ◦ Sa)uelson Ds response to t%ese 'orces 

Characteristics, Matching o$ Costs ; 6evenues

2.< The *on=!"istence o$ True *et Inco#e

#urrent Value accountin! FCS re?uire t%at all t%e 'ir)>s assets and lia*ilities *e prepared *ased on t%e current alue

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◦ Net inco)e is t%e c%an!e in t%e 'ir)>s current alue durin! t%e period

"o1eer under real 1orld conditions  Net inco)e does not exist as a 1ell-de'ined econo)ic construct

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◦ Lack o' o*Gectie state pro*a*ilities

The *on=!"istence o$ True *et Inco#e

Presence o' (nco)plete Markets  )arket alues need not exist 'or all 'ir) assets and lia*ilities

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◦ Ready )arket alues is not aaila*le, results in an i)possi*le inco)e )easure  (nco)e is not 1ell de'ined 1%en )arkets are inco)plete DBeaer 4 /e)ski 