Chapter 2 - Accounting Under Ideal Conditions (Group a)
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Description
Chapter 2
Accounting Under Ideal Conditions
GROUP A STEPHANIE CENEDESE NICHOLAS FERGUSON ELISA MARTONE J O H N S E V E R I N MARCUS TRAYNOR
AGENDA
Present Value Model under Certant! Present Value Model under Un"ertant! Reser#e Re"o$nton A""ountn$ %RRA& Hstor"al Cost A""ountn$ Non'e(sten"e o) True Net In"o*e
Present Value Model Provides
most relevant information to users of financial statements “information about a firm’s future economic prospects (dividends, cash flows, profitability)”
•
Relevant financial statements need to be reliable “information that faithfully represents the firm’s financial position and results of operations”
Present Value Model under ertainty
Certainty ! future cash flows of a firm and the economy’s interest rate are publicly "nown which can also referred to as ideal conditions Example: #ne asset firm that $enerates %&' per year for two years with no liabilities and has a value of % at the end of the two years *nterest rate + &
Present Value Model under ertainty Balance Sheet As at Time 0 Capital asset, PV $260.33
Shareholder’s equity $260.33
Income Statement For Year 1 Accretion of discount
$26.03
-et income for the year! %./00 1 & + %./0
Present Value Model under ertainty
Balance Sheet As at End of Year 1 inancial Asset Shareholder’s equity $!"0.00 $260.33 Cash penin% Value !36.36 26.03 Capital asset, PV 2-ote! assumin$ there is no dividends to be paid $2#6.36 $2#6.36 Recall: 3t time , P3 + %./00 4or year &, accretion of discount + %./0
Present Value Model under ertainty NOTES
1.
-5V of capital asset at any year6end + PV
2.
3ccretion of discount is also referred to as ex ante or expected net income 7ince all conditions are certain, e1pected net income + ex post or reali8ed net income
Present Value Model under ertainty NOTES
3. Relevant financial statement information $ives information about the firm’s future economic prospects
4uture dividends + payoff to investors
Dividend irrelevancy: under ideal conditions, the timin$ of dividends will not affect the PV ash flows are also relevant Therefore, the prior financial tate!ent " relevant
Present Value Model under ertainty NOTES
#. -et income doe not play a role in firm valuation under ideal conditions •
4uture cash flows are "nown
•
-et income (accretion of discount) is predictable
•
5alance sheet contains all the relevant information
Present Value Model under ertainty NOTES
$. *nformation that represents what it intends to represent is reliable 4inancial statements are reliable under ideal conditions since cash flows and interest rate are "nown with certainty •
3ny calculation errors would immediately be discovered •
Present Value Model under ertainty NOTES
%. 9nder ideal conditions, PV of asset:liability + mar"et value &rbitra'e: ma"in$ profits in one mar"et and sellin$ in another mar"et with identical $oods and services
Example: Present Value Model under ertainty
*nterest rate + & #wner would not sell asset for less than %./00 -o one would be willin$ to pay more than %./00 Recall: PV of asset at time + %./00
(reent )al*e +odel *nder Certainty
NOTES
. Mar"et value of the firm + sum of financial assets and PV of ;oint future receipts from its capital assets < intan$ibles = PV of liabilities >otal mar"et value of previous e1ample + %./00
Present Value Model under Uncertainty
*mportant to consider the potential for different states of nature of the economy and how they affect cash flows ?1! weather, $overnment policies, stri"es by suppliers, etc >hese states are objective, publicly known, and observable
Present Value Model under Uncertainty
oncept of ideal conditions is e1tended Characterized by: & @iven, fi1ed interest rate . omplete and publicly "nown sets of nature 0 7tate probabilities ob;ective and publicly "nown A 7tate reali8ation publicly observable
Example: (reent )al*e +odel -nder -ncertainty
35 ompany, a one6asset firm with no liabilities, has the opportunity to $enerate either %& or %. each year for two years and will then have value 3ssume an interest rate in the economy of & >here are eBual opportunities for each outcome (probability of ')
Example: Epected (reent )al*e
P3 + C(&:&& < .:&&) < C(&:&& . < .:&&.) P3 + (C2.D.D0) < (C2.ADE0) P3 + &0/0/ < &.0ED P3 + %./00 A(CCo)pany (alanceSheet As at *i)e 0 Capital Asset, at 'PV
$260.33
Shareholder&s'quity
$260.33
Example: Effect on /nco!e State!ent ABC Company Income Statement (bad economy) *nsert Marcus’ updated table For Year 1 Accretion of +iscount !0-260.33 $26.03 ess! Abnormal Earnin"s '/pected Cash los ."-$!00 1."-$200 $!"0.00 Actual Cash los $!00.00 $"0.00 et 4oss $23.5 >he ne$ative %' of une1pected cash flows results in a %' shoc" to earnin$s
for the year >his shoc" is call abnormal earnin$s, or une1pected earnin$s ?nd of Fear & ?1pected Present Value of ash 4lows! P3 & + '2(%&:&& < %.:&&) + %&0/0/
Example: Effect on 0alance Sheet
ABC Company Balance Sheet (bad economy) For Year 1 Financial Asset Cash $!00 Capital Asset 'nd of 7ear Value $!36.36
Shareholder#s e$%ity penin% Value $260.33 et 4oss 23.5
$236.36
$236.36
$
Rewor" the /nco!e State!ent and 0alance Sheet of 35 ompany assumin$ that the $ood economy state has occurred
Example: Effect on /S and 0S ood Econo!y
ABC Company Income Statement ("ood economy) For Year 1 Accretion of +iscount !0-260.33 $26.03 ess! Abnormal Earnin"s '/pected Cash los $!"0.00 Actual Cash los $200.00 $"0.00 et 8nco)e $6.03 ABC Company Balance Sheet ("ood economy) For Year 1
Financial Asset Cash $200.00 Capital Asset 'nd of 7ear Value $!36.36
Shareholder#s e$%ity penin% Value $260.33 et 4oss 6.03
$336.36 $336.36
$
Present Value Model under Uncertainty
-. Fnan"al State*ent n)or*aton s stll "o*,letel! rele#ant and rela/le. Releant! 0alan"e S1eet #alues are /ased on e(,e"ted )uture "as1 2o3s4 and d#dend rrele#an"! 1olds Relia"le! deal "ondtons ensure t1at ,resent #alue "al"ulatons )at1)ull! re,resent 5r*6s e(,e"ted )uture "as1 2o3s 7. T3o 3a!s o) "al"ulatn$ /alan"e s1eet "urrent #alues Value n use Far Value • •
Present Value Model under Uncertainty
0 *ncome statement lac"s information content when abnormal earnin$s do not e1ist *nvestors have sufficient information to calculate reali8ed net income -et income is predictable conditional on the state of nature •
A onsider all state probabilities to be ob;ective at this point in time S*b4ective probabilitie eliminate the e1istence of “ready6made” probabilities -o $uarantee of eBuivalent freBuencies of potential states in two6 period economy with sub;ective probabilities •
•
Reenue Recognition Accounting #RRA$
Current
#alue *odel 31en deal "ondtons do not e(st
SFAS
89 : a,,les to ,u/l"l! traded ol and $as "o*,anes Re;ures *ana$e*ent ? Ad*N3>*#-
/ ) E " T C E 9 0 S b i l i t y a i l e r d e R ed *c
&"' () says amortization should be chared : - #ver the useful life of the assetO and - Reflect consumption patterns
C*rrent )al*e &cco*ntin': -et income is simply an e1planation of the chan$e in current values in the period
Discussion &uestion!
Which method of accounting is better for investors and why: %istorical Cost Accounting
OR
Current Value Accounting
'he Non(E)istence o* 'rue Net Inco+e C6&/+: -et income does not e1ist as a well6defined economic construct &R-+ENT: •
•
*et income has no information content +hen conditions are ideal &ncomplete mar,ets happen +hen mar,et values do not exist for all assets and liabilities
/+(6/C&T/ONS: •
•
udement is required to estimate net income and asset valuation udement is the basis for the accountin profession.
Article! A Matter o* Principles
Rosen ar$ues a""ountn$ ,rn",les are "ontnuousl! "1an$n$+ • • •
Hstor"al "ost ,rn",le Conser#ats* ,rn",le Mat"1n$ ,rn",le
- S1)t
)ro* In"o*e State*ent to 0alan"e S1eet
' In#estors are un)a*lar 3t1 "1an$n$ ,ol"es
Recent Accounting Changes
IFRS
•
ASPE transton /alan"e s1eet and re"on"laton o) retaned earnn$s •
Ne3 IAS -9 ,enson ,lans
•
Discussion &uestion!
Onus on In#estors or A""ountn$ Aut1ortes@
Chapter 2
Accounting Under Ideal Conditions
GROUP A STEPHANIE CENEDESE NICHOLAS FERGUSON ELISA MARTONE J O H N S E V E R I N MARCUS TRAYNOR
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