Module 1: Accounting Under Ideal Conditions
Module 1: Accounting under ideal conditions
Due Process
Accounting standards –> typically there is a trade off between the conflicting interests of constituencies. Attaining a reasonable compromise requires due process and debate between the various interest groups affected by the standards. This includes broad consultation, discussion papers, exposure drafts, public hearings, and representation of different constituencies on the standard setting body itself.
More to follow in modules 8 to 10.
Recent Developments relevant to financial accounting
Enron, World Com scandals - > introduction of Sabanes-Oxley Act (SOX) in US; FASB tightened several accounting standards
Meltdown of the markets for asset-backed securities in 2007 -> collapse of stock markets and wider implications for many countries (recession); severe criticism of fair value accounting, particularly by financial institutions
(A tough read through the many acronymns and detailed description of what went wrong in the US in 2007. Come back to this later in the course and it will make much more sense at that time.)
Key Learnings
1. Financial reporting must be transparent, so that investors can properly value assets and liabilities.
2. Fair value accounting, being based on market value or estimates thereof, may understate value-in-use when markets collapse due to a severe decline in investor confidence. This leads to management objections.
3. Finally, off-balance sheet activities should be fully reported, since they can encourage excessive risk taking by management.
Present Value Accounting
Present Value accounting (also called value-in-use), is discussed under ideal conditions in mod 1 – “best” approach for accounting.
Note:
Current value accounting - general term used to refer to departures from historical cost designed to increase relevance of financial information
Fair value accounting (also called exit value or opportunity cost). Fair value is the amount the firm could sell an asset for or the cost to dispose of a liability, that is, market value.
Under ideal conditions, present value and market value are equal.
When ideal conditions do not hold, the present value of an asset or liability may differ from its market value.
Present Value Model under Certainty (with ideal conditions)
Certainty - future cash flows and interest rates are publicly known with certainty
Accretion of discount - opening PV multiplied by interest rate
ex ante NI = expected NI
ex poste NI = realized NI
(will be same $ under ideal conditions with certainty)
Dividend irrelevancy (characteristic of ideal conditions) - as long as investor can invest any dividends received at same rate as firm can earn on cash not paid out in dividends then it doesn’t matter when dividends are paid out (cash flows are just as relevant as dividends since they establish the firm’s dividend paying ability)
Arbitrage profits - if market prices for goods & services are such that, without risk, it is possible to make a profit by buying in one market and selling in another market, these profits are arbitrage profits.
Note: If future cash flows and risk free rate are publicly known (i.e. ideal conditions under certainty), market movement would quickly eliminate any price discrepancies therefore market value of asset would equal present value
Approaches to determine asset value:
Direct - discounted PV
Indirect - market value
(will be same $ under ideal conditions with certainty)
* NBV of capital asset always equals PV of future cash flows
Present Value Model under Uncertainty (with ideal conditions)
Uncertainty - given fixed interest rate
- complete and publicly known set of states (1)
- publicly observable state realization
- publicly known state probabilities
(1) uncertain future events that could affect the outcome of a decision (which cannot be controlled) are called states of nature
Note: under ideal conditions would not have unanticipated states
Ex ante (expected) and ex poste (realized) NI will not always be the same --> due to the revision of cash flows resulting from the specific state realization.
Difference in expected value of earnings and their actual realization is referred to as abnormal earnings.
Conclusions for Ideal Conditions -> Certainty & Uncertainty
Similarities:
Net income has no information content when conditions are ideal (balance sheet contains all the information)
F/S based on PV’s will be relevant (based on expected future cash flows) and will be reliable (F/S values correctly reflect expected future cash flows taking into account all states of nature - no unanticipated events will occur)
Dividend irrelevancy continues to hold
Principle of arbitrage ensures that use of direct & indirect methods of valuing assets will result in same $ amount
Difference:
Under certainty the ex ante and ex poste NI are the same; under uncertainty these will not usually be the same
Reserve Recognition Accounting (no ideal conditions)
Reserve recognition accounting (RRA), which reports expected present value of proved oil and gas reserves as supplementary information.
RRA is a US accounting standard (SFAS69) but can be found in the financial statements of several major Canadian corporations.
SFAS69 - requires supplemental disclosure of certain information (oil & gas companies) including disclosure of estimated PV of future receipts from proved oil & gas reserves (standardized measure).
Note: SFAS69 mandates a discount rate of 10%:
+ prevents management bias in choice of rates (concern is that the rate can be manipulated to achieve a desired PV)
+ provides for comparability across firms / across time for same firm
- discount rate does not reflect risk of reserves
Weaknesses:
* interest rates are not fixed; states of nature are not complete
* necessary to make unanticipated, material changes to the estimates
(i.e. may be relevant but the volatility affects the reliability)
Without ideal conditions, complete relevance & reliability are not jointly attainable therefore necessary to trade off these two desirable characteristics
Historical Cost accounting revisited
*Historical cost accounting is relatively reliable but may lack relevance. Difficult to resolve accounting issues within its framework --> therefore can be several different ways to account for same thing:
Amortization of capital assets
HB states that amortization should be recognized in a rational and systematic manner appropriate to the nature of the asset, which allows a variety of amortization methods.
Concern:
· makes comparison of profitability across firms more difficult
· allows management of reported profitability since there is a choice of methods => possible bias in reported NI
Full Cost vs Successful Efforts (2 methods allowed by HB)
Full Cost - capitalizes all costs of discovering reserves
Successful Efforts - capitalizes only costs of successful wells
Concern:
Choice of methods can result in materially different recorded costs for oil & gas reserves => amortization expense can then be materially different (diff NI) .’. affects comparison of reported NI of oil & gas firms.
Use of RRA would eliminate full cost VS SE controversy since it values oil & gas reserves at their present values. However, can’t prepare a complete set of PV based F/S with sufficient reliability.
TRADE OFF BETWEEN RELEVANCE & RELIABILITY
v can’t have complete relevance because
- historical cost based asset values can differ significantly from discounted PV’s
- subject to management manipulation
v can’t have complete reliability because
- measurement of NI is a process of matching (and the matching principle usually allows diff ways of accounting for the same thing)
Different users want different trade-offs
While historical cost accounting may seem like a reasonable trade-off between desirable characteristics of accounting information, and is still used for many important classes of assets and liabilities, actual practice has been moving toward current value accounting for some years. Present day accounting is often called a mixed measurement model.
Providing that reasonable reliability is maintained, accounting theories tell us that financial statements are "better" when they more closely approach the present value ideal. This is one reason for the movement to a mixed measurement model
In real world -> NI does not exist as a well-defined economic construct
When conditions are not ideal, market values do not resolve the question of non-existence of true net income. The reason is that market values do not exist for many assets and liabilities. When markets are incomplete, financial statements cannot be fully prepared on a market value basis (i.e. true net income does not exist)
Problem: lack of a complete set of states (ex. no single interest rate in economy, interest rates may change over time, thus unlikely that future cash flows can be accurately forecast)
\unanticipated states can occur .....leads to estimates which are not always accurate; could be biased => hence loses reliability.
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