Natasha Johansen 130518003

Fanny Agustina Gunawan 130518018

Accounting Theory Under Ideal Conditions - Week 2

In this chapter, financial accounting theory uses the present value model. We will study deeper
about under which conditions an information is relevant and also reliable. Relevant Information
is information about the firm’s future economic prospects—that is, the timing, amounts and risk
associated with its dividends, cash flows, and profitability. Reliable Information faithfully
represents the firm’s financial position and results of operations.

In ideal condition which means Ideal market values of assets and liabilities can serve as indirect
measures of present value, accounting uses current value based accounting and there are two
models of present value:
1. Present Value Under Certainty
Certainty can be defined as future cash flow of a firm and interest rate in the economy
are publicly known and it will result in a fixed outcome (the outcome never varies from
expectation). The future net revenue will be capitalized into asset value. The net book
value of the capital asset at any year-end is equal to its present value, or value in use
Thus, the net income is simply on interest in the opening of asset value or we can say as
accretion of discount. Expected income will be equal to realized income under certainty
conditions. Under the ideal conditions of future cash flows known with certainty and the
economy’s risk-free interest rate given, the present value of an asset or liability will equal
its market value. The process of arbitrage ensures that the market value of an asset
equals the present value of its future cash flows.
 PV under certainty produces a complete relevant and reliable information. It is
completely relevant because in financial statements, a firm always states their future
economy prospect in terms of timing, amounts, and risk associated with dividend,
cashflow, and profitability. Since there is dividend irrelevance theory under ideal
condition, then the cash flow will be as relevant as dividend. It is also completely reliable
because there is transparency information to external parties. Investors or external
parties can calculate the expected income by themselves because of the certainty which
means the outcome never varies. As soon as there is an error or bias in a financial
statement, investors will know.

2. Present Value Under Uncertainty

The general concept of present value under uncertainty is similar to present value under
certainty but under uncertainty there are states of nature that differentiate it with under
certainty. Every business has their own phase whether it is in a state of good economy
or bad economy. Present value under uncertainty still categorized in ideal condition but
extended version. Ideal conditions under uncertainty are characterized by:
a. Given and fixed interest rate → firm’s future cash flows are discounted,
b. Set of states of nature -- states when a the economy is good or bad is a complete
and publicly known
c. State probabilities -- probability of each states are objective and publicly known
d. State realizations -- which states will actually occur in that period is publicly
observable.
The expected net income will not be equal to the realized net income because there is
abnormal earnings or unexpected earning. Since there is an abnormal earning, the
realized net income will be equal to expected income plus or minus the abnormal
earning.

Present value under uncertainty still produces relevant and reliable information. It is still
completely relevant because balance sheet values are based on expected present value
and there is dividend irrelevance theory. It is reliable because ideal conditions ensure
that present value calculations faithfully represent the firm’s expected future cash flows.

Illustration of Present Value Accounting

What often happens in the real world is not characterized by ideal condition, and for a deeper a
study of present value accounting we will use illustrative examples:

1. Embedded Value
This is a form of present value accounting that estimates the present value of future
earnings available to shareholders.

Embedded value = net asset value + discounted PV of amounts to be collected - costs.

The discount rate used to compute PV is based on risk-free rate + risk premium, and as
for the costs it could be income taxes or charge for the capital the company is required to
hold as reserve for policy commitments. In the calculation it requires assumptions about
 discount rates, investment conditions, and life expectancies.

The embedded value itself does not include PV of expected future business. Although it
is not a full current valuation of business, providing the PV of business currently in force
will also provide highly relevant information to shareholders.

The following example is Embedded Value Report of Manulife Financial Corporation:

Additional Information: Market price of Manulife common share on December 31, 2016 was
$17.82

From the data above it is shown that the embedded value on December 31, 2016 for $23.53 is
higher than the share price for $17.82 on the same date. You might question this since
Embedded Value does not include expected future business why is it higher than the share
price? There are 2 reason for why the embedded value become higher than the share price:

1. Investors were not aware of current embedded value bc Manulife embedded value report
was not release until May 3, 2017
2. Investors may have an accurate estimation of embedded value but downgrade them due
to risk and reliability concerns

Therefore to accurately predict PV calculations it is suggested to have more variability in the

estimation itself
 2. Reserve Recognition Accounting
In RRA, it requires supplemental disclosure of a standardized measure of PV, such as
discounted at 10% of a firm's proved oil and gas reserves along with statements that explain the
changes of standardized measure during the year. RRA recognizes revenue sooner, whereas
under PV Accounting, revenue is recognized and reserves are proved, but under historical cost
accounting revenue is not recognized until reserves are lifted and sold.

ASC 932 is United States reserve recognition standards, their goal is to provide investors more
relevant information about future cash flows rather than conventional historical cost-based. The
standardized measure of PV used in ASC 932 is that the PV calculations used average oil and
gas prices during the year not when the reserves are lifted and sold. All of these are verifiable
by independent parties. However while increasing the reliability it reduces the relevancy itself.

Moreover, the estimation of future net cash flows does not represent the fair market value, there
might be changes in cost, price, variance, and there might be future changes in income tax,
royalty, and environmental regulations that affect the estimation. Since the PV model is under
uncertain condition, it is necessary to make material changes from previous estimates.

ASC 932 proved to provide alternative solution for Suncor Energy Inc. that does not operate
under ideal condition as follows:

1. Interest rates in economy are not fixed, however ASC 932 gives the alternative solution
of 10% for discounting
2. Nature affecting the amounts, prices, and timing of future production due to complex
environment where oil and gas industry operate, in this case ASC 932 reduce the
complexity by requiring that reserves be valued at market prices
3. Probability of when nature is not available for estimation

Under uncertain conditions, the information loses its reliability but gains relevance, whereas
relevance and reliability are no longer attainable and must be traded off against each other.

Historical Cost Accounting

1. Relevance versus Reliability

 Although both are characteristic of accounting information, it's necessary to trade them
off. Historical accounting is more reliable since costs of asset and liability is a verifiable
number, less error compared to PV calculation. But it is low in relevance since cost might
equal to current value only at the time of acquisition as current value changes over time.
While current value accounting has high relevance but low reliability, it depends on
estimation.

2. Revenue Recognition

Under historical cost, revenue recognizes when the inventory is sold and validated
through realization of sales, while current value accounting recognizes revenue earlier.

3. Recognition Lag

It happens when the timing of revenue recognition lag behind changes in real economic
value, current value accounting has little recognition lag since changes in economic
value are recognized when they occur. Historical cost has greater recognition lag.

4. Matching of Costs and Revenues

Net income under historical cost accounting results from matching realized revenues and
the cost of earning them through accruals, but current value accounting lacks this
concept as their net income describes how current values and liabilities have changed
during the period.

The Non-Existence of True Net Income

The equality of present value and market value under ideal condition suggest indirect approach
to true economic income. Calculation based on market rather than present value.

“If market is not complete and market value is not available net income is not well-defined”

The lack of theoretically correct concept of income caused the existence of accounting policies,
judgement asset valuation and income measurement.

The Non-Existence of True Net

Income
The Non-Existence of True Net
Income