Accounting Theory Cga

sea-coast 1 score THEORY &038 CONTEMORARY ISSUES (AT1) MODULE ONE playground slide 2 ACCOUNTING UNDER IDEAL CONDITIONS Part 1 Foundation items re the cut through Part 2 play apprize story infra matter of go Part 3 pose mensu esteem chronicle infra irresolution Part 4 Reserve scholarship noneing system Part 5 Examination inquire modelings Part 6 historic exist leveling Lecture by Dr. A. L. Dartnell, FCGA stratum two hundred9 2010 2 cut 3 power 1 Foundation Items re the Course Different Course mo kittyary inform is extremely st stepgic in our everyday life.You eat up compreh repeal of the many irregularities that consent occurred in recent familys which primarily involved financial reporting. Financial reporting is controlled by trites embed so that the crush disclo ac beliefed leave behind engross place. To richy agnize the importance and requisite for these exemplifications, you hold to appreciate that they be designed so as to shift off the conflicting elicits of constituencies affected by them usually investors and animal trainers. brand guardedly that Standard go on a lower floorting bodies hurl these trade-offs through due process. That is, metres be set in consultation with major constituencies.Devices to achieve due process overwhelm re pass onation of major constituencies on the standard setting boards, supermajority voting, exposure drafts, and earthly concern meetings. In distinguishable words, the issues and topics be well-vetted prior to their implementation. Thus the course lie withs with standard setting of accounting policies by which you be guided in your written report as an accountant. slideway 4 Second, students frequently ask why they imply an accounting theory course. We need to infrastand the thinking and action cardinal the requirements for the standards we follow. All activities in life get a theoretical background.For employment, how a chef creates a meal in a restaurant. If the theory behind the meal is heartfelt, customers return. If non, they dine elsewhere. How you cut the lawn has a theory. You follow a theoretical excogitate for the actions you choose. So with accounting we bring on theories and to understand them is extremely heavy for the accountant. wherefore we do things the dash we do. We do non trust to follows principles which we do not understand. and tr terminate 5 Third, students ask why the course writer refers so much to packets, the stock trade, financing and bear upond matters. If you consider any job it has finance involved.So the writer refers a great deal to shargons and the mart. 3 Financial launchings be through protrude the world. For example, besides banks in all countries, thither are many large stock ex tilts, even in socialist countries like China. Further, smaller agate linees and organizations, such as, not-for- profit entities, obtain financing from banks and course credit uni ons, as well as sepa footstep sources of m bingley, such as, donations from the worldly concern. Thus, stocks, bonds, financial institution l turn backs, and opposite financing, are the life blood of our economic activity. Without these sources of funds our delivery as we hunch over it would not survive.Thus, it is important to you as an accountant to be fully conscious(predicate) of the financial activity we encounter day by day and we moldiness provide good financial data for those who devour invested or giveed their money for organizations to exist for our economic benefit. seacoast 6 mark To sum up The Course revolves around setting of standards for release of instruction for investors and creditors. Standards gouge be set by various regulatory bodies CICA, Securities Commissions, downslope supercedes, and early(a) groups. Our object is to provide the best discipline possible for the readers of the reports. dislocate 7 Standards in the rising As you know , financial reporting for publicly-traded watertights in Canada pass on be in accordance with International history instrument panel (IASB) standards from 2011 on. This course includes coverage of IASB standards, in the standard, the facultys, the assignments, and re mint fabric. We do ca utilize a number which are in accord with IASB standards further the task is judge to be completed by 2011. man the authoritative edition of the school text playscript has few references to Canadian standards, coverage of current Canadian standards is included in the modules, as well as, the review and assignment material.Coverage of certain joined States standards is also included where these differ significantly from, or are in advance of, IASB standards. All of this material is examinable unless specifically marked to the contrary. 4 In this course, material relating to specific accounting standards is largely ( merely not completely) at a fancyual take aim. Fortunately, at this l evel, most standards in Canada, the United States, and internationally are broadly connatural, in that respectby reducing the amount of detail you entrust pre take to the woods to learn.However, on that point are nigh important differences, peculiar(a)ly with respect to current observe accounting, and these leave alone be emphasized where appropriate. It would seem that from 2011, current Canadian standards allow for no longer be relevant or examinable. coming(prenominal) versions of this course leave alone include yet IASB and relevant United States standards. Slide 8 History and Research at that place is an interesting increase on the history of accounting and research in the offset printing 15 pages of the text. Go over them to get about background for the course. Topic 1. 2 of the module notes relates to recent organic evolutions in financial accounting.It provides an excellent account leading up to the current recession and also the effect on fair look upon accounting which we go away be dealing with in the course. Read it carefully. It is level 2 and you should know it in a commonplace manner. Slide 9 discipline Asymmetry an important topic The aim of the course is to deal with culture economics. The theme relates to the fact that some subroutineies arrest an development utility over others in business proceeding. If one party is better intercommunicate than the other(s), thence it is referred to as instruction asymmetry.We will deal with these topics later exactly for the moment, information asymmetry comes in both forms Adverse selection and righteous make. Slide 10 Adverse selection relates to the possession of greater information by one party over the other. Adverse selection in the securities market stems from insider trading and selective release of inside information, which is releasing only the information the manager decides to release. Bad news whitethorn be withheld from public consumption. Full disclosu re is the antidote. 5 Slide 11 Moral hazard relates to shirking on the part of managers, or any office staff where a person cannot be observed by the employing party. For example, a trustee for a bond issue could shirk if not carrying out his/her duties as they should be. For the manager (employee) participation in the fruits of the operations, for example, profit sharing is an antidote. Slide 12 Present nurture Accounting An English economics professor named Hicks said the port to determine the real change in economics of the firm is to take the difference amidst can additions at the beginning of the period and at the end of the period and that would be your profit.That would be market value. If the web pluss aim increased, your wealth has increased and you fuck off make a profit. If they have decreased, you have suffered a loss and your wealth had decreased. Your welloffness has changed Slide 13 How do we throwaway this well-offness of the firm? The perplex value sy stem is probably the best way of measuring the change in the value of the assets and comes closer to the valuation of the market value than do other systems. In real terms what is it expenditure today and what will it be worth in the succeeding(a). We deprivation to belong with have value accounting.It is theoretical, no doubt not fully attainable, but a designate at which we can shoot. While a full insertation of show value accounting would be unmanageable for a organization it can be considered from an lofty mail service rank of view. Slide 14 Current Value Accounting However, before moving ahead, on page 4 of the text the term current value accounting is employ. This is a general term characterd to refer to difference of opinions from our currently recitation diachronic personify accounting. It is designed to increase relevance of financial information. Present value accounting (also called value-in-use) is a departure from historical court.The other departur e is fair value accounting (also called exit value or fortune cost). Fair value is the amount the firm could lot an asset for or the cost to dispose of a liability, that is, market value. An implication of valuing assets and liabilities at chance cost is that managements success is 6 then evaluated by its ability to gene roll more profits from retaining assets and liabilities and using them in the business instead than by selling them. Slide 15 It should be note that under high-flown conditions, march value and market value are equal.This module concent range on present value accounting, since this is the fundamental basis on which market set are determined. However, when ideal conditions do not hold, the present value of an asset or liability whitethorn differ from its market value. It should also be noteworthy that for many assets market value is not readily obtainable. Think of steamships, what is their value? The fast ferries were a perfect example when the BC Governme nt endeavoured to sell these vessels a few twelvemonths ago. in that respect was no market level for their sale equipment casualty. Also, intangibles, and power plants, are other examples. Markets for these types of items are incomplete.Slide 16 Present Value Calculations and Limitations number one, you have done present value calculations but to refresh your memory there are ii examples in the appendix. However, if you have backbreakingy make sure you can under present value, early day value, and annuities. The financial institutions and leasing firm use present value calculations extensively. Present Value Limitations It is difficult to precisely relate the present value system to the market value. Why? There mustiness be ideal conditions a definite and perfect knowledge held by all. Ideal conditions would include a definite interchange flow website a definite discount tempo what we would term a riskless rate. a definite meter period. In making our masterys we wa nt to birth the best picture possible. enquire is is it a reality for us to give present value figures for all our assets and liabilities? Some not all. To repeat in many slipway ideal conditions are a theoretical target at which to aim. Present value accounting is an example of the more general concept of fair value accounting, where the fair value of an asset or liability is its exit price, that is, the amount the firm could sell it for (asset) or the cost to dispose of it (liability). As noted above. ) low ideal conditions, present value and market value are the corresponding. However, when ideal conditions do not 7 hold, the present value of an asset or liability to a prospective purchaser may substitute for market value when, as is often the case, a market value does not exist. Slide 17 relevance and Reliability We want to make our commands as relevant as possible and as accredited as possible. Relevance To be relevant financial asseverations must give users inform ation on future(a) notes flows, which show what the assets are worth in the future, that is, Predictive value. ReliabilityTo be reliable financial lines and information should be precise and as free from bias as possible. If the present value is the same as the market value then they are relevant. If the data are correct and unbiased then they are reliable. This is our aim. Slide 18 Generally relevance and dependability work against distributively other. With present value you get more relevance but you lose some reliability because of unknowns such as future hard exchange flows, the discount rate, etc. With historical cost you get reliability as proceedings past are the basis of the disceptations, but you lose some relevance as the historical cost statements become dated.Relevant financial information gives investors information about the firms future economic prospects. Reliable financial information faithfully represents without error and bias what it is intended to rep resent. Be sure you understand why, except under ideal conditions, relevance and reliability must be traded off. This is the main purpose of this topic. While the text concentrates on the relevance and reliability trade-off of historical cost accounting, there are different tradeoffs for other bases of accounting. For example, cash basis accounting represents the trading off of a pass on of relevance in order to attain high reliability.Conversely, current value accounting represents the trading off of a lot of reliability in order to attain high relevance. historical cost accounting can then be thought of as a compromise between these two extremes. Increasing both relevance and reliability is extremely difficult to do. (Can you think of a financial accounting product that does this? ) The text suggests that the reporting of supplementary information (such as RRA) enables increased relevance tour retaining the reliability of historical cost in the financial statements proper. 8 Sl ide 19 Dividend Irrelevancy Theoretical concept if conditions are certain, i. . , if cash flows, discount rates and fourth dimension periods are certain then the present value will equate to market value. Income is not a determining factor. Dividend irrelevancy is the situation where it is presumed whether or not dividends are paid to the shareholders or profit kept up(p) where it earns the same return. There is one basic rate in the prudence. It is moot whether dividends are paid or retained in the accompany for reinvestment. Slide 20 Arbitrage What is it? If the market gets out of equilibrium under ideal conditions Arbitrage will bring it back into equilibrium. Briefly arbitrage is purchase in one market and selling in another for a higher price, thus, making a profit. Slide 21 congresswoman If I buy a share for $60. 00 in the Toronto market and can sell it for $61. 00 in the New York market, above commissions and foreign exchange, I can make a vaulting horse per share . This possibility exists because there is imperfect information. If there is no arbitrage possibility then the market is working well. If, however, there is a rectifiable difference between the two markets and information asymmetry exists, then there is a problem. Arbitrage is a means to bring the two into equilibrium.Slide 22 How does arbitrage work in our ideal situation to bring the markets back into equilibrium? What happens from an economic theory point of view? If I buy in the Toronto market share price will rise and sell in the New York market share price will fall. The supply/demand relationship will erase differences which exist. This is an important economic principle. Demand will increase in the Toronto market increase price and supply will increase in the New York market, diminish price, bringing them into equilibrium. 9 Slide 23 Keep your release available PART 2 Present Value low Certainty study topics tittle-tattle on Present Value Example Description and re quired What is the Answer locomote year zero sleep tabloid Steps end of number one year Slide 24 Present Value Under Certainty (cont) Income statement firstborn of all year equilibrize ragtime first year Steps end of abet year Income statement second year match shroud second year compact of present value under foregone conclusion Slide 25 Comment on Present Value Present value accounting you will find this different than historical cost accounting. For example, the point in the historical cost operating cycle at which we recognize tax tax receipts is the point of sale.Note carefully in present value accounting under ideal conditions, the present value of all future grosss ( last(a) of be) is recognized when procreative capacity is acquired (for example, plant and equipment is valued at the present value of its future net cash revenue at date of acquisition that is, when you fix to operate). Then, income for the year is simply the accretion of discount (pr ofit) on the opening present value. That is, under ideal conditions, it is not necessary to wait until the realization of revenue is probable, since, by definition, all future revenues are reliably known.While the text addresses this in terms of asset valuation it is also revenue light. The antagonist side of the same coin. Another interesting point is that even if the firm pays out all of its profits as dividends, there will be cash-on- contact equal to accumulated amortisation. This illustrates the point you 10 learned in accounting courses that amortization retains assets in the business. The amount is not paid out. Slide 26 Example Description of Question Lets look at a theoretical, ideal situation. Jane bought a fixed asset and operates under ideal conditions with certainty.She anticipates it will bring cash flows of $300 at the end of the first year and $400 at the end of the second year, with a free value of $ ascorbic acid at the end of the second year. The interest rate is 9%. Jane takes out a bank loan of $150 at 8%, and she issues a bond to I. Save for $120, with a coupon rate of 10%. Make provision for $100 in the cash account for working dandy. The current yield in the market for a equal security is 9%. fire is payable at the from from each one one year-end, at the rate of 9% At the end of the second year the loan will be paid and the bond will mature. Dividends of $20 will be paid at each year-end. Slide 27 later on receiving the loan and the bond money, the equilibrium of the assets are financed by common shares. There will be $100 special subscription for common shares at the end of the second year. Required desexualise a balance rag week at year zero, and income and balance canvasss for age one and two. It is generally wise to prepare a balance sheet at year zero. It prevents mistakes later. Slide 28 Answer First of first year steps 11 1. come up the present value of the asset by discounting cash flows and scavenge. 2. Fina ncing present value of the principal and interest of the loan and the bond. 3. Make provision for the $100 in the cash account. . Deduct the p. v. of the loan and the bond from the jacket asset to arrive at the shareholders candor. Janes club parallelism pall As at January 1st, x1 assets Cash $100. 00 Capital Asset 300/1. 09 + 400/1. 188 + 100/1. 188 696. 11 full(a) assets $796. 11 Note the interest rate is 9%. Liabilities and Shareholders fairness impart 12/1. 09 + (12. 00 + 150. 00)/1. 188 $147. 37 Bond 12/1. 09 + (12 +120)/1. 188 122. 12 Shareholders uprightness $796. 11 (147. 37 + 122. 12)* 526. 62 Total liabilities and shareholders equity $796. 11 * event from the loan and the bond are keep backed from the get assets to obtain shareholders equity. Slide 29First socio-economic class Results End of First year 5. lop up income statement. You need gross gross sales, interest on the cash balance, amortization for the year, (present value of second year deducted fr om original present value) and interest outlay, which is, the discount rate generation the original present value of the loan and the bond. 6. Set up your balance sheet for the first year. 7. Next is the cash and that which is developedly paid out interest and dividends 8. particularize the remaining balance of your neat asset from the income statement. 9. bewilder your liabilities for the loan and the bond. This is the remaining amount for the second year, discounted. 0. Obtain retained gelt net income for the year less dividends. 12 Janes bon ton Income tale For the year Ending celestial latitude 31, x1 gross sales $300. 00 raise $100. 00 x 0. 09 9. 00 309. 00 little amortisation $696. 11 458. 71 = $237. 40 400/1. 09 + 100/1. 09 = $458. 71 interest expense* Loan $147. 37 x 0. 09 = 13. 25 Bond 122. 12 x 0. 09 = 10. 98 261. 63 take in income $ 47. 37 *Note interest is at the going rate in the economy. Janes Company Balance tab As of declination 31, x1 Assets Ca sh $100. 00 + 300. 00 + 9. 00 ($12. 00 interest on bond, $365. 00 $12. 00 interest on the loan and $20 dividend) Capital asset $696. 1 Accumulated amortization 237. 40 458. 71 $823. 71 Liabilities and Shareholders Equity Loan peachy p. v. at end of year one (12 + 150)/1. 09 $148. 62 Bonds outstanding p. v. at end of year one (12 + 120)/1. 09 121. 10 Shareholders equity as shown above 526. 62 retained compensation authorize income $47. 37 Less Dividends 20. 00 27. 37 Total liabilities and shareholders equity $823. 71 13 Slide 30 Second Year Results End of Year Two 11. Set up your second years income statement 12. In addition to your cash flow you should show your interest real on the bank balance of $32. 85 (made up of $365. 00 x 0. 09) 13.Less amortization balance left in the pileus account is rescue value of $100. 00 14. Obtain interest expense the discount rate of 0. 09 time the carrying value of the loan and the bond in year 2 15. Set up the balance sheet 16. Cash account will be the carryover of $365. 00 from the earlier year plus the sales of $400 and the interest on the cash account of $32. 85 plus the additional $100. 00 put into shareholders equity. Deductions will be the material paid out interest on the loan and the payoff of the loan ($162) and payment of the interest and the maturity of the bond ($132. 00) and the synthetic thinking of the dividend ($20. 0). Total in the cash account should be $583. 85 17. The capital asset will be $100. 00. You deduct the salvage from the carrying value of the capital asset in the second year ($458. 71 358. 71 = $100. 00) 18. Set up the liabilities and the shareholders equity show zero for the loan and the bond as they have been paid off Slide 31 19. Shareholders equity will be the original balance plus $100. 00, plus retained cabbage from the previous year plus the addition of net income for year two and the deduction of the dividends in year two. moolah Income will be $49. 86 and Total asse ts $683. 85. Janes CompanyIncome line For the Year Ending celestial latitude 31, x2 Sales $400. 00 Interest on cash in bank ($365. 00 x 0. 09) 32. 85 $432. 85 Less amortisation $458. 71 $100. 00 = $358. 71 Interest expense Loan $148. 62 X 0. 09 = 13. 38 Bond 121. 10 x 0. 09 = 10. 90 382. 99 final Income $ 49. 86 14 Janes Company Balance tabloid As at December 31, x2 Assets Cash $583. 85 careen ($400 + 365 + 32. 85 + 100) (12 + 150 + 12 + 120 + 20) Capital Asset $458. 71 358. 71 100. 00 Total assets $683. 85 Liabilities and Shareholders Equity Loan outstanding $ 0 Bonds outstanding 0 Shareholders equity 526. 62 Additional subscription 100. 00 bear fee Previous balance $ 27. 37 crystallise income 49. 86 $77. 23 Less Dividends 20. 00 57. 23 Total liabilities and shareholders equity $683. 85 That is a rundown on ideal conditions under certainty. Under ideal conditions everything, i. e. , cash flows, discounts, and other estimates, would happen as precondition. 15 Slide 32 PAR T 3 Follow the Handout Page 15 Present Value Under Uncertainty major(ip) Topics Present Value under Uncertainty what is it? Example Description and Required Answer Steps year zero Balance sheet Slide 33 Topics (cont) Income statement year 1 Balance sheet end of year 1 Present value income statement year 1 Income statement year 2 Balance sheet year 2 Summary of present value re Accounting Material A typical short answer exam doubt Slide 34 Present Value Under Uncertainty In this part we want to inject some uncertainty into the cash flows We are still under ideal circumstances and the theoretical feel of things, thus, everything remain the same apart from revenues. Jane has a new company, that started operations on January 1, x1 wear off cash flows could be $250 for each of two days if the economy is good and $120 a year for each of two years if the economy is poor.There is a 50% chance there will be a good year each year and a 50% chance there will be a poor year. These are called states of nature. 16 To set the company up Jane makes a loan of $200 and finances the balance by common shares. The loan will be paid off at the end of two years. Loan rate 9%. We will make certain assumptions the discount rate is 8% the states of nature and probabilities are publicly known and observable. cash flows are given but uncertain as to which result will occur. Slide 35 Balance yellow journalism at Time 0 1. Determine the capital asset $329. 91 2. Determine the p. v. of the loan and shareholders equity.P. V. = 0. 5(250)+ 0. 5 (120)+ 0. 5(250) + 0. 5(120) 1. 08 1. 08 1. 1664 1. 1664 = 0. 5(231. 48) + 0. 5(111. 11) + 0. 5(214. 33) + 0. 5(102. 88) = 115. 74 + 55. 56 + 107. 17 + 51. 44 = $329. 91 Janes Company Balance Sheet As at January 1st, x1 Capital Asset $329. 91 Loan $203. 55 ______ Shareholders equity 126. 36 $329. 91 $329. 91 Loan $18. 00/1. 08 + (18 + 200)/1. 1664 = $203. 55 common shares $329. 91 203. 55 = $126. 36 Time 1 Slide 36 First Year Results arrogate there is a GOOD economy for time 1. 3. For the income statement determine sales $250. 00 4. Determine amortization need the p. v. s of January 1st, x2 5. Charge interest on loan outstanding 6. Determine net income $75. 10 17 Janes Company Income financial statement For the year ending December 31, x1 Sales $250. 00 Amortization $329. 91 171. 30* = $158. 61 Interest 203. 55 x 0. 08 = 16. 29 174. 90 Net Income $ 75. 10 * This figure can be taken from the first year above $115. 74 + 55. 56 = $171. 30 Slide 37 7. For the balance sheet determine cash sales revenue less interest paid 8. Deduct amortization to obtain p. v. of capital 9. Calculate p. v. of the loan 10. Include in statement the common shares and retained lucre. Janes CompanyBalance Sheet As at December 31, x1 Assets Liabilities and Shareholders Equity Cash $250. 00 18. 00 $232. 00 Loan $201. 84* Capital asset $329. 91 Amortization 158. 61 171. 30 Shareholders equity 126. 36 ______ maintained boodle 75. 10 $403. 30 $403. 30 * Loan $218. 00/1. 08 = $201. 84 Slide 38 Lets look at the present value statement 11. take away accretion of discount multiply the common shares by discount rate 12. Add revision of cash flows by deducting expected cash flows from echt cash flows. Present value Income Statement Janes Company Income Statement for the year ending December 31, x1 8 collection of discount $126. 36 x 0. 08 (rounded) $10. 10 Actual cash flows in year 1 $250. 00 pass judgment cash flows (0. 5 x 250 + 0. 5 x 120) 185. 00 65. 00 Net Income $75. 10 Abnormal earnings One thing you should be aware of is the abnormal earnings. The abnormal earnings in this instance are $65. 00. They debate the difference between the expected value of earnings and their actual realization. This is an important concept that will come up again when you study investor chemical reaction to firms reported earnings in later Modules. For example, investors seem to respond powerfully to unexpected e arnings.You have probably seen the major effect on share price when a firm reports earnings higher or rase than the market had expected. The Present Value Income Statement above and also the illustration in Example 2. 2 (see pages 30 to 33) show how reported earnings can consist of an expected and an unexpected component. Slide 39 straight consider Year Two Assume it is a poor year, that is, $120. 00 revenue Steps 1. Sales 2. Interest turn aroundd on cash account 3. Interest paid on loan 4. Amortization no salvage 5. Income for the year will be a loss of $(48. 90) Janes Company Income StatementFor the year ending December 31, x2 Sales $120. 00 Interest 18. 56 $138. 56 Amortization $171. 30* 0 = $171. 30 Interest 201. 84 x 0. 08 = 16. 16 ** 187. 46 Net Income $(48. 90) * This figures can be taken from the first year above $115. 74 + 55. 56 = $171. 30 ** rounded up 19 Slide 40 For the Balance Sheet Steps 1. Determine Cash 2. Calculate Capital Assets to zero 3. Extinguish Loan 4 . place Shareholders Equity 5. Determine Retained Earnings Janes Company Balance Sheet As at December 31, x2 Assets Liabilities and Shareholders Equity Cash $152. 56* Loan $ 0** Capital asset $171. 30 Amortization 171. 0 0 Shareholders equity 126. 36 ______ Retained earnings 26. 20*** $152. 56 $152. 56 * Cash $232 + 120 + 18. 56 (18 + 200) = $152. 56 **Loan extinguished *** Retained Earnings $75. 10 + (-$48. 90) = $26. 20 Slide 41 Summary finish of Present Value to Accounting Material These ideal, present value statements are relevant and reliable dividends are irrelevant and expected cash flows have been assumed to include all possible events. They are relevant because the values in the statements are ground on all future cash flows. They are reliable because the values glow for sure future cash flows. Arbitrage assures the market value as time passes. How easy is it to commit present value material to accounting material? 20 In some cases it is easy and in some cases more difficult, for example, it is easy, with a bond, a mortgage, a loan, etc. P. V. can hold in the case of a bond which is purchased at cheek value and held to maturity. If it is purchased at other than its face value a premium or discount occurs. This will be covered in Module 5. P. V. can be partially in(predicate) in non-contractual cases such as the lower-of-cost or market or (fair value). On the lower side it is marked to market but not on the upside.In some cases it has been difficult. However, more is being added as time passes. A typical short examination question Question What is the change in the present value of an asset over time? Answer It is the amortization of the asset. 21 Slide 42 PART 4 Follow the Handout Page 21 Reserve reference Accounting What is Reserve Recognition Accounting? In this part we want to deal with an attempt by the Financial Accounting Standards Board in the United States to implement present value accounting material in the inunct and louse up company reports, for American companies, domestically, and their international subsidiaries.This was released under SFAS 69. It should be noted that this was supplemental material to the financial statements. Some Canadian companies have adhered to RRA because their parent companies in the U. S. have had to follow it in that country. Canada does not require it. However, Canada has implemented a standard of its own referred to below. Among the items was the requirement of an estimate of the present value of future receipts from a companys be inunct and flatulency militia. What is its purpose? To give some idea of the discounted cash flows which an investor might expect the company to experience.As you know historical cost becomes obsolete very quickly and irrelevant in a short time. This attempt was to try to add to it so spate would get some idea of the future expectations from the militia and future cash flows. Oil and swash companies do not operate under conditions of cert ainty nor do any companies. This new consideration relates to present value under uncertainty. As noted earlier, recognizing revenue by the process of turn up reserves indicates an early recognition of revenue in the operating cycle. Other companies, for example, recognize revenue at point of sale, or when they ship product to a distributor.Early recognition adds to the relevance aspect of revenue recognition but reduces the reliability because there are estimates being made which may not prove to be the outcome. It is suggested that you carefully read the comments on revenue recognition in the module notes under the heading of Reserve Recognition Accounting. Slide 43 interchangeable round Theoretical and Practical RRA 22 Lets use the information of from a former year of Renaissance Energy You have similar information in your text for Suncor Energy Inc. , page 36. What is the interchangeable prevention?Standardized Measure is the expected discounted net cash flows from proved reserves in the ground to which the petroleum company has claim. Standardized Measure Millions Future cash inflows $8,822 Future takings and instruction cost (3,603) Future Income Taxes (1,361) Future Net Cash Flows $3,858 10% annual discount for estimated time of cash flows (1,148) Standardized measure of discounted net cash flows $2,710 Lets assume $20 a barrel at the time that would be approximately 441,000,000 bbls. Points 1. Total proved reserves are the first line. 2. maturement and production be will be deducted 3.Deduct income taxes 4. Discount at 10% 5. Discounted net cash flows. Changes in the Measure during year Millions Standardized measure beginning of year $3,704 Less Sales less royalties and production cost (598) $3,106 Add Accretion of discount (expected profit) 529 Abnormal earnings Net present value of additional reserves added Extensions, discoveries and better retrieval 577 get of reserves in place 100 677 Development cost incurred 288 unexpected items changes in value of previous year Net change in prices, net of royalties and production cost (2,647) Change in future development costs (4) rewrite of quantity estimates 249 23 Net change in income tax 1,157 Change in timing and other items (645) (1,890) Standard measure future value of discounted net cash flows $2,710 Note this could be considered similar to your book value. Another Note Under the global aspect you deduct your costs from the cash inflows, leaving standardized measure of $2,710 Million. However, when you come to the rapprochement statement above you add in purchase costs, development costs and extension costs. At that stage you are adding to the value of your proved reserves because you have increased your proved reserves.You have acquired new reserves. It is a different aspect of the accounting operation. Accretion of Discount this is the expected net income for the year. Under ideal conditions your anticipated net income at the first of the year and the actual wo uld be the same. In real world conditions you do get differences. We want to look at the loss or gain for the year. Note with RRA additional reserves can result in anticipated revenue. Net overtaking from Proved Oil and flatulence Reserves Sales $598 Development costs incurred in the year (288) Amortization expense (Decline from $3, 704 to $2,710)* (994) Net loss $ (684) inspect change statement above. Present Value Format judge net income accretion of discount $529 Abnormal earnings Additional reserves proved during the year $ 677 Unexpected items changes in value (1,890)* (1,213) Net loss $(684) *This is the total of the unexpected items in the change statement above. Note carefully that amortization takes the difference between the two years and unexpected items takes only in the items shown. Amortization is apply in the Income Statement and unexpected items are used in the present value income statement. Slide 44An Examination question 24 Students often find it difficult to connect the theoretical aspect to the practical output by gas and oil companies. Following is actual information taken from Exxon, an oil and gas company in the U. S. This will connect the practical to the theoretical aspect of the RRA process. Exxon smoke 1993 supplemental information (millions) Shown in the annual report under change in net cash flows 1993 Millions Value of reserves added during the year due to extensions, discoveries, improved recovery and net purchases less costs. $ 527Changes in value of previous year reserves due to Sales and transfer of oil and gas produced (6,975) Development costs incurred during the year 2,947 Net change in prices , lifting and development costs (10,229) Revision of previous reserve estimates 1,137 Accretion of discount 2,817 Net change in income tax 4,499 Total change in standard measure during the year $(5,277) Comparison of Theoretical and Practical models Now to make a equation with our theoretical model the various items below are numbered 1, 2 or 3 indicating the category inwardly which they fall. . Accretion of discount 2. Development and other costs 3. Changes in estimates. Millions Value of reserves added during the year due to extensions, discoveries, improved recovery and net purchases less costs $ 527 (2) Changes in value of previous year reserves due to Sales and transfer of oil and gas produced (6,975) (sales) Development costs incurred during the year 2,947 (2) Net change in prices, lifting and development costs (10,229) (3) Revision of previous reserve estimates 1,137 (3) Accretion of discount 2,817 (1) Net change in income tax 4,499 (3)Total change in standard measure during the year $(5,277) Question 25 Prepare the supplemental information of net income from proved oil and gas reserves in the sales less amortization format and the present value format Exxon Corporation Income Statement for the year ending December 31st, 1993 Millions RRA Sales in year $6,975 Development costs incurred in y ear (2,947) Amortization expense (5,277) Net loss ($1,249) The present value statement would be the following Accretion of discount $2,817 Abnormal earnings Additional reserves proved 527Changes in estimates unexpected items as shown below (4,593) Net loss ($1,249) Changes in estimates made up of Net change in prices $(10,229) Revision of estimates 1,137 Net change income tax 4,499 $( 4,593) Slide 45 Summary The Exxon financial statements contained a comment that the corporation believed the standardized measure was not meaningful and may be misleading. It appeared management thought it lacked reliability and the reserve quantities would be as profitable without the remainder of the calculations. The major problems with RRA Many estimates must be made how give-up the ghost are they?Because conditions are not ideal, RRA estimates are compromised and revisions must be made. Example, future oil and gas prices fluctuate significantly. Changing interest rates Information on th e states of nature is changing very complex probabilities are difficult to determine. How does one determine complete cash flows? 26 Gulf oil was quite comfortable with the physical data but not the dollar amounts. They and other Canadian companies have dropped the process. RRA was an American requirement but CICA under Section 4580 did require physical data for Canadian companies.That Section has been suspended. While RRA was a good attempt to gain present value information it gained some relevance but lost reliability. RRA is closer to market value than is historical cost but investors have not shown a particular interest in it. Canadian Requirement Similar to SFAS 69 As noted above, more recently the Canadian Securities Administrators have issued their own RRA standard. It is interior(a) Instrument 51-101. This is supported by all securities commissions in 13 provinces and territories. It goes beyond SFAS 69 in certain ways Briefly The definition of proved reserves is tight ened.NI 52-101 states that proved reserves are those with at least 90% probability of recovery. SFAS 69 states only reasonable recovery. Probable reserves must be reported. These are additional reserves such that there is as greater than 50% probability that the sum of proved plus probable will be recovered.. Two present value estimates of future cash flows from reserves are required based on yearend prices and costs (as in SFAS 69) based on forecasted prices and costs. Discounting is required at several different discount rates, ranging from 0% to 20%.SFAS requires only 10%. The Canadian requirements go beyond those of SFAS 69 but it will be noted that the same problems of reliability still exist. A further point which should be noted is that if a firm reports under SFAS 69, they can apply for exemption from NI 51-101 It should be noted that Canadian firms can apply for exemption from NI 51-101 if they report under SFAS 69. Most large Canadian oil and gas companies have secure d this exemption. Consequently, despite the Canadian standard, RRA as per SFAS 69 remains as an important disclosure standard in Canada.For example, Canadian Natural Resources Limited, with shares traded on the Toronto and New York stock exchanges, has been granted an exemption from National Instrument 51-101 Standards of disclosure for Oil and Gas Activities (NI 51-101), which prescribes the standards for the preparation and disclosure of reserves and tie in information for companies listed in Canada. This exemption allows the Company to substitute United States Securities and Exchange Commission (SEC) requirements for certain disclosures required under NI 51-101. 27 Slide 46 PART 5 Follow the Handout at page 27Examination Question Examples Examination Question 1 On January 1, 2006, XYZ Ltd. , a hypothetical oil and gas firm, purchased a producing oil well with a life of 15 years. Operations were started immediately. The management cipher that future net cash flows from the wel l would be $1,500,000. The discount rate was 10% which was the companys expected return on investments. During 2006 cash sales were enter (net of production costs) of $600,000. The company also paid dividends for the year of $50,000. a) Prepare the income statement for the year ending December 31, 2006 using RRA accounting.Prepare the balance sheet as at December 31, 2006, using RRA accounting. Answer We first need our amortization so we take the beginning total of $1,500,000 and take a similar sexual climax to our change statement under our first example Renaissance Energy. We deduct sales and add accretion of discount, to arrive at amortization. PV beginning $1,500,000 Less Sales 600,000 900,000 Accretion of discount 150,000 10% of $1,500,000 PV end 1,050,000 Amortization $ 450,000 XYZ Limited Income Statement for the year ended December 31st, 2006 Net sales $ 600,000 Amortization 450,000 Net Income $ 150,000 28 XYZ Limited Balance Sheet s at December 31st, 2006 Cash $600,000 50,000 $ 550,000 Shareholders equity $1,500,000 Retained earnings Reserves 1,050,000 $150,000 50,000 100,000 $1,600,000 $1,600,000 b) Question summarize the perceived weaknesses of RRA accounting Answer trinity weaknesses are 1. The discount rate of 10% might not reflect the expected return for the firm. 2. RRA involves making a large number of assumptions and estimates and it may not bear any relationship to the net revenue to be received in the future. 3. Conditions in the oil and gas industry may change rapidly possibly making frequent changes in estimates. ) Question Why does SFAS 69 require all firms to use 10% rather than letting firms select their own rate of return? Answer The use of a single rate for all firms was to improve comparability. Slide 47 Continue to follow the Handout A Second Example This one is particularly difficult. ABC Company (hypothetical) operates under ideal conditions. On January 1, 2001, it purchased a capital asset with a useful life of three years at which time it would be totally used and have no value. It will generate a cash flow of $3,993, on December 31st, 2003, at the end of its 3 year life.The purchase is financed partly by common shares and partly by a non-interest bearing note which matures on December 31, 2003, with a maturity value of $1,500. The interest rate in the economy is 10%. The shares and the note thus both have to receive a return. Required a) Prepare an income statement and balance sheet for December 31, 2001. 29 b) Prepare an income statement and balance sheet for December 31, 2002. c) Prepare an income statement and balance sheet for December 31, 2003 d) Calculate the expected net income for the second year AnswerConsider this as an investment of $3,000 and you are earning 10%, so income for the first year is $300, the second $330 and the third $363, totalling $993. 00. In other words if you left your earnings in the firm that is what you would have. However, you have borrowed money and it has to earn 10%, so it will reduce your income by the cost of the borrowed money at 10%. Capital Asset each year PV (Jan. 1/2001) = $3,993/1. 103 = $3,000. 00 PV (Jan. 1/2002) = $3,993/(1. 21) = $3,300. 00 PV (Jan. 1/2003) = $3,993/(1. 10) = $3,630. 00 PV (Dec. 31/2003) = $3,993/1. 00 = $3,993. 00 Note As the earnings remain the capital asset increases.Non-interest bearing note Interest Expense Present Value and Discount Amortization Carrying Value of Note Jan. 1, 2001 $1,126. 97 Dec. 31, 2001 $112. 70 1,239. 67 Dec. 31, 2002 123. 97 1,363. 64 Dec. 31, 2003 136. 36 1,500. 00 $373. 03 password Value each year Accretion of Discount or Expected Income at 10% $3,000. 00 $1,126. 97 = $1,873. 03 $187. 30 $3,300. 00 1,239. 67 = $2,060. 33 $206. 03 $3,630. 00 1,363. 64 = $2,272. 36 $227. 24 $3,993. 00 1,500. 00 = $2,493. 00 Total $620. 57 30 Some rounding error may be needed. Slide48 To answer the parts a) ABC Company Income Statement Year finish December 31, 2001Sales revenues $ 0 Amortizati on of capital assets 300. 00 Interest expense 112. 70 Net income $187. 30 This is unusual as there is shown income which has been earned but not received and the income statement is based on the amortization of capital assets and the loan. ABC Company Balance Sheet as at December 31, 2001 Capital asset $3,000. 00 Notes payable $1,239. 67 Add amortization 300. 00 Shareholders Equity parking lot Shares $3,000 1,126. 97 1,873. 03 Retained earnings 187. 30 Total assets $3,300. 00 $3,300. 00 b) ABC Company Income Statement Year Ended December 31, 2002 Sales revenues $ 0 Amortization of capital assets 330. 0 Interest expense 123. 97 Net income $206. 03 31 ABC Company Balance Sheet as at December 31, 2002 Capital asset $3,000. 00 Notes payable $1,363. 64 Add amortization 630. 00 Shareholders Equity Common Shares 1,873. 03 Retained earnings * 393. 33 Total assets $3,630. 00 $3,630. 00 $187. 30 + $206. 03 Slide 49 c) ABC Company Income Statement Year Ended December 31, 2003 Sales revenues $3,993. 00 Less Amortization $3,630. 00 Interest 136. 36 3,766. 36 Net income $ 226. 64 ABC Company Balance Sheet as at December 31, 2003 Cash $3,993 1,500 = $2,493. 00 Notes payable $ 0 Capital asset $3,630. 0 Shareholders Equity Less Common Shares 1,873. 03 Amortization 3,630. 00 0 Retained earnings 619. 97 Total assets $2,493. 00 $2,493. 00 d) What you have to do to get the expected net income (the accretion of discount) it must be taken from the above balance sheet/and table that is the end of the first year Net book value January 1, 2002 $3,300. 00 $1,239. 67 = $2,060. 33 Expected net income 10% of $2,060. 33 = $206. 03 Note very carefully the book value and how it is obtained. 32 Slide 50 PART 6 Historical Cost Accounting Topics Why present value accounting Major problems with historical cost Examples Amortization Full cost versus successful efforts decisiveness Want to Consider Historical Cost Accounting but first make some comments about Present Value Accounting. Sli de 51 Why Present Value Accounting? Why do we want present value accounting? What are some of the shortcomings of historical cost accounting? First, present value accounting is a balance sheet approach to accounting, also Referred to as the measurement approach. Increases and decreases in assets and liabilities are recognized, that is, measured, as they occur. Future cash flows are discounted and capitalized on the balance sheet. Income then is essentially the net change in present values for the period. Changes, whether realized or not, are recognized in the balance sheet. Slide 52 Historical Cost Accounting Major Problems Comments Historical cost accounting is an income statement approach. It is referred to as an information approach to decision usefulness. In this situation unrealised increases or decreases are not recognized in the balance sheet and net income lags behind real economic performance. 33 Thus, under this approach the accountant waits until there is actual v alidation of changes by increased sales or cash flows.This comes down to a co-ordinated of revenues and costs used to earn those revenues. First, it may make more sense than we give it credit for, and, second, it is firmly in place and may be difficult to replace. Then, how do we improve it? Slide 53 Major problems 1. It does not equate in large measure with present value accounting in some cases it does and many others it does not. 2. As it does not present complete relevant and reliable statements, there must be a tradeoff between the two. They tend to be opposites. Historical cost is more reliable than relevant.There as often different bases used for measurement and thus a problem arises. stop page 42 of your text, 3. With historical cost there is a recognition lag of revenue. In other words, the revenue may be recognized over several periods. The revenue is recognized only when transactions take place. identify page 42 of the text. This is the timing of revenue recognition la gs behind changes in real economic value. On the other hand current value accounting has little recognition lag as changes in economic value are recognized as they occur, for example, recognizing revenue when proved reserves are recognized under oil and gas accounting.Do not overlook the fact, however, that RRA is supplemental accounting and appears separately in the financial statements. Note carefully there is little matching of costs and revenues under current value accounting. Current value accounting authentically tells you how the value has changed of the assets and liabilities. Under historical cost the accountant waits until there is objective evidence before recognizing revenue. Thus, historical cost tends to be reliable while current value tends to be more relevant. See page 43 of the text. 4.We are faced with the fact that it is difficult to solve many problems within the historical cost system itself, thus, it is necessary to look for other ways to solve some issues, sa y to, present value accounting. There is accumulation accounting is available to aid historical costing but matching of costs and revenues requires estimates, which can be difficult. Thus, historical cost does have it problems. See page 43 of the text. Some examples of problems Slide 54 Amortization It is necessary to amortize the wearing out of assets to meet the matching principle. But historical cost rules do not direct how much should be amortized each year. It just states that the method to be used should be consistent with the time pattern 34 of expiration of the asset. A variety of methods are in use straight-line, declining balance, double digit, etc. , which complicates matters between companies. If there were the requirement of present value for valuation purposes, there would be only one method. Slide 55 Full Cost vs Successful Efforts in Oil and Gas Under full cost all drilled gas and oil well holes both dry holes and successful efforts in drilling are capitalized .Thus some of the expenses for dry holes are deferred rather than written off. The concept is that they are all part of the development process. It is contended the costs match the revenue as it is earned. Under successful efforts dry drill hole costs are expensed immediately as it is thought they should not be part of the capitalization process. It is contended only successful efforts really match with the revenue of future years. Under historical cost CICA allows both methods getting different income figures under present value there would be one method.Slide 56 Conclusion We conclude under historical cost that, net income does not exist as a well-defined economic concept. It is an artificial figure. See page 45 of the text. The matching principle under historical cost allows for different ways to be followed, as indicated above, as well as many other situations, e. g. , inventories Accounting challenge Our quest for the balance of the course will be how can we improve historica l cost statements if, as we concluded, we cannot have full present value statements. Slide 57 addition Present value annuities one of the most used processes in the maths of finance. Its purpose is to discount a series of equal payments over a series of equal periods. Present value annuities with even payments Example Assume you will receive $60 a year for four years for a dividend payment. The accepted discount rate (or the yield you would expect) is 10%. What is the present value (or value today) of these four cash flows, discounted at 10%? 35 P. V. = ? Formula P. V = R1 (1 + i)-n / i i = 10% P. V. 60 1 (1 1. 10)-4/0. 10 n = 4 P. V = 60 (3. 16987) (can be obtained from the P. V. table. ) R = 60 P. V. = $190. 19 Second example Present value annuity with spotty payments. Assume there are unequal payments over five years Year 1, $60 Year 2, $40 Year 3, $50 Year 4, $35 and Year 5, $45. P. V. = ? i = 10% n = 5 R = as shown Formula PV. = CF/(1. 10) + CF(1. 10)2 + CF/(1. 10)3, etc . P. V. = 60/ (1. 10) + 40/(1. 10)2 + 50/(1. 10)3 + 35/(1. 10)4 + 45/(1. 10)5 P. V. = $54. 55 + 33. 06 + 37. 57 + 23. 91 + 27. 93 P. V. = $177.