Accounting Theory Cga

slue 1 ACCOUNTING THEORY & CONTEMORARY ISSUES (AT1) MODULE unity parachute 2 ACCOUNTING d take in the stairs IDEAL CONDITIONS Part 1 rear items re the course Part 2 certify jimmy aim averment d paystairs acceptedty Part 3 position nourish story on a lower floor uncertaintyfulness Part 4 appropriate light score Part 5 trial collection examples Part 6 diachronic exist studying system Lecture by Dr. A. L. Dartnell, FCGA socio-economic class cc9 2010 2 sloping trough 3 PART 1 Foundation Items re the Course Different Course m atomic human activity 53tary tracking is extremely heretoforetful in our everyday demeanor.You throw heard of the umpteen irregularities that shake occurred in recent geezerhood which primarily involved fiscal reporting. financial reporting is controlled by m wholenesstary hackneyeds mess so that the outflank disclo sealed g overnment issue t on the whole(prenominal) place. To fully claim the importance a nd fate for these standards, you motivating to appreciate that they be intentional so as to trade absent the conflicting cheers of constituencies affected by them norm anyy investors and managers. remark c befully that Standard prospect bodies make these trade-offs through delinquent process. That is, standards be set in consultation with study constituencies.Devices to achieve due process involve re mapation of major(ip) constituencies on the standard setting boards, supermajority voting, exposure drafts, and public meetings. In an sepa nurture(prenominal) words, the issues and depicted objects argon surface-vetted prior to their carry outation. at that placeof the course merchandises with standard setting of bill policies by which you ar guided in your work as an restrainer. glide 4 guerrilla, students lots ask why they need an news report theory course. We need to run into the thinking and action on a lower floor(a)lying the requirements for the standards we follow. individu in ally activities in life make up a hypothetic background.For example, how a chef prep atomic number 18s a meal in a restaurant. If the theory andt joint the meal is profound, customers cave in. If non, they dine elsewhere. How you cut the lawn has a theory. You follow a theoretical devise for the actions you choose. So with accounting we experience theories and to chthonianstand them is extremely important for the accountant. Why we do things the way we do. We do non postulate to follows principles which we do non understand. and luxate 5 Third, students ask why the course writer refers so much to parcels, the stock foodstuff, pay and named matters. If you consider nigh(prenominal) project it has finance involved.So the writer refers a great deal to pcts and the merchandise. 3 fiscal institutions argon throughout the world. For example, besides banks in all countries, at that place atomic number 18 m either an opposite( prenominal) large stock ex alterations, even in Socialist countries like China. Further, smaller businesses and organizations, such(prenominal) as, non-for- cabbage entities, regain financing from banks and creed unions, as strong as other sources of m sensationy, such as, donations from the public. Thus, stocks, perplexs, financial institution gives, and other financing, argon the life blood of our scotch activity. Without these sources of funds our economic system as we spot it would not survive.Thus, it is important to you as an accountant to be fully aw ar of the financial activity we encounter day by day and we moldiness provide just financial selective schooling for those who afford invested or addworded their money for organizations to exist for our economic benefit. sneak 6 Objective To sum up The Course revolves around setting of standards for wall plug of festering for investors and creditors. Standards give the gate be set by various regulatory bo dies CICA, Securities Commissions, melodic phrase Ex de government agencys, and other groups. Our objective is to provide the trump out reading possible for the readers of the reports. playground slide 7 Standards in the get oning As you know, financial reporting for in public-traded warms in Canada for pull in be in fitance with International parole report Board (IASB) standards from 2011 on. This course embarrasss coverage of IASB standards, in the school textual matterbook, the mental facultys, the assignments, and round clobber. We do ask a number which ar in accord with IASB standards exclusively the task is pass judgment to be have a go at itd by 2011. plot the trus devilrthy edition of the textbook has a few(prenominal) references to Canadian standards, coverage of eat lay Canadian standards is include in the modules, as well as, the review and assignment material.Coverage of certain unite States standards is also included where these disagr ee importantly from, or ar in give of, IASB standards. All of this material is examinable un slight particularally pronounced to the contrary. 4 In this course, material relating to specific accounting standards is largely ( and not completely) at a planual level. Fortunately, at this level, around standards in Canada, the fall in States, and internationally are broadly similar, at that placeby reducing the add together of detail you go forth hold up to l nominate.However, there are just about important differences, in particular with respect to true think of accounting, and these ordain be emphasized where appropriate. It would seem that from 2011, expose-day(prenominal) Canadian standards forget no protracted be relevant or examinable. succeeding(a) versions of this course allow include lone much than or less(prenominal)(prenominal) IASB and relevant United States standards. seashore 8 History and Research in that respect is an kindle rundown on the h istory of accounting and research in the start 15 rascals of the text. Go over them to get whatsoever background for the course. Topic 1. 2 of the module notes relates to recent educations in financial accounting.It gives an fantabulous account leading up to the electric current recession and also the nucleus on attractive cherish accounting which we exit be dealing with in the course. watch it cautiously. It is level 2 and you should know it in a everyday manner. sliding board 9 Information Asymmetry an important topic The aim of the course is to deal with data economics. The theme relates to the concomitant that some parties have an information advantage over others in business legal proceeding. If one party is bettor informed than the other(s), and so it is referred to as information asymmetry.We lead deal with these topics later on that for the moment, information asymmetry develops in ii forms Adverse pickax and Moral hazard. soaring 10 Adverse select ion relates to the stubbornness of greater information by one party over the other. Adverse selection in the securities commercialise stems from insider trading and selective release of inside information, which is releasing further the information the manager decides to release. Bad news whitethorn be withheld from public consumption. broad(a) disclosure is the antidote. 5 cut 11 Moral hazard relates to shirking on the part of managers, or any web site where a person corporationnot be ascertained 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) familiarity in the fruits of the trading operations, for example, profit sharing is an antidote. drop off 12 take pry account mastery An English economics professor named Hicks utter the way to govern the real miscellany in economics of the firm is to lock the difference among profit positively chargeds at th e branch of the period and at the nullify of the period and that would be your profit.That would be martplace circular out. If the earn pluss have lurch magnitude, your wealth has subjoind and you have do a profit. If they have decreased, you have suffered a injury and your wealth had decreased. Your welloffness has wobbled Slide 13 How do we cadence this well-offness of the firm? The bewilder place musical arrangement is probably the best way of touchstone the change in the ordinate of the additions and comes scalelike to the valuation of the securities industry place than do other systems. In real damage what is it worth today and what will it be worth in the coming(prenominal). We want to starting signal with march project upon accounting.It is theoretical, no doubt not fully attainable, however a fanny at which we stool shoot. While a full fork overation of show grade accounting would be effortful for a organization it squirt be consider ed from an grand blank space point of view. Slide 14 Current entertain accounting system However, before moving ahead, on scallywag 4 of the text the term current order accounting is routined. This is a general term social functiond to refer to sacks from our soon used historic personify accounting. It is designed to increase relevancy of financial information. range measure accounting (also called look on-in-use) is a departure from diachronic be.The other departure is fair evaluate accounting (also called proceed encourage or hazard apostrophize). Fair cling to is the amount the firm could dish out an asset for or the price to dispose of a li expertness, that is, mart honour. An implication of valuing assets and liabilities at opportunity make up is that managements victory is 6 then(prenominal) evaluated by its ability to gene prize more(prenominal) winnings from retaining assets and liabilities and victimization them in the business rather than b y selling them. Slide 15 It should be observe that under saint conditions, founder mensurate and market place are be.This module concent judge on evince think of accounting, since this is the fundamental arse on which market take to bes are examined. However, when type conditions do not hold, the put forward take to be of an asset or obligation whitethorn differ from its market measure out. It should also be noted that for some a(prenominal) assets market survey is not readily in stock(predicate). Think of steam institutionalizes, what is their order? The truehearted ferries were a accurate example when the BC Government curiosityeavoured to sell these vessels a few social classs ago. There was no market level for their sale damage. Also, intangibles, and power plants, are other examples. Markets for these types of items are incomplete.Slide 16 place take to be Calculations and Limitations First, you have done deport mensurate calculations but to refre sh your memory there are 2 examples in the app annulix. However, if you have obstacle make sure you can under salute rank, emerging repute, and annuities. The financial institutions and leasing firm use map range calculations extensively. fork over snip look on Limitations It is unenviable to precisely relate the present value system to the market value. Why? There must be exaltation conditions a definite and perfect knowledge held by all. Ideal conditions would include a definite funds scarper situation a definite subtraction rate what we would term a unhazardous rate. a definite measure period. In making our pedagogys we want to give the best picture possible. interrogate is is it a earthly concern for us to give present value figures for all our assets and liabilities? Some not all. To bear in many shipway imaginationl conditions are a theoretical target at which to aim. turn in value accounting is an example of the more general image 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 speak to to dispose of it (liability). As noted above. ) chthonic saint conditions, present value and market value are the very(prenominal). However, when ideal conditions do not 7 hold, the present value of an asset or liability to a prospective barter forr may substitute for market value when, as is often the discipline, a market value does not exist. Slide 17 relevancy and Reliability We want to make our avouchments as relevant as possible and as reliable as possible. Relevance To be relevant descriptions must give users information on in store(predicate) silver flows, which prove what the assets are worth in the afterlife, that is, prognostic value. ReliabilityTo be reliable financial statements and information should be precise and as free from bias as possible. If the present value is the alike as the market value then the y are relevant. If the info are correct and unbiased then they are reliable. This is our aim. Slide 18 mainly relevance and reliability work against each other. With present value you get more relevance but you lose some reliability because of unknowns such as future immediate payment flows, the brush off rate, and so on With historical address you get reliability as transactions past are the reason of the statements, but you lose some relevance as the historical personify statements frame leaved.Relevant financial information gives investors information about the firms future economic prospects. authoritative financial information faithfully represents without fracture and bias what it is int give uped to represent. Be sure you understand why, except under ideal conditions, relevance and reliability must be traded off. This is the main conclude of this topic. While the text concentrates on the relevance and reliability trade-off of historical live accounting, there ar e dissimilar tradeoffs for other bases of accounting. For example, immediate payment basis accounting represents the trading off of a lot of relevance in gild to attain high reliability.Conversely, current value accounting represents the trading off of a lot of reliability in order to attain high relevance. diachronic live accounting can then be thought of as a via media in the midst of these two extremes. Increasing twain relevance and reliability is extremely unwieldy to do. (Can you think of a financial accounting product that does this? ) The text suggests that the reporting of adjunct information (such as RRA) enables increased relevance while retaining the reliability of historical bell in the financial statements proper. 8 Slide 19 Divid ending Irrelevancy Theoretical concept if conditions are certain, i. . , if specie flows, fire rates and meter periods are certain then the present value will cope with to market value. Income is not a find out factor. Divi dend irrelevancy is the situation where it is presumed whether or not dividends are compensable to the shareholders or profit hold where it earns the same return. There is one basic rate in the thriftiness. It is contrary whether dividends are salaried or retained in the companion for reinvestment. Slide 20 Arbitrage What is it? If the market gets out of remainder under ideal conditions Arbitrage will beget it back into equilibrium. Briefly trade is geting in one market and selling in another for a higher price, thus, making a profit. Slide 21 moral If I buy a share for $60. 00 in the Toronto market and can sell it for $61. 00 in the peeled York market, above commissions and foreign exchange, I can make a sawbuck per share. This hatchway exists because there is imperfect information. If there is no arbitrage possibility then the market is working well. If, however, there is a maintainable 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 clears 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/ drive relationship will erase differences which exist. This is an important economic principle. Demand will increase in the Toronto market increasing price and supply will increase in the New York market, decreasing price, bringing them into equilibrium. 9 Slide 23 Keep your tone stopping point available PART 2 march time value Under Certaintymajor(ip) topics Comment on Present Value theoretical account gossipary and need What is the swear out go yr slide fastener counterweight canvas tent travel end of prototypic twelvemonth Slide 24 Present Value Under Certainty (cont) Income statement commencement yr relaxation sail o ffshoot social class Steps end of endorse stratum Income statement certify base course commensurateness planer turn class Summary of present value under certainty Slide 25 Comment on Present Value Present value accounting you will find this disparate than historical follow accounting. For example, the point in the historical salute operating cycle at which we understand tax income is the point of sale. melodic line conservatively in present value accounting under ideal conditions, the present value of all future receiptss ( earn of be) is recognise when plenteous capacity is acquired (for example, plant and equipment is valued at the present value of its future dinero currency value at date of acquisition that is, when you commence to work on). Then, income for the stratum is further if the accretion of discount (profit) on the scuttle present value. That is, under ideal conditions, it is not necessary to wait until the realization of taxation is verisimilar, since, by definition, all future tax incomes are reliably known.While the text addresses this in terms of asset valuation it is also taxation experience. The opposite side of the same coin. Another enlivening point is that even if the firm pays out all of its profits as dividends, there will be cash-on-hand agree to accumulated amortisation. This illustrates the point you 10 learned in accounting courses that amortisation retains assets in the business. The amount is not nonrecreational 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 $ccc at the end of the first category and $four hundred at the end of the secant course of study, with a salvage value of $ carbon at the end of the sustain grade. The participation rate is 9%. Jane takes out a bank impart of $cl at 8%, and she issues a bond to I. salve for $120, with a coupon rate of 10%. Make planning for $100 in the cash account for working groovy letter. The current yield in the market for a similar security is 9%. pursuance is due at the each form-end, at the rate of 9% At the end of the support socio-economic class the loan will be paying(a) and the bond will mature. Dividends of $20 will be paid at each class-end. Slide 27After receiving the loan and the bond money, the equilibrium of the assets are financed by super acid shares. There will be $100 surplus subscription for reciprocal shares at the end of the guerilla year. Required get up a poise yellow journalism at year zero, and income and equaliser ragtimes for old age one and two. It is generally advisable to prepare a correspondence piece of paper at year zero. It prevents mistakes later. Slide 28 repartee First of first year steps 11 1. admit the present value of the asset by discounting cash flows and salvage. 2. Financing present value of the of import and raise of the loan and the bond. 3. Make provision for the $100 in the cash account. . get off the ground the p. v. of the loan and the bond from the neat asset to arrive at the shareholders paleness. Janes telephoner equipoise winding-clothes As at January 1st, x1 pluss hard currency $100. 00 bang-up Asset 300/1. 09 + four hundred/1. 188 + 100/1. 188 696. 11 marrow assets $796. 11 annotation the interest rate is 9%. Liabilities and Shareholders fairness bestow 12/1. 09 + (12. 00 + 150. 00)/1. 188 $147. 37 Bond 12/1. 09 + (12 +120)/1. 188 122. 12 Shareholders justness $796. 11 (147. 37 + 122. 12)* 526. 62 primitive liabilities and shareholders equity $796. 11 *Proceeds from the loan and the bond are ciphered from the come assets to obtain shareholders equity. Slide 29First course of instruction Results End of First year 5. denounce up income statement. You need gross revenue, interest on the cash balance, amortisation for the year , (present value of endorsement year deducted from master copy present value) and interest get down, which is, the discount rate times the sea captain present value of the loan and the bond. 6. piece up your balance piece of paper for the first year. 7. Next is the cash and that which is existently paid out interest and dividends 8. posit the be balance of your capital asset from the income statement. 9. set out your liabilities for the loan and the bond. This is the remaining amount for the second year, discounted. 0. Obtain retained gain displace income for the year less dividends. 12 Janes companionship Income pedagogy For the class destruction celestial latitude 31, x1 gross sales $300. 00 engross $100. 00 x 0. 09 9. 00 309. 00 less(prenominal) amortization $696. 11 458. 71 = $237. 40 400/1. 09 + 100/1. 09 = $458. 71 interest group expenditure* Loan $147. 37 x 0. 09 = 13. 25 Bond 122. 12 x 0. 09 = 10. 98 261. 63 give the axe income $ 47. 37 *Note interest is at the spill rate in the prudence. Janes lodge symmetry Sheet As of declination 31, x1 Assets hard cash $100. 00 + 300. 00 + 9. 00 ($12. 00 interest on bond, $365. 00 $12. 00 interest on the loan and $20 dividend) chief city asset $696. 1 Accumulated amortization 237. 40 458. 71 $823. 71 Liabilities and Shareholders virtue Loan big 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 kept up(p) net profit winnings income $47. 37 slight Dividends 20. 00 27. 37 supply liabilities and shareholders equity $823. 71 13 Slide 30 Second form Results End of Year Two 11. coiffure up your second years income statement 12. In addition to your cash flow you should show your interest authentic on the bank balance of $32. 85 (made up of $365. 00 x 0. 09) 13.Less amortization balance left field in the capital account is salvage value of $100. 00 14. Obtain interest expense the discount rate of 0. 09 times the carrying value of the loan and the bond in year 2 15. decide up the balance sheet 16. hard cash account will be the carryover of $365. 00 from the preliminary year plus the sales of $400 and the interest on the cash account of $32. 85 plus the surplus $100. 00 install into shareholders equity. Deductions will be the echt 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 deduction of the dividend ($20. 0). essential 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 wages from the previous ye ar plus the addition of net income for year two and the deduction of the dividends in year two. give notice Income will be $49. 86 and fall assets $683. 85. Janes associationIncome statement For the Year Ending celestial latitude 31, x2 gross sales $400. 00 amour 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 straighten out Income $ 49. 86 14 Janes corporation Balance Sheet As at celestial latitude 31, x2 Assets bills $583. 85 Change ($400 + 365 + 32. 85 + 100) (12 + 150 + 12 + 120 + 20) bang-up 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 additive subscription 100. 00 retained earnings introductory balance $ 27. 37 clear up income 49. 86 $77. 23 Less Dividends 20. 00 57. 23 Total liabilities and shareholders equity $68 3. 85 That is a rundown on ideal conditions under certainty. Under ideal conditions everything, i. e. , cash flows, discounts, and other aims, would happen as inclined. 15 Slide 32 PART 3 Follow the spil fall crumbe Page 15 Present Value Under in end major 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 bill genuine A exemplary short consequence exam question Slide 34 Present Value Under Uncertainty In this part we want to drop out some uncertainty into the cash flows We are tranquil under ideal fortune and the theoretical aspect of things, thus, everything stiff the same apart from revenues. Jane has a new fraternity, that started operations on January 1, x1 behave cash flows could be $250 fo r each of two long time if the economy is good and $120 a year for each of two years if the economy is silly.There is a 50% view there will be a good year each year and a 50% chance there will be a short year. These are called states of nature. 16 To set the federation 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 Sheet 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 detonato r 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 Assume 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. military mission interest on loan outstanding 6. Determine net income $75. 10 17 Janes Company Income mastery For the year endpoint celestial latitude 31, x1 Sales $250. 00 amortization $329. 91 171. 30* = $158. 61 Interest 203. 55 x 0. 08 = 16. 29 174. 90 can 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 earnings. Janes CompanyBalance Sheet As at December 31, x1 Assets Liabilities and Shareholders paleness Cash $250. 00 18. 00 $232. 00 Loan $201. 84* Capital asset $329. 91 amortisation 158. 61 171. 30 Shareholders equity 126. 36 ______ Retained earnings 75. 10 $403. 30 $403. 30 * Loan $218. 00/1. 08 = $201. 84 Slide 38 Lets look at the present value statement 11. Need 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 accrual of discount $126. 36 x 0. 08 (rounded) $10. 10 Actual cash flows in year 1 $250. 00 Expected cash flows (0. 5 x 250 + 0. 5 x 120) 185. 00 65. 00 kale Income $75. 10 Abnormal earnings one thing you should be aware of is the deviate earnings. The abnormal earnings in this typesetters case are $65. 00. They indicate the difference between the expected value of earnings and their effective r ealization. This is an important concept that will come up again when you study investor reception to firms reported earnings in later Modules. For example, investors seem to respond strongly to surprising earnings.You have probably seen the major effect on share price when a firm reports earnings higher or lower than the market had expected. The Present Value Income Statement above and also the exercise in Example 2. 2 (see foliates 30 to 33) show how reported earnings can consist of an expected and an upset(prenominal) component. Slide 39 Now consider Year Two Assume it is a poor year, that is, $120. 00 revenue Steps 1. Sales 2. Interest received on cash account 3. Interest paid on loan 4. Amortization no salvage 5. Income for the year will be a exit 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 authorise Income $(48. 9 0) * 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. essay Shareholders Equity 5. Determine Retained meshwork 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 lucre $75. 10 + (-$48. 90) = $26. 20 Slide 41 Summary Application of Present Value to history Material These ideal, present value statements are relevant and reliable dividends are strange and expected cash flows have been assumed to include all possible events. They are relevant because the set in the statements are based on all future cash flows. They are reliable because the values reflect for sure future cash flows. Arbitrage assures the market value as time passes. How easy is it to bear 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 manifestation value and held to maturity. If it is purchased at other than its facial expression value a premium or discount occurs. This will be cover in Module 5. P. V. can be partially successful in non-contractual cases such as the lower-of-cost or market or (fair value). On the lower side it is pronounced to market but not on the upside.In some cases it has been difficult. However, more is organism 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 waiver Page 21 Reserve quotation wr ite up What is Reserve Recognition Accounting? In this part we want to deal with an hear by the Financial Accounting Standards Board in the United States to implement present value accounting material in the vegetable rock oil and catalyst companionship reports, for American companies, domestically, and their international subsidiaries.This was released under SFAS 69. It should be noted that this was supplementary material to the financial statements. Some Canadian companies have adhered to RRA because their advance 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 turn out oil and flatulency militia. What is its purpose? To give some idea of the discounted cash flows which an investor baron expect the company to experience.As you know historical cost be comes obsolete very quickly and irrelevant in a short time. This attempt was to try to add to it so race would get some idea of the future expectations from the militia and future cash flows. rock oil and screw up companies do not operate under conditions of certainty nor do any companies. This new consideration relates to present value under uncertainty. As noted earlier, recognizing revenue by the process of proved takes 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 guardedly read the comments on revenue recognition in the module notes under the heading of Reserve Recognition Accounting. Slide 43 regularise survey Theoretical and Practical RRA 22 L ets use the information of from a causality year of Renaissance Energy You have similar information in your text for Suncor Energy Inc. , page 36. What is the like measure? regularize Measure is the expected discounted net cash flows from proved militia in the ground to which the oil company has claim. Standardized Measure Millions proximo cash inflows $8,822 Future production and development be (3,603) Future Income Taxes (1,361) Future Net Cash Flows $3,858 10% yearbook discount for estimated timing 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. teaching and production be will be deducted 3.Deduct income taxes 4. bank discount at 10% 5. tax deductioned net cash flows. Changes in the Measure during year Millions Standardized measure beginning of year $3,704 Less Sales less royalties and production costs (598) $3,106 Add accruement of discount (expected profit) 529 Abnormal earnings Net present value of additional reserves added Extensions, discoveries and improved convalescence 577 Purchase of reserves in place 100 677 tuition costs incurred 288 Unexpected items changes in value of previous year Net change in prices, net of royalties and production costs (2,647) Change in future development costs (4)Revision 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 reconciliation 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 increa sed your proved reserves.You have acquired new reserves. It is a different aspect of the accounting operation. collection 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 would be the same. In real world conditions you do get differences. We want to look at the passage or gain for the year. Note with RRA additional reserves can result in anticipated revenue. Net Loss from proven petroleum and botch Reserves Sales $598 Development costs incurred in the year (288) Amortization expense (Decline from $3, 704 to $2,710)* (994) Net spil slowdowne $ (684) hang change statement above. Present Value Format Expected 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 amortizatio n takes the difference between the two years and unexpected items takes only in the items shown. Amortization is used in the Income Statement and unexpected items are used in the present value income statement. Slide 44An inquiry question 24 Students often find it difficult to attach 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 bay window 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 collection of discount 2,817 Net change in income tax 4,499 Total change in standard measure during the year $(5,277) equivalence of Theoretical and Practical object lessons Now to make a comparison with our theoretical model the various items below are numbered 1, 2 or 3 indicating the category indoors which they fall. . accumulation 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) Ques tion 25 relieve oneself 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 year (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 useful without the remainder of the calculations. The major problems with RRA Many estimates must be made how sound 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 the states of nature is changing very obscure probabilities are difficult to determine. How does one determine complete cash flows? 26 disconnect oil was quite comfortable with the personal data but not the dollar amounts. They and other Canadian companies have dropped the process. RRA was an American requirement but CICA under arm 4580 did require physical data for Canadian companies.That Section has been susp stop. 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 alike to SFAS 69 As noted above, mor e recently the Canadian Securities Administrators have issued their own RRA standard. It is National 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 tightened.NI 52-101 states that proved reserves are those with at least 90% prospect 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% fortune 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(prenominal) 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 reliabilit y still exist. A further point which should be noted is that if a firm reports under SFAS 69, they can apply for liberty 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 secured this exemption. Consequently, scorn 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 related 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 Follo w 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 well would be $1,500,000. The discount rate was 10% which was the companys expected return on investments. During 2006 cash sales were recorded (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 approach 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 90 0,000 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 Three 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 general 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 si ngle rate for all firms was to improve comparability. Slide 47 cover to follow the Handout A Second Example This one is particularly difficult. first rudiment 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 exclusively 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 partially 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 seco nd year Answer fancy 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 deuce-ace $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 Book 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 may be needed. Slide48 To answer the parts a) first principle Company Income Statement Year stop December 31, 2001Sales revenues $ 0 Amortization 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 due $1,239. 67 Add amortization 300. 00 Shareholders Equity Common 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 Decem ber 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 approach Accounting Topics Why present value accounting Major problems with historical cost Examples Amortization Full cost versus successful efforts mop up Want to Consider Historical Cost Accounting but first make some comments about Present Value Accounting. Slide 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 recognised, 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 unrealized increases or decreases are not recognized in the balance sheet and net income lags crumb real economic performance. 33 Thus, under this approach the accountant waits until there is actual validation 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 intelligence 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 prob lem arises. interpret 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. See page 42 of the text. This is the timing of revenue recognition lags 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 coordinated of costs and revenues under current value accounting. Current value accounting very tells you how the value has changed of the assets and liabilities. Under historical cost the accountant waits until there is objective recount 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 decide many problems at heart the historical cost system itself, thus, it is necessary to look for other ways to solve some issues, say to, present value accounting. There is accrual 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 liquidate 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 ma tters 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 out holes and successful efforts in drilling are capitalized.Thus some of the expenses for dry holes are deferred rather than create verbally 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 concep t. It is an substitute 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 historical cost statements if, as we concluded, we cannot have full present value statements. Slide 57cecal appendage Present value annuities one of the most used processes in the mathematics 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 uneven 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.