chapter 4

International Financial Reporting and Analysis, 5th editionDavid Alexander, Anne Britton and Ann Jorissen

ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA

Chapter 4

Economic valuation concepts



Contents

• Introduction• The basic equation• Income and capital• Wealth and value• An array of value concepts• Economic value• Capital maintenance• Criteria for appraising alternative valuation concepts• Fisher and physic income• Hicks and capital maintenance• Calculation of economic income• Income ex ante and income ex post



Learning objectives

• Provide an overview and context of the asset valuation debate

• Explain definitions and interrelationships of income, capital and value

• Describe the variety of alternatives that need to be explored within the parameters of the valuation debate

• Outline the concepts of income developed by Fisher (1930) and Hicks (1946)

• Contrast ex ante and ex post economic income • Outline the scope of economic thinking in this area.



The basic equation

• Balance sheet balances since it is defined that it must balance

• Capital is balancing figure and defined as the liability of the business entity to the ownership entity

• Business owns net assets (= assets minus borrowings)

• Thus, capital = net assets



The basic equation (cont’d)

• Profit is the positive difference between revenues and expenses

• Profit increases net assets or capital• Dividends (drawings) reduce net assets or

capital• So: W1 + P – D = W2

W1 = Opening net assetsP = Profit for the periodD = Dividends (drawings)

W2 = Closing net assets



Income and capital

• Definition of income and capital:– Different meanings– Clear definition is difficult– Many accounting texts evade the difficulties by talking in

purely bookkeeping terms• Possibility:

– Capital is a stock of wealth that generates income– Income is the enjoyment from the use of capital

• Definitions circular and inadequate• Capital is a stock of assets capable of generating future

services (e.g. field)• Value of capital is dependent on the value of those future

services (e.g. value of crops grown on the field)



Wealth and value

• Need for evaluation by attaching a monetary value on it:

• 4 approaches of monetary value:– Historic costs– Replacement costs– Net realizable value– Net present value or economic value

• 2 assumptions:– Monetary terms– Money is a perfectly acceptable measuring unit

• Both assumptions need critical consideration!



An array of value concepts

3 dimensions:

– The form (and place) of the thing being valued

– The date of the price used in valuation– The market from which the price is

obtained



An array of value concepts (cont’d)Form and place of asset

Value date, market Initial inputs Present form Ultimate form

Past, entry Historic costs Discarded alternatives

Irrelevant

Past, exit Discarded alternatives

Discarded alternatives

Irrelevant

Current, entry Current costs Present costs Irrelevant

Current, exit Irrelevant Opportunity costs Current values

Future, entry Possible replacement costs

Possible replacement costs

Irrelevant

Future exit Irrelevant Possible selling values

Expected values



An array of value concepts (cont’d)

Edwards and Bell’s useful valuation possibilities:

• Exit values– Expected values (ultimate, future, exit): values

expected to be received in the future for output sold according to the firm’s planned course of action

– Current values (ultimate, current, exit): values actually realized during the current period for goods or services sold

– Opportunity costs (present, current, exist): values that could currently be realized if assets were sold outside the firm at best prices immediately obtained



An array of value concepts (cont’d)

• Entry values– Present costs (present, current, entry): the cost

currently of acquiring the asset being valued– Current costs (initial, current, entry): the cost

currently of acquiring the inputs which the firm used to produce the asset being valued

– Historic costs (initial, present, entry): the cost at time of acquisition of the inputs which the firm in fact used to produce the asset being valued



Economic value

Edwards and Bell exposition of the array of value concepts excludes economic value possibility



Capital maintenance

• Profit = increase in capital; or• Profit = increase in closing capital after having

maintained the original capital• Every income concept also has a definable capital

maintenance concept• Important element in the IASB framework



Criteria for appraising alternative valuation

concepts

• Accounting communicates useful information for decision making

• Different users face different decisions• Many valuation bases useful, but for different

purposes• No best overall valuation concept; it depends on

question/decision



Fisher and psychic income

• People do things because of the satisfaction they derive

• Satisfaction is a mental occurrence and cannot be measured directly or objectively

• Fisher (1930) proposes approximations for satisfaction or enjoyment income:1) Real income: physical events and material

things, measurable but with no common denominator

2) Cost of living: money paid to obtain real income3) Money income: all money received and readily

available and intended to be used for spending money



Fisher and psychic income (cont’d)

• However, satisfaction still most important• So Fisher distinguished three successive stages of a

person’s income:– Enjoyment or psychic income– Real income measured as cost of living– Money income, consisting of the money received by

someone for meeting their costs of living• Accounting: real income is the most practical since it

is closer to ultimate reality• Fisher’s definition of income does not involve a

concept of capital maintenance. It is a measure of consumption and distinguishes from the mainstream accounting thinking



Hicks and capital maintenance

• Hicks (1946) adopts a forward-looking approach to valuation and income measurement

• Approximations:1) Income is the maximum amount which can be spent

during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts

2) Income is the maximum amount the individual can spend this week, and still expect to be able to spend the same amount in each ensuing week

3) Income is the maximum amount of money which the individual can spend this week, and still expect to be able to spend the same amount in real terms in each ensuing week



Hicks and capital maintenance (cont’d)

• Hicks, as Fisher, is concerned with consumption, but is also concerned with capital maintenance or the capacity to consume

• Long run concept



Calculation of economic income

• Fisher:Income = Consumption

• Hicks:Income = Consumption + Saving

Saving = difference between the value of capital at the end and at the start of the period

So: Y = C + (Ke – Ks)

• In business, C is redefined as the realized cash flows of the period



Calculation of economic income (cont’d)

Example:

An investment on 1 January year 1 has expected receipts on 31 December each year of €1000 for 3 years. The discount rate to reflect the time value of money is 10%. So the capital as at 1 January for each of year 1, 2 and 3:

Year 1: 2486 (1000/1.1 + 1000/(1.1)2 + 1000/(1.1)3)

Year 2: 1735 (1000/1.1 + 1000/(1.1)2)

Year 3: 909 (1000/1.1)



Year C Ke Ks Y RI Cum. RI

Total

RI

Income from RI

Total

EI

0 0 2486 0 0 0 0 2486 0 0

1 1000 1735 2486 249 751 751 2486 0 249

2 1000 909 1735 174 826 1577 2486 75 249

3 1000 0 909 91 909 2486 2486 158 249

4 0 0 0 0 0 2486 2486 249 249

Calculation of economic income (cont’d)



Income ex ante and income ex post

Income ex ante (before the event):

Y = C1 + (Ke1 – Ks)

C1 = expected realized cash flow for the period anticipated at the beginning of the period

Ke1 = the closing capital as measured (estimated) at

the beginning of the period

Ks = the capital at the beginning of the period as measured (estimated) at the beginning of the period



Income ex ante and income ex post (cont’d)

Example:Suppose: the expected return from the investment in Year 3 increases to € 1100Effect on:Year 1 : no changeYear 2 : no change

Year 3 : Ks = €1000 (1100/1.1)instead of €909So, windfall gain of €91



Income ex ante and incomeex post (cont’d)

Income ex post (after the event):

Y = C + (Ke – Ks1)

C = the actual realized cash flow of the period

Ke= the closing capital measured (estimated) at the end of the period

Ks1 = the opening capital measured (estimated) at the

end of the period.




Example:

Suppose: the expected return from the investment in Year 2 increases to € 1100

Effect on:

Year 1 : no change

Year 2 : Ks = €1818 (1000/1.1 + 1100/(1.1)2)

instead of €1735

So, windfall gain of €83




Remarks:

Income ex post is still based on expectations of the future and therefore as subjective as economic income ex ante

The windfall gain only becomes realized as the cash flow is actually received

Not clear cut whether the windfall gain is income or capital as it depends on where we consider our starting point to be



Summary

• Income, capital and value are interrelated concepts

• Value can be defined in variety of ways• The economic ideas in this chapter are

– theoretically sound and logically sensible – highly subjective in application as regards

• size of future cash flows • timing of future cash flows • discount rate to apply to future cash flows

– problematic as regards windfall gains and losses – and therefore, as far as accounting is concerned,

they probably represent an unattainable ideal.

chapter 4

Documents

value of crops

approaches of monetary

concepts of income

fieldvalue of capital

future services

capitaldefinition of

interrelationships of

valuesexpected values