Accounting In Perfect And Complete Markets Essay — страница 2

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case, income in every period will be higher for firms with more valuable assets. Under the second case, the former may not be true, but total income over the life of the firm will be higher for firms with more valuable assets. Under the third case, book value plus discounted abnormal earnings are higher for firms with more valuable assets. Accounting, Income and Markets We will focus somewhat on the income number although, as mentioned, the accounting’s structure imposes relationships among income and other accounting data. And we should begin by pointing out that income is just a number. It is not something we eat or otherwise consume. Income is important because it measures our ability to acquire “things” which we like to consume directly. Our ability to engage in market

transactions to acquire things – and how we interpret income – depends on the arrangement of economic markets. In this note we will restrict our attention to an economic setting called perfect and complete markets. We begin with a brief description of these market assumptions. Exactly where these assumptions are important to the interpretation of accounting income will be made clear after we make some headway in the analysis. “Complete” is a description of what things can be bought and sold; markets are complete when everything anyone cares about can be exchanged in a market transaction. “Perfect” is a description of the structure of the market and is a little bit tricky. It has to do with costs that are incurred to organize and complete the transaction. These are

called transaction costs and include things like the cost of acquiring information about commodities or prices, or paying someone a fee to orchestrate the transaction. Perfect markets are markets without transaction costs. A market where different economic actors face different prices is not a perfect market. An individual who does not have access to the most favorable price incurs the transaction cost either by paying to acquire the wherewithal to obtain the favorable price or by simply transacting at the unfavorable price. In the latter case the transaction cost is included in the price of the commodity. One additional characteristic of the market structure which is important for our discussion of income is time. That is, it must be possible to buy or sell a commodity for

delivery later. The reason this is important is that income measurement is about the passage of time, and how the wealth position is different at the end of a time period than it was at the beginning. The way we capture temporal transactions in our market structure is with an interest rate – the price at which money now can be exchanged for money later. In this context, complete markets imply that everyone can trade across any time periods that they like – that is, everyone has an interest rate. Perfect markets imply that the interest rate is the same for everyone, and everyone knows its value. The curious reader may ask why study perfect and complete markets. After all, there are lots of things we care about that are not traded in markets (pollution?) or goods for which

different people pay different prices (insider trading?). Recall that the objective of this note is to provide some structure so we can address what we mean by income, as well as how it should be measured. It turns out that under perfect and complete markets this question is easy to address, and alas, under market incompleteness or imperfections it is extremely difficult to address. So let us start with the easy thing first — perfect and complete markets. Accounting Valuation and Income MeasurementNow that we have our market structure in place, let’s do some accounting. Assume our firm owns one asset which will produce a cash flow of $26, $24, and $22 at the end of the next three years. Everybody’s interest rate (discount rate) is 10%. A timeline appears below.

time0123|——————-|——————-|——————-|cash flows$26$24$22Timeline – Cash flowsTo prepare balance sheets (and income statements) we will use the following accounting valuation rule. Accounting valuation rule: At each point in time, assets are valued at the present value of future cash flows. Why will this valuation rule turn out to be a good one? Here perfect and complete markets enter. If markets are complete, every asset has a market value. If markets are perfect, everyone knows the cash flows that will result from holding a particular asset. And since everyone faces the same interest rate, everyone would come up with the same number for the value of the firm’s assets — in a competitive equilibrium it would be the present value of its future