Accounting In Perfect And Complete Markets Essay — страница 5

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objective) valuation rules are used. Income still retains the more-is-better property, but it is total income, not period-by-period income. So more than one period may have to pass before income appropriately ranks a firm’s decisions. Accounting may not be as timely as other information sources, but its reliability is not problematic. The previous examples illustrated that the use of any consistent accounting system implied more income (on a total basis) was better. Implicitly we assumed markets were in equilibrium, since the asset was purchased at a cost equal to the present value of future cash flows. Valuing assets at other than market valueIn this section we consider the case where the asset is at some point in time valued at some number other than its market value. We

shall see that one can still use accounting numbers to rank firms, but something other than adding up income numbers is required. Consider the previous example, where sum of the years’ digits depreciation is used. After year one, the asset no longer appears at market value. Below we reproduce the financial statements. Balance sheetsYear 0Year 1Year 2Year 3Cash$ 0$26$52.60$79.86Long term asset6030100Owners’ Equity$60$56$62.60$79.86Income StatementsYear 1Year 2Year 3Revenue: Cash Revenue$26$24$22 Interest02.605.26Depreciation expense302010Income$(4)$6.60$17.26Recall the income numbers under economic depreciation were 6, 6.6 and 7.26. For years two and three, we see the income numbers no longer add to 13.86. So adding earnings over this time period will no longer help us value

the firm.One can use the accounting numbers to value the firm in the following way. At any point in time, value is equal to the beginning book value plus the discounted future abnormal earnings. Abnormal earnings for each year are the earnings less the normal earnings on the firm’s assets. Normal earnings are defined as the beginning book value times the interest rate. The calculations appear below. Income StatementsYear 2Year 3Beg. book value$56.00$62.60Income$6.60$17.26Normal earnings (@ 10%)(5.60)(6.26)Abnormal earnings$1.00$11.00Market value = 56 + + = 56 + 10 = 66. Notice what we have done. Since book values do not equal discounted cash flows at the beginning of year two, we must use both the balance sheet and the income statement. And we must now discount abnormal

earnings. In summary then, we have the following rule which allows the reader of financial statements to convert accounting numbers to market values. Market valueBook value=+of the firm Discounted abnormal earningsConclusionsIncome can be calculated using a wide variety of techniques. Some acceptable alternative accounting techniques are given below, but, as we know, the list is virtually endless. .Straight-line or accelerated depreciation.Manufacturing costs can be allocated to different products based on material costs or machine hours.LIFO or FIFO inventory valuation.Revenue recognition may occur at various times –(e.g. Percentage of Completion or Completed Contract Method for long term construction contracts)Given the variety of accounting choices available, can accounting

data be used to rank investment alternatives?This paper demonstrates how accounting numbers can be used to value the firm in perfect and complete markets. These are strong assumptions. Nevertheless, they are useful for thinking about accounting and valuation. But still, our work has just begun. We have yet to study uncertainty; this turns out not to be a difficult extension. More importantly, we wish to further our study of accounting by considering the effect of market frictions on accounting valuation and income measurement. This extension is more formidable. ReferencesArya, Fellingham, Glover, Schroeder and Young, “Income and Efficiency in Incomplete Markets,” Working paper (1996). Arya, Fellingham, Schroeder and Young, “Double Entry Bookkeeping and Error Correction,”

Working paper, 1996. Beaver, W., and J. Demski, “Income Measurement and Valuation,” Working paper, University of Florida (1995). Demski, J., Managerial Uses of Accounting Information. Boston: Kluwer Academic (1992). Dorfman, R., P. Samuelson, and R. Solow, Linear Programming and Economic Analysis. New York: Dover Publications (1987). Edwards, E., and P. Bell. The Theory and Measurement of Business Income. University of California Press (1961). Feltham, G. and J. Ohlson, ” ,” Contemporary Accounting Research (Spring 1995) 689-. Farlee, M., J. Fellingham and R. Young, “Properties of Economic Income in a Private Information Setting,” Contemporary Accounting Research (Fall 1996). Ohlson, James, “Earnings, Book Values, and Dividends in Security Valuation,” Contemporary