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# The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory

(07 !7"# $econciliation %et&een 'conomic and Accounting (ncome The data Assume a three year business venture which involves the purchase of a non-current asset for 900 with estimates of a three year life and no residual value. The asset will generate net cash inflows after all operating and other costs except depreciation of 500 per annum. xcept for the initial purchase of the non-current asset! all cash flows occur at the end of the year and the re"uired rate of return on the venture is #0 per cent per annum. $s the business venture worthwhile% The usual way to answer the above "uestion is to calculate the business venture&s net present value as detailed below. Table #' (et present value of the business venture )ear 0 #-0 (et present value *ash flow .900/ 500 +iscount factor at #0, #.0 1.234 -resent value .900/ #!120 020

5iven the pro6ect&s positive net present value! it is a worthwhile investment and should be underta7en. *alculation of 8ideal economic income& The usual way to calculate 8ideal economic income& is to compute first of all the capital amount at times t0! t#! t1 and t0 using the present value of the future cash flows as follows.

1 Table 1' *alculation of opening and closing capital values Time period t0 t# t1 t0 *alculation of present value at #0 , .500 x 1.234/ .500 x #.905/ .500 x 0.909/ *apital #!120 343 255 0

These numbers are then used to calculate the 8ideal economic income& as the difference between opening and closing capitals ta7ing into account the actual operating cash flows as well as any additional interest income on cash amounts not distributed as a dividend .which dividend is e"ual to 8ideal economic income&/ but reinvested in the business venture. The calculations are as detailed below.
Table 0' *alculation of 8ideal economic income& # :pening capital Table 1 1 *losing capital Table 1 0 *ash flow 5iven 500 500 500 2 :perating income .1 ; 0 - #/ #15 39 25 5 Amount reinveste d .0 <2/ 095 2#0 255 4 *umulative amount reinvested 095 933 #!120 9 $nterest on reinveste d amount .4 x 0.#0/ 03 30= 3 $deal economic income .2 ; 9/ #15 #15 #15

)ear

# #!120 343 1 343 255 0 255 0 =>ounding error of #.

The 8ideal economic income& can also be calculated much more simply by applying the interest rate to the gross present value of the pro6ect as calculated in Table # .#!120 x 0.#0/ which is #15 .rounded upwards/. (otice however that in these calculations the economic income is calculated on the assumption that the capital to be maintained is the gross present value of the pro6ect which is #!120 .i.e. the total of columns 1 and 4/ and not the initial investment in the non-current asset of 900. This capital maintenance concept is made clear in the 8accounts& produced below.

0 $ncome statements for the years #! 1 and 0 on an 8ideal economic income& basis +etail (et operating cash flows +ividend ? 8ideal economic income& :perating cash flow retained for year $nterest at #0, on cumulative reinvested cash amounts Total income @.095 ; 2#0 ; 255/ ? #!120A )ear # 500 #15 095 095 )ear 1 500 #15 095 03 2#0 )ear 0 500 #15 095 30 255

The calculation of the interest on the reinvested cash amounts is shown in Table 2 below. (ote that for the balance sheet below! the value of the non-current asset is the present value of the future cash inflows that it generates in the business venture. Balance sheets as at the end of each of the years #! 1 and 0 on an 8ideal economic income& basis +etail (on-current asset valued at present value of future cash flows *urrent asset < cash received less dividends paid .Table 2/ )r # 343 095 #!12 0 "uity :pening and closing capital The cash movements are explained in the table below. Table 2' *alculation of cash amounts )ear :pening cash $nterest at #0, 0 03 30= :perating cash flow less dividend 095 095 095 *losing cash 095 933 #!120 #!12 0 )r 1 255 933 #!12 0 #!12 0 )r 0 #!12 0 #!12 0 #!12 0

# 0 1 095 0 933 =>ounding error of #.

The above accounts show that in distributing the economic income of #15 annually! the opening capital of #!120 .the gross present value of the business venture calculated in Table #/ is maintained throughout.

Chat would a typical set of accounts prepared on an historical cost basis loo7 li7e% 5iven straight line depreciation over the life of the asset and assuming that the net profit is distributed as a dividend under a capital maintenance concept which preserves the opening cash value of 900 invested in the non-current asset! the income statements and balance sheets loo7 as follows. $ncome statements for the years #! 1 and 0 under the historical cost basis +etail (et operating cash flows +epreciation .900D0/ @straight line! no residual valueA (et profit +ividend >etained profit )ear # 500 000 100 100 )ear 1 500 000 100 100 )ear 0 500 000 100 100 -

Balance sheets as at the end of each of the years #! 1 and 0 +etail (on-current asset *urrent asset < cash received less dividends paid "uity Ehare capital >etained earnings Total e"uity )ear # 400 000 900 900 900 )ear 1 000 400 900 900 900 )ear 0 900 900 900 900

Although the positive accounting income numbers for all three years confirm the investment decision was correct! the profit is radically different from the ideal economic income calculation. ven if we discount the dividend stream .100 x 1.234 ? 299/ to ta7e into account the time value of money! the different incomes still do not reconcile. :ne reason that the accounting profits are higher than the economic income numbers is because they are calculated after maintaining a much lower capital value .900 instead of #!120/. $s there any way to reconcile these numbers in order to provide the accounting income calculations with some economic 6ustification% Are the accounting income numbers overstated%

Ta7ing 8interest on investment& into account Fet us assume that instead of investing our 900 of capital in the pro6ect we were to put the money on deposit in the ban7 at #0 per cent per annum. The total cash in the ban7 at the end of the three year period would be .900 x .#.#0/0/ #!#93. $f instead we invest in the pro6ect! the amount of cash in the ban7 at the end of year 0 will be as detailed below. Table 5' *alculation of cash at ban7 at the end of the business venture nd of year # 1 0 Total *alculation 500 x .#.#0/1 500 x .#.#0/ 500 Amount 405 550 500 #!455

The difference between the two cash amounts .#!455 < #!#93/ is 259 which sum has a net present value .259 x #D .#.#0/0/ of 020! consistent with the net present value decision rule. Gence! treating the amount of money invested in the business in a similar manner to the cash invested in a ban7 in terms of earning a return of at least #0 per cent per annum should allow us to reconcile the accounting numbers to the net present value decision rule numbers. This is done by charging against net operating cash flows the full economic cost of the non-current asset! that is! ta7ing into account the interest foregone which the purchase of the asset entailed. The purchase price of the non-current asset .900/ is converted into an e"uivalent annual annuity at an interest rate of #0,. Gence the calculation is as follows .900 x #D 1.234/ 041 per annum. The income statements now loo7 as follows' $ncome statements for the years #! 1 and 0 using economic depreciation +etail (et operating cash flows conomic depreciation of non-current asset (et profit +ividend >etained profit )ear # 500 041 #03 #03 )ear 1 500 041 #03 #03 )ear 0 500 041 #03 #03 -

The present value of the dividend stream is now .#03 x 1.234/ 020 and the accounting profits in the income statement tell the same story as the original investment decision model once we allow for the time value of money. Gowever! how do our balance sheets loo7 using economic depreciation%

Balance sheets as at the end of each of the years #! 1 and 0 using economic depreciation +etail *ost of non-current asset less economic depreciation *urrent asset < cash received less dividends paid "uity Ehare capital >etained earnings Total e"uity )ear # 503 041 900 900 900 )ear 1 #94 912 900 900 900 )ear 0 .#34/ #!034 900 900 900

This is clearly an unsatisfactory state of affairs! especially in year 0! when the noncurrent asset has a negative value. Ce have ta7en into account the extra cost of the asset! but not the return it should be generating .the 8interest on investment&/. Additionally! the business is unli7ely to 7eep the surplus cash generated in a ban7 current account but will invest it in a deposit account to earn interest at #0 per cent per annum. :nce we ta7e these factors into account! the financial statements loo7 as follows.

$ncome statements for the years #! 1 and 0 using economic depreciation +etail (et operating cash flows conomic depreciation (et operating profit for year $nterest on investment in non-current asset .see below/ $nterest income on reinvested cash surplus Total profit +ividend >etained profit )ear # 500 041 #03 90 113 #03 90 )ear 1 500 041 #03 40 04 109 #03 99 )ear 0 500 041 #03 00 94 129 #03 #09

Balance sheets as at the end of each of the years #! 1 and 0 using economic depreciation +etail (on-current asset at start of year $nterest on opening investment at #0, conomic depreciation (on-current asset at end of year *urrent asset < cash received less dividends paid "uity Ehare capital >etained earnings Total e"uity )ear # 900 90 .041/ 413 041 990 900 90 990 )ear 1 413 40 .041/ 019 940 #!039 900 #39 #!039 )ear 0 019 00 .041/ 0 #!#93 #!#93 900 193 #!#93

(ote that closing e"uity of #!#93 is what would have been the amount in the ban7 at the end of year 0 had the original capital of 900 been invested in a ban7 deposit account earning interest at #0 per cent per annum. (otice also that total profit for each year is different .113! 109 and 129/ and growing reflecting the fact that some profit has been retained in each period to grow the business. )ear 1 income is 9 higher than the previous year because 90 of profit was retained at the end of year # which has earned a return of #0 per cent per annum during year 1. This retained amount earns another 9 of interest in year 0 in addition to the #0 of interest earned on the year 1 retained profit of 99 which has been invested during year 0. Table 4' *alculation of return at #0, on reinvested profits )ear # 1 :pening profit 90 99 *alculation .90 x 0.#0/ .99 x 0.#0/ $nterest at #0, 9= #0== *losing profit 99 #09

=Added in years 1 and 0. ==Added in year 0. >econciliation $n the above accounts! the capital maintained as at the end of year 0 is #!#93! which is lower than the closing capital maintained under 8ideal economic income& of #!120. The closing difference as at the end of year 0 .#!120 < #!#93/ of 25 has a present value of .25 x 0.95#/ 02 which at #0 per cent per annum purchases an annual annuity for 0 years of about .02 x 0.201/ #0! which is the difference between accounting and

3 economic income in the above calculations .#03 - #15/. The reconciliation between 8ideal economic income& and accounting income has therefore been successfully performed. The lesson illustrated is that the income reported depends fundamentally on the capital maintenance concept adopted in the first place. The :hlson model A valuation of the pro6ect or firm using the :hlson model also reconciles the accounting to the economic numbers regardless of the accounting convention employed. 5iven opening capital under the historical cost convention of 900 on which a return of #0 per cent per annum is re"uired then the 8normal earnings& are expected to be .900 x 0.#0/ 90 per year. The actual earnings in the historical cost income statement are 100 per year resulting in an 8abnormal earnings& figure of ##0 in each of the three years. The :hlson model states that the present value of these 8abnormal earnings& will be added to the historical cost boo7 value of the balance sheet to determine the mar7et value of the firm. The present value of the cash flow stream represented by these 8abnormal earnings& at an interest rate of #0 per cent per annum is .##0 x 1.234/ 190 which added to the opening balance sheet value of the firm results in a valuation of .900 ; 190/ #!#90. Gowever! this value assumes that the 8abnormal earnings& are not re-invested. $f they were re-invested! they would earn additional cash at the end of year 0 of 02 which discounted bac7 to year 0 has a present value of about 15 and when this amount is added to the #!#90 the resulting figure is #!#93 which reconciles to the numbers above.