Chapter 4

Economic valuation
concepts

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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.
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

The basic equation (contd)

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 assets
P = Profit for the period
D = Dividends (drawings)
W2 = Closing net assets
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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)
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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!

International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

An array of value concepts (contd)

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

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

An array of value concepts

(contd)
Edwards and Bells useful valuation
Exit values

possibilities:

Expected values (ultimate, future, exit): values

expected to be received in the future for output sold
according to the firms 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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

An array of value concepts

(contd)
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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Economic value

Edwards and Bell exposition of the array of value

concepts excludes economic value possibility

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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 income
3) Money income: all money received and readily
available and intended to be used for spending
money
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Fisher and psychic income

(contd)
However, satisfaction still most important
So Fisher distinguished three successive stages of a
persons 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
Fishers definition of income does not involve a
concept of capital maintenance. It is a measure of
consumption and distinguishes from the mainstream
accounting thinking
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Hicks and capital maintenance

Hicks (1946) adopts a forward-looking

to valuation and income measurement
Approximations:
1)
2)
3)

approach

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
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
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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Hicks and capital maintenance

(contd)
Hicks, as Fisher, is concerned with consumption, but
is also concerned with capital maintenance or the
capacity to consume
Long run concept

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Calculation of economic income

(contd)
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)
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Calculation of economic income

(contd)
Year

Ke

Ks

RI

Cum.
RI

Total
RI

Income
from
RI

Total
EI

2486

2486

1000

1735

2486

249

751

751

2486

249

1000

909

1735

174

826

1577

2486

75

249

1000

909

91

909

2486

2486

158

249

2486

2486

249

249

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Income ex ante and income

post (contd)

ex

Example:
Suppose: the expected return from the
investment in Year 3 increases to 1100
Effect on:
Year 1 : no change
Year 2 : no change
Year 3 : Ks = 1000 (1100/1.1)
instead of 909
So, windfall gain of 91
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Income ex ante and income

ex post (contd)
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.

International Financial Reporting and Analysis, 5th edition

David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Income ex ante and income

ex post (contd)
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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

Income ex ante and income

ex post (contd)
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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA

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.
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 2011 Cengage Learning EMEA