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Accounting Notes Financial Accounting, Analysis and Valuation Notes

5. Hicks' Income Notes

Updated 5. Hicks' Income Notes

Financial Accounting, Analysis and Valuation Notes

Financial Accounting, Analysis and Valuation

Approximately 85 pages

AC330: Financial Accounting, Analysis and Valuation

These notes cover the AC330 Financial Accounting, Analysis and Valuation course at LSE. "The course addresses the theory and practice of financial reporting. Accounting practices are examined in the light of historical development, regulatory requirements, theories of income and capital and other approaches to accounting theory and to the use of accounting information in business analysis and valuation.

Financial accounting with particular ref...

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Central Concept of Income (Value and Capital, 1946)

  • Hicks - “the maximum value which he can consume during a week and still expect to be as well off at the end of the week as he was at the beginning”

  • To be made operational, must be clear on what is meant by “well off”

    • This is where his approximations come in, each of which has a concept of ‘capital’ that needs to be maintained to maintain ‘well-offness’

  • Ex ante = calculations made at the beginning of the year in the light of knowledge and expectations at that time

    • This is the one relevant for decision making

  • Ex post = calculations made at the end of the year in the light of knowledge and expectations at that time

    • Normally still very subjective since it is still based upon expectations of the future from time 1 onwards

  • The concept of income is only fully determinable and objective where there are ‘complete and perfect markets’ (Beaver)

Hicks’ Number 1 Measure of Income

  • “Income No. 1 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 (in money terms)”

  • The level of welloffness is the NPV of future cash flows

  • Y01=D1+V1V0=rV0t0

    • The cash flow arising at time 1 + capital value at time 1 + capital value at time 0

    • Capital value = PV of FCF from time x onwards

    • i.e. the realised cash flow for the period plus the change in capital value over the period

Number 1 ex ante

  • Y01=D1t0+V1t0V0t0=rV0t0

  • Will always equal interest on the capital value at the start of the period

Number 1 ex post Version A and Version B

  • The versions differ in their treatment of windfall gains and losses

    • i.e. those that arise from differences between expected interest rates and actual interest rates, or changes in expected interest rates when we no longer assume interest rates are constant

  • Version A: Y01=D1t1+V1t1V0t0

    • The actual cash flow for the period, plus capital accumulation including windfalls

  • Version B: Y01=D1t1+V1t1V0t1=rV0t1

    • The actual cash flow for the period, plus capital accumulation excluding windfalls

Hicks’ Number 2 Measure of Income

  • Takes into account changes in interest rate, which changes the concept of “welloffness”

  • “The maximum amount the individual can spend this week and still expect to be able to spend the same amount in each ensuing week”

    • Capital is ‘the maintainable or permanent income”

  • Closer to the central concept of income

Number 2 ex ante

  • Ex ante (solving for Y): Y=r1t0(D1t0+V1t0Y)

Number 2 ex post

  • Income number 2 will be affected if there are differences between expected and actual current year cash flows or differences between originally expected future cash flows and revised expectations

  • Version A:

    • “the maximum amount an individual can consume in a period and still expect to be able to consume the originally foreseen number 2 ex ante income in all future periods”

    • $\mathbf{D}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}\mathbf{+}\mathbf{V}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}\mathbf{-}\frac{\mathbf{original\ no.2\ ex\ ant}\mathbf{e}}{\mathbf{r}_{\mathbf{1}}\mathbf{t}_{\mathbf{1}}}$

  • Version B:

    • “the maximum amount an individual can consume in a period and still expect to be able to consume the same amount in all future periods”

    • Y=r1t1(D1t1+V1t1Y)

Hicks’ Number 3 Measure of Income

  • “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”

Accounting Using Hicks’ Concepts of Income

Advantages of Hicks’ Income Accounting

  • Accounting ‘grounded in theory prevalent in economics’ as sought by the Board’s framework, is good in principle, provided the full theory is understood, used and interpreted properly

  • Has objectivity if income is confined to income from fully exchangeable assets where everyone faces the same prices and discount rates (Beaver and Demski, 1979)

  • Use of income ex-post is objective, but ex-post “bygones are bygones” and have no relevance to decisions (Hicks, 1946)

Disadvantages of Hicks’ Income Accounting...

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