© 2006 Pearson Education Canada Inc.2-1 Chapter 2 Accounting Under Ideal Conditions.

© 2006 Pearson Education Canada Inc.

2-1

Chapter 2

Accounting Under Ideal Conditions


2-2

Ideal Conditions of Certainty

• Assumptions– Known future cash receipts– Given interest rate

• Basis of Accounting– Present value


2-3

Ideal Conditions of Certainty, Cont’d

• Income Recognition– As changes in present value occur


2-4

Ideal Conditions of Uncertainty

• Assumptions– States of nature

•Known set•Realization publicly observable

– State probabilities •objective •publicly known

– Given interest rate


2-5

Ideal Conditions of Uncertainty, Cont’d

• Basis of Accounting– Expected present value

• Income Recognition– As changes in expected present

value occur


2-6

Ideal Conditions of Uncertainty- Example

• You pay $100 to a bank to buy a 2-year investment which pays in each year $73.02 with prob. = 0.5 and $33.02 with prob. = 0.5. The interest rate in the economy is 4%.


2-7

Example, Cont’d

• PA0 = [.5(73.02) + .5(33.02)]/1.04 + [.5(73.02) + .5(33.02)]/(1.04)2 = (36.51 + 16.51)/1.04 + (36.51 + 16.51)/(1.04)2

= 53.02/1.04 + 53.02/1.0816 = 50.98 + 49.02 = $100.00

• NB: Risk-Neutral Valuation


2-8

Example, Cont’d

• Assume at End of Year 1, you Receive $73.02– PA1 = 73.02 + [.5(73.02)

+ .5(33.02)]/1.04

= 73.02 + 50.98 = $124


2-9

Example, Cont’d

• Net Income for the Year– Sales less amortization format

73.02 - (100 - 50.98) = 73.02 - 49.02 = $24

– Alternative format•100 x .04 + (24 - 4) = 4 + 20 = $24

– Change in balance sheet net assets•124 - 100 = $24


2-10

Lack of Ideal Conditions

• Problems when conditions not ideal– State probabilities are subjective, not

objective– Incomplete markets

• Definition of Incompleteness• Reasons for Incompleteness

– thin markets– information asymmetry


2-11

Implications of Lack of Ideal Conditions

• Need for Estimates (quantities, prices, timing) of states of nature

• Need for Estimates of State Probabilities

• Market Value Need Not Equal Present Value

• True Net Income Does Not Exist


2-12

Implications of Lack of Ideal Conditions,

Cont’d.• Relevance and Reliability

Must be Traded Off (next slide )

• Historical Cost Accounting a Better Tradeoff?– Relevance of historical cost

accounting?– Reliability of historical cost

accounting?


2-13

Relevance v. Reliability Tradeoff


2-14

Fair Value Accounting

• Implementing Accounting Under Ideal Conditions when Ideal Conditions do not Exist

• Meaning of “Fair Value”– Present value approach– Market value approach– Model-based approach

•E.g., option pricing models


2-15

Reserve Recognition Accounting

• An Application of Present Value Accounting When Ideal Conditions do not Exist– Proved reserves– Discounted at mandated rate of

10%– Revenue recognized as reserves

are proved– Major adjustments to previous

estimates


2-16

Reserve Recognition Accounting, Cont’d

• Relevance of RRA information?• Reliability of RRA information?• Management’s Reaction to RRA

– Concern about relevance and reliability

– Concern about legal liability


2-17

Asset Valuation is Equivalent to Income

Recognition • Proved reserves valued at

present value income recognized as reserves are proved

• Proved reserves valued at cost income recognized as reserves are sold


2-18

The Challenge of Historical Cost

Accounting• Amortization of Capital Assets

– Consider earlier example• Straight-line amortization

Net Income: 73.02 - 100/2 = 73.02 - 50 = $23.02

• Sum of years digits amortizationNet Income: 73.02 - 2/3 x 100 = 73.02 - 67 =

$6.02

Little theoretical basis to choose between different ways of accounting for the same thing. Relevance? Reliability?

© 2006 Pearson Education Canada Inc.2-1 Chapter 2 Accounting Under Ideal Conditions.

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Transcript of © 2006 Pearson Education Canada Inc.2-1 Chapter 2 Accounting Under Ideal Conditions.