Financial Accounting Theory SeventhEdition William R. Scott. Chapter 2 Accounting Under Ideal Conditions

Transcription

1 Financial Accounting Theory SeventhEdition William R. Scott Chapter 2 Accounting Under Ideal Conditions

2 Main Ideas For Chapter 2 Focus is on the Ideal Conditions box on the left Under Ideal Conditions we know for certain what would happen BUT we have 2 types of Ideal Conditions Absolute certainty = 100% certainty of everything Probability certainty see next page

3 Main Ideas For Chapter 2 What is probability certainty? When we are uncertain, we are uncertain of one or both things: Probability (= chance of something happening) Amount (= how much if it happens) What if we know FOR CERTAIN the PROBABILITIES and the AMOUNTS? e.g. for certain -50% probrevenue of $500, 50% prob revenue of $1,500 => what does it mean? On AVERAGE I am very certain that I will get $1,000 But FOR EACH TIME I am NOT sure if $500 or $1,500

4 Main Ideas For Chapter 2 Two types of Ideal Conditions studied here: Absolute certainty - we know EVERYTHING EXACTLY e.g. $1,000 of revenue for certain What accounting numbers should we use? Probability certainty -we know FOR CERTAIN the PROBABILITIES and the AMOUNTS? e.g. for certain -50% probrevenue of $500, 50% probrevenue of $1,500 What accounting numbers should we use?

5 Main Ideas For Chapter 2 Absolute certainty or probability certainty What if we know EVERYTHING EXACTLY? => IF know everything exactly, then current value What if we only know FOR CERTAIN the PROBABILITIES and the AMOUNTS? => Then RELEVANT vs RELIABLE in deciding => Current value or historical cost? => Depends on many things = problems we face

6 Chapter 2 Accounting Under Ideal Conditions

7 2.2 Ideal Conditions of Certainty Assumptions Known future cash receipts Given interest rate Basis of accounting Present value Income recognition As changes in present value occur

8 2.3Ideal Conditions of Uncertainty Assumptions States of nature The set of possible states of nature is publicly known State realization publicly observable State probabilities objective publicly known Given interest rate >> Continued

9 2.2 Ideal Conditions of Certainty Basic information Company buys one asset with annual revenue of $1,000, asset has five year life Shareholder paid cash to buy shares to purchase this asset Dividend of $40 from year 3 onwards Interest rate of 10% No depreciation or salvage value

10 2.2 Ideal Conditions of Certainty What is the purchase price / value of the asset today? Same as the present value of the cash flow over its life Present value of a $1,000 annuity for five years at discount rate of 10% = $3,791

11 2.2 Ideal Conditions of Certainty So shareholder paid cash of $3,791 to the company to buy its share The company then use this cash to buy the asset (at time = 0) What happens in the first year?

12 2.2 Ideal Conditions of Certainty What is the value of the asset at the end of Year 1? = $3,170 Year 2? = $2,487 Year 3? = $1,736 Year 4? = $909 Year 5? = $0 What happens in the second to fifth year? How about the $30 dividends to be paid starting year 3?

13 2.2 Ideal Conditions of Certainty How about the 2 nd scenario of only having probability certainty => for certain -50% probrevenue of $500, 50% probrevenue of $1,500

14 What Is The Difference? What is the difference between using current value and historical value?

15 What Is The Difference? For current value accounting => balance sheet approach (value of asset show on BS) => income statement not as important because showing value change = measurement perspective For historical cost accounting => income statement approach (sold and gain shown here) => balance sheet not as important because unrealized gains and losses not shown there = information perspective

16 2.3Ideal Conditions of Uncertainty Basis of accounting Expected present value Income recognition As changes in expected present value occur

17 Relevance versus Reliability Relevant information Information about future firm performance Reliable information Representationally faithful Free from bias Verifiable Under ideal conditions, complete relevance and reliability is attained Why?

18 Lack of Ideal Conditions State probabilities are subjective, not objective Objective probabilities Rolling a pair of fair dice Subjective probabilities What if you are not sure the dice are fair?» Continued

19 Lack of Ideal Conditions Incomplete markets Definition? Significance Cannot always use market value as proxy for present value Reasons for Incompleteness thin markets information asymmetry

20 Lack of Ideal Conditions Implications Estimates needed to apply current value accounting Future state realizations may not be currently known, leading to need for Estimates of quantities of future sales and purchases Estimates of prices of future sales and purchases Estimates of timing of future transactions Estimates needed of (subjective) probabilities of future state realizations Note current value = future quantity future price their probabilities These probabilities usually subjective Estimates are subject to error and bias

21 Lack of Ideal Conditions Conclusions Greater relevance requires more estimates But, more estimates decrease reliability Relevance and reliability must be traded off See next slide

22 Relevance v. Reliability Tradeoff

23 2.5 Historical Cost v Current Value Accounting Different tradeoffs between Relevance and reliability Timing of revenue recognition Recognition lag Matching of costs and revenues >> Continued

24 2.5 Historical Cost v Current Value Accounting The mixed measurement model Current value accounting for Accounts receivable Financial instruments Accounts payable Post-retirement benefits Historical cost accounting for Inventory Property, plant & equipment Purchased goodwill Why different bases of accounting for different financial statement items?

25 2.6 The Non-Existence of True Net Income Why? Incomplete markets Reasons for incompleteness thin markets As for oil and gas reserves information asymmetry Too much asymmetry, no market develops If no market value, cannot use market value as proxy for present value If have to estimate present value, true net income does not exist >> Continued

26 2.6 The Non-Existence of True Net Income Implications for accountants Accountants not needed if true net income did exist Judgement required to estimate net income Judgement is essence of a profession