Financial accounting theory 5e scot ch02

Chapter 2

Accounting Under Ideal
Conditions

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Chapter 2
Accounting Under Ideal Conditions

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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

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2.3 Ideal Conditions of Uncertainty
• Assumptions
– States of nature
• Known set
• State realization publicly observable

– State probabilities
• objective
• publicly known

– Given interest rate

» Continued

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2.3 Ideal Conditions of Uncertainty
(continued)

• Basis of Accounting
– Expected present value

• Income Recognition
– As changes in expected present value occur

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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?

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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

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Lack of Ideal Conditions (continued)
• Incomplete markets
– Definition?
– Significance
• Cannot always use market value as proxy for present value

• Reasons for Incompleteness
– thin markets
– information asymmetry

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Implications of Lack of Ideal
Conditions
• 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

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Conclusion re: Lack of Ideal
Conditions
• Greater relevance requires more estimates
• But, more estimates decrease reliability
• Relevance and reliability must be traded off
– See next slide

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Relevance v. Reliability Tradeoff

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2.5.1 Comparing Different
Measurement Bases
• Current value accounting
– Fair value v. present value approach?
– Relevance v. reliability?
– Recognition lag?

• Historical cost accounting
– Relevance v. reliability?
– Recognition lag?
– Matching and accruals?

• Cash flow accounting
– Relevance v. reliability?
– Recognition lag?

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The Mixed Measurement Model
• Current value accounting for some items
– Accounts receivable, financial instruments
– Pension and lease liabilities

• Historical cost accounting for some items
– Inventory
– Long-term debt
– Property, plant & equipment, purchased goodwill

• Cash flow accounting for some items
– Self-developed goodwill
• Shows up in income statement as realized
»

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Continued

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The Mixed Measurement Model
(continued)

• Why use different measurement bases?
– Different tradeoffs between relevance and reliability
• Some assets and liabilities require more estimates than
others
• If too many estimates, revert to historical cost to retain
reasonable reliability
• If reasonable reliability still not attained, revert to cash
basis
– E.g., research costs written off as incurred

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2.4 Reserve Recognition Accounting I
• An application of present value accounting when
ideal conditions do not exist
• SFAS 69
–
–
–
–

Applies to proved reserves only
Discounted at mandated rate of 10%
Revenue recognized as reserves are proved
Major adjustments to previous estimates usually
needed

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2.4 Reserve Recognition Accounting II
• Relevance of RRA information?
• Reliability of RRA information?
• Management’s Reaction to RRA

– Concern about relevance and reliability
– Concern about legal liability

• Why is RRA reported as supplementary
information?

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2.4 Reserve Recognition Accounting III
• Canadian reserve recognition accounting
–
–
–
–

Text, Chapter 2, Problem 24, NI 51-101
Relevance compared to SFAS 69?
Reliability compared to SFAS 69?
Why do many large firms opt out in favour of SFAS 69?

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2.6 Conclusion
• True net income does not exist

– Why?
– Implications for accountants
• Accountants not needed if it did exist
• Judgement required to estimate net income
• Judgement is essence of a profession

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