Chapter Accounting Under Ideal Conditions Copyright © 2009 by Pearson Education Canada 2-1 Chapter Accounting Under Ideal Conditions Copyright © 2009 by Pearson Education Canada 2-2 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 Copyright © 2009 by Pearson 2-3 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 Copyright © 2009 by Pearson 2-4 2.3 Ideal Conditions of Uncertainty (continued) • Basis of Accounting – Expected present value • Income Recognition – As changes in expected present value occur Copyright © 2009 by Pearson 2-5 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? Copyright © 2009 by Pearson 2-6 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 Copyright © 2009 by Pearson 2-7 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 Copyright © 2009 by Pearson 2-8 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 Copyright © 2009 by Pearson 2-9 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 Copyright © 2009 by Pearson 2- Relevance v Reliability Tradeoff Copyright © 2009 by Pearson - 11 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? Copyright © 2009 by Pearson 2- 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 » Copyright © 2009 by Pearson Continued 2- 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 Copyright © 2009 by Pearson 2- 2.4 Reserve Recognition Accounting I • An application of present value accounting when ideal conditions 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 Copyright © 2009 by Pearson 2- 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? Copyright © 2009 by Pearson 2- 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 many large firms opt out in favour of SFAS 69? Copyright © 2009 by Pearson 2- 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 Copyright © 2009 by Pearson 2- ... flow accounting – Relevance v reliability? – Recognition lag? Copyright © 2009 by Pearson 2- The Mixed Measurement Model • Current value accounting for some items – Accounts receivable, financial. .. Different Measurement Bases • Current value accounting – Fair value v present value approach? – Relevance v reliability? – Recognition lag? • Historical cost accounting – Relevance v reliability? –... 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