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Chapter 2

Chapter 2. Accounting Under Ideal Conditions. 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 Income Recognition As changes in present value occur.

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Chapter 2

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  1. Chapter 2 Accounting Under Ideal Conditions

  2. Chapter 2Accounting Under Ideal Conditions

  3. 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

  4. 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

  5. 2.3 Ideal Conditions of Uncertainty (continued) • Basis of Accounting • Expected present value • Income Recognition • As changes in expected present value occur

  6. 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?

  7. 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

  8. 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

  9. 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

  10. 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

  11. Relevance v. Reliability Tradeoff

  12. 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?

  13. 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 • Continued

  14. 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

  15. 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

  16. 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?

  17. 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?

  18. 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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