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Copyright © 2009 by Pearson Education Canada Chapter 2 Accounting Under Ideal Conditions
Copyright © 2009 by Pearson Education Canada Chapter 2 Accounting Under Ideal Conditions
Copyright © 2009 by Pearson Education Canada Assumptions –Known future cash receipts –Given interest rate Basis of Accounting Present value Income Recognition –As changes in present value occur 2.2 Ideal Conditions of Certainty
Copyright © 2009 by Pearson Education Canada 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 Education Canada Ideal Conditions of Uncertainty (continued) Basis of Accounting –Expected present value Income Recognition –As changes in expected present value occur
Copyright © 2009 by Pearson Education Canada 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 Education Canada 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 Education Canada 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 Education Canada 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 Education Canada 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 Education Canada Relevance v. Reliability Tradeoff
Copyright © 2009 by Pearson Education Canada 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 Education Canada 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
Copyright © 2009 by Pearson Education Canada 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 Education Canada 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
Copyright © 2009 by Pearson Education Canada Reserve Recognition Accounting II Relevance of RRA information? Reliability of RRA information? Managements Reaction to RRA –Concern about relevance and reliability –Concern about legal liability Why is RRA reported as supplementary information?
Copyright © 2009 by Pearson Education Canada Reserve Recognition Accounting III Canadian reserve recognition accounting –Text, Chapter 2, Problem 24, NI –Relevance compared to SFAS 69? –Reliability compared to SFAS 69? –Why do many large firms opt out in favour of SFAS 69?
Copyright © 2009 by Pearson Education Canada 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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