Chapter 2

Accounting Under Ideal

Conditions

2-1
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 Chapter 2
Accounting Under Ideal Conditions

2-2
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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
» 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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