SMU Classification: Restricted
Lecture 01
ACCT 332 – Accounting Thought and Governance
Introduction and Accounting under Ideal Conditions
- Course syllabus
- Chapters 1 and 2
SMU Classification: Restricted
Course Objective
•This course builds on the knowledge you obtained in your
introductory and intermediate accounting courses and provide a
framework to unify these courses.
•This course helps you understand the theoretical foundations of
corporate financial reporting and the underlying reasons “why” certain
accounting policies and practices are adopted.
•This course helps you to develop skills to think independently and
critically about various accounting and finance issues.
•Prepare for the SCAQ Business Value, Governance and Risk (BG)
and Financial Management modules
SMU Classification: Restricted
Course Organization (1)
•Instructor:
•Professor Liandong Zhang
•Address: 4015 School of Accountancy
•Phone: 68289665
•e-mail: ldzhang@smu.edu.sg
•Teaching Assistant: Eulabius Lam
(eulabiuslam.2022@accountancy.smu.edu.sg)
•Course Website: http://elearn.smu.edu.sg
 Slides, readings, group questions will be posted by 5pm, the Friday
before the class
•Office Hours:
By appointment.
SMU Classification: Restricted
Course Organization (2)
•Course Materials:
- Textbook: Financial Accounting Theory by W.R. Scott, Prentice Hall,
2019 (8th Edition)
• Solutions to textbook questions are available in my office
- Code of Corporate Governance
- COSO 2013 Internal Control Framework
- ISO 31000: Risk Management Guidelines
- Journal articles, FASB/IASB opinions, and other supplementary
articles (available on the course website)
SMU Classification: Restricted
Course Organization (3)
• Class sessions will typically consist of two parts:
lecture and group exercises.
• Groups:
- Form your group and sit with them for the remaining
term.
- Submit the names of each person in your group
today.
- Each week, one group will be assigned to lead the
group discussions as we go over the exercise
problems together during the second half of class.
SMU Classification: Restricted
Course Organization (4)
•Grading:
•Classroom Contributions (individual and group)
•Midterm Exam
•Project
•Project Presentation
•Final Exam
10%
20%
10%
10%
50%
100%
How do I contribute to the learning environment?
Midterm: In-class in Week 7
Final exam: TBA (Cumulative)
SMU Classification: Restricted
Course Organization (5)
• Important dates:
- Week 1: Groups are formed
- Week 7: Mid-term exam
- Week 7: Guidelines of term paper
- Week 9: Submit hard copies of paper outlines
- Week 13: Final paper and in-class presentation due
SMU Classification: Restricted
How do I succeed in this course?
• Before class
- Read the required readings
• In class
- Learn concepts and theories
- Apply theories to group exercises
- Actively participate class discussions (Q&A)
• After class
- Review lecture material
- Review group exercise problems
- Understand and digest, instead of simply
memorizing.
SMU Classification: Restricted
Academic Integrity
• All acts of academic dishonesty (including, but not
limited to, plagiarism, cheating, fabrication, facilitation
of acts of academic dishonesty by others, unauthorized
possession of exam questions, or tampering with the
academic work of other students) are serious offences.
All work (whether oral or written) submitted for
purposes of assessment must be the student’s own
work. Penalties for violation of the policy range from
zero marks for the component assessment to
expulsion, depending on the nature of the
offense. When in doubt, students should consult the
instructors of the course. Details on the SMU Code of
Academic Integrity may be accessed
at http://www.smuscd.org/resources.html.
SMU Classification: Restricted
Lecture 1
• Introduction
- Chapter 1 (In particular, 1.9, 1.10, 1.12)
• Accounting under Ideal Conditions
- Chapter 2
• After this course, you should be able to:
 Understand the two types of information asymmetry problems
and explain them using examples
 Explain the role of information and financial reporting in the
financial market
 Understand the concept of ideal conditions, explain why these
conditions are unlikely to hold in reality, and the implications of
non-existence of ideal conditions
SMU Classification: Restricted
The Big Picture of The Course
SMU Classification: Restricted
Ideal Conditions
• What are the ideal conditions
- Perfect and complete markets
- No information asymmetry
- Accounting reports in this setting are both relevant and
reliable.
(Note: Perfect markets are when every party in the economy has the
same information or can obtain information without any costs; complete
markets are when anything that anyone cares about can be sold.)
• This is the first-best setting
- as we will see, a setting where there is little role for accounting
standards.
SMU Classification: Restricted
Information Asymmetry
• Relax ideal assumptions  information relevant to evaluate the
firm is not costlessly available.
• Two potential issues:
- Adverse Selection:
• One or more parties to a business transaction, or potential transaction,
have an information advantage over other parties
• Buyers (e.g.. Investors) do not have the information necessary to
separate good from bad products (e.g., firm shares)
- Moral Hazard:
• One or more parties to a contract can observe their action in fulfillment
of the contract but other parties cannot
SMU Classification: Restricted
SMU Classification: Restricted
Adverse Selection - Intuitions
• Nike Panda Shoes…where to buy them??
• Assuming that I have no way of distinguishing authentic items ($250) from
counterfeits ($120), what is likely to happen in an online auction?
 I will bid no more than $185 (0.5*250+0.5*120) for a pair of these shoes.
 Only sellers of counterfeits will list their items since the authentic sellers
will incur a loss.
 This is the consequence of the adverse selection issue (aka lemons
problem by economics Akerlof 1970)
• What can be done to circumvent this problem?
 Voluntarily provide more information!! (e.g. pictures, ratings,
descriptions, guarantees, etc.)
SMU Classification: Restricted
Adverse Selection in Capital Markets
• Implication of adverse selection in capital markets
- Investors cannot distinguish good firms from bad
firms
- Investors either walk away from the investment or
apply deep price discount
- Only bad firms remain in the market, leading to
market collapse
• How to mitigate the adverse selection problems in
capital markets?
SMU Classification: Restricted
Moral Hazard - Intuitions
• Un-observability of actions
• Consequences of moral hazard problems
- How hard would the seller attempt to satisfy the buyer’s
requests if they know they will get S$185 regardless? (e.g.
no exchanges or refunds)
- Moral hazard can lead to the problem that a party insulated
from risk may behave differently from the way it would
behave if it were fully exposed to the risk.
• What are some other examples of moral hazard?
SMU Classification: Restricted
Exercise: Read the case and identify the moral hazard problems
SMU Classification: Restricted
Moral Hazard in Capital Markets
• Implication of moral hazard in capital markets
- Investors would like managers to behave in investors’ best
interest
- Investors cannot observe managers' effort
- Managers may shirk or steal
• How to mitigate the moral hazard problems in capital markets?
SMU Classification: Restricted
Role of Financial Reporting
in a Market Economy
• Control adverse selection (Information role)
Convert inside information into outside information
Provide more useful information to investors
• Control moral hazard (Stewardship role)
Accounting reports can be used in contracts
SMU Classification: Restricted
The Role of Accounting Standards
• The demand for regulation
- Market failures
• The challenge
It does not take too much reflection to conclude that
the conflicting objectives of accounting reports used in
the adverse selection setting versus the moral hazard
setting creates difficult challenges for accounting
policy-makers.
 the most reliable numbers are better for
contracting, but they do not provide relevant
information needed to address the adverse
selection problem.
SMU Classification: Restricted
Accounting under Ideal Conditions
• Concepts of ideal conditions
• Financial statements under ideal conditions
• Current value-based accounting
- value-in-use, such as the discounted future cash flows;
(Think of value-in-use as the present value of the firm)
- fair value, which refers to exit price or opportunity cost (i.e., the
amount the firm receives if the asset is disposed of)
(Think of fair value as the market price of the firm)
SMU Classification: Restricted
Concept of Ideal Conditions


With Certainty:

Future cash flows are known

Discount rates are known
If Uncertain, we also know:

Possible states of nature

Probabilities of states

Ex post realization of the state is publically
observable

Fixed interest rates
SMU Classification: Restricted
Financial Statements in this Setting
 How to prepare financial statements:

Assets/liabilities = the present value of future cash
flows

Net income: the accretion of discount + abnormal
earnings
- Reflects the change in shareholders’ equity
- Accretion of discount (expected income) =
opening balance x interest rate
SMU Classification: Restricted
Under Ideal
Example of F/S Under Certainty
• Assume SMU Ltd., a one-asset firm with no liabilities
will generate end-of-year cash flows of $150 each year
for two years and then will have zero value. Assume
interest rate in the economy is 10%.
 What is the present value of the firm at t=0? Assets?
S/E?
Both Asset and S/E are $263 (S/E = Assets because no liabilities)
Asset = 150/(1+10%)^1 + 150/(1+10%)^2 = $260.33
 What is net income at t=1?
SE1 - SE0 = $286-$260 = $26
Net Income when t=1, $260.33 * 10% = $26.03
 What is the present value of the firm at t=1? Assets?
S/E?
Revenue $150
Expense ($176)
Net Profit ($26)
FV of Assets at t=1 = 150/(1+10%) = $136
Add: Cash received of $150
Total Assets at t=1, $136+$150=$286
SE is $286 at t=1
Net Income is the change in FV growth/ change in Shareholder Equity
SMU Classification: Restricted
Example of F/S Under Uncertainty
• Assume the same interest rate as before, except now
there are two states. In the good state, cash flows are
$200, and in the bad state, cash flows are $100.
Assume the probability of each state is 50%.
 What is the present value of the firm at t=0? Assets?
S/E?
Same as above
 Is the market value also the same?
Same as above
 What is net income at t=1?
Good State: Net Income at t1 = $260.33*10% + ($200-$150) = $76.03
Bad State: Net Income at t1 = $260.33*10% + ($100-$150) = ($23.97)
 What is the present value of the firm at t=1? Assets?
S/E?
Good State: $136+$200=$336
SMU Classification: Restricted
Financial Statements in this Setting
 Characteristics of financial statements:

F/S are relevant and reliable
•

Accounting information reflects the firm’s future
performance and nobody can lie about as they
have the same information.
Net income has no information content beyond B/S
•
Everyone can calculate based on the value of
shareholders and interest rate.
SMU Classification: Restricted
Evaluation of the Assumptions of “Ideal Conditions”
 Which of these assumptions are realistic?
Can we know:
-
Future cash flows?
-
Discount rates?
-
States of nature & probabilities?
-
Ex post realization of the state?
None of these assumptions are realistic (meaning we are able to predict and determine accurately
SMU Classification: Restricted
Lack of Ideal Conditions

Incomplete markets


Reasons for Incompleteness

thin markets

information asymmetry
Lots of trader and if there is a lot of information
aysmettry, easy to not get complete details
and loss out in information
Significance of incomplete markets

Cannot always use market value as proxy for
can ascertain the discount rate (almost all information) if you cannot
present value Only
get clear information (meaning different people have different estimations)

If there’s no market value, then we will have to
estimate the present value
If we have to estimate the present value, then everyone’s estimates
of the present value of assets and thereafter net income are likely
to be different.
SMU Classification: Restricted
Implications of the 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/price of future sales and purchases
•
timing of future transactions
Need to estimate (subjective) probabilities of future state
realizations
•

These probabilities are usually subjective
Estimates are subject to error and bias
Have to rely on estimates of (future cash flows, discount rate etc) in an incomplete market
As such, these estimates may not be 100% accurate due to a lack of information
SMU Classification: Restricted
Relevance - Reliability
Trade off relevance of estimates for reliability

The fundamental tradeoff in accounting

Relevant information: informative about future firm
performance More relevant information requires more estimations, leading to less reliable data

Reliable information: complete (i.e., nothing left
out); free from material error and bias

Greater relevance requires more estimates

But, more estimates decrease reliability

How are these two qualitative characteristics
illustrated in the historical cost vs. fair value
Value is more relevant than historical cost as the fair value is the
frameworks? Fair
current value NOW but historical cost is based on information from the past

What is the measurement model used for financial
reporting? Historical cost, fair value, or mixed
but subjective, due to perfect ideal conditions, fair value would
(examples)?
be more reliable than historical cost. but historical cost would be
useful in determining depreciation etc
Eg, if i were to account for revenue using revenue recognition
- i would recognise revenue when service/goods has been delivered/rendered and revenue has been earned
- if i wany my revenue to be reliable, then i would wait until i collect the revenue
- but this number may not be so relevant as the sale has already been completed and is less relevant
Hence, if i want a reliable estimate, I must make assumptions about collectability of my AR
Currently, we use both a mix model for
- inventory (historical/ fair value)
- intangible (fair value)
- stationery (historical)
SMU Classification: Restricted
Non-existence of True Net Income


Implications of lack of ideal conditions

“True” economic income does not exist outside the
ideal setting.

Why?
Under non-ideal conditions, our subjective estimations will result in no "true" net income
Implications of this for accountants

Accountants are not needed if true net income does
exist because everyone can obtain a concensus on the true net income under ideal conditions

Judgement is required to estimate net income
SMU Classification: Restricted
Takeaways and reflections
•
•
“True” economic income does not exist outside the
ideal setting (reasons).
-
“True” economic income is defined as an objective
income number that everyone agrees on.
-
Judgement is required to estimate net income.
Accountants are not needed if true net income does
exist.
-
•
Net income provided by firms reflect managers’
estimate of firm performance and can have value
relevant information to investors
Which concepts we learnt today are useful to you? Any
other comments?