Financial Accounting Theory Seventh Edition William R. Scott Chapter 2 Accounting Under Ideal Conditions Main Ideas For Chapter 2 • Focus is on the “Ideal Conditions” box on the left • Under “Ideal Conditions” we know for certain what would happen • BUT we have 2 types of “Ideal Conditions” – Absolute certainty = 100% certainty of everything – Probability certainty – see next page Main Ideas For Chapter 2 • What is probability certainty? • When we are uncertain, we are uncertain of one or both things: – Probability (= chance of something happening) – Amount (= how much if it happens) • What if we know FOR CERTAIN the PROBABILITIES and the AMOUNTS? – e.g. for certain - 50% prob revenue of $500, 50% prob revenue of $1,500 => what does it mean? – On AVERAGE I am very certain that I will get $1,000 – But FOR EACH TIME I am NOT sure if $500 or $1,500 Main Ideas For Chapter 2 • Two types of “Ideal Conditions” studied here: • Absolute certainty - we know EVERYTHING EXACTLY • e.g. $1,000 of revenue for certain • What accounting numbers should we use? • Probability certainty - we know FOR CERTAIN the PROBABILITIES and the AMOUNTS? • e.g. for certain - 50% prob revenue of $500, 50% prob revenue of $1,500 • What accounting numbers should we use? Main Ideas For Chapter 2 • Absolute certainty or probability certainty • What if we know EVERYTHING EXACTLY? => IF know everything exactly, then current value • What if we only know FOR CERTAIN the PROBABILITIES and the AMOUNTS? => Then RELEVANT vs RELIABLE in deciding => Current value or historical cost? => Depends on many things = problems we face 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 2.3 Ideal Conditions of Uncertainty • Assumptions – States of nature • The set of possible states of nature is publicly known • State realization publicly observable – State probabilities • objective • publicly known – Given interest rate >> Continued 2.2 Ideal Conditions of Certainty • Basic information – Company buys one asset with annual revenue of $1,000, asset has five year life – Shareholder paid cash to buy shares to purchase this asset – Dividend of $40 from year 3 onwards – Interest rate of 10% – No depreciation or salvage value 2.2 Ideal Conditions of Certainty • What is the purchase price / value of the asset today? • Same as the present value of the cash flow over its life • Present value of a $1,000 annuity for five years at discount rate of 10% = $3,791 2.2 Ideal Conditions of Certainty • So shareholder paid cash of $3,791 to the company to buy its share • The company then use this cash to buy the asset (at time = 0) • What happens in the first year? 2.2 Ideal Conditions of Certainty • What is the value of the asset at the end of Year 1? = $3,170 Year 2? = $2,487 Year 3? = $1,736 Year 4? = $909 Year 5? = $0 • What happens in the second to fifth year? • How about the $30 dividends to be paid starting year 3? 2.2 Ideal Conditions of Certainty • How about the 2nd scenario of only having probability certainty => for certain - 50% prob revenue of $500, 50% prob revenue of $1,500 What Is The Difference? • What is the difference between using current value and historical value? What Is The Difference? • For current value accounting => balance sheet approach (value of asset show on BS) => income statement not as important because showing value change = “measurement perspective” • For historical cost accounting => income statement approach (sold and gain shown here) => balance sheet not as important because unrealized gains and losses not shown there = “information perspective” 2.3 Ideal Conditions of Uncertainty • Basis of accounting – Expected present value • Income recognition – As changes in expected present value occur 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? 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 Lack of Ideal Conditions • Incomplete markets – Definition? – Significance • Cannot always use market value as proxy for present value • Reasons for Incompleteness – thin markets – information asymmetry Lack of Ideal Conditions Implications • 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 Lack of Ideal Conditions Conclusions • Greater relevance requires more estimates • But, more estimates decrease reliability • Relevance and reliability must be traded off – See next slide Relevance v. Reliability Tradeoff 2.5 Historical Cost v Current Value Accounting • Different tradeoffs between – – – – Relevance and reliability Timing of revenue recognition Recognition lag Matching of costs and revenues >> Continued 2.5 Historical Cost v Current Value Accounting • The mixed measurement model – Current value accounting for • • • • Accounts receivable Financial instruments Accounts payable Post-retirement benefits – Historical cost accounting for • Inventory • Property, plant & equipment • Purchased goodwill – Why different bases of accounting for different financial statement items? 2.6 The Non-Existence of True Net Income • Why? – Incomplete markets – Reasons for incompleteness • thin markets – As for oil and gas reserves • information asymmetry – Too much asymmetry, no market develops – If no market value, cannot use market value as proxy for present value – If have to estimate present value, true net income does not exist >> Continued 2.6 The Non-Existence of True Net Income • Implications for accountants – Accountants not needed if true net income did exist – Judgement required to estimate net income – Judgement is essence of a profession