1. © 2006 Pearson Education Canada Inc.2-1 Chapter 2 Accounting Under Ideal Conditions

2. © 2006 Pearson Education Canada Inc.2-2 Ideal Conditions of Certainty Assumptions –Known future cash receipts –Given interest rate Basis of Accounting –Present value

3. © 2006 Pearson Education Canada Inc.2-3 Ideal Conditions of Certainty, Cont’d Income Recognition –As changes in present value occur

4. © 2006 Pearson Education Canada Inc.2-4 Ideal Conditions of Uncertainty Assumptions –States of nature Known set Realization publicly observable –State probabilities objective publicly known –Given interest rate

5. © 2006 Pearson Education Canada Inc.2-5 Ideal Conditions of Uncertainty, Cont’d Basis of Accounting –Expected present value Income Recognition –As changes in expected present value occur

6. © 2006 Pearson Education Canada Inc.2-6 Ideal Conditions of Uncertainty- Example You pay $100 to a bank to buy a 2-year investment which pays in each year $73.02 with prob. = 0.5 and $33.02 with prob. = 0.5. The interest rate in the economy is 4%.

7. © 2006 Pearson Education Canada Inc.2-7 Example, Cont’d PA 0 = [.5(73.02) +.5(33.02)]/1.04 + [.5(73.02) +.5(33.02)]/(1.04) 2 = (36.51 + 16.51)/1.04 + (36.51 + 16.51)/(1.04) 2 = 53.02/1.04 + 53.02/1.0816 = 50.98 + 49.02 = $100.00 NB: Risk-Neutral Valuation

8. © 2006 Pearson Education Canada Inc.2-8 Example, Cont’d Assume at End of Year 1, you Receive $73.02 –PA 1 = 73.02 + [.5(73.02) +.5(33.02)]/1.04 = 73.02 + 50.98 = $124

9. © 2006 Pearson Education Canada Inc.2-9 Example, Cont’d Net Income for the Year –Sales less amortization format 73.02 - (100 - 50.98) = 73.02 - 49.02 = $24 –Alternative format 100 x.04 + (24 - 4) = 4 + 20 = $24 –Change in balance sheet net assets 124 - 100 = $24

10. © 2006 Pearson Education Canada Inc.2-10 Lack of Ideal Conditions Problems when conditions not ideal –State probabilities are subjective, not objective –Incomplete markets Definition of Incompleteness Reasons for Incompleteness –thin markets –information asymmetry

11. © 2006 Pearson Education Canada Inc.2-11 Implications of Lack of Ideal Conditions Need for Estimates (quantities, prices, timing) of states of nature Need for Estimates of State Probabilities Market Value Need Not Equal Present Value True Net Income Does Not Exist

12. © 2006 Pearson Education Canada Inc.2-12 Implications of Lack of Ideal Conditions, Cont’d. Relevance and Reliability Must be Traded Off (next slide ) Historical Cost Accounting a Better Tradeoff? –Relevance of historical cost accounting? –Reliability of historical cost accounting?

13. © 2006 Pearson Education Canada Inc.2-13 Relevance v. Reliability Tradeoff

14. © 2006 Pearson Education Canada Inc.2-14 Fair Value Accounting Implementing Accounting Under Ideal Conditions when Ideal Conditions do not Exist Meaning of “Fair Value” – Present value approach – Market value approach – Model-based approach E.g., option pricing models

15. © 2006 Pearson Education Canada Inc.2-15 Reserve Recognition Accounting An Application of Present Value Accounting When Ideal Conditions do not Exist –Proved reserves –Discounted at mandated rate of 10% –Revenue recognized as reserves are proved –Major adjustments to previous estimates

16. © 2006 Pearson Education Canada Inc.2-16 Reserve Recognition Accounting, Cont’d Relevance of RRA information? Reliability of RRA information? Management’s Reaction to RRA –Concern about relevance and reliability –Concern about legal liability

17. © 2006 Pearson Education Canada Inc.2-17 Asset Valuation is Equivalent to Income Recognition Proved reserves valued at present value  income recognized as reserves are proved Proved reserves valued at cost  income recognized as reserves are sold

18. © 2006 Pearson Education Canada Inc.2-18 The Challenge of Historical Cost Accounting Amortization of Capital Assets –Consider earlier example Straight-line amortization Net Income: 73.02 - 100/2 = 73.02 - 50 = $23.02 Sum of years digits amortization Net Income: 73.02 - 2/3 x 100 = 73.02 - 67 = $6.02 Little theoretical basis to choose between different ways of accounting for the same thing. Relevance? Reliability?