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Lectu

ure 2
ACCT 332 Accounting
g Thought and Practice
Accounting Underr Ideal Conditions
- Chapter
p 2

Objectives for Todays Class


What are ideal conditionss?
Ch
Characteristics
t i ti off F/S whe
hen ideal
id l conditions
diti
are mett
Accounting under non-ide
eal conditions
Reserve Recognition Acccounting
Non-existence of true nett income

Concept of Ide
eal Conditions
With Certainty:
F t
Future
cash
h flows
fl
are known

Ideal Conditions: Probabilities of the states,


and the future cash flows, are known. No
information asymmetry, or other barriers to
fair and efficient workings of the market.

Discount rates are know


wn

However, there could still be uncertainty.

If Uncertain, we also know


w:
Possible states of nature

E.g. it is going to rain tomorrow (100%


certainty) - Ideal with Certainty
it might rain tomorrow (50% certainty) Ideal with Uncertainty

Probabilities of states
Ex post realization of th
he state is publically
observable
Fixed interest rates

One interest rate means simply that everyone agrees on the same
base interest rate (w/o premiums), not that there is only one
interest rate in the economy.

Financial Stateme
ents in this Setting

How to prepare finan


ncial statements:
Assets/liabilities = the present
p
value of future cash
flows
Net income: the accretio
on of discount + abnormal
earnings
- Reflects the change in shareholders eq
equity
it
- Accretion of discount = opening balance x interest
rate

Done

Example of F/S Under Certainty

Assume SMU Ltd., a one--asset firm with no liabilities


will generate end-of-year
end of year cash flows of $150 each year
for two years and then will have zero value. Assume
interest rate in the econom
my is 10%.
What is the present value of the firm at t=0? Assets?
S/E?
150 / (1.1) + 150 / (1.1 ^ 2) = 260.33

What is net income at t=1?


Accretion of discount: 260.33 * 0.1 = 26.03
Abnormal earnings: 0
Net Income: 26.03 + 0 = 26.03

What is the present value of the firm at t=1? Assets?


S/E?
PV = 150 + 150 / (1.1) = 286.36
Alternatively, 260.33 + 26.03 = 286.36

Done

Example of F/S Under


U
Uncertainty

Assume the same interestt rate as before, except now


there are two states
states. In the
e good state,
state cash flows are
$200, and in the bad state
e, 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?
Is the market value also
a
the same?

200 (0.5) + 100 (0.5) = 150


PV = 150 / 1.1 + 150 / (1.1 ^ 2) = 260.33

What is net income at t=1?


Bad year: 260.33 * 0.1 + (- 50) = - 23.97
Good year: 260.33 * 0.1 + (50) = 76.03
Expected Net Income: (- 23.97 + 76.03) (0.5) = 26.03 (the same)

What is the present value of the firm at t=1? Assets?


S/E?
Assuming everyone is rational, riskBad year: 150 / 1.1 + 100 = 236.36 (260.33 - 23.97)
Good year: 150 / 1.1 + 200 = 336.36 (260.33 + 76.03)
PV = 50% * (236.36 + 336.36) = 286.36

averse individuals, the market value


will equal the present value.

Financial Stateme
ents in this Setting

Characteristics of fin
nancial statements:
F/S are relevant and reliable
Net income has no inforrmation content beyond B/S
Dividends are irrelevantt

Evaluation of the Assump


ptions of Ideal Conditions
Which of these assum
mptions are realistic?
Can we know:
FCFs subject to too many factors, not possible to
know exactly beforehand

Future cash flows?

may be able to lock down the interest rate, but we may not
Discount rates? We
all agree on the same discount rate.

Too many factors, not possible


States of nature & probabilities?
p
to know exactly beforehand

financial
Ex post realization of
o the state? Biased/inaccurate
reporting.

Lack of Idea
al Conditions
Incomplete markets

Complete Markets: Market value for every asset is known; there


is a market for anything that anyone cares about.
Perfect Markets: No frictions, no opportunities for arbitrage, no
info asymmetry

Significance:
Si
ifi
Cannot
C
t alw
lways use market
k t value
l as
proxy for present value
Reasons for Incompletene
ess
thin markets

Markets with low trade volumes

i f
information
ti asymmetry
t

Can discourage trade of assets

Implications of the La
ack of Ideal Conditions
Estimates needed to apply current value accounting
Future
F
t
state
t t realizations
li ti
ma
ay nott be
b currently
tl known,
k
leading to need for estimate
es of

quantities/price of future sales and purchases

timing of future transactio


ons

Need to estimate (subjective) probabilities of future state


realizations

These probabilities are usually


u
subjective

Estimates are subject to errror and bias

Relevance - Reliability
Text

The fundamental tradeofff in accounting


Relevant information: in
nformative of future firm
performance
Reliable information: re
epresentationally faithful; free
from bias
Greater relevance requ
uires more estimates
But, more estimates de
ecrease reliability
How are these two qualita
q
ative characteristics
illustrated in the historicall cost vs. fair value
frameworks?
Historical: Low relevance, high reliability
Fair Value: High relevance, low reliability

Reserve Recog
gnition Accounting
An application of present value
v
accounting when ideal
conditions do not exist
SFAS 69 of FASB

This is in footnotes
(additional disclosure), not Proved: Reasonable (>75%) certainty
BS.
that under the current economic, operating
and regulatory conditions, that the reserve
will be able to generate FCFs

A li tto proved
Applies
d reservves only
l

Discounted at mandated
d rate of 10%
Revenue recognized as reserves are proved
Uses oil & gas prices ass at end of period
- Not when expected to be sold
Management critiques of SFAS
S
69?

Logically too high (e.g.


for oil, which is highly
linked to inflation, 10%
is way too high). Set at
this rate for
comparability and
conservatism.

Using prices at end of period makes little


sense, due to hedging, prices rising due to
inflation, etc.

The information provided is likely to not be reliable. However, it has relevance

Non-existence of True Net Income


Implications of lack of idea
al conditions
True economic
T
i iincome does
d
nott exist
i t outside
t id th
the
ideal setting.
Why?

Unable to know future cash flows and their probabilities. Therefore


need to make subjective estimates prone to error and bias. Tradeoff
encountered between relevance and reliability of estimates made.

I li ti
Implications
off thi
this ffor acccountants
t t
Accountants are not ne
eeded if true net income does
exist
Judgement is required to
t estimate net income
In other words, accountants are needed to estimate net income.

Group Questions
Q

40 minutes to complete grroup questions


A i
Assignment
t off discussion
di
i -leading
l di groups
Notes allowed but no lapto
ops

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