LectuACCT 332 AccountingACCT 332 Accounting

Accounting Under

- Chapter 2p

ure 2g Thought and Practiceg Thought and Practicer Ideal Conditions

Objectives for

What are ideal conditions

Ch t i ti f F/S h Characteristics of F/S whe

Accounting under non-ide

Reserve Recognition Acc

Non-existence of true net

Todays Class

s?

id l diti ten ideal conditions are met

eal conditions

counting

t income

Concept of Ide

With Certainty:

F t h fl k Future cash flows are k

Discount rates are know

If Uncertain, we also know

Possible states of natu

Probabilities of states

Ex post realization of thobservable

Fixed interest rates

eal Conditions

kknown

wn

w:

re

he state is publically

Amos LimIdeal 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.

However, there could still be uncertainty.

E.g. it is going to rain tomorrow (100% certainty) - Ideal with Certainty

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

Amos LimOne 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.

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Financial Stateme

How to prepare finan Assets/liabilities = the p

flows

Net income: the accretioearnings

Reflects the change i- Reflects the change i

- Accretion of discount raterate

ents in this Setting

ncial statements:present value of future cash

on of discount + abnormal

n shareholders eq itn shareholders equity

= opening balance x interest

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Example of F/S

Assume SMU Ltd., a one-will generate end-of-yearwill generate end of year for two years and then wilinterest rate in the econom

What is the present valS/E?

What is net income at t

What is the present valS/E?

Under Certainty

-asset firm with no liabilities cash flows of $150 each yearcash flows of $150 each year l have zero value. Assume

my is 10%.

ue of the firm at t=0? Assets?

=1?

ue of the firm at t=1? Assets?

Amos Lim150 / (1.1) + 150 / (1.1 ^ 2) = 260.33

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

Amos LimPV = 150 + 150 / (1.1) = 286.36Alternatively, 260.33 + 26.03 = 286.36

Amos LimDone

Example of F/S U

Assume the same interestthere are two states In thethere are two states. In the$200, and in the bad stateAssume the probability of

What is the present valS/E?

Is the market value a

What is net income at t

What is the present valS/E?

Under Uncertainty

t rate as before, except now e good state cash flows aree good state, cash flows are e, cash flows are $100. each state is 50%.

ue of the firm at t=0? Assets?

also the same?

=1?

ue of the firm at t=1? Assets?

Amos Lim200 (0.5) + 100 (0.5) = 150PV = 150 / 1.1 + 150 / (1.1 ^ 2) = 260.33

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

Amos LimBad 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

Amos LimAssuming everyone is rational, risk-averse individuals, the market value will equal the present value.

Amos LimDone

Financial Stateme

Characteristics of fin F/S are relevant and rel

Net income has no infor

Dividends are irrelevant

ents in this Setting

nancial statements:iable

rmation content beyond B/S

t

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Evaluation of the Assump

Which of these assumCan we know:

- Future cash flows?- Discount rates?

States of nature & p- States of nature & p- Ex post realization o

ptions of Ideal Conditions

mptions are realistic?

probabilities?probabilities?of the state?

Amos LimWe may be able to lock down the interest rate, but we may not all agree on the same discount rate.

Amos LimFCFs subject to too many factors, not possible to know exactly beforehand

Amos LimToo many factors, not possible to know exactly beforehand

Amos LimBiased/inaccurate financial reporting.

Lack of Idea

Q Incomplete markets

Si ifi C t l Significance: Cannot alwproxy for present value

Q Reasons for IncompleteneQ Reasons for Incompletene

thin markets

i f ti t information asymmetry

al Conditions

k t lways use market value as

essess

Amos LimComplete 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

Amos LimMarkets with low trade volumes

Amos LimCan discourage trade of assets

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Implications of the La

Q Estimates needed to apply cuF t t t li ti Future state realizations maleading to need for estimate quantities/price of futurequantities/price of future timing of future transactio

Need to estimate (subjectiv Need to estimate (subjectivrealizations These probabilities are u

Estimates are subject to err

ack of Ideal Conditions

rrent value accountingt b tl kay not be currently known,

es of sales and purchasessales and purchases

onse) probabilities of future statee) probabilities of future state

usually subjectiveror and bias

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Relevance

Q The fundamental tradeoff Relevant information: in Relevant information: in

performance Reliable information: re Reliable information: re

from bias

Greater relevance requ

But, more estimates de

Q How are these two qualitaqillustrated in the historicalframeworks?

- Reliability

f in accountingnformative of future firmnformative of future firm

epresentationally faithful; freeepresentationally faithful; free

uires more estimates

ecrease reliability

ative characteristics l cost vs. fair value

Amos LimText

Amos LimHistorical: Low relevance, high reliabilityFair Value: High relevance, low reliability

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Reserve Recog

An application of present vconditions do not existconditions do not exist

SFAS 69 of FASBA li t d Applies to proved reserv

Discounted at mandated

Revenue recognized as

Uses oil & gas prices as

- Not when expected to

Management critiques of S

gnition Accounting

value accounting when ideal

lves only

d rate of 10%

reserves are proved

s at end of period

be sold

SFAS 69?

Amos LimProved: Reasonable (>75%) certainty that under the current economic, operating and regulatory conditions, that the reserve will be able to generate FCFs

Amos LimLogically 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.

Amos LimThis is in footnotes (additional disclosure), not BS.

Amos LimUsing prices at end of period makes little sense, due to hedging, prices rising due to inflation, etc.

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

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Non-existence of

Q Implications of lack of idea

T i i True economic incomideal setting.

Why? Why?

I li ti f thi fQ Implications of this for acc

Accountants are not neexistexist

Judgement is required t

True Net Income

al conditions

d t i t t id the does not exist outside the

t tcountants

eeded if true net income does

to estimate net income

Amos LimUnable 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.

Amos LimIn other words, accountants are needed to estimate net income.

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Group Q

40 minutes to complete gr A i t f di i Assignment of discussion Notes allowed but no lapto

Questions

roup questions

l di-leading groups

ops