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

• Assumptions

– Known future cash receipts

– Given interest rate

• Basis of accounting

– Present value

• Income recognition

– As changes in present value occur

2.2 Ideal Conditions of Certainty

• 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

2.3 Ideal Conditions of Uncertainty

• 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

2.2 Ideal Conditions of Certainty

What Is The Difference?

• What is the difference between using current value and

historical value?

• 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”

What Is The Difference?

• Basis of accounting

– Expected present value

• Income recognition

– As changes in expected present value occur

2.3 Ideal Conditions of Uncertainty

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

• 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

• 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 Implications

• Greater relevance requires more estimates

• But, more estimates decrease reliability

• Relevance and reliability must be traded off

– See next slide

Lack of Ideal Conditions Conclusions

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

• 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?

2.5 Historical Cost v Current Value Accounting

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

• Implications for accountants

– Accountants not needed if true net income did exist

– Judgement required to estimate net income

– Judgement is essence of a profession

2.6 The Non-Existence of True Net Income