CCOUNTING UNDER IDEAL CONDITIONS

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2

Copyright © 2015 Pearson Canada Inc.

7

CHAPTER 2

A

CCOUNTING UNDER IDEAL CONDITIONS

2.1 Overview 2.2 The Present Value Model Under Certainty

2.2.1 Summary

2.3 The Present Value Model Under Uncertainty

2.3.1 Summary

2.4 Examples of Present Value Accounting

2.4.1 Embedded Value

2.4.2 Reserve Recognition Accounting (RRA)

2.4.3 Critique of RRA

2.4.4 Summary of RRA

2.5 Historical Cost Accounting Revisited

2.5.1 Comparison of Different Measurement Bases

2.5.2 Conclusion

2.6 The Non- Existence of True Net Income 2.7 Conclusion to Accounting Under Ideal Conditions L

EARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

• To Appreciate the Concept of Ideal Conditions

This concept is drawn on throughout the book. Roughly speaking, by ideal conditions I mean conditions where future firm cash flows and interest rates are known with certainty or, if not known with certainty, where there is a complete and publicly known Financial Accounting Theory Canadian 7th Edition Scott Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2

Copyright © 2015 Pearson Canada Inc.

8 set of states of nature and associated objective probabilities which enables a completely relevant and reliable expected present value of the firm to be calculated.I assume risk- neutral investors in this Chapter, so that valuation of the firm is on the basis of expected present value, that is, no adjustment for risk is needed. The concept of a risk-averse investor is introduced in Section 3.4, and a capital asset pricing model of the firm’s shares is described in Section 4.5.

• To Use the Present Value Model Under Ideal Conditions to Prepare an

Articulated Set of Financial Statements for a Simple Firm The text limits itself to financial statements for the first year of operations. The problem material extends the accounting to a subsequent year (see problems 1, 2, 3, 5, 15, and 19). In subsequent years, the firm earns interest on opening cash balance. This is picked up by the accretion of discount calculation, since cash is included in opening net assets. Interest earned on cash balances leads naturally to the role of dividends in present-value accounting and the concept of dividend irrelevance.

• To Critically Evaluate Reserve Recognition Accounting (RRA) as an

Application of the Present Value Model I usually allow some class time to criticize the assumptions of ideal conditions. Some students want to “blow off steam” because they perceive these assumptions as quite strong. I find that RRA is an excellent vehicle both to motivate and critique present value- based accounting. The fact that it is on line encourages students to take the present value model seriously, which I emphasize by basing class discussion on an example of RRA disclosure for a Canadian oil and gas firm that also reports to the SEC.Such disclosures are usually in SEC Form 40-F, not in the annual report (which says something about management’s view of RRA).I also emphasize the point that present value-based accounting products run into severe implementation problems when the ideal conditions they need do not hold.

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2

Copyright © 2015 Pearson Canada Inc.

9 I sometimes receive comments that the text over-emphasizes RRA. I find RRA so helpful to illustrate numerous course concepts that I have resisted such comments.However, instructors may wish to emphasize that RRA, based on a United States accounting standard, is relevant to Canadian oil and gas firms whose shares are traded in the United States. In this regard, it is worth noting that Husky Energy Inc., used as the text RRA illustration in Section 2.4.2, is a Canadian-based corporation.

• Historical Cost Accounting in the Mixed Measurement Model

Instructors may wish to discuss historical cost accounting in relation to current value accounting, since historical cost is still an important component of the mixed measurement model. Section 2.5 compares these measurement bases in terms of relevance and reliability, timing of revenue recognition, recognition lag, and matching.This is a good place to emphasize the trade-off between relevance and reliability, and how different measurement bases imply different trade-offs.This is also a good place to discuss the relative importance of the balance sheet and income statements under the two measurement bases. That is, historical cost accounting takes the view that the income statement is of greater importance because it gives the current installment of the firm’s earning power, and provides a place to start to predict future firm performance. Under current value accounting, the balance sheet is of greater performance, the argument being that current values of assets and liabilities provides a better prediction of future firm performance.

• To Question the Existence of Net Income as a Well-Defined Economic

Construct I use the reliability problems of RRA to question the existence of “true” economic income except under ideal conditions. With the text example, or some other example, of RRA disclosure in front of us, I ask the students if they would be willing to pay the RRA value for the proved reserves of an oil and gas company. Discussion usually brings out a negative response, for reasons such as difficulties in assessing expected quantities

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2

Copyright © 2015 Pearson Canada Inc.

10 and prices, disagreement with a 10% discount rate, possible inside information about costs, additional reserves, etc.I then point out that there are numerous other assets and liabilities for which a quoted market price does not exist, and argue that information asymmetry is a major reason why market prices may not exist. The market for used cars and problems surrounding insurance markets in the presence of adverse selection and moral hazard provide other examples of “missing” markets.Having established that there are not quoted market prices available for “everything,” I point out that it is then impossible to fully value a firm on this basis and, as a result, it is also impossible to measure true economic income. I take a sort of perverse pleasure in asking those students who are heading for a professional accounting career if they really want to devote their lives to measuring something which does not exist. I am careful to end on an upbeat note, however, by pointing out that lack of a true measure of income means that a large amount of judgement is required to come up with a useful measure, and that judgement is the basis of a profession.I usually do not go further than the above intuitive argument that incomplete markets are at the heart of problems of income measurement. However, instructors who wish to dig into incompleteness more deeply and precisely can assign Beaver & Demski’s “The Nature of Income Measurement” (The Accounting Review, January, 1979).