Module 1 summary
Outline of the course and update on recent developments
This module begins with an outline of the course as given in Chapter 1, with particular attention to the structure of accounting standard setting bodies and the concept of due process. You should be aware of the structure of standard setting, since standard setting comes up many times in the course.
The module also provides an outline of important events leading up to the market meltdowns beginning in 2007, since these events have several important implications for accountants and are not discussed specifically in Section 2.1 in the text.
Accounting under ideal conditions
This module defines the concepts of ideal conditions and illustrates preparation of financial statements when ideal conditions hold. Balance sheet values are on the basis of expected present values of future cash receipts from assets and liabilities. Net income is composed of accretion of discount on opening net assets, plus or minus any deviation of actual cash flows for the period from expected cash flows. Reserve recognition accounting (RRA) for oil and gas companies is used to illustrate the challenges of present value accounting when ideal conditions do not hold. The concepts of relevance and reliability of financial statement information are reviewed, and the reliability problems of RRA are explained.
Historical cost-based accounting is analyzed in terms of relevance and reliability, revenue recognition, recognition lag and matching. It provides a trade-off of these characteristics, between the extremes of current value accounting and cash flow accounting. Despite the moves by accounting standard setters toward increased use of current values, accounting for several important classes of assets and liabilities remains based on historical costs.
Explain the concept of due process and understand how the structure of accounting standard setting bodies attains due process.
- This module begins with an outline of the structure of the course (text, Chapter 1), with particular attention to the concept of due process in standard setting. Due process is essential if reasonable compromises between the interests of investors and managers in standard setting are to be attained.
Review recent development relevant to financial accounting.
Implications for financial accounting of Enron and World.com scandals and the current market collapse:
- Off-balance sheet activities should be fully reported, since they can encourage excessive risk taking by management.
- Reporting must be transparent, so that investors can properly value assets and liabilities.
- Fair value accounting may understate value-in-use when markets collapse, and therefore lead to management objection.
Define the concept of ideal conditions and outline the necessary assumptions that underlie the definition.
- Ideal conditions exist under conditions of certainty when
- the future cash flows of the firm are publicly known with certainty
- the single interest rate in the economy is given and publicly known
- Ideal conditions are then extended to conditions of uncertainty in which
- a complete and publicly known set of states of nature exists
- the probabilities of states of nature are objective and publicly known
- the single interest rate in the economy is given and publicly known state realization is publicly observable
Explain and illustrate the concepts of states of nature and the probabilities of states of nature (both objective and subjective).
- States of nature, also called states for short, are uncertain future events that may affect the amount of the payoff. An example would be the state of the economy (good times or bad times).
- Under ideal conditions, the probabilities of the states of nature are publicly known and objective.
- In the real world, these probabilities would have to be assessed based on available information. These are called subjective probabilities.
Explain and illustrate the concepts of expected value of an asset or liability, abnormal earnings, and risk.
- The expected value of an asset or liability is calculated as the sum of the various possible cash flows, based on the probabilities assigned to the various states of nature, discounted at the given fixed interest rate for the economy.
- Net income under ideal conditions consists of expected cash flows (accretion of discount) plus or minus any abnormal earnings.
- Abnormal earnings are defined as the difference between expected and actual cash flows.
- Risk under ideal conditions is the knowledge that one of several different possible state realizations will occur, but not knowing for sure which one it will be.
Use the present value model, under conditions of certainty, to prepare an articulated set of financial statements for a simple firm.
- Using the definition of ideal conditions under certainty
- Financial statements are prepared on the basis of present value of future cash flow, discounted at the given interest rate.
- Assets and liabilities are valued at their present values.
- Net income is equal to accretion of discount.
Use the present value model, under conditions of uncertainty, to prepare an articulated set of financial statements for a simple firm.
- Using the definition of ideal conditions extended to conditions of uncertainty
- Financial statements are prepared on the basis of expected present value of future cash flows, discounted at the given interest rate.
- Assets and liabilities are valued at their expected present values.
- Net income is equal to accretion of discount plus or minus the difference between expected and actual cash flows.
Critically evaluate reserve recognition accounting (RRA) as an application of the present value model.
- The Canadian Securities Administrators have issued NI 51-101, which requires present value-based disclosures of reserves for Canadian oil and gas companies.
- Most large Canadian oil and gas companies have received exemption from NI 51-101 providing they disclose under the less detailed requirements of SFAS 69 of the Financial Accounting Standards Board of the United States.
- SFAS 69 requires affected firms to report supplementary information about the expected present value, based on year-end prices, of their proven oil and gas reserves, and the factors that have changed that expected present value during the year.
- Present value of cash flows is discounted at a given interest rate of 10%.
- Since ideal conditions do not hold in the real world, estimates are subject to wide errors, due to revisions of amounts and timing of extraction of proven reserves and changes in prices. As a result, RRA suffers from problems of reliability.
- Possible manager bias also reduces reliability (for example, Royal Dutch/Shell).
- RRA is often criticized by oil and gas company management, due to concerns about accuracy, and about legal liability if reserves are overstated.
Explain why relevance and reliability of accounting information have to be traded off.
- The problems faced by RRA give insight into the nature of relevance and reliability of accounting information.
- Relevant information is defined as information that enables investors to predict the firm’s future cash flows.
- Reliable information is information that faithfully represents without bias what it is intended to represent.
- RRA information represents high relevance, since present values of future receipts predict future cash flow, by definition.
- Unfortunately, much reliability is lost, since conditions are not ideal.
- When ideal conditions do not hold, relevance and reliability must be traded off.
Evaluate historical cost-based accounting in terms of relevance and reliability, revenue recognition, recognition lag, and matching.
- Historical cost accounting represents an intermediate tradeoff between relevance and reliability.
- While historical-cost-based accounting information is not as relevant as present value-based information, it is more reliable.
- Historical cost accounting can also be evaluated in terms of revenue recognition, recognition lag, and matching. As is the case for relevance and reliability, historical cost represents an intermediate tradeoff between these characteristics of accounting information.
- While “true” net income does not exist in the non-ideal world in which accountants operate, theory shows that current value accounting for specific assets and liabilities is desirable, provided that it can be accomplished with reasonable reliability.
- Current value accounting is now quite common in practice, although historical cost accounting for major classes of assets and liabilities remains. Current practice can be described as a mixed measurement model.