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2006 Pearson Education Canada Inc.,2-1,Chapter 2Accounting Under Ideal Conditions, 2006 Pearson Education Canada Inc.,2-2,Ideal Conditions of Certainty,AssumptionsKnown future cash receiptsGiven interest rateBasis of AccountingPresent value, 2006 Pearson Education Canada Inc.,2-3,Ideal Conditions of Certainty, Contd,Income RecognitionAs changes in present value occur, 2006 Pearson Education Canada Inc.,2-4,Ideal Conditions of Uncertainty,AssumptionsStates of natureKnown setRealization publicly observableState probabilities objective publicly knownGiven interest rate, 2006 Pearson Education Canada Inc.,2-5,Ideal Conditions of Uncertainty, Contd,Basis of AccountingExpected present valueIncome RecognitionAs changes in expected present value occur, 2006 Pearson Education Canada Inc.,2-6,Ideal Conditions of Uncertainty- Example,You pay $100 to a bank to buy a 2-year investment which pays in each year $73.02 with prob. = 0.5 and $33.02 with prob. = 0.5. The interest rate in the economy is 4%., 2006 Pearson Education Canada Inc.,2-7,Example, Contd,PA0 = .5(73.02) + .5(33.02)/1.04 + .5(73.02) + .5(33.02)/(1.04)2 = (36.51 + 16.51)/1.04 + (36.51 + 16.51)/(1.04)2 = 53.02/1.04 + 53.02/1.0816 = 50.98 + 49.02 = $100.00NB: Risk-Neutral Valuation, 2006 Pearson Education Canada Inc.,2-8,Example, Contd,Assume at End of Year 1, you Receive $73.02PA1 = 73.02 + .5(73.02) + .5(33.02)/1.04 = 73.02 + 50.98 = $124, 2006 Pearson Education Canada Inc.,2-9,Example, Contd,Net Income for the YearSales less amortization format 73.02 - (100 - 50.98) = 73.02 - 49.02 = $24Alternative format100 x .04 + (24 - 4) = 4 + 20 = $24Change in balance sheet net assets124 - 100 = $24, 2006 Pearson Education Canada Inc.,2-10,Lack of Ideal Conditions,Problems when conditions not idealState probabilities are subjective, not objectiveIncomplete marketsDefinition of IncompletenessReasons for Incompletenessthin marketsinformation asymmetry, 2006 Pearson Education Canada Inc.,2-11,Implications of Lack of Ideal Conditions,Need for Estimates (quantities, prices, timing) of states of natureNeed for Estimates of State ProbabilitiesMarket Value Need Not Equal Present ValueTrue Net Income Does Not Exist, 2006 Pearson Education Canada Inc.,2-12,Implications of Lack of Ideal Conditions, Contd.,Relevance and Reliability Must be Traded Off (next slide )Historical Cost Accounting a Better Tradeoff?Relevance of historical cost accounting?Reliability of historical cost accounting?, 2006 Pearson Education Canada Inc.,2-13,Relevance v. Reliability Tradeoff, 2006 Pearson Education Canada Inc.,2-14,Fair Value Accounting,Implementing Accounting Under Ideal Conditions when Ideal Conditions do not Exist Meaning of “Fair Value” Present value approach Market value approach Model-based approachE.g., option pricing models, 2006 Pearson Education Canada Inc.,2-15,Reserve Recognition Accounting,An Application of Present Value Accounting When Ideal Conditions do not ExistProved reservesDiscounted at mandated rate of 10%Revenue recognized as reserves are provedMajor adjustments to previous estimates, 2006 Pearson Education Canada Inc.,2-16,Reserve Recognition Accounting, Contd,Relevance of RRA information?Reliability of RRA information?Managements Reaction to RRAConcern about relevance and reliabilityConcern about legal liability, 2006 Pearson Education Canada Inc.,2-17,Asset Valuation is Equivalent to Income Recognition,Proved reserves valued at present value income recognized as reserves are provedProved reserves valued at cost income recognized as reserves are sold, 2006 Pearson Education Canada Inc.,2-18,The Challenge of Historical Cost Accounting,Amortization of Capital AssetsConsider earlier exampleStraight-line amortization Net Income: 73.02 - 100/2 = 73.02 - 50 = $23.02
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