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
 2.2 Ideal Conditions of Certainty
• Assumptions
– Known future cash receipts
– Given interest rate
• Basis of accounting
– Present value
• Income recognition
– As changes in present value occur
 2.3 Ideal Conditions of Uncertainty

• 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
 2.2 Ideal Conditions of Certainty
• 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
 What Is The Difference?
• What is the difference between using current value and
historical value?
 What Is The Difference?
• 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”
 2.3 Ideal Conditions of Uncertainty
• Basis of accounting
– Expected present value
• Income recognition
– As changes in expected present value occur
 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
 Lack of Ideal Conditions
• 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 Implications
• 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 Conclusions
• Greater relevance requires more estimates
• But, more estimates decrease reliability
• Relevance and reliability must be traded off
– See next slide
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
2.5 Historical Cost v Current Value Accounting
• 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?
2.6 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
 2.6 The Non-Existence of True Net Income
• Implications for accountants
– Accountants not needed if true net income did exist
– Judgement required to estimate net income
– Judgement is essence of a profession