module 1 - handout 5e[1]
TRANSCRIPT
1
Financial Accounting Theory
Chapter 1 - Introduction
2
References
Reading 1.4: Principles-Based Accounting Standards, 4th
Global Public Policy Symposium (Jan 2008)
IAN
Reading 1.2: Louder than Words (in short), Retrieved August 2009, from http://www.frc.org.uk
FRC
Reading 1.3: Shortridge, R. T., & Myring, M. (2004). Defining Principles-Based Accounting Standards, The CPA Journal
AICPA
Reading 1.1: Corporate Reporting, Financial Management, July/August 2009, pp 31 – 32
CIMA
Framework for the Preparation and Presentation of Financial
Statements (Dec 2007)
Preface to HKFRS (Dec 2007)HKICPA
Framework for the Preparation and Presentation of Financial
Statements (Apr 2001) (ED May 2008)
Preface to IFRS (Jan 2010)IASB
Chapter 1 – IntroductionGodfrey (2010)
Chapter 1 – IntroductionScott (2009)
3
Course objective
• To create an awareness and understanding of the
financial reporting environment in a market economy
– To describe and explore various theories that
underlie financial accounting and reporting
– To explain and illustrate the relevance of these
theories in order to understand the practice of
financial accounting and reporting
4
Definition
� Definition of theory: (Hendriksen, 1970)
– … the coherent set of hypothetical, conceptual
and pragmatic principles forming the general
framework of reference for a field of inquiry
� Accounting theory: (Hendriksen, 1970)
– … logical reasoning in the form of a set of broad
principles that:
1. provide a general framework of reference by
which accounting practice can be evaluated and
2. guide the development of new practices and
procedures
5
Development of accounting theory
• Accounting theory is primarily a modern conceptwhen compared with, say, theories emanating from mathematics or physics
• Accounting has developed in an improvised, i.e. ad hoc fashion rather than systematically from a structured theory
• Accounting has frequently been described as a body of practices which have been developed in response to practical needs rather than by deliberate and systematic thinking (Chambers, 1963)
6
Accounting theory timeline
7
Stages of major development
1. 1800 - 1955: General scientific period
2. 1956 - 1970: Normative period
3. 1970s: Specific scientific theory/Positive era period
4. 1980s: Behavioural accounting theory period
5. 1990s: Conceptual framework period
6. 2000s: Mixed development period (IASB Framework)
8
1800 - 1955: General scientific period
• Most theory developments were concerned with providing explanations of practice
• The emphasis was on providing an overall framework to explain and develop accounting practice
• Theories were developed largely on the basis of empirical analysis, which relies on real-world observations rather than solely on logic
• It involves developing a theory on the basis of what is observed, i.e. how firms already practised accounting
9
1956 - 1970: Normative period
• Attempted to establish norms for best accounting practice
• Developed theories that prescribed what should happen, i.e. what should be vs what is
• Adopt an objective (ideal) stance and then specify the means of achieving the stated objective
• Two groups dominated the normative period:
1. The critics of historical cost accounting
2. The conceptual framework proponents
10
1970s: Specific scientific theory period
• Two major criticisms of normative theories:
1. Normative theories do not involve hypothesis testing
2. Normative theories are based on value judgments
• A new form of empiricism which operates under the broad label of positive theory, the positive era
• The objective of positive accounting theory (PAT) is to explain and predict accounting practice
11
Example - Bonus plan hypothesis
• This theory relies on managers being wealth-maximisers who would rather have more wealth than less, even at the expense of shareholders
• If managers are remunerated partly with bonuses based on reported accounting profits, the managers have incentives to use accounting policies that maximize reported earnings in periods when they are likely to receive bonuses
• This theory leads to the prediction (hypothesis) that managers who are remunerated via bonus plans use profit-increasing accounting methods more than managers who are not remunerated via bonus plans
12
1980s:
Behavioural accounting theory period
• The study of the behaviour of accountants or the behaviour of non-accountants as they are influenced by accounting functions and reports
• Primarily concerned with the broader sociological implications of accounting numbers and the associated actions of key players such as managers, shareholders, creditors and the government as they react to accounting information
• Tends to focus on psychological and sociological influences on individuals in their use and/or preparation of accounting
13
Example -
Behavioural accounting theory
• This theory predicts that loan managers cannot process all the financial information they receive, so they assess firms’ credit risk using the information that is most relevant to the background of the loan manager
• If the loan manager had been involved with loans to firms that defaulted on their debt agreements because of poor cash flows, despite profitable activities, the manager would be predicted to place more reliance upon cash flow information than other information
14
Example -
Behavioural accounting theory
• On the other hand, if the loan manager had been involved with loans to firms that defaulted because of unprofitable operations, the manager would be predicted to place more reliance upon the reported profit or loss and earnings prospects of prospective borrowers
• Behavioural accounting research (BAR) is concerned with improving the quality of decision making
• Has grown in acceptance but PAT still currently dominates the accounting research literature
15
1990s: Conceptual framework period
• An attempt to provide a definitive statement of the nature and purpose of financial reporting and
• To provide appropriate criteria for deciding between alternative accounting practices
• Outlined the objective, qualitative characteristics and rules for the definition (i.e. recognition) and measurement of assets and liabilities
• Used in developing accounting standards and attempting to reduce the inconsistencies that arose from earlier ad hoc theory and practice developments
16
Conceptual Framework of Accounting
• Defined by the Financial Accounting Standards Board
(FASB) in the United States as:
– A constitution, a coherent system of interrelated
objectives and fundamentals that can lead to a
consistent standards and that prescribes the nature,
function and limits of financial accounting and
financial statements
17
2000s: Mixed development period
• Positive and behavioural theories
• Framework for the Preparation and Presentation of Financial Statements, adopted by IASB in April 2001
1. Defines the objective of financial statements
2. Identifies the qualitative characteristics that make information in financial statements useful
3. Defines the basic elements of financial statements and the concepts for recognising and measuring them in financial statements
18
Current structure of the IASB
19
IASC Foundation
• The IASC Foundation
‒ is an independent organisation having two main
bodies, the Trustees and the IASB,
‒ as well as a Standards Advisory Council (SAC) and
the International Financial Reporting Interpretations
Committee (IFRIC)
• The IASC Foundation Trustees
‒ appoint the IASB members, exercise oversight and
raise the funds needed,
‒ but the IASB has sole responsibility for setting
accounting standards
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IASB
• Has sole responsibility for setting accounting standards
– 15 board members as at January 2010, who come
from different countries and have a variety of
functional backgrounds (14 board members in 2009
and 16 in 2012)
– members not dominated by any particular
constituency or regional interest
– foremost qualification for IASB membership is
technical expertise
21
IFRIC
• Review, on a timely basis within the context of current
IFRS and the IASB Framework, accounting issues that
are likely to receive divergent or unacceptable
treatment in the absence of authoritative guidance,
with a view to reaching consensus on the appropriate
accounting treatment
• Address issues of reasonably widespread importance,
not issues that are of concern to only a small minority
of entities
• The findings are summarised and published in its
IFRIC Interpretations
22
IFRS, IAS and Interpretations
• IFRS are Standards and Interpretations issued by the
IASB and comprise, as issued at 1 January 2010:
– International Financial Reporting Standards (9 IFRS);
– International Accounting Standards (29 IAS); and
– Interpretations (16 IFRIC and 11 SIC)
– Standing Interpretations Committee (SIC)
• The difference between IFRS and IAS:
‒ IASB has designated its accounting standards as IFRS ‒ IAS were issued by the IASB’s predecessor, the International Accounting Standards Committee (IASC)
‒After the establishment of the IASB, IFRS includes IAS
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Accounting standards setting in
Hong Kong
HKSA (Hong Kong Society of Accountants): Jan 1973 – Sep 2004
becomes HKICPA (Hong Kong Institute of Certified Public Accountants) in Sep 2004
HKSSAP (Hong Kong Statements of Standard Accounting Practice): Jan 1973 – Dec 2003
becomes HKAS (Hong Kong Accounting Standards) in 2004
becomes HKFRS (Hong Kong Financial Reporting Standards) in 2004
24
25
Textbook objective
• The book is about accounting, not how to account,
based on information economics
• Critically examines the broader implications of
financial accounting for the fair and efficient
operation of our market economy
• An understanding of the current financial accounting
and reporting environment, taking into account the
diverse interests of both external users and
management
26
Organization of the textbook
27
Figure 1.1 - Organization of the book
=>
Precise and
sensitive
information
Motivate and
evaluate
manager
performance
Moral
hazard
(manager
effort)=>
Managers
Chs 8-11
Standard
setting
Current
value-
based
accounting
Chs 1-2
Chs 12-13
=>
Decision
usefulness,
full
disclosure
Rational
investment
decision
Adverse
selection
(inside
information)=>
External
users
Chs 3-7
MediationAccounting
reaction
User decision
problem
Information
asymmetry
Ideal
conditions
Users /
Chapters
28
Ideal conditions
• Chapter 2 reviews and analyzes the present value model,
under both certainty and uncertainty
• Under ideal conditions in an Arrow-Debreu economy,
accounting is based on the present values of future cash
flows
• The present value model is highly relevant to financial
statement users as it looks at the cash flows and
profitability of the firm
29
Ideal conditions
• Present value accounting (direct approach) is an example of the more general concept of fair value accounting
• Another approach to fair value accounting is to value assets and liabilities at their market values (indirect approach)
• Under ideal conditions, present value and market value are the same (principle of arbitrage), present value accounting is the more fundamental concept
• When market values are not available, accountants usually fall back on present value to determine fair value
30
Determination of fair value -
Fair value hierarchy
• Level 1 - The estimate of fair value shall be determined by reference to observable prices of market transactions for identical assets or liabilities at or near the measurement date whenever that information is available
• Level 2 - Determined by adjusting observable prices of market transactions for similar assets or liabilitiesthat occur at or near the measurement date
• Level 3 - Determined using other valuation techniques
31
Current value-based accounting
• Two main current cost alternatives to historical cost
for assets and liabilities
1. Value-in-use such as discounted present value of
future cash flows
2. Fair value, also called exit value or opportunity cost,
the amount that would be received or paid should the
firm dispose of the asset or liability (“the price that
would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market
participants at the measurement date”, ED/2009/5)
32
Information asymmetry
• Information asymmetry - Some parties to business
transactions may have an information advantage over
others
• Two main types of information asymmetry:
– Adverse selection
• Persons with an information advantage exploit
this advantage - Insider trading
– Moral hazard
• Manager knows his/her actions in managing firm
but shareholders do not - Manager shirking
33
Examples - Information asymmetry
• Example 1: Who would be first in line to purchase life insurance if there were no medical examination?
– Is it Adverse selection or Moral hazard?
• Example 2: What quality of used cars are likely to be brought to market?
– Is it Adverse selection or Moral hazard?
• Example 3: How hard would you work in this course if there were no exams?
– Is it Adverse selection or Moral hazard?
34
Adverse selection
• Definition: A type of information asymmetry whereby
one or more parties to a business transaction, or
potential transaction, have an information advantage
over other parties (Chapter 1, page 13)
• The tendency for the people who accept contracts to be
those with private information that they plan to use to
their own advantage and to the disadvantage of the less
informed party
35
Moral hazard
• Definition: A type of information asymmetry whereby
one or more parties to a business transaction, or
potential transaction, can observe their actions in
fulfillment of the transaction but other parties cannot
(Chapter 1, page 14)
• When one of the parties to an agreement has an
incentive, after the agreement is made, to act in a
manner that benefits himself or herself at the expense of
the other party
36
User decision problem
• In presence of adverse selection problem
– Rational investment decision
• In presence of moral hazard problem
– Motivate and evaluate manager performance
37
Role of financial reporting
• To control adverse selection problem
– Decision usefulness
• Full and timely disclosure
• To control moral hazard problem
– Net income as a managerial performance measure
• Sensitive and precise net income
• Serve as an input into executive compensation
contracts to motivate manager performance
• Inform the managerial labour market, so that a
manager who shirks will suffer a decline in
income, reputation, and market value in long run
38
The fundamental problem of
financial accounting theory
• Investors’ interests are best served by information that
enables better investment decisions and better-
operating capital markets
• Providing it is reasonably reliable, fair value accounting
fulfils this role, since it provides up-to-date information
about assets and liabilities, hence of future firm
performance, and reduces the ability of insiders to take
advantage of changes in fair values
39
The fundamental problem of
financial accounting theory
• Managers’ interests are best served by information that
is highly informative about their effort in running the
firm, since this enables efficient compensation contracts
and better operation of managerial labor markets
• From a managerial perspective, a less volatile and more
conservative income measure, such as one based on
historical cost, may better fulfill a role of reporting on
manager effort
40
The fundamental problem of
financial accounting theory
• The best measure of net income to control adverse
selection is not the same as the best measure to
motivate manager performance
– This implies that investor and manager interests
conflict
– Standard setting is viewed as mediating the
conflicting interests of investors and managers in
financial reporting
41
Enron Corp - Background
• A large US corporation with initial interests in natural
gas distribution
• Successfully expanded its operations to become an
intermediary between natural gas producers and
users
• Subsequently extended this business model to a
variety of other trading activities, including steel,
natural gas, electricity, and weather futures
• To finance rapid expansion and support share price,
Enron needed both large amounts of capital and
steadily increasing earnings
42
Enron Corp - Background
• Meeting these needs was complicated by the fact that
its forays into new markets were not always profitable,
creating a temptation to disguise losses
• In the face of these challenges, Enron resorted to
devious tactics
• One tactic was to create various special purpose
entities (SPEs) - limited partnerships formed for
specific purposes, and effectively controlled by senior
Enron officers
43
Enron Corp - Background
• These SPEs were financed largely by Enron’s
contributions of its own common stock, in return for
notes receivable from the SPE
• The SPE could then borrow money using the Enron
stock as security, and use the borrowed cash to repay
its notes payable to Enron
• In this manner, much of Enron’s debt did not appear
on its balance sheet - it appeared on the books of the
SPEs instead
44
Enron Corp
• On Enron’s books:
Notes receivable $1.1 (billion) Capital stock $1.1 (billion)
Capital stock issued to SPE owned by Enron officers
• GAAP requires amounts due from shareholders be deducted from shareholders’ equity
– Is a limited partnership, owned by Enron officers, a shareholder?
45
Enron Corp
• Off-balance sheet financing
– On SPE’s books:
Cash xxx
Debt xxx
SPE borrowed money, using Enron stock as security
Notes payable to Enron xxx
Cash xxx
Cash was paid to Enron to reduce its notes
receivable from SPE
– Enron had the cash but debt did not appear on its
books
46
Enron Corp - Background
• In addition, Enron received fees for management and
other services supplied to its SPEs, and also
investment income
• By applying fair value accounting to its holdings of
Enron stock, the SPE included increases in the value
of this stock in its income
• As an owner of the SPE, Enron included its share of
the SPE’s income in its own earnings - in effect,
Enron was able to include increases in the value of its
own stock in its reported earnings
47
Enron Corp
• Enron rendered services to the SPE
Accounts receivable $628 (millions)
Net income $628 (millions)
Services rendered to SPE 1997-2000 included
• If limited partnership had been consolidated, revenue
would not have been recognized, i.e. recognized only
when earned outside the consolidated entity
48
Enron Corp
• Enron recorded its share of SPE profits
Investment in SPE xxx
Net income xxx
Equity method of accounting for investment
• SPE profits included increases in fair value of its
holdings of Enron shares
• Result: Enron included increases in the market value
of its shares in its net income
49
Enron Corp
• In 3rd quarter of 2001, Enron recognized that the SPE
should have been consolidated:
Shareholders’ equity $1.1 (billion)
Notes receivable $1.1 (billion)
To deduct loan to SPE from shareholders’ equity
• Also, restated previous 4 years’ earnings to reduce by
$628 millions
50
Enron Corp
• Impacts of the write-offs:
– No effect on operating cash flow
– Debt/equity ratio, debt covenants affected
– Loss of investor confidence
– Share price fell from $90 to 66¢
– Filed for bankruptcy protection on 2 December 2001
– Investigations by SEC, Department of Justice and
Congress
– Where were the auditors? The Board?
51
Enron Corp - Lessons
• Crucial role of investor confidence in financial
information
• Role of auditor in adding credibility to financial
information
• Off-balance sheet financing
• Earnings management
• Increased legislative reporting requirements -
Sarbanes-Oxley Act 2002
• Standard setting: SIC-12 Consolidation - Special
Purpose Entities (ED 10 Consolidated Financial
Statements Dec 2008)
• Could comprehensive theory have prevented this?
52
Financial Accounting Theory
Chapter 2 – Accounting under
Ideal Conditions
53
References
Reading 2.4: Basis for Conclusions – Revenue from Contracts with Customers, Exposure Draft, Jun 2010
Reading 2.3: Revenue from Contracts with Customers, Exposure Draft, Jun 2010
Reading 2.1: Revenue Recognition, IASB Project, Jan 2008
IASB
Reading 2.2: Snapshot – Revenue from Contracts with Customers, Exposure Draft, Jun 2010
Chapter 6 – Accounting Measurement SystemsGodfrey (2010)
Chapter 2 – Accounting under Ideal ConditionsScott (2009)
54
Organization of Chapter 2
55
Ideal conditions of certainty
• Assumptions
– Known future cash receipts
– Given interest rate
• Basis of accounting
– Present value
• Income (true net income) recognition
– As changes in present value occur
56
Example 2.1 -
Present value model under certainty
• Consider P.V. Ltd, a one-asset firm with no liabilities
• The asset will generate end-of-year cash flows of $150
each for two years and then will have zero value
• The risk-free interest rate in the economy is 10%
• Time line: ---------- 0 ---------- 1 ---------- 2
$150 $150
57
Example 2.1 -
Present value model under certainty
• At time 0 (the beginning of the first year of the asset’s
life), the present value of the firm’s future cash flows is
PA0 = $150/1.10 + 150/(1.10)2
= $136.36 + 123.97
= $260.33
• At the end of year 1, the present value of the remaining
cash flows from the firm’s asset is
PA1 = $150/1.10 = $136.36
58
Example 2.1 - Present value model under certainty
$286.36$260.33Total equity
26.03?Net income
$260.33$260.33Opening value
Shareholders’ equity
$286.36$260.33Total asset
(123.97)Accumulated amortization
?Amortization expense
260.33$260.33Opening value
Capital asset
$150.00?Cash
Financial asset
BS 1IS 1BS 0Financial statements
59
Example 2.1 -
Present value model under certainty
• Since future net revenues are capitalized into asset value,
net income (NI) is simply interest on opening asset value
= PA0 x 10% = $260.33 x 10% = $26.03 (accretion of
discount)
• It is also referred to as ex ante or expected net income
since, at time 0, the firm expects to earn $26.03
• Since all conditions are known with certainty, the
expected net income will equal the ex post or realized net
income
60
Example 2.1 -
Present value model under certainty
• The firm’s net income plays no role in firm valuation
under ideal conditions of certainty
• Future cash flows are known and hence can be
discounted to provide balance sheet valuations
• Net income is then perfectly predictable, being simply
accretion of discount
61
Example 2.1 -
Present value model under certainty
• In effect, under ideal conditions, the balance sheet
contains all the relevant information and the income
statement contain none, i.e. no information content
• There is no information in the current net income that
helps investors predict future economic prospects of the
firm
• These are already known to investors, and capitalized
into asset valuation, by assumption
62
Example 2.1 -
Present value model under certainty
• Under ideal conditions, it is possible to prepare relevant
financial statements that are also reliable
• The process of arbitrage ensures that the market value of
an asset equals the present value of its future cash flows
• The market value of the firm is then the value of its net
financial assets plus the value of its capital assets (less
any liabilities)
63
Ideal conditions of uncertainty
• Assumptions
– States of nature
• Known set
• Realization publicly observable
– State probabilities
• Objective
• Publicly known
– Given interest rate
64
Ideal conditions of uncertainty
• Basis of accounting
– Expected present value
• Income (true net income) recognition
– As changes in expected present value occur
65
Example -
Ideal conditions of uncertainty
• You pay $100 to a bank to buy a 2-year investment
which pays in each year $73.02 when the economy is
good with prob = 0.5 and $33.02 when the economy is
bad with prob = 0.5
• The interest rate in the economy is 4%
66
Example -
Ideal conditions of uncertainty
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
= $100.00
NB: Risk-neutral valuation
67
• Assume at end of year 1, the economy is good and so
you receive $73.02
PA1 = $73.02 + [.5(73.02) + .5(33.02)]/1.04
= $73.02 + 50.98
= $124.00
Example -
Ideal conditions of uncertainty
68
Net income for the year (good economy):
1. Sales less amortization format
– $73.02 - (100 - 50.98) = $73.02 - 49.02 = $24
2. Alternative format of abnormal earnings
– $100 x .04 + [73.02 – (0.5 x 73.02 + 0.5 x 33.02)] =
$4 + 20 = $24
3. Change in balance sheet net assets
– $124 - 100 = $24
Example -
Ideal conditions of uncertainty
69
Example - Present value model under uncertainty
$124.00$100.00Total equity
24.00$24.00Net income ($124 – 100)
$100.00$100.00Opening value
Shareholders’ equity
$124.00$100.00Total asset
(49.02)Accumulated amortization
(49.02)Amortization expense ($100.00 – 50.98)
100.00$100.00Opening value
Capital asset
$73.02$73.02Cash
Financial asset
BS 1IS 1BS 0Financial statements (Good economy)
70
Example - Present value model under uncertainty
?$100.00Total equity
??Net loss
?$100.00Opening value
Shareholders’ equity
?$100.00Total asset
?Accumulated amortization
?Amortization expense
?$100.00Opening value
Capital asset
??Cash
Financial asset
BS 1IS 1BS 0Financial statements (Bad economy)
71
Net income for the year (bad economy):
1. Sales less amortization format
– $
2. Alternative format of abnormal earnings
– $
= $
3. Change in balance sheet net assets
– $
Example -
Ideal conditions of uncertainty
72
Lack of ideal conditions
• Problems when conditions are not ideal
– State probabilities are subjective, i.e. not objective
– Incomplete markets
• Definition of incompleteness - market values do not
exist for all firm assets and liabilities
• Reasons for incompleteness
– Thin markets - ready market value is not available
– Information asymmetry
73
Implications of lack of ideal conditions
• Need for estimates (quantities, prices, timing) of states
of nature
• Need for estimates of state probabilities
• Market value need not equal present value
• True net income does not exist
74
Implications of lack of ideal conditions
• Relevance and reliability must be traded off
• Historical cost accounting a better tradeoff?
– Relevance of historical cost accounting?
– Reliability of historical cost accounting?
75
Fair value accounting
• Implementing accounting under ideal conditions when
ideal conditions do not exist
• Meanings of fair value (FV)
– Present value approach => present value (PV)
– Market value approach => market value (MV)
– Model-based approach, e.g. option pricing models
=> intrinsic value (IV)
76
Reserve recognition accounting (RRA)
• Present value accounting applied to oil and gas
reserves
• An application of present value accounting when ideal
conditions do not exist
– Proved reserves
– Discounted at mandated rate of 10%
– Revenue recognized as reserves are proved
– Major adjustments to previous estimates
77
Reserve recognition accounting
• Relevance of RRA information?
• Reliability of RRA information?
• Management’s reaction to RRA
– Concern about relevance and reliability
– Concern about legal liability
78
Asset valuation is equivalent
to income recognition
• Proved reserves valued at present value ⇔⇔⇔⇔ income recognized as reserves are proved
• Proved reserves valued at cost ⇔⇔⇔⇔ income recognized as reserves are sold
• Recognition versus realization
79
The challenge of
historical cost accounting
Amortization of capital assets (Good economy)
1. Straight-line (SL) amortization: Net income = $73.02 -
100/2 = $73.02 - 50 = $23.02
2. Sum-of-years-digits (SOYD) amortization: Net
income = $73.02 - 2/3 x 100 = $73.02 – 66.67 = $6.35
• Little theoretical basis to choose between different
ways of accounting for the same thing - Relevance?
Reliability? => Net income does not exist as a well-
defined economic construct
80
Assignment questions
1. Question 2-14 (page 48)
2. Question 2-15 (page 49)
81
Question 2-14
• Sure Corp operates under ideal conditions of certainty
• It acquired its sole asset on January 1, 2008
• The asset will yield $500 cash at the end of each year
from 2008 to 2010, inclusive, after which it will have no
market value and no disposal costs
• The interest rate in the economy is 6%
• Purchase of the asset was financed by the issuance of
common shares
• Sure Corp will pay a dividend of $50 at the end of 2008
and 2009
82
Question 2-14
Required
a. Prepare a balance sheet for Sure Corp as at the end of
2008 and an income statement for the year ended
December 31, 2008
b. Prepare a balance sheet for Sure Corp as at the end of
2009 and an income statement for the year ended
December 31, 2009
83
Question 2-14
c. Under ideal conditions, what is the relationship
between present value (i.e., value-in-use) and market
value (i.e., fair value)? Why? Under the real conditions
in which accountants operate, to what extent do
market values provide a way to implement fair value
accounting? Explain
d. Under real conditions, present value calculations tend
to be of low reliability. Why? Does this mean that
present value-based accounting for assets and
liabilities is not decision useful? Explain
84
Question 2-15
• P Ltd operates under ideal conditions
• It has just bought a capital asset for $3,100, which will
generate $1,210 cash flow at the end of one year and
$2,000 at the end of the second year
• At that time, the asset will be useless in operations and
P Ltd plans to go out of business
• The asset will have a known salvage value of $420 at the
end of the second year
• The interest rate in the economy is constant at 10% per
annum
85
Question 2-15
• P Ltd finances the asset by issuing $605 par value of
12% coupon bonds to yield 10%
• Interest is payable at the end of the first and second
years, at which time the bonds mature
• The balance of the cost of the asset is financed by the
issuance of common shares
86
Question 2-15
Required
a. Prepare the present value-based balance sheet as at
the end of the first year and an income statement for
the year. P Ltd plans to pay no dividends in this year
b. Give two reasons why ideal conditions are unlikely to
hold
c. If ideal conditions do not hold, but present value-
based financial statements are prepared anyway, is net
income likely to be the same as calculated in part a?
Explain why or why not
87
Reference 1
� Hendriksen, E. (1970). Accounting Theory. Illinois: Richard D. Irwin
� A classic textbook in accounting theory
Return
88
Reference 2
� Godfrey, J., Hodgson, A., Tarca, A., Hamilton, J., &
Holmes, S. (2010). Accounting Theory (7th ed.). Milton: John Wiley & Sons Australia
� A widely respected accounting theory textbook
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Reference 3
� Scott, W. R. (2009). Financial Accounting Theory (5th ed.). Toronto: Pearson Prentice Hall
� Written in a friendly style with clear explanations, the
textbook provides a thorough presentation of financial
accounting theories
� Within this clear framework, it illustrates the
theoretical concepts with plenty of examples to place
them in context
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