Accounting Theory Ch 2

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Instructor’s Manual—Chapter 2

CHAPTER 2 Accounting Under Ideal Conditions 2.1 2.2 Overview The Present Value Model Under Certainty 2.2.1 Summary 2.3 The Present Value Model Under Uncertainty 2.3.1 Summary 2.4 Reserve Recognition Accounting (RRA) 2.4.1 An Example of RRA 2.4.2 Summary 2.4.3 Critique of RRA 2.4.4 Summary 2.5 Historical Cost Accounting Revisited 2.5.1 Comparison of Different Measurement Bases 2.5.2 Accruals 2.5.3 Summary 2.6 2.7 The Non-Existence of True Net Income Conclusion to Accounting Under Ideal Conditions

Copyright © 2009 Pearson Education Canada


Instructor’s Manual—Chapter 2


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 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. 2. 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, 4, 5, and 14). 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. 3. 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

Copyright © 2009 Pearson Education Canada


Instructor’s Manual—Chapter 2

example of RRA disclosure from an annual report. However, 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. 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 SFAS 69, is relevant to Canadian oil and gas firms whose shares are traded in the United States. In this regard, it is worth noting that Suncor Energy Inc., used as the text RRA illustration in Section 2.4.1, is a Canadian corporation. Since most large Canadian oil and gas companies report under SFAS 69, I have retained reporting under this standard in the body of this chapter. However, if more attention to Canadian oil and gas accounting is desired, instructors may wish to refer to National Instrument 51-101 of the Canadian Securities Administrators. This standard is available on the Alberta Securities Commission website. Problem 24 of this chapter presents an illustration of reporting under National Instrument 51-101. 4. To Interrelate Basic Accounting Concepts

Having worked through a rather “far out” basis of accounting, it...
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