Accounting Theory Lesson 1: Accounting Under Ideal Conditions
Lesson Objectives: 1. What would accounting look like under ideal conditions? ...................................................................... 1 1.1. Ideal Conditions under Certainty ...................................................................................................... 1 1.2. Ideal conditions under uncertainty ................................................................................................... 3 2. An application of present value accounting: Reserve Recognition Accounting (RRA) .......................... 6 3. How does current value accounting match up against historical cost accounting? ...view middle of the document...
It acquires an asset on Jan 1, 2011, which will yield $500 annually from 2011 to 2013, with zero residual value. Interest rate is 6%. Sure Corp acquired the asset by issuing common shares, on which it would pay an annual dividend of $50 at yearend in 2011 and 2012. How much did the asset cost on Jan 1, 2011? Recall, under ideal conditions, asset values equal the present value of discounted cash flows. Accordingly: PMT N FV I/Y 500 3 0 6
PV
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Lesson 1: Accounting Under Ideal Conditions © 2012, Harjinder Deol
1.1. Ideal Conditions under Certainty
How much did the asset earn during 2011? The income should equal accretion of discount on the opening PV at the interest rate of 6% Thus, income for 2011 = 6% * $___________ = $______________ Sure Corp Balance Sheet Dec 31, 2011 Assets Cash Capital asset Equity Common Shares Retained earnings
Sure Corp Income Statement Year ended Dec 31, 2011 Net income (ignoring taxes)
Sure Corp Balance Sheet Dec 31, 2012 Assets Cash Capital asset Equity Common Shares Retained earnings
Sure Corp Income Statement Year ended Dec 31, 2012 Net income (ignoring taxes)
OK… hold on to your brickbats. We did not say that accounting operates under ideal conditions, but we need some sort of a starting point before we let things get messy. Let’s start unraveling things by relaxing the assumption of certainty.
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Lesson 1: Accounting Under Ideal Conditions © 2012, Harjinder Deol
1.2. Ideal conditions under uncertainty Before we shoot too far ahead, keep in mind that we are still talking about ideal conditions under certainty which are characterized by: (i) A given, fixed interest rate at which the firm’s cash flows are discounted (ii) A complete and publicly known sets of states of nature (don’t you love the jargon here?) or shall we say, the economic conditions [good / bad] (iii) State probabilities are objective and publicly known (we all know what the likelihood of the good economy is versus the bad one) (iv) State realization is publicly observable (everyone is able to see whether the economy is good or bad) So pray, what is uncertain here? Just the future cash flows, because they depend on the condition of the economy. However, since the probabilities for the states of nature are known, we can calculate the expected present value from the expected value of future cash flows. Under such a situation, net income equals accretion of discount plus abnormal earnings (actual cash flows minus expected cash flows). Example 2: Adapted from CGA Exam AT1 June 2010 A pharmaceutical start-up company, Inoculate Unlimited, operates under ideal conditions of uncertainty. Inoculate produces a single influenza vaccine, the demand for which will fall to zero at the end of 2 years. At that time, the highly specialized equipment used to produce the vaccine will be worthless. The required equipment was all purchased on January 1, 2008. This capital expenditure was financed by a bank loan of $5,000 and the...
