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

20

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

23

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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