Chapter 2 Accounting Under Ideal Conditions

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Chapter 2 - Accounting Under Ideal Conditions

• Assuming away Information Asymmetry and Moral
  Hazard

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Information Asymmetry and Moral Hazard

• Information Asymmetry occurs when one individual
  knows more than the other individuals in a
  situation. For example
• Managers know more about the business than
  stockholders
• The person selling their home knows more than the
  person thinking about buying the home
• I know more about our test than you do
• Moral Hazard occurs when an individual takes
  advantage of information asymmetry
• Insurance pays more for the cost of treating an
  injury
• Arson
• Spending on a business trip
• Managers hiding information about their actions

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Role of Financial Reporting

• Information asymmetries lead to
• Adverse Selection (insider trading)
• Accounting solution Full and timely
  disclosure
• Moral Hazard (manager shirking)
• Accounting solution Net income as a
  managerial performance measure (stewardship)

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Assumptions Ideal Conditions with Certainty

• Certainty
• All expectations are realized
• All future prices of assets and claims are known
• Interest rates are
• Held constant over time (for purposes of
  illustration)

• Perfect Complete Markets have
• Zero transaction costs
• No abnormal earnings opportunities
• No arbitrage profits
• Prices are invariant to actions of individuals or
  firms
• Markets are very rich

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Results of the Assumptions

• Present value of future cash flows strictly ranks
  all investment opportunities
• No information asymmetries exist
• Adverse selection - irrelevant
• Moral hazard irrelevant
• Firm value the PV of future cash flows
• You cant get a deal or bargain because everyone
  know everything
• Economic income is well defined
• Income is recognized as changes in present value
  occur (change in wealth)
• Net income does not provide additional info
• We dont have to worry about estimating future
  performance. Why?

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Assumptions Ideal Conditions with Uncertainty

• Uncertainty
• States of nature
• Publicly known set
• Realization publicly observable
• State probabilities
• Objective
• Publicly known
• Participants are risk neutral
• Interest rates
• Held constant over time (for purposes of
  illustration)

• Perfect Complete Markets
• Zero transaction costs
• No abnormal earnings opportunities
• No arbitrage profits
• Prices are invariant to actions of individuals or
  firms
• Markets are very rich

A simple extension of the ideal setting with
certainty
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Results of the Assumptions

• Accounting and valuation is based on the expected
  present value
• The recognized income changes and the expected
  present value changes

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Example

• How much would you pay to a bank to buy a 2-year
  investment which pays you a dividend each year?
• If the economy is good, the dividend will be
  73.02.
• If the economy is bad, the dividend will be
  33.02.
• There is a 50/50 chance of a good or bad year.
• The interest rate in the economy is 4.
• Assuming the economy is good in the first year
  and bad in the second year, created the necessary
  I/S and B/S for your investment.

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Finding present value of investment book
method
.5 (70.21 31.75) .5 (67.51 30.53) .5
101.96 .5 98.04 50.98 49.02 100
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Expected Values
Expected Values.5 73.02 36.51
.5 33.02 16.51
n2, i4, pmt 53.02, FV0,
Lets use Excel to calculate the value and create
the FSs
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Important Points

• Net Income for the Year
• Revenue less amortization format
• 73.02 - (100 - 50.98) 73.02 - 49.02 24
• Change in balance sheet net assets
• 124 - 100 24
• Computing net income is redundant
• Balance sheet has all of the necessary
  information
• Dividend Irrelevance (in a nutshell)

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Ideal vs. Non-ideal

• How do the assumptions of an ideal world match up
  with real world conditions?
• So, why would we be interested in the ideal
  setting?

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Understanding the Relevance vs. Reliability
Tradeoff
First, tell me what the relevance vs. reliability
tradeoff is. Why does this tradeoff not exist
under ideal conditions?
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Using the Ideal Setting to Examine Accounting
Methods

• Historical Cost-Based Net Income
• Straight-line amortization
• Net Income 73.02 - 100/2 73.02 - 50 23.02
• SYD amortization
• Net Income 73.02 - 2/3 x 100 73.02 - 67
  6.02
• Little theoretical basis to choose between
  different amortization methods
• Change in fair value more useful?

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Fair Value Accounting

• Implementing accounting under ideal conditions
  when ideal conditions do not exist
• Meaning of Fair Value
• Present value of future cash flows approach
• Market value approach
• Current exit value (net realizable value)
• Current entry value (replacement cost)
• Model-based approach
• E.g., option pricing models
• RRA Example

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Ideal vs. Non-Ideal(reconstructed by TG)
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Conclusion

• a theoretically well-defined concept of net
  income does not exist in the complex, real world
  in which accountants operate.
• Scott, 2006, p. 50
• Next Chapter evaluating accounting in a
  decision usefulness framework