Financial Accounting Theory

Chapter 1 - Introduction

1
 References
Scott (2009) Chapter 1 – Introduction
Godfrey (2010) Chapter 1 – Introduction
IASB Preface to IFRS (Jan 2010)
Framework for the Preparation and Presentation of Financial
Statements (Apr 2001) (ED May 2008)
HKICPA Preface to HKFRS (Dec 2007)
Framework for the Preparation and Presentation of Financial
Statements (Dec 2007)
CIMA Reading 1.1: Corporate Reporting, Financial Management,
July/August 2009, pp 31 – 32
FRC Reading 1.2: Louder than Words (in short), Retrieved August
2009, from http://www.frc.org.uk
AICPA Reading 1.3: Shortridge, R. T., & Myring, M. (2004). Defining
Principles-Based Accounting Standards, The CPA Journal
IAN Reading 1.4: Principles-Based Accounting Standards, 4th
Global Public Policy Symposium (Jan 2008)
2
 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

3
 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

4
 Development of accounting theory
• Accounting theory is primarily a modern concept
when 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)

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Accounting theory timeline

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 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)

7
 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

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 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

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 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

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 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
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 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

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 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

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 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

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 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

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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

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 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

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Current structure of the IASB

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 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
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 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
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 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

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24
 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

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Organization of the textbook

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 Figure 1.1 - Organization of the book
Users / Ideal Information User decision Accounting Mediation
Chapters conditions asymmetry problem reaction
External Adverse Rational Decision
users selection investment usefulness,
=> (inside decision full =>
Chs 3-7 information) disclosure

Chs 1-2 Current

value-
based
accounting
Chs 12-13 Standard
setting
Managers Moral Motivate and Precise and
hazard evaluate sensitive
Chs 8-11 => (manager manager information =>
effort) performance

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 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

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 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

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 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 liabilities
that occur at or near the measurement date

• Level 3 - Determined using other valuation

techniques

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 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)

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 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

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 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?

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 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

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 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

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 User decision problem
• In presence of adverse selection problem
– Rational investment decision

• In presence of moral hazard problem

– Motivate and evaluate manager performance

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 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
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 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

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 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

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 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

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 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

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 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

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 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

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 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?

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 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

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 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

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 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

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 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

48
 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

49
 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?

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 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?
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Financial Accounting Theory

Chapter 2 – Accounting under

Ideal Conditions

52
 References
Scott (2009) Chapter 2 – Accounting under Ideal Conditions
Godfrey (2010) Chapter 6 – Accounting Measurement Systems
IASB Reading 2.1: Revenue Recognition, IASB Project, Jan
2008
Reading 2.2: Snapshot – Revenue from Contracts with
Customers, Exposure Draft, Jun 2010
Reading 2.3: Revenue from Contracts with Customers,
Exposure Draft, Jun 2010
Reading 2.4: Basis for Conclusions – Revenue from
Contracts with Customers, Exposure Draft, Jun 2010

53
Organization of Chapter 2

54
 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

55
 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

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 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

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Example 2.1 - Present value model under certainty
Financial statements BS 0 IS 1 BS 1
Financial asset
Cash ? $150.00
Capital asset
Opening value $260.33 260.33
Amortization expense ?
Accumulated amortization (123.97)
Total asset $260.33 $286.36
Shareholders’ equity
Opening value $260.33 $260.33
Net income ? 26.03
Total equity $260.33 $286.36

58
 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

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 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

60
 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

61
 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)

62
 Ideal conditions of uncertainty
• Assumptions
– States of nature
• Known set
• Realization publicly observable
– State probabilities
• Objective
• Publicly known
– Given interest rate

63
 Ideal conditions of uncertainty
• Basis of accounting
– Expected present value

• Income (true net income) recognition

– As changes in expected present value occur

64
 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%

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 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

66
 Example -
Ideal conditions of uncertainty
• 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

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 Example -
Ideal conditions of uncertainty
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

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Example - Present value model under uncertainty
Financial statements (Good economy) BS 0 IS 1 BS 1
Financial asset
Cash $73.02 $73.02
Capital asset
Opening value $100.00 100.00
Amortization expense ($100.00 – 50.98) (49.02)
Accumulated amortization (49.02)
Total asset $100.00 $124.00
Shareholders’ equity
Opening value $100.00 $100.00
Net income ($124 – 100) $24.00 24.00
Total equity $100.00 $124.00

69
Example - Present value model under uncertainty
Financial statements (Bad economy) BS 0 IS 1 BS 1
Financial asset
Cash ? ?
Capital asset
Opening value $100.00 ?
Amortization expense ?
Accumulated amortization ?
Total asset $100.00 ?
Shareholders’ equity
Opening value $100.00 ?
Net loss ? ?
Total equity $100.00 ?

70
 Example -
Ideal conditions of uncertainty
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
– $

71
 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

72
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

73
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?

74
 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)

75
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

76
 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

77
 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

78
 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

79
 Assignment questions
1. Question 2-14 (page 48)

2. Question 2-15 (page 49)

80
 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

81
 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

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 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

83
 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

84
 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

85
 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

86
 Reference 1

Hendriksen, E. (1970). Accounting Theory. Illinois:
Richard D. Irwin

A classic textbook in accounting theory

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 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

Return88
 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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