Ideal Accounting

Ideal Accounting

1. "Theoretically" Ideal

   • all future cash flows are fully disclosed
   • information
     • precise
     • free from bias

2. Conditions of Certainty

   • assumption
     • known future cash flow
     • known cost of capital
   • PV accounting
     • aka VIU
     • Balance sheet shows total asset in PV
       • discounted PV of the future net cash inflows
   • Income Recognition
     • As changes in present value occur
     • expected income = realized income
       • due to certainty
   • Book value = PV = market value = fair value
     • FV can be determined
       • directly
         • PV of future cash flows
       • Indirectly
         • market value
   • financial statements are both perfectly relevant and reliable

3. Primary Qualities of Accounting

   • RELEVANCE
     • information about the firm’s economic prospects
   • RELIABILITY
     • Precise
     • Free from bias
   • Relevance = reliability = 100% ONLY UNDER IDEAL CONDITIONS

4. Conditions of Uncertainty

   • Assumptions
     • states of nature is known and publicly observable
     • state objectives are known and objective
     • interest rates are given
   • Absolute relevance
     • even in uncertain world, we still can prepare relevant FS
       • statements based on expected future cash flows
   • Absolute reliability
     • As long as you know the probability for certain
     • calculations precise and unbiased for expected PV

5. Difference between Certainty and Uncertainty

   • Working with expected values
   • REALIZED and EXPECTED CASHFLOWS
     • what actually happens and what is expected to happen

6. Profit Loss Statement

   • no content beyond BS
   • Unexpected state probabilities are realized each period and DO NOT affect future state probabilities
     • unexpected earnings do not persist
     • unexpected earnings today tell you nothing about future states

7. Implications of non-ideal conditions

   • Relevance and reliability must be traded off