CHAPTER 2 NOTES

Relevance and reliability are the two primary qualitative characteristics that make accounting information useful for decision making. Relevant information refers to information that is useful for predictions of an entity's future economic prospects. Reliable information refers to information that faithfully represents without bias what it is intended to represent. Reliability has three main dimensions: Representational faithfulness is achieved if the accounting evaluation or description of an item is in agreement with the real item the information represents. Verifiability is achieved when knowledgeable and independent observers (e.g., accountants and auditors) are able to come up with the same value. Neutrality is achieved when accounting valuation is free of bias (e.g. free from management manipulation).

In practice, there is a tradeoff between relevance and reliability.

Ideal conditions under certainty Characterized by: Known future cash receipts Given interest rate Ideal conditions under uncertainty Characterized by: a given fixed interest rate a complete and publicly known set of states of nature objective and publically known state probabilities publically observable state realization assumption investors are risk-neutral and the state realizations are independent (to eliminate complications) Present value model under certainty The net book value of capital assets at year-end equals its fair value (amortization expense is the change in present value over the year) Net income = interest on opening asset value; also accretion of discount /ex ante/expected net income; when all conditions are known with certainty, the expected net income will = realized net income Net income plays no role in a firms value as all its value is on the balance sheet

Chapter 2 Notes

With ideal conditions, there is dividend irrelevancy Under ideal conditions, complete relevance and reliability is attained The present value of an asset or liability will equal its market value

Present value model under uncertainty Financial statement information is both completely relevant and reliable The present value of an asset or liability will equal its market value Despite the fact that expected and realized net income need not be equal, the income statement still has no information when abnormal earnings do not persist. Investors also have sufficient information to calculate for themselves what the realized net income will be once they know the current years state realization There is dividend irrelevancy Reserve recognition accounting Present value accounting applied to oil and gas companies is known as reserve recognition accounting (RRA) Under Statement of Financial Accounting Standards No.69: Estimated future receipts from a companys proved oil and gas reserves are discounted at mandated rate of 10% Revenue is recognized as reserves are proved Major adjustments to previous estimates usually needed In Canada, National Instrument 51-101 of Canadian Securities Administrators requires similar but considerably expanded present value disclosure (See problem 2-24) Relevance of RRA information? Recognizing unrealized increase in asset value and equivalently recognizing revenue sooner increases relevance, and thus investor receives an earlier reading on future cash flows. Reliability of RRA information? Representational faithfulness is reduced to the large numbers and amounts of changes in estimates under RRA. Verifiability is questionable since different individuals may come up with different values (for example, different estimates of proved reserves or different timing assumptions for lifting and selling). The need for estimates also creates the opportunity for manager bias. Comparison of Different Measurement Bases Relevance versus reliability trade off: Historical cost accounting is relatively reliable since the cost of an asset or liability to a firm is usually a verifiable number that is less subject to errors of estimation and bias than are present value calculations. However, the relevance of current value accounting generally exceeds that of historical cost. But the need for estimates when conditions are not ideal opens current value accounting up to problems of reliability. Page 2 of 3

Chapter 2 Notes

Revenue recognition: Current value accounting implies earlier revenue recognition than under historical accounting. Recognition lag: Current value accounting has little recognition lag, since changes in economic value are recognized as they occur. Historical cost accounting has greater recognition lag. Revenue is not recognized until increases in inventory value are validated, usually through realization as sales. Thus, revenue recognition lags behind the economic value of inventory. Matching of costs and revenues: Matching is primarily associated with historical cost accounting. There is little matching under current value accounting and cash flow accounting.

The non-existence of true net income True net income does not exist (1) lack of object state probabilities, net income open to subjective measurements, assets and liabilities estimated based on present value model are low in reliability as present values do not accurately reflect the uncertainty facing the firm, (2) market values do not exist for all assets and liabilities (incomplete markets) therefore, the subjectivity of net income makes true net income non-existent.

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