1/15/2021

AF5102
Accounting Theory

Lecture 1
Introduction &
Accounting Under Ideal Conditions

Dr. Zhang Yong

Email: yong.zhang@polyu.edu.hk
Office: M1042
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AF5102 Accounting Theory

• Instructor
• Dr. Zhang Yong
• Textbook
• Financial Accounting Theory 7th edition (William R.
Scott)
• Assessment
• Class Attendance and Participation 10%
• Individual Homework 25%
• Midterm Exam 40%
• Group Research Proposal 25%

Details of individual homework, group

research proposal, and midterm exam will be
announced in class as we progress.

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What’s this class about?

• We do not talk about debits/credits.
• But you are assumed to have some background about how debits/credits work
and the system of financial reporting (financial statements) in general.

• We talk about the accounting system from a higher level and talk about why we
have accounting and what kind of roles it’s supposed to serve in an economy.
• In the process, we’ll quick review some academic research and their findings
(empirical evidence etc.).
• At the end of this class, you may not have an answer to everything, but hopefully
you have a more systematic way of thinking about many issues, and some
knowledge about the scientific methods that people use to answer many
questions.

Some Important Questions

• What is the role of accounting information in a
market economy?
• How to make accounting information more useful to
its users?
• Why do we need accounting standards?

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Accounting Under Ideal Conditions

• Ideal conditions of certainty
• Future cash flows of the firm publicly known with certainty
• Interest rate of the economy publicly known with certainty
• Ideal conditions of uncertainty
• Future cash flows discounted at given, fixed interest rate
• Complete and publicly known set of states of nature
• State probabilities objective and publicly known
• State realization publicly observable

Accounting Under Certainty

• Certainty Inc.
• Only one asset, no liabilities
• Cash flow generated by the asset
• $150 each year for 2 years
• No residual value
• Discount rate is 10%

Present value of the future cash flows at the end of Year 0

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Balance Sheet As at End of Year 0

Capital Asset $260.33 Shareholders’ Equity $260.33

Income Statement for Year 1

Accretion of discount $26.03

Balance Sheet As at End of Year 1

Cash $150.00 Shareholder’s Equity

Capital Asset 136.36

$286.36 $286.36

Balance Sheet As at End of Year 1

Cash $150.00 Shareholder’s Equity

Capital Asset 136.36

$286.36 $286.36

Income Statement for Year 2

Accretion of discount $28.64

Balance Sheet As at End of Year 2

Cash $315.00 Shareholder’s Equity

Capital Asset 0

$315.00 $315.00

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Income Statement for Year 1

(Traditional Format)
Revenue $150 $150
Amortization Expense $260.33 - $136.36 = $260.33/2 = $130.17
$123.97
Net Income $26.03 $19.83

Income Statement for Year 2

(Traditional Format)
Revenue $150 + $15 = $165 $165
Amortization Expense $136.36 $130.17
Net Income $28.64 $34.83

Accounting Under Uncertainty

• Uncertainty Inc.
• Same conditions as Certainty Inc. except
• Cash flow generated each year will depend on the state of
economy
• Good economy: $200
• Bad economy: $100
• During each year the two states of economy occur with same
probability (0.5)

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PV Year 0
B, 0.5
G, 0.5

200 100 Year 1

G, 0.5 G, 0.5 B, 0.5

B, 0.5

200 100 200 100 Year 2

Expected present value of the future cash flows at the end of Year 0

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Balance Sheet As at End of Year 0

Capital Asset $260.33 Shareholders’ Equity $260.33

Income Statement for Year 1 (Bad Economy)

Accretion of discount (0.1 x $260.33) $26.03

Less: Abnormal earnings (due to bad economy) 50.00

Net Loss $23.97

Balance Sheet As at End of Year 1 (Bad Economy)

Cash $100.00 Shareholder’s Equity

Capital Asset 136.36

$236.36 $236.36

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Balance Sheet As at End of Year 1 (Bad Economy)

Cash $100.00 Shareholder’s Equity

Capital Asset 136.36

$236.36 $236.36

Income Statement for Year 2 (Good Economy)

Accretion of discount (0.1 x $236.36) $23.64

Add: Abnormal earnings (due to good economy) 50.00

Net Income $73.64

Balance Sheet As at End of Year 2 (Good Economy)

Cash Shareholder’s Equity

$310.00 $310.00
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Income Statement for Year 1 (Bad Economy)

Revenue $100
Amortization Expense $260.33 - $136.36 = $123.97
Net Income (Loss) $(23.97)

Income Statement for Year 2 (Good Economy)

Revenue $200 + $10
Amortization Expense $136.36
Net Income $73.64

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Accounting Under Ideal Conditions

• Book value of assets = present value
• Present value = Market value (force of arbitrage, risk-
neutral investors)
• Income statement and balance sheet provide
duplicate information
• Current earnings not useful in predicting future cash
flow
• Accounting information is both completely relevant
and completely reliable

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Accounting Under Non-ideal Conditions

• Goodwill measurement (Yum! Brands)

• Pre-SFAS 142: Straight-line amortization (20 years)
• SFAS 142: Annual impairment test
• Assign goodwill to reporting units
• Estimate the fair value of each reporting unit using discounted
cash flow method
• Compare carrying value with fair value to determine if impairment
has occurred

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The impact of adoption of SFAS 142

Source: Yum! Brands 2002 Annual Report

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The impact of adoption of SFAS 142

Source: Yum! Brands 2002 Annual Report

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Some background information about goodwill accounting

• Source: Shalev, Zhang, and Zhang

(2013)

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Accounting Under Non-Ideal Conditions

• Book value of assets may not be equal to present value
• Measurement bases matters
• Present value may not be equal to market value
• Market frictions, incomplete markets
• “Real” earnings does not exist
• Objective of financial reporting needs to be defined
• Tradeoff between relevance and reliability
• The mixed measurement model
• Income statement and balance sheet may provide distinct
information
• Dirty surplus

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Information Asymmetry

• Adverse Selection
• Unobserved type
• Good company versus bad company

• Moral Hazard
• Unobserved action
• Hardworking manager versus shirking manager

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The Role of Financial Reporting in Resolving

Information Asymmetry

• Control Adverse Selection

• Converting inside information to public information
• Help investors make better investment decisions

• Control Moral Hazard

• Measure performance of managers
• Motivate managers to work harder

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The Fundamental Problem Of Financial

Accounting Theory
The best measure of net income to control adverse selection may
not be the same as the best measure to control moral hazard
• Useful information for predicting future cash flow (Valuation)
• Fair value accounting?
• Useful information for measuring manager performance
(Stewardship)
• Historical cost accounting?

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Role of Standard Setting

• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces are subject to failure
• Regulation steps in to try to correct market failures
• Regulation is costly
• Standard setting mediates between conflicting
interests of investors and managers
• Managers may object to releasing all the information that
investors want

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How Financial Reporting Standards are set?

• Standard setting organizations:
• International Accounting Standards Board (IASB) → Interna onal Financial
Reporting Standards (IFRS), used in over 115 countries
• Financial Accounting Standards Board (FASB) → Statements of Financial
Accounting Standards (SFAS), also called U.S. GAAP, used in the U.S.

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• Post-
implementation
review
• Revision of
previous
standards, or set
new standards
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How is academic research reflected in the

setting of accounting standards
• Academic members on the board of IASB and FASB.
• IASB/FASB research takes into account research evidence.
• Academic comments to standards (discussion papers and exposure drafts)
are solicited.
• The rise of evidence-based standard-setting.

Shalev, Zhang and Zhang (2013) has been cited and discussed in
• IASB Agenda Paper 12A (December 2014)
• IASB Discussion Paper DP/2020/1 (March 2020)
[Topic: business combination, accounting for intangible assets, and goodwill
impairment]

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Just like in all other decisions ….

• Accounting standard-setters are not machines; they are subject to
influences just like all human beings.
• Other parties are involved too… For example, legislators and
regulators. They are also subject to influences.
• Ramanna (2008 JAE). In the revision of SFAS 142 (on goodwill
accounting), members of congress took strong positions against the
proposed accounting standard. These congresspersons can be linked,
using political contributions, to firms opposed to the proposed
accounting standard.

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Theories Relevant to Financial Accounting

• Decision Theory
• Making rational investment decisions
• Efficient securities markets
• Share prices quickly and fully incorporate information
• Behavioural Theory
• Investors’ judgement and decision making can be irrational
• Game theory
• Anticipating other players’ move
• Agency theory
• Self-serving managers

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