(Solution Manual) Financial Accounting Theory

Scott, 7

Business

Solution Manual

7th Edition

• $15.00 $50.00

---

Description

Solution Manual for Financial Accounting Theory, The downloadable file consists of 568 pages, and the total size of the file is 1.45 MB. Purchase now only for highly discounted price.

Author(s): Scott

---

---

Study Note Preview

INSTRUCTOR ’S SOLUTIONS MANUAL for Financial Accounting Theory Seventh Edition William R. Scott University of Waterloo Toronto Copyright © 2015 Pearson Canada Inc., Toronto, Ontario. All rights reserved. This work is protected by Canadia n copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the Internet) will destroy the integrity of the work and is not permitted. The copyright holder grants permission to instructors who have adopted Financial Accounting Theory , Seventh Edition, by William R. Scott to post this material online only if the use of the website is restricted by access codes to students in the instr uctor’s class that is using the textbook and provided the reproduced material bears this copyright notice. Copyright © 2015 Pearson Canada Inc. Contents Chapter 1 Introduction.................................................................................................. 1 Chapter 2 Accounting Under Ideal Conditions .......................................................... 7 Chapter 3 The Decision Usefulness Approach to Financial Reporting...................... 68 Chapter 4 Efficient Securities Markets ...................................................................... 129 Chapter 5 The Value Relevance of Accounting Information ..................................... 153 Chapter 6 The Measurement Approach to Decision Usefulness ................................ 194 Chapter 7 Measurement Applications ........................................................................ 237 Chapter 8 The Efficient Contracting Approach to Decision Usefulness .................... 285 Chapter 9 An Analysis of Conflict ...........................................................................321 Chapter 10 Executive Compensation .........................................................................371 Chapter 11 Earnings Management .............................................................................425 Chapter 12 Standard Setting: Economic Issues ..........................................................487 Chapter 13 Standard Setting: Political Issu es.............................................................527 Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 1 Copyright © 2015 Pearson Canada Inc. CHAPTER 1 INTRODUCTION 1.1 The Objective of This Book 1.2 Some Historical Perspective 1.3 The 2007- 2008 Market Meltdowns 1.4 Efficient Contracting 1.5 A Note on Ethical Behaviour 1.6 Rules-Based v. Principles -Based Accounting Standards 1.7 The Complexity of Information in Financial Accounting and Reporting 1.8 The Role of Accounting Research 1.9 The Importance of Information Asymmetry 1.10 The Fundamental Problem of Financial Accounting Theory 1.11 Regulation as a Reaction to the Fundamental Problem 1.12 The Organization of This Book 1.12.1 Ideal Conditions 1.12.2 Adverse Selection 1.12.3 Moral Hazard 1.12.4 Standard Setting 1.12.5 The Process of Standard Setting 1.13 Relevance of Financial Accounting Theory to Accounting Practice Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 2 Copyright © 2015 Pearson Canada Inc. LEARNING OBJECTIVES A ND SUGGESTED TEACHING APPROACHES 1. The Broad Outline of the Book I use Figure 1.1 as a template to describe the broad outline of the book. Since the students typically have not had a chance to read Chapter 1 in the first course session, I stick fairly closely to the chapter material. The major points I discuss are: • Accounting in an ideal setting. Here, present -value-based accounting is natural. I go over the ideal conditions needed for such a basis of accounting to be feasible, but do not go into much detail because this topic is covered in greater depth in Chapter 2. • An introduction to the concept of information asymmetry and resulting problems of adverse selection and moral hazard. These problems are basic to the book and I feel it is desirable for the students to have a “first go” at them at this point. I concent rate on the intuition underlying the two problems. For example, adverse selection can be illustrated by asking who would be first in line to purchase life insurance if there was no medical examination, or what quality of used cars are likely to be brought to market. For moral hazard I try to pin them down on how hard they would work in this course if there were no exams. • The environment in which financial accounting and reporting operates. My main goal at this point is that the students do not take this environment for granted. I discuss the procedures of standard setting briefly and point out that this is really a process of regulation. In the past, there have been well -known cases of deregulation, such as airlines, trucking, financial institutions, power generation . However, we are entering what is likely to be a period of increasing regulation, at least for financial institutions. Instructors Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 3 Copyright © 2015 Pearson Canada Inc. may wish to discuss briefly the pros and cons of markets v. regulation (since this book tends to be market -oriented) of economic activity. 2. The Concept of Information By now, I will have referred to the term “information” several times. I suggest that it is easy to take this term for granted, and call for definitions. This usually generates considerable hesitation by the students. The purpose at this point is simply to get them to realize that information is a complex commodity. Indeed, I make an analogy between the financial accounting and reporting industry and a stereotypical manufacturing industry such as agriculture or automobiles, and ask what is the product of the accounting industry, why is it valuable, how is it quantified ? I do not go deeply into the answers to questions like these, since some decision -theoretic machinery needs to be developed (Section 3.3) before a precise definition of information can be given. Nevertheless, I try to end up with the conclusions that information has something to do with improving the process of decision -making, and that it is crucial to the operation of securities markets. 3. Relevance to Accounting Practice My undergraduate accounting theory classes usually consist of a majority of students who are heading for a professional accounting designation. There are usually also some students heading for careers in management. Since students who are facing professional accounting exams can be quite focused in their learning objectives, it is essential that the nature of the course in relation to these objectives be discussed up front. I begin by pointing out that the book is intended to give the student an appreciation and understanding of the financial reporting environment, which should help with breadth questions on professional exams. I also argue that one’s career continues well beyond attainment of a professional accounting designation, and that the nature of the te xtbook is longer -run and designed to Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 4 Copyright © 2015 Pearson Canada Inc. foster a critical awareness of the financial accounting environment which is needed if one is to become a thoughtful professional. Arguments such as these can only be pushed so far . Nevertheless, I think it is important to make them. I also point out that the text includes coverage of major accounting standards such as financial instruments, impairment, consolidations, de-recognition, and that they will have the opportunity to learn about these standards on the way through. I also refer the students to Section 1.13 , and emphasize that the text recognizes an obligation to convince them that the material is relevant to their careers. To do this, the text explains theoretical concepts i n intuitive terms, and illustrates and motivates the concepts based on a series of Theory in Practice vignettes, and problem material based frequently on articles from the financial press and relevant research findings . For the management students in the c lass, and for the professional accounting students who may some day be managers, I emphasize that the text does not ignore them. Chapters 8 to 11 inclusive (the bottom branch of Figure 1.1) deal with topics of interest to managers, including economic consequences, conflict resolution, executive compensation and earnings management. All of these topics demonstrate that management has a legitimate interest in financial reporting. I also argue that Chapters 2 to 7 inclusive (the top branch of Figure 1.1) are relevant to managers since they give insights into how financial accounting information is used by investors. Finally, since management is a major constituency in standard- setting, a critical awareness of the need for standard setting and the standard- setting process (Chapters 12 and 13) is useful for any manager. I have not had problems with student course evaluations as a result of using the material in this book. In fact, I have constantly been surprised at how far one can push the students in a theoretic al direction providing that I rely on the textbook material to give the students an intuitive understanding, and concentrate in class Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 5 Copyright © 2015 Pearson Canada Inc. on illustrating, motivating and discussing the application of the concepts. For this, I find that the financial media are helpful sources of current articles which I bring to class to serve as a basis for discussion. Numerous such articles form the basis of most “Theory in Practice” vignettes scattered throughout the text. 4. The Structure of Standard- Setting Bodies This edition continues to orient itself to International Accounting Standards Board (IASB) standards , although attention is also given to several U.S. standards. Instructors may wish to briefly discuss the structure of standard setting bodies at this point. 5. Social Issues Underlying Regulation Instructors who wish to dig more deeply into social issues underlying financial reporting and standard setting can usefully spend a class session on the 1982 Merino and Neimark paper (in Section 1.2). This paper raises f undamental issues about the role of financial reporting in society which go well beyond the textbook coverage of this paper, which confines itself largely to a brief description of reporting problems leading up to the great stock market crash of 1929 and t he creation of the SEC. It provides food for thought both for those who do and do not favour the present financial reporting environment. For a contrasting view from that of Merino and Neimark, Benston’s 1973 article is also worth assigning. This edition c ontinues its discussion of the Enron and WorldCom financial reporting disasters , since these are still relevant to accounting theory and practice. I continue to include (Section 1.3) a description of the 2007-2008 market meltdowns surrounding financial ass ets and institutions , since these events are driving many new accounting standards and changes in executive compensation discussed later in the text. In spite of the bewildering collection of acronyms, instructors may wish to discuss these market meltdowns early in the course, since they pervade the book and continue to have major implications for financial accounting. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1 6 Copyright © 2015 Pearson Canada Inc. Section 1. 5 introduces the topic of ethics. With the extent of accountant and auditor involvement in numerous financial reporting disasters that have come to light since 2000, such as Enron and WorldCom, and more recent criticisms of fair value accounting and off -balance sheet entities, the importance of ethical behaviour is very much apparent. Indeed, ethical behaviour underlies the distinction between rules -based and principles -based accounting standards (Section 1.6). This distinction is important since the IASB constitution commits the IASB to principles -based standards. I emphasize, however, that ethics tends to produce similar behaviour as a longer - run maximization of one’s own interests (although the mind sets are different) . Thus, a longer–run view of ethical behaviour quickly turns into questions of full disclosure, usefulness, reputation, and cooperative behaviour . The text tends to emphasize these latter components of professional responsibility. Some instructors may wish to introduce and discuss ethical issues more broadly. 6. Some influential accounting academics are critical of the moves by standard setting bodies towards current v alue accounting. Chapter 8 is devoted to an alternative view, namely efficient contract theory (also called positive accounting theory). A brief introduction to this topic is given in Section 1.4. Instructors who wish to introduce this topic now may wish t o discuss why accountants are generally regarded as conservative, whether financial accounting can help to attain strong corporate governance, and whether managers like current value accounting. 7. I have not prepared any questions and problems for this ch apter. One reason is that I usually like to let the first week of classes pass before giving formal assignments. More fundamentally, I use this first week to describe and motivate the text material, as outlined above, and most of the material in Chapter 1 is covered in greater detail later. However, extensive problem material is provided for the remaining chapters of the book. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 7 CHAPTER 2 ACCOUNTING UNDER IDEAL CONDITIONS 2.1 Overview 2.2 The Present Value Model Under Certainty 2.2.1 Summary 2.3 The Present Value Model Under Uncertainty 2.3.1 Summary 2.4 Examples of Present Value Accounting 2.4.1 Embedded Value 2.4.2 Reserve Recognition Accounting (RRA) 2.4.3 Critique of RRA 2.4.4 Summary of RRA 2.5 Historical Cost Accounting Revisited 2.5.1 Comparison of Different Measurement Bases 2.5.2 Conclusion 2.6 The Non- Existence of True Net Income 2.7 Conclusion to Accounting Under Ideal Conditions LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1. To Appreciate the Concept of Ideal Conditions This concept is drawn on throughout the book. Roughly speaking, by ideal conditions I mean conditions where future firm cash flows and interest rates are known with certainty or, if not known with certainty, where there is a complete and publicly known Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 8 set of states of nature and associated objective probabilities which enables a completely relevant and reliable expected present value of the firm to be calculated. I assume risk- neutral investors in this Chapter, so that valuation of the firm is on the basis of expected present value, that is, no adjustment for risk is needed. The concept of a risk-averse investor is introduced in Section 3.4, and a capital asset pricing model of the firm’s shares is described in Section 4.5. 2. To Use the Present Value Model Under Ideal Conditions to Prepare an Articulated Set of Financial Statements for a Simple Firm The text limits itself to financial statements for the first year of operations. The problem material extends the accounting to a subsequent year (see problems 1, 2, 3, 5, 15, and 19). In subsequent years , the firm earns interest on opening cash balance. This is picked up by the accretion of discount calculation, since cash is included in opening net assets. Interest earned on cash balances leads naturally to the role of dividends in present-value accounting and the concept of dividend irrelevance. 3. To Critically Evaluate Reserve Recognition Accounting (RRA) as an Application of the Present Value Model I usually allow some class time to criticize the assumptions of ideal conditions. Some students want to “blow off steam” because they perceiv e these assumptions as quite strong. I find that RRA is an excellent vehicle both to motivate and critique present value-based accounting. The fact that it is on line encourages students to take the present value model seriously, which I emphasize by basing class discussion on an example of RRA disclosure for a Canadian oil and gas firm that also reports to the SEC . Such disclosures are usually in SEC Form 40 -F, not in the annual report (which says something about management’s view of RRA). I also emphasize the point that present value- based accounting products run into severe implementation problems when the ideal conditions they need do not hold. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 9 I sometimes receive comments that the text over -emphasizes RRA. I find RRA so helpful to illustrate numerous course concepts that I have resisted such comments. However, instructors may wish to emphasize that RRA , based on a United States accounting standard , is relevant to Canadian oil and gas firms whose shares are traded in the United States. In this regard, it is worth noting that Husky Energy Inc., used as the text RRA illustration in Section 2.4.2, is a Canadian- based corporation. 4. Historical Cost Accounting in the Mixed Measurement Model Instructors may wish to discuss historical cost accounting in relation to current value accounting, since historical cost is still an important component of the mixed measurement model. Section 2.5 compares these measurement bases in terms of relevance and reliability, timing of revenue recognition, recognition lag, and matching. This is a good place to emphasize the trade- off between relevance and reliability, and how different measurement bases imply different trade- offs. This is also a good place to discuss the relative importance of the balance sheet and income st atements under the two measurement bases. That is, historical cost accounting takes the view that the income statement is of greater importance because it gives the current installment of the firm’ s earning power, and provides a place to start to predict future firm performance. Under current value accounting, the balance sheet is of greater performance, the argument being that current values of assets and liabilities provides a better prediction of future firm performance. 6. To Question the Existence of Net Income as a Well -Defined Economic Construct I use the reliability problems of RRA to question the existence of “true” economic income except under ideal conditions. With the text example, or some other example, of RRA disclosure in front of us, I ask the students if they would be willing to pay the RRA value for the proved reserves of an oil and gas company. Discussion usually brings out a negative response, for reasons such as difficulties in assessing expected quantities Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 10 and prices, disagreement with a 10% discount rate, possible inside information about costs, additional reserves, etc. I then point out that there are numerous other assets and liabilities for which a quoted market price does not exist, and argue that information asymmetry is a major r eason why market prices may not exist. The market for used cars and problems surrounding insurance markets in the presence of adverse selection and moral hazard provide other examples of “missing” markets. Having established that there are not quoted market prices available for “everything,” I point out that it is then impossible to fully value a firm on this basis and, as a result, it is also impossible to measure true economic income. I take a sort of perverse pleasure in asking those students who are heading for a professional accounting career if they really want to devote their lives to measuring something which does not exist. I am careful to end on an upbeat note, however, by pointing out that lack of a true measure of income means that a large amount of judgement is required to come up with a useful measure, and that judgement is the basis of a profession. I usually do not go further than the above intuitive argument that incomplete markets are at the heart of problems of income measurement. However, instructors who wish to dig into incompleteness more deeply and precisely can assign Beaver & Demski’s “The Nature of Income Measurement” ( The Accounting Review , January, 1979). Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 11 Suggested Solutions to Questions and Problems 1. P.V. Ltd. Income Statement for Year 2 Accretion of discount (10% × 286.36) $28.64 P.V. Ltd. Balance Sheet As at Time 2 Financial Asset Shareholders’ Equity Cash $315.00 Opening balance $ 286.36 Net income 28.64 Capital Asset Present value 0.00 $315.00 $315.00 Note that cash includes interest at 10% on opening cash balance of $150. 2. Suppose that P.V. Ltd. paid a dividend of $10 at the end of year 1 (any portion of year 1 net income would do). Then, its year 2 opening net assets are $276.36, and net income would be: P.V. Ltd. Income Statement For Year 2 Accretion of discount (10% × 276.36) $27.64 Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 12 P.V.’s balance sheet at time 2 would be: P.V. Ltd. Balance Sheet As at Time 2 Financial Asset Shareholders’ Equity Cash: (140 + 14 + 150) $304.00 Opening balance: $276.36 (286.36 - 10.00 dividend) Capital Asset , at Net income 27.64 Present value 0.00 $304.00 $304.00 Thus, at time 2 the shareholders have: Cash from dividend $10.00 Interest at 10% on cash dividend, for year 2 1.00 Value of firm per balance sheet 304.00 $315.00 This is the same value as that of the firm at time 2, assuming P.V. Ltd. paid no dividends (see Question 1). Consequently, the firm’s dividend policy does not matter to the shareholders under ideal conditions. Note that a crucial requirement here, following from ideal conditions, is that the investors and the firm both earn interest on financial assets , including reinvested dividends, at the same rate of return. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 13 Note also that if the investor spends the dividend rather than investing it, this must be becaus e he/she values current consumption as preferable to investing. Thus, the investor is no worse off if the dividend is spent. Also, if the firm pays no dividend, and the investor wants to consume $10, he/she can borrow at 10%. This liability is offset b y the additional $10 increase in firm value on the $10 additional retained earnings. Again, the investor is no worse off . 3. Expected net income is also called accretion of discount because the firm’s expected future cash flows are one year closer at year end than at the beginning. Consequently, the opening firm value is rolled forward or “accreted” at the discount rate used in the present value calculations. 4. The procedure here is similar to that used in Question 2. Assume that the good economy state is realized for year 1. Assume also that P.V. Ltd. pays a dividend of, say, $40 at time 1. If the good economy state is also realized in year 2, P.V.’s year 2 net income will then be: P.V. Ltd. Income Statement For Year 2 (good economy in year 2) Accretion of discount [(336.36 – 40) ×.10] 29.64 Abnormal earnings, as a result of good state realization in year 2 (200 – 150) 50.00 Net income year 2 $79.64 PV’s balance sheet at the end of year 2 will then be: P.V. Ltd. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 14 Balance Sheet As at Time 2 Financial Asset Shareholders’ Equity Cash (200 - 40 + 200 + 16) $376.00 Opening balance $336.36 Less: Dividend end Capital Asset 0.00 of year 1 40.00 $296.36 Add: Net income 79.64 $376.00 $376.00 Thus, at time 2 shareholders have: Cash from time 1 dividend $40.00 Interest period 2 on time 1 dividend: $40 ×0.10 4.00 Value of firm per balance sheet , time 2 376.00 $420.00 Note: cash balance of $376 assumes no dividend paid for year 2. If P.V. Ltd. paid no dividend at time 1, the value of the firm at time 2 would be: Cash: 200 + 200 + 20 $420.00 Capital asset 0.00 $420.00 Thus, the shareholders’ wealth is the same at time 2 whether the firm pays a year 1 dividend or not. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 15 An identical analysis applies if the low state is real ized in year 2. Shareholders’ wealth is $320 at time 2 regardless of whether P.V. Ltd. pays a dividend at time 1. A similar analysis applies if the low state is realized in period 1. Therefore, regardless of the state that is realized, shareholders are indifferent to dividend policy. As long as ideal conditions hold, the introduction of uncertainty does not invalidate dividend irrelevancy. 5. Cash end Interest on opening Sales State realization Probability of year 1 cash balance year 2 Total bad, bad 0.25 100 10 100 210 bad, good 0.25 100 10 200 310 good, bad 0.25 200 20 100 320 good, good 0.25 200 20 200 420 $1,260 Thus, the liquidating dividend will be $210, $310, $320, or $420; each with probability 0.25. Thus, present value, at time 0, of expect ed liquidating dividend is: 𝑃𝐴 0=1 1.102[0.25(210 +310 +320 +420)] 33.260$260,110.125.0 2=×= Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 16 Expected cash flow in each year is 0.5 × 100 + 0.5 × 200 = 50 +100 = $150 Assuming no dividends, present value of future cash flows is thus: 𝑃𝐴0=1 1.102(150 +15+150)=1 1.102(315)=$260 .33, where $15 is the expected return on investing period 1 cash. Note: it is assumed that state realizations in each period are independent. 6. a. The expected value of a single roll of a fair die is: 5.3)654321(61=+++++×=x b. First, you would have to write down a set of possible states of nature for the die. One simple possibility would be to define: State 1: die is fair State 2: die is not fair. Then, subjective probabilities of each state need to be assessed, based o n any prior information you have. For example, if the person supplying you with the die looks suspicious , you might assess the probability of state 2 as 0.50, say. A problem with this approach, however, is that to go on to calculate the expected value of a single roll when the die is not fair , you do not have probabilities for each possible outcome of the roll. That is, you do not know just how unfair the die is. A more elaborate alternative would be to formally recognize that the probability of rolling a 1 can be anything from zero to one inclusive, and similarly for rolling a 2, 3, . . . , 6, subject to the requirement that the six probabilities sum to one. Formally, we can regard a state as a 1 × 6 vector Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 17 P = [ p 1, p2, . . . , p 6], subject to pi ≥ 0 i = 1, 2, . . . , 6 ∑ pi = 1 Thus, the set of states consists of all vectors satisfying these requirements. All vectors except the one with all pi = 1/6 represent a different possible bias. Next, it is necessary to assess state probabilities. It is by no means obvious how to do this. You would have to bring to bear any information or subjective feelings that you may have. Lacking any objective information, one possibility is to assume that each possible state is equally lik ely. Then, the expected value of a single roll is 3.5. This does not mean that you believe the die is fair, even though this is the same answer as in part a . Rather, it means that the various possible biases cancel each other out, since you feel that they are equally likely. Your uncertainty about the true state of the die suggests that you would be interested in any information that would help you refine your subjective probability assessment, which leads to part c. c. It will never be known with certainty whether the die is fair or not because luck might influence the outcome of the rolls. However, after a few rolls you should be able to better predict future rolls. Yes, the four rolls should affect your belief that the die is fair because you can calculat e the average roll, which is 1/4 (6 + 4 + 1 + 3) = 3.5 here. Since this is exactly the average roll that would be expected if the die was fair, you would probably increase your belief that it is fair. Note: The main purpose of this question is to anticipat e what happens when objective state probabilities are not available, in preparation for the introduction of decision making under uncertainty in Section 3.3. The analogy of this question is Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 18 to the problem of subjectively assessing probabilities over the tr ue state of the firm and of the role of financial statement information in refining these probabilities. Questions 7, 8, and 9 of this chapter can usefully be assigned in conjunction with this question. Alternatively, this question could be assigned as part of Chapter 3. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 19 7. Under ideal conditions of certainty, future cash flows are known by assumption. Thus estimates are not applicable. Under ideal conditions of uncertainty, by assumption, there is a complete and publicly known set of states of nature, known cash flows conditional on each state, and objective probabilities of those states. Also, the interest rate to be used for discounting is given. Then, expected present value is a simple calculation that does not require estimates to prepare. 8. Under non- ideal conditions, it may be difficult to write down a complete set of states of nature and associated cash flows. Even if these can be written down, difficulties remain because objective state probabilities are not available. This is perhaps the most fundamental difficulty, since these probabilities must be subjectively estimated. Also an interest rate is not necessarily given. All of these difficulties lead to reliability problems of lack of representational faithfulness and possible bias. The expected present value calculation can still be made, but it is an estimate because the probabilities and other values that go into it are estimates. 9. Market value will be affected if the RRA information affects investors’ subjective probabilities of states of nature concerning future firm performance. This could happen, for example, if the RRA statements show an increase or decrease in the present values of proved reserves. This evidence, whil e highly relevant, suffers from low reliability. Also, it is included in the financial statement notes, not in the financial statements proper. Nevertheless , if the relevance of RRA outweighs its low reliability, investors will increase or decrease their s ubjective probabilities over states of nature . This would affect their evaluations of future earnings and/or cash flows, their buy/sell decisions, hence the market value of the firm. It can be argued that firm value will not be affected by pointing out that the RRA information may be perceived by investors as so unreliable that they ignore it. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 20 10. Relevant information is information that enables investors to estimate the present value of future receipts from an asset (or payments under a liability). In an accounting context, relevant information helps investors to predict future firm performance, such as cash flows . Reliable information is information that faithfully represents what it is supposed to represent . Note: In this book, we use the term relevance to refer to what the Conceptual Framework now calls representational faithfulness. We do this because the term is shorter and familiar from past usage. Instructors who wish to expose students with the Framework terminology may wish to do so in this question. See Chapter 1, Note 14. When conditions are not ideal, the estimation of the present value of future firm cash flows (i.e., relevant information) requires specification of a set of possible future cash flow amounts (i.e., states of nature) . The probabilities of these states are subjective, which means that they must be estimated by the preparer. Also, an interest rate must be specified for the discounting calculations. All of these procedures are subject to errors and possible bias , reducing reli ability. Thus, like almost all predictions of the future, relevant information tends to be unreliable. Conversely, reliable information, such as the historical cost of a capital asset or the face value of debt , tends to be low in relevance because this bas is of valuation involves no direct estimates of future receipts or payments. Rather, cost is based on market transactions at the acquisition date. While, at time of acquisition, historical costs generally reflect estimates of future receipts or payments, t hey quickly lose relevance since market values, expected future receipts, and interest rates change over time. Then, historical cost -based valuations lose relevance. Therefore, the accountant who tries to secure greater relevance by predicting future event s must cope with less reliability. Consequently, these two desirable Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 21 characteristics of accounting information must be traded off, since an increase in one leads to a decrease in the other. 11. Several reasons can be suggested why oil company managers hav e reservations about RRA: • The discount rate of 10% might not reflect the firm’s cost of capital. • Low reliability. RRA involves making a large number of assumptions and estimates . While RRA deals with low reliability in part by requiring average prices of oil and gas for the period to be used (rather than prices anticipated when the reserves are expected to be sold), management may feel that average past prices bear little relationship to the net revenue the company will receive in the future. Furthermo re, management may be concerned about low reliability of other estimates, such as reserve quantities. • Frequent changes in estimates. Conditions in the oil and gas market can change rapidly, making it necessary for the firm to make frequent changes in estimates. • Investors may ignore. Investors may not understand the RRA information. Even if they do, m anagement may believe the RRA information is so unreliable that investors will ignore it. If so, why prepare it? • Legal liability. Management may be concerned that if the RRA estimates are not realized, the firm will be subject to lawsuits from investors. Management’s reservations may be an attempt to limit or avoid liability. 12. a. Most industrial and retail firms regard revenue as earned at t he point of sale. Since sale implies a contract with the buyer and change of ownership, t his Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 22 is usually the earliest point at which significant risks and rewards of ownership pass to the buyer, the seller loses control of the items sold ( e.g.., title passe s to buyer) and at which the amount of revenue to be received can be determined with reasonable reliability. b. Under RRA, revenue is recognized when oil and gas reserves are proven. This point in the operating cycle does not meet the IAS 18 criteria for revenue recognition. Since the oil and gas are still in the ground and the reserves are not sold, the significant risks and rewards of ownership have not been passed on and control remains with the producer . Also, the large number of revisions to estimates under RRA cast s doubt on the reliability of the amount of revenue recognized. Presumably, this is why RRA is presented as supplementary information only. Presumably , however, collection is reasonably assured since oil and gas have ready markets. Note: This question illustrates that the trade- off between relevance and reliability can be equivalently framed in terms of revenue recognition as well as balance sheet valuation. In effect, balance sheet valuation is in terms of the debit side of asset valuation whereas criteria for revenue recognition are in terms of the credit side. The basic trade- off is the same, however. In particular, it should be noted that early revenue recognition increases relevance, even though it may lose reliability. 13. a. From a balance sheet perspective under ideal conditions , inventory is valued at current value. This could be the present value of expected future cash receipts from sale, that is, value- in-use. Alternatively, i nventory could be valued at market value , that is, at fair value since under ideal conditions these 2 values would be the same ). Note: In the present value examples of this chapter, all production is assumed sold for cash. If all production is not sold, inventory would be valued at current value, and cash would be less by this amount. Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 2 Copyright © 2015 Pearson Canada Inc. 23 Since the firm’s balance sheet includes inventory at current value, it is included at current value in the accretion of discount calculation . Thus, in effect, revenue on unsold production is recognized as the inventory i s manufactured. b. Cost basis accounting for inventory is due to lack of ideal conditions. Then, current value requires estimation, opening up inventory valuation to error and possible manager bias. Accountants must feel that this reduction in reliability outweighs the greater relevance of current inventory value. Historical cost accounting for inventories is not completely reliable, since firm managers still have some room to manage (i.e., bias) their reported profitability through their choice of cost methods (FIFO, LIFO, etc.) . Furthermore, even the cost of inventories is not always reliable. For example, overhead costs are usually allocated to the cost of manufactured inventory. These costs are affected by manager decisions about allocation rates and production volumes. Note: it could also be mentioned that historical cost accounting for inventories is accompanied by the lower -of-cost-or-market rule. Then, reliability issues of estimating current valuation re- arise. Also, it is possible that the firm may attempt to hide obsolescence by not writing down obsolete inventory at all. 14. This practice implies that r evenue is recognized as cash is collected. This basis of valuation might be used if the firm sells with litt le or no money down and a long collection period. Valuation of accounts receivable at the amount of the sale would require estimating credit losses. This estimate may be too unreliable under these conditions, outweighing the greater relevance of recognizing revenue as a sale is made. 15. a. Present value of capital asset 2015, 2016, and 2017