ACCT30001 Lecture Notes - Lecture 2: Normal Distribution, Efficient-Market Hypothesis, Customer Satisfaction
28 May 2018
School
Department
Course
Professor
FAT lecture 2:
Structure of the lecture:
1. Recognition criteria in standards
Ø Revenue
Ø Expenses
Ø Provisions
Ø Intangibles
2. Recognition ( and measurement) of intangibles
3. Consequences of recognition criteria for Bias and Precision of Financial reports
4. How would we account for intangibles
Recognition Criteria in Accounting Standards (IASB Framework 83)
An item that meets the definition of an element should be recognized if:
1. It is probable that any future economic benefit will flow to or from the entity; and
2. The item has a cost or value that can be measured with reliability
Probable means: more likely, it is never clearly defined in the accounting standard. It says in
the standard ‘more likely than not’. It doesn’t have to be the same definition in other
standards.
Asset exists as soon as there is a probability greater than 0 of that resource giving rise to a
future cash flows è you have an asset.
Example: Lotto has some probability of winning; it is really small but it is greater than 0. So
lotto ticket is an asset.
If I owned a R&D lab, and the probability of that R&D lab discovering drugs for cancer is 5%
but the payoff from that is million dollars è then you have an asset worth 50,000.
So everything that has a probability of less than 50% is not reported in the financial
statements which give rise to substantial bias in the way we use these reports.
Implication for Bias in Financial reports
• Probability criterion creates a bias downward for both assets and liabilities (so
anything with a probability of less than 50% is not reported).
• Reliability criterion creates a bias downward for both assets and liabilities
Bias Downward and Skewness of Asset Payoffs
• This bias could be made more severe due to nature of distribution of assets payoffs
• Share/Asset returns have systematic skewness implying a small number of extreme
low probability events have very high payoffs
• This is consistent with corporate managers having an investment strategy/portfolios
with high positive skewness.
• This implies high expected value projects (low probability * high payoff) may not be
recognized and thus value and monitored under accounting standards
Normal distribution è our heights. You will never see that someone is 5 metres.
In asset distribution, asset payoffs are highly skewed è like a 5 metre person è google,
Amazon, Facebook. These company has been sitting on the tail.
Those really high returns have low probability of occurring but when it occurs, it pays a huge
amount. But the existing accounting standards would not recognize and report these
projects.
Recognition Criteria
• Revenue from Contracts with Customers (AASB115)
• Expense Recognition
• Property, Plant and Equipment (AASB 116)
• Intangibles (AAB 138)
• Provisions and Contingencies (AASB 137)
Revenue recognition:
• GAAP specifies two recognition criteria that must both be meet for revenue to be
recognized on the income statement:
– Earned (delivered a service or good) and
– The cash flow is realized or realizable (high probability of getting the cash, if
the probability is not high then we don’t recognize it)
Expense Recognition
• Expenses are recognized under the accrual basis of accounting as follows:
– Costs directly associated with revenues must be recognized as expenses in
the period when a firm recognizes revenue (product costs)
– Costs not directly associated with revenues must be recognized as expenses
in the period when a firm consumes the services or benefits (period costs)
AASB 116 Property, Plant and Equipment
The cost of an item of property, plant and equipment shall be recognised as an asset if, and
only if:
(a) it is probable that future economic benefits associated with the item will flow to the
entity; and
(b) the cost of the item can be measured reliably.
Because I bought the truck, surely that the cash flow from use of that truck is probable. And
if you don’t make cash flow from the use of the truck you can sell it off anyway.
In general, most physical property satisfy this criteria and we do recognize them in the
standards , we do not face biases in terms of the physical assets in the recognition criteria.
There are issues with the way we measure it, which we’ll do next week.
AASB 137 Provisions:
Not on the exam but good to know: Provision has greater uncertainty than the accrual. We
accrual for wages (someone worked for 2 weeks) whereas provision the amount is more
uncertain (provision for warranty, the amount of customers that are going to return the
item è hard to know).
Contingent assets/Liabilities
• an entity shall not recognise a contingent liability
• an entity shall not recognise a contingent asset
Example: Law suit.
The court has not headed down their ruling, the company might need to pay damages but it
may not with a 10% probability of this occurring. This is a liability è cannot be accounted
for.
If you are an investor and want to buy a stock => you look at the stock and very clearly you
would say that there is 10% probability that this company is going to make a payout. You
would take that into account in valuing that company. Very clearly it is a liability => this will
give rise to a bias in the use of financial reports. But accountants do not report it.
Biases in Reporting on Contingent Liabilities
• Net Assets will be overstated
• In the period in which contingent liability arises net income is overstated and the
impact on ROE is ambiguous.
• In subsequent periods as long as the contingent liability remains contingent then net
assets will be overstated and there is no effect on net income so ROE will be
understated
Fundamental accounting system is the double entry system è if you reported you
contingent liability from the balance sheet, you will record it as CR contingent liability DR
Document Summary
Structure of the lecture: recognition criteria in standards. Intangibles: recognition ( and measurement) of intangibles, consequences of recognition criteria for bias and precision of financial reports, how would we account for intangibles. Recognition criteria in accounting standards (iasb framework 83) Probable means: more likely, it is never clearly defined in the accounting standard. It says in the standard more likely than not". It doesn"t have to be the same definition in other standards. Asset exists as soon as there is a probability greater than 0 of that resource giving rise to a future cash flows you have an asset. Example: lotto has some probability of winning; it is really small but it is greater than 0. If i owned a r&d lab, and the probability of that r&d lab discovering drugs for cancer is 5% but the payoff from that is million dollars then you have an asset worth 50,000.
