# ACCO 400 Study Guide - Final Guide: Day Count Convention, Historical Cost, Revenue RecognitionPremium

12 pages19 viewsFall 2015

School

Concordia UniversityDepartment

AccountancyCourse Code

ACCO 400Professor

Ahmad HammamiStudy Guide

FinalThis

**preview**shows pages 1-3. to view the full**12 pages of the document.**ACCO 400 Final Review: Chapter conclusions

1) Accounting Under Ideal Conditions:

Ideal Conditions:

• Relevance: “provides information about the firm’s future economic projections”

• Reliability: “faithfully represents the firm’s financial position and result of operations”

- Complete - Free from material error - Free from bias

• Assumptions: Known FCF + interest rate

- Basis of accounting: PV

- Income recognition: As changes in PV occur

Ideal Conditions of Uncertainty

• Assumptions: States of nature objective + publicly known + Given interest rate

- Basis of accounting: Expected PV

- Income recognition: As changes in expected PV occur

When no Ideal Conditions: RRA Reserve Recognition Accounting (OIL RESERVES)

1) Applies to proved reserves only

2) Discounted at mandated rate of 10%

3) Revenue recognized as reserves are proved

4) Uses oil & gas prices as at end of period (Not when expected to be sold)

Downsides of no IDEAL C: estimates can be wrong and hard to state= legal liabilities

a) Greater relevance requires more estimates

b) But, more estimates decrease reliability

SOLUTION: Relevance and reliability must be traded off AND use RRA as supplement info not main.

Historical Cost vs. Current Value

Accounting:

• Different trade-offs between:

1) Relevance and reliability

2) Timing of revenue recognition

3) Recognition lag

4) Matching

The Non‐Existence of True Net Income:

Reason: Incomplete markts due to:

- thin markets (oil reserve for ex)

- if information asymmetry, no market develops so cannot use market value as proxy for PV, if we

have to estimate PV = true net income does not exist

Solution: The mixed measurement model

• Current value accounting for: A/R, fin. Instrmt,

A/P, Pensions

• Historical cost accounting for: Invtry , PPE,

goodwill

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2) The decision usefulness approach to financial reporting

a) Investors are an important part of accounting and It is their responsibility to make investment

decisions

b) The theory of rational decision making helps accountant to know investors’ decision needs to

prepare useful financial statements

• The Rational Decision Theory Model:

- It claims that investor decisions to maximize expected utility EU

- Role in FIN.REPORTN: helps accountant provide useful information for investment decisions

- Risk-averse investor trades off risk and return: If risk incr, he demands higher return

• The Information System: Evidence Probabilities, Conditional on Each State (good news vs bad news) for

Input into Bayes’ Theorem

- The higher the financial statement informativeness the better the investor can predict future firm

performance

- Prior probabilities are subjective: Investor assesses them based on all information available prior to the

investment

- Information system probabilities are objective: Reflect quality of GAAP

How is that known by investor? The theory assumes the investor quickly figures out the

- If prior probabilities are subjective, so are posterior probabilities (plus they are better predictors of

future firm performance than prior probabilities)

• Bayes’ Theorem: formula allows investors to revise prior probabilities into posterior probabilities.

• Principle of Portfolio Diversification: Divide all events affecting the returns on firms’ shares into two

1) Market‐wide factors: central bank changes the interest rate

2) Firm‐specific factors: GN or BN in a firm’s financial statements

a) If investor buys a portfolio of securities, firm‐specific factors tend to cancel out

b) A diversified portfolio: firm‐specific factors completely cancel out, leaving only undiversifiable market‐

wide factors to affect returns.

• Management Discussion and Analysis: MORE RELEVANCE than F/S – predict earnings for next 4Qrtr

a) To supplement the financial statements

b) Forward‐looking orientation

c) Risks facing the firm

Result: more rational decision making: increase main diagonal probabilities of information

• Desirable characteristics of accounting information

– Relevance: Information about future economic prospects

– Reliability: “faithful representation” + Complete, free from material error, and unbiased

The Conceptual Framework seems consistent with the

rational decision theory model

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3) Efficient Securities Markets (ESM)

• Definition: At all times, market price of a security fully reflects all public available info about that security

• Characteristics of ESM:

a) Security prices dsnt reflect inside information

b) Efficiency is relative to publicly available information

c) Investing is a fair game (no bargains)

d) Security prices fluctuate randomly over time

• Accounting Implications of ESM:

a) Full disclosure, including all acc. Policies

b) Accounting policies do not matter (unless is effects cash flow)

c) “Naïve” investors price‐protected

d) Accountants are in competition with other information providers

• The Informativeness of Price about share Value: if ESM share $ fully reflect publicly available info.

BUT THERE IS A LOGICAL INCONSICTENCY WITH INFORMATIVENESS:

a) If share prices are fully informative, no one would gather info, since we assume we can’t beat the

market.

b) If no one gathers information, share prices will not reflect all publicly available info.

c) If share prices do not reflect all publicly available information: investors will gather information so

share price will quickly become fully informative

d) Then, no‐one would bother to gather information, etc., etc.

SOLUTION: Noise trading

• A Capital Asset Pricing Model: CAPM

Assumptions:

a) rational expectations • Investors assumed to know beta (when in practice, investors do not know beta,

so must estimate it, creating estimation risk)

b) common knowledge • Everyone knows that everyone knows beta, etc. (this rules out sophisticated

investors’ ability to take advantage of ordinary investors who have inferior knowledge of beta)

c) no transactions costs and liquid markets

d) rational investors

• Information Asymmetry:

a) The fundamental value of a share –no inside information

b) Inside information – Information about the firm that is not publicly available

c) Effect of estimation risk on share prices – Efficient market price includes a “discount” for expected

estimation risk: investors demand a higher return

d) Controlling estimation risk: Insider trading laws + Financial reporting by converting inside information

into outside= reducing estimation risk

• Social Significance of ESM: better allocation of scarce capital

• Social role of financial reporting: max. amount of publicly available information to help markets be efficient

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