Theory Homework - chapter 2

ACT601 Financial Accounting Theory Student Exercises Chapter 2 Accounting Under Ideal Conditions 1. Do you think that the market value of an oil and gas firm will be affected when RRA-based net income information is presented in addition to historical cost-based earnings from oil- and gas-producing activities? Explain why or why not. I think it will be affected. Also reporting RRA-based net income information and historical cost-based information not only provides relatively reliable information, but also provides more relevant information about future cash flows, reducing the extent to which the resulting present value predicts future cash flows and risk for a particular company. If this information is useful to investors and they are very professional, then investors may make better decisions about the future performance of the company and the market value of the company may be affected. 2. Explain why, under non-ideal conditions, it is necessary to trade off relevance and reliability when estimating future cash flows. Define relevance and reliability as part of your answer. Relevance requires accounting information to be able to influence the decisions of its users. This relates to timeliness, comparability, and understandability. This accounting information is closely related to the future economic performance of the company. An example is cash flow. Reliability means complete information without distortion and free from errors. Verifiability and credibility are important issues here. Reliability means that it will be reported truthfully and credibly to managers. Estimating the present value of future cash flows when conditions are not ideal requires specifying a set of future cash flow amounts. The probabilities of these states are subjective, and interest rates must be specified, all of which are subject to error and bias and reduce reliability. Reliable information (also known as historical cost) is unreliable because it does not involve a direct estimate of future income. Costs are based on market transactions at the date of acquisition. As market values, expected future earnings and interest rates change over time, they lose relevance. Ensuring a more significant correlation would therefore reduce reliability. Therefore trade-offs need to be made. 3. SC Ltd. operates under ideal conditions of uncertainty. On January 1, 2019, it purchased a capital asset that will last for two full years and then will be retired with no salvage. The purchase price was financed with an issue of common stock. SC Ltd. plans to pay no dividends until after the end of 2020. The interest rate in the economy is 6 percent. 1
ACT601 Financial Accounting Theory Student Exercises Chapter 2 Accounting Under Ideal Conditions SC Ltd. is certain that net cash flow from its only asset will be $100 in 2019. However, net cash flow in 2020 is uncertain. Net cash flows in 2020 will be $200 (the high state) with objective probability 0.80 and $50 (the low state) with objective probability 0.20. All cash flows are received at their respective year-ends. At the end of year 2 it becomes known that the high state is realized. Required: a. How much did SC Ltd. pay for its capital asset at the beginning of 2019? Show calculations. b. Prepare, in good form, a current value-based income statement for SC Ltd. for the second year of operations—that is, 2020. c. Prepare, in good form, a current value-based balance sheet for SC Ltd. at the end of 2020 (before any dividend payments). 2
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