Chapter 2 Flashcards
What are ideal conditions in accounting?
A hypothetical scenario where future cash flows and interest rates are publicly known with certainty
What are the two key assumptions of ideal conditions?
1) Future cash flows are known
2) Interest rates are fixed and publicly known
Why don’t ideal conditions exist in real life?
Because future cash flows and interest rates are uncertain and unpredictable
Under ideal conditions, what financial information can be perfectly predicted?
The present value of assets, net income, and future firm performance
What is present value accounting?
A method of valuing assets based on the discounted value of future cash flows
Why is present value accounting useful under ideal conditions?
It provides completely relevant and reliable asset valuations
How does present value accounting compare to historical cost accounting?
Present value accounting is more relevant but less reliable due to estimation errors
What is the relevance vs. reliability tradeoff?
Financial information can be either highly relevant (useful for decision-making) or highly reliable (verifiable and objective), but rarely both
Which accounting method prioritizes reliability over relevance?
Historical cost accounting
Why is historical cost considered reliable but not always relevant?
It records assets at purchase price, ,which may not reflect their current value
Why is fair value accounting considered relevant but not always reliable?
It reflects market-based values, but those values can be volatile and subjective
As something becomes more reliable what happens?
It becomes less relevant
Under ideal conditions, how many of the 6 accounting characteristics are possible?
all 6 are possible under ideal conditions
What is accretion of discount?
this is the process where the present value of an asset or liability increases over time as it gets closer to its expected cash flow date
What happens to financial reporting when ideal conditions do not exist?
Estimates and assumptions must be made, reducing reliability
How do uncertain interest rates affect financial reporting?
They make it difficult to accurately discount future cash flows
What is the dividend irrelevancy theory?
The timing of dividends does not impact firm value under ideal conditions
Under ideal conditions doe the timing of dividends impact the firms value?
No - because of the dividend irrelevancy theory
What happens to dividend irrelevancy when real world uncertainty is introduced?
Investors may prefer dividends now due to risk and uncertainty
Why does the dividend irrelevancy theory hold under ideal conditions?
Because investors can reinvest dividends at the same rate as the firm’s return
What is accretion of discount in present value accounting?
The increase in an asset’s present value as time passes and cash flows get closer
How is accretion of discount calculated?
Accretion = beginning present value x discount rate
What happens to asset values over time due to accretion of discount?
They increase, reflecting the passage of time until cash flow realization
Why are estimates necessary in financial reporting?
Because future cash flows, interest rates, and risks are uncertain
What is an example of accounting estimate?
Depreciation, warranty liabilities, or expected credit losses
How do estimates impact reliability
They introduce subjectivity and potential bias, reducing reliability
How does market risk affect present value accounting?
Higher risk means a higher discount rate, reducing present value
What happens when an asset is perceived as high risk?
Its present value decreases due to a higher required rate of return
How is revenue recognized in present value accounting?
Revenue is recognized earlier, based on expected future cash flows
What is recognition lag in historical accounting?
The delay between when an asset gains value and when that value is recorded
How does historical cost accounting create a recognition lag?
It only records gains when realized, not when they occur
What is the matching principle in accounting?
Expenses should be recognized in the same period as the revenues they help generate
Which accounting method follows the matching principle?
Historical cost accounting, using accruals (depreciation, bad debt expense)
Why does present value accounting have little matching?
It focuses on changes in asset values rather than direct cost-revenue matching
In a perfect world accounting information would be: (6)
Relevant
A faithful representation of reality
Understandable
Verifiable
Timely
Facilitate comparisons
What conditions are the 6 accounting characteristics achieved in?
in ideal conditions where future cash flows and interest rate are publicly known with certainty
What does neutrality mean?
absence of bias intended to attain a predetermined result
