Accounting In Perfect And Complete Markets Essay

Accounting In Perfect And Complete Markets Essay, Research Paper Accounting in Perfect and Complete MarketsIntroductionThis note represents a preliminary step in the study of accounting. Accounting serves many purposes, and it is not easy to decide where to begin ; we begin by exploring the relationship between accounting numbers and the value of a firm and its assets. Market structure affects value, and furthermore, the relationship between value and accounting. We will consider the relationship between the balance sheet and income statement, and how they keep track of the unfolding of economic events. But before we plunge in, we should mention a few other aspects of accounting that are also important. First, accounting provides structure that disciplines our planning of

future economic events and our interpretation of economic events underlying the numbers reported in financial statements. An important example is the budgeting exercise. We begin with a sales budget, add a cash collections/payments policy and an inventory policy, and accounts receivables, inventory values, and accounts payable follow. Add a cash “inventory” policy, and we quickly move from cash balances to financing decisions. And, of course, the balance sheet and income statement follow thereafter. You see how these steps in the budgeting process are influenced by the structure of accounting. Second, the structure of accounting is such that errors (unintentional or intentional) are unlikely to persist. For example, overstating ending inventory in one period overstates income

in that period, but causes the next period’s income to be understated (unless further inventory overstatements take place). Third, accounting produces an earnings number (income) which has many important properties. The income number may not only be important to individuals acting on their own behalf, but may also tell us something about the economy in the aggregate. For example, under certain conditions the income number is related to productive and social efficiency. So we should keep in mind the range of the phenomena affected by accounting. An extensive study of accounting involves understanding accounting in its broader context. We return to the study of accounting income and its relation to market valuation. In this note, we construct a simple model characterized by a

commonly known price of money (interest rate). In the specified setting individuals’ consumption possibilities are greatest if they maximize the present value of future cash flow. Due to the competitive nature of markets, it follows that asset prices will be equal to discounted cash flows. Most important, in this simple but illuminating setting of perfect and complete markets it is clear how to construct balance sheets and financial statements so that they communicate what one needs to know about the firm. Assets are valued at their market values which, as mentioned, are equal to their discounted cash flows. And income is equal to the change in net assets.Although this approach may look a little abstract, both market and present value approaches are sometimes recommended by

(United States) Generally Accepted Accounting Principles. For example, we see the use of lower-of-cost-or-market for inventories, market value for marketable securities, and present value for bonds and notes. Perhaps the most important aspect of this note is the careful links developed between accounting and the value of the firm. In this note we first assume assets are booked at cost, and that at each point in time the asset appears on the balance sheet at its market price (economic depreciation). Next we consider the case where the asset is booked at cost, but depreciation follows common practice (e.g., straight line). Finally, we consider the case where the asset is initially booked at some value other than cost, but a consistent depreciation method is used. Under the first