ch02_029-063

# In this example there is no need to make forecasts so

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In this example there is no need to make forecasts, so correct facts are the only things that matter. Part II of this case introduces forecasts in accounting and the consequent appearance of accounting risk. The horse business example: Part II—Introduction of Accounting Risk Assume the same facts as in Part I except that now the horse is sold the first time for a lottery ticket hav- ing the following payoffs: \$2800 at probability of 0.25 and \$0 at probability of 0.75. How much was earned in the horse business now, assuming the profi t needs to be calculated before the lottery payoff date? Analysis: Part II Again, if the auditor can verify that these facts, including the probabilities and payoffs from the lottery corporation, are 100 percent true, then the audit risk is zero. But what is the profi t under GAAP? Under contingency accounting, we cannot recognize a contingent gain from the lottery ticket; therefore the profi t is \$900 \$1400 = \$500, in other words, a \$500 loss. There is 0.25 probability that this loss is wrong, however. This 0.25 is the accounting risk associated with recording a \$500 loss. This loss is the way the business risk associated with the lottery ticket is disclosed in financial reporting via account- ing for contingencies. We would probably want to disclose the contingent gain in the notes to the fi nan- cial statements. But this raises a deeper question of whether fairness of presentation requires that every contingent gain should be disclosed in the notes no matter how unlikely the gain. Or, should there be a cutoff probability for such disclosures? An added complexity associated with accounting risk is that there may be a confl ict between account- ing standards. For example, under fair value accounting, treating the lottery ticket as a “fi nancial instru- ment” would give us an expected value of \$700 for the lottery ticket, the result being that the profi t becomes what it was in Part I of the Analysis—\$200. But note that the accounting risk associated with recording \$200 is a probability of 1.00; that is, it is guaranteed to be wrong! This is because, assum- ing the lottery ticket is not sold before the payoff date, only two profi t states are possible: there is a \$2800 payoff yielding a profi t of \$2300 (at 0.25 probability, so if you record \$2300 then the account- ing risk is 0.75) or a loss of \$500 (at 0.75 probability of being correct, so accounting risk is 0.25). These results contrast greatly with that in Part I, where only one profi t state is possible because there is no accounting risk. The question is, therefore, which profi t calculation should be acceptable to the auditor? The answer is that it depends on which accounting risk is acceptable. Note that in both cases the facts are known with 100 percent certainty. The only issue is proper disclosure of the facts. The point is then that account- ing risk needs to be properly disclosed and that this is a fi nancial accounting issue. If GAAP are unclear it creates challenges for the auditor when deciding what presents fairly, and he must use professional judgment when deciding what is fair presentation in the particular circumstance. Note, too, that the

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• Fall '12
• Smith
• Auditor's report

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