Question - Rainy Ltd. Operates under ideal conditions of uncertainty. Its cash flows depend crucially on the weather. On January 1, 2010, Rainy acquired equipment to be used in its operations. The equipment will last two years, at which time its salvage value will be zero. Rainy financed the equipment purchase by issuing common shares.
In 2010, net cash flows will be $700 if the weather is rainy and $200 if it is dry. In 2011, cash flows will be $900 if the weather is rainy and $300 if it is dry. Cash flows are received at year-end. In each year, the probability that the weather is rainy is 0.3 and 0.7 that it is dry. The interest rate in the economy is 6% in both years.
Rainy pays a dividend of $50 at the end of 2010.
Required:
1. In 2010, the weather is rainy. Prepare a balance sheet at the end of 2010 and an income statement for 2010.
2. If we attempt to apply the present value model under uncertainty to the more realistic conditions under which accountants operate, the expected present value calculations often become unreliable. Explain why.
3. Explain why well-defined (true) net income does not exist under the realistic conditions under which accountants operate. In place of true net income, what criterion have accountants adopted to guide their financial accounting and reporting decisions?