Fundamentals of Financial Accounting Theory

Learning Objectives

This chapter introduces the foundational concepts of financial accounting theory, focusing on the demand and supply of accounting information, information asymmetry, qualitative characteristics of accounting information, earnings management, and the interaction between accounting and securities markets.

• Explain the sources of demand and supply of accounting information.

• Apply concepts of information asymmetry, adverse selection, and moral hazard to accounting and management situations.

• Describe qualitative characteristics of accounting information that help alleviate adverse selection and moral hazard.

• Evaluate circumstances likely to result in earnings management.

• Explain how accounting information interacts with securities markets.

Demand and Supply of Accounting Information

Definition and Purpose

Accounting is the production and transmission of information about an enterprise. The fundamental purpose is to communicate information from those who possess it (e.g., managers) to those who need it (e.g., investors, creditors).

• Demand: External parties (investors, creditors) require reliable financial information for decision-making.

• Supply: Enterprises provide accounting information through financial statements and disclosures.

Branches of Accounting

Types and Functions

Accounting is divided into several branches, each serving different stakeholders and purposes.

• Financial Reporting: Provides information to external parties such as investors and creditors.

• Managerial Accounting: Focuses on internal reporting for management decision-making.

• Tax Accounting: Determines taxable amounts for government revenue authorities.

Generally Accepted Accounting Principles (GAAP)

Definition and Role

GAAP refers to the broad principles, conventions, rules, procedures, and techniques that guide the preparation of accounting entries, compilation of financial statements, and understanding of financial reports.

• Purpose: Ensure consistency, reliability, and comparability of financial information.

• Application: Used by public and private companies, and not-for-profit organizations.

Financial Accounting at the Intermediate Level

Scope and Questions

Intermediate accounting addresses the 'What?', 'How?', and 'Why?' of financial reporting, focusing on the application and rationale behind accounting standards and practices.

• What? The content and nature of financial information.

• How? The methods and processes used to prepare and present financial information.

• Why? The reasons and motivations for financial reporting choices.

Accounting Regulatory Agencies

Standard-Setting Bodies

Several organizations are responsible for establishing accounting standards globally and nationally.

• Financial Accounting Standards Board (FASB): Sets standards in the U.S. for public, private, and not-for-profit organizations following GAAP.

• International Accounting Standards Board (IASB): Develops International Financial Reporting Standards (IFRS) in London, England.

• Accounting Standards Board (AcSB): Sets standards in Canada.

Uncertainty and Information Asymmetries

Concepts and Implications

Information asymmetry occurs when some parties have more or better information than others, leading to potential market inefficiencies and risks.

• Adverse Selection: Hidden information from the past or present gives one party an advantage (e.g., seller knows more about a used car than the buyer).

• Moral Hazard: Hidden actions relating to future fulfillment of contracts (e.g., insured party may take more risks because insurer cannot observe all actions).

Examples of Adverse Selection and Moral Hazard

Applications in Accounting and Business

• Adverse Selection Example: Used car market ('lemons problem') where sellers have more information than buyers, leading to market inefficiency.

• Signalling: Sellers may use costly signals (e.g., warranties, audits) to convey credibility; cheap talk is not credible.

• Moral Hazard Example: Insurance contracts where insured parties may act less carefully, increasing risk for the insurer.

Principal-Agent Problem

Separation of Ownership and Control

Occurs when owners (principals) cannot fully monitor managers (agents), leading to potential conflicts of interest and moral hazard.

• Solution: Use of independent audits, incentive pay, and contractual covenants to align interests.

Qualitative Characteristics of Accounting Information

Desirable Traits and Trade-Offs

High-quality accounting information should be relevant, reliable, verifiable, and not prone to manipulation. However, trade-offs may be necessary between these characteristics.

• Relevance: Information must be useful for decision-making.

• Reliability: Information should be accurate and free from bias.

• Verifiability: Information can be confirmed by independent parties.

• Trade-Offs: Sometimes relevance and reliability may conflict, requiring judgment in standard-setting.

Economic Consequences of Accounting Choices and Earnings Management

Impacts and Motivations

Accounting standards are written broadly to apply to various businesses, but this flexibility allows for managerial discretion and potential earnings management.

• Earnings Management: Managers may bias reported information to influence stakeholders.

• Motivations: Increase share price, meet contractual or regulatory requirements, improve bargaining position, or reduce taxes.

Positive Accounting Theory

Understanding Managerial Behavior

Positive accounting theory seeks to explain and predict managers' choices in accounting policies and their reactions to standards, focusing on incentives and consequences.

• Key Question: What do managers do and why?

Earnings Management

Definition and Examples

Earnings management refers to managers' efforts to bias reported accounting information, affecting income statements, balance sheets, and other financial reports.

• Upward Management: To increase share price, obtain funding, meet covenants, or regulatory requirements.

• Downward Management: To reduce taxes, qualify for subsidies, or take a 'big bath' in a bad year for future benefits.

Accounting and Securities Markets

Interaction and Information Flow

Public companies trade equity, debt, or other securities in markets that rely on accounting information for pricing and investment decisions. Securities markets also provide feedback for accounting processes.

• Efficient Market Hypothesis: Security prices reflect all publicly available information (semi-strong form); in strong form, prices reflect all information, public and private.

• Implications: Accounting information competes with other sources; only new information affects prices; abnormal profits are difficult using public information alone.

Using Information from Securities Markets in Accounting

Market Prices and Financial Statements

Market prices of traded securities are considered reliable indicators of fundamental value, while other components (e.g., inventory, equipment) are often measured using historical cost.

• Application: Investments in marketable securities are valued at market prices; other assets may use historical cost or fair value as appropriate.

Summary Table: Types of Information Asymmetry

Key Formulas and Concepts

• Efficient Market Hypothesis (Semi-Strong Form):

• Earnings Management:

Additional info: Some explanations and examples have been expanded for clarity and completeness, based on standard intermediate accounting textbooks.