Transcript ADMS 2500.03 WEEK 10

ADMS 4510
ACCOUNTING THEORY
Prof. Kate Bewley
[email protected]
Office: ATK 258C
416 736 5210
Acknowledgement: Some of these slides are based on a
presentation originally created by Paul Dunn, PhD.
ADMS 4510
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ADMS 4510 - SESSION 1
ACCOUNTING THEORY- OVERVIEW
Objective of course to explore ‘theory’ that has been developed
to explain
• why accounting exists
• the way accounting is
• how it got that way
• how it should be, given differing circumstances
OVERVIEW
Two important views of accounting that
have been developed in recent years’
research are
1. decision usefulness
2. information economics
ACCOUNTING AS INFORMATION
- decision usefulness
 Accounting information affects decisions,
it has “information content”
• e.g. share prices respond to reported
net income
=>Accounting measurement is
important
ACCOUNTING AS INFORMATION
- information economics
 Accounting is an information system
 Financial info is a commodity, a product
 There is a demand for this product
 There is also a supply of financial info
DEMAND FOR INFORMATION
 Financial information users include:
•
•
•
•
•
•
investors & creditors
management
labour
suppliers
government
society
 Conflicts may exist among these parties
due to information asymmetry
[ adverse selection & moral hazard]
SUPPLY OF INFORMATION
Sources of financial information :
• firm disclosures, other firms, analysts,
government, etc.
 Financial disclosure costs :
• collection & processing costs
• litigation costs
• political costs
• competitive disadvantage
• constraints on managerial behaviour

INFORMATION ASYMMETRY
 When one party has more information
than another
 2 types:
• adverse selection
• moral hazard
INFORMATION ASYMMETRY
Adverse selection (‘hidden information’)
– one party has information advantage
over the other
Moral hazard (‘hidden action’)
– one party cannot fully observe the
other's actions
ADVERSE SELECTION
Assumptions :
 Investors are rational & want reasonable return
 Large numbers of rational investors
trade in a properly working, efficient market
 Full disclosure => investors have sufficient
information to make rational predictions about
firm performance
=> Accounting information is useful to investors
Decision usefulness perspective
(CICA s.1000, FASB)
MORAL HAZARD
Assumptions :
 Firm is a nexus of contracts
 Contracts facilitate agency relationships
 Contracts use accounting numbers, e.g. bonus
contracts, debt covenants
=> Accounting policies matter because they
influence management’s compensation and
debt restrictions
Economic consequences perspective
( Positive accounting theory )
FUNDAMENTAL PROBLEM OF
FINANCIAL ACCOUNTING THEORY
 ‘Best’ measure of net income to inform
investors and control adverse selection
will be reliable AND relevant about future
economic prospects
 ‘Best’ measure of net income to control
moral hazard will be highly correlated
with manager’s past efforts, and within
manager’s control
Can one ‘bottom line’ do both ?
Framework of accounting theory - Figure 1-1
Inside
information
Investment
decision
Regulation
- Accounting
standard
setting
Value-based
accounting
(Ideal)
Unobservable
manager
effort
Full
disclosure
Contracts
-compensation
-debt covenants
‘Hard’
Net Income
ACCOUNTING STANDARD SETTERS
 CICA recommendations have force of law
• Canada & Ontario Business Corp. Acts
 Other regulators
• OSC, FASB, SEC, International Accounting
Standards Committee
 All characterized by due process
Standard-setting:
Accounting concepts
BACKGROUND
FASB
1978 Statement of Financial Actg Concepts #1 for businesses
 1980 SFAC #4 - for non-business, not-for-profits &
government

CICA
1988 Handbook Section 1000
– financial statement concepts
 1991 Section 1000 extended to non-profits

CICA Section 1000
Financial statement concepts
Objectives of financial statements
Section 1000.15 --> joint perspective
Communicate information that is useful for :
• making investment & resource decisions
and/or
• assessing management stewardship
Unlike U.S., both are equally important
CICA - Section 1000
Financial statement concepts
Objectives of financial statements
Cost- benefit constraint, materiality
Qualitative characteristics :
• relevance & reliability
• understandability & comparability
• trade-offs
Elements, recognition, measurement
GAAP (basis on which f/s are normally prepared)
Generally Accepted Accounting
Principles
CICA - Section 1100
 primary and other sources of GAAP
CICA - Section 1400
 standards of f/s presentation
CICA - Section 1505
 disclosure of accounting policies
CICA - Section 1300
 differential reporting
RELEVANCE AND RELIABILITY
Relevance
• the information can make a difference in the
user’s decision
• predictive & feedback value, timeliness
Reliability
• the information faithfully represents underlying
economic substance
• verifiable, unbiased, conservative
THE CASE FOR HISTORICAL COST
Historical cost accounting reflects a particular
trade-off between RELEVANCE & RELIABILITY.
Which one does it favour ? ? ? ?
RELIABILITY
• by waiting until changes in value are REALIZED
income is more certain
• by smoothing out cash flows income reflects the
longer-run earnings power of the business
REMAINDER OF SEMESTER
Decision usefulness approach
– Investor's point of view
 Economic consequences model
– Management's point of view
 Earnings management
 Economics and politics of standard setting
 Midterm exam on theory
 Current accounting issues

OVERVIEW
 N.B. accounting has been developed by
humans, to fill human and social needs
largely driven by trading and other forms
of contracting
 thus the ‘theories’ of accounting are not
like the theories explaining natural
physical/scientific phenomena
OVERVIEW
 accounting is best seen as a social
science that is at the intersection of
economics, psychology, and sociology
 accounting uses techniques and
methods drawn from these fields such as
statistics, probabilities, ‘income’,
‘welfare’, optimization, etc.