ADMS 4510ADMS 4510 ACCOUNTING THEORY ACCOUNTING THEORY

Prof. Kate BewleyProf. Kate Bewley

kbewleykbewley@yorku.ca@yorku.ca

Office: ATK 258COffice: ATK 258C

Secretary: Vita Sabatini 416 736 Secretary: Vita Sabatini 416 736

52105210

Acknowledgement: These slides are based on a presentation originally created by Paul Dunn, PhD.

ADMS 4510ADMS 4510

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ADMS 4510 - SESSION 1 ACCOUNTING THEORY- OVERVIEW

Objective of course-Objective of course- to explore ‘theory’ that has been to explore ‘theory’ that has been

developed to explaindeveloped to explain• why accounting existswhy accounting exists

• the way accounting isthe way accounting is

• how it got that way how it got that way

• how it should be, given differing how it should be, given differing circumstancescircumstances

OVERVIEW

N.B. accounting has been N.B. accounting has been developed by humans, to fill developed by humans, to fill human and social needs largely human and social needs largely driven by trading and other driven by trading and other forms of contractingforms of contracting

thus the ‘theories’ of accounting thus the ‘theories’ of accounting are not like the theories are not like the theories explaining natural explaining natural physical/scientific phenomenaphysical/scientific phenomena

OVERVIEW

accounting is best seen as a accounting is best seen as a social science that is at the social science that is at the intersection of economics, intersection of economics, psychology, and sociologypsychology, and sociology

accounting uses techniques and accounting uses techniques and methods drawn from these fields methods drawn from these fields such as statistics, probabilities, such as statistics, probabilities, ‘income’, ‘welfare’, optimization, ‘income’, ‘welfare’, optimization, etc.etc.

OVERVIEW

Two important views of accounting Two important views of accounting that have been developed in that have been developed in recent years’ research are recent years’ research are

1. decision usefulness1. decision usefulness

2. information 2. information

economicseconomics

ACCOUNTING AS INFORMATION - information economics Accounting is an information systemAccounting is an information system

Financial info is a commodity, a Financial info is a commodity, a

productproduct

There is a demand for this productThere is a demand for this product

There is also a supply of financial There is also a supply of financial

infoinfo

DEMAND FOR DEMAND FOR INFORMATIONINFORMATION

Financial information users include:Financial information users include:• investors & creditorsinvestors & creditors• managementmanagement• labourlabour• suppliers suppliers • governmentgovernment• societysociety

Conflicts may exist among these Conflicts may exist among these parties due to parties due to information information asymmetryasymmetry [ adverse selection & moral hazard][ adverse selection & moral hazard]

SUPPLY OF INFORMATION

Sources of financial information :Sources of financial information :• firm disclosures, other firms, analysts, firm disclosures, other firms, analysts,

government, etc.government, etc. Financial disclosure costs :Financial disclosure costs :

• collection & processing costscollection & processing costs• litigation costslitigation costs• political costspolitical costs• competitive disadvantagecompetitive disadvantage• constraints on managerial behaviourconstraints on managerial behaviour

INFORMATION ASYMMETRY

When one party has more When one party has more

information than anotherinformation than another

2 types: 2 types:

• adverse selection adverse selection

• moral hazardmoral hazard

INFORMATION ASYMMETRY

Adverse selection Adverse selection (‘hidden (‘hidden

information’)information’)

– – one party has information one party has information

advantage over the otheradvantage over the other

Moral hazard Moral hazard (‘hidden action’)(‘hidden action’)

– one party cannot fully observe – one party cannot fully observe

the other's actionsthe other's actions

ADVERSE SELECTION

Assumptions :Assumptions : Investors are rational & want reasonable Investors are rational & want reasonable

returnreturn Large numbers of rational investorsLarge numbers of rational investors

trade in a properly working, efficient markettrade in a properly working, efficient market Full disclosure => investors have sufficient Full disclosure => investors have sufficient

information to make rational predictions information to make rational predictions about firm performanceabout firm performance

=> Accounting information is useful to => Accounting information is useful to investorsinvestors

Decision usefulness perspective Decision usefulness perspective (CICA s.1000, FASB)(CICA s.1000, FASB)

MORAL HAZARD

Assumptions : Assumptions : Firm is a nexus of contractsFirm is a nexus of contracts Contracts facilitate agency relationshipsContracts facilitate agency relationships Contracts use accounting numbers, e.g. Contracts use accounting numbers, e.g.

bonus contracts, debt covenantsbonus contracts, debt covenants

=> Accounting policies matter because => Accounting policies matter because they influence management’s they influence management’s compensation and debt restrictionscompensation and debt restrictions

Economic consequences perspectiveEconomic consequences perspective( Positive accounting theory ) ( Positive accounting theory )

FUNDAMENTAL PROBLEM FUNDAMENTAL PROBLEM OF FINANCIAL OF FINANCIAL ACCOUNTING THEORYACCOUNTING THEORY ‘‘Best’ measure of net income to Best’ measure of net income to

inform investors and control adverse inform investors and control adverse selection will be reliable AND selection will be reliable AND relevant about future economic relevant about future economic prospectsprospects

‘‘Best’ measure of net income to Best’ measure of net income to control moral hazard will be highly control moral hazard will be highly correlated with manager’s past correlated with manager’s past efforts, and within manager’s controlefforts, and within manager’s control

Can one ‘bottom line’ do both ?Can one ‘bottom line’ do both ?

Value-based accounting

(Ideal)

Unobservablemanager

effort

Contracts-compensation

-debt covenants

‘Hard’Net Income

Insideinformation

Investmentdecision

Fulldisclosure

Regulation- Accounting

standardsetting

Framework of accounting theory - Figure 1-1Framework of accounting theory - Figure 1-1

Standard-setting: Standard-setting: Accounting concepts Accounting concepts

BACKGROUNDBACKGROUNDFASBFASB 1978 Statement of Financial Actg

Concepts #1 - for businesses 1980 SFAC #4 - for non-business, not-

for-profits & governmentCICACICA 1988 Handbook Section 1000

– financial statement concepts 1991 Section 1000 extended to non-

profits

CICA Section 1000CICA Section 1000Financial statement conceptsFinancial statement concepts

Objectives of financial statementsObjectives of financial statements

Section 1000.15 --> joint perspectiveSection 1000.15 --> joint perspective

Communicate information that is useful Communicate information that is useful

for : for : • making investment & resource decisions making investment & resource decisions

and/orand/or• assessing management stewardshipassessing management stewardship

Unlike U.S., both are equally importantUnlike U.S., both are equally important

CICA - Section 1000CICA - Section 1000Financial statement conceptsFinancial statement concepts

Objectives of financial statementsCost- benefit constraint, materiality

Qualitative characteristics :Qualitative characteristics :• relevance & reliabilityrelevance & reliability• understandability & comparabilityunderstandability & comparability• trade-offstrade-offs

Elements, recognition, measurementGAAP (basis on which f/s are normally prepared)

RELEVANCE AND RELEVANCE AND RELIABILITYRELIABILITY

RelevanceRelevance• the information can make a difference the information can make a difference

in the user’s decisionin the user’s decision• predictive & feedback value, timelinesspredictive & feedback value, timeliness

ReliabilityReliability• the information faithfully represents the information faithfully represents

underlying economic substanceunderlying economic substance• verifiable, unbiased, conservativeverifiable, unbiased, conservative

THE CASE FOR THE CASE FOR HISTORICAL COSTHISTORICAL COST

Historical cost accounting reflects a Historical cost accounting reflects a particular trade-off between particular trade-off between RELEVANCERELEVANCE && RELIABILITYRELIABILITY. Which one does it . Which one does it favour ? ? ? ?favour ? ? ? ?

RELIABILITYRELIABILITY• by waiting until changes in value are by waiting until changes in value are

REALIZED income is more certainREALIZED income is more certain

• by smoothing out cash flows income reflects by smoothing out cash flows income reflects the longer-run earnings power of the businessthe longer-run earnings power of the business

REMAINDER OF SEMESTER

Decision usefulness approachDecision usefulness approach – – Investor's point of viewInvestor's point of view Economic consequences modelEconomic consequences model

– Management's point of view– Management's point of view 7 weeks of specific accounting issues 7 weeks of specific accounting issues Earnings managementEarnings management Economics and politics of standard Economics and politics of standard

settingsetting

GOOD

GOOD

NIGHTNIGHT