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ADMS 4510 ACCOUNTING THEORY

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Title: ADMS 4510 ACCOUNTING THEORY


1
ADMS 4510 ACCOUNTING
THEORY
  • Prof. Kate Bewley
  • kbewley_at_yorku.ca
  • Office ATK 258C
  • Secretary Vita Sabatini 416 736 5210
  • Acknowledgement These slides are based on a
    presentation originally created by Paul Dunn, PhD.

2
ADMS 4510 web links
  • Powerpoint slides -
  • Sessions 1, 2, 3, 11, 12
  • www.atkinson.yorku.ca/kbewley/4510theory2002.ppt
  • Session 10
  • www.atkinson.yorku.ca/kbewley/4510prei.ppt
  • Shedule of theory sessions -
  • www.atkinson.yorku.ca/kbewley/4510sched_s02kb.doc

3
ADMS 4510 - SESSION 1
ACCOUNTING THEORY- OVERVIEW
  • Objective of course-
  • to explore theory that has been developed to
    explain
  • the way accounting Is
  • how it got that way
  • how it should be, given differing circumstances

4
ADMS 4510 ACCOUNTING
THEORY- OVERVIEW
  • Objective of course-
  • theories of accounting can be
  • descriptive/positive or
  • normative/prescriptive

5
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

6
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.

7
OVERVIEW
  • Two important views of accounting that have been
    developed in recent years research are
  • 1. decision usefulness
  • 2. information economics

8
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

9
DEMAND FOR INFORMATION
  • Variety of users of financial information
    investors, management labour, suppliers
    creditors, government, society
  • May be conflicts among these parties due to
    adverse selection moral hazard

10
SUPPLY OF INFORMATION
  • Variety of sources of financial information
    firm disclosures, other firms, government
  • Costs to financial disclosures collection
    processing costs litigation costs political
    costs competitive disadvantage constraints on
    managerial behaviour

11
INFORMATION ASYMMETRY
  • Asymmetry - when one party has more information
    than another
  • 2 types
  • adverse selection
  • moral hazard

12
INFORMATION ASYMMETRY
  • Adverse selection one party has information
    advantage over the other (hidden information)
  • Moral hazard one cannot fully observe the
    other's actions (hidden action)

13
ADVERSE SELECTION
  • Investors are rational want reasonable return
  • Large numbers of rational investorsgt properly
    working gt efficient market
  • Full disclosure - investors have sufficient
    information to make rational predictions about
    firm performancegt accounting info is useful to
    investors
  • Decision usefulness perspective
  • (CICA s.1000, FASB)

14
MORAL HAZARD
  • Assumption Firm is a nexus of contracts
  • Contracts use accounting numbers, e.g. bonus
    contract, debt covenants
  • Accounting policies matter gt they influence
    managements compensation and debt restrictions
  • Economic consequences perspective (Positive
    accounting theory)

15
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 managers
    past efforts, and within managers control
  • Can one bottom line do both ?

16
REMAINDER OF SEMESTER
  • Conceptual framework - FASB CICA
  • Decision usefulness approach Investor's point of
    view
  • 6 weeks of specific accounting issues
  • New developments in accounting theory
  • Economic consequences model Management's point
    of view
  • Establishing accounting standards

17
GOOD NIGHT
18
ADMS 4510 - SESSION 2
ACCOUNTING THEORY
  • OVERVIEW
  • DECISION USEFULNESS
  • INVESTORS PERSPECTIVE
  • QUALITITATIVE CHARACTERISTICS OF USEFUL
    ACCOUNTING INFORMATION
  • Acknowledgement These slides are based on a
    presentation originally created by Paul Dunn,
    PhD.

19
OBJECTIVES OF FINANCIAL REPORTING
  • DECISION USEFULNESS
  • Investors make investment decisions how much,
    when to invest, how longNeed information to
    estimate probable returns chose among
    alternative investmentsFinancial information
    helps investors assess likelihood of future
    returns, cash flows, dividends

20
INVESTORS
  • Rational want a reasonable returnRisk averse
    gt diversify portfolio portfolio risk versus
    systematic riskFinancial information should help
    reduce portfolio risk by estimating probabilities
    of future returns

21
BACKGROUND
  • 1978 FASB issues Statement of Financial
    Accounting Concepts 1 - for businesses
  • 1980 issues SFAC 4 - for non-business
    not-for-profits government
  • 1988 CICA issues Section 1000 financial
    statement concepts
  • 1991 CICA Section 1000 includes non-profits

22
CONSTRAINTS
  • Information pertains to firms, rather than to
    industries or economy as a whole
  • Measures are often approximate, not exact
  • Largely reflects events of the past
  • This is but one source of information about the
    firm
  • The information is provided used at a cost

23
FOCUS
  • Objectives stem primarily from needs of external
    users
  • Focus is on general purpose external financial
    reporting
  • Objectives are broad-based, not narrow
  • Relate to financial reporting, not just f/s

24
MAIN OBJECTIVE
  • Provide useful information to present potential
    investors creditors in making rational
    investment credit decisions
  • Assumes a reasonably intelligent thoughtful
    reader of the financial information
  • Decision-usefulness approach

25
SECONDARY OBJECTIVES
  • Assess the amounts, timing uncertainty of
    prospective cash receipts
  • Economic resources, obligations, equity their
    changes
  • Financial performance earnings
  • Cash flows, liquidity solvency
  • Management's stewardship performance

26
DECISION USEFULNESS
  • Approach is justified on basis that investors
    creditors are the most prominent usersThis does
    not narrow the scope of financial reporting since
    this approach would be useful to other user
    groupsThe other users include almost everyone

27
CICA APPROACH
  • Section 1000.15 - joint perspectiveCommunicate
    information that is useful in making
    investment resource decisions and/or
    assessing management stewardshipUnlike U.S.,
    both are equally important

28
CONTEXT
  • Often there's too much informationInvestor needs
    to assess quality financial statements, press
    releases, analysts' briefings, investor
    presentations, web siteShould be relevant
    reliable for comparability consistencyPresent
    ed clearly

29
QUALITY INFORMATION
  • most important relevance reliabilityRelevance
    - the information is capable of making a
    difference in the decisionReliability - the
    information is reasonably free from error
    bias- it faithfully represents what it purports
    to represent

30
RELEVANCE
  • Predictive value - useful in correctly
    forecasting the outcome of some eventFeedback
    value - confirms or corrects a previous
    expectationTimely - available before it loses
    its capacity to influence decisions

31
RELIABILITY
  • Verifiable - can be measured to ensure it
    represents what it purports to represent or
    measurement method is free of error
    biasNeutral - free of biasRepresentational
    faithfulness - agreement between
    description/measurement the phenomenon it
    purports to represent

32
CLARITY
  • Degree to which information can be easily
    understoodPresented in organized, clear, concise
    fashionAppropriate balance between brevity with
    sufficiency

33
OTHER CHARACTERISTICS
  • Comparability - identify similarities
    differences between 2 sets of phenomenaConsistenc
    y - conformity period to period with policies
    proceduresMateriality - would change of
    influence the judgment of a reasonable
    personConservatism - uncertainty risk are
    adequately considered

34
GOOD NIGHT
35
ADMS 4510 - SESSION 3
ACCOUNTING THEORY - OVERVIEW
  • Decision usefulness to investors
  • - present value vs. historic cost
  • - relevance and reliability
  • Market efficiency role of information
  • Demand for information, full disclosure
  • Acknowledgement These slides are based on a
    presentation originally created by Paul Dunn, PhD.

36
DECISION USEFULNESS - INVESTOR'S PERSPECTIVE
  • INVESTORS CASH FLOWS
  • Value of firm is PV of future dividends
    function of firm's cash flows interest rate
  • Ideal conditions know both cash flows
    interest rate with certainty
  • Dividend policy is irrelevant value of firm is
    known with certainty

37
PRESENT VALUE
  • Present value financial statements
  • Reliable precise free from bias
  • Relevant useful for predicting future
    cash-flow for predicting if good news or bad
    news will persist into future periods

38
IS HISTORIC COST USEFUL?
  • Historic cost is reliable assets liabilities
    measured at cost
  • May not be relevant as market changes, cost may
    not equal PV
  • Accountants trade relevance for reliability
    amortization lower of cost market

39
INVESTOR UNCERTAINTY
  • Decisions under conditions of uncertainty
  • Investor is risk averse gt diversifies
    portfolio market-wide risk firm-specific risk
  • F/S gt assess probability of future states
    predict future investment returns predict
    whether good/bad news will persist predict
    future cash-flows

40
EFFICIENT MARKETS
  • Prices fully reflect all publicly available
    information (semi-strong)
  • Prices need not reflect underlying value poor
    quality, not enough, misinterpreted
  • Decision makers constantly revise their
    predictions as new information is received
  • Financial reporting improves quantity quality
    of public information

41
MARKET INEFFICIENCIES
  • Why don't markets behave efficiently ?
  • Prospect theory- low (high) probabilities are
    over (under) weighted
  • Post-announcement drift investors don't fully
    digest good/bad news
  • Earnings fixation focus on EPS ignore its
    components

42
INCONSISTENCY
  • Prices reflect all publicly available info
  • But, information acquisition is costly
  • Cannot beat the market if prices reflect all
    information
  • Therefore, no motivation to collect new info
  • Result gt share prices should self-destruct

43
CONTINUOUS DEMAND
  • Random element in all markets trades not based
    on rational evaluation of info
  • Over time, on average, prices are efficient
  • At any point, prices can be over/under valued
  • Result gt continuous search for private info
  • Note no clear line between public/private
    information

44
ADVERSE SELECTION
  • Insiders can take advantage of the market using
    their private information
  • Problem reduced penalties, fines for insider
    trading full disclosure, but reporting is costly

45
DECISION USEFULNESS
  • Provide information useful in making investing
    credit decisions
  • Reflect expectations about the future often
    based on evaluation of the past
  • Financial reporting focuses on earnings its
    components does not directly measure value
    provides information to estimate value

46
IMPLICATIONS
  • Accounting policies don't matter, unless they
    have direct effect on cash-flows
  • Don't worry about naive investors
  • Market is interested in all relevant information,
    not just accounting information
  • Disclose as much as is feasible

47
ACCOUNTING-BASED VALUATION RESEARCH Lee 1999
article
  • Prediction of future payoffs to shareholders is
    the key to valuation models
  • Accounting information is not directly
    informative about value, but is useful in
    prediction / forecasting models -gt
  • net income is a reasonable performance measure
  • ex post settling up actuals vs. forecasts

48
ACCOUNTING-BASED VALUATION RESEARCH Lee 1999
article
  • Residual Income Model
  • Firm Value Book value (capital invested)
  • PV of future
    abnormal earnings
  • Other
    information not in f/s
  • Accounting research can improve key forecasting
    estimates, e.g. long-term earnings, cost of
    capital, book-value growth

49
GOOD NIGHT
50
ADMS 4510 - SESSION 11
ACCOUNTING THEORY
  • OVERVIEW
  • Managers perspective - Economic consequences,
    contracting
  • Positive accounting theory
  • Market efficiency and economic consequences

51
ECONOMIC CONSEQUENCES - MANAGER'S PERSPECTIVE
  • ECONOMIC CONSEQUENCES
  • Efficient Market Hypothesis accounting policies
    do not matter as long as they are disclosed
    have no cash flow effects Economic
    Consequences managers take accounting policies
    seriouslyTwo Examples foreign currency
    translations business combinations

52
FOREIGN CURRENCY
  • Temporal method integrated operations
    translation gains/losses go through net
    incomeCurrent rate method self-sustaining
    gains/losses separate component of equityTwo
    perspectives Manager policy has an impact on
    net income Investor policy does not change
    cash flows

53
BUSINESS COMBINATIONS
  • Purchase Accounting goodwill is the excess of
    fair value of net identifiable assets formerly
    amortized over time (lt 40 years)Pooling of
    Interest show no amortization expensePolicy
    impacts net income, but not cash flows

54
BUSINESS COMBINATIONS- FASB 141MANAGEMENTS VIEWS
  • Pooling method should be retained for public
    policy reasons, e.g. impede consolidation of
    certain industries, reduce the amount of capital
    flowing into certain industries, and slow the
    development of new technology versus
  • Differences between the pooling and purchase
    methods affected competition in markets for
    mergers and acquisitions.
  • FASB reasoning for eliminating pooling
  • neutrality necessary and important characteristic
    of accounting information (FASB concepts stmt 2)
  • accounting standards should neither encourage
    nor discourage business combinations but rather,
    provide information about those combinations that
    is fair and evenhanded.

55
POSITIVE ACCOUNTING
  • Firm is a nexus of contracts minimize
    transaction contracting costsManager chooses
    accounting policies to reflect unique economic
    reality of firm to minimize contracting
    costsTheory also assumes manager is risk averse,
    effort averse opportunistic

56
AGENCY THEORY
  • Non-cooperative model - prisoners'
    dilemmaInterests of managers (agents)
    investors (principals) may be different moral
    hazard problem principal cannot fully observe
    the efforts of the agent therefore, investor
    designs contract that aligns interest of agent
    with those of the principal

57
EMPLOYMENT CONTRACTS
  • Manager is effort averse gt will shirkManager
    knows the effort level, but the owner does not
    (moral hazard)If effort observable gt
    performance is based on effort (first-best
    contract)If effort not observable gt give
    manager a share of the pay-off (second-best
    contract)

58
SECOND BEST CONTRACT
  • Net income used as proxy for effort assumption
    correlation between effort NIManager may
    choose opportunistic policiesInvestor reduces
    managerial options GAAP, audits, historic cost
    (HC) accountingBest measure for contracting (HC)
    may not be best measure for informing investors
    (PV)

59
THREE HYPOTHESES
  • Bonus Plans - managers will shift income from
    future periods to current period
  • Debt Covenants - managers will shift income from
    future periods to current period
  • Political Costs - managers will defer current
    income to future periods

60
ECONOMIC CONSEQUENCES
  • Efficient market hypothesis
  • Accounting policies don't matter as long as
    they're disclosed have no cash impact
  • Economic consequences
  • Yet, users seem to react to accounting policies
    that have no cash impact
  • Accounting policies matter, even in the absence
    of cash flow effects

61
GOOD NIGHT
62
ADMS 4510 - SESSION 12
ACCOUNTING THEORY
  • OVERVIEW
  • Need for accounting regulation
  • Information asymmetry and signalling
  • Politics of standard setting

63
STANDARD SETTING
  • REGULATION
  • Needed to reduce information asymmetry
  • Adverse selection problem prevent insider
    trading
  • Moral hazard problem but, firms may disclose
    without regulation signal that they are not
    low-type firms

64
SIGNALING THEORY
  • Akerfof's market for lemons
  • High-types signal that they are not low-types
  • Signal must be credible
  • Cost to high-types lt cost to low-types
  • Irrational for low-types to issue a costly signal
  • Examples
  • Conservative accounting policies
  • Voluntary disclosure of earnings forecast

65
IMPLICATIONS
  • Audits add credibility to financial reports
    enhances reliability
  • Release non-historic-based information more
    relevant for investorsBenefits to firm improve
    efficiency of contracting reduce cost of capital

66
MARKET FAILURE
  • Markets fail because of
  • Externalities free-rider problems no
    incentive to release/pay for information
  • Information asymmetry, moral hazard averse
    selection problems management incentive
    contracts - 2nd best
  • Hence, a need for standard setting

67
ACCOUNTING RECOGNITION and INFORMATION CONTENT
  • Liang article (2001)
  • linking measurement perspective (accounting
    practices) to information economics
  • need to relate measurement/recognition techniques
    to economic decisions
  • key role of accounting information is in
    confirming other (perhaps less reliable)
    information

68
POLITICAL THEORIES
  • Objectives of regulation maximize social
    welfare prevent market failure
  • Public Interest Theory central authority looks
    after society's needs
  • Interest Group Theory regulation goes to those
    who are most politically effective in convincing
    legislators

69
REGULATORS
  • 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 interest group
    theory

70
ACCOUNTING STANDARDS COMMITTEE
  • Full-time Chair, 8 members, 2 full-time CICA
    employeesProcess Topic on agenda gt research
    paper by staff Task Force gt Statement of
    Principles ASC approval gt Exposure Draft
    Comments received gt Dropped, re-exposed, or
    incorporated as recommendation

71
PROBLEMS
  • Difficult to know which accounting policy is
    right what are its economic consequences?
  • Difficult to know trade-offs required to reach
    political compromise is it decision useful for
    investors management?

72
CRITERIA FOR STANDARDS
  • Standards should be decision useful
    acceptable to both management investors
  • Reduce information asymmetry efficient
    markets approach first-best contracts
  • Requires use of professional judgment

73
THEORY RECAP - Important themes
  • Accounting as information
  • Information asymmetry vs. ideal conditions
  • Investors perspective
  • rational investment decision
  • Managers perspective
  • contracting/economic consequences
  • Role of accounting standards

74
New Developments RECAP - Important themes
  • New Economy issues
  • intangibles value creation
  • new performance measures
  • new accounting standards
  • stakeholders other than shareholders
  • economic, social and environmental sustainability
    -TRIPLE BOTTOM LINE
  • new Global Reporting standards

75
GOOD NIGHT
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