ADMS 4510 ACCOUNTING THEORY

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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.

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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

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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

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ADMS 4510 ACCOUNTING
THEORY- OVERVIEW

• Objective of course-
• theories of accounting can be
• descriptive/positive or
• normative/prescriptive

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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

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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.

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OVERVIEW

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

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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

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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

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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

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INFORMATION ASYMMETRY

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

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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)

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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)

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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)

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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 ?

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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

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GOOD NIGHT
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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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CLARITY

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

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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

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GOOD NIGHT
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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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GOOD NIGHT
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ADMS 4510 - SESSION 11
ACCOUNTING THEORY

• OVERVIEW
• Managers perspective - Economic consequences,
  contracting
• Positive accounting theory
• Market efficiency and economic consequences

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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

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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

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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

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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.

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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

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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

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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)

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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)

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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

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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

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GOOD NIGHT
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ADMS 4510 - SESSION 12
ACCOUNTING THEORY

• OVERVIEW
• Need for accounting regulation
• Information asymmetry and signalling
• Politics of standard setting

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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

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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

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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

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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

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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

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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

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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

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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

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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?

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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

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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

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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

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GOOD NIGHT