ADMS 4510 ACCOUNTING THEORY

1. ADMS 4510 ACCOUNTING THEORY Prof. Kate Bewley kbewley@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 4510web links Powerpoint slides for the sessions- www.atkinson.yorku.ca/pevans To print Powerpoint slides - Select “Print” from “File” menu In the “Print” dialog box under “Print what?” select: -> Handouts (3 per page is recommended) -> Pure black and white

3. 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

4. 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

5. 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.

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

7. 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

8. 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]

9. 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

10. INFORMATION ASYMMETRY • When one party has more information than another • 2 types: • adverse selection • moral hazard

11. 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

12. ADVERSE SELECTION Assumptions : • Investors are rational & want reasonable return • Large numbers of rational investorstrade 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)

13. 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 )

14. 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 ?

15. Framework of accounting theory - Figure 1-1 Inside information Investment decision Full disclosure Value-based accounting (Ideal) Regulation - Accounting standard setting Unobservable manager effort Contracts -compensation -debt covenants ‘Hard’ Net Income

16. 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

17. CICA Section 1000Financial 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

18. CICA - Section 1000Financial 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)

19. 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

20. 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

21. REMAINDER OF SEMESTER • Decision usefulness approach – Investor's point of view • Economic consequences model– Management's point of view • 7 weeks of specific accounting issues • Earnings management • Economics and politics of standard setting

22. GOOD NIGHT