Financial Accounting Theory
,Financial Accounting Theory
Week 1. Accounting Scandals
In the 1960’s, there were significant changes in accounting research, being:
• Rational decision making under uncertainty
• Efficient securities markets
• Information economics
This changed the focus in accounting research. Now researchers are really focussing on the
decision usefulness of financial accounting information.
The Early 2000’s
There were some huge accounting problems in the early 2000s. First of all, we had the so
called “internet Bubble” this being the securities market crash in the hi-tech industry. This
caused some changes in the financial accounting world. Being new revenue recognition
standards, the creating of SPE’s (Special Purpose Entities) and some corporate governance
regulations.
The years 2007 – 2008
Most accounting students are familiar with the 2008 financial crisis. It happened because of a
lack of transparency and fraud in the asset-backed securities market. As a result, accounting
practices changed, focusing more on financial leverage and off-balance sheet leverage. Fair
value accounting for financial instruments also became important, comparing market value
with value-in-use.
More recently
Recent accounting changes include the introduction of ESG reporting, also known as
sustainability reporting. To oversee sustainability standards, the International Sustainability
Standards Board (ISSB) was established. ISSB standards will be part of the broader
International Financial Reporting Standards (IFRS) and will be known as IFRS-S.
Additionally, in 2023, the EU adopted the European Sustainability Reporting Standards
(ESRS) for companies under the Corporate Sustainability Reporting Directive (CSRD).
The accounting lessons that we’ve learned from this.
Transparency and full disclosure in financial reporting are crucial but can be viewed
differently by investors and management. Market prices may not always reflect a company's
true value due to liquidity pricing. Off-balance sheet activities can lead to an incomplete
financial picture. Additionally, accounting standards evolve over time in response to real
changes and ongoing debates.
But, where are we now?
We are now in the era of uneven distribution of information (i.e. information asymmetry), the
adverse selection (negative risicoselectie) and moral hazard. A moral hazard is that people
tend to care less about their risks, because they are insured for any damage they may get.
,A nice example is a share in Facebook. How much will you pay for this, if you know the
following:
Or, how much will you pay the CEO of your company? These are all questions that we need
to answer and have been answered. That is what this course is all about.
Information Asymmetry problems
Adverse selection (Negatieve risicoselectie)
The adverse selection is a situation where sellers only sell the product when it is favourable
to them. (e.g. selling overvalued shares). Or the highest cost buyers end up buying a
particular product (e.g. health insurance
Scott and O’Brien (2024) argue the following about adverse selection:
The best measure of net income to solve the adverse selection problem is not the best
measure of net income to solve the moral hazard problem.
Moral Hazard
Any situation in which one person makes the decision about how much risk to take, while
someone else bears the cost if things go badly.” (Paul Krugman, 2009). In other words,
holiday insurance, manager shirking.
Fundamental problem
Two equally important functions
You need to inform investors, owners (board of directors) and the other stakeholders (people
and planet).
Fundamental financial accounting problem
A key challenge in financial accounting is addressing adverse selection and moral hazard.
However, a major issue that arises is balancing relevance and reliability, as well as sensitivity
and precision in financial reporting.
Accounting under ideal circumstances
Under ideal circumstances the present value model (DCF-model) provides the utmost in
relevant and reliable financial accounting information. But what are ideal circumstances?
Ideal circumstances are:
- All states are known.
- State realisation public knowledge
- Objective state probabilities
- Given interest rates
, In other words, all relevant information about the company is publicly known, interest rates
are accurate and fixed, and objective probabilities are reliable. Investors have full knowledge
of both the company and the economy, allowing them to make well-informed and safe
investment decisions.
What is relevant information?
This is information about future economic prospects. For example, you already know that
company X will make € xxx,- profit in the upcoming years, and the profits will be stable.
What is reliable information?
Reliable information is information that “faithfully represents what it is intended to represent”
complete and without (un)intentional bias. For example, if a company reports $10 million in
revenue, and this amount is supported by actual sales transactions, verified invoices, and an
independent audit, then the information faithfully represents reality. It is complete, accurate,
and free from intentional or unintentional bias, making it reliable for investors and
stakeholders.
The DCF (Discounted Cash Flow model) under certainty.
For example, a company has:
- No debt
- One asset with a life of 2 years
- Cash flow of € 150 per year
- Interest rate of 10%
150 150
Then the 𝑃𝑉0 = + = 260.33
1,10 1,102
Balance sheet
Capital Asset 260,33 Equity 260,33
Totaal: € 260,33 € 260,33
In year (x) we have some sales and costs, which look like this:
Income statement
Sales 150,00
Depreciation 123,97
Net income 26,03
Depreciation calculation:
The asset at 𝑃𝑉0 = 260.33
Depreciation: .10 = 136.36
260.33 – 136.36 = 123.97
The asset is good for 150,- in sales every year, so that’s why we take the 150, instead of the
260,33.
Ending Balance sheet
Capital Asset Equity
Opening value 260,33 Opening value 260,33
Depreciation -123,97 136,36 Net income 26,03
Cash 150,00
Totaal: € 286,36 € 286,36
,Financial Accounting Theory
Week 1. Accounting Scandals
In the 1960’s, there were significant changes in accounting research, being:
• Rational decision making under uncertainty
• Efficient securities markets
• Information economics
This changed the focus in accounting research. Now researchers are really focussing on the
decision usefulness of financial accounting information.
The Early 2000’s
There were some huge accounting problems in the early 2000s. First of all, we had the so
called “internet Bubble” this being the securities market crash in the hi-tech industry. This
caused some changes in the financial accounting world. Being new revenue recognition
standards, the creating of SPE’s (Special Purpose Entities) and some corporate governance
regulations.
The years 2007 – 2008
Most accounting students are familiar with the 2008 financial crisis. It happened because of a
lack of transparency and fraud in the asset-backed securities market. As a result, accounting
practices changed, focusing more on financial leverage and off-balance sheet leverage. Fair
value accounting for financial instruments also became important, comparing market value
with value-in-use.
More recently
Recent accounting changes include the introduction of ESG reporting, also known as
sustainability reporting. To oversee sustainability standards, the International Sustainability
Standards Board (ISSB) was established. ISSB standards will be part of the broader
International Financial Reporting Standards (IFRS) and will be known as IFRS-S.
Additionally, in 2023, the EU adopted the European Sustainability Reporting Standards
(ESRS) for companies under the Corporate Sustainability Reporting Directive (CSRD).
The accounting lessons that we’ve learned from this.
Transparency and full disclosure in financial reporting are crucial but can be viewed
differently by investors and management. Market prices may not always reflect a company's
true value due to liquidity pricing. Off-balance sheet activities can lead to an incomplete
financial picture. Additionally, accounting standards evolve over time in response to real
changes and ongoing debates.
But, where are we now?
We are now in the era of uneven distribution of information (i.e. information asymmetry), the
adverse selection (negative risicoselectie) and moral hazard. A moral hazard is that people
tend to care less about their risks, because they are insured for any damage they may get.
,A nice example is a share in Facebook. How much will you pay for this, if you know the
following:
Or, how much will you pay the CEO of your company? These are all questions that we need
to answer and have been answered. That is what this course is all about.
Information Asymmetry problems
Adverse selection (Negatieve risicoselectie)
The adverse selection is a situation where sellers only sell the product when it is favourable
to them. (e.g. selling overvalued shares). Or the highest cost buyers end up buying a
particular product (e.g. health insurance
Scott and O’Brien (2024) argue the following about adverse selection:
The best measure of net income to solve the adverse selection problem is not the best
measure of net income to solve the moral hazard problem.
Moral Hazard
Any situation in which one person makes the decision about how much risk to take, while
someone else bears the cost if things go badly.” (Paul Krugman, 2009). In other words,
holiday insurance, manager shirking.
Fundamental problem
Two equally important functions
You need to inform investors, owners (board of directors) and the other stakeholders (people
and planet).
Fundamental financial accounting problem
A key challenge in financial accounting is addressing adverse selection and moral hazard.
However, a major issue that arises is balancing relevance and reliability, as well as sensitivity
and precision in financial reporting.
Accounting under ideal circumstances
Under ideal circumstances the present value model (DCF-model) provides the utmost in
relevant and reliable financial accounting information. But what are ideal circumstances?
Ideal circumstances are:
- All states are known.
- State realisation public knowledge
- Objective state probabilities
- Given interest rates
, In other words, all relevant information about the company is publicly known, interest rates
are accurate and fixed, and objective probabilities are reliable. Investors have full knowledge
of both the company and the economy, allowing them to make well-informed and safe
investment decisions.
What is relevant information?
This is information about future economic prospects. For example, you already know that
company X will make € xxx,- profit in the upcoming years, and the profits will be stable.
What is reliable information?
Reliable information is information that “faithfully represents what it is intended to represent”
complete and without (un)intentional bias. For example, if a company reports $10 million in
revenue, and this amount is supported by actual sales transactions, verified invoices, and an
independent audit, then the information faithfully represents reality. It is complete, accurate,
and free from intentional or unintentional bias, making it reliable for investors and
stakeholders.
The DCF (Discounted Cash Flow model) under certainty.
For example, a company has:
- No debt
- One asset with a life of 2 years
- Cash flow of € 150 per year
- Interest rate of 10%
150 150
Then the 𝑃𝑉0 = + = 260.33
1,10 1,102
Balance sheet
Capital Asset 260,33 Equity 260,33
Totaal: € 260,33 € 260,33
In year (x) we have some sales and costs, which look like this:
Income statement
Sales 150,00
Depreciation 123,97
Net income 26,03
Depreciation calculation:
The asset at 𝑃𝑉0 = 260.33
Depreciation: .10 = 136.36
260.33 – 136.36 = 123.97
The asset is good for 150,- in sales every year, so that’s why we take the 150, instead of the
260,33.
Ending Balance sheet
Capital Asset Equity
Opening value 260,33 Opening value 260,33
Depreciation -123,97 136,36 Net income 26,03
Cash 150,00
Totaal: € 286,36 € 286,36
