Financial Accounting Theory (2026/2027)
William. R. Scott, Patricia. C. O’Brien
Chapter 1 – Introduction to Financial Accounting Theory
Financial accounting theory = a construction of legal reasonings to increase
our understanding of accounting practices and to help guide future
developments. The stock market crash of 1929 led to major changes by the
US government. The most noteworthy was the creation of the Securities and
Exchange Commission (SEC) by the Securities Exchange Act of 1934, with
a focus on protecting investors by means of a disclosure-based structure. The Act
regulates dealing in the securities of firms that meet certain size tests and whose
securities are traded in more than one state.
In the 1960’s new theories were developed: rational decision making under
uncertainty, efficient securities market and information economics. The focus was
on decision usefulness. The conceptual framework of the IASB and FASB is also
based on decision usefulness. It states that the goal of financial statements is to
provide information that can help investors in making their investment decisions.
Standard setters in numerous countries required some disclosures of the effects
of changing prices. For example, after a period of high inflation in the US,
Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards No. 33 (1979) required supplementary disclosure of the
effects on earnings of specific and general price level changes for property, plant,
equipment, and inventories. This standard was subsequently withdrawn.
However, this withdrawal was due more to a reduction of its cost-effectiveness as
inflation declined in later years than to the debate having been settled.
In the year 2000 there is an Internet bubble and market crash in the high-tech
industry. The cause of this were unclear criteria for revenue recognition. This led
to too early recognition of revenues. Also, companies were using special purpose
entities (SPEs) to carry their debt to improve their debt ratio. One example is
Enron. This resulted in a lack of trust in financial reporting by society and
eventually in the Sarbanes- Eley Act (SOX) and several governance codes.
Points relevant to accountants that stand out from events that happened in 2007
– 2008:
- Financial reporting must be transparent so that investors can properly
value assets and liabilities, and the firms that possess them. Transparency
includes full reporting of models used to determine value, disclosure of all
related obligations or enhancements, and explanations of risk exposures
and risk-management strategies.
- Because fair value accounting is based on market value or estimates
thereof, it may understate value in use when markets collapse due to
liquidity pricing and how financial reporting may help to control it.
- Off-balance sheet activities should be fully reported, even if not
consolidated, since they can encourage excessive risk-taking by
management.
,Efficient contracting is an alternative view of financial reporting. It argues that
the contracts that firms enter into (e.g. debt contracts and managerial
compensation contracts) create a primary source of demand for accounting
information. The role of accounting information is viewed as one of helping to
maximize contract efficiency or, more generally, to aid in efficient corporate
governance. Such contracts usually depend on accounting variables, such as net
income (basing manager compensation on net income increases investor trust by
helping to align manager and shareholder interests). The role of financial
reporting for debt and compensation contract purposes is to generate trust
(lenders willing to lend to the firm and shareholders willing to delegate
managerial responsibilities to managers). An efficient contract generates this
trust at lowest cost.
Efficient contracting emphasizes trustworthiness in accounting numbers,
especially those used in contracts. In contrast, the valuation approach
emphasizes timeliness in accounting information conveyed to investors. Two
differences:
- One difference is an increased emphasis, relative to current value
accounting, on the reliability of accounting information. It benefits
lenders by increasing their trust.
- A second difference is the role of conservatism in financial reporting.
Under conservatism, unrealized losses from declines in value are
recognized when they take place but gains from increases in value are not
recognized until they are realized.
To restore the confidence of the public it is possible to increase regulation.
Besides that ethical behaviour of accountants and auditors is required. They
should ‘do the right thing’. They must behave with integrity and independence in
putting the public interest ahead of the employer’s and client’s interests, should
these interests conflict. An accountant can however act in his/her own self-
interest and still behave ethically.
Rules-based accounting standards: attempt to lay down detailed rules for
how to account. Principles-based accounting standards: the accounting
standards lay down general principles only and rely on the auditor's professional
judgement to ensure that the application of the standards is not misleading. The
world is moving toward principles-based standards because detailed rules do not
seem to work. Punishment is a powerful deterrent to fraud too, but it’s preferable
to prevent misleading reporting in the first place.
The environment of accounting is very complex and challenging. It is complex
because the product of accounting is information, a powerful and important
commodity. The main reason for this complexity is the absence of perfect or true
accounting concepts and standards. As a result, different groups (like investors or
bondholders) may prefer different approaches. Another reason for the complexity
of information is that it does more than affect individual decisions. It also affects
the working of markets, such as securities markets and managerial labour
markets.
There are two complementary ways that we can view the role of accounting
research:
, - it has effects on rules and regulations, due to significant findings.
- it helps us understand the (current) accounting environment.
Information asymmetry occurs when some parties to business transactions
have an information advantage over others or may take actions that are
unobservable to others. There are two major types of information asymmetry:
- Adverse selection: one or more parties to a business transaction, or
potential transactions, have an information advantage over other parties.
For example, insiders vs outside investors.
- Moral hazard: one or more parties to a contract can observe their actions
in fulfilment of the contract but other parties cannot. It occurs because of
the separation of ownership and control. Managers know how hard he/she
is working but investors do not.
Accounting net income can help to control moral hazard in 2 ways:
- Net income can serve as an input into executive compensation contracts to
motivate manager performance.
- Net income can inform the managerial labour market, so that a manager
who shirks will suffer a decline in income, reputation, and personal market
value in the longer run.
Fundamental problem = combining the investor-informing and manager
performance-evaluating role of financial accounting information (FAI). Given the
absence of perfect accounting concepts, it turns out that the most useful
measure of financial accounting to control for adverse selection may not be the
same as the perfect measure to control for moral hazard. Investors' interests are
best served by information that enables better investment decisions and better-
operating capital markets. Current value accounting fulfils this role, since it
provides up-to-date information about assets and liabilities, hence of future firm
performance, and reduces the ability of insiders to take advantage of changes in
asset and liability values. Managers' legitimate interests are best served by
information that is highly informative about their performance in running the firm
since this enables efficient compensation contracts and better working of
managerial labour markets. Fair value accounting fulfils this role. For
management performance, it is not fair to consider the reduced revenue and
profit, because they could hardly be regarded as management’s responsibility.
Yet, from the standpoint of investors who are interested primarily in future firm
cash flows, earnings including these events have greater relevance.
Another approach to reconciling the two roles. The other comprehensive
income (OCI) approach. It is a compromise to secure manager acceptance of
current value standards since it excludes these gains and losses from net income.
Thus, it includes unrealized current value gains and losses resulting from fair
value accounting for securities, foreign currency translation adjustments,
changes in some pension expense components, and several other items. The
sum of net income and other comprehensive income is called comprehensive
income. the comprehensive income is a compromise between the two roles,
because unrealized results are communicated but not part of the official
acknowledged result.
William. R. Scott, Patricia. C. O’Brien
Chapter 1 – Introduction to Financial Accounting Theory
Financial accounting theory = a construction of legal reasonings to increase
our understanding of accounting practices and to help guide future
developments. The stock market crash of 1929 led to major changes by the
US government. The most noteworthy was the creation of the Securities and
Exchange Commission (SEC) by the Securities Exchange Act of 1934, with
a focus on protecting investors by means of a disclosure-based structure. The Act
regulates dealing in the securities of firms that meet certain size tests and whose
securities are traded in more than one state.
In the 1960’s new theories were developed: rational decision making under
uncertainty, efficient securities market and information economics. The focus was
on decision usefulness. The conceptual framework of the IASB and FASB is also
based on decision usefulness. It states that the goal of financial statements is to
provide information that can help investors in making their investment decisions.
Standard setters in numerous countries required some disclosures of the effects
of changing prices. For example, after a period of high inflation in the US,
Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards No. 33 (1979) required supplementary disclosure of the
effects on earnings of specific and general price level changes for property, plant,
equipment, and inventories. This standard was subsequently withdrawn.
However, this withdrawal was due more to a reduction of its cost-effectiveness as
inflation declined in later years than to the debate having been settled.
In the year 2000 there is an Internet bubble and market crash in the high-tech
industry. The cause of this were unclear criteria for revenue recognition. This led
to too early recognition of revenues. Also, companies were using special purpose
entities (SPEs) to carry their debt to improve their debt ratio. One example is
Enron. This resulted in a lack of trust in financial reporting by society and
eventually in the Sarbanes- Eley Act (SOX) and several governance codes.
Points relevant to accountants that stand out from events that happened in 2007
– 2008:
- Financial reporting must be transparent so that investors can properly
value assets and liabilities, and the firms that possess them. Transparency
includes full reporting of models used to determine value, disclosure of all
related obligations or enhancements, and explanations of risk exposures
and risk-management strategies.
- Because fair value accounting is based on market value or estimates
thereof, it may understate value in use when markets collapse due to
liquidity pricing and how financial reporting may help to control it.
- Off-balance sheet activities should be fully reported, even if not
consolidated, since they can encourage excessive risk-taking by
management.
,Efficient contracting is an alternative view of financial reporting. It argues that
the contracts that firms enter into (e.g. debt contracts and managerial
compensation contracts) create a primary source of demand for accounting
information. The role of accounting information is viewed as one of helping to
maximize contract efficiency or, more generally, to aid in efficient corporate
governance. Such contracts usually depend on accounting variables, such as net
income (basing manager compensation on net income increases investor trust by
helping to align manager and shareholder interests). The role of financial
reporting for debt and compensation contract purposes is to generate trust
(lenders willing to lend to the firm and shareholders willing to delegate
managerial responsibilities to managers). An efficient contract generates this
trust at lowest cost.
Efficient contracting emphasizes trustworthiness in accounting numbers,
especially those used in contracts. In contrast, the valuation approach
emphasizes timeliness in accounting information conveyed to investors. Two
differences:
- One difference is an increased emphasis, relative to current value
accounting, on the reliability of accounting information. It benefits
lenders by increasing their trust.
- A second difference is the role of conservatism in financial reporting.
Under conservatism, unrealized losses from declines in value are
recognized when they take place but gains from increases in value are not
recognized until they are realized.
To restore the confidence of the public it is possible to increase regulation.
Besides that ethical behaviour of accountants and auditors is required. They
should ‘do the right thing’. They must behave with integrity and independence in
putting the public interest ahead of the employer’s and client’s interests, should
these interests conflict. An accountant can however act in his/her own self-
interest and still behave ethically.
Rules-based accounting standards: attempt to lay down detailed rules for
how to account. Principles-based accounting standards: the accounting
standards lay down general principles only and rely on the auditor's professional
judgement to ensure that the application of the standards is not misleading. The
world is moving toward principles-based standards because detailed rules do not
seem to work. Punishment is a powerful deterrent to fraud too, but it’s preferable
to prevent misleading reporting in the first place.
The environment of accounting is very complex and challenging. It is complex
because the product of accounting is information, a powerful and important
commodity. The main reason for this complexity is the absence of perfect or true
accounting concepts and standards. As a result, different groups (like investors or
bondholders) may prefer different approaches. Another reason for the complexity
of information is that it does more than affect individual decisions. It also affects
the working of markets, such as securities markets and managerial labour
markets.
There are two complementary ways that we can view the role of accounting
research:
, - it has effects on rules and regulations, due to significant findings.
- it helps us understand the (current) accounting environment.
Information asymmetry occurs when some parties to business transactions
have an information advantage over others or may take actions that are
unobservable to others. There are two major types of information asymmetry:
- Adverse selection: one or more parties to a business transaction, or
potential transactions, have an information advantage over other parties.
For example, insiders vs outside investors.
- Moral hazard: one or more parties to a contract can observe their actions
in fulfilment of the contract but other parties cannot. It occurs because of
the separation of ownership and control. Managers know how hard he/she
is working but investors do not.
Accounting net income can help to control moral hazard in 2 ways:
- Net income can serve as an input into executive compensation contracts to
motivate manager performance.
- Net income can inform the managerial labour market, so that a manager
who shirks will suffer a decline in income, reputation, and personal market
value in the longer run.
Fundamental problem = combining the investor-informing and manager
performance-evaluating role of financial accounting information (FAI). Given the
absence of perfect accounting concepts, it turns out that the most useful
measure of financial accounting to control for adverse selection may not be the
same as the perfect measure to control for moral hazard. Investors' interests are
best served by information that enables better investment decisions and better-
operating capital markets. Current value accounting fulfils this role, since it
provides up-to-date information about assets and liabilities, hence of future firm
performance, and reduces the ability of insiders to take advantage of changes in
asset and liability values. Managers' legitimate interests are best served by
information that is highly informative about their performance in running the firm
since this enables efficient compensation contracts and better working of
managerial labour markets. Fair value accounting fulfils this role. For
management performance, it is not fair to consider the reduced revenue and
profit, because they could hardly be regarded as management’s responsibility.
Yet, from the standpoint of investors who are interested primarily in future firm
cash flows, earnings including these events have greater relevance.
Another approach to reconciling the two roles. The other comprehensive
income (OCI) approach. It is a compromise to secure manager acceptance of
current value standards since it excludes these gains and losses from net income.
Thus, it includes unrealized current value gains and losses resulting from fair
value accounting for securities, foreign currency translation adjustments,
changes in some pension expense components, and several other items. The
sum of net income and other comprehensive income is called comprehensive
income. the comprehensive income is a compromise between the two roles,
because unrealized results are communicated but not part of the official
acknowledged result.
