Financial Accounting Theory Exam Summary
Week 1 Introduction to financial accounting theory
Why Accounting Matters=
• Informs investors and other stakeholders; helps deter and detect fraud.
• Essential infrastructure for a well-functioning market economy.
What Is “Financial Accounting Theory”?
• A science of reasoning about accounting: builds logical arguments to explain current practice and guide
future development.
Lessons from History=
• Transparency & full disclosure are central (investor vs management perspectives).
• Market price can understate real value (liquidity effects).
• Balance sheets can be incomplete (off-balance items).
• Standards evolve as economies and debates evolve.
Information Economics: Core Problems=
• Information asymmetry: uneven information across parties.
o Adverse selection: hidden information before contracting (e.g., overvalued share issues).
o Moral hazard: hidden action/effort after contracting (e.g., manager shirking).
Fundamental Problem of Financial Accounting=
• Accounting serves two equally important functions:
1. Inform investors (valuation/decision usefulness).
2. Inform owners/boards (performance evaluation & contracts) — plus wider stakeholders (people &
planet).
• Therefore, trade-offs:
o Relevance vs reliability (valuation vs verifiability).
o Relevance: forward-looking estimates that help predict future cash flows and risks.
o Reliability: verifiable historical data with minimal bias.
• Sensitive vs precise information (contracting: reduce noise for incentives).
• Key idea (Scott & O’Brien): the best income measure for adverse selection is not the best for moral
hazard → balancing valuation and contract efficiency is the core challenge.
Ideal Circumstances: All future states and their probabilities are known; state realization is public; the
discount rate is given.
• Implications for accounting:
o Use the DCF (present value) model: with certainty, PV of known cash flows gives the best (most
relevant and most reliable) measures.
o No information asymmetry and no estimates are needed; measurements are objective and fully
verifiable.
o Reported values directly equal the economic values implied by the known cash flows and discount
rate.
Ideal conditions (certainty): DCF model
Assumptions
No debt; one asset; 2 years; CF each year = 150; discount rate r = 10%.
1) Present value at t=0
150 150
𝑃𝑉0 = + = 136.36 + 123.97 = 260.33
1.10 1.102
,2) Opening balance sheet (t=0)
• Asset (capital asset) = 260.33
• Equity = 260.33 (no debt ⇒ assets financed by equity)
3) Year-1 income statement (two equivalent presentations)
(i) Sales–Depreciation view
• Sales (cash inflow) = 150
• Carrying value end-of-year-1 = PV of remaining CF: 150/1.10 = 136.36
• Depreciation = opening carrying value − closing carrying value
= 260.33 − 136.36 = 123.97
• Net income = 150 − 123.97 = 26.03
(ii) Accretion-of-discount view
• Accretion = 𝑟 ×opening equity = 0.10 × 260.33 = 26.03
• Net income = 26.03
(Both yield the same NI.)
4) Balance sheet at end of Year-1
• Capital asset = 136.36
• Cash = 150
• Assets = 286.36
• Equity = opening 260.33 + NI 26.03 = 286.36
5) Key takeaways under certainty
• Book value = Present value = Market value (PV=BV=MV).
• Income statement is just the accretion of discount; dividends (if any) affect cash and retained
earnings, not NI.
Ideal framework but uncertainty in cash flows=
Assumptions
No debt; one asset; 2 years; each year CF is 100 or 200 (prob. 0.5 each); r = 10%.
1) Present value at t=0
Expected CF each year = 150 ⇒ same PV as before:
100 100 200 200
𝑃𝑉0 = 0.5 ( + 2
) + 0.5 ( + ) = 260.33
1.10 1.10 1.10 1.102
2) Depreciation rule (unchanged)
• Carrying value at end-of-Year-1 = expected PV of remaining CF:
100 200
0.5 ( ) + 0.5 ( ) = 136.36
1.10 1.10
Depreciation = 260.33 − 136.36 = 123.97(same as certainty).
3) Net income via accretion ± abnormal earnings
• Accretion piece: 0.10 × 260.33 = 26.03
• Abnormal earnings =Actual CF − Expected CF (150)
Case 1 — Recession (actual CF = 100)
• Abnormal = 100 − 150 = −50
• Net income = 26.03 − 50 = −23.97
• End-Y1 B/S: Asset 136.36; Cash 100; Equity 260.33 − 23.97 = 236.36
Case 2 — Boom (actual CF = 200)
• Abnormal = 200 − 150 = +50
• Net income = 26.03 + 50 = 76.03
• End-Y1 B/S: Asset 136.36; Cash 200; Equity 260.33 + 76.03 = 336.36
4) Takeaways under uncertainty
• Still 𝑃𝑉 = 𝐵𝑉 = 𝑀𝑉within the ideal model (risk-neutral pricing).
• The income statement splits into:
NI𝑡 = 𝑟 × BV𝑡−1 ± abnormal earnings.
,Fair value vs. Value in use=
• Fair value (exit price): current market price between willing buyers/sellers.
o Pros: highest relevance; improves transparency and forward-looking usefulness; if deep/liquid
markets exist, reliability can be high.
o Cons: where markets are thin/absent, estimates and bias rise → reliability falls. Using FV for
everything can add little information if markets already impound it.
• Value in use (present value of expected cash flows): firm-specific PV of future benefits.
o Pros: highly relevant for decisions.
o Cons: relies on subjective forecasts and discount rates → lower reliability.
Present-value–based accounting=
• Focus: estimate current value of future cash flows using a discount rate.
• Under uncertainty: estimation error and bias reduce reliability, but relevance remains high.
Alternative income statement (accretion of discount)=
• Formula: Net income𝑡 = 𝑃𝑉0 (𝑆𝐸0 ) × 𝑟(plus/minus abnormal earnings under uncertainty).
• Note: dividends never appear on the income statement; they affect cash and retained earnings only.
Real-world (non-ideal) conditions=
• Subjective probabilities and estimates are unavoidable.
• PV (value in use) can differ from market (fair) value.
• There is no single “true” net income; income is an estimate of performance.
• Trade-off intensifies: historical cost vs current value (measurement) and valuation vs contracting
(information).
• Practice uses a mixed-measurement model and professional judgment to balance relevance and
reliability.
Are ideal conditions likely?
• Rare: future cash flows and a single stable discount rate are unlikely to be known.
• Expect changes in estimates and interest rates → deviations from “ideal” expected income.
• DCF still applies under uncertainty, but outputs are more relevant and less reliable.
Chapter 1 Introduction
Current value measures (vs. historical cost)=
• Value in use (VIU): PV of expected future cash flows.
• Fair value (FV / exit price): price to sell/transfer today; “opportunity cost.”
• Use current values when not distinguishing VIU vs. FV.
Well-working capital markets=
• Market prices ≈ underlying fundamental values.
Arrow’s Possibility Theorem → Decision usefulness
• No single “perfect” accounting concept will satisfy all; aim for decision-useful information, not “true
income.”
Revenue recognition (core)=
• Contract with a customer required.
• Recognize revenue as performance obligations are satisfied (customer obtains control).
• Collection must be probable.
• Historically, revenue restatements were the most common restatements.
, 2007–2008 crisis: structures & lessons=
• SIVs → ABS → CDOs, leverage, and CDS magnified risk; housing decline triggered losses.
o Variable interest entities (VIEs): risks/returns borne by variable-interest holders;
o Expected loss notes (ELNs) shifted expected losses to third parties to avoid consolidation.
• Liquidity risk/pricing can result in a market value less than value in use
• Reporting lessons:
o Full transparency (models, assumptions, risks, enhancements, off-balance-sheet exposures).
o FV may understate VIU in fire-sale markets—explain and disclose.
o Tighten consolidation/compensation disclosures and governance
Efficient contracting view (stewardship)=
• Purpose: support efficient contracts (debt, compensation) and governance.
• Emphasis: reliability, especially net income for covenants and pay.
• Conservatism: recognize losses early, gains later.
• Contrast with valuation view: contracting favors reliability; valuation favors timeliness/relevance.
• Central tension: balance FV’s decision usefulness with reliable measures for contracts.
Standards: rules- vs principles-based=
• Rules-based: detailed, easier to follow, but gameable (e.g., Enron tactics).
• Principles-based: broad concepts + professional judgment; aims to prevent misleading reporting; trend
toward this approach.
• Challenge: pressure from managers/governments; ethics and long-term responsibility are critical.
Information economics: formally recognizes that some parties to business transactions may have an information
advantage over others or may take actions that are unobservable to others. When this happens, we say that the
economy is characterized by information asymmetry.
Adverse selection (hidden information)=
• Assume investors are rational on average and maximize expected utility.
• Goal of reporting: provide decision-useful information.
• Two decision-usefulness versions:
1. Information approach: form/location of disclosure doesn’t matter; sophisticated investors process
notes/supplements just as well as statements.
2. Measurement approach: put current values for assets/liabilities directly into the financial
statements, not only in disclosures.
Moral hazard (hidden actions/effort)=
• Managers’ effort is unobservable; temptation to shirk.
• Net income serves as an indirect performance measure.
• Reporting design problem: structure financial reporting to motivate and evaluate managers (e.g., tie
compensation and monitoring to income-based measures).
Role of accounting net income against moral hazard=
1. Input to compensation contracts (align incentives).
2. Signals to the managerial labor market (affects reputation and future pay).
Fundamental Problem of Financial Accounting=
• Two roles, different needs
o Inform investors: timely, relevant, reasonably reliable → favors current value.
o Evaluate/motivate managers: conservative, stable, highly reliable → favors historical cost.
• Conflict: one income measure must serve both roles.
• Current value
o Reduces adverse selection for investors.
o Adds volatility; can distort performance evaluation and be gamed.
Week 1 Introduction to financial accounting theory
Why Accounting Matters=
• Informs investors and other stakeholders; helps deter and detect fraud.
• Essential infrastructure for a well-functioning market economy.
What Is “Financial Accounting Theory”?
• A science of reasoning about accounting: builds logical arguments to explain current practice and guide
future development.
Lessons from History=
• Transparency & full disclosure are central (investor vs management perspectives).
• Market price can understate real value (liquidity effects).
• Balance sheets can be incomplete (off-balance items).
• Standards evolve as economies and debates evolve.
Information Economics: Core Problems=
• Information asymmetry: uneven information across parties.
o Adverse selection: hidden information before contracting (e.g., overvalued share issues).
o Moral hazard: hidden action/effort after contracting (e.g., manager shirking).
Fundamental Problem of Financial Accounting=
• Accounting serves two equally important functions:
1. Inform investors (valuation/decision usefulness).
2. Inform owners/boards (performance evaluation & contracts) — plus wider stakeholders (people &
planet).
• Therefore, trade-offs:
o Relevance vs reliability (valuation vs verifiability).
o Relevance: forward-looking estimates that help predict future cash flows and risks.
o Reliability: verifiable historical data with minimal bias.
• Sensitive vs precise information (contracting: reduce noise for incentives).
• Key idea (Scott & O’Brien): the best income measure for adverse selection is not the best for moral
hazard → balancing valuation and contract efficiency is the core challenge.
Ideal Circumstances: All future states and their probabilities are known; state realization is public; the
discount rate is given.
• Implications for accounting:
o Use the DCF (present value) model: with certainty, PV of known cash flows gives the best (most
relevant and most reliable) measures.
o No information asymmetry and no estimates are needed; measurements are objective and fully
verifiable.
o Reported values directly equal the economic values implied by the known cash flows and discount
rate.
Ideal conditions (certainty): DCF model
Assumptions
No debt; one asset; 2 years; CF each year = 150; discount rate r = 10%.
1) Present value at t=0
150 150
𝑃𝑉0 = + = 136.36 + 123.97 = 260.33
1.10 1.102
,2) Opening balance sheet (t=0)
• Asset (capital asset) = 260.33
• Equity = 260.33 (no debt ⇒ assets financed by equity)
3) Year-1 income statement (two equivalent presentations)
(i) Sales–Depreciation view
• Sales (cash inflow) = 150
• Carrying value end-of-year-1 = PV of remaining CF: 150/1.10 = 136.36
• Depreciation = opening carrying value − closing carrying value
= 260.33 − 136.36 = 123.97
• Net income = 150 − 123.97 = 26.03
(ii) Accretion-of-discount view
• Accretion = 𝑟 ×opening equity = 0.10 × 260.33 = 26.03
• Net income = 26.03
(Both yield the same NI.)
4) Balance sheet at end of Year-1
• Capital asset = 136.36
• Cash = 150
• Assets = 286.36
• Equity = opening 260.33 + NI 26.03 = 286.36
5) Key takeaways under certainty
• Book value = Present value = Market value (PV=BV=MV).
• Income statement is just the accretion of discount; dividends (if any) affect cash and retained
earnings, not NI.
Ideal framework but uncertainty in cash flows=
Assumptions
No debt; one asset; 2 years; each year CF is 100 or 200 (prob. 0.5 each); r = 10%.
1) Present value at t=0
Expected CF each year = 150 ⇒ same PV as before:
100 100 200 200
𝑃𝑉0 = 0.5 ( + 2
) + 0.5 ( + ) = 260.33
1.10 1.10 1.10 1.102
2) Depreciation rule (unchanged)
• Carrying value at end-of-Year-1 = expected PV of remaining CF:
100 200
0.5 ( ) + 0.5 ( ) = 136.36
1.10 1.10
Depreciation = 260.33 − 136.36 = 123.97(same as certainty).
3) Net income via accretion ± abnormal earnings
• Accretion piece: 0.10 × 260.33 = 26.03
• Abnormal earnings =Actual CF − Expected CF (150)
Case 1 — Recession (actual CF = 100)
• Abnormal = 100 − 150 = −50
• Net income = 26.03 − 50 = −23.97
• End-Y1 B/S: Asset 136.36; Cash 100; Equity 260.33 − 23.97 = 236.36
Case 2 — Boom (actual CF = 200)
• Abnormal = 200 − 150 = +50
• Net income = 26.03 + 50 = 76.03
• End-Y1 B/S: Asset 136.36; Cash 200; Equity 260.33 + 76.03 = 336.36
4) Takeaways under uncertainty
• Still 𝑃𝑉 = 𝐵𝑉 = 𝑀𝑉within the ideal model (risk-neutral pricing).
• The income statement splits into:
NI𝑡 = 𝑟 × BV𝑡−1 ± abnormal earnings.
,Fair value vs. Value in use=
• Fair value (exit price): current market price between willing buyers/sellers.
o Pros: highest relevance; improves transparency and forward-looking usefulness; if deep/liquid
markets exist, reliability can be high.
o Cons: where markets are thin/absent, estimates and bias rise → reliability falls. Using FV for
everything can add little information if markets already impound it.
• Value in use (present value of expected cash flows): firm-specific PV of future benefits.
o Pros: highly relevant for decisions.
o Cons: relies on subjective forecasts and discount rates → lower reliability.
Present-value–based accounting=
• Focus: estimate current value of future cash flows using a discount rate.
• Under uncertainty: estimation error and bias reduce reliability, but relevance remains high.
Alternative income statement (accretion of discount)=
• Formula: Net income𝑡 = 𝑃𝑉0 (𝑆𝐸0 ) × 𝑟(plus/minus abnormal earnings under uncertainty).
• Note: dividends never appear on the income statement; they affect cash and retained earnings only.
Real-world (non-ideal) conditions=
• Subjective probabilities and estimates are unavoidable.
• PV (value in use) can differ from market (fair) value.
• There is no single “true” net income; income is an estimate of performance.
• Trade-off intensifies: historical cost vs current value (measurement) and valuation vs contracting
(information).
• Practice uses a mixed-measurement model and professional judgment to balance relevance and
reliability.
Are ideal conditions likely?
• Rare: future cash flows and a single stable discount rate are unlikely to be known.
• Expect changes in estimates and interest rates → deviations from “ideal” expected income.
• DCF still applies under uncertainty, but outputs are more relevant and less reliable.
Chapter 1 Introduction
Current value measures (vs. historical cost)=
• Value in use (VIU): PV of expected future cash flows.
• Fair value (FV / exit price): price to sell/transfer today; “opportunity cost.”
• Use current values when not distinguishing VIU vs. FV.
Well-working capital markets=
• Market prices ≈ underlying fundamental values.
Arrow’s Possibility Theorem → Decision usefulness
• No single “perfect” accounting concept will satisfy all; aim for decision-useful information, not “true
income.”
Revenue recognition (core)=
• Contract with a customer required.
• Recognize revenue as performance obligations are satisfied (customer obtains control).
• Collection must be probable.
• Historically, revenue restatements were the most common restatements.
, 2007–2008 crisis: structures & lessons=
• SIVs → ABS → CDOs, leverage, and CDS magnified risk; housing decline triggered losses.
o Variable interest entities (VIEs): risks/returns borne by variable-interest holders;
o Expected loss notes (ELNs) shifted expected losses to third parties to avoid consolidation.
• Liquidity risk/pricing can result in a market value less than value in use
• Reporting lessons:
o Full transparency (models, assumptions, risks, enhancements, off-balance-sheet exposures).
o FV may understate VIU in fire-sale markets—explain and disclose.
o Tighten consolidation/compensation disclosures and governance
Efficient contracting view (stewardship)=
• Purpose: support efficient contracts (debt, compensation) and governance.
• Emphasis: reliability, especially net income for covenants and pay.
• Conservatism: recognize losses early, gains later.
• Contrast with valuation view: contracting favors reliability; valuation favors timeliness/relevance.
• Central tension: balance FV’s decision usefulness with reliable measures for contracts.
Standards: rules- vs principles-based=
• Rules-based: detailed, easier to follow, but gameable (e.g., Enron tactics).
• Principles-based: broad concepts + professional judgment; aims to prevent misleading reporting; trend
toward this approach.
• Challenge: pressure from managers/governments; ethics and long-term responsibility are critical.
Information economics: formally recognizes that some parties to business transactions may have an information
advantage over others or may take actions that are unobservable to others. When this happens, we say that the
economy is characterized by information asymmetry.
Adverse selection (hidden information)=
• Assume investors are rational on average and maximize expected utility.
• Goal of reporting: provide decision-useful information.
• Two decision-usefulness versions:
1. Information approach: form/location of disclosure doesn’t matter; sophisticated investors process
notes/supplements just as well as statements.
2. Measurement approach: put current values for assets/liabilities directly into the financial
statements, not only in disclosures.
Moral hazard (hidden actions/effort)=
• Managers’ effort is unobservable; temptation to shirk.
• Net income serves as an indirect performance measure.
• Reporting design problem: structure financial reporting to motivate and evaluate managers (e.g., tie
compensation and monitoring to income-based measures).
Role of accounting net income against moral hazard=
1. Input to compensation contracts (align incentives).
2. Signals to the managerial labor market (affects reputation and future pay).
Fundamental Problem of Financial Accounting=
• Two roles, different needs
o Inform investors: timely, relevant, reasonably reliable → favors current value.
o Evaluate/motivate managers: conservative, stable, highly reliable → favors historical cost.
• Conflict: one income measure must serve both roles.
• Current value
o Reduces adverse selection for investors.
o Adds volatility; can distort performance evaluation and be gamed.
