Financial Accounting Theory

The "why" of accounting

Introduction to financial accounting theory

Financial accounting theory focuses on the “why” of accounting – the reasons why transactions are reported in certain ways.

The majority of introductory accounting courses, cover the “what” and “how” of accounting. These include hundreds of journal entries, gaining familiarity with all the common accounts that companies use, learning how financial statements are put together, and how to calculate the proper debit and credit amounts.

This article will explore the “why” of financial accounting theory.

 

Financial Accounting Theory

 

Uncertainty and information asymmetry

A key factor of accounting involves the transmission of financial information to anyone who may need the information. These users then use this accounting information to make business and investment decisions or may choose to make no decision at all. However, in order to make proper decisions, the information being provided needs to be reliable and relevant.

In financial reporting, we commonly encounter a phenomenon called information asymmetry. This is a situation in which one party has more or less information than another party. There are two types of information asymmetry pertinent to accounting.

There are two types of information asymmetry pertinent to financial accounting theory:

 

Adverse SelectionMoral Hazard
Hidden InformationHidden Action/Behavior
One party has an information advantage over another partyOne party can observe the actions while the other party cannot
Hidden information from the past and presentHidden future action
Example: buying a used carExample: instructors assigning a higher weighting on exams than homework

 

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In an ideal world, the economy would be characterized by perfect markets with a lack of information asymmetry. Financial statements issued by companies could then be said to be 100% relevant and 100% reliable. Relevant in the fact that the information will prove to be useful to external users, and reliable in the fact that they will be completely free from bias.

The lesson here is that in the world we live in today, we must be aware of the fact that no set of financial statements are 100% reliable and 100% relevant. In accounting and in today’s markets, there will always be a trade-off between reliability and relevance.

 

Supply and demand of accounting information

The existence of information asymmetry creates a supply and demand for financial reporting. Financial reporting is the preparation of information about the reporting entity and the transmission of that information from those who have it (supply) to those who need it (demand).

Suppliers of accounting information refer to accountants and the body that produces the financial statements.

Those who demand the information refer to internal/external users who require that information to make investment decisions.

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The Purpose of Financial Reporting

Although the specific objective and purpose of financial reporting may be different for different accounting bodies, the general theme is highly similar.

According to IFRS, the objective of financial reporting is to “provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit.”

IFRS also states that these decisions depend on the user’s expectations on the risk, amount, and timing of future net cash inflows of the reporting entity.

Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit.” IFRS also states that these decisions depend on the user’s expectations on the risk, amount, and timing of future net cash inflows of the reporting entity.

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Positive financial accounting theory

Given the non-ideal market that we live in today, it is only natural that management will take advantage of this information asymmetry.

Although company perceptions are important, managers are predominantly concerned with ways of maximizing their perks and their compensation. This is commonly referred to as earnings management; management’s efforts to bias financial information in one way or another.

Therefore, there is a theory called positive accounting theory that tries to understand manager’s motivations, accounting policy choices, and reactions to different accounting standards.

Some reasons why earnings management is done may include the following reasons:

 

Reasons for Upward Earnings ManagementReasons for Downward Earnings Management
Bonuses are given out in relation to net incomeReduction in taxes
Meeting debt covenantsIncrease the chances of obtaining government assistance
Enhancing the perception of the company (i.e. reducing the perception of risk)Taking a “big bath” in a bad year by recording more expense than usual so future years are more likely to show higher profitability

 

Securities law and financial accounting theory

Securities laws around the world are fully aware of this information asymmetry phenomenon in our economy and have measures put in place to protect investors.

For example, public companies must adhere to the securities laws set out by the Canadian Securities Administrators (CSA) in Canada or the Securities and Exchange Commission (SEC) in the United States.

An example of a specific measure is when these laws set out “black-out periods” where individuals in management and other individuals with access to more sources of information are not allowed to buy or sell company shares because they have an information advantage over users that only have access to the financial statements.

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More accounting resources

We hope this has been a helpful guide to understanding financial accounting theory.  At CFI our mission is to help you advance your career.  With that goal in mind, we’ve designed these additional resources for you: