Intermediate Accounting

Fifth Edition, Volume One

Chapter 1
Fundamentals of Financial
Accounting Theory

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Learning Objectives
L.O. 1-1. Explain the sources of demand and supply of
accounting information.
L.O. 1-2. Apply concepts of information asymmetry, adverse
selection, and moral hazard to a variety of accounting,
management, and related situations.
L.O. 1-3. Describe the qualitative characteristics of
accounting information that help to alleviate adverse
selection and moral hazard.
L.O. 1-4. Evaluate whether and what type of earnings
management is more likely in a particular circumstance.
L.O. 1-5. Explain how accounting information interacts with
securities markets.
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CPA Competencies Addressed in
Chapter 1
1.1.1 Evaluates financial reporting needs (Level B)
1.1.2 Evaluates the appropriateness of the basis of
financial reporting (Level B)
1.1.3 Evaluates reporting systems, data requirements,
and business processes to support reliable
financial reporting (Level B)
1.2.1 Develops or evaluates appropriate accounting
policies and procedures (Level B)

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The Demand and Supply of Accounting
Information (L.O. 1-1)
• Accounting = the production and transmission of
information about an enterprise
• Fundamental to accounting is communicating
information from those who have it to those who need
it

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Branches in Accounting
• Financial Reporting – Provide information to external
parties
• Managerial Accounting – Reporting within the
enterprise
• Tax Accounting – Taxable amounts to government
revenue authorities

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Generally Accepted Accounting
Principles (GAAP)
• Broad principles and conventions of general
accounting application
• Rules, procedures and techniques that prepare
accounting entries, compile financial statements, and
understand financial reports

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Financial Accounting at the
Intermediate Level

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Other Accounting Regulatory Agencies
• Financial Accounting Standards Board (FASB) in
Norwalk, Connecticut establishes financial accounting
and reporting standards for public and private
companies and not-for-profit organizations that follow
GAAP in the U.S.
• International Accounting Standards Board (IASB) in
London, England
• Accounting Standards Board (AcSB) in Canada

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Uncertainty and Information
Asymmetries (L.O. 1-2)
• Information: Evidence that can potentially affect an
individual’s decisions.
• External parties’ decision-making needs create
demand for financial reporting.
• Supply and demand for financial reporting is due to
the presence of information asymmetry.
• Uncertainties exist

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Information Asymmetry
• A condition in which some people have more
information than others.
• Two types:
Adverse selection and Moral hazard

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1. Adverse Selection Example (1 of 2)
• Example – buying a used car
• Seller has more information than you
• Rational buyers will always pay the lowest price of
their own price range.
• Rational sellers will only accept a price that matched
their expectation, thus sellers who feel their cars are
worth more than buyers’ price will never enter the
market. So, only bad cars are available on the market,
or “ lemons”.—Akerlof, George A. “The Market for ‘Lemons’: Quality
Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 no. 3
(1970): 488–500.

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1. Adverse Selection Example (2 of 2)
• Seller uses costly signalling (or signalling) –
Information that is otherwise unverifiable
• Seller uses cheap talk – Unverifiable disclosures.
• A costless signal is not credible.

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2. Moral Hazard Example
• One party to a contract cannot observe some actions
relating to the fulfillment of the contractual terms by
the other
• Example – a person buys insurance for a car
• We call this moral hazard because the insurance
encourages less care and effort, and higher risk (it
creates a hazard to our morals). The higher risk is
expected by both.
• Moral hazard is costly

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3. Adverse Selection and Moral Hazard
Defined
• For adverse selection: A type of information
asymmetry whereby one party to a contract has an
information advantage over another party
– “hidden information from the past and present”

• For moral hazard: A type of information asymmetry

whereby one party to a contract cannot observe some
actions relating to the fulfillment of the contractual
terms by the other party
– “hidden actions and involves information about what
happens in the future”

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4. Application of Adverse Selection and
Moral Hazard to Accounting
• To overcome the adverse selection:
– Hiring independent auditors to attest to the financial
statements and paying dividends (costly signalling)
• To overcome moral hazard:
– Measuring performance and incentive pay such as
bonuses (principal-agent problem: shareholders and
CEO )
– Specifying covenants during the term of the loan
(Banks and Firms)

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Agency/Principal-Agent Problem
• Separation of ownership and management
• The owners (principals) not able to monitor
management (the agents) to ensure the agent(s)
make(s) decisions in the best interest of the
principal(s).

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5. Moral Hazard in Action: The Financial
Crisis of 2008
• Critical role in the financial crisis
• Banks packaged mortgages together and sold them to
other investors: mortgage-backed securities (MBS)
• Buying insurance through a financial instrument called
a credit default swap (CDS)
• Passing on risk: result – bankers and lenders became
careless

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Desirable Characteristics of Accounting
Information and Trade-Offs (L.O. 1-3)
• Investors demand relevant (to investment decisions)
information
• Since management has incentives to exaggerate
firm’s performance, investors and creditors demand
reliable information
– Verifiable
– Not prone to manipulation
• Trade-offs must be made

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Economic Consequences of Accounting
Choice and Earnings Management (L.O. 1-4)

• Accounting standards are written in general terms so

that they can be applied to a variety of businesses.
• Why do these choices exist?
– One size does not fit all
– Accrual accounting requires estimates (e.g. allowance
for accounts receivable, FIFO vs. LIFO)
• What can happen? ( Management may take
advantage of these trade-offs)
– Earnings management

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Defining “Positive Accounting Theory”
• “A theory for understanding managers’ motivations,
accounting choices, and reactions to accounting
standards.”
– What do managers do and why do they do it?

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Defining “Earnings Management”
• Managers’ efforts to bias reported accounting
information in one way or another are called earnings
management.
• The term applies to biases in income statement,
balance sheet, or other financial information.
• For example, to exaggerate earnings, assets, and
equity upward, and manage liabilities downward.
• Firms do earnings management to influence investors,
banks, creditors, shareholders, etc.

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Motivations for Managing Earnings
Upward
• Pay more for the firm’s shares
• Get more funds or pay a lower interest rate
• Meet its contractual obligations such as debt
covenants
• Meet regulatory requirements, such as capital
requirements for banks
• Provide a stronger bargaining position in merger
negotiations
• Obtain higher compensation

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Motivations for Managing Earnings
Downward
• Reduce additional taxes or regulations
• Increase the likelihood of receiving government
subsidies and trade protection
• Take a “big bath” in a bad year resulting in:
– Higher future compensation
– Higher stock price
• Improve the firm’s bargaining position relative to
employee unions

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Accounting and Securities Markets
(L.O. 1-5)
• Referring to a market for securities
• Firms with equity, debt, or other securities traded in
public markets are called public companies.
• Securities markets take accounting information for
pricing
• Securities markets provide information for use in
accounting process.

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1. Accounting Information in Securities
Markets (1 of 3)

Efficient securities market (semi-strong form): A market

in which the prices of securities traded in that market at
all times properly reflect all information that is publicly
known about those securities.
A market that is strong form efficient has prices that
reflect all information, whether publicly or privately
known.

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1. Accounting Information in Securities
Markets (2 of 3)
Efficient market theory has several important
implications for accounting:
a. Security prices react quickly to accounting information.
b. Accounting information competes with other sources of
information.
c. It is important to distinguish new information from what
has already been reflected in prices.
d. Using only publicly available information, it is difficult to
earn abnormal profits.

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1. Accounting Information in Securities
Markets (3 of 3)
Efficient market theory has several important
implications for accounting: (Con’t)
e. It is possible to earn abnormal profits using information
that is not publicly available.
f. Accounting reports and standards can assume that users
have a reasonable level of sophistication.
g. Efficient market theory influences legal doctrine.

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2. Using Information from Securities
Markets in Accounting
• Firms hold investments in Treasury bills, corporate
bonds, or shares in other corporations that trade in the
securities market.
• The market prices of the securities traded in the
securities markets are reliable information to indicate
their fundamental values.
• Other components in financial statements, such as
inventory or equipment, are measured using historical
cost.

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Summary
L.O. 1-1. Explain the sources of demand and supply of
accounting information.
L.O. 1-2. Apply concepts of information asymmetry, adverse
selection, and moral hazard to a variety of accounting,
management, and related situations.
L.O. 1-3. Describe the qualitative characteristics of
accounting information that help to alleviate adverse
selection and moral hazard.
L.O. 1-4. Evaluate whether and what type of earnings
management is more likely in a particular circumstance.
L.O. 1-5. Explain how accounting information interacts with
securities markets.
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