ACCT30001 Lecture Notes - Lecture 1: Net Present Value, Cash Flow, Risk Aversion
28 May 2018
School
Department
Course
Professor
The financial reporting environment: Harvard business school
Adverse selection: asymmetries of information between savers and entrepreneurs. Managers and
entrepreneurs have better information about the company than the saver/investor.
Moral hazard: arises when managers, after receiving money from investors, act in their own best interests
rather than the interest of the investors.
Market economies have evolved some considerable number of institutional arrangements that mitigate these
problems but of course it cannot limit them. Which are:
1) Corporate financial reporting (most important mechanism)
Ø Reduces both problems
Adverse selection
Moral hazard
• Provides basic information for
investors before they make a
decision their initial capital resource
allocation.
• By supplying information about
business outcomes.
• Provides a basis of contracting
between the manager and the
investor to reduce conflict of
interest
However, because the financial reporting is used to attract investors capital and to monitor managers
performance, managers have the incentive to bias and distort the information to make their performance
appear better. So investors face another moral hazard if they have limited means to monitor managerial
distortions of financial information.
2 intermediaries:
1. Financial
2. Informational (auditors, agencies…), act as the agents to investors reporting on the quality of various
business investment opportunities or of the information reported by management.
Creating financial reporting:
Accrual accounting: attempts to measure the full economic consequences from a period’s business activities.
Lecture 1:
Financial accounting is an information reporting system designed to relieve information asymmetry in
economics. If we knew the true value of the firm, none of us will have jobs.
Demand for accounting information:
There are two distinct sources of demand:
1. For valuation to address adverse selection problems and ensure capital market efficiency
2. For stewardship and efficient contracting to address contracting and moral hazard problems
Objectives of financial reports è valuation and stewardship
Information Asymmetry (IA):
• Information asymmetry occurs when one party to a transaction is at an informational disadvantage to
the other (i.e. he/she does not know as much as the other party)
• Information asymmetry cause a friction in the market, if this friction is not resolved then the market
would not function properly.
• A unifying theme that formally recognizes that some parties to business transactions may have an
information advantage over others
There are two main types of information asymmetry:
1. Adverse selection (valuation) => pre transaction
• A type of information asymmetry where a party to a potential transaction has an informational
advantage over other parties
o Ex: a potential buyer from a seller, and one of those party is at informational
disadvantage.
o One knows more than the other
o The car seller has an information advantage over me. And I wont trade unless this thing is
resolved. When you resolve that, it will be worth a lot of money
o EX: they are resolving adverse selection (EBay, Uber),
o EBay: the sellers have more info than you, how does EBay resolve that problem? The
seller are going to be scored. Same as Uber.
• There is adverse selection between shareholders and management and between shareholders
themselves
2. Moral hazard (stewardship/efficient contracting) => post transaction
• A type of information asymmetry whereby a party to a transaction/contract can observe their actions
in fulfilment of the transaction but the other cannot
o Post transaction where you cannot observe the action of the counterparty in fulfilment of
the contract
o EX: if I took my car to a mechanic, I would not know if he put a new or an old motor. Because
I cannot monitor what he is doing.
• Management potentially suffers from moral hazard since they can undertake actions that are in their
own self-interest at the detriment of shareholders
Adverse selection vs. Moral hazard:
o Both adverse selection and moral hazard result from information asymmetry.
o The differences are that:
§ Adverse selection involves hidden information about a firm’s future cash flow
before transaction.
§ Moral hazard involves hidden action, i.e., the manager knows how hard he/she is
working but investors do not, after transaction.
An example of IA – Job application:
• Employer has huge amount of information asymmetry about the prospective applicants –adverse
selection risk
– How can the employer mitigate this risk? Tests, interviews, referees.
• Employee – once offered employment and signs contract, shirks
– How to mitigate moral hazard?
Adverse selection in capital markets:
Managers and SH:
• Managers know more about the current condition and future prospects of the firm than outside
investors
• Investors face adverse selection as managers may behave opportunistically, may
delay or selectively release information thereby reducing the ability of investors to
make good investment decisions
SH and SH:
• Information asymmetry between outside investors as some investors may know more than other
investors
Consequences of Adverse Selection:
• Increased information risk and thus a higher cost of capital è this occur because the manager has an
incentive to issue shares at overvalued price, under the condition of IA, potential investors do not
know whether the share is correctly price or overpriced. All they know is that the manager might have
Document Summary
Adverse selection: asymmetries of information between savers and entrepreneurs. Managers and entrepreneurs have better information about the company than the saver/investor. Moral hazard: arises when managers, after receiving money from investors, act in their own best interests rather than the interest of the investors. Market economies have evolved some considerable number of institutional arrangements that mitigate these problems but of course it cannot limit them. Which are: corporate financial reporting (most important mechanism) Provides basic information for investors before they make a decision their initial capital resource allocation: by supplying information about business outcomes. Provides a basis of contracting between the manager and the investor to reduce conflict of interest. However, because the financial reporting is used to attract investors capital and to monitor managers performance, managers have the incentive to bias and distort the information to make their performance appear better. So investors face another moral hazard if they have limited means to monitor managerial distortions of financial information.
