AFM291 Chapter Notes - Chapter 1: Tax Accounting In The United States, Financial Accounting, Accounting
18 May 2018
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AFM 291: Chapter 1 Notes
• Accounting is the production of information about an enterprise and the transmission
of that information from those who have it to those who need it
• Accounting: fundamentally about communicating information
o Financial reporting: enterprises provide information to external parties
o Managerial accounting: reporting within enterprise
o Tax accounting: reporting of taxable amounts to government revenue authorities
• Ties all branches together: idea that some people have info that others need.
• GAAP: Generally accepted accounting principles: broad principles and conventions of
general application as well as rules and procedures that determine accepted accounting
practices
• Accounting is subject to economic good and subject to the laws of supply and demand
• Accounting standards reflect and respond to (imperfectibly) the demand for financial
information and the ability of enterprises to supply that information
• Financial accounting theory helps us to understand the complexities in the production
and consumption (use) of accounting information.
• Thus, fiaial ifoatio a e, ad is, a sujet of igoous eooi aalsis.
Uncertainty and Information Asymmetries
• Information: Eidee that a potetiall affet a idiidual’s deisios.
o evidence need only potentially affect decisions; it need not in fact alter any
particular decision
o evidence can be information to one person but not to another. It all depends on
the decision context.
• People make decisions under uncertainty. For the simple reason that decisions affect
the future, even the very near future, outcomes will be uncertain to some extent.
• I fiaial epotig, the issue of uetait is patiulal otieale. Paties eteal
to the reporting enterprise make decisions regarding whether they should lend to,
invest in, sell product to, or work for an enterprise.
o The outcomes of these deisios deped o the fi’s pefoae i the futue
(among other things), and past performance is a good source of information to
help predict the future.
o Thus, decision-making needs of external parties create the demand for
financial reporting.
• Those who have more and better information supplies the information demanded by
external parties
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o Senior managers and members of board of directors (insiders) have superior
ifoatio aout opa opaed to opa’s editos, iestos,
suppliers and employees (outsiders).
o Thus, the supply ad dead for fiaial reportig is due to the presee of
information asymmetry, where some people have more information than
others.
• There are two types of information asymmetry in the context of markets: adverse
selection and moral hazard.
• 1) Adverse selection example on p. 29
o Given your price limit, a transaction will occur only if one or more sellers value
their car at or below this value. In other words, you will be successful buying this
car only if it is the worst possible car in the group that you are considering. This
is why we call this adverse selection.
o Lemons = bad ones
o Costly signalling (or just signalling): Communication of information that is
otheise ueifiable, by means of an action that is costly to the sender;
contrast with cheap talk
o Cheap talk: Communicatio of ueifiable information, by means that are
virtually costless; contrast with costly signalling.
o It is important that the signal be costly; a costless signal is not credible because
anyone can send such a signal.
• 2) Moral hazard example on p. 31
o Moral hazard: the provision of insurance encourages less care and effort, and
therefore higher risk (i.e., it creates a hazard to our morals), but the higher risk is
expected by both sides of the insurance contract.
o The insurance company must anticipate the higher risk and increase insurance
premiums accordingly. Thus, moral hazard is costly.
▪ In practice, this cost cannot be eliminated because the insurance
company cannot monitor the insured to make certain that they drive
carefully, and neither can the insured credibly commit to drive carefully
▪ E.G. to mitigate cost: insured can agree to pay for part of the damages
incurred in the form of a deductible or percentage co-payment.
o Thus, there is an inverse relationship between risk and the extent of moral
hazard. When the insured has full insurance he or she faces low risk, and
therefore provides little effort to prevent accidents; the moral hazard is
accordingly high, and the cost of insurance must also be high.
• 3) Adverse Selection and moral hazard defined
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o Adverse selection: A type of information asymmetry whereby one party to a
contract has an information advantage over another party.
o Moral hazard: A type of information asymmetry whereby one party to a contract
cannot observe soe atios elatig to the fulfillment of the contractual terms
by the other party.
o uial diffeee: oal hazad ioles ifoatio aout oe pat’s atios
that is not available to the other party. For this reason, moral hazard is succinctly
summed up as hidden actions. Because actions are involved, moral hazard
involves information about what happens in the future.
o Adverse selection concerns no actions other than whether the parties choose to
reveal information that they possess.
o Adverse selection involves hidden information from the past and present
although suh ifoatio ould hae aifiatios fo the futue.
• 4) Application of adverse selection and moral hazard to accounting
o Investors are at an information disadvantage relative to a firm’s isides i.e.,
management and the board of directors
o A firm’s aageet eeds to poide edile eidee to iestos so that its
shaes ae ot pied as leos.
o Claim by the CEO that the firm is underpriced is just cheap talk, since any CEO
could make such a claim
▪ Such evidence can come in the form of financial statements that help
summarize the financial condition and operations of the enterprise.
▪ To add credibility, the firm can hire independent auditors to attest to the
finanial stateets’ opliae ith aoutig stadads.
o To oeoe the adese seletio pole elatig to a opa’s shae pie,
the company can also use costly signalling, such as the payment of dividends.
▪ To be able to pay dividends on a regular basis, a firm needs to be
profitable enough to generate suffiiet ash flows in the future to fund
those dividends.
▪ Thus, the oitet to pa diideds eeals aageet’s eliefs
about the firm’s futue pospets.
▪ So, investors react quite strongly to announcements of new dividend
increases and decreases.
o In relation to accounting, we are concerned with the actions of management.
o When there is a separation of ownership and management, we have an agency
problem (also called a principal–agent problem): the owners (principals) are not
able to monitor management personnel (the agents) to ensure that
management makes decisions in the best interests of the owners.
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Document Summary
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