FINANCIAL ACCOUNTING THEORY

Dr.BALAMURUGAN MUTHURAMAN

Chapter 1

Accounting Theory is defined as

The basic

◦ assumptions

◦ definitions

◦ principles and

◦ concepts that underlie

the rule making by a

legislative body

The reporting of

◦ accounting and

◦ financial information

Applicable to financial

accounting, not to

◦ governmental or

◦ managerial

Accounting Theory includes

Conceptual

Frameworks

Accounting

Legislation

Concepts

Valuation Models

Hypotheses and

Theories

Accounting Theory & Policy Making

3 inputs to policy making function

◦ Accounting Theory

◦ Political Factors

◦ Economic Conditions

Once policy is made

◦ Accounting Practice implements the policy

◦ Users observe effects of implementation

Financial Accounting Environment

Accounting

Theory Political

Factors

Economic

Conditions

Users of Accounting

Data and Reports

Accounting

Practice

Accounting

Policy Making

Accounting

Theory Political

Factors

Economic

Conditions

Users of Accounting

Data and Reports

Accounting

Practice

Accounting

Policy Making

Audit

Function

Measurement is defined as

The assignment of

numbers to the

attributes or

properties being

measured

Measurement Categories

Direct or Indirect

◦ Direct is preferable; managers like

◦ Indirect is a roundabout way of making the

measurement

Assessment and Prediction

◦ Assessment measures are concerned with particular

attributes of objects

◦ Prediction measures are concerned with factors that

may be indicative of conditions in the future

Measurement Process

Is not simple

There is not just one

absolutely correct

measure

The process will

depend on several

factors:

1. The object itself

2. The attribute being

measured

3. The measurer

4. Counting operations

5. Instrument used

6. Constraints

affecting the

measurer

Measurement Types (NOIR)

Nominal

◦ Most simple

◦ Groups like objects (e.g., chart of accounts)

Ordinal

◦ Indicates an order of preference

◦ Degree of preference among the ranks is not necessarily the same

Interval: change in the attribute being measured is equal

Ratio: same as interval, but zero point has a unique quality

Quality of Measurements

Objectivity or Verifiability

◦ The degree of agreement among measurers

◦ Statistically, this means the less variance there

is, the higher the objectivity

Bias

Timeliness

Cost Constraint

Theories Relevant to Financial

Accounting The rational investor ◦ A model of how an investor may use new

information to revise beliefs about future firm performance ◦ Rationality holds on average, not necessarily for

each individual

Efficient securities markets ◦ Share prices fully reflect all publicly available

information ◦ Efficiency is relative to a stock of information ◦ Role of financial reporting in improving/expanding

the stock of information

Continued

Theories Relevant to Financial

Accounting (continued)

Behavioural theories

◦ Investors do not use all the information in

financial statements → securities markets not fully efficient

Agency theory

◦ Efficient contracts to motivate manager

performance and achieve good corporate

governance

Structure of Standard Setting

Bodies IASB

◦ International standards

FASB

◦ United States standards

ACSB

◦ Canadian standards

Securities commissions

◦ Role in enforcing firms to follow standards

◦ May set standards themselves

◦ Why do they delegate most standard setting?

The Fundamental Problem Of

Financial Accounting Theory

The best measure of net income to control adverse selection not the same as the best measure to motivate manager performance

◦ Investors want information about future firm performance

Current value accounting?

◦ Good corporate governance requires that managers “work hard”

Do historical cost accounting, conservatism better reflect manager effort?

Main issues for difference of

Financial Accounting Theory

Differences in taxation system

Differences in economic and political

influences on financial reporting

Modifications made to IFRS at national

level

Differences in implementation,

monitoring and enforcement