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