Financial accounting theory

by (2011)
ISBN-10 0135119154 ISBN-13 9780135119150
316 Flashcards en notities
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Samenvatting - Financial accounting theory

  • 1.2 Some Historical Perspective

  • Alternative valuation bases have become more common over the years, to the point where we now have a mixed measurement system. There is a gradual movement from historical cost accounting to current cost alternatives .
  • Two current cost alternatives:
    • Value-in-use: discounted present value of future cash flows; 
    • Fair value (exit price, opportunity cost): amount that would be received or paid if firm should dispose of the asset or liability.
  • Theory of rational decision-making uncertainty: 
    • How do individuals revise their beliefs upon receipt of new information?


    Possibility Theorem of Arrow: 
    • In general it is not possible to combine differing preferences of individual members of society into a social preference ordering that satisfies reasonable conditions;
    • No set of concepts will be fully satisfactory for both parties;
    • Negotiation and compromise are needed to make both parties accept the conditions although they are not perfectly satisfactory. 
  • IASB/Framework: the objective of financial statements is to provide information to assist investors to make investment decisions. 

    Development of the economics of imperfect information was important as well. This leaded to the agency theory.
  • Enron: 
    • Special Purpose Entities (SPE) so that the debt of Enron would not appear on its balance sheet, but on the SPEs instead. 
    • Due to current value accounting to its holdings of Enron stock, the SPE included increases in the value of this stock in its income. 
    • Enron was able to include increases in the value of its own stock in its reported earnings. 
  • Sarbanes-Oxley:
    • Creating Public Company Accounting Oversight Board (PCAOB);
    • PCAOB could set auditing standards and inspect and discipline auditors of public companies;
    • Restricts several of non-audit services by auditing firms to their clients;
    • Auditor needs to report to audit committee of client and not to the management;
    • Audit committee must be independent from the company;
    • Financial reports shall include all material correcting adjustments and disclose all material off-balance-sheet loans and other relations with unconsolidated entities;
    • CEO and CFO must certify that financial statements present fairly the company's results of operations and financial position. 
  • 1.3 The 2007-2008 Market Meltdowns

  • Structured Investment Vehicles (SIV's): 
    • Vehicles created by lenders to securitize their holdings of financial assets;
    • Institution would transfer large pools of these assets to the SIVs it sponsors;
    • SIV would pool them into asset-backed securities (ABS), which are tranches of similar credit quality;
    • ABS were frequently further securitized as collateralized debt obiligations (CDO), which consisted of tranches of similar quality ABS tranches, a procedure that further increased diversification;
    • To obtain cash to pay the sponsor for assets transferred, SIVs borrowed money by issuing asset-backed commercial paper (ABCP);
    • SIV could retain ABSs rather than selling them on to investors. 
    • ABS generated higher returns than the cost of funds borrowed to acquire them, SIV became money machines;
    • Borrowing and lending where out of sync: ABS where long-term investments while ABCP borrowing was short-term;
    • ABSs needed some form of credit enhancement if SIV was able to borrow at a low interest rate;
    • SIV could hedge their risk by credit default swaps (CDS) from intermediary.

    NOG VERDER LEZEN!!!
  • Four relevant point learned from the fraudulent events:
    • Financial reporting needs to be transparent, so assets and liabilities can be properly valued;
    • Off-balance sheet activities should be fully reported;
    • Accounting standards are a form of regulation, substantial changes to existing standards are taking place;
    • Fair value accounting may understate value-in-use when markets collapse due to liquidity pricing that results from a severe decline in investor confidence. 
  • 1.4 Conservative Accounting

  • The stock market crash of 1929 leaded to a strengthening of the historical cost basis of accounting.

    Conservatism: the requiring of a higher standard of verification to record gains than to record losses, resulting in persistent understatement of assets, earnings and shareholders' equity relative to their current values (Basu, 1997). 

    In sum: unrealized losses from declines in value are recognized when they take place, but gains from increases in value are not recognized until they are realized. 
  • 1.5 A Not on Ethical Behaviour

  • How to restore and maintain public confidence in financial reporting?
    • Increased regulation: new accounting standards, ethical behavior by accountants and auditors;


    Ethical behavior:
    • Doing the right thing;
    • Accountants need to behave with integrity and independence in putting public interest ahead of the employer's and client's interests, should these conflict.
  • 1.6 Rules-Based Versus Principles-Based Accounting Standards

  • Rules-based standards attempt to lay down detailed rules for how to account.
    Principles-based standards attempt to lay down general principles and rely on auditor professional judgement to ensure that application of the standards is not misleading.
  • 1.7 The Complexity of Information in Financial Accounting and Reporting

  • Environment of accounting is complex and challenging.

    It is complex because the product of accounting is information. 
    Main reasons for complexity:
    • The absence of perfect or true accounting concepts and standards;
    • It affects the individual decisions and working of markets.
  • 1.9 The Importance of Information Asymmetry

  • There are two types of information asymmetry:
    1. Adverse selection: one or more parties to a business transaction have an information advantage over the other parties;
    2. Moral hazard: one or more parties to a business transaction can observe their actions in fulfillment of the transaction but other parties cannot.


    Adverse selection occurs because some persons will know more about the current condition and future prospects of the firm than outside investors.

    Moral hazard occurs because of the separation of ownership and control that characterizes most large business entities.
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