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Information asymmetry
Adverse selection: A type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, have an information advantage over the other parties.   Moral hazard: A type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, can observe their actions in fulfillment of the transaction but the other parties cannot.
The fundamental problem of financial accounting theory
Given that there is only one bottom line, the fundamental problem of financial accounting theory is how to design and implement concepts and standards that best combine the investor-informing and manager performance-evaluating (stewardship) roles for accounting information. 
The decision usefulness approach 
As it is impossible to prepare theoretically correct financial statement accountants have adopted the decision usefulness approach.
  1. Who are the users?
  2. What are the decision problems of users?
Once these have been answered the financial statements may be made useful by balancing user’s needs for relevance and reliability (representation faithfulness).   Relevant: Capable of making a difference in the decisions made by users.   Reliable: Verifiable by a third party.   *Timeliness is considered a constraint on relevance and reliability
The meaning of market efficiency
  1. Market prices are efficient with regards to publicly known information
  2. Efficiency is relative; prices reflect available information not underlying value or cash flow.
  3. The market will quickly adjust to new information
  4. Given market efficiency the market price should fluctuate randomly (random walk)

The information approach
This approach to decision usefulness is an approach to financial reporting that recognises individual responsibility for predicting future firm performance and that concentrates on providing useful information for that purpose. The approach assumes security market efficiency, recognising that the market will react to useful information from any source, including financial statements.
Earning response coefficient 
Measures the extent of a security’s abnormal market return in response to the unexpected components of reported earnings of the firm issuing that security.
The measurement approach
The measurement approach to decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statement proper, providing this can be done with reasonable reliability, thereby recognising the increased obligation to assist investors to predict firm performance and value.
Prospect theory
The prospect theory provides a behavioral-based alternative to the rational decision theory. An investor considering a risky investment will separately evaluate prospective gains and losses instead of the effect on their total wealth.
Clean surplus theory
  • Ohlson’s clean surplus theory shows how market value of a firm can be determined from balance sheet and income statement information.
  • From the income statement, the theory takes actual earnings and calculates goodwill as the difference between actual and expected earnings.
  • For the “clean surplus,” net income must contain all gains and losses.
  • From the balance sheet, expected earnings are calculated as shareholders’ equity multiplied by the firm’s cost of capital.
  • Although the model may not accurately predict actual share value, it is useful because empirical studies suggest that the ratio of model value to actual value is a good predictor of future share returns.
  • Then, to determine the value of the firm, add the calculated goodwill to the book value.
  • To calculate a share price, take the above value and divide by the number of shares outstanding.
  1. The ethical rule must have universal application
  2. You must treat people as ends and not as means to an end
  Decisions are based on abstract universal principals such as fairness. The decision maker must focus on what is right (constant with principals).   Leads to:
  1. Theory of rights: Individuals have certain entitlements and ethical standards should promote individual welfare
  2. Theory of justice: Decisions should lead to fair and equitable allocation of resources
  While this theory is widely used principals may conflict.
Virtue ethics
Focus on moral character and motivations/intentions over actions   Ethics of care
  • Trying to understand the other’s situation, point of view
  • Interconnectedness of individuals
  • Appropriate balance if interests
Best decision yields the greatest net social benefit to society. While it is practical it is often difficult to evaluate all consequences and stakeholders over an infinite time period. It often means that the rights of the minority will be disregarded.
Significant accounting policy
  • Management policy that affects net income but does not affect cash
    • Non-cash does not influence investment or credit decision
    • Beaver said that accounting policies do not matter if they have no impact on cash; investors can make all the necessary adjustments to convert between policies; full disclosure – all must be disclosed
  • Occurs when judgment has been exercised to choose between alternatives
  • Reported earnings will be different but cash flows will not be
  • Link examples to reported earnings and cash flows
  • Significant because they can influence a decision maker
    • Net income is important – which portion is due to cash vs. non-cash
    • Usefulness is diminished without this non-cash information
  • Examples:
    • Inventory policy
    • Amortization policy
    • Revenue recognition 
Normative theory
prescriptive; explains what should be done
Descriptive theory
positive; explains what actually happens
any person or group that has an interest in a firm           Primary – directly affected           Secondary – indirectly affected 
Economic theory
narrow focus; mgmt is only responsible to investors & bondholders
Stakeholder theory
broader perspective; responsible to all who have a direct or indirect interest in the firm 
Compliance approach
obey the law
Accountability approach
takes everything into account; ethics matter
Historic cost accounting
  • Highly reliable – information is trustworthy and free from bias
  • Not highly relevant so cannot help to predict future transactions
  • No limitation on usefulness as long as policies are disclosed
  • Investors want to predict future cash flows – present value is required
  • Feltham Ohlson model – financial disclosures give investors enough information so they can calculate goodwill and firm value
    • Clean surplus model – historic cost has a greater goodwill than under PV
    • Value can be calculated either way therefore no difference 
Efficient market hypothesis
  • Stock price reflects all publically available information – financial and non-financial
  • Stock prices react instantaneously to new information
  • Stock market as a whole is efficient; on any given day, any given stock can be inaccurately priced
  • Ball & Brown – correlation between news and stock prices
    • Good news, stock price goes up
    • Bad news, stock price goes down
    • No new news, stock price remains constant 
Notes for exam
Be sure to LINK relevance and reliability to the USEFULNESS of information. 1)  Explain the theory 2)  Apply the theory to case facts 3)  Draw a conclusion 
Theory of rights
individuals have entitlements but also obligations; promotes individual welfare
Theory of justice
equals are treated equally; decisions should lead to fair and equitable allocation of resources
Post-announcement drift
abnormal share returns drift upwards (good news) and downwards (bad news) for some time following the month of release of the news; not logical; investors don’t fully digest good and bad news
Earnings events
          Permanent – persist indefinitely           Transitory – affecting earnings in the current year, but not future years           Price-irrelevant – persistence of zero (ie – amortization policy) 
Single-person decision theory
rational individual makes optimal decisions in the presence of uncertainty; identify a set of acts and probabilities; optimal decision maximizes expected return
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