Explaining Financial Accounting Theory Accounting Essay

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Scott (2006) explained that his book 'Financial Accounting Theory' is about accounting and not how to account. He also argues that accounting students, having been exposed to the methodology and practice of accounting, need at least one course that critically examines the broader implications of financial accounting for the fair and efficient operation of our economy.

What is the objective of the book and why it designed a such way that every reader have to understand the current financial accounting and reporting and at same time have to consider the diverse interest of the external users and management?

Nowadays, accounting is seen synonym in our life. Whatever we do, we often related with accounting. Even, in our business, we are using the account almost every time. So, what meaning of accounting? And what is the purpose of accounting until all people using it. According to American Institute of Certified Public Accountants (AICPA, 1953), accounting defined as the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are in part at least, of a financial character, and interpreting the result thereof.

However, Belkaoui et al. (2000) have clarify in their book 'Accounting Theory', in where, the scope of accounting in this definition is limited. A broader perspective is offered in the following definition of accounting, also by AICPA (1966), as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. Furthermore, the purpose of accounting is to provide and produce the information about the economic behavior resulting from a firm's activities within its environment and is needed by firm for decision making.

Generally, the view of the accounting are including financial accounting and management accounting, however, for this paper, only focused to financial accounting especially financial accounting theory. Before go too far, let looks the meaning of the financial accounting based on a few previous sources, financial accounting is the field of accountancy concerned with the preparation of financial statements for decision makers and focused to people outside the organization or not involved in the day to day running of the firm. On the other hand, financial accounting is performed according to Generally Accepted Accounting Principles (GAAP) guidelines. Accounting as a discipline cannot hold without a body of knowledge called theory. There are various perspectives as what constitutes a theory. The Oxford English Dictionary provides various definitions including, 'a scheme or system of ideas or statements held as an explanation or account of a group of facts and phenomena'. It also defined as a coherent group of general propositions used as principles of explanation for a class of phenomena (Macquarie Dictionary). According to FASB (1976), theory is defined as a coherent system of interrelated objectives and fundamentals that can lead to consistent standards'.

While, accounting theory is a set of basic concepts and assumptions and related principles that explain and guide the accountant's action in identifying, measuring and communicating economic information. It more provides a logical framework for accounting practice. Zeff and Keller (1987) discuss in detail the standard setting process and the structure of a conceptual framework that is the basis of accounting theory. Accounting theory discusses standard setting, accounting measurement and the disclosure of different accounts. It is clear with definition of accounting theory by Underdown and Taylor (1985): "…. to provide a framework for (1) evaluating current financial accounting practice and (2) developing new practice," in which cannot apply anywhere outside the accounting field. Watt and Zimmerman stated that a comprehensive theory of accounting should provide rules for recognizing certain relevant economic objects and also judging whether a given practice is good or bad. While, Belkaoui (1992) definition seems to enter the modern area, in which the primary objective of an accounting theory is to provide a basis for the prediction and explanation of accounting behavior and events.

Consequently, many textbooks in accounting theory provide a straightforward the meaning of accounting theory like the meanings are stated above. And, when they do, the answer is often related only to accounting. But William R. Scott (2006), within his book "Financial Accounting Theory" defines the fundamental of accounting theory on different way. In which, Scott explained that his book 'Financial Accounting Theory' is about accounting and not how to account. He also argues that accounting students, having been exposed to the methodology and practice of accounting, need at least one course that critically examines the broader implications of financial accounting for the fair and efficient operation of our economy. Thus, this paper is trying to answer the questions about; What is the objective of this book and why it designed a such way that every reader have to understand the current financial accounting and reporting and at same time have to consider the diverse interest of the external users and management?.

Financial Accounting Theory by William R. Scott has been recognized as a one of the best textbooks on accounting theory since the first edition was published in 1997 (Breton, 2004). The book steps back from the usual discourse about the standard setting process and the places accounting in its environments. But now, with Scott's book (2006), accounting theory enters a new era. The basis of accounting becomes an object of research and his discourse is theoretical. Since accounting is supposed to provide information for decision making, the theory of accounting is firstly a theory of decision. Thus, it could be fulfill the objective, to give the reader an understanding of the current financial accounting and reporting and at same time have to consider the diverse interest of the external and internal users.

To attract the understanding of the reader about financial accounting and reporting, the first lesson of Scott's book was discussed about some historical perspective. This purpose is to enable the reader knows about history of accounting and to answer the questions such as who is father of accounting, when the double entry bookkeeping system is appear and other relating questions. At the same time, this book looking to primary basis of accounting i.e. historical cost basis. The going concern concept is important attributes of the historical cost accounting such as waiting to recognize revenue until objective evidence of realization is available and other. Other than that, historical cost has only recently begun to yield to fair value accounting and the renewed importance of the balance sheet. In which, the term fair value generally is a general expression for the valuation of any asset or liability on the basis of its market value. Under this cost, for several major asset categories such as inventories, long-term portfolio investments and capital assets including intangibles, is cost or cost less amounts written off as amortization. For the liability side, long term debt is valued at cost, in the sense that the carrying value of such debt is based on interest rates in effect when the debt was issued. Historical cost accounting is relatively reliable because the cost of an asset or liability is usually an objective number that is less subject to error of estimation and bias than are present value.

While, present value model provides the more relevant information to financial statement users, in which relevant information defined as information about the firm's future economic prospects, that is its dividends, cash flows and profitability. The difference between present value based accounting and historical cost based accounting is timing of recognition of changes in asset value. Where, present value accounting is a balance sheet approach to accounting also called a measurement perspective. Whereas, the historical cost accounting is an income statement approach and also called an information perspective. Therefore, based on understanding about both of this perspective, the reader can analyze either historical cost accounting provide better information about firm's future economic prospects or present value based accounting. Thus, the results from this analysis by reader could fulfill the implementation of this book's objective, where the good results can reflect the understanding of accounting and reporting related to the reader.

In terms of design, this book is divided into four sections with a number of purposes. The first purpose is to improve our understanding of the accounting and reporting. Example, the topic of agency theory model particularly, has improved our understanding of managers' interests in financial reporting and controlling management's operation, in which such plans use accounting information. While, the second purpose of this book is to consider its effects on accounting and economic. For example, a decision usefulness approach that discussed in this book, in which, this approach allows the investors supplied with information to help them make good investment decisions.

Thus, four basic sections of Scott's book contains refers to Figure 1.1 are, first section is about what accounting would look like under ideal condition (i.e. if neither adverse selection nor moral hazard problems existed). Then, second section introduces adverse selection and the means to address it, where the author discusses the decision usefulness approach, efficient financial markets and information and measurement perspectives on decision usefulness. The third section addresses moral hazard about the problem of management compensation and the use of hard numbers as a solution. At here, Scott focuses on economic consequences, the use of game theory to understand conflict and issues such as management compensation and earnings management. The final section examines how accounting standard setters address these divergent objectives.

Figure 1.1: Framework of Scott's Book


Adverse Selection


Standard Setting


Ideal Conditions


Moral Hazard

Before considering the problems introduction into accounting by information asymmetry, it is useful to consider what accounting would be like under ideal conditions. A characterize of economy under ideal condition reflected as perfect and complete markets or equivalently, by a lack of information asymmetry and other barriers to fair and efficient market operation. In which, asset and liability valuation is on the basis of expected present values of future cash flows. With certainty and a fixed risk-free interest rate in the economy, it is possible to prepare relevant financial statements that are also reliable. Definitely, the process ensures that present values of future cash flows and market values are equal. While, for present value model under uncertainty, economy reflected in a bad or good state. Uncertain future events such as the state of the economy are called states of nature, i.e. no one can control which of the states is realized. The condition that effect cash flows are weather, government policies, strikes by suppliers and equipment breakdowns. However, the ideal conditions under uncertainty are similar to conditions of certainty except that future cash flows are known conditionally on the states of nature. The major difference between the certainty and uncertainty cases is that expected and realized net income need no longer be the same under uncertainty and the difference is called abnormal earning. However, financial statements based on expected values continue to be both, relevant because based on expected future cash flows and reliable because financial statement values objectively reflect these expected future cash flows.

Nevertheless, a present values seems impossible to prepare financial statements that are both completely relevant and completely reliable, because relevance and reliability must be traded off. Only the historical cost basis of accounting can be thought of as one such traded off between relevance and reliability. However, complete relevance is not attained because historical cost-based asset values need bear little resemblance to discounted present value. And complete reliability is also not attained, since the possibility of imprecision and bias remains. So, accountants have tried to make the historical cost-based financial statements more useful. However, a study of accounting under ideal conditions is worthwhile because it helps us to see what the real problems and challenges of fair value accounting are when the ideal conditions that they require do not hold and so on.

The second component of the framework is introduces the adverse selection problem, that is the problem of communication from the firm to outside investors. The role of accounting is to provide a 'level playing field' through full disclosure of relevant, reliable, timely and cost-effective information to investors and other financial statement users. To understand how accounting can help to control the adverse selection problem, it is related to how investors make decisions. Because, knowledge of investor decision processes is essential if the is to know what information they need. This book also assumes that the most investors are rational, that is they make decisions as to maximize their expected utility or satisfaction from wealth. The information that is useful to rational investors is called the decision usefulness approach. Decision usefulness is contrasted with another view of the role of financial reporting namely stewardship, whereby the role is to report on management's success or lack thereof in managing the firm's resources. As accountants, basically they have adopted a decision usefulness approach to financial reporting as a reaction to the impossibility of preparing theoretically correct financial statements. According to Trueblood Committee reports, the decision usefulness approach to financial reporting implies that accountants need to understand the decision problems of financial statement users. The decision usefulness approach also leads to the problems of identifying the users of financial statements and selecting the information they need to make good decisions.

When a large number of rational investors interact in a properly working securities market, the market becomes efficient. Efficiency is defined as a relative to a stock of information, in other word, a model of how a securities market operates. Meanwhile, the situation is reflected has an efficient securities market is one where the prices of securities traded on the market at all times properly reflect all information that is publicly known about those securities. In this theory, accounting is viewed as being in competition with other information sources such as news media, financial analysts and even market price itself. And accounting will survive only if it is relevant, reliable, timely and cost-effective, relative to other sources. Furthermore, efficient securities market theory also alerts us to what is the primary theoretical reason for the existence of accounting i.e. information asymmetry. Basically, securities market that efficient has important implications for financial accounting and one of the implications is leads directly to the concept of full disclosure. Full disclosure is the supplying of large amounts of information to help investors make their own predictions on of future firm performance. Efficiency implies that is the information content of disclosure, not the form of disclosure itself, which is valued by the market. With this, information can be released as easily in notes and supplementary disclosures as in the financial statement proper. Besides, the theory also affects how accountant should think and reaction about reporting on firm risk.

Thus, the reaction on decision usefulness is called the information perspective. The information perspective is an approach to financial reporting that recognizes individual responsibility for predicting future firm performance and concentrates on providing useful information for this purpose. The approach assumes securities market efficiency, recognizing that the market will react to useful information from any source including financial statements. In which, the level of usefulness can be measured by the extent of volume or price change following release of the information. Such the information content of reported net income, it can be measured by the extent of security price change or equivalently by the abnormal market return, around the time the market learns the current net income. Rationally, informed investors will revise their expectations about future earnings and returns on the basis of current earnings information. Even, revised beliefs trigger buy or sell decisions, as investors move to restore the risk tradeoffs in their portfolios to desired levels. If there are no information content in net income there would be no belief revision for resulting buy or sell decisions and hence no associated price changes. While, for unexpected net income, the extent of security price change or abnormal returns depends on factors like firm size, capital structure, risk, growth prospects and earnings quality.

The empirical literature in financial accounting is vast and one of the pioneering studies is by Ball and Brown. The researchers found that empirical research has demonstrated a differential market response depending on three factors. First, they have overcome substantial statistical and experimental design problems. Second, they show that the market is, on average, very sophisticated in its ability to evaluate accounting information. And finally, they support the decision usefulness approach to financial reporting. These empirical results support the efficient markets theory and related theories. The essence of information perspective is that investors are viewed as attempting to predict future returns from their investments and seek all relevant information, not just accounting information.

The measurement perspective under decision usefulness implies greater usage of fair values in the financial statements proper including for leases, pensions, other post-retirement benefits and financial instruments. Scott define the measurement perspective on decision usefulness is an approach to financial reporting under which accountants undertake a responsibility to incorporate fair values into the financial statements proper, providing that this can be done with reasonable reliability, thereby recognizing an increased obligation to assist investors to predict fundamental firm value. In this perspective also discussed about clean surplus theory, that is emphasizes the fundamental role of financial accounting information in determining firm value, which has role to leads measurement.

The third component of the framework relate to information asymmetry problem is moral hazard. It is arising from the unobservability of the manager's effort in running the firm. That is, the manager's decision problem is to decide on how much effort to devote to running the firm on behalf of the shareholders. Other than that, executive compensation contracts involve a delicate balancing of incentives, risk and decision horizon. An efficient contract needs to achieve a higher level of motivation to properly align the interests of managers and shareholders, besides avoiding the imposition of too much risk on the manager. It is because, too much risk of manager, can have dysfunctional consequences such as shortening a manager's decision horizon, adoption of earnings-increasing tactics and others. Consequently, to attain proper alignment, incentive plans usually feature a combination of salary, various and other types of stock. These components of compensation are usually based on two performance measures namely net income and share price. Nevertheless, it appears that executive compensation is related to performance but that the strength of the relationship is low. But for large firms at least this low relationship is to be expected and also, the relative proportion of net income-based and share price-based compensation components seems to vary as the theory predicts. This theory defined as the relative proportion of each in the compensation plan depends on both their relative precision and sensitivity, and the length of manager decision horizon that the firm wants to motivate.

Besides, with given the importance of reported net income to the manager, it is natural that he or she is concerned about the accounting policies that are used to determine net income. This is a concept of economic consequences, which it is a concept that asserts that, despite implications of efficient securities market theory, accounting policy choice can affect firm value. According to financial accounting perspective, managers may be able to affect the market value of their firm's shares by earning management. Earning management means the choice by a manager of accounting policies so as to achieve some specific objective. Example, firms may want to create the impression of smooth and growing earnings overtime. So, with securities market efficiency, it requires firms to draw on their inside information. Thus, earning management can be vehicle for the communication of management's inside information to investors. Whereby, both of these perspectives lead to the interesting and perhaps surprising, conclusion that a little bit of earning management can be good. In contrast, some managers may abuse earning management, to benefit themselves at the expense of other contracting parties.

The last component in Scott's book is standard setter, who as a mediator between the conflicting interest of investors and managers. But the fundamental problem now is how to conduct this mediation, how to reconcile the financial reporting and other questions. It shows that the extent of standard setting is a challenging one for accountant. Because of that, many aspects of firms' information production are regulated and many of these regulations are laid down by accounting standard setting bodies, in the form of GAAP. Furthermore, the extent of regulation is often increasing, as more accounting standards are promulgated. So, as mentioned, the standard setter must then seek a compromise between these conflicting interests, because of that, the structure of standard setting bodies is designed to facilitate such a compromise.

The conclusion of that design, Scott's book broad coverage of financial accounting theory provides a very good overview of the major topics of financial accounting theory. More importantly, the book is broken up into discrete parts that make it easy for reader to concentrate on areas of particular interest. The author is especially effective in explaining broad concepts such as information asymmetry or the social significance of accounting information.

At the same time, Scott also defines that accounting theory as the provision of different relevant information for both internal and external users. In which, for external users, the principal purpose of the information provided is to reduce adverse selection, while for internal users the goals are to motivate managers and avoid moral hazard. His definition, based on a situation of fundamental information asymmetry, offers a substantial improvement over past definitions expressed clearly or implicitly.