This is an overview of all the information you need to know for the exam of Financial Accounting Theory of the RUG in only twelve pages. The summary is written in English.
Chapter 11 summary of the book financial accounting theory by william r scott
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Chapter 1 Introduction
Financial accountnn theory = a constructon of legal reasonings to increase our understanding of accountng
practces and to help guide future developments.
1920 In 1929, there was a stock market crash. This resulted in the Securites ct and the Securites Echange
Commission. The new focus was on the income statement and on true income. Scientsts started
looking for a conceptual framework for accountants and accountng.
1960 New theories were developed: ratonal decision making under uncertainty, efcient securites market
and informaton economics. The focus was on decision usefulness. The conceptual framework of the
I SB and F SB is also based on decision usefulness. It states that the goal of fnancial statements is to
provide informaton that can help investors in making their investment decisions.
2000 Internet bubble and market crash in the high-tech industry. The cause of this were unclear criteria for
revenue recogniton. This led to too early recogniton of revenues. lso, companies were using special
purpose enttes (SP s) to carry their debt to improve their debt rato. ne eEample is nron. This
resulted in a lack of trust in fnancial reportng by society and eventually in the Sarbanes- Eley ct
(S X) and several governance codes.
2008 Intransparancy and fraud in the asset-backed securites market resulted in a global fnancial crisis.
There was a demand for more value-in-use.
2018 The society is now characterized by informaton economics: there is an uneven distributon of
informaton, i.e. informaton asymmetry.
There are two kinds of informaton asymmetry:
- Adverse selecton = the agent has more informaton than the principal (life insurance).
- Moral hazard = the acton of the agent a not observable for the principal (holiday insurance).
Fundamental problem = combining the investor-informing and manager performance-evaluatng role of
fnancial accountng informaton (F I). The frst role requuires fair value accountng, whereas the second
requuires historical cost accountng. F I can’t at the same tme solve adverse selecton (for investors) and moral
hazard (for owners). lso, there is a trade-of between relevance and reliability.
The other comprehensive income is a soluton to the fundamental problem. It is equual to comprehensive
income minus net income. The other comprehensive income consists of unrealized gains and losses. It is the
part of the result that is not yet acknowledged as accountng result. This way, they are not taken into account
in the net income. ther comprehensive income is a compromise between the two roles, because unrealized
results are communicated but not part of the ofcial acknowledged result.
Chapter 2 Ideal conditions
Ideal conditons under certainty = future cash fows and the interest rate are known with certainty. The
present value model provides the utmost in relevant and reliable informaton. Due to arbitrage, the market
value is equual to the present value under ideal conditons.
Ideal conditons under uncertainty = the interest rate is known and fEed, states of nature are complete and
publicly known, state probabilites are objectve and publicly known and state realizaton is publicly observable.
We assume risk neutrality and can thus use the same discount rate in all states.
> Diference: cash fows are known conditonally on the states of nature. lso, eEpected and realized income
need no longer be the same.
In ideal conditons, there is no informaton asymmetry. Future cash fows can be estmated based on objectve
probabilites. If conditons are not ideal, it is necessary to trade-of relevance and reliability. Subjectve
estmatons have to be made or less relevant informaton has to be used.
, In ideal conditons, the income statement has no informaton content for investors. They can simply determine
the result themselves based on the opening value of the equuity in the balance sheet and the interest in the
market.
Relevant informaton = the informaton gives insight about the future prospects of the company.
Reliable informaton = the informaton faithfully represents what it is intended to and it is precise without bias.
ccording to the conceptual framework “to be useful, fnancial informaton must faithfully represent the
phenomena that it purports to represent”. faithful representaton includes three components:
- Complete.
- Free from material error.
- Neutral.
Estmaton risk = the risks that eEists because it is unknown which state of nature will occur. The decision
maker is uncertain about the values of the underlying parameters that infuence his decision.
Accreton of discount = PV0 E discount rate. It is the increase in the value of a discounted instrument as tme
passes. The value will grow (accrete) at the interest rate. The stream of cash receipts is one year closer at the
end of the year than it was at the beginning. The result is equual to the accreton of equuity at the interest rate in
the economy. Future net revenues are capitalized into asset value, thus net income is equual to the interest on
the opening asset value. This is just like the interest income from a savings account. The accreton of discount is
the eE ante or eEpected net income.
theoretcally correct measure of income is the net income of a frm for a period calculated on a present
value basis. This is the accreton of discount on the opening frm present values plus or minus any diferences
between eEpected and actual cash fows for the period. ccording to Scot there is no theoretcally correct
measure of net income in the real-world conditons in which accountants must operate, because ideal
conditons don’t eEist. Future cash fows can’t be reliably estmated.
Chapter 3 Decision usefulness
Decision usefulness = F I helps investors making good decisions. In non-ideal circumstances there is no true
net income, because measuring net income is then a subjectve mater depending on who makes the decision.
Financial reportng should in that situaton be more useful. Usefulness is determined by the users and the
decision and investment theory.
F I has two roles:
- Stewardship role = making sure that the interests of a manager are aligned with the interests of the
owners of a company to prevent opportunistc behavior and eliminate moral hazard.
- Decision usefulness role = making sure that investors make good decisions.
Sinnle-person decision theory = shows how F I can be useful to investors. It takes the perspectve of an
individual investor and assumes ratonal decision making under uncertainty. The investor makes an estmaton
of the prior probabilites based on all the informaton he has.
In case of risk neutrality, investors choose the opton with the highest amount of eEpected payof in euros.
However, investors are risk averse and use the utlity functon in their decision. This measure combines risk
and return. The utlity functon of a risk averse investor is concave instead of linear.
Investors have another opton. They can obtain more informaton and decide later. They can await the annual
report, because they deliver direct proof of the state of the frm. Based on the new informaton, investors can
review their prior probabilites and calculate their posterior probabilites. The prior probabilites included all
informaton that was available up to just prior to analyzing the fnancial statements. They are subjectve.
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