Financial
Accounting
Theory (R.
Scott
,Summary Financial Accounting Theory (R.
Scott)
1. Introduction to Financial Accounting Theory
Financial accounting theory studies why accounting practices exist and how they affect
decision-making. It focuses on how accounting information helps investors, creditors, and
other users make economic decisions.
Two major approaches:
● Normative theory: Suggests what accounting should be.
● Positive theory: Explains and predicts what accounting actually is.
2. Decision Usefulness Approach
The main objective of financial reporting is to provide useful information for decision-making.
Key ideas:
● Investors rely on financial statements to decide whether to buy, sell, or hold shares.
● Useful information must be:
○ Relevant
○ Reliable
○ Comparable
○ Understandable
This approach became dominant after the 1960s.
3. Efficient Market Hypothesis (EMH)
EMH states that financial markets quickly reflect all available information in stock prices.
Types:
1. Weak form: Prices reflect past market data.
2. Semi-strong form: Prices reflect all public information.
, 3. Strong form: Prices reflect all public and private information.
Implication: New accounting information affects stock prices immediately.
4. Decision Theory and Information
Accounting provides signals about a company’s financial performance.
Concepts:
● Information asymmetry: Managers know more than investors.
● Risk and uncertainty: Investors use accounting data to evaluate risk.
● Bayesian updating: Investors update beliefs when new information appears.
5. Agency Theory
Agency theory explains the relationship between owners (principals) and managers (agents).
Problems arise because:
● Managers may act in their own interests rather than shareholders’.
● Accounting systems help monitor managerial behavior.
Solutions include:
● Performance-based compensation
● Auditing
● Financial disclosure
6. Positive Accounting Theory (PAT)
PAT tries to predict which accounting methods firms will choose.
Three main hypotheses:
1. Bonus Plan Hypothesis
Managers choose accounting methods that increase reported profit if their bonuses
depend on income.
, 2. Debt Covenant Hypothesis
Firms close to breaking loan agreements may use accounting methods that increase
income or assets.
3. Political Cost Hypothesis
Large firms may reduce reported profit to avoid government regulation or taxes.
7. Earnings Management
Managers may manipulate accounting numbers to achieve certain goals.
Common techniques:
● Changing depreciation methods
● Adjusting provisions
● Timing revenue recognition
This affects the quality of financial reporting.
8. Accounting Standards and Regulation
Accounting standards exist to ensure consistency and transparency.
Important standard-setting bodies include:
● International Accounting Standards Board (IASB)
● Financial Accounting Standards Board (FASB)
These organizations develop frameworks such as IFRS and GAAP.
9. Measurement in Accounting
Accounting measurement involves determining how financial elements are valued.
Common bases:
● Historical cost
● Fair value
● Present value
Accounting
Theory (R.
Scott
,Summary Financial Accounting Theory (R.
Scott)
1. Introduction to Financial Accounting Theory
Financial accounting theory studies why accounting practices exist and how they affect
decision-making. It focuses on how accounting information helps investors, creditors, and
other users make economic decisions.
Two major approaches:
● Normative theory: Suggests what accounting should be.
● Positive theory: Explains and predicts what accounting actually is.
2. Decision Usefulness Approach
The main objective of financial reporting is to provide useful information for decision-making.
Key ideas:
● Investors rely on financial statements to decide whether to buy, sell, or hold shares.
● Useful information must be:
○ Relevant
○ Reliable
○ Comparable
○ Understandable
This approach became dominant after the 1960s.
3. Efficient Market Hypothesis (EMH)
EMH states that financial markets quickly reflect all available information in stock prices.
Types:
1. Weak form: Prices reflect past market data.
2. Semi-strong form: Prices reflect all public information.
, 3. Strong form: Prices reflect all public and private information.
Implication: New accounting information affects stock prices immediately.
4. Decision Theory and Information
Accounting provides signals about a company’s financial performance.
Concepts:
● Information asymmetry: Managers know more than investors.
● Risk and uncertainty: Investors use accounting data to evaluate risk.
● Bayesian updating: Investors update beliefs when new information appears.
5. Agency Theory
Agency theory explains the relationship between owners (principals) and managers (agents).
Problems arise because:
● Managers may act in their own interests rather than shareholders’.
● Accounting systems help monitor managerial behavior.
Solutions include:
● Performance-based compensation
● Auditing
● Financial disclosure
6. Positive Accounting Theory (PAT)
PAT tries to predict which accounting methods firms will choose.
Three main hypotheses:
1. Bonus Plan Hypothesis
Managers choose accounting methods that increase reported profit if their bonuses
depend on income.
, 2. Debt Covenant Hypothesis
Firms close to breaking loan agreements may use accounting methods that increase
income or assets.
3. Political Cost Hypothesis
Large firms may reduce reported profit to avoid government regulation or taxes.
7. Earnings Management
Managers may manipulate accounting numbers to achieve certain goals.
Common techniques:
● Changing depreciation methods
● Adjusting provisions
● Timing revenue recognition
This affects the quality of financial reporting.
8. Accounting Standards and Regulation
Accounting standards exist to ensure consistency and transparency.
Important standard-setting bodies include:
● International Accounting Standards Board (IASB)
● Financial Accounting Standards Board (FASB)
These organizations develop frameworks such as IFRS and GAAP.
9. Measurement in Accounting
Accounting measurement involves determining how financial elements are valued.
Common bases:
● Historical cost
● Fair value
● Present value
