ADMS 4510 Accounting Theory Notes

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York University *

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4590

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Accounting

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Apr 3, 2024

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ADMS 4510 Accounting Theory Notes Chapter 1 Historical Perspective - This is a dilemma in accounting theory should accounting be based on relevance or reliability. - Compromission of one when choosing the other. - During the 1930 People relied on relevance over reliability. - Is accounting information useful? This is the question revolved around this course and the theory. - There are two types of information asymmetry. o Adverse selection occurs before a transaction and involves one party having superior information, leading to potentially unfavourable outcomes for the less informed party. This can result in market inefficiency as parties with more information tend to participate selectively, distorting prices and reducing overall market activity. o Moral hazard, on the other hand, occurs after a transaction and involves one party changing their behaviour due to the presence of incomplete information on the part of the other party. This can lead to inefficiency as it encourages riskier behaviour by the party insulated from the consequences, affecting the overall stability and efficiency of markets. Both types of information asymmetry hinder the smooth functioning of markets by distorting incentives and outcomes, ultimately impacting market efficiency. After obtaining insurance, the individual might become less vigilant about fire prevention measures or may even engage in risky behaviours, such as leaving candles unattended, knowing that the insurance will cover the costs of any potential damage.

Chapter 2 – Accounting Under Ideal Conditions (one question from this on the midterm) - The main question is with or without certainty? - Firm Value is the PV of future dividends; because stakeholders expect a higher return in the future this makes a company’s value more based on future assumptions. - Relevant = information helps predict firm value. - Reliable = no room to minimize the information. - Under ideal conditions dividends do not affect the value of the firm it is unchanged based on the dividend irrelevance theory. - The difference between certainty and uncertainty checks the Excel examples specifically the last year’s balance sheet and Income Statement for 2.1 and 2.2. - To understand arbitrage, go to page 42 it has a good example to show the understanding of under ideal conditions with certainty. - Decision usefulness approach o

Chapter 3 Decision Usefulness Theory/Approach of Financial Reporting (this could be on the midterm the formula for Bayes theorem would be given) - Single Person Decision Theory uses uncertainty because certainty is very limited. - Higher utility means higher satisfaction from the decisions. - Risk-averse is defined as the utility square root of payoff. - Risk neutral is defined as the actual amount of payoff. - A risk taker is defined as a utility squared of payoff. - Bays theorem – use Post Probability Formula. - There are subsections of probability. - P= Probability (GN= Given/H = High State) - P= Probability (GN= Given/L = Low State) - Look at the example it is really good. - Information is the evidence that has the potential to affect an individual’s decision. - This follows along the lines of Management discussion and analysis.

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Chapter 4 Efficient Securities Market. - This assumes that markets are efficient. - Investors have different perspectives and have different views, on the stock market and changes. - The efficient market hypothesis is used to explain the market reactions. - The inductive approach is the approach that solves what happened in the capital market. - EMH says that a market is going in a zigzag at a constant line. However, when new information is brought into the market then the constant line is broken and moved based on the information (good or bad) and shifts accordingly. Further, once the market adjusts to the information the constant line is created at another level which is above or below the old constant. - The strong form of the market uses both public and private information. - The semi-strong form of the market uses only public information. (the market will react to news, will act quickly, and will act correctly) - The weak form of the market only reflects on historical information. - Individual forecasts never outperform census for example, if 2 people choose to buy and one decides to sell then overall the market is in a buy consensus, which means the cumulative consensus is not the same but still the market consensus is buy. (remember the game of 5 investors and 3 companies Netflix, Costco, and RBC) - Logical inconsistencies there are never incentives to gather information. - Noise traders can force the shift by becoming neutral to change the curve or market census. For example, being a tarator to the example for the individual forecast. - Expected return = Risk-free investment + beta to reflect individual firm risk * (market return – Risk-free investment) - Beta can tell whether the Expected return is risky (beta is greater than 1), the same (beta is equal to 1), or not risky (beta is less than 1).

Chapter 5 – The Value Relevance of Accounting Information. - The earnings response coefficient is the measure of to what extent accounting information is reflected in stock price. The greater the coefficient the greater the earnings, and vice versa. Understand this conceptually. If the reaction is the same with different unexpected prices, then that means the firm that has a lower price difference has a higher ERC. - Abnormal share return = actual share return – expected share return. - Actual Share return = (Price today- Price yesterday)/price yesterday or ((price today + dividend)/price yesterday – 1) This is a firm-specific reaction. - Expected share return = Risk-free investment + beta to reflect individual firm risk * (market return or risk premium – Risk-free investment) This is a worldwide reaction. - Unexpected earnings are also known as earnings surprises. This is the difference between expectation and actual, if there is a difference then there are unexpected earnings. If there is no difference, then there are no unexpected earnings. - Cash flow statements are a better use than income statements because there are no accruals in a cash flow statement. - Earnings response coefficient o Measures the extent to a securities market return response to unexpected earnings. The higher the percentage the more ERC which also means that the reaction is more to that firm with new information. o Firm Risk  Higher risk > lower ERC o Earnings quality  Higher Persistence > higher ERC  A higher number of accruals > Lower ERC o Capital Structure  Higher debt-to-equity ratio > Lower ERC o Growth opportunities  Higher opportunities > higher ERC o Similarity of investor expectations  Similarity of investor expectations > Higher ERC o Informativeness of price  More informative price > Lower ERC

Chapter 6 valuation approach to decision usefulness. 1% bonus mark if you can complete the CTS example on your own using manual calculation. - A valuation approach that involves greater use of current value in the financial statements proper. - Paradigm shift, before the move it does not matter where the information is disclosed. - Paradigm shift, After the move, it does matter where the information is presented. - Valuation approach when the market is inefficient. - Behavioural-based evidence o Limited attention  Not looking at all the information o Over-conservatism or over-confidence  Pessimistic versus optimistic. o Representativeness  Investors put more weight on their own decisions based on evidence, they are biased to search out evidence that supports their decisions. o Self-attribution bias  Investors attribute good decision outcomes to their abilities and bad decision outcomes to other factors. o Motivated reasoning  Investors accept information consistent with their preferences while discrediting information inconsistent with their preferences. -

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