The Fundamental Problem of Financial Accounting Theory
Given the absence of perfect or true accounting concepts, it turns out that the most useful measure of net income to inform investors—that is, to control adverse selection—need not be the same as the best measure to measure and motivate manager stewardship—that is, to control moral hazard. This was recognized by Gjesdal (1981). Investors’ interests are best served by information that enables better investment decisions and better-operating capital markets. Providing it is reasonably reliable, current value accounting fulfils this role, since it provides up-to-date information about assets and liabilities, hence of future firm performance, and reduces the ability of insiders to take advantage of changes in asset and liability values. Managers’ legitimate interests are best served by information that is highly informative about their performance in running the firm, since this enables efficient compensation contracts and better working of managerial labour markets. Fair value accounting can improve reporting on stewardship since, ultimately, the manager is responsible for everything, including current value gains and losses. If the manager cannot earn an acceptable return on the fair value of net assets, these assets (or the manager) should be disposed of.
However, current value accounting can also interfere with reporting on stewardship. Current values are very volatile in their impact on reported earnings, and can even increase earnings volatility beyond the real volatility faced by the firm. Also, unless market values are readily available, current values may be more subject to bias and manipulation by the manager than historical cost-based information. Thus, from a managerial perspective, a less volatile and more conservative income measure, such as one based on historical cost, or at least a measure that excludes certain unrealized gains, may better fulfil a role of motivating and evaluating managers. 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 roles for accounting information. In future, we will refer to combining these two roles of financial reporting as the fundamental problem.
Other comprehensive income (OCI) is another approach to reconciling the two roles. A statement of OCI was originally created in the United States by FASB’s Statement of Financial Accounting Standards 130 (SFAS 130; 1997), now included in Accounting Standards Codification (ASC) 220-10-45. As mentioned earlier, standard setters have moved increasingly to current value accounting. We can view OCI as a compromise to secure manager acceptance of current value standards, since it excludes these gains and losses from net income. Thus OCI includes unrealized current value gains and losses resulting from fair value accounting for securities, foreign currency translation adjustments, changes in some pension expense components, and several other items. As these gains and losses are realized or amortized, they are generally transferred to net income. The sum of net income and other comprehensive income is called comprehensive income.
- Scott, W. R. (2015). Financial Accounting Theory 7th Pearson Canada Inc. ISBN 978-0-13-298466-9
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