Financial Accounting Standards Setting Essay (Book Review)

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What is meant by the term “efficient markets” (semi-strong)? If the markets are efficient (semi-strong), then how does that affect financial accounting standard setting? If they are not efficient (semi-strong), then how does that affect financial accounting standard setting?

Semi-strong market efficiency denotes a situation where markets reflect all information available in the public domain. The theory suggests that any stock prices adjust in a quick manner in a way that the new rates measure up to the newly available information. In stock markets, semi-strong market efficiency suggests that investors would only purchase stocks upon the release of the available information since such information also reflects the new prices (Scott 110).

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Semi-strong market effectiveness influences accounting standards. Any accounting standards should guarantee fairness while trading on securities. Assuming that markets reflect the publicly available information, an appropriate accounting standard should not create room for insiders to gain more in any market compared to outsiders. This claim does not imply that such possibilities do not exist.

Markets are inefficient (are not semi-strong) in some situations. Some insiders may earn more profits from investments by taking advantage of the information that is not available in the public domain. Hence, an appropriate accounting standard should help to ease worries about insider trading (Scott 110). Securities in the United States are traded pursuant to the legal provisions of SEC standards. SEC focuses on ensuring the disclosure of information to external investors. In the case of market imperfections, IASB suggests the use of models for measuring asset flow.

Accounting standards today use a mix fair value accounting and historical cost accounting. What are some examples of each in the standards? What are the arguments to do more fair value accounting? What are the arguments to do less fair value accounting?

Today, bookkeeping standards use a mix of fair value accounting (FVA) and historical cost accounting (HCA). Examples of FVA and HCA standards can be demonstrated by an organization, say, company AB, which bought a parcel of land in the 1990s for $1 million and another identical parcel in 2010 for $3 million. Under HCA, in 2010, the two parcels would appear in the balance sheet as different and costing $1 million and $3million, respectively. However, under FVA, in 2010, since the two parcels of land were identical, they would cost $3mllion each.

Arguments that uphold and/or are against FVA rest on three typologies, namely, financial reporting, economic contexts, and markets. In support of doing more FVA, Laux and Leux argue that in the case of perfect markets and considering the presence of a crisis, the measure can help in providing the necessary and relevant information to creditors and investors (829). Hence, critical issues on FVA with respect to HCA do not render any support for HCA costs measurement approaches during an economic crisis.

In case of imperfect markets and focusing on periods of economic crisis, it is paramount to do less FVA since the cost measurement approach provides information that is less relevant in decision-making due to the possibility of misinterpreting various items of the balance sheet. FVA is critiqued for introducing high volatilities in financial statements. For example, Laux and Leux assert, “in booms, the fair value would allow the revaluation of assets while the historical cost would create “hidden” reserves” (829).

What role does accounting research play in the accounting standard process? Discuss three empirical research articles that have been mentioned in class or in the text and how they could possibly be relevant to accounting standard setters (FASB, IASB).

Accounting research plays a role in the process of developing new standards. It forms the foundation of financial accounting practice. For example, “a decision usefulness approach underlines the IASB/FASB framework” (Scott 20). Therefore, standards are set in line with information derived from accounting research. Through research, mechanisms for sealing the existing loopholes in the current standards are achieved.

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Barth discusses drastic changes that have occurred in the ‘accounting field for business combinations, particularly in the sector of intangibles (1159). Hence, accounting reporting entities have to refocus their attention on enhancing transparency. The process needs to be consistent with standards established by bodies such as IASB and FASB. In support of the relevance of transparency in setting standards for accounting bodies, Haswell and McKinnon argue that some intangibles do not fit in balance sheets since they are non-capitalizable (8).

Power discusses the necessity of transparency in financial accounting by adopting appropriate accounting practice that best suits a given scenario in which a financial statement is prepared (198). Consistent with IASB, the current accounting standards enhance transparency. This goal is achieved by steadily altering financial reporting to assume a fair value based on the market. Hence, disclosure of items that may not be expensed during major organizational changes is necessary for the reporting standards advocated for by bodies such as IASB and FASB.

What is information asymmetry and why is it relevant to financial accounting standard setting and financial accounting theory?

Information asymmetry refers to a situation in an economy when some parties to business transactions possess information that advantages them compared to others (Scott 21). This situation is usually common among insiders who are the repositories of a firm’s information. Such people can fit themselves into a given situation in a manner that advantages them. Hence, in setting standards, considering such asymmetries is necessary to eliminate any adverse selection and moral hazards information asymmetries in an economy.

Information asymmetry impairs the ability of investors to make well-informed decisions (Scott 21). Consequently, it is relevant to financial accounting standard-setting and financial accounting theory. For example, accounting theory provides the theoretical paradigm of the decision-making process by investors, hence suggesting that accounting information forms the basis of investment decision-making (Scott 20). Therefore, with information asymmetry, investors make inappropriate decisions.

Financial accounting is the branch of accounting that is concerned with tracking the financial transaction of an organization. Therefore, information asymmetry is relevant to financial accounting since the branch of accounting functions to control adverse selection through “timely and credible conversation of inside information into the outside information” (Scott 21).IASB/FASB framework allows efficient reporting of accounting information to various rational investors (Scott 25).

How is here a tradeoff between “relevance and reliability” in financial accounting? What would this tradeoff look like under

  1. perfect ideal conditions,
  2. full current value accounting in realistic conditions,
  3. full historical cost accounting in realistic conditions?

Reliability and relevance are important concepts in financial accounting. However, their consideration introduces some tradeoffs. Relevance implies that accounting information meets the utilities of different intended users. Under perfect ideal conditions, the single interest rate applicable to any nation is publicly known. Future expected cash flows of any organization are also known in the public domain with certainty. Therefore, highly relevant and reliable financial statements can be prepared (Scott 38).

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Under full current value accounting in realistic conditions, not all quoted market prices are readily available. Therefore, any accounting procedure is accomplished using estimates. Although highly relevant information may be produced, errors and biased estimates yield accounting information with incredibly reduced reliability coupled with questions on the usefulness of the current values (Scott 52).

Under full historical cost accounting in realistic conditions, liability, or asset costs are verifiable without bias or estimation errors (Scott 53). This situation makes it (historical cost accounting) relatively reliable. Historical costs have less relevant. Although cost is equal to the current value at the time of the acquisition, equity is eroded as time progresses due to changes in the current values.

How, and why, does financial disclosure affect the cost of equity capital?

Disclosure influences the cost of equity capital. This process underlines one of the reasons why regulations are necessary to promote disclosure. For example, in a single firm, Scott (154) notes that disclosures lower equity capital costs. The same relationship is also observed in multi-firm contexts.

Lee, So, and Wang provide empirical evidence that disclosures lower equity capital market costs for firms that operate in a given industry (12). The economic theory observes that high levels of reporting make firms raise the level of liquidity of their stock markets. The disclosure also reduces the risk of estimation by investors. Such risks accrue from future returns uncertainties coupled with payout distributions.

One may want to know what happens when such risks escalate. The accrued risk has the effect of attracting reliable long-term investors. The situation has a positive impact on an organization’s stock marketability. Consequently, equity financing is reduced.

Works Cited

Barth, Martins. “Global financial reporting: Implications for US academics.” The Accounting Review 83.2 (2010): 1159–1179. Print.

Haswell, Stephen, and James McKinnon. “IASB standards for Australia by 2005: Catapult or trojan horse?” Australian Accounting Review 13.1 (2009): 8–16.Print.

Laux, Christian, and Christian Leux. “The crisis of fair-value accounting: Making sense of the recent debate.” Accounting, Organizations and Society 34.6 (2009): 826-834. Print.

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Lee, Charles, Eric So, and Charles Wang. Evaluating implied Cost of Capital Estimates, Stanford University, Harvard University, and MIT, 2010. Print.

Power, Martin. “Fair Value Accounting, Financial Economics and the Transformation of Reliability.” Accounting and Business Research 40.3 (2010): 197-210. Print.

Scott, William. Financial Accounting Theory, Toronto, Ontario: Pearson Canada Inc., 2012. Print.

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