ACC3615

Accounting Theory
Lecture 1
Instructor: Jie Zhou
Email: bizzj@nus.edu.sg
Office: BIZ1 #07-14
1

Suggested Reading
Financial Accounting Theory
Skim Chapter 1
Chapter 2
Read 2.1 ~ 2.3 carefully
Skim 2.4 ~ 2.7

Agenda
ACC3615 General Information
Introduction

What is (Positive )Accounting Theory

Why Accounting Theory Is Important
Development of Theory
Historical Perspective
The Overall Structure

Link to Lecture 2
An Example
A Twist
An exercise

Aside: Bayes Theorem

ACC3615 General Information

Lecturers
Jie Zhou (Weeks 1 ~ 9)
Lectures 1 ~ 9
Format: seminar

Tutorials 1 ~ 9
Project Presentation (Asian Content)
Problem Solving

Oliver Li (Weeks 10 ~ 12)

Textbook (used for Lectures 1 ~ 9)

Financial Accounting Theory 6th edition (William R.
Scott)

ACC3615 General Information

Prerequisites --- an elementary knowledge of

accounting
pricing theory
finance
Statistics

Provided as Aside

ACC3615 General Information

Assessment
Class participation 15%
Voluntary participation
Mandatory participation
Group project 20%
Overall quality of presentation
Individual performance of presentation
Participation in other project presentations

Midterm test 30%

Final Exam 35%
6

What is (Positive) Accounting Theory

Theory provides an explanation for accounting
and auditing practice
Why some firms use accelerated depreciation methods
and others use straight line
Why some firms use Big Four auditors and others do
not

Theory does not present a rule for choosing

among alternative accounting procedures
Which better matches revenue and expenses

Why Accounting Theory is Important

Corporate managers
Public accountants

Investors and financial analysts

Accounting standard setting bodies such as FASB
and SEC

Development of a Theory
Assumptions
Assuming that parties act so as to maximize their own
welfare (expected utility)

Hypotheses
Determining the relation between accounting reporting
decisions and variables affecting welfare
Accounting numbers and stock/bond prices
Accounting numbers and budget/resources

Historical Perspective
Old times
Describe accounting practice
Unregulated

The Creation of SEC

Normative Accounting Theory
What is the best accounting practice

Positive Accounting Theory

To explain and predict phenomena
10

The Overall Structure

Introduction (Lecture 1)
Decision Usefulness (Valuation)
Rational Decision Theory (Lecture 2)
Efficient Market Hypothesis (Lecture 3)
Accounting Earnings and Stock Prices (Lectures 4 & 5)
The Information Approach
Are security markets fully efficient? (Lecture 6)
The Measurement Approach
Stewardship
Positive Accounting Theory (Lecture 7)
Application: Earnings Management (Lectures 8 & 9)
Standard
Rationale for disclosure regulation (Lecture 9)
11

The Overall Structure (Contd)

An alternative view
Information Asymmetry
Adverse Selection: a type of information asymmetry
whereby one or more parties to a business transaction,
or potential transaction, have an information advantage
over other parties
Moral Hazard: a type of information asymmetry
whereby one or more parties to a business transaction,
can observe their actions in fulfillment of the
transaction but other parties cannot

12

Link to Lecture 2: An Example

Consider a firm
With one-asset and no liabilities
Cash flow generated by the asset
$150 at the end of each year for two years
No residual value
Discount rate is 10%

Required
Prepare balance sheet and income statement for this
firm
Measurement base: present value
13

Balance Sheet As at Time 0

Capital Asset $260.33

Shareholders Equity $260.33

Income Statement for Year 1

Accretion of discount

$26.03

Balance Sheet As at Time 1

Cash $150.00
Capital Asset $136.33
$286.36

Shareholders Equity

$286.36
14

Link to Lecture 2: A Twist

Same firm
Cash flow generated each year will depend on the state
of economy
Good economy: $200
Bad economy: $100
Two states occur with same probability (0.5)
independently for each period
Investors are risk neutral

Required
Prepare balance sheet and income statement for this
firm
Measurement base: present value
15

Balance Sheet As at Time 0

Capital Asset $260.33

Shareholders Equity $260.33

Income Statement for Year 1 (Bad Economy)

Accretion of discount
Less: Abnormal earnings
Net Loss

$26.03
$50.00
$23.97

Balance Sheet As at Time 1

Cash $100.00
Capital Asset $136.33

Shareholders Equity

$236.36

$236.36

16

Link to Lecture 2: An Exercise

Consider a firm
With one-asset and no liabilities
Cash flow generated by the asset
$150 at the end of each year for two years
No residual value
Discount rate is 10%

Required
Prepare balance sheet and income statement for this
firm
Measurement base: Historical Cost accounting with
straight line depreciation
17

Link to Lecture 2
Take away from the examples
Accounting is useless under ideal conditions

This raises the following question

When is accounting (decision) useful?

Next class: rational decision theory

18

Aside: Bayes Theorem

A device to revise state probabilities upon
receipt of new evidence
is state of nature
m is message received
P() is prior probability of (subjective)
Formula
P Pm /
P / m
Pm / P

19

Aside: Bayes Theorem

is state of firm
1 = G = Good Economy
2 = B = Bad Economy
m is evidence received from the financial statements
m1 = H = financial statements show high income
m2 = L = financial statements show low income
Suppose H is received:
How will investors revise their belief?

20

Homework
Form study groups (6 groups in total)
5 students per group
Can be 4 or 6 depending on situation
Deadline to receive group member information (via
email) is 6:00PM Feb 4th, 2014
Email should be sent by one group representative to
bizzj@nus.edu.sg
Email should contain the following information:
how many students in the group; name of every
group member

Chapter 2
Q7, Q18, Q19, Q24
21

Plan for Tutorial 1

Presentation (10~15 minutes for each group)
Introduce yourself
Project assignment
Chapter 2 problems if time allowed

22