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2 - 1Introduction to Financial Accounting Theory...

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1 Introduction to Financial Accounting Theory: Information Asymmetry A. Why do we need financial accounting theory? Financial accounting is the process by which enterprises provide information to external parties (as contrasted with managerial accounting internal to the enterprise). Broadly speaking, financial accounting (or financial reporting) involves any form of communication, formal and informal, written or verbal. Financial statements are just one form of financial reporting, but so is a press release from a company, or a conference call with stock analysts. Up to this point, your learning and understanding of financial accounting has been of the type, “we record [choose and account or transaction] using the _____ method because doing so is consistent with Generally Accepted Accounting Principles (GAAP).” This knowledge involves the “what” and “how” of accounting: what to record and how to record it. A deeper level of understanding involves consideration of whether and how the particular method of accounting is consistent with the “conceptual framework” underlying GAAP. The deepest level of understanding involves “why.” This is the role of financial accounting theory. It is also a common misunderstanding to believe that the current financial reporting regime results by fiat as mandated by government or quasi-governmental regulatory agencies, such as the Accounting Standards Board (AcSB) of the Canadian Institute of Chartered Accountants (CICA), or the International Accounting Standards Board (IASB). Rather, as an economic good, financial reporting is subject the laws of supply and demand. Accounting Standards reflect and respond to, although imperfectly, the demand and supply of financial information. Financial accounting theory helps us to understand the complexities in the production and consumption (use) of accounting information. Viewed in this way, financial information can be, and is, a subject of rigorous economic analysis. The following is a sample of questions that financial accounting theory will help to answer: Why does financial reporting exist? Why do companies and their managers report information to external parties? Why do some companies voluntarily disclose information and others do not? 2-1
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Why has a system of mandatory disclosures (GAAP) been put in place? What is the rationale behind the conceptual framework in GAAP? How do capital (stock/bond) markets react to financial statement information? Why do capital markets react to financial statement information? How are financial statements used for contracting purposes (i.e., shareholders with senior managers, corporations / managers with creditors)?
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