Part 1: Accounting fundamentals, accounting quality and the information environment

Question 1

What is accounting quality?

Answer 1

In this book, we take the perspective that accounting should be utilitarian; that is, it should be useful. If it is useful, it is considered of high quality

Question 2

What is the capital market (economic) perspective?

Answer 2

Accounting has economic consequences – for all capital market participants as well as the economy as a whole. In order for capital markets to function efficiently and for an efficient resource allocation, information is needed. Financial accounting constitutes an important source of information in this context. Useful (and consequently high-quality) accounting is that which provides users with such information to let them make informed decisions with respect to the decision models they employ. This perspective recognises two types of users: 1) investors, and 2) creditors

Question 3

What is useful accounting referred to?

Answer 3

When accounting provides users with information that allows them to make informed decisions

Question 4

What are the determinants of accounting quality?

Answer 4

Firm-specific factors

• • Underlying transactions
• — Faithful representation
• —– Complete
• —– Neutral
• —– Free from error
• — Relevant
• —–Confirmatory value
• —–Predictive value
• • Reporting incentives
• — Economic incentives
• —– Managerial level incentives
• —– Firm level incentives
• — Social/ legitimization incentives
• —– Institutional theory
• —– Legitimisation theory
• • Monitoring mechanisms
• — Board of directors
• — Auditors
• — Efficient contracts

Institutional factors

• • Regulation
• • Enforcement
• • Other institutional factors (e.g., culture)

Question 5

What are the two reasons for uncertainty in accounting?

Answer 5

Measurement uncertainty – preparers having incomplete information
Information asymmetry – between preparers and users

Question 6

What are the two types of accounting theories?

Answer 6

Descriptive (positive) – describes and explains various phenomena, including the determinants and consequences of financial accounting
Prescriptive (normative) – describes what ought to be

Question 7

What are the two widely accepted roles of accounting?

Answer 7

Valuation role – use of accounting for security pricing

Stewardship role – use of accounting in contractual relations

Question 8

Describe the valuation role of accounting

Answer 8

Ex ante, pre-transaction perspective, where key concepts are adverse selection and the influence of financial accounting in decision-making when buying and selling shares. Financial reporting of high quality is potentially an effective way of reducing information asymmetry and aiding investors in the estimation of firm value.

Question 9

Describe the stewardship role of accounting

Answer 9

Ex post, post-transaction perspective where owners use financial reports to ensure their investment is protected in the presence of information asymmetry

Question 10

What is the trade-off between the valuation and the stewardship role?

Answer 10

The valuation role, which has received more attention from standard setters, has a greater future orientation as investors aim to estimate values based on predictions of future firm performance, whereas the stewardship role focuses on providing historical feedback. This distinction is important to consider when evaluating the usefulness of the information, since it will depend on the perspective taken.