This post recieved an upvote from minnowpond. All posts. Newcomers' Community. Steemit Feedback. Explore communities…. If liquid markets exist, fair value is nothing but a reference to the current price at the time of financial reporting.
In these cases, the question is whether current price is reliable. Were we to deny the reliability of current price, there would be no place for fair value accounting. It seems pointless to replace reliability with faithful representation with the intention of avoiding the confusion between reliability and measurement precision in order to enlarge the scope of fair value measurement.
While in the past the influence of asset and liability price fluctuation on measurement was considered noise in inflation accounting [16] and isolated from income recognition, nowadays the same phenomenon is expected to be relevant in fair value accounting. Moreover, the characteristics of each phenomenon to be measured and the interrelation thereof should be grasped before choosing among available methods. However, based on the dogmatic dichotomy of historical cost and fair value measurement, the advocates of each camp continue to strive for the full application of their favorite dogma and the complete exclusion of the other side.
Conceptual framework for financial accounting , Discussion Paper. Tokyo: Financial Accounting Standards Foundation. Search in Google Scholar. American Institute of Accountants. Five monographs on business income. New York: American Institute of Accountants. New York: Macmillan. Barker, R. Moving the conceptual framework forward: Accounting for uncertainty.
Contemporary Accounting Research , 37 1 , — Bignon, V. Edwards, E. The theory and measurement of business income. Berkeley: University of California Press. Statement of financial accounting concepts No. Norwalk: Qualitative Characteristics of Accounting Information. Fisher, I. The theory of interest: As determined by impatience to spend income and opportunity to invest it. Hicks, J. Value and capital: An inquiry into some fundamental principles of economic theory 2nd ed.
Oxford: Clarendon Press. Klamer, A. An accountant among economists: Conversations with Sir John R. Journal of Economic Perspectives , 3 4 , — Using a stylized model, we contrast both concepts assuming that two sets of standards are available. One set emphasizes relevance and the other emphasizes reliability. Relevance in our model translates into early reporting of the information, in the sense of timeliness. Reliability is tantamount to late, but less noisy reporting, in order to ensure a high level of credibility.
We consider a two-period principal-agent relationship. The agent performs an effort in both periods and the principal aims at providing incentives via an appropriate compensation contract. One out of two different types of accounting or reporting systems is possibly implemented. Both systems produce identical information at the end of each period.
Inter-period correlation of the signals is present. The first system reports accounting information immediately, that is, in the period it is produced. The second system delays reporting of each signal by one period reflecting strong emphasis on reliability.
Later reporting goes along with less noisy signals. In what follows, we denote the former system the timely or early information system, and the latter the late information system. To provide an example for our presumed setting, assume that annual revenues are used for performance measurement. Revenue, e. Typical indicators for realization are the transfer of significant risks and control over the good to the buyer. In addition, the amount to be recorded needs to be reliably measurable and an actual flow of benefits to the firm has to be probable.
Whether these indicators are fulfilled at some point in time, in many cases is a matter of judgement. Eventually, whether recognition occurs sooner or later depends on how much emphasis is put on relevance, as opposed to reliability. In terms of our story, the timely system records revenue earlier. The amount reported, however, is noisy. The late system, in contrast, demands a higher level of reliability w.
As a result, recognition occurs with some delay but future benefits of the amount recorded can be safely assumed. Reporting is a necessary precondition for contractability in our setting, as it renders information verifiable by a third party.
Beyond that, delay of reporting critically affects contractability. To see that, consider a signal that is reported sometime after the agent has left the firm in a distant future. In terms of our above example, revenue from some long-term service or construction contract is possibly realized only with considerable delay. Such a signal becomes practically non-contractible as waiting for its realization is unsuitable.
We reflect this aspect in our model by assuming that information is contractible only if it becomes observable and verifiable within the two period horizon of our game.
Thus, the direct effect of late information in the model is less contractible information. With the late accounting information system in place, the second-period accounting signal becomes unavailable for contracting, as it will not be reported throughout the game.
The late accounting system, in fact, is one that provides a reduced set of performance measures for contracting, as compared to the early information system. Footnote 6 We assume, however, some non-accounting measure is present in this case, such that incentive setting is generally possible in period two.
Within this structure, we contrast a full commitment and a limited commitment setting. Full commitment implies that the principal and the agent agree upon a two-period contract at the start of the game, which remains unchanged throughout the game. In the limited commitment setting, we consider a setting with two short-term contracts such that sequentially optimal contracting decisions apply. With full commitment, we find that the late system is preferred to the early one only if the reduction in noise from the early to the late first period signal is sufficiently strong and if the second-period action can be controlled with sufficient precision.
However, in most real live settings, it is unlikely that contracting parties can effectively commit to stick to an ex post inefficient contract. Studying limited commitment instead, first of all, we find that the expected payoff to the principal decreases no matter which accounting system is used.
Given the assumed correlation of signals over time, limited commitment causes optimal ex post but suboptimal ex ante incentives in period two. As a result, agency costs increase as opposed to full commitment. With regard to preferability of either the early or the late system under limited commitment, our results differ depending on the presumed correlation of signals over time.
If the signals are negatively correlated, our results pretty much resemble the ones from full commitment. With positive intertemporal correlation they differ qualitatively. It turns out that in some settings the late accounting system becomes optimal, when the reduction in noise from the early to the late system is small, and the early system dominates if noise reduction is large.
Whether intertemporal correlation of accounting measures is more likely to be positive or negative depends on the situation at hand. Using the example of revenues once again, correlation is likely to differ with the specifics of the goods considered. For convenience goods we would expect intertemporal correlation to be positive, as larger sales in one period trigger repeated purchases in future periods. In contrast, specialty goods that are purchased in one period might not be purchased in the next and v.
More generally, accounting accruals or even accounting errors are likely to reverse sometime in the future and thus induce a negative correlation. If, on the other hand, underlying economic effects such as a persistent increase in demand are present, this favors positive correlation.
Ultimately, both, accruals and persistent effects, might be simultaneously relevant and positive or negative correlation hinges on which effect is stronger. Footnote 7. To sum up our main results, with limited commitment and negative intertemporal correlation and also with full commitment , the results are almost what we would expect: Early recognition is helpful and a late system is preferred only if the increase in precision decrease in noise is sufficiently large.
However, with positive correlation, the opposite might be true. Intuitively, persistent noise counteracts overly high ex post incentives that are present with positive correlation, and in this sense serves as a commitment to lower incentives. It follows from these findings that even from a pure contracting perspective neither relevance nor reliability can be identified as the uniquely preferred concept.
Accordingly, we cannot derive a clear-cut recommendation to standard setters from our model. We do show, however, that both concepts are potentially beneficial. Thus, our model suggests that diversity in systems, and flexibility of firms to choose from different systems, helps to reduce overall agency costs.
Having said this, we find no strong argument in favor of the aforementioned trend towards relevance. From a management control perspective, our results show that the accounting system choice affects optimal incentive setting and contracting costs. Which system is preferable for a particular firm depends on finer details, however.
In particular, the correlation of the performance measures is crucial. Under limited commitment and negative correlation, the reliable relevant system turns out to be more less beneficial the stronger the reduction in noise over time and the more precise an available non-accounting performance measure and v. Conversely, with highly positive correlation in accounting signals, the reliable relevant system is more less preferable if reduction in noise is low and no high-quality non-accounting measure is available for contracting in period two.
Thus, from an empirical perspective, our model predicts diverse system choices across firms reflecting differences in finer details.
Our paper is naturally related to the large body of literature that examines the trade-off between relevance and reliability. Many of those papers, however, do so rather indirectly, e.
Some explicitly focus on relevance versus reliability such as Dye and Sridhar , and more recently Zhang Dye and Sridhar consider an accountant who observes some pieces of information directly and receives a report on other pieces from a manager. Direct observation is considered reliable information while reported information is relevant, but less reliable.
The accountant aggregates this information when setting up financial statements and can either put more emphasis on reliable or on relevant information.
They also oppose information aggregation to disaggregation. Allowing for voluntary disclosure to complement mandatory disclosure, he finds that reducing the latter to reliable information not only induces more voluntary reporting but also might increase welfare.
We are not aware, however, of a paper that investigates the relevance and reliability trade-off with reference to timeliness of reporting, as we do in this paper. Besides, limited commitment has no role in this literature, but is crucial in our setting. Hence, our paper also relates to the literature on limited commitment. It does so in two ways: First, we strongly rely on findings from previous work on limited commitment. Specifically, we rely on Fudenberg et al.
Fudenberg et al. They also show that ex post efficient contracts may well be inefficient from an ex ante perspective. This can usually be achieved through a combination of consistency and disclosure of accounting policies. However, consistency is not an end in itself nor should it be allowed to become an impediment to the introduction of improved accounting practices.
Consistency can also be useful in enhancing comparability between entities, although it should not be confused with a need for absolute uniformity. For example, information that does not properly reflect and communicate the substance of transactions and other events will not help users to understand the entity's financial performance or financial position.
This is considered further in Chapter 7. Those preparing financial statements are entitled to assume that users have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided. While the paragraphs above describe the characteristics that, if present, will mean that the usefulness of the financial information has been maximised, the materiality test asks whether the resulting information content is of such significance as to require its inclusion in the financial statements.
Furthermore, when immaterial information is given in the financial statements, the resulting clutter can impair the understandability of the other information provided. In such circumstances, the immaterial information will need to be excluded.
The principal factors to be taken into account are set out below. It will usually be a combination of these factors, rather than any one in particular, that will determine materiality. This includes, for example, considering how the item affects the evaluation of trends and similar considerations. In such circumstances, a trade-off needs to be found that still enables the objective of financial statements to be met. Choosing the amount at which to measure an asset or liability will sometimes involve just such a conflict.
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