Financial Accounting

Topics: Moral hazard, Scientific method, Information asymmetry Pages: 10 (3485 words) Published: October 25, 2009
This essay is to critically evaluate the usefulness of the accounting theory to practicing accountants today. It will provide a general assessment of information asymmetry and the fundamental problem of accounting, and it will also briefly discuss the normative and positive accounting theories and their usefulness to practicing accountants. After those discussions, it will specifically discuss the strength and limitation of positive accounting theory and assess its usefulness to practicing accountants.

Critically evaluate means that it must discuss the strengths and limitations of the topic. Therefore, evaluate the usefulness of accounting theory to practicing accountants today must discuss the advantages and the disadvantages of the accounting theory. To be usefulness, accounting theory should include the stewardship and information roles. It means that accounting theory should provide the relevant and reliable information to practicing accountants. First of all, it is important to understand what accounting theory is and who the practicing accountants are. The practicing accountants should include those people who work in or relate to the accounting, such as the financial accountants, management accountants, auditors and regulators. Hendriksen (1970, p. 1) defined the accounting theory as:

…logical reasoning in the form of a set of board principles that (1) provide a general framework of reference by which accounting practice can be evaluated and (2) guide the development of new practices and procedures. Normative theories and positive theories are the two major parts of accounting theory. Normative theories dominated the 1950s and 1960s. The normative theorists paid their attention to make the accountants know what should be done to get a good outcome (Godfrey et al. 2006). Positive theories were developed during 1970s. The positive theorists paid more attention to describe the behaviors of people, find the reasons for those behaviors and forecast what to be done in the future (Godfrey et al. 2006).

Information asymmetry
Information asymmetry occurs when some parties have more business information than the other parties in trading. One type of information asymmetry is adverse selection. It happens because the parties inside the business, such as managers, they could get more information about the business of right now and the future that the outside parties could not obtain. The other type is moral hazard and this happens because some parties could not see the behaviors of the other parties in the transaction (Scott 1997). Moral hazard is the problem of motivate managers to work hard for the owners’ interest and this happens because the owners and the managers of the firm is separated. The managers may work hard for their own interest rather than that of shareholders, and at the same time, the shareholders of the company could not see what the managers’ behaviors and whether they are working for maximize the wealth of the company (Scott 1997). To solve this moral hazard problem, the accounting net income could be used as a tool to measure how the managers perform. There are two reasons for that: firstly, the managers could work hard to increase the accounting net income in order to increase their remuneration. Secondly, it could also give chances for outsiders to evaluate the managers’ performance and it will monitor the managers’ behaviors.

Fundamental problem of financial accounting theory
The investors would against both the moral hazard and adverse selection problems at the same time. The fundamental problem of financial accounting theory arise as the result of control these two problems together and the problem is that how to reconcile the different roles for accounting information. The relevant information could make the outsiders know the firm’s development plans in the future, and the reliable information could make the investors get the neutral and correct information of the company (Scott 1997)....
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