2.1: Definition and Information Asymmetry
The International Accounting Standards Board (IASB) has stated that the purpose of financial reporting is "to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, providing or settling loans and other forms of credit, or exercising rights to vote on, or otherwise influence, management's actions that affect the use of the entity's economic resources." (International Accounting Standards Board, 2019). The key elements of this definition are that information must be useful and that it must assist in the decision-making function. Although this primary definition identifies investors, lenders, and creditors as the user groups, the IASB does acknowledge that other users may also find financial statements useful. The IASB also acknowledges two key characteristics of the financial-reporting environment. First, most users, such as shareholders or lenders, do not have the ability to access information directly from the reporting entity. Thus, those users must rely on general-purpose financial statements as well as other sources to obtain the information. Second, management of the company has access to more information than the external users, as they can access internal, nonpublic sources from the company's records. These two conditions result in information asymmetry , which is a key concept in understanding the purpose and development of accounting standards.
Information asymmetry simply means that one individual has more information than another individual. This concept is very easy to understand and is obviously true in all kinds of interactions that occur in your life on a daily basis. When you enter the room to write an exam, you know how much sleep you had the night before and what you ate for breakfast, but your professor does not. This type of information advantage is not very useful to you, however, as your professor is interested only in what you write on your exam paper, not the conditions that led up to those responses. In other cases, however, it is possible that you could gain an information advantage that could be useful to your performance on the exam. In the broader perspective of financial accounting, we are concerned the implications and problems that may be caused by information asymmetry. To explore this concept further, we need to consider two different forms of information asymmetry: adverse selection and moral hazard .
Adverse selection occurs because employees and managers of a company have more knowledge of the company's operations than the general public and, more specifically, investors. Because these individuals know more about the company and its potential future profitability, they may be tempted to take advantage of this knowledge. For example, if a manager of a company knew that a contract had just been signed with a new customer that was going to significantly increase revenues in the following year, the manager may be tempted to purchase shares of the company on the open market before the contract is announced to the public. By doing so, the manager may benefit when the news of the contract is released and the price of the share rises. In this case, the manager has unfairly used his or her information advantage to gain a personal benefit, which can be considered adverse to the interests of other investors. Because investors are aware of this potential problem, they may lose confidence in the securities market. This could result in investors generally paying less for shares than may be warranted by the fundamental factors of the business. The investors would do this because they wouldn't completely trust the information they were receiving. If this lack of confidence became serious or widespread, it is possible that securities markets wouldn't function at all.
The field of financial accounting clearly has a role in trying to solve the adverse selection problem. By making sufficient, high-quality information available to investors in a timely manner, accountants can reduce the adverse effects of this form of information asymmetry. However, it is impossible to eliminate the problem completely, as insiders of a company will always receive the information first. The accounting profession must thus work toward cost-effective and reasonable (but imperfect) solutions to convey useful information to investors.
Moral hazard is a different type of problem caused by an information imbalance. Except for very small businesses, most companies operate under the principle of separation of ownership and management. Shareholders can be numerous and geographically diverse; it is impossible for them to be directly involved in the running of the business. To solve this problem, shareholders hire managers to act as stewards of their investment. One feature of corporate law is the presumption that managers will always work toward the best interests of the company. Shareholders assume this to be true, but they do not have a very effective method of directly observing manager behaviour. Managers know this; thus, there may be an incentive – or at least an opportunity – not to work as hard or as effectively as the shareholders would like. If the company's performance suffers because of poor manager effort, the manager can always blame outside factors or other economic conditions. In extreme cases, the manager may even be tempted to manipulate financial reports to cover up poor performance.
To give shareholders the ability to monitor manager performance, financial accounting must seek ways to provide financial performance measures. Many analytical techniques use financial accounting as a basis for the calculations. However, shareholders must have confidence not only in the accuracy of the information but also in the usefulness of the information for evaluation of management stewardship. Again, there is no perfect solution here, as the complexities and qualitative features of management activity can never be perfectly captured by numbers alone. Still, financial accounting information can help investors assess the quality of the managers they hire, which can potentially reduce the moral hazard problem.