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. In such circumstances, it will usually be appropriate to use the information that is the most relevant of whichever information is reliable.
That is because a delay in providing information can make it out-of-date, which will affect its relevance, yet reporting on transactions and other events before all the uncertainties involved are resolved may affect the information's reliability. On the other hand, leaving information out of the financial statements because of reliability concerns may affect the completeness, and therefore reliability, of the information that is provided.
Although financial information should generally be made available as soon as it is reliable and entities should do all that they reasonably can to speed up the process necessary to make information reliable, financial information should not be provided until it is reliable. This tension exists only where there is uncertainty, because it is only then that prudence needs to be exercised.
When there is uncertainty, the competing demands of neutrality and prudence are reconciled by finding a balance that ensures that the deliberate and systematic understatement of gains and assets and overstatement of losses and liabilities do not occur. However, information that is relevant and reliable should not be excluded from the financial statements simply because it is too difficult for some users to understand.
The maximum number of documents that can be ed at once is So your request will be limited to the first documents. To make your more manageable, we have automatically split your selection into separate batches of up to 25 documents. Skip to main content. Relevance 3. Footnote Choosing between alternative measurement bases is considered in Chapter 6. You are attempting to documents. The reliable system reports a more precise signal, but with a one period delay.
Accounting information is contractible only if it is reported within the two-period horizon of the game. Accordingly, accounting information produced in the second period becomes un contractible with the reliable system in place. Non-accounting information needs to be used for contracting to provide any second period incentives at all. We derive optimal compensation contracts in a full and in a limited commitment setting. With full commitment, the reliable system trades-off more precise first and less precise second-period contractible information, as compared to the relevant system.
If the reduction of noise in the accounting signals is strong and the distortion in the non-accounting measure is weak, the reliable system is preferred. With limited commitment we identify a similar trade-off if intertemporal correlation of the signals is negative. If it is positive, this trade-off might reverse: The reliable system is possibly preferred if noise reduction is small and the non-accounting measure is heavily distorted.
Noisiness in performance measures then serves as a commitment device. It reduces otherwise overly high powered incentives and thus benefits the principal. In this paper we juxtapose two well-known accounting concepts: relevance and reliability.
Relevance requires that accounting information is capable of affecting decisions made by its users. This relates to timeliness, comparability, and understandability. Reliability refers to undistorted complete information that is free from errors. Verifiability and credibility are important issues here. Unfortunately, both concepts are not necessarily consistent.
At least for some reporting items the need to ensure reliability of information may result in delayed publication, which in turn reduces relevance see, e. For such items, users as well as standard setting bodies need to stress either one or the other: relevance or reliability. Contemplating recent developments in accounting standard setting and practice, an increased number of firms seems to lean towards relevance rather than reliability.
Footnote 1 Multiple factors drive this trend. This includes fair value accounting, revaluation of assets, and revenue recognition based on percentage of completion. Footnote 3 Finally, local standard setters, e. Footnote 4. Whether a focus on relevance rather than reliability renders accounting information more useful, however, is far from obvious. To tackle this question at all, we need to acknowledge that accounting information is used for different purposes, in particular valuation and contracting purposes.
Since an accounting system that is preferred for valuation is not necessarily preferred for contracting and v. Footnote 5. 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. The inefficiency results in a loss in welfare that can be avoided in special cases only. Indjejikian and Nanda and Christensen et al. Footnote 8 This result directly extends to our paper. Second, our results show some similarities to previous papers on limited commitment even though they are derived from a different setting.
In particular, Indjejikian and Nanda show that aggregation of performance signals may be valuable under limited commitment. In contrast, in our setting, there is no information aggregation. Rather, the differences in noisiness of first- and second-period contractible information and the different timeliness of this information is crucial.
We consider a two-period LEN-model of repeated moral hazard. Footnote 9 In fact, throughout this paper we generally restrict contractability to measures that become observable and verifiable within the two-period horizon of our game.
Footnote We consider two alternative accounting systems. Reporting from both systems is depicted in Fig. Both systems differ with respect to the timing of reporting and the precision of the reported items.
Once a piece of information is reported in the financial statements, it becomes contractible. The second system can be regarded as a more conservative accounting system that requires a higher degree of reliability in order to report a certain type of information. Note, however, that the information produced under both accounting systems is identical. In the latter case we assume that once a reporting system is implemented, it cannot be changed throughout the game.
To be able to control second-period effort at all, the firm needs to contract on an alternative non-accounting measure. We assume that such a measure exists. This is an admittedly strong assumption, but serves our needs and allows us to keep the model tractable. To account for alternative assumptions, in Sect. The alternative measure is defined by. It is uncorrelated to all other random variables of the model.
We restrict attention to incentive contracts that are linear in the performance measures. This assumption combined with exponential utility and normality leads to the well-known LEN-specification. The principal is risk neutral. In this section we characterize the full commitment setting.
Both contracting parties can commit to a long-term two-period contract that cannot be renegotiated after it has been signed. The risk-neutral principal maximizes her net return subject to two conditions.
The individual rationality constraint IR is binding at the optimum and ensures that the agent accepts the contract. Further, the agent chooses his actions in order to maximize personal welfare.
This is reflected in the incentive compatibility constraint IC. In Fig. In this section we relax our previous assumption that the principal and the agent can commit to a long-term two-period incentive contract. We rather assume that parties can only agree on short-term, one-period, contracts. To sustain an equilibrium of the game we follow Christensen et al. Note that the equilibrium outcome of a sequence of two short-term contracts, in terms of induced actions and surplus, is identical to the outcome under an optimal renegotiation-proof long-term contract see Christensen et al.
We use this equivalence result in our paper. Even though short-term contracts are more descriptive in many real-world settings, working with a renegotiation-proof contract allows to contrast full and limited commitment more easily.
Thus, we proceed considering a renegotiation-proof long-term contract in this section. Christensen et al. In other words, the optimization problem to be considered under limited commitment is identical to the one from the full commitment setting except that sequentially optimal second-period incentive rates apply.
Importantly, there is a conflict between ex ante efficient and ex post efficient contracting decisions. At the end of the first period, however, the first-period effort has already been performed and, thus, becomes irrelevant when determining second period contracting parameters.
Particularly, at the end of the first period the principal considers solely the variance of the second-period compensation given the information obtained in the first period. The informativeness principle holds true under limited commitment, too, but under the requirement that signals and their incentive weights have to be chosen sequentially optimal. In addition to the trade-off between systems identified under full commitment, the effect both accounting systems have on sequentially optimal second-period effort values determines which one is preferred.
As stated in the previous section, second-period incentive rates are to be chosen sequentially optimal with limited commitment. Thus, in the first step, we determine sequentially optimal incentive rates under both accounting systems.
The corresponding program is given by. Given that the sequentially optimal incentive weights have been determined, the overall solution under limited commitment will be found by substituting the sequentially optimal incentive rates into the full commitment programs from Sect.
Accordingly, both incentive rates must be chosen sequentially optimal, i. Using an incentive rate with the opposite sign of the correlation coefficient triggers the hedge effect. Recall from the analysis of the full commitment setting that positively correlated noise ceteris paribus leads to low optimal effort incentives, while negative correlation results in an intertemporal insurance effect such that high effort incentives will be set.
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