The Two Roles of Financial Accounting

At the beginning of this chapter, the informational role of financial accounting was emphasized. From this perspective, both the FASB and corporate managers select accounting principles that yield the most useful information. However, as shown above, accounting principles also have economic consequences. These consequences arise in several ways. First, accounting serves as a basis for contracting. That is, some contracts (compensation plans and debt contracts) are based on accounting numbers. Because different accounting principles result in different accounting numbers, the choice of accounting principles can modify the terms of these contracts. Second, accounting principles may affect a firm’s exposure to political costs, such as taxes and regulation. Finally, the costs to implement different accounting principles vary. Some accounting principles are quite complex and costly, whereas others are rather simple.

For all these reasons, accounting principles can affect the wealth of a firm and its managers. The managers have an obvious incentive to select the principles that increase their wealth. Such an incentive may conflict with the notion that managers select accounting principles to provide useful information. This implies that financial statement readers must carefully evaluate the accounting principles used by a firm. The selection may not result in the most useful financial statement information. In subsequent chapters, managers’ selections of accounting principles will be examined from both informational and economic incentive perspectives.

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