ACCT 90013
Introduction
Seminar
By Stefan F. Schantl
1. Brief Recap of Introductory Lecture
2. Discussion of Problem Set Questions
Structure of Today’s Seminar
Recap of Lecture
Information Asymmetry
Information asymmetry occurs when one party (e.g., seller) to a
transaction knows more about the transaction (e.g., product quality)
than another party (e.g., buyer)
– Uninformed party is at a disadvantage
– Informed party can exploit her/his advantage
Information Asymmetry
Information
Asymmetry
Moral Hazard
Adverse
Selection
Financial Reporting: Roles
Moral Hazard
Contracting Perspective
Role of accounting reports to
steer decisions
Stewardship Role
Information Users
Adverse Selection
Capital Markets Perspective
Role of accounting reports to
value the firm
Valuation Role
Fundamental qualitative characteristics
– Relevance
– Faithful representation (aka “reliability”)
Enhancing qualitative characteristics
– Comparability
– Verifiability
– Timeliness
– Understandability
Characteristics of Useful Financial
Information
Discussions
Question: Why do we talk about used cars in an accounting class?
• Used car market is easy to understand and descriptive of a
simple problem of information asymmetry
Question 1: Adverse Selection
George Akerlof 2001 Nobel Prize in Economics
Question: How does the adverse selection problem in the used
car market work?
Information asymmetry: the seller may have better information
about the quality of a car than the buyer
Buyers set the same price for good cars and bad cars because they
are unable to distinguish them
Owner of a good car cannot receive its true
economic value-why undersell?
The result: A lemons market
The Market for “Lemons”
Question: What tools are there to mitigate the adverse selection
problem in the used car market?
Certified periodic checks on cars and service book
Inspection prior to transaction
Insurance with a clawback or warranty
– That if any problems arise within 1, 2, 3 years after
transaction the seller covers the buyer
Curbing Adverse Selection
Question: How does adverse selection in the used car market
relate to adverse selection in capital markets?
• Sellers = initial owners of firms/entrepreneurs
• Buyers = investors
• Transaction = IPO, SEO, corporate bond issuance
• The object of transaction = a stake in the future returns of the
firm
• Information asymmetry = economic viability of technologies,
product quality, proposed (de)mergers etc.
• Means to mitigate information asymmetry
• Certified periodic checks = audited financial statements
• Inspection prior to transaction = due diligence
• Insurance = securities regulation
Capital Markets
Among the worldwide largest financial institutions and thus highly competitive
in a competitive industry with many providers of different sizes
Services
– Community banking
– Wholesale banking
– Wealth and investment management
Question 2: Wells Fargo
Lower level employees engaged in fraudulent behaviour for over 14 years
– Opening of 1.5 million checking accounts in the name of unknowing
customers
– Originating 500,000 credit cards without customers’ authorization
– Creation of fake IDs, forging of signatures
– Transfer of customers’ money without consent
Main reason
– Compensation plans: Excessively high sales targets
– Inadequate oversight by senior executives
Sales Fraud
Fraud got exposed when customers noticed fees on accounts and cards they
were not aware existed
Consequences
– Impairment of thousands of customers’ credit scores
– $142 million settlement with harmed customers
– Billions in penalties incurred by Wells Fargo (and its investors) from CFPB
and SEC
– Layoff of 5300 employees
– Loss of major clients
– Reputational damage
Sales Fraud
Question: Who are the relevant parties that would be part of a moral hazard
problem in Wells Fargo?
– Parties: Lower-level employees, management
– Transaction: Supply of labor in exchange for salary
Were the actions of Wells Fargo’s employees observable?
– Likely with adequate oversight by management
Moral Hazard
Question: What are potential solutions to mitigate the moral hazard problem
in Wells Fargo?
– Change incentives: Foregoing of bonuses based on accomplishing sales
targets
Moral Hazard
Source
Who are the relevant parties that would be part of an adverse selection
problem with Wells Fargo?
– Parties: Wells Fargo management, Wells Fargo shareholders and
depositors
– Transaction: Providing capital
When does the Wells Fargo scandal constitute an adverse selection problem?
– If management knew about the actions of lower-level employees
Adverse Selection
Reality check
“Despite five years of explicit and
repeated warnings, the executive team
and the board of directors were
remarkably slow to see the breadth and
gravity of this fraud, and to address it
effectively.
According to Stumpf’s testimony, a
board committee became aware of the
fraud “at a high level” back in 2011.
Stumpf testified that he personally
became aware in 2013 when, after two
years of ineffective solutions within the
business unit, the volume of fake
accounts was still increasing.”
Adverse Selection
Source
What are potential solutions to
mitigate the adverse selection
problem in Wells Fargo?
– Observability: Centralized risk
management and control to
enhance oversight over
company’s operations
– Information: More
transparency and disclosure
– Deterrence: Deter bad
behaviors by imposing large
penalties
Adverse Selection
Source
Skim Woolworth’s 2020 Annual Report and find examples for the
fundamental qualitative characteristics
• Relevance
• Representational faithfulness (aka “reliability”)
and the enhancing qualitative characteristics
• Verifiability
• Timeliness
• Understandability
• Comparability.
Question 3: Characteristics
Accounting information should have
• Predictive value (primary) → valuation role
• Confirmatory value (secondary under IFRS) → stewardship/contracting role
Relevance
Example: Profit
Relevance (Valuation)
Example: Profit
Relevance (Valuation)
Example: Profit
Relevance (Valuation)
Underlying reasons for why profits are lower:
1. 2020: Change in leasing accounting standard (majority of leases now
accounted for as finance leases) boosting finance costs
2. 2019: Sale of petrol business for a profit
Correcting for both (assuming no change in finance costs):
1,926 (2020) vs. 1,558 (2019) = Increase of 368 m$ in operating profits
Annual Report Announcement Date: 27 August 2020
Relevance (Valuation)
Observations
• Bad news (i.e., investors
had higher expectations)
• Investors may not have
been completely aware of
the implications of the
leasing accounting
standard change
• OR: Investors did not
properly understand the
off-balance sheet
obligations
33
34
35
36
37
38
39
40
41
Example: Remuneration report-short term incentives (p. 57)
Relevance (Stewardship)
Example: Remuneration report-long term incentives (p. 59)
Relevance (Stewardship)
=


=

−
Requirements: 1. Complete, 2. neutral, 3. free from error
Reliability
Example: Restatement due to salaried team member remediation (p. 86)
“In February 2019, a review was initiated which identified that certain salaried
team members across the Group were not paid in full compliance with the
Group’s obligations under the General Retail Industry Award (GRIA). While the
review was continuing to determine the extent of the remediation required, the
Group recorded a provision of $50 million for the payment shortfalls as at 30
June 2019, which represented the best estimate at the time of the potential
exposure.”
“As at 28 June 2020, the Group has recognised total one-off costs for salaried
team remediation of $500 million of which $390 million relates to salary
payment shortfalls and $110 million to interest and other remediation costs.
These costs were recognised as a provision of $50 million in F19, an adjustment
to prior periods of $265 million, and an incremental expense of $185 million
during the current period (refer to Note 1.5 for further details).”
Reliability
Example: Restatement due to salaried team member remediation (p. 87)
Even material errors are part of accounting practice – important role of
restatements with clarifying information
Reliability
Given assumptions and data, a professional accountant would produce same
information
Example: Property, Plant, and Equipment (p. 99)
Verifiability
Given assumptions and data, a professional accountant would produce same
information
Example: Property, Plant, and Equipment (p. 99)
Verifiability
Could we verify the information based on the information that is conveyed in
the annual report?
Answer: No, this would not be practical and would impair understandability.
If we would go into the company and get the information, we would
(hopefully) be able to verify.
Example: Financial reporting impacts of COVID-19 (p. 88)
Timeliness and Understandability
Example: Financial reporting impacts of COVID-19 (p. 88)
Timeliness and Understandability
Is this information timely?
Pro: Woolworth’s shares recent developments
Con: COVID-19 substantially changed supermarket business – waiting for
earnings announcement too late?
Example: Financial reporting impacts of COVID-19 (p. 88)
Timeliness and Understandability
Is this information understandable?
Pro: Written in understandable language
Con: What is material?! No quantifications provided…
Comparability
Intertemporal comparability: Comparing a company’s financials over time
Cross-sectional comparability: Comparing two/multiple companies’ financials
at the same time
Example: Intertemporal comparability of profits and assets and liabilities
Comparability
Example: Intertemporal comparability of profits and assets and liabilities (p.
84)
Not very comparable over time…
Comparability
Read the business news article “Buttonwood: The cash bug”
dated 20 February 2020.
The IFRS Conceptual Framework states:
“Accrual accounting depicts the effects of transactions and other
events and circumstances on a reporting entity’s economic
resources and claims in the periods in which those effects occur,
even if the resulting cash receipts and payments occur in a
different period. This is important because information about a
reporting entity’s economic resources and claims and changes in
its economic resources and claims during a period provides a
better basis for assessing the entity’s past and future
performance than information solely about cash receipts and
payments during that period.”
Question 4: Accrual Accounting
Question: Why do standard setters argue that information from
accrual-based accounting enables a better assessment of the
firm’s present and continuing ability to generate cash flows than
information from cash-based accounting?
• “Lumpiness” of cash flows
• Capital expenditures:
– Arise in discrete intervals and in large amounts
• A major issue with cash flow accounting:
– Which of the cash outflows are due to past obligations and
which will lead to future cash inflows?
– Answer from accrual accounting: expenses vs. assets
Economic vs. Financial Activity
Economic vs. Financial Activity
Purchase of a
machine
Generation of
cash inflows
Question: When was value created?
A part when we purchased the machine and a
part when we sold the produced goods
successfully to customers!
Lumpiness
Economic vs. Financial Activity
2017 2018 2019
net income
cash flows
The Framework: accrual accounting enables better prediction of
future operating cash flows by recording changes in assets and
liabilities in the period in which the major economic activity
generating those assets and liabilities takes place.
Accruals: record expected cash inflows as assets and revenues, and
expected cash outflows as liabilities and expenses, before the cash
itself is received or paid.
By smoothing out lumpy operating cash flows and recording their
expected amounts in the financial statements on a timely basis,
accruals enable a better prediction of cash flows and reflect better
the firm’s economic performance.
Economic vs. Financial Activity
Relevance vs. reliability of cash-based and accrual-
based accounting: The common belief!
Economic vs. Financial Activity
Cash-based Accrual-based
Relevance
Reliability
low
very high varying>
very high<
Question: What characteristics does financial accounting
information need if it is to be useful to the primary users?
• The basic characteristics are that financial statement information
should be capable of making a difference in the decisions made
by users
• To maximize usefulness, financial statement decisions trade-off
between characteristics of relevance and reliability
Information Characteristics
Concluding
Remarks
Adverse selection and moral hazard problems are
widespread in everyday life and business
Accounting information can help mitigate these
problems
Accounting information has a valuation role and a
stewardship role and distinct qualitative characteristics
Accrual-based accounting captures economics of a firm
better
In a Nutshell
Lecture Week and Topic Due Tuesdays 11.59AM (noon)
Week 3: Recognition 21 March
Week 6: Equity Valuation 18 April
Week 8: Compensation Contracting 2 May
Week 11: Disclosure 23 May
49
Engagement Assignments
1. Watch the lecture recording
2. Pick a specific idea/observation/argument from the lecture
3. Find a high-quality business press article on a firm, fund, or professional
body
4. Write an essay outlining the specific idea/observation/argument (in your
own words), summarizing the main issues in the article, and reflecting on
how these issues relate to the idea/observation/argument
5. Submit pdf
Detailed guidelines, a sample essay, and a marking guide are provided via LMS.
Ask questions
• via email (stefan.schantl@unimelb.edu.au)
• via the discussion board on LMS or
• during consultations (see LMS)
Conclusion