Relevance, Reliability, and Information Asymmetry in Accounting

Relevance and Reliability in Accounting Information

To be useful, information needs to be relevant and reliable. Relevance and reliability are of crucial importance, but, unfortunately, they are not always compatible. Hence, we have to trade-off between them.

Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable. If we wait while the information gains reliability, its relevance is lost. After the balance sheet date, during the time when an audit is carried out, it becomes clear which debts were realized and which were not, hence it improves the reliability of the bad debts estimate, but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.

The Importance of Relevance vs. Reliability

It is difficult, if not impossible, to always have equally high degrees of relevance, reliability, and comparability in accounting information. What to do? This is where the Full Disclosure principle comes into play. If you know how an information item was developed and what its limitations are, you can still use it, even if it is not "perfect in every way".

Adverse Consequences of Information Asymmetry

Information Asymmetry can lead to two main problems:

1. Adverse selection: Immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not in optimal health may be more inclined to purchase life insurance than someone who feels fine.
2. Moral Hazard: Immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance.

Positive and Negative Consequences of Standardized Accounting

Same transactions = same accounting. BUT, uniformity may limit information on genuine business differences. Risk: rigid standards lead to restructuring of transactions to meet accounting objectives.

Accounting standardization limits flexibility (FASB and IASB).

• Uniform standards limit the possibility to account for identical economic transactions differently across firms and time.
• They increase credibility, but also reduce flexibility, which may have adverse economic consequences.

The Value of Flexibility in Accounting

Flexibility in accounting is beneficial. Depending on the firm and its business, there will be more or less flexibility.

In a pharmaceutical company, there is flexibility on how to account for research costs. All firms have flexibility over amortization method, inventory method, classification of financial instruments, etc. The less flexibility there is, the less useful accounting information will be to understand the business, but also, there will be less manipulation.

Moral Hazard in Information Economics

In information economics, one of the consequences of information asymmetry is moral hazard on the side of those preparing the information.

Moral Hazard Explained

Moral Hazard: The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities, or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Example of Moral Hazard

If your bike is not insured you will take great care to avoid it getting stolen. If it becomes insured for its value then if it gets stolen you do not really lose out. Therefore, you have less incentive to protect against theft.