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The Corporate Finance Institute Accounting
Uncertainty and information asymmetry
One key factor in accounting involves the transmission of financial
information to anyone who may need the information. These users
then use this accounting information to make business and investment
decisions or may choose to make no decision at all. However, in order
to make proper decisions, the information being provided needs to be
reliable and relevant. In financial reporting, we commonly encounter a
phenomenon called information asymmetry. This is a situation in which
one party has more or less information than another party.
There are two types of information asymmetry pertinent to financial
accounting theory:
Adverse Selection Moral Hazard
Hidden information Hidden action/behavior
One party has an information One party can observe the actions
advantage over another party while the other party cannot
Hidden information from the past Hidden future action
and present
Example: Buying a used car Example: Instructors assigning higher
weight on exams than homework
In an ideal world, the economy would be characterized by perfect
markets without information asymmetry. Financial statements issued
by companies could then be said to be 100% relevant and 100% reliable.
Relevant in the fact that the information will prove useful to external
users, and reliable in the fact that they will be completely free from bias.
The lesson here is that in the world we live in today, we must be aware
of the fact that no set of financial statements are 100% reliable and
100% relevant. In accounting and in today’s markets, there will always
be a trade-off between reliability and relevance.
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