Corporatefinanceinstitute com 1 The Corporate Finance Institute Accounting For more eBooks please visit

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:
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.
Adverse Selection
Moral Hazard
Hidden information
Hidden action/behavior
One party has an information 
advantage over another party
One party can observe the actions 
while the other party cannot
Hidden information from the past 
and present
Hidden future action
Example: Buying a used car
Example: Instructors assigning higher 
weight on exams than homework

---

corporatefinanceinstitute.com
28
The Corporate Finance Institute
Accounting