Accounting Question

The purpose of this assignment is to apply concepts and theories discussed in the course to

practical issues.

You will be required to prepare a research paper The paper should include the theories or concepts discussed in the course. For example, you may relate theories discussed in class which either confirm or contradict or expand upon the material you find in the public domain. The total length for the paper should not exceed 4 pages doublespaced, minimum 11-point font.

Grading will be based on the following criteria:

 Identification of relevant theories

 Understanding of theory

 Appropriate application of theory to the company

 Conclusions

There is not set amount of theories that you need to include in your paper; however, you are required at a minimum to apply at least one theory from the material covered pre-midterm (Chapters 1 – 5), and at least one theory from the material covered post midterm (Chapters 6 – 11) Entity selected for Fall 2023 term: Walmart Inc. NYSE:WMT

Materials to use: you may use any information on the entity that is in the public domain, your text book, your notes from class. Hint: check out the company’s Investor Relations section of the company’s website Walmart Investor Relations – Financials Investor Relations > Financials. I suggest that you refer to the most recent annual report, which is included in their 2023 Annual Report (also referred to as 10-K Report); however you are not restricted to this information.

Financial Accounting Theory
Eighth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial reporting
environment in a market economy
Copyright © 2015 Pearson Canada Inc.
1-1
Chapter 1
Introduction
Copyright © 2015 Pearson Canada Inc.
1-2
1.2 Some Historical Perspective
• Early development
• Great depression of 1930s reinforced historical cost accounting
• Alternatives to historical cost
• Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
• Mixed measurement model
Copyright © 2015 Pearson Canada Inc.
1-3
1.2 Collapse of the Stock Market Boom of Late
1990s
• Enron
• WorldCom
• Collapse of public confidence in capital markets
• Effects on financial reporting
• Increased regulation and corporate governance
• Sarbanes-Oxley Act
• Tighten rules re off-balance sheet entities
Copyright © 2015 Pearson Canada Inc.
1-4
1.3 Market Meltdowns, 2007-2008
• Terminology
• Securitization
• Financial instruments
• Asset-backed securities
• Collateralized debt obligations
• Asset-backed commercial paper
• Credit default swaps
• Expected loss notes
• Liquidity risk
• Liquidity pricing
• Counterparty risk
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-5
Market Meltdowns, 2007-2008 (continued)
• Financial accounting issues leading up to the market meltdowns
• Fair value accounting for financial instruments
• Liquidity pricing
• Fair value less than value-in-use
• Severe criticism of fair value accounting
• High leverage of financial institutions
• Off-balance sheet liabilities
• Use of expected loss notes to avoid consolidation of structured investment vehicles
• Was disclosure of off-balance sheet liabilities adequate?
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-6
Market Meltdowns, 2007-2008 (continued)
• Response of standard setters
• Stopgap measures in response to government pressure
• Fair value accounting guidance during liquidity pricing
• Increased use of internal estimates (value-in-use)
• Increased use of cost-based valuation
• New accounting standards
• Consolidation
• Derecognition
• Increased disclosure
• Response of standard setters considered in greater detail in Chapter 7
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-7
Market Meltdowns, 2007-2008 (continued)
• Response of other regulators
• Increased disclosure of managerial compensation
• Move transactions to security exchanges and clearing houses from shadow
banking system
• Increased capital reserves for financial institutions
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-8
Market Meltdowns, 2007-2008 (continued)
• Implications for accountants
• Need for transparency
• Value-in-use v. fair value accounting
• Full disclosure of off-balance sheet activities
• New accounting standards to help prevent future abuses?
Copyright © 2015 Pearson Canada Inc.
1-9
1.4 Efficient Contracting
• A different view of the purpose of financial reporting
than the current value orientation of standard setters
• Basic characteristics of efficient contracting view
• Emphasis on contracts. A firm can be defined by the
contracts it enters into
• E.g., debt contracts, compensation contracts…
• Emphasis on corporate governance
• Those firm policies that align the firm’s activities with the
interests of investors and society
Copyright © 2015 Pearson Canada Inc.
1 – 10
Efficient Contracts
• For good corporate governance, contracts should be
efficient
• Contracting parties must trust each other
• E.g., a firm can generate lenders’ trust by incorporating a covenant
into a borrowing contract. Covenants are a cost of contracting
• Lenders reward firm with lower interest rate. This is a benefit of
contracting
• An efficient contract is the best tradeoff between contracting
costs and benefits
>> Continued
Copyright © 2015 Pearson Canada Inc.
1 – 11
Efficient Contracts (continued)
• Efficient contracting emphasizes manager stewardship
• Compensation contracts should motivate managers to work in the best
interests of firm owners
• An efficient compensation contract does so at lowest compensation cost.
Copyright © 2015 Pearson Canada Inc.
1 – 12
Accounting Policy Implications of Efficient
Contracting
• Financial reporting should be reliable
• Reliable reporting generates investor trust
• Financial reporting should be conservative
• E.g., write assets down if current value less than book value. But, write
assets up only if can be done reliably.
• Rationale: encourages stewardship
• Prevents managers from increasing reputation and compensation by increasing
reported profits through non-reliable asset writeups
• These policies often conflict with current value accounting
• Current value accounting sacrifices reliability for relevance
Copyright © 2015 Pearson Canada Inc.
1 – 13
1.5 Ethical Behaviour by Accountants/Auditors
• Was accountant/auditor behaviour leading up to Enron, WorldCom,
and 2007-2008 market meltdowns episodes ethical?
• Serve the client (short run view) or serve society (long run view)?
• Why would you serve the client or serve society in similar
circumstances?
• Ethical principles require you to do the right thing
• Long run interests of profession require you to do the right thing
• But mindsets differ
Copyright © 2015 Pearson Canada Inc.
1 – 14
1.6 Rules-Based v. Principles-Based Accounting
Standards
• Do rules-based accounting standards work?
• Enron, WorldCom
• Expected loss notes
• Will more rules in new accounting standards work to prevent
abuse?
• Principles-based standards
• Important role of Conceptual Framework
• Relies on ethical accounting/auditing profession
Copyright © 2015 Pearson Canada Inc.
1 – 15
1.7 The Complexity of Information
• Individual reactions to same information may differ
• Reporting to investors v. reporting on stewardship complicates
reporting
• Current value v. efficient contracting views
• Information also affects how well markets work
Copyright © 2015 Pearson Canada Inc.
1 – 16
1.9 Information Asymmetry
• Adverse selection
• One or more parties to a business transaction have an information advantage
over other parties
• Affects operation of capital markets
• Moral hazard
• One of more parties to a contract can observe their actions but other parties
cannot
• Affects effectiveness of contracts
• Both types of information asymmetry affect efficient working of the
economy
9/8/2021
Copyright © 2015 Pearson Canada Inc.
1 – 17
Information Asymmetry (continued)
• Role of accounting information to control adverse selection
• Convert inside information into outside
• Supply useful information to investors
• Role of accounting information to control moral hazard
• Control manager shirking
• Improve corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 18
1.10 The Fundamental Problem Of Financial
Accounting Theory
• The best measure of net income to control adverse selection not the same
as the best measure to motivate manager performance
• Investors want information about future firm performance
• Current value accounting?
• Good corporate governance requires that managers “work hard”
• Does more reliable information and conservatism better reflect manager effort than current
value information?
Copyright © 2015 Pearson Canada Inc.
1 – 19
1.11 Regulation as a Reaction to the
Fundamental Problem of Standard Setting
• Standard setting is a form of regulation
• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces subject to failure
• Adverse selection
• Moral hazard
• Regulation steps in to try to correct market failures
• Regulation is costly
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 20
Regulation as a Reaction to the Fundamental
Problem of Standard Setting (continued)
• Standard setting mediates between conflicting interests of investors
and managers
• Investors want lots of useful information
• Managers may object to releasing all the information that investors desire
• Due process in standard setting mediates between investors’ and managers’
interests
• Representation of diverse constituencies
• Super-majority voting
• Exposure drafts
Copyright © 2015 Pearson Canada Inc.
1 – 21
1.12.5 The Process of Standard Setting
• Structure
• IASB
• International standards
• FASB
• United States standards
• Securities commissions
• Role in enforcing firms to follow standards
• May set standards themselves
• Why do they delegate most standard setting?
Copyright © 2015 Pearson Canada Inc.
1 – 22
Theories Relevant to Financial Accounting
• The rational investor
• A model of how an investor may use new information to revise beliefs about future
firm performance
• Rationality holds on average, not necessarily for each individual
• Efficient securities markets
• Efficiency is a matter of degree
• Share prices reasonably reflect all publicly available information
• Efficiency is relative to a stock of information
• Role of financial reporting in improving/expanding the stock of information
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 23
Theories Relevant to Financial Accounting
(continued)
• Behavioural theories
• Investors do not use all the information in financial statements → securi es
markets not fully efficient
• Agency theory
• Efficient contracts to motivate manager performance (stewardship) and
achieve good corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 24
Chapter 2 – Part 2
Present Value Accounting in the
real world
• The real world is not characterized by ideal
conditions; however, there are real world
examples of present value accounting.
• Consider Reserve Recognition Accounting
(RRA) for oil and gas companies.
• RRA provide sufficient information to prepare
a present value based income statement.
Reserve Recognition Accounting
• RRA requires supplemental disclosure of
present value, discounted at 10%, of a firm’s
proven oil and gas reserves.
– No IASB standard
– NI 51-101 (in Canada) requires supplemental
disclosure but not RRA
– ASC 932 (in the US) requires RRA disclosures
Reserve Recognition Accounting
• ASC 932
– Requires companies to provide values of proven reserves
based on discounted expected future cash flows at a fixed
rate of 10%.
– Advantages:
• Historic cost of these reserves may have little predictive value
• Avoids problems of full cost vs. successful efforts
– Intent: to provide investors with more relevant information
about future cash flows than that contained in
conventional historical cost-based financial statements.
The mechanics of RRA
• These things affect the • These things are shifts
between the reserve
reserve “asset” and
“asset” and other
total assets:
assets:
– Change in prices, costs,
timing, estimates,
taxes, quantities
– Extensions and
discoveries and
purchases of reserves
in place
– Accretion of discount
– Sales
– Development costs
incurred
Reserve Recognition Accounting
• To address concerns of subjectivity and uncertainty,
companies:
– Only look at proven reserves
– Use a prescribed discount rate of 10%
– Use prices and costs in effect at balance sheet date
• Nevertheless, substantial estimations and revisions
are necessary regarding:
– Quantities of reserves
– Timing of cash flows
– Revisions to prices and costs
Reserve Recognition Accounting
• Results in asset values and income that:
– Fluctuate substantially
– Are very different from historic cost counterparts
• Mixed evidence whether RRA is informative or not
(covered in Chapter 5)
Reserve Recognition Accounting
• Do oil and gas firms operate under ideal
conditions?
– What is the impact on present value accounting
under RRA requirements?
Reserve Recognition Accounting
• Without ideal conditions, complete relevance
and reliability are no longer jointly attainable.
One must be traded off against the other.
Why do I have to learn this?
• The mechanics of RRA are what accountants have to
do in general if we adopt asset valuations based on
present values (=revenue recognition at different
point). Accounting for asset retirement obligations
works similarly to this, for example
• Accounting also changes if we adopt asset valuations
based on market values
Current Value vs. Historical Costs
• we have seen that ideal conditions do not
hold resulting in volatility and reliability issues
(consider RRA discussion)
• Will current value accounting (eg. present
value accounting) replace historical cost
accounting?
Current Value vs. Historical Costs
• Relevance vs. Reliability
• Revenue Recognition
• Recognition Lag
• Matching of Costs and Revenues
Current Value vs. Historical Costs
• Relevance vs. Reliability
– Historical cost = reliable, not relevant
– PV = relevant, not reliable (unless ideal conditions
hold)
Current Value vs. Historical Costs
• Revenue recognition
– revenue is recognized earlier under current value
accounting vs. historical cost accounting
• Recognition Lag
– the extent to which timing of revenue recognition
lags behind changes in real economic value.
Current Value vs. Historical Costs
• Matching of costs and revenues
– matching is primarily associated with historical
cost accounting
– matching is accomplished by the use of accruals
(accounts receivable, accounts payable, allowance
for bad debts, amortization, etc.)
– Little matching under current value accounting
• What is the impact of matching on reliability
of historical cost financial accounting? …think
estimates…
Current Value vs. Historical Costs
• There are often several ways of accounting for
the same thing.
• Lack of well defined concept of net income
(should it be based on changes in current
values of assets and liabilities or on historical
costs and accruals?)
– Requires a great deal of judgement to value assets
and measure income … this is why we have an
accounting profession
Current Value vs. Historical Costs
• As there is value in both approaches to
financial accounting, the profession has
turned their efforts to making financial
statements more useful.
• Chapter 3 – The Decision Usefulness Approach
to Financial Reporting
Recap – Ideal Conditions
Recap – Ideal Conditions
• Ch. 2. Q7 – Explain why, under ideal
conditions, there is no need to make
estimates when calculating expected present
values?
Recap – Ideal Conditions
• Ch.2. Q10 – Explain why, under non-ideal
conditions, it is necessary to trade off
between relevance and reliability when
estimating future cash flows. Define relevance
and reliability as part of your answer.
Admin items
Recap Chapter 1
Chapter 2
Admin
• Slides
– before class I will post a PDF document of the
slides with certain slides removed for discussion
purposes
– after each class I will provide copies of the slides
used with my speaking notes
• Solutions to text book problems – at the end
of each chapter I will provide solutions to the
textbook problems – there are no questions in
Chapter 1
Admin
• What is the best way to study for this class?
– Read the chapter before class
– Attempt some of the problems that are at the end
of each chapter
– Read business section of newspaper/news
websites and relate to what has been covered in
class
Recap – Chapter 1
Recap – Chapter 1
• What is the “fundamental problem” of
financial accounting theory?
Recap – Chapter 1 cont.
• The best measure of net income to control
adverse selection not the same as the best
measure to motivate manager performance
– Investors want information about future firm
performance
• Current value accounting?
– Good corporate governance requires that
managers “work hard”
• Does more reliable information and conservatism
better reflect manager effort than current value
information?
Recap – Chapter 1 cont.
• What is the reaction to the fundamental
problem?
Recap – Chapter 1 cont.
• Reaction to the fundamental problem is
Standard setting:
– Accounting guidance from IASB, FASB, AcSB, etc.
– Regulation from securities commissions (SEC, OSC)
Recap – Chapter 1 cont.
• The market crash of 1929 reinforced historical
cost accounting, what are some alternatives to
historical cost accounting?
Recap – Chapter 1 cont.
• Alternatives to historical cost
– Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
– Mixed measurement model
Chapter 2
Accounting Under Ideal Conditions
Accounting under ideal conditions
• In a perfect world, accounting information would:
– be relevant;
– be a faithful representation of “reality”
– be understandable;
– be verifiable;
– be timely; and
– facilitate comparisons.
Under what conditions would this be achieved?
Accounting under ideal conditions
• Assume you have a situation where:
– the future cash flows of the firm are publicly known with
certainty (=$150 at end of year 1, $150 at end of year 2)
– the interest rate for the firm’s cash flows is publicly
known with certainty=10%
• Present value of the asset = $260.33
• =($150/1.10) + ($150/1.102) = $136.36 + $123.97
• Who would be willing to pay more for this asset?
• Who would be willing to sell this asset for less?
Accounting under ideal conditions
Balance Sheet of P.V. Ltd at time 0:
Capital asset
$ 260.33
Shareholders’ Equity $260.33
Accounting under ideal conditions
For period 1, the income statement shows:
Revenue
$150.00
Amortization Expense
123.97
Net income (260.33*10%)
26.03
The amortization expense represents the decline in
the asset’s service-rendering potential:
Service rendering potential, time 0:
$260.33
Service rendering potential, time 1:
136.36
Decline
123.97
Accounting under ideal conditions
Balance Sheet of P.V. Ltd at time 1:
Cash
$ 150.00
Capital asset 260.33
S/H equity, to $260.33
Less amort. 123.97
+ net income 26.03
$ 286.36
$ 286.36
• If there were only one share, it would be worth
$286.36
Accounting under ideal conditions
• For period 2, the income statement shows:
Revenue
$150.00
Interest income
15.00
Amortization Expense
136.36
Net income
28.64
The amortization expense represents the decline in the
asset’s service-rendering potential:
Service rendering potential, time 1:
$ 136.36
Service rendering potential, time 2:
0
Decline
136.36
Accounting under ideal conditions
• Balance Sheet of P.V. Ltd at time 2:
Cash
$ 315.00
Capital asset 136.36 S/H equity, t1 $ 286.36
Less amort.
136.36 + net income
28.64
$ 315.00
$ 315.00
• Is this information inclusive of the desirable
characteristics of relevance, representational
faithfulness (reliability), understandability,
verifiability, timely, and comparable?
Accounting under ideal conditions
• Why is the firm’s net income in the previous
example not considered in the valuation of
the firm?
– future cash flows are known and can be discounted to provide balance
sheet valuations. Net income is then perfectly predictable, being the
opening balance sheet multiplied by the interest rate.
– $260.33 x 10% = $26.03
A bit of help on the terminology
• Info is a “Faithful representation” of the realworld economic phenomena if the sub-criteria
of neutrality, completeness and freedom from
error are met
“Confirmatory Value” is the ability to confirm or
correct previous evaluations
• Verifiability implies that different knowledgeable
and independent observers would reach general
consensus, although not necessarily complete
agreement, either:
a. That the information represents the economic
phenomena that it purports to represent without
material error or bias (by direct verification); or
b. That the chosen recognition or measurement method
has been applied without material error or bias (by
indirect verification).
• Neutrality is the absence of bias intended to attain
a predetermined result or to induce a particular
behavior
Ideal conditions with uncertainty: Q17
• We now consider a situation with the following conditions:
– a given fixed interest rate (3%) for firm’s cash flows and
borrowings
– a complete and publicly known set of states
– asset yields publicly known state probabilities
Probability
annual cash flow
.30 (no snow)
$300
.70 (snow)
$900
– publicly observable state realization
– Equipment financed by bank loan of $500 and remainder by
issuing common shares
– Pays a dividend of $50 at end of each year of operation
• What is the present value of North Ltd.’s asset on August 1,
2015 (time 0) and July 31, 2016 (end of year 1)?
Q17 cont.
What is the present value of North Ltd.’s asset on August
1, 2015 (time 0) and July 31, 2016 (end of year 1)?
Q17 cont.
• What items would appear on North Ltd.’s
balance sheet?
Q17 cont.
Q17 cont.
• How do we calculate year one net income?
Q17 cont.
For 2016, with snowy (good) state realization, the income
statement shows:
Revenue
$900.00
Amortization expense
678.67
Interest expense
15.00
Net income
$206.33
The amortization expense represents the decline in the
asset’s service-rendering potential:
Service rendering potential, time 0:
$1,377.70
Service rendering potential, end of yr. 1:
699.03
Decline
$ 678.67
Q17 cont.
Alternatively, for 2016, with snowy (good) state
realization, the income statement could show:
Accretion of discount ($1,377.70 x .03) $ 41.33
Interest accrued on bank loan ($500x.03) (15.00)
Abnormal earnings (actual revenues of
$900 less expected revenues of $720)
180.00
Net income
$206.33
• Expected revenues (based on probabilities of
outcomes) of $720
= (.7 x $900) + (.3 x $300) = $630 + $90 = $720
Q17 cont.
• What would the net income be under
historical cost accounting?
• Assumptions:
– North Ltd. paid the present value of the
equipment at time 0 (calculated earlier)
– The equipment is amortized over 2 years on a
straight line basis
Q17 cont.
• Under the more realistic assumption that ideal
conditions do not hold, which measure of net
income, present value basis or historical cost
basis, is most relevant? Which is most
reliable? Why?
Don’t get lost in the mechanics:
• Investment on B/S = PV of expected future cash
flows
• Expected future cash flows = sum of (cash flow of
each realization * its probability)
Traditional Format income statement:
• Amortization = change in PV of asset
• Cash on hand earns interest
Alternative format income statement
• Opening asset value*discount
rate=accretion=expected income
• Difference between actual realizations and
expected = unexpected income
Financial Accounting Theory
Eighth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial reporting
environment in a market economy
Copyright © 2015 Pearson Canada Inc.
1-1
Chapter 1
Introduction
Copyright © 2015 Pearson Canada Inc.
1-2
1.2 Some Historical Perspective
• Early development
• Great depression of 1930s reinforced historical cost accounting
• Alternatives to historical cost
• Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
• Mixed measurement model
Copyright © 2015 Pearson Canada Inc.
1-3
1.2 Collapse of the Stock Market Boom of Late
1990s
• Enron
• WorldCom
• Collapse of public confidence in capital markets
• Effects on financial reporting
• Increased regulation and corporate governance
• Sarbanes-Oxley Act
• Tighten rules re off-balance sheet entities
Copyright © 2015 Pearson Canada Inc.
1-4
1.3 Market Meltdowns, 2007-2008
• Terminology
• Securitization
• Financial instruments
• Asset-backed securities
• Collateralized debt obligations
• Asset-backed commercial paper
• Credit default swaps
• Expected loss notes
• Liquidity risk
• Liquidity pricing
• Counterparty risk
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-5
Market Meltdowns, 2007-2008 (continued)
• Financial accounting issues leading up to the market meltdowns
• Fair value accounting for financial instruments
• Liquidity pricing
• Fair value less than value-in-use
• Severe criticism of fair value accounting
• High leverage of financial institutions
• Off-balance sheet liabilities
• Use of expected loss notes to avoid consolidation of structured investment vehicles
• Was disclosure of off-balance sheet liabilities adequate?
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-6
Market Meltdowns, 2007-2008 (continued)
• Response of standard setters
• Stopgap measures in response to government pressure
• Fair value accounting guidance during liquidity pricing
• Increased use of internal estimates (value-in-use)
• Increased use of cost-based valuation
• New accounting standards
• Consolidation
• Derecognition
• Increased disclosure
• Response of standard setters considered in greater detail in Chapter 7
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-7
Market Meltdowns, 2007-2008 (continued)
• Response of other regulators
• Increased disclosure of managerial compensation
• Move transactions to security exchanges and clearing houses from shadow
banking system
• Increased capital reserves for financial institutions
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-8
Market Meltdowns, 2007-2008 (continued)
• Implications for accountants
• Need for transparency
• Value-in-use v. fair value accounting
• Full disclosure of off-balance sheet activities
• New accounting standards to help prevent future abuses?
Copyright © 2015 Pearson Canada Inc.
1-9
1.4 Efficient Contracting
• A different view of the purpose of financial reporting
than the current value orientation of standard setters
• Basic characteristics of efficient contracting view
• Emphasis on contracts. A firm can be defined by the
contracts it enters into
• E.g., debt contracts, compensation contracts…
• Emphasis on corporate governance
• Those firm policies that align the firm’s activities with the
interests of investors and society
Copyright © 2015 Pearson Canada Inc.
1 – 10
Efficient Contracts
• For good corporate governance, contracts should be
efficient
• Contracting parties must trust each other
• E.g., a firm can generate lenders’ trust by incorporating a covenant
into a borrowing contract. Covenants are a cost of contracting
• Lenders reward firm with lower interest rate. This is a benefit of
contracting
• An efficient contract is the best tradeoff between contracting
costs and benefits
>> Continued
Copyright © 2015 Pearson Canada Inc.
1 – 11
Efficient Contracts (continued)
• Efficient contracting emphasizes manager stewardship
• Compensation contracts should motivate managers to work in the best
interests of firm owners
• An efficient compensation contract does so at lowest compensation cost.
Copyright © 2015 Pearson Canada Inc.
1 – 12
Accounting Policy Implications of Efficient
Contracting
• Financial reporting should be reliable
• Reliable reporting generates investor trust
• Financial reporting should be conservative
• E.g., write assets down if current value less than book value. But, write
assets up only if can be done reliably.
• Rationale: encourages stewardship
• Prevents managers from increasing reputation and compensation by increasing
reported profits through non-reliable asset writeups
• These policies often conflict with current value accounting
• Current value accounting sacrifices reliability for relevance
Copyright © 2015 Pearson Canada Inc.
1 – 13
1.5 Ethical Behaviour by Accountants/Auditors
• Was accountant/auditor behaviour leading up to Enron, WorldCom,
and 2007-2008 market meltdowns episodes ethical?
• Serve the client (short run view) or serve society (long run view)?
• Why would you serve the client or serve society in similar
circumstances?
• Ethical principles require you to do the right thing
• Long run interests of profession require you to do the right thing
• But mindsets differ
Copyright © 2015 Pearson Canada Inc.
1 – 14
1.6 Rules-Based v. Principles-Based Accounting
Standards
• Do rules-based accounting standards work?
• Enron, WorldCom
• Expected loss notes
• Will more rules in new accounting standards work to prevent
abuse?
• Principles-based standards
• Important role of Conceptual Framework
• Relies on ethical accounting/auditing profession
Copyright © 2015 Pearson Canada Inc.
1 – 15
1.7 The Complexity of Information
• Individual reactions to same information may differ
• Reporting to investors v. reporting on stewardship complicates
reporting
• Current value v. efficient contracting views
• Information also affects how well markets work
Copyright © 2015 Pearson Canada Inc.
1 – 16
1.9 Information Asymmetry
• Adverse selection
• One or more parties to a business transaction have an information advantage
over other parties
• Affects operation of capital markets
• Moral hazard
• One of more parties to a contract can observe their actions but other parties
cannot
• Affects effectiveness of contracts
• Both types of information asymmetry affect efficient working of the
economy
9/8/2021
Copyright © 2015 Pearson Canada Inc.
1 – 17
Information Asymmetry (continued)
• Role of accounting information to control adverse selection
• Convert inside information into outside
• Supply useful information to investors
• Role of accounting information to control moral hazard
• Control manager shirking
• Improve corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 18
1.10 The Fundamental Problem Of Financial
Accounting Theory
• The best measure of net income to control adverse selection not the same
as the best measure to motivate manager performance
• Investors want information about future firm performance
• Current value accounting?
• Good corporate governance requires that managers “work hard”
• Does more reliable information and conservatism better reflect manager effort than current
value information?
Copyright © 2015 Pearson Canada Inc.
1 – 19
1.11 Regulation as a Reaction to the
Fundamental Problem of Standard Setting
• Standard setting is a form of regulation
• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces subject to failure
• Adverse selection
• Moral hazard
• Regulation steps in to try to correct market failures
• Regulation is costly
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 20
Regulation as a Reaction to the Fundamental
Problem of Standard Setting (continued)
• Standard setting mediates between conflicting interests of investors
and managers
• Investors want lots of useful information
• Managers may object to releasing all the information that investors desire
• Due process in standard setting mediates between investors’ and managers’
interests
• Representation of diverse constituencies
• Super-majority voting
• Exposure drafts
Copyright © 2015 Pearson Canada Inc.
1 – 21
1.12.5 The Process of Standard Setting
• Structure
• IASB
• International standards
• FASB
• United States standards
• Securities commissions
• Role in enforcing firms to follow standards
• May set standards themselves
• Why do they delegate most standard setting?
Copyright © 2015 Pearson Canada Inc.
1 – 22
Theories Relevant to Financial Accounting
• The rational investor
• A model of how an investor may use new information to revise beliefs about future
firm performance
• Rationality holds on average, not necessarily for each individual
• Efficient securities markets
• Efficiency is a matter of degree
• Share prices reasonably reflect all publicly available information
• Efficiency is relative to a stock of information
• Role of financial reporting in improving/expanding the stock of information
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 23
Theories Relevant to Financial Accounting
(continued)
• Behavioural theories
• Investors do not use all the information in financial statements → securi es
markets not fully efficient
• Agency theory
• Efficient contracts to motivate manager performance (stewardship) and
achieve good corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 24
• Chapter 6 – The Measurement Approach to
Decision Usefulness
Recap Chapter 5 – Value Relevance
• accounting information has “value relevance”
when security prices respond to the
information released.
• Ball & Brown study – Stock market reacts to
earnings information but anticipates the
information
• ERC – Does quality of earnings affect
magnitude of abnormal share return
Ball & Brown Findings
Chapter 6 – Measurement
Approach
Is the market efficient?
• Market efficiency relies on rational investors.
On an individual basis, lots of evidence that
people aren’t rational:
– People take credit for their successes, blame
nature for failures. So if stocks go up, people feel
they’re smart, buy more, causing momentum.
However, they don’t want to sell losers, resulting
in underreactions….
– Prospect Theory
Prospect Theory
• People are loss-averters, so they will hang on
to losers and sell winners
• Individuals also tend to overweight salient,
anecdotal and extreme evidence
– Underestimate probabilities of likely states
– Overestimate probabilities of unlikely states
What Is the Measurement
Approach?
• Greater use of current values in the financial
statements proper
• Recall two versions of current value
– Fair value: exit price
– Value-in-use: present value of future cash receipts
or payments
• Goal of measurement approach is to increase
decision usefulness by increasing financial
statement relevance
Why the Measurement Approach?
• Decision Usefulness Perspective tells us
whether information released has an
influence on decisions (presumably because it
changed users’ assessment of firm value) BUT:
• It does NOT tell us whether the original or revised
assessments of firm value are reasonable
So, our next question is:
• What is the relationship between accounting valuation
(particularly the balance sheet) and market valuation
and can we strengthen that relationship?
Why Are Accountants Moving
Towards a Measurement
Approach?
• To extent average investor not fully rational
and securities markets not fully efficient, a
measurement perspective may improve
decision-making and market efficiency
– The greater relevance of current values may
enable ordinary investors to improve their
decision making
– This assumes that the increased relevance is not
outweighed by lower reliability
Why Are Accountants Moving
Towards a Measurement
Approach?
• Empirical evidence that net income explains
very little share price variation (i.e., net
income has a low “market share” in terms of
information that drives the market). Lev
(1989), Section 6.9
• Better measurement (eg. fair value
measurement?) may increase accounting
“market share” in explaining share price
changes.
Why Are Accountants Moving
Towards a Measurement
Approach?
• Ohlsön’s clean surplus theory
– A theoretical framework supportive of a
measurement approach
• Auditor Liability
– Better measurement may reduce auditor liability
when firms become financially distressed
Measurement Approach
• Accounting should help users value investment
alternatives
– De we provide info about risk, future cash flows? Even if
we do, can investors calculate value themselves?
• Standard setters currently face many challenges
related to valuation
– Intangibles in new economy? Financial instruments?
• Accountants are under increasing pressure to ensure
that financial statements are relevant to investors
– More litigation
– Higher public expectations
– Many highly publicized business failures
In Class Discussion
• Chapter 6 Textbook Question 1
• Why does a measurement approach to
decision usefulness suggest more value
relevant information in the financial
statements proper, when efficient securities
market theory implies that financial statement
notes or other disclosure would be just as
useful?
Auditor Liability
• Will a measurement approach reduce auditor
liability?
– Perhaps
• Auditor can claim that the financial statements proper
anticipated value changes, rather than buried in
supplemental information or not disclosed at all
• But, current values may be subject to manager
bias if no market value available (incomplete
markets)
• Then, may be hard for auditor to resist manager bias
Auditor Liability and Conservative
Accounting Example
– A change in asset value has already occurred
– Assume investor is risk averse
– Investor opportunity loss of expected utility if a
decline in asset value is not recorded = 1.02
– Investor opportunity loss if an increase in asset
value not recorded = .52
– Then, investor more likely to sue auditor if a
decline in asset value not recorded.
– Auditor reaction: impairment tests, to reduce
likelihood a decline in asset value is unrecorded,
thereby reducing likelihood of lawsuit
In Class Discussion
• Chapter 6 Textbook Question 4
• Explain in your own words what “post
announcement drift” is. Why is this an
anomaly for securities market efficiency? Give
two behavioral biases that could generate
post announcement drift.
Measurement Approach
• Accounting should help users value investment
alternatives
– De we provide info about risk, future cash flows? Even if
we do, can investors calculate value themselves?
• Standard setters currently face many challenges
related to valuation
– Intangibles in new economy? Financial instruments?
• Accountants are under increasing pressure to ensure
that financial statements are relevant to investors
– More litigation
– Higher public expectations
– Many highly publicized business failures
Conclusions on Measurement
Approach
• Assuming reasonable reliability, current value
accounting can increase decision usefulness relative
to historical cost accounting
• Increased use of current value accounting (including
impairment tests) in financial reporting because:
• Markets not fully efficient
• Low explanatory power of net income for share returns
• Ohlsön clean surplus theory
• Auditor liability
• Decision usefulness for investors may be further
increased by conservative accounting
Chapter 6 – Question for
Discussion
• The 2007 – 2008 meltdown of the market for
asset-backed securities is often blamed on lax
mortgage lending practice, poor risk controls
by financial firms, greedy managers, and
inadequate regulation. However, the
meltdown also has important implications for
financial accounting and reporting practice.
Give two such implications and, for each one,
explain why accountants should be aware of it
and take is seriously. (Hint: see also Chapter 1
– Section 1.3)
• Recap Ball & Brown
• Chapter 5
Ball & Brown Study
• B&B methodology
– For Each Sample Firm:
• Estimate investors’ earnings expectations (proxied by
last year’s actual)
• Classify each firm as GN (actual earnings > expected
earnings) or BN (vice versa)
• Estimate abnormal share return for month of release of
earnings (month 0), using procedure of Figure 5.2
Ball & Brown Findings
Ball & Brown Conclusions
• B&B conclusion
– Stock market reacts to earnings information in
month zero, but begins to anticipate the GN or BN
in earnings 12 months prior
– Consistent with securities market efficiency and
underlying rational decision theory
ERC vs. Ball & Brown
• Ball & Brown looked at the direction of the
reaction (good news vs. bad news) and
direction of the stock price (price increase or
decrease)
• ERC looks at the magnitude of the change vs.
amount of new informaiton
Group Discussion #1
• Explain what is meant by the value relevance
of accounting information. Does it rely on the
historical cost basis of accounting?
Group Discussion #1
• Value relevance studies the reaction of
security returns to accounting information. It
assumes average investor rationality and
securities market efficiency, under which
investors base investment decisions on
accounting information providing they find it
useful. Greater security market response
implies greater decision usefulness.
Group Discussion #1
• Value relevance is consistent with the
historical cost basis of accounting, but does
not rely on it. It appears, on the basis of both
theory and empirical evidence, that financial
statements, traditionally containing a large
historical cost-based component, do provide
useful information to investors.
Group Discussion #1
• However, there is no particular reason why
the information must be historical cost-based.
RRA information is not historical cost-based,
nor is much of the information in notes and
MD&A. These disclosure formats contain a
large current value and forward-looking
component.
Group Discussion #2
• IAS recognizes the need for full disclosure of
the components of reported net income.
Explain why full disclosure of net income
components is important if investors are to
properly interpret the implications of current
reported net income for future firm
performance.
Group Discussion #2
• To properly interpret the implications of
current reported net income for future firm
performance, investors must be able to
evaluate earnings persistence. Consequently,
low persistence items, such as lawsuit
settlements, material writedowns and any
reversals thereof, restructuring provisions and
any reversals, gains and losses on disposals
need to be disclosed. Otherwise, investors
may over estimate net income persistence.
Group Discussion #3
• What is classification shifting? Why does
classification shifting make it more difficult for
investors to predict future firm performance
from current reported net income? How could
the problem of classification shifting be
reduced?
Group Discussion #3
• Classification shifting is the inclusion of fixed
costs in extraordinary items (FASB) or in lowpersistence income statement cost items
(IASB), such as restructuring provisions,
lawsuits, etc.
Group Discussion #3
• It seems reasonable that costs such as these should bear
some share of the firm’s fixed costs, such as the costs of
full-time employees who plan and implement
organizational changes, and costs of the firm’s legal
department. However, such costs must be allocated, and
the amount of allocation is a subjective judgement. Thus,
it is tempting for a management that wishes to increase
the apparent persistence of reported earnings to allocate
an excessive amount of fixed costs to low persistence
cost items. As a result of fixed cost allocation to low
persistence items, investors may overestimate earnings
persistence, particularly if amounts allocated are
excessive.
Group Discussion #3
• This problem could be reduced by separate
reporting of the direct and allocated costs of
low persistent cost items.
Ball & Brown Question
• PART A: The findings of Ball and Brown (1968), as
depicted in the following graph, provide various
insights. What on their graph supported their
main finding that the market reacts efficiently to
earnings announcements?
• PART B: Describe what on their graph suggests
that the market is INEFFICIENT? Why?
• PART C: If a well-conducted study finds that
information released to the market is valuable, is
society better off if standard setters require that
firms produce that information? Why or why
not?
Solution
• PART A: While it’s not very visible, there is an
upwards “blip” at time 0 for good news firms,
and a downwards “blip” at time 0 for bad
news firms.
Solution
• PART B: There is an upward drift for GN firms
after time 0 and a downwards drift for BN
firms after time time 0, indicating that the
market did not quickly impound the
information. This would allow people to earn
abnormal returns by buying GN firms after the
announcement, for example, which is publicly
available information.
Solution
• PART C: No. Must still consider the costs. If
the costs are greater than the benefits, society
would be worse off if the standard was
adopted.
• Chapter 6 – The Measurement Approach to
Decision Usefulness
Recap Chapter 5 – Value Relevance
• accounting information has “value relevance”
when security prices respond to the
information released.
• Ball & Brown study – Stock market reacts to
earnings information but anticipates the
information
• ERC – Does quality of earnings affect
magnitude of abnormal share return
Ball & Brown Findings
Chapter 6 – Measurement
Approach
Is the market efficient?
• Market efficiency relies on rational investors.
On an individual basis, lots of evidence that
people aren’t rational:
– People take credit for their successes, blame
nature for failures. So if stocks go up, people feel
they’re smart, buy more, causing momentum.
However, they don’t want to sell losers, resulting
in underreactions….
– Prospect Theory
Prospect Theory
• People are loss-averters, so they will hang on
to losers and sell winners
• Individuals also tend to overweight salient,
anecdotal and extreme evidence
– Underestimate probabilities of likely states
– Overestimate probabilities of unlikely states
What Is the Measurement
Approach?
• Greater use of current values in the financial
statements proper
• Recall two versions of current value
– Fair value: exit price
– Value-in-use: present value of future cash receipts
or payments
• Goal of measurement approach is to increase
decision usefulness by increasing financial
statement relevance
Why the Measurement Approach?
• Decision Usefulness Perspective tells us
whether information released has an
influence on decisions (presumably because it
changed users’ assessment of firm value) BUT:
• It does NOT tell us whether the original or revised
assessments of firm value are reasonable
So, our next question is:
• What is the relationship between accounting valuation
(particularly the balance sheet) and market valuation
and can we strengthen that relationship?
Why Are Accountants Moving
Towards a Measurement
Approach?
• To extent average investor not fully rational
and securities markets not fully efficient, a
measurement perspective may improve
decision-making and market efficiency
– The greater relevance of current values may
enable ordinary investors to improve their
decision making
– This assumes that the increased relevance is not
outweighed by lower reliability
Why Are Accountants Moving
Towards a Measurement
Approach?
• Empirical evidence that net income explains
very little share price variation (i.e., net
income has a low “market share” in terms of
information that drives the market). Lev
(1989), Section 6.9
• Better measurement (eg. fair value
measurement?) may increase accounting
“market share” in explaining share price
changes.
Why Are Accountants Moving
Towards a Measurement
Approach?
• Ohlsön’s clean surplus theory
– A theoretical framework supportive of a
measurement approach
• Auditor Liability
– Better measurement may reduce auditor liability
when firms become financially distressed
Measurement Approach
• Accounting should help users value investment
alternatives
– De we provide info about risk, future cash flows? Even if
we do, can investors calculate value themselves?
• Standard setters currently face many challenges
related to valuation
– Intangibles in new economy? Financial instruments?
• Accountants are under increasing pressure to ensure
that financial statements are relevant to investors
– More litigation
– Higher public expectations
– Many highly publicized business failures
In Class Discussion
• Chapter 6 Textbook Question 1
• Why does a measurement approach to
decision usefulness suggest more value
relevant information in the financial
statements proper, when efficient securities
market theory implies that financial statement
notes or other disclosure would be just as
useful?
Auditor Liability
• Will a measurement approach reduce auditor
liability?
– Perhaps
• Auditor can claim that the financial statements proper
anticipated value changes, rather than buried in
supplemental information or not disclosed at all
• But, current values may be subject to manager
bias if no market value available (incomplete
markets)
• Then, may be hard for auditor to resist manager bias
Auditor Liability and Conservative
Accounting Example
– A change in asset value has already occurred
– Assume investor is risk averse
– Investor opportunity loss of expected utility if a
decline in asset value is not recorded = 1.02
– Investor opportunity loss if an increase in asset
value not recorded = .52
– Then, investor more likely to sue auditor if a
decline in asset value not recorded.
– Auditor reaction: impairment tests, to reduce
likelihood a decline in asset value is unrecorded,
thereby reducing likelihood of lawsuit
In Class Discussion
• Chapter 6 Textbook Question 4
• Explain in your own words what “post
announcement drift” is. Why is this an
anomaly for securities market efficiency? Give
two behavioral biases that could generate
post announcement drift.
Measurement Approach
• Accounting should help users value investment
alternatives
– De we provide info about risk, future cash flows? Even if
we do, can investors calculate value themselves?
• Standard setters currently face many challenges
related to valuation
– Intangibles in new economy? Financial instruments?
• Accountants are under increasing pressure to ensure
that financial statements are relevant to investors
– More litigation
– Higher public expectations
– Many highly publicized business failures
Conclusions on Measurement
Approach
• Assuming reasonable reliability, current value
accounting can increase decision usefulness relative
to historical cost accounting
• Increased use of current value accounting (including
impairment tests) in financial reporting because:
• Markets not fully efficient
• Low explanatory power of net income for share returns
• Ohlsön clean surplus theory
• Auditor liability
• Decision usefulness for investors may be further
increased by conservative accounting
Chapter 6 – Question for
Discussion
• The 2007 – 2008 meltdown of the market for
asset-backed securities is often blamed on lax
mortgage lending practice, poor risk controls
by financial firms, greedy managers, and
inadequate regulation. However, the
meltdown also has important implications for
financial accounting and reporting practice.
Give two such implications and, for each one,
explain why accountants should be aware of it
and take is seriously. (Hint: see also Chapter 1
– Section 1.3)
Chapter 7
Copyright © 2015 Pearson Canada Inc.
7- 1
Current Value Accounting
• Value-in-use
– Also called amortized cost
– Valued at discounted present value of future receipts
– Relevance: high
– Reliability:
• Error and possible bias in estimating
• Management may opportunistically change intended use to
increase present value or avoid impairment writedown
>> Continued
Copyright © 2015 Pearson Canada Inc.
7- 2
Current Value Accounting (continued)
• Fair value
– Definition under IFRS 13
• The price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date
– Also called exit price
– Exit price measures opportunity cost of retaining
asset/liability in firm
• Hence a stewardship aspect in addition to valuation aspect.
• If manager cannot earn at least cost of capital on asset,
should be sold
>> Continued
Copyright © 2015 Pearson Canada Inc.
7- 3
Current Value Accounting (continued)
• Market price does not exist for many
assets
– Fair value hierarchy; IFRS 13, ASC 820-10
• Level 1: market price exists
• Level 2: market price of similar asset exists
• Level 3: no market price, fair value must be
estimated
– Effect on reliability as move from level 1 to
levels 2 and 3?
>> Continued
Copyright © 2015 Pearson Canada Inc.
7- 4
Examples of Current Value
Accounting
• Accounts receivable and payable
– Approximates value-in-use if time is short
• Lower-of-cost-or-market rule
– E.g., inventories
– Rule is example of conservativism, also a partial
application of current value accounting
>> Continued
Copyright © 2015 Pearson Canada Inc.
7- 5
Examples of Current Value
Accounting (continued)
• Revaluation option for property, plant &
equipment, IAS 16
– Option to value at fair value
– Not available under FASB standards
• Impairment tests
– E.g., property, plant & equipment
• Valued at recoverable amount if less than book value
• An example of conservatism, also a partial application of
current value accounting
Copyright © 2015 Pearson Canada Inc.
7- 6
Financial Instruments
• Definition
– A contract that creates a financial asset of one firm and
a financial liability or equity instrument of another firm
• Note broad definition of financial assets and liabilities
• Includes both primary and derivative financial instruments
Copyright © 2015 Pearson Canada Inc.
7- 7
Financial Instruments
• IFRS 9
• Financial assets and liabilities recorded at fair value at
acquisition
• After acquisition, financial assets valued at fair value,
with unrealized gains and losses generally included in
OCI,
• Unless objective of firm’s business model is to hold an
asset to collect interest and principal.
– Then, valuation is at amortized cost (i.e., value-in-use),
subject to impairment test
– Business model concept makes it more difficult for
management to opportunistically change intended use of
the asset
• After acquisition, most liabilities valued at amortized
cost
Copyright © 2015 Pearson Canada Inc.
7- 8
The Fair Value Option for Financial
Instruments
• Under IFRS 9, firm may designate financial
assets/liabilities at acquisition as valued at fair value
to reduce a mismatch.
– Applies to assets/liabilities otherwise valued at amortized
cost
– Mismatch: Accounting volatility greater than real volatility
• E.g., loans receivable valued at fair value
• Bonds payable hedge the loans, valued at amortized cost
• Unrealized gains/losses on loans included in net income
• No offsetting loss/gain recorded on bonds
• If bonds fair valued, losses/gains on bonds offset gains/losses
on loans
>> Continued
Copyright © 2015 Pearson Canada Inc.
7- 9
The Fair Value Option for Financial
Instruments (continued)
• Accounting for changes in own credit risk
– Firm has opted under IFRS 9 to fair value debt outstanding
– Firm’s debt receives a credit downgrade
– Market value of debt falls
– Firm writes debt down to fair value, records a gain
– Has firm really gained?
• Barth, Hodden, and Stubben (2008)
– IFRS 9 requires own credit risk gains/losses to be included
in OCI
Copyright © 2015 Pearson Canada Inc.
7 – 10
Loan Loss Provisioning
• Applies to loans valued at amortized cost
• During 2007-2008 securities market meltdowns,
huge loan losses reported by financial institutions
contributed to investor loss of confidence
• 2013 IASB exposure draft
– Include estimate of future losses in expected loan
collections
– Loan losses thus recognized sooner than when actually
impaired, reducing investor shock
– Relevance v. reliability tradeoff? Decision useful?
– Currently awaiting agreement with FASB on a converged
standard
Copyright © 2015 Pearson Canada Inc.
7 – 11
Fair Value v. Historical Cost
• The 2007-2008 market meltdowns generated
serious complaints about fair value accounting
• Several analytical models study conditions under
which each system is preferred
– Allen & Carletti (2008)
– Plantin, Sapra, & Shin (2008)
– Models have restricted assumptions
– Mixed empirical support
Copyright © 2015 Pearson Canada Inc.
7 – 12
Derecognition and Consolidation
•
Purpose of new standards is to reduce abuses leading up to
2007/2008 market meltdowns
– Derecognition
• When can a firm remove assets from its books?
– A serious question leading up to 2007-2008 market meltdowns
– E.g., many firms transferred securitized mortgage assets to SIVs
• IFRS 9.
• Can derecognize when substantially all risks and rewards of
ownership are transferred.
• But no derecognition if control retained
– Consolidation
• IFRS 10
– Required when one entity controls another
– Control exists when one firm has power over another and bears risk
of return on its investment
Copyright © 2015 Pearson Canada Inc.
7 – 13
Derivative Financial Instruments
• Derivatives are financial instruments
• Definition
– A contract, the value of which depends on some underlying…
– May not require an initial cash outlay
– Generally settled in cash, not in kind
• Derivatives valued at fair value under IFRS 9
• Unrealized gains and losses included in net income,
except certain hedging contracts
>> Continued
Copyright © 2015 Pearson Canada Inc.
7 – 14
Derivative Financial Instruments
(Continued)
• Hedge Accounting
– Purpose of hedges is to manage risk
• Price risks (e.g., commodity prices, interest and foreign
exchange rates), credit risks (credit default swaps)
– Fair value hedges
• Gains and losses on the hedging instrument included in
net income
– Fair valuing the hedged item offsets effect on net income
– Cash flow hedges
• Gains and losses on the hedging instrument included in
OCI, until the future transaction affects net income
» Continued
Copyright © 2015 Pearson Canada Inc.
7 – 15
Derivative Financial Instruments
(continued)
• Benefits of Hedge Accounting
– Reduces earnings volatility
• Offset gains/losses by fair valuing hedged item (fair
value hedge)
• Delay gain/loss recognition by including in OCI until
realized (cash flow hedge)
» Continued
Copyright © 2015 Pearson Canada Inc.
7 – 16
Derivative Financial Instruments
(Continued)
• To Obtain Benefits of Hedge Accounting
– Hedges must qualify
• Must be highly effective
– High negative correlation with hedged item
– Hedges must be designated
• To reduce temptation to speculate
• Requires elaborate procedure and documentation
Copyright © 2015 Pearson Canada Inc.
7 – 17
Accounting for Intangibles
• Many intangibles are not on balance sheet
• Purchased intangibles, on balance sheet
– Goodwill arising from an acquisition
• Accounted for at cost
• No amortization
• Subject to impairmentg test
– Can lead to major writedowns
– Management devices to work around goodwill and
related writedowns
• “Pro-forma income,” e.g., TD Bank, 2000 Annual
Report, JDS Uniphase Corp. See Theory in Practice
7.5
» Continued
Copyright © 2015 Pearson Canada Inc.
7 – 18
Accounting for Intangibles (continued)
• Self-developed intangibles
– Self-developed goodwill, e.g., from R&D
• Hard to reliably determine fair value
• Research costs written off as incurred, development costs
capitalized, under IAS 38
• Development costs also written off under FASB standards
• Recognition lag: instead of valuation on balance sheet,
goodwill value from R&D shows up over time on income
statement
• Recognition lag responsible for low ability of net income to
explain stock returns?
– Lev & Zarowin (1999) argue yes
>> Continued
Copyright © 2015 Pearson Canada Inc.
7 – 19
Accounting for Intangibles (continued)
• Lev & Zarowin (1999), “The Boundaries of
Financial Reporting…”
– Their study documents a decreasing usefulness of
earnings information
– Usefulness evaluated by ability of earnings to explain
abnormal share return
• Low R2
– And falling?
• Low ERCs
• Especially for research-intensive firms
» Continued
Copyright © 2015 Pearson Canada Inc.
7 – 20
Accounting for Intangibles (continued)
• Lev & Zarowin (continued)
– Conclusion
• Accounting for intangibles is inadequate
• Their suggestion to improve usefulness
– Capitalize successful intangibles after a “trigger point”
is attained
• Amortize over useful life
• Like successful efforts accounting in oil and gas
• Amounts capitalized and amortized may reveal inside
information to investors, since it is management that has
best knowledge of R&D value
>> Continued
Copyright © 2015 Pearson Canada Inc.
7 – 21
Accounting for Intangibles (continued)
• Capitalization of intangibles creates a problem of
low reliability
– Kanodia, Singh, & Spiro (2005) present a model
suggesting that some degree of unreliability is “good”
Copyright © 2015 Pearson Canada Inc.
7 – 22
Reporting on Risk
• Risk controlled by natural hedging + hedging
with derivatives
• Some reasons for managing firm-specific risk,
even though investors can diversify it away
– Reduce investor estimation risk
– Cash availability for planned capital expenditures
– Control speculation by managers
– Reduce likelihood of major losses, which often lead
to lawsuits
>> Continued
Copyright © 2015 Pearson Canada Inc.
7 – 23
Reporting on Risk
(continued)
• Reporting on Risk
– Some reasons why reporting on other (firm-specific)
risks also relevant to investors
• Risk information may reduce estimation risk
• Hedging may prevent losses, reducing auditor & firm legal
liability
• Risk reporting may control manager speculation
>> Continued
Copyright © 2015 Pearson Canada Inc.
7 – 24
Reporting on Risk
(continued)
• A Measurement Perspective on Risk
Reporting
• Narrative, in MD&A
– Canadian Tire Corp. 2012 Annual report
• Text, Section 3.6
• Sensitivities Analysis
– Husky Energy Inc., 2012 Annual Report
• Table 7.2
• Value at Risk
– Microsoft Corp., 2012 Annual Report
Copyright © 2015 Pearson Canada Inc.
7 – 25
Conclusions on Application of the
Measurement Approach
• Standard setters continue to favour current value
measurements in financial statements
– Conceptual framework emphasizes balance sheet
approach
– Some current value measurements are one-sided
• Lower-of-cost-or-market, ceiling tests
– Some backing off from fair value post 2007- 2008 market
meltdowns
• E.g., IFRS 9 business model concept allows increased use
of amortized cost
• Accountants are recognizing an increased
obligation to measure and report on firm risk
Copyright © 2015 Pearson Canada Inc.
7 – 26
• Chapter 8 – The Efficient Contracting Approach
to Decision Usefulness
The Efficient Contracting Approach
to Decision Usefulness
• Consider management’s role in financial
reporting
• Firms enter into many contracts, in particular,
debt contracts with lenders and compensation
contracts with managers
• Contracts are based on accounting
information
• An efficient contract motivates the manager
to act on investors’ best interests at lowest
cost to the firm
What is Efficient Contracting
Theory?
• Focus is on role of financial accounting
information in moderating information
asymmetry between contracting parties
– Debt contracts and managerial compensation
contracts
– Lenders’ interests and managers’ interests may
conflict with interests of shareholders
– An efficient contract generates trust between
these conflicting interests at lowest cost to firm.
– Contracts may be formal written documents or
implicit
Sources of Contracting Demand for
Financial Accounting Information
• Lenders – Lenders face payoff asymmetry
• They can lose heavily if firm does poorly, but do not
directly share in gains if firm does well
• As a result, they demand early warning of financial
distress
• Shareholders – Managers assumed rational
and will act in their own interest, which may
conflict with shareholders’ interests
• As a result, shareholders demand information to
encourage responsible manager effort and limit
opportunistic actions
Accounting Policies for Efficient
Contracting
• Reliability
– Lenders demand reliable information to help
protect against opportunistic manager policies
that hide losses and record unrealized gains
• Conservatism
– Lenders demand conservative information to help
predict financial distress
– Shareholders demand conservative information
for stewardship purposes
Accounting Policies for Efficient
Contracting (continued)
• Efficient contracting demand for reliable and conservative
information conflicts with Conceptual Framework
• Framework more oriented to future-oriented (i.e., relevant)
information (fair value accounting)
– More heavily weighted towards relevance over reliability.
• Framework more oriented to information needs of investors than
to stewardship
– Framework does state that investors need information about
manager stewardship, but ignores the fundamental problem that
best information for investor decision making and for stewardship
evaluation need not be the same
Contract Rigidity
• Many contracts depend on accounting variables
• Debt contracts contain accounting-based covenants
• Manager compensation contracts depend on net income
• Both types of contract tend to be long-term
• Accounting standards often change during contract term, affecting
net income and debt covenants
• Probability of debt covenant violation may increase
• Manager compensation may be affected
• Since contracts are hard to change (rigid), unlikely
that contracts can be renegotiated to allow for
changes in GAAP
Contract Rigidity (continued)
• As a result, managers are concerned about
changes in accounting standards and policies,
even if no effects on cash flows
• May lobby against proposed accounting standards
• May exploit the flexibility of GAAP to change accounting policies to
offset effects of changes in accounting standards on contracts (e.g.,
increase net income by lengthening useful life of capital assets)
• May change operating policies (e.g., R&D, extent of hedging)
• A new accounting standard has economic
consequences if it motivates managers to
change accounting and/or operating policies
Distinguishing Efficiency and
Opportunism in Contracting
• A basic question in contract theory
– Are managers’ accounting policy choices driven by
• Opportunism: manager benefits at expense of
investors
• Efficiency: manager chooses accounting policies to
maximize contract efficiency (i.e., good corporate
governance)
– Opportunistic view
• Managers choose accounting policies to maximize
their own expected utility
– Efficient contracting view – Managers choose
accounting policies to attain efficient contracting
Conclusions
• Contract theory argues that the role of financial
reporting is to generate trust between
contracting parties
– Debt and managerial compensation contracts emphasized
• Contract theory conflicts somewhat with
Conceptual Framework
– Supports increased emphasis on reliability and conditional
conservatism
• Managers have accounting policy choice
– Is this flexibility consistent with efficient contracting or with
manager opportunism?
• Empirical evidence is mixed.
In Class Discussion
• Debt contracts may contain covenants, such as
maintaining a specified level of working
capital, not exceeding a specified debt-equity
ratio, or maintaining an agreed times interest
earned ratio (debt service coverage). Explain
how these covenants help to generate the
lenders’ trust that is necessary if the firm is to
borrow at reasonable cost. Do these
covenants give lenders complete trust that
their interest and principal will be paid?
Explain.
• Maintaining a specified level of working
capital generates lender trust by helping to
ensure that the firm has the cash needed to
pay interest and principal, since the firm is
constrained from paying excessive dividends
and manager compensation. To the extent
that this covenant discourages additional
borrowing (which would increase interest and
principal payments), lender trust is further
increased.
• Limiting the debt-to-equity ratio constrains
the firm from issuing additional debt, which
would dilute the security of existing lenders
• Requiring the firm to maintain a specified
times interest ratio also constrains the firm
from additional borrowing. Also, should
earnings fall, the firm is motivated to increase
earnings, by cutting costs and/or increasing
revenue.
• These covenants increase lenders’ trust, but
do not give them complete trust because they
do not guarantee that the firm will not
become financially distressed. Also, despite
conditional conservatism and numerous
impairment tests, managers of financially
distressed firms may have sufficient flexibility
to manage earnings upwards to prevent or
delay covenant violation.
In Class Discussion #2
• Use contract theory to explain how
conditionally conservative accounting can
contribute to efficient contracting. Consider
both debt and managerial compensation
contracts.
• Conditionally conservative accounting = eg.
impairment testing on non-current assets
• Conditionally conservative accounting (eg.,
impairment testing) contributes to efficient
debt contracting by providing an early warning
system of financial distress. This increases the
trust of lenders that any operating policies
that have led to impairment will be corrected
by management and/or the Board of
Directors. Also, conditional conservatism, by
creating a systematic understatement of net
asset value, provides lenders with a lower
bound on net assets to help them evaluate
their loan security.
• Impairment tests also lower debt covenant
ratios, providing additional security and
protection for lenders. For example, tighter
covenant constraints reduce the likelihood of
excessive dividend and manager
compensation payments and lower the
likelihood of additional borrowing by the firm,
all of which dilute the security of existing
lenders. As a result of this increased
protection and trust, lenders accept lower
interest rates
• Conditionally conservative accounting increases
the efficiency of managerial compensation
contracts by meeting a shareholder demand for
reporting on manager stewardship. It makes it
more difficult for managers to record unrealized
income-increasing gains to enhance their
reputations and compensation. Also, recording
unrealized losses may motivate early manager
action to correct operating policies that have led
to such losses and, if they do not, alerting Boards
of Directors to take timely steps to correct
management’s lack of action
• Chapter 9 – An Analysis of Conflict
Recap
• The course to date has focused on accounting in the
context of the management – investor relationship:
– single person decision theory suggests that investors need
information about future cash flows
– the decision usefulness approach suggests that
• investors find accounting information, particularly the income
statement, useful
• market is reasonably efficient
• we should move towards fuller disclosure
• the measurement approach suggests that accounting
should (and is) incorporating more information about
expected future cash flows, places more emphasis on the
balance sheet
Recap
• Within this context, management should be
indifferent to different accounting policies that
affect income (level or variability) as long as
cash flow is unaffected. This is not the case.
• Positive accounting research has shown that
firms are not indifferent among accounting
policies: firms in certain circumstances tend to
favour certain types of accounting policies.
• Why do we have contracts (employment,
lending) if they lead to this behaviour?
Agency Theory
• Agency theory, a branch of game theory,
which studies the design of contracts between
principal and agent that motivate the agent to
work in the best interest of the principal.
• An efficient contract will do this at the lowest
cost to the principal.
• In many cases the effort of the agent is not
directly observable by the principal – this
creates a moral hazard problem – agent needs
to be sufficiently motivated to work hard.
Relevance of Agency Theory to
Accountants
• Examples of agency relationships:
– professional atheletes, professionals (lawyers,
doctors, accountants, …) how are they motivated
to work hard?
• Managers bear considerable risk of changes in
accounting policies, most significant are those
that cause income volatility
• Holmstrom: accounting competes with share
price as performance measure
Holmstrom
• Properties of a good performance measure =
the best trade off between sensitivity and
precision
• Properties of good information to investors =
best trade off between relevance and
reliability
Agency contracts between firm
owner and manager
• Example 9.1 – A Firm Owner-Manager Agency
Problem
• single owner (principal) and single manager
(agent)
• contract for a single period
• payoff = $100 or $55 cash flows
• If the manger works hard they will realize
$100 60% of the time and $55 40% of the time
• If the manger does not work hard they will
realize $100 40% of the time and $55 60% of
the time
• The manager will be paid a fixed salary of $25
• Expected utility = value of the payoff to that
individual (ie. owners EU is 57 if the manager
works hard)
• Owner’s expected utility if manager works
hard
• EU = 0.6 x (100 – 25) + 0.4 x (55 – 25)
•
= 0.6 x 75 + 0.4 x 30
•
= 45 + 12
•
= 57
• Owner’s expected utility if manager does not
work hard
• EU = 0.4 x (100 – 25) + 0.6 x (55 – 25)
•
= 0.4 x 75 + 0.6 x 30
•
= 30 + 18
•
= 48
• What does the manager have to do for the
owner to get maximum utility? … 57 > 48
• Let’s assume that the manager is risk averse
and their expected utility is = the square root
of their remuneration (√25 = 5)
• However, the manager is also effort averse,
working hard reduces their expected utility by
2 (5 – 2 = 3 expected utility of working hard)
• Not working hard (still working) creates a
disutility of 1.71 (5 – 1.71 = 3.29 expected
utility of not working hard
• What will they choose?
• What can be done to protect the owner from
managers not working hard?
– Don’t hire the manager
– Design contracts to control moral hazard
– Direct monitoring (first best)
– Indirect monitoring
– Rent the firm to the manager
– Give manager a share of the profits (base
compensation on a performance measure)
Earnings Management
• An example of a performance measure is net
income
• If their compensation is based on net income,
managers have a bias to engage in earnings
management
• Net income is a mixed measurement model
(not ideal conditions) so earnings
management is possible
Summary Single Period Agency
Model
Protecting Lenders from Manager
Information Advantage
Implications of Conflict Theory on
Accounting Theory
• Chapter 10 – Executive Compensation
Recap – Agency Theory
• Agency theory, a branch of game theory,
which studies the design of contracts between
principal and agent that motivate the agent to
work in the best interest of the principal.
• An efficient contract will do this at the lowest
cost to the principal.
• In many cases the effort of the agent is not
directly observable by the principal – this
creates a moral hazard problem – agent needs
to be sufficiently motivated to work hard.
Holmstrom
• Properties of a good performance measure =
the best trade off between sensitivity and
precision
• Properties of good information to investors =
best trade off between relevance and
reliability
Executive Compensation
• Executive compensation plans follow agency
theory but are complex and generally span
multiple periods
• Attempts to align the interest of the owners
and manager by basing the mangers
compensation on one or more measures of
the managers performance in operating the
firm
• Many are based on two measures: net income
and share price
Executive Compensation
• Why are incentive contracts necessary?
– As discussed in Chapter 9, managers have the
option to work hard or not, contracts are needed
to align managers and owners interests, that the
manager will work hard for the owner
• Fama (1980) study suggests that the simple
contracts as discussed in chapter 9 are not
necessary, that the managerial labour market
will control manager shirking – reputational
risk.
Executive Compensation
• What was missing from Fama’s argument
– managers have the ability to hide shirking in the
short run by controlling the release of information
(moral hazard)
• Conclusion: managerial labour forces control
manager tendencies to shirk, they do not
eliminate them
• Effort incentives based on some measure of
the payoff (ie. net income) are desirable for
efficient contracting
RBC Example
• See Example 10.1
• RBC compensation structure considers
incentives, decision horizon, and risk
properties.
• Three main incentive components:
– short term inventive awards based on earnings
and individual achievement
– long term stock option whose value depends on
share price performance
– mid term awards whose value depends on both
Theory of Exec. Compensation
• what determines the relative importance of
net income and share price in evaluating
managers performance?
– important consideration for accountants as
motivating manager performance is an important
social goal
• …the more sensitive net income is to manager
effort the greater the weighting to net income
in measuring manager performance
Theory of Exec. Compensation
• How to make net income more sensitive to
manager effort:
– reduce recognition lag by moving to current value
accounting
– this increases sensitivity since more of the future
payoff from manager effort show up in current net
income
• However, current value accounting reduces
the precision of net income
Theory of Exec. Compensation
• How to make net income more sensitive to
manager effort:
– full disclosure of low persistence items
– allows compensation committee to better
evaluate manager effort and ability and thus to
evaluate earnings persistence
Theory of Exec. Compensation
• Consider sensitivity of share price
– Holmstrom – it will always reveal addition payoff
information beyond that contained in net income
• Consider precision of share price
– low due to economy wide factors that can impact
share price
• Therefore, we generally see a mix of net
income and share price measurement of
performance
Theory of Exec. Compensation
• If we have a mixed model (using share price
and net income to measure manager
performance) we need to consider how the
mix of these measures impacts the decision
horizon of the manager
– does it encourage short term or long term
thinking, or a balance?
Theory of Exec. Compensation –
Risk
• Consider managers effort from a risk
perspective
– in chapter 9 we learned that in the presence of
moral hazard, the manager must bear some
compensation risk if effort if to be motivated
• The higher the risk the manager bears, the
higher their expected compensation needs to
be
Theory of Exec. Compensation –
Risk
• Need a balance of risk imposed on the
manager – too much and they will avoid
investing in some projects that could benefit
the firm, too little and they will not work hard
• How to control compensation risk:
– relative performance evaluation (RPE)
– bogey (ie. minimum limits, not requiring payment
to the firm in the case of a loss)
– cap – a maximum
– conservative accounting – delaying recognition of
unrealized gains
Theory of Exec. Compensation –
Risk
• Conservative accounting, however, also will
limit the managers incentive to invest in riskier
projects – this is why share price is included as
a measure as well, to encourage longer term
decision horizon
• ESO’s (Employee Stock Options) are a
commonly used tool – they can however have
negative impacts. eg. Enron and Worldcom
fraudulent financial reporting to support stock
price
Theory of Exec. Compensation –
Risk
• Conclusion:
– a mix of performance measures is desirable
– Compensation in the form of ESO’s and or
company shares encourages upside risk and a
longer run decision horizon while net income
based compensation (if differed and subject to
claw back) imposes some downside risk to
discourage excessive risk taking that pure share
based compensation may create
– Corporate governance – compensation committee
Politics of Exec. Comp.
• significant public backlash after high executive
compensation payments made
• studies including Gayle & Miller (2009)
suggest that managers are not overpaid
relative to shareholder value created
• Compensation is to cover effort disutility
(recall from chapter 9 the disutility of having
to work hard) and compensation risk the
manager bears
Power Theory
• Until now we have focussed on efficient
contracting view of executive compensation
– compensation committees are sophisticated in
their use of accounting information
– managers may not be over compensated (when
considering disutility function)
• We will now look at Power Theory
– executive compensation in practice is driven by
manager opportunism, not efficient contracting
Power Theory
• managers have sufficient power to influence
their own compensation and they use this
power to generate excessive pay at the
expense of shareholder value
• The power theory questions the efficiency of
the managerial labour market
• How to control manager power
– Strong corporate governance
– public “outrage”
– possibility of takeover / dismissal
Power Theory
• How can accountants help
– assist in the governance process
– full disclosure of low persistence items
– requirement to record an expense for ESO’s at
grant date
– disclosure of executive compensation
• other ways to control abuse of power
– restrictions on the amount of executive
compensation that is tax deductible for a firm
– surtaxes on high bonuses (UK and France)
Conclusions
• Financial reporting plays two important roles
in motivating manager effort
– Provides an informative performance measure
input into compensation contracts
• helps compensation committees tie pay to
performance, control manager power, and increase
contract efficiency
– Improves working of managerial labour markets
• Full disclosure helps labour market evaluate manager
performance and establish reputation
Conclusions
• Role of financial reporting in motivating
manager performance and improving the
working of managerial labour markets equally
important to social welfare as improving
operation of capital markets
• Chapter 11 – Earnings Management
Recap – Executive Compensation
• Attempts to align the interest of the owners
and manager by basing the mangers
compensation on one or more measures of
the managers performance in operating the
firm
• Many are based on two measures: net income
and share price
Recap – Executive Compensation
• Fama argued that contracts were not
necessary, that the managerial labour market
would control manager effort
• However, managers have the ability to hide
shirking in the short run by controlling the
release of information (moral hazard)
• Conclusion: managerial labour forces control
manager tendencies to shirk, they do not
eliminate them
Recap – Executive Compensation
• Compensation structures consider incentives,
decision horizon, and risk properties
• Three main incentive components:
– short term inventive awards based on earnings
and individual achievement
– long term stock option whose value depends on
share price performance
– mid term awards whose value depends on both
Recap – Executive Compensation
• Need a balance of risk imposed on the
manager – too much and they will avoid
investing in some projects that could benefit
the firm, too little and they will not work hard
Recap – Executive Compensation
• Compensation in the form of ESO’s and or company
shares encourages upside risk and a longer run
decision horizon while net income based
compensation (if differed and subject to claw back)
imposes some downside risk to discourage excessive
risk taking that pure share based compensation may
create
• High executive compensation is to cover effort
disutility (recall from chapter 9 the disutility of
having to work hard) and compensation risk the
manager bears
Recap – Executive Compensation
• Power Theory – executive compensation in
practice is driven by manager opportunism,
not efficient contracting
Recap – Executive Compensation
• Properties of a good performance measure =
the best trade off between sensitivity and
precision
• Financial reporting plays two important roles
in motivating manager effort
– Provides an informative performance measure
input into compensation contracts
• helps compensation committees tie pay to performance, control
manager power, and increase contract efficiency
– Improves working of managerial labour markets
• Full disclosure helps labour market evaluate manager performance
and establish reputation
Earnings Management
• Earnings management is the choice by a
manager of accounting policies (accruals), or
real actions, that affect earnings so as to
achieve some specific reported earnings
objective
– Real actions to manage earnings include, for
example, cutting or increasing R&D and advertising;
manufacturing for stock
– Accrual-based earnings management includes, for
example, managing the allowance for bad debts,
changing amortization policy
Earnings Management
• Here, we concentrate primarily on the role of
accruals in earnings management
– Note the “iron law” of accruals reversal: if accruals
increase earnings this period, their reversal lowers
earnings in future periods
•
Two types of accruals
– Non-discretionary: management has little discretion to
control amounts
– Discretionary: management has discretion to control
amounts
– To discover role of accruals in earnings management,
accountant needs to separate these two types
Earnings Management
• Patterns of earnings management
– Bath
– Income minimization
– Income maximization
– Income smooth
Earnings Management
• Motivation for earnings management:
– A contractual motivation –
• Managing earnings to maximize cash bonus
• To avoid violation of debt covenants
• To avoid political costs (tariff protection)
• To meet investors’ earnings expectations (strong
negative share price reaction if expectations not met,
damage to manager reputation if expectations not met)
• Initial public offerings (to increase proceeds of new
share issues)
The Good Side of Earnings
Management
• Investor-based arguments for good earnings
management:
– To credibly communicate inside information to
investors
• Discretionary accrual management as a way to credibly
reveal management’s inside information about
earnings expectations
The Good Side of Earnings
Management
• Contract-based arguments
– To give firm some flexibility in the face of rigid,
incomplete contracts
• Bonus contracts based on net income
– New accounting standards may lower net income and/or
increase volatility, lowering manager’s expected utility of
compensation. May adversely affect manager effort
• Debt covenant contracts
– New accounting standards may increase probability of debt
covenant violation
– Contract violation is costly, earnings management
may be low-cost way to work around
The Bad Side of Earnings
Management
• Contracting Perspective
– Healy (1985) – Reports evidence of management
use of accruals to maximize their cash bonuses
The Bad Side of Earnings
Management
• Financial Reporting Perspective
– Argues investors and analysts look to core
earnings, ignoring provisions for non-core
extraordinary and non-recurring items
– This implies manager not penalized for non-core
provisions, such as writedowns, provisions for
restructuring
– But current non-core provisions increase core
earnings in future years, through lower
amortization, and absorption of future costs
Recent examples of bad earnings
management
• Groupon Inc., Theory in Practice 11.1
• Extreme income maximization
• Capitalize marketing costs
• Emphasize pro-forma income
Standard setters response to bad
earnings management
• IAS 37
– Before recording a provision, payments must be
probable and capable of reliable estimation
– Provision must be valued at fair value
– No excess provision as a result of uncertainty
– Provisions must be used only to absorb costs for
which provision originally set up
• ASC 420-10-25
– No provision until liability incurred
Can accountants help reduce bad
earnings management?
• Yes, if full disclosure of
– Revenue recognition policies
– Unusual, non-recurring and extraordinary events
• Enables investors to better evaluate earnings
persistence
– Effect of previous writeoffs on current core
earnings
• Hanna ( 1999)
Conclusion
• Earnings management can be good if used
responsibly
• Full disclosure helps to control bad earnings
management
In class discussion
• Question 8 – Chapter 11 – General Electric
Company
Financial Accounting Theory
Eighth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial reporting
environment in a market economy
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1-1
Chapter 1
Introduction
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1.2 Some Historical Perspective
• Early development
• Great depression of 1930s reinforced historical cost accounting
• Alternatives to historical cost
• Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
• Mixed measurement model
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1.2 Collapse of the Stock Market Boom of Late
1990s
• Enron
• WorldCom
• Collapse of public confidence in capital markets
• Effects on financial reporting
• Increased regulation and corporate governance
• Sarbanes-Oxley Act
• Tighten rules re off-balance sheet entities
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1.3 Market Meltdowns, 2007-2008
• Terminology
• Securitization
• Financial instruments
• Asset-backed securities
• Collateralized debt obligations
• Asset-backed commercial paper
• Credit default swaps
• Expected loss notes
• Liquidity risk
• Liquidity pricing
• Counterparty risk
>> Continued
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Market Meltdowns, 2007-2008 (continued)
• Financial accounting issues leading up to the market meltdowns
• Fair value accounting for financial instruments
• Liquidity pricing
• Fair value less than value-in-use
• Severe criticism of fair value accounting
• High leverage of financial institutions
• Off-balance sheet liabilities
• Use of expected loss notes to avoid consolidation of structured investment vehicles
• Was disclosure of off-balance sheet liabilities adequate?
>> Continued
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Market Meltdowns, 2007-2008 (continued)
• Response of standard setters
• Stopgap measures in response to government pressure
• Fair value accounting guidance during liquidity pricing
• Increased use of internal estimates (value-in-use)
• Increased use of cost-based valuation
• New accounting standards
• Consolidation
• Derecognition
• Increased disclosure
• Response of standard setters considered in greater detail in Chapter 7
>> Continued
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1-7
Market Meltdowns, 2007-2008 (continued)
• Response of other regulators
• Increased disclosure of managerial compensation
• Move transactions to security exchanges and clearing houses from shadow
banking system
• Increased capital reserves for financial institutions
>> Continued
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Market Meltdowns, 2007-2008 (continued)
• Implications for accountants
• Need for transparency
• Value-in-use v. fair value accounting
• Full disclosure of off-balance sheet activities
• New accounting standards to help prevent future abuses?
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1.4 Efficient Contracting
• A different view of the purpose of financial reporting
than the current value orientation of standard setters
• Basic characteristics of efficient contracting view
• Emphasis on contracts. A firm can be defined by the
contracts it enters into
• E.g., debt contracts, compensation contracts…
• Emphasis on corporate governance
• Those firm policies that align the firm’s activities with the
interests of investors and society
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Efficient Contracts
• For good corporate governance, contracts should be
efficient
• Contracting parties must trust each other
• E.g., a firm can generate lenders’ trust by incorporating a covenant
into a borrowing contract. Covenants are a cost of contracting
• Lenders reward firm with lower interest rate. This is a benefit of
contracting
• An efficient contract is the best tradeoff between contracting
costs and benefits
>> Continued
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Efficient Contracts (continued)
• Efficient contracting emphasizes manager stewardship
• Compensation contracts should motivate managers to work in the best
interests of firm owners
• An efficient compensation contract does so at lowest compensation cost.
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Accounting Policy Implications of Efficient
Contracting
• Financial reporting should be reliable
• Reliable reporting generates investor trust
• Financial reporting should be conservative
• E.g., write assets down if current value less than book value. But, write
assets up only if can be done reliably.
• Rationale: encourages stewardship
• Prevents managers from increasing reputation and compensation by increasing
reported profits through non-reliable asset writeups
• These policies often conflict with current value accounting
• Current value accounting sacrifices reliability for relevance
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1.5 Ethical Behaviour by Accountants/Auditors
• Was accountant/auditor behaviour leading up to Enron, WorldCom,
and 2007-2008 market meltdowns episodes ethical?
• Serve the client (short run view) or serve society (long run view)?
• Why would you serve the client or serve society in similar
circumstances?
• Ethical principles require you to do the right thing
• Long run interests of profession require you to do the right thing
• But mindsets differ
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1.6 Rules-Based v. Principles-Based Accounting
Standards
• Do rules-based accounting standards work?
• Enron, WorldCom
• Expected loss notes
• Will more rules in new accounting standards work to prevent
abuse?
• Principles-based standards
• Important role of Conceptual Framework
• Relies on ethical accounting/auditing profession
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1.7 The Complexity of Information
• Individual reactions to same information may differ
• Reporting to investors v. reporting on stewardship complicates
reporting
• Current value v. efficient contracting views
• Information also affects how well markets work
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1.9 Information Asymmetry
• Adverse selection
• One or more parties to a business transaction have an information advantage
over other parties
• Affects operation of capital markets
• Moral hazard
• One of more parties to a contract can observe their actions but other parties
cannot
• Affects effectiveness of contracts
• Both types of information asymmetry affect efficient working of the
economy
9/8/2021
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Information Asymmetry (continued)
• Role of accounting information to control adverse selection
• Convert inside information into outside
• Supply useful information to investors
• Role of accounting information to control moral hazard
• Control manager shirking
• Improve corporate governance
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1.10 The Fundamental Problem Of Financial
Accounting Theory
• The best measure of net income to control adverse selection not the same
as the best measure to motivate manager performance
• Investors want information about future firm performance
• Current value accounting?
• Good corporate governance requires that managers “work hard”
• Does more reliable information and conservatism better reflect manager effort than current
value information?
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1.11 Regulation as a Reaction to the
Fundamental Problem of Standard Setting
• Standard setting is a form of regulation
• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces subject to failure
• Adverse selection
• Moral hazard
• Regulation steps in to try to correct market failures
• Regulation is costly
• Continued
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Regulation as a Reaction to the Fundamental
Problem of Standard Setting (continued)
• Standard setting mediates between conflicting interests of investors
and managers
• Investors want lots of useful information
• Managers may object to releasing all the information that investors desire
• Due process in standard setting mediates between investors’ and managers’
interests
• Representation of diverse constituencies
• Super-majority voting
• Exposure drafts
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1.12.5 The Process of Standard Setting
• Structure
• IASB
• International standards
• FASB
• United States standards
• Securities commissions
• Role in enforcing firms to follow standards
• May set standards themselves
• Why do they delegate most standard setting?
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Theories Relevant to Financial Accounting
• The rational investor
• A model of how an investor may use new information to revise beliefs about future
firm performance
• Rationality holds on average, not necessarily for each individual
• Efficient securities markets
• Efficiency is a matter of degree
• Share prices reasonably reflect all publicly available information
• Efficiency is relative to a stock of information
• Role of financial reporting in improving/expanding the stock of information
• Continued
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Theories Relevant to Financial Accounting
(continued)
• Behavioural theories
• Investors do not use all the information in financial statements → securi es
markets not fully efficient
• Agency theory
• Efficient contracts to motivate manager performance (stewardship) and
achieve good corporate governance
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