" Cash Flows Fixed by Contract...-..-|--cscccseeee He Stock Market Reaction to Successful-Efforts Accounting in the Oil and Gas Industry ÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔó ốc The Relationship Between
Trang 2Preface
CHAPTER 1
CHAPTER 3
TREVOAUCEION d Q G LH HH1 kg E1 5 5e E21585605551s 160 s33 5501033893 5E8* i
1.1 The Objective of Thịs Book L eieiirrrre 1 1.2 5ome Flistorical PerspeCtIW€ cieieerisrrrirrirree 1 1.3 The Complexity of Information in
Financial Accounting and eporfing eeeccceeererree 6
1.4 “The Role of Accounting Research eceesrerrreerree 6
1.5 The Importance of lnformation Âsymmetry -.-ee- 7 1.6 The Fundamental Problem of Financial Accounting Theory 8 1.7 Regulation as a Reaction to the Eundamental Problem 9 1.8 The Orpanizaton of Thịs Book | -.cc-esierrrsee 10 1.8.1 ldeal Condtfions cccsccsssskkrersrscsrrersrie 1ö 1.8.2 Adverse Selecfion ccScSrkEsskrrrrsrsrerrervee 11 1.8.3 MMoral Hazard -|c-ccecrrerrrerercee 12
1.8.4 Standard Setting cccs-l kserirkrisrrereree 13
1.9 Relevance of Financial Accounting Theory to Accounting Practice 13
CHAPTER 2 Accounting Under ldeal (GHlifi00M ìăìà.TS.ccceexececeeesricree 16
PM H? na LÃ(:Œ-443 ÔỎ 16
2.2 The Present Value Model Ủnder Certainty 16
2.3 The Present Value Model Under Ứncertainty 21
2.4 Reserve Recognidon Âccounfing -Lsssrssrssseresrrerree 29
2.4.1 Ấn Example of RRA cceLieeiirieee 29 ZA.2 Criique of RRẢ cieekiLirirrirrirrre 33 2.4.3 SumMmAFV ì Hee 35
2.5 Historcal Cost Âccounting Revisited cccccrrroeeerree 35
2.5.1 The Challenge of Historical Cost Accounting 36
2.5.2 Accountants’ Reaction to the Challenge 39
2.5.3 SummAFV series 39
2.6 The Non-Existence of True Net Ïncome cc<e 40
“Mon nägDD B), :::: 41 The Decision Usefulness Approach to Financial Reborffng 51 SA) 51
3.2 The Decision Ủsefulness Approach -cccciserrreosrree 52
3.3 Single-Person Decision Theory .ssssccocssssecsssseseussssesssanecenssecsane 53
3.3.1 Decision Theory Applied occ eescsscscscesssecesssessteesnecesneeens 53 3.3.2 The Information System c doi 57
3.3.3 Information Defined
Trang 3iv Contents
CHAPTER 4
CHAPTER 5
kẻ 9o
3.4 The Rational, Risk-Averse Ïnvestor .|+cccsrs-<xseeceeee 3.5 The Principle of Portfolio Diversification | -.ec-ceereeree 3.6 The Optimal Investment Decision Lee 3.7 xi {ca
3.7.1 Calculating and Interpreting eta
3.7.2 Portfolio Expected Value and Varlance
3.7.3 Portfolio Risk as the Number of Securities Increases
3.7.4 SUMIMALY esc eecesseeseeseeessesseesessssessessessaesssesssesapeaseesensecssetsans 3.8 The Reaction of Professional Accounting Bodies to the Decision Dsefulness Approach -. -cccccesLicerrrrrrrrerrres 3.9 Conclusions on Decision sefulness L-c-ccccccceccccecss Efficient Securities ÌMĨArÉ6fS ccceceeeerrrrertrtrtrireriieieriirerrreriee N9 .dAH,)
4.2 Efficlent Securitles Mlarkets co cecLcccccsrkererrrxree 4.2.1 The Meaning of Effciency vieeierrerreee 4.2.2 How Do Market Prices Properly Reflect All Available Information? v c.c.cccceccsssescsssssscsedessessescsessersees 4.2.3 Sumimary chu 4.3 Implications of Efficient Securities Markets for Financial Reporting cesesscssessesssessessessseessessneefesssesueeateenucenes 4.3.1 Implications series 4.3.2 Summary cverierreererrireeirerrreriee 4.4 “The Informativeness of Price -. -cccscscee [Sex ksversesxs 4.4.1 A Logical Ínconsistency, eecssrecrrreerrreerres A AQ Summary ccecerieriikrierrrtrrksrrerreee 4.5 A Capital Asset Pricing Model esescssseeccseteesyeccveseneeseedieeees 4.6 Information Äsymm€try ceeerrirrrkrrrrrirrrrerres 4.6.1 The Concept of Information Asymmctry
46.2 SUMIMALY oo
4.7 The Social Significance of Properly Working Securities Markets .cccsscssssssssssssccssscssvssssesstsssssssuce) seccuseeseeeesstaes 4.8 Examples of Full Disclosure c ccsssssesssessesssessssereefeccnesssssseesseeaee 4.8.1 IntroducHon HT [k2 sgsreseea 4.8.2 Management Discussion and Analysis
4.8.3 Euture-Oriented Financial Information cce- 4.9 Summary and Conclusions 5-ccscc.|<ccccccrseccceeccrs The Information Perspective on Decision Use fitness c.sscecsohessrscapecseesenens SH) ˆ (‹dddÁẢ(: 5.2 Qutline ofthe Research Problem 2Ss 52 [Ăcscsc22zeczsrsreces
5.2.1 Reasons for Market Ñesponse 2-ccccccce
Trang 4~ Contents v
CHAPTER 6
5.2.2 Finding the Market Response —— 140
5.2.3 Separating Market-Wide and Firm-Specific |Factors 141
5.2.4 Comparing Returns and Income scsecssepereseenerecees 142
5.3 The Ball and Brown Study ceccceeerrrrrrrrrerree 144 5.3.1 Methodology and Fïindings - 144
5.3.2 Causation versus ÀssoCIALOH c-icccccersercseeseee 146
5.3.3 Outcomes of the BB Study | e-cececeereeree 147 5.4 Earnings Response Coefficients Liceereeeererrriee 148
5.4.1 Reasons for Differential Market Response 148 5.4.2 Imphcations of ERC Research .e 154
5.4.3 Measuring Investors’ Earnings Expectations) 154
5.4.4 SUmMAFV cceceeecrrrerrerrecretrxrxerrrkrrrrrrrrrree 156
5.5 Dnusual, Non-recurring and Extraordinary Ïtems 156
5.6 A Caveat about the “Best” Áccounting Poliey 158
57 The Information Content of RRA | -.-<-.-e+ 160
5.8 Summary and Conclusions ca Lee 164 The Measurement Perspective on Decision USefuÏness 174
B.1 OV ELVIEW (444 HLL ÔÔỎ 174 6.2 Are Securittes Markets Efficlent? L -.ccccccecei 175 6.2.1 Introduction Ă co eeeeeerErrrerrerrreeerrecre 175
6.2.2 Prospect Theory ceeiL ii 176
6.2.3 Ïs Beta Dead?, con kg 179 6.2.4 Excess 5tock Market Volatility L -o-ccccceeereeeses 180 6.2.5 Stock Market Bubbles -.L 5 cscccrceekrkrerkrs 181 6.2.6 Efficient Securities Market Anomalies 181
6.2.7 Implications of Securities Market Inefficiency
for Financial Ñeporting -sse|Lseeeerrrrtereerrkee 187 6.2.8 Conclusions About Securities Market Efficiency 188 6.3 Other Reasons Supporting a Measurement Perspective .++ 189 6.4 The Value Relevance of Financial Statement Inforrnation 190
6.5 Ohlsons Clean Surplus Theory |S-c.cecskierrerrree 191
6.5.1 Three Formulae for Firm Value 5-5 sscccrercee 191
6.5.2 Earnings Persistence ccceerirrirrvee 195 6.5.3 Esttmating Firm Value | cccskecrecrecce, 198
6.5.4 Empirical Studies of the Clcan Surplus Model 202
Trang 58.5 8.6 8.7
72.1 7.2.2 7.2.3 7.2.4
"The Lower-of-Cost-or-Market Rule
Ceiling Test for Capital Àssets
7.2.5 Push-Down Áccounting -. -
7.2.6 Conclusions eeereerrrrrerrrree More Recent Fair-Value-Oriented Standards
7.3.1 Pensions and Other Post-Employment Benefi 7.3.2 Impaired Loans
Fimanctal lnstrume€nfs -eesrersererire TAA Introduction ec-ieeeereeriiree
7.4.2 Valuation of Debt and Equity Securities
7.5.3 Self-Developed Goodwill
7.5.4 The Clean Surplus Model Revisited
7.5.5 SUMATV cccreerrrrrrrrrrrererrrre
Reporting on ÑIsk ceeierieerrririerrereee 7.6.1 Beta Rsk ì ii
7.6.2 5tock Market Reaction to Ôther Risks
7.6.3 A Measurement Perspective on Risk Reportin
7.64 Conclusions .cccssssccseccesssesecseeseseneneeneesees
Summary and Conclusions
The Rise of Economic Consequences Employee S5tock Ôptions cc-cccccere
Accounting for Government Âssistance
8.4.1 The PIP Grant Accounting Controversy 8.42 Summary
Accounts Recervable and Payable " Cash Flows Fixed by Contract - -| cscccseeee He
Stock Market Reaction to Successful-Efforts Accounting
in the Oil and Gas Industry ÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔÔó ốc
The Relationship Between Efficient Securities Market Theory
and Economic Consequences
The Positive Theory of Accounting 8.7.1 Outline of Positive Accounting Theory
8.7.3 Empirical PAT Research
co
8.7.2 The Three Hypotheses of Positive Accounting Theory
«QC 9 Họ 9 6Á Km HH NA Ậm 6 0.0 6b D9 9 b0 4# 6 0 6
Trang 6Contents vii
8.7.4 Distinguishing the Opportunistic and Efficient
Contracting Versions of PÄTT' -teereereerrmrrre 283
8.7.5 Conclusions -.-e eeerrrresrserrserrrrirerrrrrrirem 286 CHAPTER 9 An Analysis of Cenffkt eeeeeeeeeeeenrerrrrrrrrrreetrrhtrrrrrrrreerrrre 298
QA Overview cecereieererrrrerrrerirrrerrrirtririrrrrirrtririir 298 9.2 Understanding Game Theory «ccserereedtrerrrrrrerrrrrre 299
9.3 A Non-cooperative Game Model of Manager-Investor Contflict 300 9.3.1 Summary eereeeeererreeerrerrrerrrrrrerrirrrrrr 305 9.4 Some Models of Cooperative Game Theory . -eeeee 305
9.4.1 Introduction c-ccererreerrtetrrrerrterirrerirerree 305 9.4.2 Agency Theory : An Employment Contract Between
Firm Owner and Mlanager -csecs|eceeeeersrreeerrre 306 9.4.3 Agency Theory : A Bondholder-Manager Lending
9.5 Implications of Agency Theory for Âccounting 318
9.5.1 Holmströms Agency Model -. -e« 318 9.5.2 Rigidity of ContractS eccceeetrrrrrrerrerrrrrrr 319
9.6 Reconciliation of Efficient Securities Market Theory with
Economic ConsedueniC€s -. ccerrrerrerrrrrrrririrrirrrriee 321 9.7 Summary and Conclusions -ccecerreteeerrerrrrreerrireer 322 CHAPTER 10 Execuliue C01P€HSAFI0H eceeeeesenneeerrreeretererrtrlserrrrrrrerereie 335
10.1 VerVIEW ì.ĂcrrrerrerrErrrirrrrrrrrrrririirlrrrrieriree 335 10.2 Are lncentive Contracts Necessary? eeeeeesierserrerreree 336
10.3 A Managcrial Compensation PÏan | -eeeieeerre 338
10.4 The Theory of Executive Compensation -.«ecerrereeceee 345
10.5 The Role of Risk in Executive Compensation .eere.x 348
10.6 Empirical Compensation Research L-.eecceerererriiree 350
10.7 The Politics of Executive Compensation L c-c-eecerrrrer 353
10.8 Summary ececeeerrterrtrrtrirtrirrrriiriiirieeiererrrirriire 356 CHAPTER 11 Earnings Àaiage1€HH àeeeceeeeeeerieerieiieiriiirrririirrre 368
PDD Overview oe ccccceecccsccsecsersectenvesssnsstsssssssssassnsassnesessecnansesceesapesssecseanens 368 11.2 Evidence of Earnings Management for Bonus Purposes 369 11.3 Other Motivatons for Earnings Management 377 11.3.1 Other Contractual Motivations . c-c-sececeee 377 11.3.2 Political MotivatlOnS cceieiireierrrrrrree 379 11.3.3 Taxation Motivatlons ceeceeiiereire 379 11.3.4 Changes of CEO c.cieceeririikiirrrrie 380 11.3.5 Initial Public Ofiferings cceeeesiieriieeire 382 11.3.6 To Communicate Information to ÍnvestOrs | 383 11.4 Patterns of Earnings Management L-cvcecdreiererre 383
Trang 7viii Contents
CHAPTER 12
CHAPTER 13
11.5 Why Does Earnings Management Persist?
11.6 The “Good” Side of Earnings Management
11.7 The “Bad” Side of Earnings Management
11.8
Standard Setting: Economic ÏSSM63 «-ccceceeeeserreserrrer
12.1 12.2 12.3
12.4
12.5 12.6 12.7 Standard Setting: Political Issues
13.1 13.2
13.3
13.4
13.5 13.6
9 7
Regulaton of Economic ẢctiVIfV cceeeeeee
Private Incentives for Information Production
12.3.1 Ways to Characterize Information Production
12.3.2 Contractual Incentives for Information Produ 12.3.3 Market-Based Incentives for Information Pro 12.3.4 Securities Market Response to Full Disclosure 12.3.5 Other Information Production Incentives
12.3.6 Conclusions cccccccccceccscsessssessecsssecsessnenesceed
Sources of Market Failure
12.4.1 Externalities and Free-Riding -
12.4.2 The Adverse Selection Problem
12.4.3 The Moral Hazard Problem
13.3.2 The Ontario Securities Commission
13.3.3 The Financial Accounting Standards Board
13.3.4 The Securities and Exchange Commission
The International Accounting Standards Board
13.4.1 Establishment and Objectives of the IASB
13.4.2 Structure of the IASB
13.4.3 Authority of the IASB
Relationship to ‘Theories of Regulation
Conflict and Compromise 13.6.1 An Example of Constituency Conflict 13.6.2 Comprehensive Income
13.6.3 Conclusions
Summary and Conclusions - ccc-cceec-
13.3.1 The Canadian Institute of Chartered Accountants
Bete e ner e ce cou nen catnooscencerananasorions
Trang 8Bibliography
Index
13.7 Criteria for Standard Setting 13.7.1 Decision sefulness cc-c-cscsss<cece- 13.7.2 Reduction of Information Asymmetry
13.7.3 Economic Consequences of New Standards
13.7.4 The Political Aspects of Standard Setting
13.7.5 Summary
13.8 Conclusions
Contents
Trang 9PREFACE
This book began as a series of lesson notes for a financial
course of the Certified General Accountants’ Association of (
notes grew out of a conviction that we have learned a great de:
financial accounting and reporting in our society from secu
information economics-based research conducted over man
financial accounting theory comes into its own when we forn
information asymmetries that pervade business relationships
The challenge was to organize this large body of reseay framework and to explain it in such a manner that professio
dents would both understand and accept it as relevant to the fi
environment and ultimately to their own professional careers
This book seems to have achieved its goals In addition t
CGA program of professional studies for a number of years,
sively class-tested in financial accounting theory courses at
Waterloo, Queen’s University, and several other universities,
undergraduate and professional Master's levels | am encourag
by and large, the students comprehend the material and, in
object if the instructor follows it too closely in class This fr¢
accounting theory lanada The lesson
al about the role of rities markets and
ly years, and that nally recognize the
ch into a unifying nally oriented stu-
nancial accounting
o being part of the
it has been exten- the University of both at the senior
ed by the fact that,
deed, are likely to
es up class time to
expand coverage of areas of interest to individual instructors
particular topics by means of articles from the financial press a:
academic literature
Despite its theoretical orientation, the book does not ign!
al structure of financial accounting and standard setting It fe
coverage of financial accounting standards Many important
reserve recognition accounting, management discussion and
stock options, postretirement benefits, financial instruments,
and ceiling tests, and hedge accounting are described and criti
structure of standard-setting bodies is also described, and the
helping to engineer the consent necessary for a successful sta
While the text discussion concentrates on relating standard
framework of the book, the coverage provides students with th
the contents of the standards themselves
I have also used this material in Ph.D seminars Here, I research articles that underlie the text discussion Nevertheless,
ciate the framework of the book as a way of putting specific 1
perspective Indeed, the book proceeds in large part by selecting
papers for description and commentary, and provides extensive
research papers underlying the text discussion Assignment of|
themselves could be especially useful for instructors who wish
ological issues that, with some exceptions, are downplayed in t
role:of structure in ndard is evaluated
s to the theoretical
he occasion to learn
concentrate on the the students appre-
esearch papers into
important research
references to other
the research papers
to dig into method-
he book itself
Trang 10xii Preface
In this third Canadian edition, I have added references and discussion of
recent research articles, updated the coverage of financial accounting standards of
Canada and the United States, and generally revised the exposition as a result of experience in teaching from carlier editions Major changes include a brief outline
of the historical development of financial accounting in Chapter 1, an expanded
discussion of the possibility of securities market inefficiency in Chapter 6 includ-
ing behavioural underpinnings and recent analytical modelling, further expansion
of the discussion of clean surplus accounting in Chapter 6, and/ updating of the structure of international accounting standard setting in Chapter 13 In addition,
I have changed the tone somewhat of the coverage of earnings) management in Chapter 11 In previous editions, it was argued that earnings management is pri- marily “good,” since it can reveal management's inside information about future earning power This point of view is retained, but modified to give greater recog-
nition to the possibility that earnings management can be “bad,” that is, intended
to manipulate investors’ perceptions of the firm so as to possibly increase share price This latter possibility becomes of greater concern once it ig recognized that
securities markets may not be as fully efficient as previously believed
Despite these changes, the book largely retains the structure, organization
and markets-oriented outlook of the earlier editions In particular, it retains the
view that investor rationality and efficient securities market theory are still the most useful theories to guide accountants in their disclosure decisions, and that the motivation of responsible managerial performance is an equally important
role of financial reporting as the providing of useful information to investors
Supplements
The Instructor’s Manual includes suggested solutions to the end-of-chapter Questions and Problems, including a number of new problems added in this edi- tion It also discusses the Learning Objectives for each chapter and suggests teaching approaches that could be used In addition, it comments on other issues for consideration, suggests supplementary references, and contains some addi-
tional problem material In addition to this material, the third edition Instructor's
Manual adds PowerPoint slides to the Instructor's Manual
The Instructor’s Manual for the third edition is available in hard copy with all the solutions and PowerPoint Presentations also included on a CD ROM electronic format | intend to use this flexibility to add discussions of relevant new topics and interesting new problem material as they arise
For students who wish to explore the Internet as a dynamic|source for up-to- the-minute information, Pearson Education Canada is proud to present Accounting Central This site contains numerous features designed to help students and instructors with all their accounting courses You will find Accounting Central at www.pearsoned.ca/accounting The features on the site include
Education Canada’s accounting catalogue, drop-down menus
accounting, Companion Websites and text-resource sites where
links to Pearson
for all Canadian
rou can find text-
Trang 11I have received a lot of assistance in writing this book First, I thank CGA
Canada for their encouragement and support over a number of years Much of
the material in the questions and problems has been reprinted lor adapted from
the Accounting Theory I course and examinations of the Certified General Accountants’ Association of Canada These are acknowledged where used
At Pearson Education Canada I would like to thank Samantha Scully, Judith
Scott, Laurie Goebel, and Karen Hunter I extend my thanks and appreciation to
the following reviewers as well: Joel Amernic, University of Toronto; Bert Dartnell, Certified General Accountants’ Association of Canada; Johan de Rooy, University of British Columbia; Steve Fortin, McGill University; Maureen
Gowing, Concordia University; George Lan, University of Windsor; A William
Richardson, Brock University, Pamela Ritchie, University of New Brunswick,
David Senkow, University of Regina I acknowledge the financial assistance of the Ontario Chartered Accountants’ Chair in Accounting at the University of Waterloo, which has enabled teaching relief and other support in the preparation
of the original manuscript Financial support of the School of Business of Queen's University is also gratefully acknowledged
I also thank numerous colleagues and students for advice and feedback
These include Sati Bandyopadhyay, Phelim Boyle, Dennis Chung, Len Eckel,
Haim Falk, Steve Fortin, Jennifer Kao, David Manry, Patricia O’Brien, Bill Richardson, Gordon Richardson, Dean Smith, and Dan Thornton
I thank the large number of researchers whose work underlies this book As previously mentioned, numerous research papers are described and referenced
However, there are many other worthy papers that I have not referenced This
implies no disrespect or lack of appreciation for the contributions of these authors
to financial accounting theory Rather, it has been simply impossible to include
them all, both for reasons of space, and the boundaries of my own knowledge
I am grateful to Carolyn Holden for skillful, timely, and cheerful typing of
the original manuscript in the face of numerous revisions, and to Jill Nucci for research assistance
Finally, I thank my wife and family who, in many ways, have been involved
in the learning process leading to this book
William Scott
Trang 12oduction
This book is about accounting, not how to account It argues that accounting students, having been exposed to the methodology and practice of accounting, need at least one course that critically examines the broader implications of
financial accounting for the fair and efficient operation of] our economy Its
objective is to give the reader an understanding of the current financial account- ing and reporting environment, taking into account the divers¢ interests of exter-
Accounting has a long history The first complete description of the double entry bookkeeping system appeared in 1494, authored by Luca Paciolo, an Italian
monk/mathematician.! Paciolo did not invent this system—it had developed over
a long period of time Segments that developed first included, for example, the
collection of an account receivable “Both sides” of such a transaction were easy to
see, since cash and accounts receivable have a physical and/or legal existence, and the amount of the increase in cash was equal to the decrease in accounts receiv-
able The recording of other types of transactions, such as sale of goods or the
incurring of expenses, however, took longer to develop In the ¢ase of a sale, it was
obvious that cash or.accounts receivable increased, and that goods on hand decreased But, what about the difference between the selling price and the cost of the goods sold? There is no physical or legal representation of the profit on the
sale For the double entry system to handle transactions such af this, it was neces- sary to create abstract concepts of income and capital By Paciolo’s time, a com- plete double entry system quite similar to the one in use today was in place
Indeed, it was the abstract nature of the system, including the properties of
Trang 13capi-2 Chapter 1
tal as the accumulation of income and income as the rate of change of capital? that
attracted the attention of mathematicians of the time The “method of Venice,” as Paciolo’s system was called, was frequently included in mathematics texts in sub- sequent years
Following 1494, the double entry system spread throughout Europe, and
Paciolio’s work was translated into English in 1543 It was in England that
another sequence of important accounting developments took place
By the early eighteenth century, the concept of a joint stock company had developed in England to include permanent existence, limited liability of share-
holders, and transferability of shares Transferability of shares led in turn to the development of a stock market where shares could be bought and sold Obviously,
investors needed financial information about the firms whose shares they were
trading Thus began a Jong transition for financial accounting, from a system to enable a merchant to control his/her own operations to a system to inform investors who were not involved in the day-to-day operations of the firm [t was in the joint interests of the firm and investors that financial information provided by the firm
was trustworthy, thereby laying the groundwork for the development of an auditing profession and government regulation In this regard, the 1844 Companies Act was
notable It was in this act that the concept of providing an audited balance sheet to shareholders first appeared in the law, although this requirement was dropped in subsequent years° and not reinstated until the early 1900s During the interval, vol-
untary provision of information was common, but its effectiveness was hampered
by a lack of accounting principles This was demonstrated, for example, in the con- troversy of whether amortization of capital assets had to be deducted in determin-
ing income available for dividends (the courts ruled it did not)
In the twentieth century, major developments in financial accounting shifted
to the United States, which was growing rapidly in economic power The intro- duction of a corporate income tax in the United States in 1909] provided a major
impetus to income measurement, and, as noted by Hatfield (11927, p 140), was
influential in persuading business managers to accept amortization as a deduction from income
Nevertheless, accounting in the United States continued to be relatively
unregulated, with financial reporting and auditing largely voluntary However, the stock market crash of 1929 and resulting Great Depression led to major changes
The most noteworthy was the creation of the Securities and Exchange
Commission (SEC) by the Securities Act of 1934, with a focus on protecting investors by means of a disclosure-based regulatory structure
Merino and Neimark (1982) (MN) examined the conditions leading up to
the creation of the SEC In the process, they reported on some of the securities market practices of the 1920s and prior Apparently, voluntary disclosure was
widespread, as also noted by Benston (1973) However, MN claim that such dis-
closure was motivated by big business’s desire to avoid regulations to enhance
“potential competition,” that is, to avoid regulations to encourage competition
Trang 14
Introduction 3
Full disclosure regulations would encourage competition by enabling potential
entrants to identify high-profit industries Presumably, if voluntary disclosure was adequate, the government would not feel regulated disclosure wag necessary Thus, informing investors was not the main motivation of disclosure Instead, investors
were “protected” by a “2-tiered” market structure whereby prices were set by knowledgeable insiders, subject to a self-imposed “moral regulation” to control misleading reporting Unfortunately, moral regulation was not|always effective,
and MN refer to numerous instances of manipulative financial reporting and other abuses, which were widely believed to be the immediate causes of the 1929 crash
The 1934 securities legislation can then be regarded as a movement away from
a potential competition rationale for disclosure towards the supplying of better-
quality information to investors as a way to control manipulative financial practices.4 One of the practices of the 1920s that received criticism
appraisal of capital assets, the values of which came crashing down in 1929 A
major lesson learned by accountants as a result of the Great Depression was that values were fleeting The outcome was a strengthening of the historical cost basis
of accounting This basis received its highest expression in the famous Paton and
Littleton monograph, An Introduction to Corporate Accounting Standards, of 1940 This document elegantly and persuasively set forth the case for historical cost
accounting, based on the concept of the firm as a going concern This concept jus- tifies important attributes of historical cost accounting such as jwaiting to recog-
nize revenue until objective evidence of realization is available, the matching against realized revenues of the allocated costs of earning those revenues, and the deferral of unrealized gains and losses on the balance sheet until the time came to match them with revenues As a result, the income statement reliably shows the current “installment” of the firm's earning power The income statement replaced
the balance sheet as the primary focus of financial reporting
It is sometimes claimed that the Paton and Littleton monograph was “too”
persuasive, in that it shut out exploration of alternative bases of accounting As we
shall see in this book, historical cost is still the primary basis ofaccounting and it
has only recently begun to yield to fair value accounting and the renewed impor-
tance of the balance sheet The term “fair value” is a general expression for the valu- ation of any asset or liability on the basis of its market value, the discounted present value of its future receipts, or in some cases by means of a mathematical model.” Another lesson learned by accountants was how to survivelin the new SEC- regulated environment The SEC has the power to establish the accounting stan- dards and procedures used by firms under its jurisdiction If the|SEC chose to use this power, the prestige and influence of the accounting profession would be
' greatly eroded, possibly to the point where financial reporting becomes a process
of “manual thumbing” with little basis for professional judgement and little influ-
ence on the setting of accounting standards However, the SEC chose (and still
chooses) to delegate most standard setting to the profession.° To retain this dele-
gated authority, however, the accounting profession must retain the SEC’s confi-
Trang 15
4 Chapter 1
dence that it is doing a satisfactory job of creating and maintaining a financial reporting environment that protects and informs investors and
proper operation of capital markets Thus began the search for acc
ples, those underlying truths on which the practice of accounting 1
based This was seen as a way to improve practice by reducing inc
choice of accounting policies across firms and enabling the acco
reporting challenges’ to be deduced from basic principles rather t
in an ad hoc and inconsistent way
Accountants have laboured long and hard to find these basic
with relatively little success.’ Indeed, they have never agreed on
what accounting principles are, let alone a list of them
As a result, accounting theory and research up to the late 1 largely of a priori reasoning as to which accounting principles and
“best.” For example, should the effects of changing prices and inf}
encourages the ounting princi-
š, or should be,
onsistencies in inting for new
cial statements be taken into account, and, if so, how? This debate can be traced
back at least as far as the 1920s Some accountants argued that the fair values of
specific assets and liabilities held by the firm should be recognized, with the resulting unrealized holding gains and losses included in net income Other
accountants argued that inflation-induced changes in the purchasing power of
money should be recognized During a period of inflation, the firm suffers a pur-
chasing power loss on assets such as cash and accounts receiv
amounts of goods and services that can be obtained when they at
able, since the
e collected and
spent is less than the amounts that could have been obtained when they were cre-
ated Conversely, the firm enjoys a purchasing power gain on liabilities such as accounts payable and long-term debt Separate reporting of these
would better reflect real firm performance, it was argued Still ot
argued that the effects of both specific and inflation-induced ch
should be taken into account Others, however, often including
ment, resisted these suggestions One argument, based in part on
the Great Depression, was that estimates of fair values and m
inflation were unreliable, so that taking them into account would
improve the measurement of the firm’s performance
pains and losses
her accountants
Jangeés in prices
: firm manage- experience from easutements of
not necessarily
Nevertheless, standard setters in numerous countries did require some disclo- sures of the effects of changing prices In Canada, for example, Section 4510 of the CICA Handbook required disclosure in the notes to the financial st
fair values of inventories and capital assets, and of purchasing p
losses resulting from inflation Section 4510 was subsequen
However, this withdrawal was due more to the decline in inflation
lowing introduction of the section rather than to the debate havin
The basic problem with debates such as the accounting for
was that there was little theoretical basis for choosing among the
atements of the ower gains and tly withdrawn
in the years fol-
» been settled changing prices various alterna- tives, particularly since, as mentioned, accountants were unable to agree on a set
of basic accounting principles
Trang 16Introduction 5
During this period, however, major developments were taking place in other
disciplines In particular, a theory of rational decision making under uncertainty
developed as a branch of statistics The theory of efficient securities markets
developed in economics and finance The Possibility Theorem lof Arrow (1963)
led to the realization that there was no such thing as “true” net income, implying that the search for the best accounting principles and practices was a “will-o’-the- wisp.” These theories, which began to show up in accounting theory in the latter half of the 1960s, generated the concept of decision—useful (in place of “true”) financial statement information This concept first appeared lin the American
Accounting Association (AAA)? monograph, A Statement of Basic Accounting
Theory, in 1966 Current statements of basic accounting principles, most notably
the Conceptual Framework of the Financial Accounting Standards Board
(FASB), are based on decision usefulness
Equally important was the development of the economics af imperfect infor-
mation, a branch of economics that formally recognizes that|some individuals have an information advantage over others This led to the development of the
theory of agency, which has greatly increased our understanding of the legitimate interests of business management in financial reporting and standard setting
These theories suggest that the answer to which way to account, if any, for
changing prices outlined above will be found in the extent to which they lead to
good investment decisions Furthermore, any resolution will haye to take the con-
cerns of management into account
In Canada, the development of financial accounting and 1 ceeded differently, although the end result is basically similar to
States Financial reporting requirements in Canada were laid down in federal and
provincial corporations acts, along the lines of the English corporations acts referred to above The ultimate power to regulate financial reporting rests with the
legislatures concerned However, in 1946, the Committee on Accounting and Auditing Research, now the Accounting Standards Board (AcSB), of The Canadian Institute of Chartered Accountants (CICA) began to issue bulletins on
financial accounting issues These were intended to guide Canadian accountants as
eporting has pro-
that of the United
to best practices, and did not have force of law In 1968, these w
the CICA Handbook At first, adherence to these provisions ¥
given their prestigious source, were difficult to ignore Over t
gained recognition as the authoritative statement of Ge
Accounting Principles (GAAP) in Canada Ultimately, proving
missions and the corporations acts formally recognized this auth
in 1975 the Canada Business Corporations Act required adhe
Handbook to satisfy reporting requirements under the act The
similar to that in the United States in that the body with ultim
ere formalized into
was voluntary but,
me, the Handbook nerally Accepted ial securities com- ority For example, rencé to the CICA end result, then, is
ate authority to set
accounting standards has delegated this function to a private professional body.12
‘These various developments set the stage for the current fij and reporting environment that is the subject of this book
nancial accounting
Trang 176 Chapter 1 |
The environment of accounting is both very complex and very ch
complex because the product of accounting is information—a
important commodity One reason for the complexity of informati
viduals are not unanimous in their reaction to it For example,
investor may react positively to the valuation of certain firm assets
the grounds that this will help to predict future firm perform
investors may be less positive, perhaps because they feel that fair
tion is unreliable, or simply because they are used to historical cost information Furthermore, managers, who will have to report the fair values, might react quite negatively While ultimately part of management's job is to anticipate changes in fair values, such changes are typically perceived by managers as beyond their con-
trol Thus, they argue, unrealized gains and losses resulting from value do not reflect their performance and should not be included
result, accountants quickly get caught up in whether reported net
fulfill a role of facilitating the prediction of firm performance, or 4 ing on management’s stewardship of the firm’s resources
Another reason for the complexity of information is that it
affect individual decisions In affecting decisions it also affects t markets, such as securities markets and managerial labour mark
operation of such markets is important to the efficiency and fairn
omy itself
The challenge for financial accountants, then, is to survive a complex environment characterized by conflicting pressures from with an interest in financial reporting This book argues that th survival and prosperity will be enhanced if accountants have a cr
of the impact of financial reporting on investors, managers, and th
changes in fair
in income Asa income should role of report-
does more than
he operation of
ets The proper
ess of the econ-
nd prosper in a different groups
Section 1000 of the CICA Handbook, and the Conceptual Fra
FASB in the United States The essence of this approach is that
complementary
er its effects on oach underlies
mework of the nvestors should