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Summary of Financial Accounting Theory (FAT). Summary describes all the important information from Scott's book including the various articles.
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Chapter 1 Introduction1.2 Some historical perspective
Accounting began with the double entry bookkeeping system which first appeared in 1494. For the
double entry system to handle transaction it was necessary to create abstract concepts of income
and capital. In Europe another important accounting development took place, the V.O.C. was the first
company who issued shares in 1602. Investors therefore needed information and there was a
transition from a system to control own operations to a system to inform investors. In the twentieth
century major developments in accounting shifted to the USA, in 1909 they introduced corporate
income tax and therefore the need for income measurement.
Until then accounting was relatively unregulated, but this changed after the stock market crash of
1929. The most noteworthy change was the creation of the SEC in 1934 with a focus on protecting
investors by means of a disclosure-based structure. In the 1920s and prior informing investors was
not the main motivation for voluntary disclosure, it was to avoid regulation regarding disclosure
which would reduce the monopoly power by better enabling entrants to identify high-profit
industries. The 1934 legislation can be regarded as a movement away from this rationale for
disclosure. Because of the frequent over statement of capital assets a major lesson learned by
accountant was that values are fleeting; the outcome was a strengthening of the historical cost basis
of accounting. Concepts as the use of accruals to match costs and income were introduced and the
income statement replaced the balance sheet as primary focus.
Alternative valuation bases have become more common over the years, to the point where we now
have a mixed measurement system. Historical cost is still the primary basis of accounting for
important assets and liability classes; however, assets can also decline in value due to depreciation
and amortization. Standard setters have moved steadily toward current value alternatives to
historical cost accounting over the past years. In the USA the SEC has the power to establish
accounting standard, however they delegated this to the profession to create and maintain a
financial reporting environment that protects and informs investors and encourages well working
capital markets. Thus, began the search for basic accounting concepts, but despite great effort,
accountant never agreed on a set of accounting concepts. As a result, the theory consisted largely on
‘best practices’ and priori reasoning. One argument was that measurement of inflation and the
consequences of it on the value of the firm was problematic and current values were very volatile, so
that taking them into account would not necessarily improve the measurement of the performance
of the firm. Nevertheless, the standard setters did require some disclosure of the effect of changing
prices, the basic problem with debates as how to account for changing prices was that there was
little theoretical basis for choosing among alternatives.
During this period major developments were taking place in other disciplines theories such as the
theory about rational decision making under uncertainty and the theory about efficient markets were
developed. The theory of possibility which stated that it is not possible to combine different
preferences which implies there is no perfect or true accounting concept since these different
preferences. In the latter half of the 1960s accounting theory began to show up, the concept of
decision usefulness was generated, the latest standards are also based on this concept. Equally
important was the development of imperfect information based on the theory of rational thinking
which led to the agency theory.
Subsequently, several events such as the 1990s market boom and the early 2000s market collapse
had a major impact on financial accounting and reporting. A contribution factor to the market
collapse was the revelation of numerous financial reporting irregularities whereby the most common
restatement was the restatement of revenue and the continuous discussion regarding the moment
of recognition.
,Numerous other failures of financial reporting came to light such as Enron who created SPEs which
could borrow money using Enron’s common stock through which the debt was not on the balance
sheet of Enron but the balance sheet of the SPE, which was financed by Enron. Because Enron did not
consolidate these SPEs seemingly with the agreement of their auditor the debt was not visible, when
they finally did consolidate their debt increased and their shareholders’ equity decreased massively
through which their share price declined to almost zero. A second major abuse involved Worldcom
Inc. they overstated their earnings by about 11 billion. One result of the reduction of public
confidence was increased regulation, the most notable is the SOX legislation which tightens the audit
function and improves corporate governance, the policies that align the firm’s activities with the
interest from the shareholders. To improve this the SOX created the PCAOB which is an agency who
has the power to set auditing standard and to inspect and discipline auditors of public companies.
The SOX also required that firm’s financial report include material correction adjustment and
disclosure of all material off-balance sheet loans. Finally, the CEO, CFO and auditor need to certify
the proper operation of the firms’ internal controls over financial reporting and publicly reported.
1.3 The 2007-2008 market meltdowns
Despite new regulations and standards the use of SPEs did not decline. Financial institutions transfer
pools of assets, including mortgages and credit card balances to the SIV who pools them into asset-
backed securities (ABS) and sold them to investors. They were popular with investors because they
were as same as bonds but had a higher return. The perception of safety was because house prices
would continue to rise and there was apparent diversification of credit risk. ABS’s were frequently
further securitized as CDO’s which tended to be arranged and sold privately and often consisted of
riskier mortgages. SIVs borrowed money through ABCPs to finance holdings of ABSs, their borrowed
short term for long-term investments therefore some credit losses could occur reducing the safety of
ABCPs. Therefore, some form of credit enhancement was necessary through for example a credit
default swap who protected the ABSs from further increase or a “liquidity put” by which the sponsor
would buy back the ABS when the market collapsed. Because of the high level of debt of the SIVs the
sponsors had an incentive to avoid consolidation.
Under the variable interest entities legislation there should be consolidation if the sponsor absorbed
a majority of the expected losses and received a majority of its expected gains. By mandating
consolidation, the financial reporting for financial institutions would be improved. Nevertheless,
many sponsors avoided consolidation by creating expected loss notes, the owner of this ELN would
absorb losses and receive the gains and therefore the sponsor did not need to consolidate. Beginning
2007 it came crashing down because there came more bad mortgages to supply the demand of ABSs,
the ABSs lacked transparency. Therefore, valuation methods based on well-working market variables
were not applicable. Instead, valuation was based on projected interest rates and historical interest
rates which did not anticipate the high default rate that began to appear. The rational growing
suspicion about the value is to lower the price offered, or not to buy at all, leading to a further
decline. Because many SIV’s purchased CDSs to reduce the risk of their ABS the confidence in the CDS
issuers also declined. In addition to their role in providing insurance CDS became a vehicle for
speculators since any event that would lower the value of an ABS would increase the value of the
CDSs.
Because of the huge amount of CDO and CDOs private trading due to the high demand, combined
with the off-balance sheet nature of many VIEs the shadow banking systems emerged. As a result, it
was difficult to know how many CDSs were outstanding against specific ABSs. In sum, counterparty
risk was a major contributing factor to the ABS market collapse. Since ABS securities were often
secured by ABCP, the ABCP market was also threatened with collapse and thus the SIVs faced several
problems with the value of the ABSs and the ability to sell them and the collapsing markets of the
ABCP and CDSs. Eventually the sponsors needed to buy back and write down the “toxic assets” they
,acquired, many sponsors failed, raised additional capital or were rescued by government resulting in
a major contraction of the financial system.
The blame for the initial collapse of the market for ABSs is usually laid at the feet of lax mortgage
lending practices and inadequate regulation. The lack of transparency of the complex financial
instruments was also at fault. Sponsors’ failure to adequately control the risks of excessive leverage
in the quest for leverage profits was for accountants significant. There also came criticism of fair
value accounting since writing down to the fair value created huge losses and in inactive markets fair
values had to be estimated by other means. These concerns had some validity because of the lack of
transparency of the ABSs all the ABSs were valued the same at a low price whilst some were worth
way more, allowing institutions to value these assets using their own estimates would eliminate
excess write-downs. Accounting standard setters attempted to hold their ground in the face of fair
value criticism. However, faced with threats that governments would step in to override fair value
accounting, they did relax some requirement. Because it seems that relatively unregulated markets
are subject to catastrophic market failure theories based on underlying economic models of rational
investor behavior and asset pricing have come under intense criticism following their failure to
predict the market crash. The question then is, how and to what extent should regulation be
increased as a result of this most recent failure?
Responses to the failure are; (1) require financial institutions to hold increased capital reserves; (2)
new or expanded accounting and disclosure standards; (3) limit or modify the managerial
compensation practices of financial institutions, since including large amount of stock options
contributed to the meltdown.
In sum, four points relevant to accountants stand out from the events just described; (1) financial
reporting must be transparent, so that investors can properly value assets and liabilities; (2) fair value
accounting, being based on market value or estimates thereof, may understate value-in-use when
markets collapse due to liquidity pricing that result from a severe decline in investors’ confidence; (3)
off-balance sheet activities should be fully reported, even if not consolidated; (4) substantial changes
to existing accounting standards including increased disclosures of manager compensation, have
taken place.
1.4 Efficient contracting
The severe criticism of fair value accounting arising from the security market meltdown have
strengthened an alternative view of financial reporting, the efficient contracting approach. This
theory states that the contract a firm enter into create a primary source of demand for accounting
information. The role of accounting information is viewed as one of helping to maximize contract
efficiency or, to aid in efficient corporate governance. The role of financial reporting for debt and
compensation is to generate trust, to lend to firm or to delegate managerial responsibilities to
managers. Alignment of manager and shareholder interest is the stewardship role of financial
reporting. One difference is an increased emphasis on reliability. This benefits shareholders by
increasing their trust. The second difference is the role of conservatism, unrealized losses from
declines in value are recognized when they take place but gains from increases are not recognized
until they are realized.
1.5 A note on ethical behavior
One response after the collapse of public confidence after accounting scandals was increased
regulation. However, ethical behavior by accountant and auditor is also required. They should “do
the right thing”, they must behave with integrity and independence in putting the public interest
ahead of the employer’s and the client’s interest. It is important to note that rules and regulations
are not enough to restore cooperative behavior, since no set of rules could anticipate all human
, interaction. What is needed, in addition, is that people must recognize that it is in their joint interest
to cooperate. So, besides regulations and legislations, ethical behavior is needed. There is also a time
dimension to ethical behavior, by taking into account the longer-run costs for behaving unethically,
the accountant will be motivated to behave ethically. In effect, in the longer run, self-interested
behavior and ethical behavior match.
1.6 Rule based versus principles-based accounting standards
Rule based standards attempt to lay down detailed rules for how to account. An alternative is to lay
down general principles and rely on auditor judgement to ensure that application of standards is not
misleading. It is often stated that IASB standard are more principle based than those of the US. Ball
however attributed the rules-based nature of US financial reporting to its high degree of regulation
and possible punishment. Punishment is not always effective and it if the question of whether the
world can effort to wait for these punishments, it would be preferable to prevent misleading
reporting in the first place. Principle based standards are seen as a way to accomplish this,
accounting bodies already encourage this through codes of conduct, discipline committees and the
process of standard setting. However, ball points out that such rules have been widely ignored.
Nevertheless, the SEC recommends that the FASB adopt a principle-based approach to accounting
standards. Yet, even with a strong conceptual framework, such standards will face pressure from
managers, and even governments to bend financial reporting to their wishes. To resist such
pressures, accountants will have to adopt the longer-view of their responsibilities.
1.7 The complexity of information in financial accounting and
reporting
It is complex because the product is information. The main reason for this complexity is the absence
of perfect or true accounting concepts and standards. Different shareholders would like different
types of information and therefore, would like different valuation methods, so there is no valuation
and therefore information that satisfies the needs of all the shareholders. This may seem self-serving,
since part of management’s job is to anticipate changes in values and take steps to protect firm from
adverse effect of these changes. Another reason is that the information does more than effect
individual decisions, is also affects the working of markets. The challenge for accountants is to survive
and prosper in a complex environment characterized by conflicting preferences of different groups
with an interest in financial reporting.
1.8 The role of accounting research
Thera re two complementary ways that we can view the role of research. The first is to consider its
effects on accounting practice. For example, the essence of the decision usefulness approach that
underlies the framework is that investors should be supplied with information to help them make
good investment decisions. Secondly, it is to improve our understanding of the accounting
environment, which should not be taken for granted.
1.9 The importance of information asymmetry
There are two major types of information asymmetry. (1) The first is adverse selection, this is a type
whereby one or more parties to a business transaction, or potential transaction, for example
managers and other insiders, have an information advantage over others. These insiders they can
exploit their information advantage, such tactics are adverse to the interest of ordinary investors. We
can think of financial accounting and reporting as a mechanism to control adverse selection by timely
and credible conversion of inside information into outside information. (2) The second is moral
hazard, this arises when one party to a contractual relationship takes actions that are unobservable
to other contracting parties. For example, it is impossible for shareholders to monitor the quality of
top managers on their behalves. Then, the manager may be tempted to take actions which are on
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