Chapter 11 summary of the book financial accounting theory by william r scott
Summary of Chapter 10 of the book Financial Accounting theory
Accounting theories and practice chapter 9 summary of the book financial accounting theory
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Summary Accounting & Governance
Book: Scott - Financial Accounting Theory
Chapter 1 - 13
Content
Chapter 1: Introduction.............................................................................................................................................................................................. 2
Chapter 2: Accounting under ideal conditions............................................................................................................................................................7
Chapter 3: The decision usefulness approach to financial reporting.........................................................................................................................11
Chapter 4: Efficient Securities Markets.....................................................................................................................................................................17
Chapter 5: The value relevance of accounting information......................................................................................................................................25
Chapter 6: The measurement approach to decision usefulness................................................................................................................................30
Chapter 7: Measurement applications.....................................................................................................................................................................38
Chapter 8: The efficient contracting approach to decision usefulness......................................................................................................................46
Chapter 9: An analysis of conflict.............................................................................................................................................................................52
Chapter 10: Executive compensation....................................................................................................................................................................... 59
Chapter 11: Earnings management...........................................................................................................................................................................66
Chapter 12: Standard setting: economic issues........................................................................................................................................................72
Chapter 13: Standard setting: political issues...........................................................................................................................................................80
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,Chapter 1: Introduction
1.2 Some historical perspective
Mixed measurement system historical cost is still the primary basis of accounting for important asset and liability
classes, such as capital assets, inventories, and long-term debt. However, if assets are impaired, they are frequently
written down to a lower value. Standard setters have moved steadily toward current value alternatives to historical
cost accounting over the past number of years.
There are two main current value alternatives to historical cost for assets and liabilities:
1. Value-in-use discounted present value of future cash flows
2. Fair value the amount that would be received or paid should the firm dispose of the asset/liability
a. Also called: exit price or opportunity cost
Well-working capital markets markets on which the market values of assets and liabilities equal, or reasonability
approximate, their real underlying fundamental values.
Possibility Theorem of Arrow no set of concepts will be fully satisfactory to both parties. For example: investors
will prefer different accounting concepts than will managers.
The Conceptual Framework of the IASB and the Financial Accounting Standards Board included the concept of
decision usefulness the objective of financial statements is to provide information to assist investors to make
investment decisions.
Corporate governance those policies that align the firm’s activities with the interest of its investors and society. For
example: creation of an audit committee of the Board of Directors is a corporate governance polity to tighten the
audit function by improving communication between the Board and the firm’s auditor, particularly where the auditor
has concerns about the manager’s operation of the firm’s accounting and reporting system.
Public Company Accounting Oversight Board (PCAOB) the power to set auditing standards and to inspect and
discipline auditors of public companies. The financial statements have to present fairly the company’s results of
operations and financial position.
1.3 The 2007-2008 market meltdowns
Structured investment vehicles (SIVs) often created by lenders such as banks, mortgage companies, and other
financial institutions to securitize their holdings of mortgages, credit card balances, auto loans, and other financial
assets. The institution would transfer large pools of these assets to the SIVs it sponsors. The SIV would pool them into
asset-backed securities (ABSs). That is, into tranches of similar credit quality.
Credit risk the risk that a party to a financial contract (mortgage) will be unable to meet its financial obligations.
ABSs were frequently further securitized as collateralized debt obligations (CDOs), which consisted of tranches of
similar quality ABS tranches, a procedure that further increased diversification.
Asset-backed commercial paper (ABCP) paid higher interest rates than treasury bills and, like the underlying ABSs,
typically received high ratings from investment rating agencies. It was popular with companies and other investors
who wanted to invest surplus cash for a short term.
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,ABSs long-term investments.
ABCP short term borrowings.
1.4 Efficient contracting
Standard setters apparently feel that fair value accounting is the best way to implement the decision usefulness
concept that, as described in section 1.2, developed during the 1960s. However, the severe criticism of fair value
accounting arising from the security market meltdowns have strengthened an alternative view of financial reporting,
namely the efficient contracting approach to financial reporting the contracts that firms enter into (e.g., debt
contracts and managerial compensation contracts) create a primary source of demand for accounting information.
The role of accounting information is one of helping to maximize contract efficiency or to aid in efficient corporate
governance.
Debt and compensation contracts depend on accounting variables, such as net income. The role of financial reporting
for debt and compensation contract purposes is to generate trust. This is needed if lenders are to be willing to lend to
the firm and if shareholders are to be willing to delegate managerial responsibilities to managers. Net income can be
used as a measure of manger performance. Alignment of manager and shareholder interest is the stewardship role of
financial reporting, one of the oldest concepts in accounting.
Efficient contracting leads to some major accounting policy differences from the measurement approach (current
value accounting) of financial reporting envisaged by standard sets, since trust is compromised to the extent that
managers are able to manipulate the values of accounting variables used in contracts. The differences are:
Increased emphasis on reliability of accounting information benefits lenders by increasing their trust that
the firm manager will not take actions that harm their interests (e.g., disguising deteriorating earnings). Also
benefits compensation contracting by increasing shareholders’ trust that managers cannot cover up poor
performance by opportunistically manipulating reported net income and balance sheet values.
Role of conservatism in financial reporting unrealized losses from declines in value are recognized when
they take place, but gains from increases in value are not recognized until they are realized.
o Lower-of-cost-or-market (inventories), impairment tests (for capital assets and financial
instruments).
Two conflicting roles:
Standard setters’ view conservatism reduces the probability of lawsuits that invariable result when firms
report major unexpected losses.
o This role point out that fair value accounting is, in effect, conservative when fair value fall, but can
also serve a useful investor-informing role when fair values rise.
Contracting view conservatism is a vehicle to improve contract efficiency by providing investors,
particularly debt investors, with an “early warning system” of financial distress. Also serves a stewardship role
by preventing managers from overstating their performance and compensation by recognizing unrealized
gains.
o This role is more concentrated about low reliability of conservative accounting in order to attain the
benefits of contract efficiency and good corporate governance, they argue that low reliability of
unrealized fair value gains works against conservatism, contract efficiency, and governance.
1.5 A note on ethical behaviour
How to restore and maintain public confidence in financial reporting? Response = increased regulation, including new
accounting standards. However, ethical behaviour by accountants and auditors is also required, since numerous
accountants designed, were involved in, or at least knew about the various reporting irregularities.
Ethical behaviour accountants and auditors should “do the right thing”. Accountants must behave with integrity
and independence in putting the public interest ahead of the employer’s and client’s interests, should these conflict.
There is a time dimension to ethical behaviour. An accountant can act in his own self-interest and still behave
ethically. Self-interested behaviour and ethical behaviour can merge.
1.6 Rules-based versus principles-based accounting standards
Rules-based standards attempt to lay down detailed rules for how to account.
US financial reporting.
3
, Principles-based standards lay down general principles only, and rely on auditor professional judgement to ensure
that application of the standards is not misleading.
IASB standards.
It seems that the world is moving toward principles-based standards. Yet, even with a strong conceptual framework,
such standards will face pressures from managers, and even governments, to bend financial reporting to their wishes.
To resist such pressures, auditors and accountants will have to adopt the longer-term view of their responsibilities.
1.7 The complexity of information in financial accounting and reporting
The environment of accounting is both very complex and very challenging:
Very complex because the product of accounting is information (powerful and important commodity).
Reasons:
o The absence of perfect or true accounting concepts and standards. As a result, individuals will not be
unanimous in their reaction to even the same information.
o It does more than affect individual decisions. It also affects the working of markets, such as securities
markets and managerial labour markets.
The challenge for financial accountants is to survive and prosper in a complex environment characterized by
conflicted preferences of different groups with an interest in financial reporting.
1.8 The role of accounting research
There are two complementary ways that we can view the role of research (in this book we use both):
1. To consider its effects on accounting practice.
2. To improve our understanding of the accounting environment.
1.9 The importance of information asymmetry
Information economics some parties to business transactions may have an information advantage over others or
may take actions that are unobservable to others. When this happened, the economy is said to be characterized by
information asymmetry.
There are two major types of information asymmetry:
Adverse selection one or more parties to a business transaction, or a potential transaction, have an
information advantage over other parties.
o Insider persons (firm manager) will have better information about the current condition and future
prospects of the firm than outside investors.
Moral hazard one or more parties to a contract can observe their actions in fulfilment of the contract but
other parties cannot.
o Occurs because of the separation of ownership and control that characterizes most large business
entities.
Both adverse selection and moral hazard result from information asymmetry. The difference is that adverse selection
involves inside information about matters affecting future firm performance and resulting security returns. Moral
hazard involved manager effort – the manager knows how hard he is working but investors do not.
1.10 The fundamental problem of financial accounting theory
Given the absence of perfect or true accounting concepts, it turns out that the most useful measure of net income to
inform investors – that is, to control adverse selection – need not be the same as the best measure to measure and
motivate manager stewardship – that is, to control moral hazard.
Investors’ interests are best served by information that enables better investment decisions and better-operating
capital markets. Providing it is reasonable reliable, current value accounting fulfils this role, since it provides up-to-
date information about assets and liabilities, hence of future firm performance, and reduces the ability of insiders to
take advantage of changes in asset and liability values.
Managers’ legitimate interests are best served by information that is highly informative about their performance in
running the firm, since it enables efficient compensation contracts and better working of managerial labour markets.
Fair value accounting can improve reporting on stewardship since, ultimately, the manager is responsible for
everything, including current value gains and losses.
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