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www.downloadslide.net www.downloadslide.net FINANCIAL ACCOUNTING THEORY Seventh Edition William R. Scott University of Waterloo Toronto www.downloadslide.net To Mary Ann, Julie, Martha, Kathy, Paul, and Cary Acquisitions Editor: Megan Farrell Sponsoring Editor: Kathleen McGill Marketing Manager: Claire Varley Program Manager: Madhu Ranadive Developmental Editor: Rebecca Ryoji Project Manager: Jessica Hellen Production Services: Raghavi Khullar, Cenveo® Publisher Services Permissions Project Manager: Joanne Tang Text Permissions Research: Anna Waluk, Electronic Publishing Services Cover Designer: Suzanne Behnke Cover Image: © demonishen/Fotolia Credits and acknowledgments of material borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page. If you purchased this book outside the United States or Canada, you should be aware that it has been imported without the approval of the publisher or author. Copyright © 2015, 2012, 2009, 2006, 2003, 2000, 1997 Pearson Canada Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Canada Inc., Permissions Department, 26 Prince Andrew Place, Don Mills, Ontario, M3C 2T8, or fax your request to 416-447-3126, or submit a request to Permissions Requests at www.pearsoncanada.ca. 10 9 8 7 6 5 4 3 2 1 [EB] Library and Archives Canada Cataloguing in Publication Scott, William R. (William Robert), 1931-, author Financial accounting theory / William R. Scott. – Seventh edition. Includes bibliographical references and index. ISBN 978-0-13-298466-9 (bound) 1. Accounting—Textbooks. I. Title. HF5635.S36 2014 657’.044 C2013-906491-5 ISBN 978-0-13-298466-9 www.downloadslide.net Contents Preface xi Acknowledgments 1 xv Introduction 1 1.1 1.2 1.3 The Objective of This Book 1 Some Historical Perspective 1 The 2007–2008 Market Meltdowns 10 1.4 Efficient Contracting 16 1.5 A Note on Ethical Behaviour 18 1.6 Rules-Based versus PrinciplesBased Accounting Standards 20 1.7 The Complexity of Information in Financial Accounting and Reporting 21 1.8 The Role of Accounting Research 21 1.9 The Importance of Information Asymmetry 22 1.10 The Fundamental Problem of Financial Accounting Theory 24 1.11 Regulation as a Reaction to the Fundamental Problem 26 1.12 The Organization of This Book 27 1.12.1 1.12.2 1.12.3 1.12.4 1.12.5 Ideal Conditions 27 Adverse Selection 27 Moral Hazard 28 Standard Setting 28 The Process of Standard Setting 29 1.13 Relevance of Financial Accounting Theory to Accounting Practice 32 2 Accounting Under Ideal Conditions 37 2.1 2.2 Overview 37 The Present Value Model Under Certainty 38 2.3 The Present Value Model Under Uncertainty 41 2.2.1 2.3.1 2.4 2.4.3 2.4.4 2.5.2 2.7 47 Embedded Value 48 Reserve Recognition Accounting 49 Critique of RRA 52 Summary of RRA 56 Historical Cost Accounting Revisited 56 2.5.1 2.6 Summary 41 Examples of Present Value Accounting 48 2.4.1 2.4.2 2.5 Summary Comparison of Different Measurement Bases 56 Conclusion 58 The Non-Existence of True Net Income 58 Conclusion to Accounting Under Ideal Conditions 59 3 The Decision Usefulness Approach to Financial Reporting 72 3.1 3.2 Overview 72 The Decision Usefulness Approach 73 3.2.1 Summary 74 www.downloadslide.net 3.3 Single-Person Decision Theory 74 3.3.1 3.3.2 3.3.3 3.3.4 3.4 The Rational, Risk-Averse Investor 83 The Principle of Portfolio Diversification 85 Increasing the Decision Usefulness of Financial Reporting 87 3.5 3.6 3.6.1 3.6.2 3.6.3 3.6.4 3.6.5 3.7 Introduction 87 Objectives of Management Discussion and Analysis 88 An Example of MD&A Disclosure 89 Is MD&A Decision Useful? 99 Conclusion 101 The Reaction of Professional Accounting Bodies to the Decision Usefulness Approach 102 3.7.1 3.7.2 3.8 4 Decision Theory Applied 74 The Information System 78 Information Defined 82 Summary 83 The Conceptual Framework 102 Summary 107 Conclusions on Decision Usefulness 107 Efficient Securities Markets 120 4.1 4.2 Overview 120 Efficient Securities Markets 121 4.2.1 4.2.2 4.2.3 iv The Meaning of Efficiency 121 How Do Market Prices Fully Reflect All Available Information? 124 Summary 126 Contents 4.3 Implications of Efficient Securities Markets for Financial Reporting 127 4.3.1 4.3.2 4.4 The Informativeness of Price 129 4.4.1 4.4.2 4.5 4.5.2 4.5.3 4.6.2 4.6.3 4.8 129 A Capital Asset Pricing Model 132 Critique of the Capital Asset Pricing Model 135 Summary 137 Information Asymmetry 137 4.6.1 4.7 A Logical Inconsistency Summary 132 A Model of Cost of Capital 132 4.5.1 4.6 Implications 127 Summary 128 A Closer Look at Information Asymmetry 137 Fundamental Value 140 Summary 142 The Social Significance of Securities Markets that Work Well 143 Conclusions on Efficient Securities Markets 145 5 The Value Relevance of Accounting Information 153 5.1 5.2 Overview 153 Outline of the Research Problem 154 5.2.1 5.2.2 5.2.3 5.2.4 Reasons for Market Response 154 Finding the Market Response 156 Separating Market-Wide and Firm-Specific Factors 156 Comparing Returns and Income 157 www.downloadslide.net 5.3 The Ball and Brown Study 5.3.1 5.3.2 5.3.3 5.4 5.4.2 5.4.3 5.4.4 5.6 5.7 6 6.1 6.2 The Measurement Approach to Decision Usefulness 189 Overview 189 Are Securities Markets Fully Efficient? 191 6.2.5 6.2.6 6.3 6.4 Reasons for Differential Market Response 163 Implications of ERC Research 169 Measuring Investors’ Earnings Expectations 170 Summary 172 A Caveat about the “Best” Accounting Policy 173 The Value Relevance of Other Financial Statement Information 174 Conclusions on Value Relevance 176 6.2.1 6.2.2 6.2.3 6.2.4 6.5 Methodology and Findings 159 Causation Versus Association 160 Outcomes of the BB Study 162 Earnings Response Coefficients 163 5.4.1 5.5 159 Introduction 191 Prospect Theory 194 Is Beta Dead? 197 Excess Stock Market Volatility 199 Stock Market Bubbles 200 Discussion of Securities Market Efficiency Versus Behavioural Finance 200 Efficient Securities Market Anomalies 202 Limits to Arbitrage 206 A Defence of Average Investor Rationality 209 6.5.1 6.5.2 Dropping Rational Expectations 209 Dropping Common Knowledge 211 6.6 Summary re Securities Market Inefficiencies 215 6.7 Conclusions About Securities Market Efficiency and Investor Rationality 216 6.8 Other Reasons Supporting a Measurement Approach 219 6.9 The Low Value Relevance of Financial Statement Information 219 6.10 Ohlson’s Clean Surplus Theory 221 6.10.1 Three Formulae for Firm Value 221 6.10.2 Earnings Persistence 225 6.10.3 Estimating Firm Value 227 6.10.4 Empirical Studies of the Clean Surplus Model 230 6.10.5 Summary 233 6.11 Auditors’ Legal Liability 233 6.12 Asymmetry of Investor Losses 236 6.13 Conclusions on the Measurement Approach to Decision Usefulness 241 7 Measurement Applications 252 7.1 7.2 Overview 252 Current Value Accounting 253 7.2.1 7.2.2 7.2.3 Two Versions of Current Value Accounting 253 Current Value Accounting and the Income Statement 255 Summary 256 Contents v www.downloadslide.net 7.3 Longstanding Measurement Examples 256 7.3.1 7.3.2 7.3.3 7.3.4 7.3.5 7.3.6 7.4 7.5 Financial Instruments Defined 259 Primary Financial Instruments 259 7.5.1 7.5.2 7.5.3 7.5.4 7.5.5 7.6 7.7 7.8 7.9 Accounts Receivable and Payable 256 Cash Flows Fixed by Contract 256 The Lower-of-Cost-or-Market Rule 257 Revaluation Option for Property, Plant, and Equipment 258 Impairment Test for Property, Plant, and Equipment 258 Summary 259 Standard Setters Back Down Somewhat on Fair Value Accounting 259 Longer-Run Changes to Fair Value Accounting 261 The Fair Value Option 262 Loan Loss Provisioning 264 Summary and Conclusions 266 Fair Value Versus Historical Cost 267 Liquidity Risk and Financial Reporting Quality 270 Derecognition and Consolidation 271 Derivative Financial Instruments 275 7.9.1 7.9.2 Characteristics of Derivatives 275 Hedge Accounting 278 7.10 Conclusions on Accounting for Financial Instruments 281 vi Contents 7.11 Accounting for Intangibles 282 7.11.1 Introduction 282 7.11.2 Accounting for Purchased Goodwill 283 7.11.3 Self-Developed Goodwill 287 7.11.4 The Clean Surplus Model Revisited 289 7.11.5 Summary 289 7.12 Reporting on Risk 290 7.12.1 Beta Risk 290 7.12.2 Why Do Firms Manage FirmSpecific Risk? 291 7.12.3 Stock Market Reaction to Other Risks 292 7.12.4 A Measurement Approach to Risk Reporting 294 7.12.5 Summary 297 7.13 Conclusions on Measurement Applications 297 8 The Efficient Contracting Approach to Decision Usefulness 311 8.1 8.2 8.3 Overview 311 What Is Efficient Contracting Theory? 313 Sources of Efficient Contracting Demand for Financial Accounting Information 314 8.3.1 8.3.2 8.4 Accounting Policies for Efficient Contracting 315 8.4.1 8.4.2 8.5 8.6 8.7 Lenders 314 Shareholders 314 Reliability 315 Conservatism 316 Contract Rigidity 318 Employee Stock Options 322 Discussion and Summary of ESO Expensing 329 www.downloadslide.net 8.8 Distinguishing Efficiency and Opportunism in Contracting 330 8.9 Summary of Efficient Contracting for Debt and Stewardship 334 8.10 Implicit Contracts 335 8.10.1 Definition and Empirical Evidence 335 8.10.2 A Single-Period NonCooperative Game 336 8.10.3 A Trust-Based Multi-Period Game 340 8.10.4 Summary of Implicit Contracting 344 8.11 Summary of Efficient Contracting 344 9 9.1 9.2 An Analysis of Conflict 357 Overview 357 Agency Theory 358 9.2.1 9.2.2 9.3 Manager’s Information Advantage 369 9.3.1 9.3.2 9.3.3 9.3.4 9.4 9.5 9.6 Introduction 358 Agency Contracts Between Firm Owner and Manager 359 Earnings Management 369 The Revelation Principle 371 Controlling Earnings Management 373 Agency Theory with Psychological Norms 375 Discussion and Summary 378 Protecting Lenders from Manager Information Advantage 379 Implications of Agency Theory for Accounting 383 9.6.1 9.6.2 Is Two Better Than One? 383 Rigidity of Contracts 387 9.7 9.8 Reconciliation of Efficient Securities Market Theory with Economic Consequences 388 Conclusions on the Analysis of Conflict 389 10 Executive Compensation 403 10.1 Overview 403 10.2 Are Incentive Contracts Necessary? 404 10.3 A Managerial Compensation Plan 407 10.4 The Theory of Executive Compensation 409 10.4.1 The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance 409 10.4.2 Short-Run Effort and LongRun Effort 412 10.4.3 The Role of Risk in Executive Compensation 415 10.5 Empirical Compensation Research 420 10.6 The Politics of Executive Compensation 422 10.7 The Power Theory of Executive Compensation 428 10.8 The Social Significance of Managerial Labour Markets that Work Well 431 10.9 Conclusions on Executive Compensation 432 11 Earnings Management 444 11.1 Overview 444 11.2 Patterns of Earnings Management 447 Contents vii www.downloadslide.net 11.3 Evidence of Earnings Management for Bonus Purposes 448 11.4 Other Motivations for Earnings Management 454 11.4.1 Other Contracting Motivations 454 11.4.2 To Meet Investors’ Earnings Expectations 455 11.4.3 Stock Offerings 457 11.5 The Good Side of Earnings Management 458 11.5.1 Blocked Communication 459 11.5.2 Empirical Evidence of Good Earnings Management 461 11.6 The Bad Side of Earnings Management 465 11.6.1 Opportunistic Earnings Management 465 11.6.2 Do Managers Accept Securities Market Efficiency? 469 11.6.3 Analyzing Managers’ Speech to Detect Bad Earnings Management 471 11.6.4 Implications for Accountants 472 11.7 Conclusions on Earnings Management 472 12 Standard Setting: Economic Issues 487 12.1 Overview 487 12.2 Regulation of Economic Activity 489 12.3 Ways to Characterize Information Production 490 12.4 First-Best Information Production 491 viii Contents 12.5 Market Failures in the Production of Information 492 12.5.1 Externalities and Free-Riding 492 12.5.2 The Adverse Selection Problem 493 12.5.3 The Moral Hazard Problem 493 12.5.4 Unanimity 493 12.6 Contractual Incentives for Information Production 494 12.6.1 Examples of Contractual Incentives 494 12.6.2 The Coase Theorem 495 12.7 Market-Based Incentives for Information Production 497 12.8 A Closer Look at Market-Based Incentives 497 12.8.1 The Disclosure Principle 497 12.8.2 Empirical Disclosure Principle Research 499 12.8.3 Signalling 503 12.8.4 Private Information Search 505 12.9 Are Firms Rewarded for Superior Disclosure? 506 12.9.1 Theory 506 12.9.2 Empirical Tests of Measures of Reporting Quality 509 12.9.3 Is Estimation Risk Diversifiable? 511 12.9.4 Conclusions 513 12.10 Decentralized Regulation 514 12.11 How Much Information Is Enough? 516 12.12 Conclusions on Standard Setting Related to Economic Issues 519 www.downloadslide.net 13 Standard Setting: Political Issues 530 13.7 International Integration of Capital Markets 546 13.7.1 Convergence of Accounting Standards 546 13.7.2 Effects of Customs and Institutions on Financial Reporting 548 13.7.3 Enforcement of Accounting Standards 550 13.7.4 Benefits of Adopting High-Quality Accounting Standards 551 13.7.5 The Relative Quality of IASB and FASB GAAP 554 13.7.6 Should Standard Setters Compete? 555 13.7.7 Should the United States Adopt IASB Standards? 556 13.7.8 Summary of Accounting for International Capital Markets Integration 558 13.1 Overview 530 13.2 Two Theories of Regulation 532 13.2.1 The Public Interest Theory 532 13.2.2 The Interest Group Theory 532 13.2.3 Which Theory of Regulation Applies to Standard Setting? 535 13.3 Conflict and Compromise: an Example of Constituency Conflict 535 13.4 Distribution of the Benefits of Information, Regulation FD 536 13.5 Criteria for Standard Setting 538 13.5.1 Decision Usefulness 538 13.5.2 Reduction of Information Asymmetry 539 13.5.3 Economic Consequences of New Standards 540 13.5.4 Consensus 540 13.5.5 Summary 541 13.6 The Regulator’s Information Asymmetry 541 13.8 Conclusions and Summing Up 558 Biblography 573 Index 596 Contents ix