CONTENTS Preface... xi CHAPTER 1 Introduction... 1 1.1 The Objective of This Book... 1 1.2 Some Historical Perspective... 1 1.3 The Complexity of Information in Financial Accounting and Reporting... 6 1.4 The Role of Accounting Research... 6 1.5 The Importance of Information Asymmetry... 7 1.6 The Fundamental Problem of Financial Accounting Theory... 8 1.7 Regulation as a Reaction to the Fundamental Problem... 9 1.8 The Organization of This Book... 10 1.8.1 Ideal Conditions... 10 1.8.2 Adverse Selection... 11 1.8.3 Moral Hazard... 12 1.8.4 Standard Setting... 13 1.9 Relevance of Financial Accounting Theory to Accounting Practice... 13 CHAPTER 2 Accounting Under Ideal Conditions... 16 2.1 Overview... 16 2.2 The Present Value Model Under Certainty... 16 2.3 The Present Value Model Under Uncertainty... 21 2.4 Reserve Recognition Accounting... 29 2.4.1 An Example of RRA... 29 2.4.2 Critique of RRA... 33 2.4.3 Summary... 35 2.5 Historical Cost Accounting Revisited... 35 2.5.1 The Challenge of Historical Cost Accounting... 36 2.5.2 Accountants Reaction to the Challenge... 39 2.5.3 Summary... 39 2.6 The Non-Existence of True Net Income... 40 2.7 Conclusion... 41 CHAPTER 3 The Decision Usefulness Approach to Financial Reporting... 51 3.1 Overview... 51 3.2 The Decision Usefulness Approach... 52 3.3 Single-Person Decision Theory... 53 3.3.1 Decision Theory Applied... 53 3.3.2 The Information System... 57 3.3.3 Information Defined... 60
iv Contents 3.3.4 Conclusion... 60 3.4 The Rational, Risk-Averse Investor... 61 3.5 The Principle of Portfolio Diversification... 63 3.6 The Optimal Investment Decision... 69 3.7 Portfolio Risk... 72 3.7.1 Calculating and Interpreting Beta... 72 3.7.2 Portfolio Expected Value and Variance... 74 3.7.3 Portfolio Risk as the Number of Securities Increases... 75 3.7.4 Summary... 76 3.8 The Reaction of Professional Accounting Bodies to the Decision Usefulness Approach... 76 3.9 Conclusions on Decision Usefulness... 80 CHAPTER 4 Efficient Securities Markets... 91 4.1 Overview... 91 4.2 Efficient Securities Markets... 92 4.2.1 The Meaning of Efficiency... 92 4.2.2 How Do Market Prices Properly Reflect All Available Information?... 94 4.2.3 Summary... 96 4.3 Implications of Efficient Securities Markets for Financial Reporting... 97 4.3.1 Implications... 97 4.3.2 Summary... 99 4.4 The Informativeness of Price... 99 4.4.1 A Logical Inconsistency... 99 4.4.2 Summary... 102 4.5 A Capital Asset Pricing Model... 102 4.6 Information Asymmetry... 105 4.6.1 The Concept of Information Asymmetry... 105 4.6.2 Summary... 108 4.7 The Social Significance of Properly Working Securities Markets... 108 4.8 Examples of Full Disclosure... 110 4.8.1 Introduction... 110 4.8.2 Management Discussion and Analysis... 110 4.8.3 Future-Oriented Financial Information... 119 4.9 Summary and Conclusions... 128 CHAPTER 5 The Information Perspective on Decision Usefulness... 137 5.1 Overview... 137 5.2 Outline of the Research Problem... 138 5.2.1 Reasons for Market Response... 138
Contents v 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... 142 5.3 The Ball and Brown Study... 144 5.3.1 Methodology and Findings... 144 5.3.2 Causation versus Association... 146 5.3.3 Outcomes of the BB Study... 147 5.4 Earnings Response Coefficients... 148 5.4.1 Reasons for Differential Market Response... 148 5.4.2 Implications of ERC Research... 154 5.4.3 Measuring Investors Earnings Expectations... 154 5.4.4 Summary... 156 5.5 Unusual, Non-recurring and Extraordinary Items... 156 5.6 A Caveat about the Best Accounting Policy... 158 5.7 The Information Content of RRA... 160 5.8 Summary and Conclusions... 164 CHAPTER 6 The Measurement Perspective on Decision Usefulness... 174 6.1 Overview... 174 6.2 Are Securities Markets Efficient?... 175 6.2.1 Introduction... 175 6.2.2 Prospect Theory... 176 6.2.3 Is Beta Dead?... 179 6.2.4 Excess Stock Market Volatility... 180 6.2.5 Stock Market Bubbles... 181 6.2.6 Efficient Securities Market Anomalies... 181 6.2.7 Implications of Securities Market Inefficiency for Financial Reporting... 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 Information... 190 6.5 Ohlson s Clean Surplus Theory... 191 6.5.1 Three Formulae for Firm Value... 191 6.5.2 Earnings Persistence... 195 6.5.3 Estimating Firm Value... 198 6.5.4 Empirical Studies of the Clean Surplus Model... 202 6.5.5 Summary... 204 6.6 Auditors Legal Liability... 204 6.7 Conclusions... 205 CHAPTER 7 Measurement Perspective Applications... 213 7.1 Introduction... 213 7.2 Longstanding Measurement Examples... 213
vi Contents 7.2.1 Accounts Receivable and Payable... 213 7.2.2 Cash Flows Fixed by Contract... 214 7.2.3 The Lower-of-Cost-or-Market Rule... 214 7.2.4 Ceiling Test for Capital Assets... 215 7.2.5 Push-Down Accounting... 216 7.2.6 Conclusions... 216 7.3 More Recent Fair-Value-Oriented Standards... 216 7.3.1 Pensions and Other Post-Employment Benefits... 216 7.3.2 Impaired Loans... 217 7.4 Financial Instruments... 218 7.4.1 Introduction... 218 7.4.2 Valuation of Debt and Equity Securities... 219 7.4.3 Derivative Instruments... 221 7.4.4 Hedge Accounting... 225 7.4.5 The Joint Working Group Draft Standard... 228 7.5 Accounting for Intangibles... 230 7.5.1 Introduction... 230 7.5.2 Accounting for Purchased Goodwill... 231 7.5.3 Self-Developed Goodwill... 236 7.5.4 The Clean Surplus Model Revisited... 237 7.5.5 Summary... 238 7.6 Reporting on Risk... 238 7.6.1 Beta Risk... 238 7.6.2 Stock Market Reaction to Other Risks... 240 7.6.3 A Measurement Perspective on Risk Reporting... 242 7.6.4 Conclusions... 244 7.7 Summary and Conclusions... 244 CHAPTER 8 Economic Consequences and Positive Accounting Theory... 259 8.1 Overview... 259 8.2 The Rise of Economic Consequences... 260 8.3 Employee Stock Options... 262 8.4 Accounting for Government Assistance... 267 8.4.1 The PIP Grant Accounting Controversy... 269 8.4.2 Summary... 270 8.5 Stock Market Reaction to Successful-Efforts Accounting in the Oil and Gas Industry... 270 8.6 The Relationship Between Efficient Securities Market Theory and Economic Consequences... 272 8.7 The Positive Theory of Accounting... 273 8.7.1 Outline of Positive Accounting Theory... 273 8.7.2 The Three Hypotheses of Positive Accounting Theory... 276 8.7.3 Empirical PAT Research... 279
Contents vii 8.7.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT... 283 8.7.5 Conclusions... 286 CHAPTER 9 An Analysis of Conflict... 298 9.1 Overview... 298 9.2 Understanding Game Theory... 299 9.3 A Non-cooperative Game Model of Manager-Investor Conflict.. 300 9.3.1 Summary... 305 9.4 Some Models of Cooperative Game Theory... 305 9.4.1 Introduction... 305 9.4.2 Agency Theory : An Employment Contract Between Firm Owner and Manager... 306 9.4.3 Agency Theory : A Bondholder-Manager Lending Contract... 315 9.5 Implications of Agency Theory for Accounting... 318 9.5.1 Holmström s Agency Model... 318 9.5.2 Rigidity of Contracts... 319 9.6 Reconciliation of Efficient Securities Market Theory with Economic Consequences... 321 9.7 Summary and Conclusions... 322 CHAPTER 10 Executive Compensation... 335 10.1 Overview... 335 10.2 Are Incentive Contracts Necessary?... 336 10.3 A Managerial Compensation Plan... 338 10.4 The Theory of Executive Compensation... 345 10.5 The Role of Risk in Executive Compensation... 348 10.6 Empirical Compensation Research... 350 10.7 The Politics of Executive Compensation... 353 10.8 Summary... 356 CHAPTER 11 Earnings Management... 368 11.1 Overview... 368 11.2 Evidence of Earnings Management for Bonus Purposes... 369 11.3 Other Motivations for Earnings Management... 377 11.3.1 Other Contractual Motivations... 377 11.3.2 Political Motivations... 379 11.3.3 Taxation Motivations... 379 11.3.4 Changes of CEO... 380 11.3.5 Initial Public Offerings... 382 11.3.6 To Communicate Information to Investors... 383 11.4 Patterns of Earnings Management... 383
viii Contents 11.5 Why Does Earnings Management Persist?... 384 11.6 The Good Side of Earnings Management... 385 11.7 The Bad Side of Earnings Management... 389 11.8 Summary and Conclusions... 392 CHAPTER 12 Standard Setting: Economic Issues... 411 12.1 Overview... 411 12.2 Regulation of Economic Activity... 412 12.3 Private Incentives for Information Production... 413 12.3.1 Ways to Characterize Information Production... 413 12.3.2 Contractual Incentives for Information Production... 415 12.3.3 Market-Based Incentives for Information Production... 417 12.3.4 Securities Market Response to Full Disclosure... 418 12.3.5 Other Information Production Incentives... 420 12.3.6 Conclusions... 427 12.4 Sources of Market Failure... 428 12.4.1 Externalities and Free-Riding... 428 12.4.2 The Adverse Selection Problem... 429 12.4.3 The Moral Hazard Problem... 429 12.4.4 Unanimity... 430 12.4.5 Conclusions... 430 12.5 How Much Information Is Enough?... 431 12.6 Decentralized Regulation... 432 12.7 Summary... 432 CHAPTER 13 Standard Setting: Political Issues... 447 13.1 Overview... 447 13.2 Two Theories of Regulation... 448 13.2.1 The Public Interest Theory... 448 13.2.2 The Interest Group Theory... 449 13.3 Standard Setting in Canada and the United States... 450 13.3.1 The Canadian Institute of Chartered Accountants... 450 13.3.2 The Ontario Securities Commission... 452 13.3.3 The Financial Accounting Standards Board... 453 13.3.4 The Securities and Exchange Commission... 455 13.4 The International Accounting Standards Board... 456 13.4.1 Establishment and Objectives of the IASB... 456 13.4.2 Structure of the IASB... 457 13.4.3 Authority of the IASB... 457 13.5 Relationship to Theories of Regulation... 459 13.6 Conflict and Compromise... 460 13.6.1 An Example of Constituency Conflict... 460 13.6.2 Comprehensive Income... 464 13.6.3 Conclusions... 465
Contents ix 13.7 Criteria for Standard Setting... 466 13.7.1 Decision Usefulness... 466 13.7.2 Reduction of Information Asymmetry... 466 13.7.3 Economic Consequences of New Standards... 467 13.7.4 The Political Aspects of Standard Setting... 468 13.7.5 Summary... 468 13.8 Conclusions... 469 Bibliography... 484 Index... 499