AT1 summary

Module 1 summary: Accounting under ideal conditions

This module defines the concepts of ideal conditions and illustrates preparation of financial statements when ideal conditions hold. Statement of financial position values are on the basis of expected present

values of future cash receipts from assets and liabilities. Net income is composed of accretion of discount

on opening net assets, plus or minus any deviation of actual cash flows for the period from expected cash flows. Reserve recognition accounting (RRA) for oil and gas companies is used to illustrate the challenges

of present value accounting when ideal conditions do not hold. The concepts of relevance and reliability of financial statement information are reviewed, and the reliability problems of RRA are explained.

Historical cost–based accounting is analyzed in terms of relevance and reliability, revenue recognition, recognition lag and matching. It provides a trade-off of these characteristics, between the extremes of

current value accounting and cash flow accounting. Despite the moves by accounting standard setters

toward increased use of current values, accounting for several important classes of assets and liabilities remains based on historical costs.

Explain the concept of due process and understand how the structure of accounting standard-setting bodies attains due process.

Since true net income does not exist in the real accounting world, the measurement of income requires much judgment and estimation. Different parties may thus differ in their preferred

accounting policies, and the standards that lay down those policies, to determine net income. Due process is essential if reasonable compromises between the interests of investors and

managers in standard setting are to be attained.

Outline recent developments relevant to financial accounting.

The implications for financial accounting of the Enron and WorldCom scandals and the 2007-2008 market collapse include

Off–statement of financial position activities should be fully reported, since they can encourage

excessive risk taking by management.

Reporting must be transparent, so that investors can properly value assets and liabilities.

Fair value accounting may understate value-in-use when markets collapse, and therefore lead to

management objection.

Define the concept of ideal conditions and outline the necessary assumptions that underlie the definition.

Ideal conditions exist under conditions of certainty when

o the future cash flows of the firm are publicly known with certainty

o the single interest rate in the economy is given and publicly known

Ideal conditions are then extended to conditions of uncertainty in which

o a complete and publicly known set of states of nature exists

o the probabilities of states of nature are objective and publicly known

o the single interest rate in the economy is given and publicly known state realization is

publicly observable

Use the present value model under conditions of certainty to prepare an articulated set of financial statements for a simple firm.

Using the definition of ideal conditions under certainty o Financial statements are prepared on the basis of present value of future cash flow,

discounted at the given interest rate. o Assets and liabilities are valued at their present values.

o Net income is equal to accretion of discount.

Explain and illustrate, through preparation of an articulated set of financial

statements for a simple firm using the present value under conditions of uncertainty, the concepts of states of nature, probabilities of states of

nature (objective and subjective), expected value of an asset or liability, abnormal earnings, and risk.

States of nature, also called states for short, are uncertain future events that may affect the

amount of the payoff. An example would be the state of the economy (good times or bad times).

Under ideal conditions, the probabilities of the states of nature are publicly known and objective.

In the real world, these probabilities would have to be assessed based on available information.

These are called subjective probabilities.

The expected value of an asset or liability is calculated as the sum of the various possible cash

flows, based on the probabilities assigned to the various states of nature, discounted at the given

fixed interest rate for the economy.

Net income under ideal conditions consists of expected cash flows (accretion of discount) plus or

minus any abnormal earnings.

Abnormal earnings are defined as the difference between expected and actual cash flows.

Risk under ideal conditions is the knowledge that one of several different possible state

realizations will occur, but not knowing for sure which one it will be.

Using the definition of ideal conditions extended to conditions of uncertainty

o Financial statements are prepared on the basis of expected present value of future cash

flows, discounted at the given interest rate.

o Assets and liabilities are valued at their expected present values. o Net income is equal to accretion of discount plus or minus the difference between expected

and actual cash flows.

Critically evaluate reserve recognition accounting (RRA) as an application of the present value model.

The Canadian Securities Administrators have issued NI 51-101, which requires present value-

based disclosures of reserves for Canadian oil and gas companies.

SFAS 69 (now ASC 932-235-50-29) requires affected firms to report supplementary information

about the expected present value of their proven oil and gas reserves, and the factors that have

changed that expected present value during the year.

Present value of cash flows is discounted at a given interest rate of 10%.

Since ideal conditions do not hold in the real world, estimates are subject to wide errors, due to

revisions of amounts and timing of extraction of proved reserves and changes in prices. As a

result, RRA suffers from problems of reliability.

Possible manager bias also reduces reliability (for example, Royal Dutch/Shell).

RRA is often criticized by oil and gas company management due to concerns about reliability, and

about legal liability if reserves are overstated.

Explain why relevance and reliability of accounting information have to be traded off, and evaluate historical cost–based accounting in terms of relevance and reliability, revenue recognition, recognition lag, and

matching.

The problems faced by RRA give insight into the nature of relevance and reliability of accounting

information.

Relevant information is defined as information that enables investors to predict the firm’s future

cash flows.

Reliable information is information that faithfully represents without bias what it is intended to

represent.

RRA information represents high relevance, since present values of future receipts predict future

cash flow, by definition.

Unfortunately, much reliability is lost, since conditions are not ideal.

When ideal conditions do not hold, relevance and reliability must be traded off. Historical cost

accounting represents an intermediate trade-off between relevance and reliability.

While historical cost–based accounting information is not as relevant as present value–based

information, it is more reliable.

Historical cost accounting can also be evaluated in terms of revenue recognition, recognition lag,

and matching. As is the case for relevance and reliability, historical cost represents an

intermediate trade-off between these characteristics of accounting information.

Explain why true net income exists only under ideal conditions.

While ―true‖ net income does not exist in the non-ideal world in which accountants operate,

theory shows that current value accounting for specific assets and liabilities is desirable, provided

that it can be accomplished with reasonable reliability.

Current value accounting is now quite common in practice, although historical cost accounting for

major classes of assets and liabilities remains. Current practice can be described as a mixed

measurement model.

Module 2 summary: Decision usefulness approach to financial reporting

This module describes the theory of how risk-averse investors make rational investment decisions. It also

demonstrates that the theory is consistent with the Joint Conceptual Framework of the IASB and FASB as a guide to the preparation of useful financial accounting information.

Define the concept of decision usefulness.

The decision usefulness approach is an approach to the preparation of financial accounting

information that studies the theory of investor decision making in order to infer the nature and

types of information that investors need.

Perform calculations in accordance with single-person theory of decision making under uncertainty, define an information system, and describe how

financial statements form an information system.

Single-person theory of decision making under uncertainty suggests how a rational individual

makes optimal decisions in the presence of uncertainty.

It requires the decision maker to identify a set of acts from which one must be chosen.

It requires the identification of a set of states of nature and the assessing of subjective prior

probabilities of these states.

The optimal decision is the one that maximizes the decision maker’s expected utility based on the probabilities of the states of nature.

Prior probabilities of states of nature are probabilities of the various states of nature that might

occur. These probabilities incorporate all that the decision maker knows, up to the point in time just before the decision is to be taken.

Before making a decision, the individual may want to get more evidence.

An example of more evidence is the information contained in the most recent financial

statements.

Posterior probabilities of states of nature are probabilities of the various states that might occur,

after using Bayes’ theorem to revise prior probabilities following the receipt of additional

information. These posterior probabilities then form the basis for the investor’s buy/sell investment decision.

Bayes’ theorem is a formula that enables the decision maker to revise prior probabilities into

posterior probabilities.

where

P(H|GN) = the subjective posterior probability of the high state, given a good-news financial

statement P(H) = the subjective prior probability of the high state

P(GN|H) = the objective probability that the financial statements show good news, given that the

firm is in the high state P(GN|L) = the objective probability that the financial statements show good news, given that the

firm is in the low state

Information systems are a way of conceptualizing the information content of financial

statements.

Information systems are represented by a table that gives, conditional on each state of nature,

the objective probability of each possible financial statement evidence item (for example, GN or BN). These probabilities are inserted into Bayes’ theorem.

The higher the main diagonal probabilities of the information relative to the off-main diagonal

probabilities, the tighter is the link between the firm’s current performance and its future performance. That is, the more useful is the financial statement evidence.

Relevance and reliability are important properties of financial statements that increase the main

diagonal probabilities.

Since relevance and reliability must be traded off, the increase in main diagonal probabilities

resulting from greater financial statement relevance is offset by the decrease in these

probabilities from lower reliability. The net effect on decision usefulness depends on whether or

not the increase from greater relevance outweighs the decrease from lower reliability.

Define a rational investor in relation to risk.

A rational investor is one who makes investment decisions in accordance with the single-person decision theory model.

A risk-averse investor is one who derives less expected utility from an investment, given that the

investment return is constant but the risk is higher.

A risk-averse investor will want information on the riskiness of investments and their expected

returns.

Explain the principle of portfolio diversification.

Increased expected utility of an investment decision for the risk-averse investor is possible by

choosing portfolio investments rather than a single investment.

Some of the risk cancels out when more than one investment is held. This is the firm-specific

risk.

Maximum diversification is obtained when the investor holds some of all the investments in the

economy (the market portfolio).

Describe the optimal investment decision ignoring transaction costs

When transactions costs are ignored, the optimal investment decision is to buy that combination

of the market portfolio and the risk-free asset that yields the best trade-off between expected

return and risk.

The availability of stock market index funds and related securities enables the investor to closely

approach holding the market portfolio.

When transaction costs are not ignored, the optimal decision is to hold relatively few securities.

Then, the investor needs information about stocks’ expected returns and betas to trade off

expected return and risk.

Define beta and beta risk, and calculate expected return and variance of a portfolio and its covariance with other portfolios.

Beta measures the co-movement between the changes in the market prices of a security and the changes in the market value of the market portfolio.

The risk of changes in the market value of the market portfolio is called economy-wide, or

systematic, risk.

Since economy-wide risk affects all securities in much the same way, it cannot be diversified

away.

For well-diversified risk-averse investors, the only useful information about the riskiness of an

investment security is its beta. Expected rate of return = the sum of rate of return × probability, for each payoff

Variance = the sum of (rate of return per payoff – expected rate of return)2 × probability

Variance of a portfolio = weighted sum of the variances of individual securities

Covariance between two securities (A and B) in a portfolio

Relate decision theory to the conceptual framework for financial reporting.

The Joint Conceptual Framework of the IASB and FASB is consistent with the decision theory

model as a guide to the preparation of useful financial statement information.

The Joint Conceptual Framework, IAS 1, and IAS 8 contain evidence of the decision theory

model.

The pronouncements of these organizations recognize that financial statement information should

be useful for investors by:

o Helping them to assess the amounts, timing, and uncertainty of future cash flows

o Enhancing relevance and reliability of accounting information

Outline the ethical issues related to the usefulness criterion in financial statement preparation.

The accountant/auditor is often caught between the demands of management and responsibility for the interests of investors, including lenders.

If a management’s demands involve unethical behaviour, the accountant must take into account

the perspective of the deceived.

Module 3 summary: Efficient securities markets

This module reviews the theory of efficient securities markets and explains the capital asset pricing model (CAPM). Implications of efficient securities market theory for accountants are described, including the

importance of full disclosure. The concept of information asymmetry and its implications for the proper

operation of capital markets are also described. Management discussion and analysis (MD&A) is used to illustrate an accounting standard that promotes full disclosure.

Define an efficient securities market and explain how market prices reflect available information.

An efficient securities market, in the semi-strong form, is a market where the prices of securities

fully reflect all public information at all times.

Security prices fully reflect all public information because rational investors immediately react to

new information, triggering buy/sell decisions that affect share price. While individual reactions to new information may differ, on average their biases cancel out, leaving a share price that reflects

the average knowledge across all investors.

Explain the implications of securities market efficiency for financial

accounting and reporting.

The financial accounting policies used by a firm will not affect its share price as long as

o the policies used are fully disclosed o the market is sufficiently sophisticated that it can understand the implications of the policies

for future firm performance

Non-sophisticated investors are price-protected by the efficient market.

Accountants must compete with other information sources as suppliers of information.

Describe the extent to which securities market prices act as a source of information to investors, and how prices complement accounting

information as inputs into investor decisions.

If semi-strong efficiency is literally true, share prices are said to be fully informative with respect

to publicly available information — they fully reflect everything known about the firm. That is, prices are the only source of information needed by the investor.

In this case, no investor would gather and process public information since all would be price-

protected.

But, if no investor gathers public information, how could share prices reflect publicly available

information? This is a logical inconsistency that threatens efficient markets theory.

To ―rescue‖ the theory, introduce the concept of noise traders (also called liquidity traders).

Noise traders are investors whose buy/sell decisions come at random. These random buy/sell

decisions affect share price (that is, through forces of demand and supply).

Then, share price no longer reflects everything known about the firm — it is always possible that

share price is above or below its ―fully reflects‖ value due to noise. In this case, share prices are only partly informative to investors.

When prices are only partly informative, it is worthwhile for investors to gather and process

information, so as to discover over- or underpriced shares.

Some of the information gathered by investors is contained in financial statements prepared and

audited by accountants.

Explain the Sharpe-Lintner capital asset pricing model’s implications for securities pricing.

CAPM specifies what the expected return of a share traded on an efficient securities market should be (equivalently, the firm’s cost of capital).

The expected return on that share = a constant × the risk-free interest rate + another constant

× the expected return on the market portfolio.

The constants depend only on the share’s beta and the return on the risk-free asset.

Firm-specific risk is diversified away by rational investors and therefore does not affect the

share’s price.

Holding beta risk, risk-free rate, and expected return on the market constant, expected return for

firm j does not change when new information about firm j comes along. Consequently, share

price changes in response to the new information to maintain expected return at the value it should be per CAPM.

The CAPM assumes beta is stationary, and that there is no information asymmetry. When these

assumptions are not true, estimation risk arises. This causes the firm’s actual cost of capital to be somewhat greater than CAPM.

Explain how information asymmetry and, in particular, the adverse selection problem, are significant to financial accounting theory.

Information asymmetry is present when one or more market participants have more information

than others.

Then, there is the potential for the information advantage to be exploited.

Adverse selection is one form of information asymmetry.

Adverse selection is a situation in which insiders may earn excess profits at the expense of

outside investors by taking advantage of their inside information.

Insiders can take advantage of their inside information by buying shares when they know the

market price is too low, or by selling shares when they know the price is too high.

Adverse selection creates a problem for securities markets because inside information is a source

of estimation risk (that is, the lemons problem).

Investors then demand higher return (than the return given by the CAPM) to compensate, that

is, they lower the price they pay for all shares or may withdraw from the market completely.

Full disclosure has an important role to play in financial accounting theory by reducing the extent

of inside information and estimation risk.

Evaluate the social role of efficient securities markets in allocating capital resources in the economy.

Full disclosure reduces inside information and estimation risk.

Then, securities market efficiency ensures that share prices are as close as possible to their

fundamental value.

When share prices reflect fundamental value, firms with high-quality projects are encouraged to

proceed because they receive a high price for their shares, and vice versa.

This leads to proper allocation of scarce capital in the economy, thereby increasing social welfare.

Analyze the information content of management discussion and analysis (MD&A)/management commentary.

MD&A is a reporting product that has the potential to increase full disclosure by helping investors to interpret current firm performance and predict future performance.

MD&A should consist of more than a rehash of information already available from the financial

statements. To do this it should o be written from management’s perspective,

o have a forward-looking orientation,

o discuss risks and uncertainties.

By going beyond minimum disclosure requirements, management can

meet a high ethical standard,

create a reputation for full disclosure, which

o reduces investors’ estimation risk o raises share price and lowers cost of capital,

convey to investors that management has a confident view of its future.

Module 4 summary: Information approach to decision usefulness

This module describes and evaluates the implications of empirical research in financial accounting. Some

of the problems of empirically finding a securities market response to financial accounting information are

outlined, and researchers’ procedures to overcome these problems are explained. Research that documents a market response to the information content of reported net income has been particularly

successful, and is consistent with the predictions of decision theory and efficient securities market theory. Implications for standard setters of findings about market response to net income are described. These

include expanded disclosures for smaller firms, full disclosure of liabilities, segment disclosures, and greater detail in the income statement.

Explain why a securities market responds to information that investors find useful, in light of the efficient securities market and decision usefulness

theories, and outline some of the difficulties of conducting empirical research to discover evidence of securities market reaction to accounting

information.

The efficient securities market theory recognizes that the market will respond to information from

any source, including financial statements.

The decision usefulness approach recognizes that individual investors are responsible for

predicting future firm performance and concentrates on providing useful information for this

purpose.

Since efficient markets react quickly, the researcher must find the date on which the market first

became aware of the information.

o For net income, the date the firm announces its earnings in the financial press is a successful

proxy. o For other types of information, such as the financial statements themselves, the appropriate

date is much more difficult to determine.

It is also necessary to separate market-wide and firm-specific components of security returns so

as to adjust for the components that affect all shares’ returns.

o This is usually accomplished using the market model to predict expected share returns. o The deviation of expected and actual share returns is taken as firm-specific return.

Explain Ball and Brown’s research techniques and findings.

First, the assumption is that the market reacts to new information only if it differs from what was

expected, so an estimate of what the market expected is required.

For net income, successful expectation proxies include net income for the corresponding period in

the previous year and analysts’ forecasts.

If reported net income exceeds what is expected, Ball and Brown expected to observe a positive

firm-specific return on the firm’s shares during a narrow window surrounding the date of the

earnings announcement, and vice versa. Their expectation was confirmed.

Define the concept of an earnings response coefficient (ERC) and identify the factors that explain its magnitude.

An earnings response coefficient measures the amount of abnormal share returns in response to the amount of the unexpected component of reported net income. It identifies and explains why

share returns respond more strongly to net income for some firms than for others.

ERCs have been found to be higher for

o less-risky firms (in a beta sense) o less-levered firms

o firms with higher earnings persistence o firms with higher earnings quality

o growth firms

o firms for which investors’ expectations of earnings are similar

Theory predicts that firms with less informative share price (such as smaller firms) should have

higher ERCs, but this has been difficult to document.

Apply the earnings response coefficient concept to the concept of

persistence

ERC research tells us that more disclosure in the income statement is desirable so that earnings

persistence can be evaluated.

Evaluation of earnings persistence is a particular problem when the firm has low persistence

items such as non-recurring or unusual items of gains or losses.

Unless these items are fully disclosed, investors may regard them as persistent when, in fact,

they are not.

This will decrease the usefulness of financial statements for investors.

Describe why an accounting policy that produces the greatest share price

reaction may not be best for society.

Accounting information is a public good. This means that its use by one investor does not destroy

it for use by another.

Investors do not bear the full costs of the information that they use.

Therefore, supply and demand will not ensure that the ―right‖ amount of information is

produced; that is, the cost to firms and society of producing this information may not equal the

benefits to investors.

Nevertheless, the more useful investors find financial accounting information, the greater is the

securities market response to that information.

Thus, accountants can be guided by market response in choosing accounting policies and

designing better financial statements, even though standard setters cannot be guided by market

response in designing the ―best‖ accounting standards.

Evaluate the empirical evidence of securities market response to RRA.

Securities market response to RRA is explored as an example of non-income financial statement

information.

If investors find RRA information useful, there should be a response to the share returns when

this information is released.

Results are mixed — it has been hard to find strong evidence of usefulness.

Possible reasons include low reliability or methodological problems in determining the date on

which the market first became aware of the information. Also, more timely sources of reserves

information (for example, media reports, management announcements) may pre-empt the information content of RRA.

It is possible, however, that investors may route statement of financial position and

supplementary information through the ERC.

Module 5 summary: Measurement approach to decision usefulness

This module defines and illustrates the measurement approach to decision usefulness. Several reasons

for increased attention to fair values in financial statements, including theory and evidence that securities markets may not be fully efficient, are suggested. Fair value accounting is illustrated with reference to

several Canadian (that is, IASB) accounting standards with some references to U.S. standards. These include standards dealing with accounting for financial instruments, such as derivative instruments, and

accounting for purchased goodwill. Issues in the reporting of firm risk are also described and illustrated.

Explain the measurement approach to financial reporting.

The measurement approach to financial reporting is an approach by which accountants undertake the responsibility to incorporate current values into the financial statements proper,

provided this can be done with reasonable reliability.

This approach recognizes an increased obligation, beyond that of the information approach, to

assist investors in predicting future firm performance.

Summarize theory and evidence suggesting that securities markets may

not be fully efficient.

Historical-cost-based earnings have low ability to explain abnormal securities returns (that is, low

value relevance).

Investors need more help in predicting future securities returns. This argument is supported by

theory and evidence that question average investor rationality and efficient securities markets.

Auditor liability is pushing accountants to a conservative measurement approach.

The development of clean surplus theory provides a theoretical framework that supports the

measurement approach.

Efficient securities market theory has been questioned in recent years, for several reasons:

o increasing attention to alternative theories of investor behaviour, such as prospect theory;

o evidence of excess stock market volatility and bubbles; o evidence of anomalies, that is, share price reactions to accounting information that do not

match those predicted by the efficient markets theory.

Explain why financial reporting is moving in a measurement direction.

The text concludes that the theory and evidence questioning efficient securities market theory

have not progressed to the point where efficient market theory should be rejected.

Efficient securities market theory is still the most useful theory to assist accountants in supplying

useful information to investors.

However, theory and evidence questioning efficient securities market theory has progressed to

the point where it encourages a measurement approach. The measurement approach has the

potential to improve the decisions of non-rational investors and increase securities market efficiency.

Explain Ohlson’s clean surplus theory and its role in firm valuation.

Ohlson’s clean surplus theory shows how the market value of a firm can be determined from

statement of financial position and income statement information.

From the income statement, the theory takes actual earnings and calculates goodwill as the

difference between actual and expected earnings.

For the ―clean surplus,‖ net income must contain all gains and losses.

From the statement of financial position, expected earnings are calculated as shareholders’ equity

multiplied by the firm’s cost of capital.

o Then, to determine the value of the firm, add the calculated goodwill to the book value. o To calculate a share price, take the above value and divide by the number of shares

outstanding.

Although the model may not accurately predict actual share value, it is useful because an

empirical study suggests that the ratio of model value to actual value is a good predictor of future share returns.

Outline measurement-oriented accounting standards.

When future cash flows are fixed by contract, such as for accounts receivable and payable, valuation is generally based on expected future cash flows. When the time period is short, such

cash flows may not be discounted.

Other examples involve a partial application of fair value, such as the lower-of-cost-or-market

rule.

Other measurement-oriented standards include

o ceiling tests for property, plant, and equipment (partial application);

o pensions and other post-retirement benefits (present-value-based approaches).

Evaluate the important concepts of derivative financial instruments and describe the major accounting standards for reporting of financial

instruments.

There are two types of financial instruments:

o primary — including accounts and notes receivable, investments in debt and equity securities;

o derivative — contracts, the value of which depends on some underlying price, interest rate,

foreign exchange rate, or other variables; examples are options and swaps.

To help control the volatility of unrealized gains and losses resulting from current valuation of

financial instruments, SFAS 130 created the concept of other comprehensive income. Similar

international standards are now in place (IAS 1). These are the important aspects of other comprehensive income:

o Unrealized gains and losses from the fair valuing of available-for-sale securities are included

in other comprehensive income. o Other comprehensive income also includes unrealized gains and losses on fair valuing of

derivatives designated as hedges of anticipated future transactions. o Comprehensive income is the sum of net income and other comprehensive income.

o As items of other comprehensive income are realized, they are generally transferred to net income.

Accounting standards require extensive supplementary disclosures concerning financial

instruments, including disclosures of gains and losses, and disclosures of fair values if not already fair valued in the financial statements proper. Many of these disclosure requirements are

contained in IFRS 7. While the whole standard is not prescribed reading, you should be aware of its requirements concerning the fair value hierarchy and reporting on risk.

Auditor legal liability appears to be increasing.

The auditor is more likely to be held liable for overstatements of assets and earnings than for

understatements.

This leads to conservative accounting, such as ceiling tests, since conservative accounting

reduces the likelihood of overstatements.

Describe the standard setters’ response to the 2007-2008 market

meltdowns.

IFRS 9 introduces the concept of business model — financial instruments paying interest and

principal can be valued at amortized costs (subject to a ceiling test) if the firm’s business model includes the holding of these instruments for the purpose of realizing interest and principal. Other

financial instruments are valued at fair value.

Standard setters also have reconsidered standards relating to derecognition and consolidation,

since weaknesses in existing standards in these areas contributed to the 2007-2008 market

meltdowns. IFRS 10 lays down new rules for consolidations. The existing derecognition rules in

IAS 39 are retained, but extensive new supplementary disclosures are required.

These new standards come into effect on January 1, 2013. Consequently, they are not

examinable, except for the brief summaries contained in the text and this module.

Explain accounting for derivative instruments and explain hedge accounting.

Derivative financial assets and liabilities are valued at fair value.

Firms acquire or issue financial instruments for hedging and speculation.

Fair value hedges hedge assets or liabilities owned by the firm. If the hedge is over a period end,

it is fair valued, as is the asset or liability.

Cash flow hedges hedge price risk of a firm’s products. If the hedge goes over a period end, it is

fair valued. To avoid income volatility, the unrealized gains or losses are put through other

comprehensive income.

Hedges to qualify for hedge accounting must be designated by management and be highly

effective.

If derivatives are not held as hedges, they are speculative and are classified into the ―at fair

value through profit and loss‖ category.

Explain the problems of accounting for intangibles

Goodwill is an important intangible asset for many firms.

There are two types of goodwill:

o Purchased

This arises when one firm acquires another.

Management disliked amortization of purchased goodwill. Standard setters responded by eliminating amortization, but in its place imposed a ceiling test.

Elimination of goodwill amortization in 2001 may have reduced management’s emphasis on pro forma income.

o Self-developed

This often arises from successful R&D. Self-developed goodwill is usually not recorded on the firm’s books due to severe

reliability problems. This may explain the low relationship between net income and share price.

Clean surplus theory may provide a way to value self-developed goodwill.

Evaluate alternative approaches to reporting on risk.

Two types of risk are identified:

o price risk — risk arising from changes in interest rates, commodity prices, and foreign exchange rates;

o credit risk — risk that other parties to a contract will not fulfil their obligations.

Recently, firms have greatly expanded their reporting on firm risk, including in MD&A, despite the

implication of the theory of optimal investment decision that a stock’s beta is its only firm-specific

risk measure.

Reasons for control and reporting of firm-specific risk include

o Risk reporting reduces investors’ estimation risk. This risk is not included in the CAPM.

o Firms may wish to ensure availability of cash for future investment projects.

o Risk reporting helps to control, or at least to inform investors about, possible speculation by management.

o Hedging to control risk may reduce losses and resulting lawsuits and legal liability.

IFRS 7 requires information about different types of risk, including credit risk, and in particular

quantitative risk disclosure, which is consistent with a measurement approach. Also, risk

disclosure is to be based on the risk information provided internally to management.

Risk disclosure requirements laid down in IAS 39, and also in U.S. standards, have moved risk

reporting in a measurement direction. These requirements include o value at risk — the loss in earnings, cash flows, or fair values resulting from future price

changes that have a specified low probability of occurring; o sensitivity analysis — the impact on earnings, cash flows, or fair values of various price risks.

Module 6 summary: Economic consequences

This module defines and illustrates the concept of economic consequences. According to this concept,

changes in accounting policies, including changes resulting from new accounting standards, matter to firms and their managers, even if those accounting policy changes have no differential cash flow effects.

This seems inconsistent with the theory of efficient securities markets, which predicts that the market will see through the financial statement impact of different accounting policies, with the result that firms’

share prices should be unaffected by accounting policy choice. In turn, this implies that accounting policy

choice should not matter to firms and their managers.

Examples of economic consequences are described. Based on these examples, it seems that accounting

policies do have economic consequences. Not only do accounting policy choices matter to managers, they may also matter to investors, since accounting policies can affect manager actions, and hence firm value.

Positive accounting theory asserts that management concern about accounting policies is driven by the contracts that firms enter into, and, for very large firms, by political costs that result if these firms are

seen to be highly profitable.

Explain the concept of economic consequences.

Economic consequences asserts that, despite the implications of efficient securities market

theory, accounting policy choice can affect firm value.

If accounting policies affect firm contracts and political heat, they concern management.

Apply the concept of economic consequences to employee stock options

(ESOs).

Many large firms issue stock options to executives, and often to other employees, as part of

compensation.

For many years, no expense needed to be recorded for ESOs providing that exercise price

equalled intrinsic value on the grant date.

Even if intrinsic value is zero, ESOs have a fair value on their grant date. This can be estimated

by

o expected value of ESO on exercise date (under very simplifying assumptions)

o modifications of the Black/Scholes option pricing formula.

A 1993 attempt by the FASB to require firms to record an expense for ESOs ran into extreme

opposition from management. It had to be withdrawn.

Recent financial reporting horror stories were often suspected to have been driven by ESOs. This

led to renewed pressure to expense ESOs.

Despite concerns about the reliability of estimating ESO expense, expensing is now required in

Canada, the United States, and internationally.

Describe the relationship between efficient securities market theory and economic consequences.

Economic consequences exist.

Efficient securities market theory predicts that if an accounting policy has no impact on cash

flows and underlying profitability, then there should be no share price reaction.

If there is no share price reaction, management should not care about accounting policy choice.

Yet, management reacted strongly to ESO expense recognition, even though recognizing ESO

expense did not affect cash flows.

This raises the question of whether efficient securities market theory and economic

consequences can be reconciled.

Describe the concept of positive accounting theory and its predictions

about manager reaction to compensation contracts, debt covenants, and political pressures.

Positive accounting theory is concerned with predicting firms’ choices of accounting policies and

their response to new accounting standards.

Positive accounting theory is structured around three hypotheses:

o The bonus plan hypothesis predicts that managers who are compensated by means of a bonus plan dependent on reported net income will be likely to maximize current reported

profits by choosing accounting policies that shift reported profits from future to current periods.

o The debt covenant hypothesis predicts that the closer a firm is to violating debt covenants based on accounting variables, the more likely is the firm manager to choose accounting

policies that shift reported profits from future to current periods.

o The political cost hypothesis predicts that the greater the political costs faced by a firm (for example, very large firms are often felt to be more subject to political scrutiny than smaller

firms), the more likely is the firm manager to choose accounting policies that shift reported profits from current to future periods.

Empirical research has produced a large body of evidence consistent with these predictions.

Compare the opportunistic and efficient contracting versions of positive accounting theory, and explain how positive accounting theory contributes

to economic consequences.

Positive accounting theory assumes that managers are rational, that is, they choose accounting

policies to maximize their own expected utility.

Thus, the accounting policies that managers choose are not necessarily best for the firm’s

shareholders.

Managers that choose accounting policies for their own benefit at the expense of shareholders

and lenders are said to be behaving opportunistically (unethically).

Through astute corporate governance, including clever contract design, firms can motivate

managers to perceive that choosing accounting policies in the best interests of shareholders is also in their own best interest — this is called the efficient contracting form of positive accounting

theory.

While examples of opportunistic behaviour persist, empirical research has produced considerable

evidence consistent with the efficient contracting form.

Conservative accounting, as, for example in ceiling tests, creates an early warning system of

possible financial distress, and also increases the likelihood of debt covenant violation.

Debtholders’ interests are thus protected before it is too late. These protections increase investor confidence in the firm, enabling a lower interest rate.

Conservative accounting makes it more difficult for managers to overstate reported earnings and

increase their compensation. Shareholders benefit since it is then more likely that the manager will have to work hard to earn his or her compensation.

Positive accounting theory shows how accounting policies can have economic consequences:

o Even without cash flow effects, accounting policies matter because they affect the provisions of contracts based on financial statement variables and can affect the firm’s political

environment.

o Thus, accounting policies matter to managers — they have economic consequences.

Module 7 summary: An analysis of conflict

This module addresses the concept of conflict. Accountants are involved in conflict situations because they are frequently caught between the conflicting interests of investors and managers. Conflict is

modelled by means of game theory and agency theory. These models provide insights into conflict resolutions, helping you to understand why firm managers may adopt certain accounting and reporting

policies, even if these policies may bias net income and may not be the best for reporting to investors. The module also enables you to complete the reconciliation of efficient securities market theory, which

predicts that investors will look through and adjust for different accounting policies, creating economic

consequences, and thus that accounting policies matter.

Explain the basic principles of games in the context of game theory.

A non-cooperative game is a game between rational players in which the players are not able to enter into binding agreements as to which strategy or action to take.

Each player faces a thinking opponent. That is, the action chosen by each player depends on

what action that player thinks the other player will take.

Explain and determine the Nash equilibrium, explain the basic principles of the cooperative solution to a non-cooperative game, and provide a game theoretic argument for constrained — as opposed to unconstrained —

maximization.

The Nash equilibrium is the strategy pair in which, given the strategy chosen by the other player,

no player wishes to depart from his or her chosen strategy. It is the predicted outcome of a non-cooperative game, particularly when the game is played only once. However, ethical principles

may enable the attainment of the cooperative solution even in a single play.

The cooperative solution to a non-cooperative game is the strategy pair in which no player can

be made better off without making the other player worse off.

The cooperative solution need not be a Nash equilibrium, and hence may not be played.

Since binding agreements are not possible, one or the other of the parties is unwilling to play the

cooperative strategy for fear that the other party will cheat. As a result, the outcome of the game

is driven to the Nash equilibrium.

This is unfortunate because then the parties attain lower payoffs from the game than the

maximum achievable under the cooperative solution.

If the game is repeated many times, the players may come to realize that it is to their mutual

advantage to play cooperatively.

Under unconstrained maximization, players play the Nash equilibrium.

Under constrained maximization, players are transparent in their intention to act in a trustworthy manner. Consequently, players are willing to play the cooperative solution, even in a single play

of the game.

Firms are candidates for constrained maximization because their managers realize that to

maximize profits in the long run, the firm must act transparently and cooperatively.

Explain the basic principles of agency theory, including the concepts of

reservation utility, fixed versus moving support, and first-best versus second-best contracts.

Agency theory is a branch of game theory that studies the design of contracts to motivate an

agent to act in the best interests of a principal.

Conflict arises because the principal usually cannot observe the effort the manager devotes to

running the firm (moral hazard problem). The principal wants to maximize his or her utility, as does the manager.

When effort cannot be observed, the (effort-averse) manager must, ideally, be motivated to work

hard by a contract based on firm payoff (that is, the cash flow resulting from the manager’s effort in running the firm).

However, payoff is usually not observable until after the compensation contract has ended, and

consequently a performance measure that predicts the payoff (for example, net income) is

needed.

When manager effort cannot be directly observed or inferred, the most efficient contract is the

one that gives the manager a share of just enough of the performance measure so that he or she

is willing to work for the firm, while providing an incentive to work hard.

If net income is an unbiased performance measure, greater precision (that is, less noise) in net

income enables an increase in contract efficiency.

Explain the manager’s motivation to manage earnings and how contracts can be designed to control the manager’s opportunistic behaviour.

The manager may bias net income. This is called earnings management.

In a single-period contract, the rational manager will manage net income upwards as much as

possible, thereby maximizing compensation.

It is possible to motivate the manager not to manage net income (revelation principle), but this

requires giving the manager the same compensation he or she would receive if net income were

unmanaged.

However, GAAP can limit (as opposed to eliminate) the ability of the manager to manage net

income, thereby increasing contract efficiency. This suggests that some earnings management

can be ―good.‖

Reservation utility

Reservation utility is the minimum utility that a manager will accept before deciding to go

elsewhere.

Essentially, reservation utility represents the utility to the manager of his or her ―market value.‖

Fixed versus moving support

Fixed support is the situation in which the set of performance measure realizations is fixed regardless of the action choice. For example, net income can be any real number, regardless of

whether the manager shirks or works hard.

Moving support occurs when the set of performance measure realizations is different depending

on the action taken. When moving support holds, manager effort can be inferred if the low payoff under shirking is realized. Then the manager will be penalized by receiving only a very low

salary. The threat of this happening motivates the manager to work hard. That is, the first-best contract can be attained.

First-best versus second-best contracts

The first-best contract gives the owner the maximum attainable utility and gives the agent his or

her reservation utility. This contract can be attained if the manager’s effort can be directly observed, or inferred.

Agency cost is the reduction in the principal’s utility if the first-best contract cannot be attained.

The second-best contract is the most efficient contract short of the first-best. The agency cost of

the second-best contract is the minimum attainable considering the unobservability of the

manager’s effort.

Analyze the important implications of agency theory for financial

accounting.

Contracts of interest to accountants include compensation contracts between the firm and its top

management, and contracts between the firm and its debt-holders.

Frequently, these contracts depend on financial statement variables.

For example, compensation contracts may depend on reported net income, and debt covenants

may depend on liquidity or debt-to-equity ratios.

Study of such contracts gives accountants a better understanding of management’s interest in

accounting policy choice and why accounting policies can have economic consequences.

Describe the properties net income needs to compete with share price as a

performance measure, and explain how agency theory serves to reconcile efficient securities market theory and economic consequences.

For compensation contracts, when more than one performance measure is available, both of which contain incremental information about the manager’s effort in running the firm, both

should be used in the compensation contract (for example, net income and share price).

The relative proportions of each payoff measure in an efficient contract depend on the sensitivity

and precision of those measures.

Sensitivity is the rate at which the performance measure increases as manager effort increases.

Precision is the reciprocal of the variance of the performance measure (more precision = less

noise).

To maximize the relative proportion of net income in compensation contracts, accountants must

seek the most informative trade-off between sensitivity and precision. Many important contracts depend on accounting variables.

Since contracts are rigid and incomplete, new accounting standards during the life of a contract

may negatively affect the level and volatility of manager compensation, and may lead to debt covenant violation, even if the new accounting standards do not affect the firm’s cash flows.

Consequently, accounting policies have economic consequences.

Nothing in this argument conflicts with securities market efficiency.

Module 8 summary: Conflict between contracting parties

This module considers two applications of the agency theory. The first is executive compensation. Reported net income has an important role to play as a performance measure in executive compensation

contracts. However, share price can be another performance measure. Most executive compensation contracts for large, publicly traded firms use both net income and share price as performance measures,

although in varying proportions. To the extent that net income is informative about manager effort, the

proportion of compensation based on net income will be maintained and enhanced, to accountants’ competitive advantage.

The role of monitoring manager performance and enabling efficient compensation contracts is as important to society as the role of communicating useful information to investors.

The second application is earnings management. Given that reported net income influences compensation, the probability of debt covenant violation, political visibility, and share price, positive

accounting theory predicts that managers and firms will be concerned about the accounting policies used

to calculate reported net income. Managers may use the flexibility of GAAP to manage earnings for a variety of reasons. This management can be ―good,‖ as when it is used to reveal management’s inside

information about future earning power, or ―bad,‖ as when management behaves opportunistically to maximize bonuses or to attempt to deceive investors.

Explain why incentive contracts are necessary.

Incentive contracts are necessary to align shareholders’ and managers’ interests in the presence

of moral hazard.

An executive compensation plan is an incentive contract between the firm and its manager that

attempts to align the interests of owners and managers.

This is done by basing the manager’s compensation on one or more performance measures, that

is, measures that predict the payoff from the manager’s effort in operating the firm.

Describe how an incentive plan can align manager and shareholder interests.

When compensation is based on performance measures, the manager is motivated to work hard.

This aligns manager and shareholder interests.

Compensation based on share price motivates a longer manager decision horizon than

compensation based on net income.

The relative proportions of these performance measures control the length of the manager’s

decision horizon.

Evaluate the theory and evidence pertaining to executive compensation and identify devices for controlling compensation risk.

Theory predicts that compensation committees will design compensation plans with an efficient combination of sensitivity, precision, decision horizon, and risk.

Net income is low in sensitivity (less so under fair value accounting), but high in precision (less so

under fair value accounting).

Persistent earnings components are more sensitive than unusual, non-recurring, and

extraordinary items. These items are generally less informative about manager effort than core earnings, and are also subject to manager manipulation.

Share price is high in sensitivity but low in precision.

Bushman and Indjejikian (1993) show that the relative proportions of net-income-based and

share-based incentives can control the length of the manager’s decision horizon.

Lambert and Larcker (1987) found that the relative proportions of accounting-based and share-

based compensation vary as the theory predicts:

o For example, growth firms’ compensation plans are based more on share price, since net income of growth firms is low in sensitivity.

Baber, Kang, and Kumar (1999) found that compensation committees value persistent earnings

more highly than transient, low-persistence items when setting manager compensation.

Indjejikian and Nanda (2002) found that when firm risk was low, the firms in their sample tended

to award higher bonuses relative to salary.

Since managers are assumed to be risk averse and cannot diversify their compensation risk, incentive

plans are designed to control risk while still maintaining effort motivation.

Devices to control compensation risk include

o compensation based on more than one performance measure

o a bogey in the compensation plan o the compensation committee

o relative performance evaluation

ESOs control downside risk but encourage upside risk taking.

Explain the political ramifications of executive compensation.

Executive compensation attracts political controversy due to the large amounts of compensation

that are often involved.

Some argue that executives as a group are overpaid, pointing to low sensitivity of executive

compensation to firm performance, especially when performance is poor.

Others argue that executives are not overpaid, pointing out that the amount of compensation

received is very small relative to the shareholder values created. Also, managers cannot diversify

away their compensation risk.

Regulators have reacted to this controversy by requiring increased disclosure of executive

compensation, on the grounds that the managerial labour market and the shareholders of

individual firms can act if pay becomes excessive.

There is evidence that this regulation is having the desired effect (Lo, 2003).

Evaluate the power theory of executive compensation in relation to efficient contracting theory.

The power theory predicts that executives will use their power in the organization to opportunistically increase their compensation above competitive levels, thereby attaining more

than reservation utility.

To reduce outrage at this behaviour, managers use a variety of devices, such as hiring of outside

consultants and comparison with peer groups, to camouflage their high compensation.

Regulators’ mandating of increased disclosure of executive compensation helps to counteract

excessive compensation.

Power theory suggests that executive compensation contracts are more consistent with the

opportunistic version of positive accounting theory than with efficient contracting.

If managerial labour markets are to work properly to hold managers to their reservation utility

levels, a minimal requirement is that the market knows how much compensation the manager is

receiving.

Controlling the moral hazard problem is important to a market-based economy because social

welfare is enhanced if managers work hard to create efficient production and capital investment decisions.

Accounting earnings must be a sensitive measure of manager effort if it is to serve as an

informative input into managerial compensation.

Full disclosure of both compensation and low-persistence gains and loss as well as manager-

controlled items contributes to efficient contracting by controlling manager effort to obtain

excessive compensation

Explain the various motivations for and identify patterns of earnings

management.

Earnings management is a manager’s choice of accounting policies so as to achieve some specific

objective.

Earnings management can be studied by analyzing the accruals over which management has

some discretion, such as provisions for doubtful accounts.

There is empirical evidence that managers do engage in patterns of earnings management that

accomplish certain objectives.

There are four main patterns of earnings management:

o Taking a bath — If expected earnings are below the bogey, go all the way with write-offs, and so on.

o Earnings minimization — This is earnings reduction that is not as severe as taking a bath. It may occur if management expects earnings to exceed the bonus cap.

o Earnings maximization — This occurs when the firm is between the bogey and the cap. It

may also be used to avoid violation of debt covenants. o Income smoothing — This is used to avoid excessive volatility of earnings.

The objectives of earnings management are to

o maximize bonuses

o meet investors’ earnings expectations o avoid the consequences of violation of debt covenants

o increase the proceeds of initial public offerings o reduce political visibility

o influence government policy

o communicate blocked inside information to investors

Some of these objectives can be ―good‖ (that is, efficient). Others can be ―bad‖ (that is,

opportunistic).

Describe evidence of accrual use to manage earnings for bonus purposes.

The Healy (1985) study is a test of the bonus plan hypothesis of positive accounting theory.

The main problem is obtaining a good estimate of discretionary accruals.

Net income = cash flow from operations ± net accruals

Earnings are managed through discretionary accruals.

Determining discretionary from non-discretionary can be difficult and includes

o working item-by-item through the statement of financial position and statement of cash flow

o using total accruals as a proxy o picking a specific account for which it is relatively easy to determine the discretionary portion

as valid evidence of discretionary accrual use o using the Jones model, which uses a regression equation, to extract the non-discretionary

portion while taking into account the effects of the level of business activity.

Healy’s results support the bonus plan hypothesis.

Compare earnings management that reveals inside information to the market and earnings management that attempts to deceive the market.

Whether managers use earnings management opportunistically (bad earnings management) or

responsibly (good earnings management) is an important question for accountants, who are

often the ones advising management about accounting policies. o Bad earnings management involves the manager selecting accounting policies to maximize

his or her own expected utility rather than the expected utilities of the owners. Policies to maximize bonuses are an example.

o Good earnings management is used to communicate blocked inside information about future

earnings prospects to investors, and to avoid the consequences of rigid and incomplete contracts.

Explain the significance of the ―iron law‖ of accruals.

There is an ―iron law‖ of earnings management — accruals reversal.

If a manager uses discretionary accruals to increase reported earnings this year, the reversal of

those accruals in future years decreases future earnings by the same amount.

As a result, the manager must work ―harder‖ to find new income-increasing accruals in future

years if the pattern of income-increasing earnings management is to be maintained.

Conversely, if a manager records excessive income-decreasing discretionary accruals this year,

such as excessive provisions for re-organization or site restoration, this increases future reported earnings. This is called putting earnings ―in the bank.‖

Furthermore, the banked earnings are typically buried in future core earnings, leading investors

to overestimate earnings persistence. This tempts management to ―overdose‖ on low-persistence income-decreasing discretionary accruals.

Accountants could reveal banked earnings by separately reporting the effects of previous accruals

on current core earnings.

Evaluate whether or not managers accept securities market efficiency.

Despite evidence to the contrary, many managers appear to believe that they can ―fool‖ the

market, implying that they do not accept market efficiency.

If the securities market is efficient, managers must hide opportunistic earnings management

behind poor disclosure to avoid detection.

Implication for accountants: Improve disclosure, regardless of whether managers do or do not

accept market efficiency.

Module 9 summary: Standard setting: Economic issues

This module considers whether market forces are sufficient to generate the ―right‖ amount of information

in society, or whether regulation by some central authority is needed. At present, there is a high, and increasing, degree of regulation of firms’ financial reporting decisions, for example, in the form of GAAP.

However, past years have seen substantial deregulation of several industries. Will society benefit if the information ―industry‖ is also deregulated? To address this question, you need to think of information as

a commodity, subject to market forces of supply and demand. This module outlines and evaluates these forces as they apply to the information ―market.‖

Because information is a very complex commodity, we are unable to reach a conclusion as to the ―right‖

extent of regulation. Nevertheless, a study of forces that motivate managers to produce information even in the absence of regulation makes accountants aware that indefinite expansion of rules and regulations

in financial reporting is not necessarily cost effective from a social perspective.

The accountant’s role increases in importance when regulation does not completely prescribe how to

report. Indeed, competent and ethical judgment about full and fair disclosure is then even more necessary.

Compare proprietary and non-proprietary information.

Information can be categorized as proprietary or non-proprietary.

The release of proprietary information will directly affect the firm’s future cash flows — for

example, the release of valuable patent or process information.

The release of non-proprietary information, such as earnings, forecasts, and risks, does not

directly affect cash flows.

This distinction is important because regulation of firms’ information production applies primarily

to non-proprietary information. It is often very costly to the firm to require release of proprietary information.

Outline the complexity of measuring costs and benefits of information to society.

Information can be produced in several ways: o finer information, which provides more detail

o additional information o more credible information.

While investors may benefit from an increased amount of information, there is a cost to the firm,

and therefore to society, to produce that information.

Identify and explain sources of market failure in the private production of

information.

Market failure is the failure of market forces to drive the ―socially correct‖ amount of production,

in this case, information production.

The socially correct amount of information is that level that equates the marginal social benefit of

information production with the marginal social cost of that production.

Market failure arises from externalities and free riding, adverse selection, and moral hazard,

leading to lack of unanimity.

Outline private incentives for information production, including private

information search.

Externalities and free riding arise because accounting information has characteristics of a public

good — firms cannot charge investors for the value of the information they produce. Consequently, they produce less than they should, from a social perspective.

Free riding is the benefit received by investors from the information that firms do produce, but

for which investors do not pay.

Adverse selection results in insider trading and managers’ failure, or delay, to release all

information. o As a result, investors do not perceive the securities market as a level playing field.

o They may withdraw from the market, in which case the market loses liquidity. o This means that the securities market does not operate as well as it could to motivate firms

and investors to produce information.

Moral hazard tempts managers to shirk and disguise their shirking, at least in the short run,

through opportunistic earnings management. o Such earnings management distorts the firm’s information production, leading to market

failure.

Lack of unanimity arises when the amount of information investors desire is different from

what the manager wants to produce.

o This can happen even if the manager produces information to the point of maximizing the firm’s share value, because in the presence of market failures, firms’ share prices are lower

than the prices they would be if there were no market failures.

Contractual incentives to produce information arise from the contracts firms enter into.

o Examples include managerial compensation contracts and debt contracts.

o These contracts usually depend on financial accounting variables.

o They are only effective when a few parties are involved.

Market-based incentives to produce information arise from securities markets and managerial

labour markets.

o They encourage managers to produce information so as to create and maintain a reputation for full disclosure.

o Such a reputation benefits the firm and manager through lower cost of capital and higher reservation utility.

o Theoretical and empirical evidence reveals that firms with good disclosure practices enjoy

lower costs of capital.

Other private incentives to produce information arise from the disclosure principle, signalling, and

private information search.

o The disclosure principle states that firms will release information because, otherwise, the market will assume the worst and act as if the unrevealed information is the worst possible.

However, this principle does not always work because it requires assumptions that are often

not met in reality. Then, only partial information release is likely. o Signals are actions taken by a high-type manager that would not be rational if that manager

was of the low type. Signals enable managers to credibly communicate information about their type, which

would not be credible if the manager simply announced the information. For a signal to be credible, it must be less costly for the high-type manager to give the

signal than it would be for a low-type manager.

o A private information search encourages investors to produce information in the search for mispriced securities.

Even when securities markets are efficient, mispriced securities may exist because of noise trading.

However, such activities are inefficient from society’s standpoint because many

individuals expend resources to discover similar information.

Describe the findings of empirical studies on whether or not firms benefit from disclosing information.

The complexities of calculating the socially correct amount of information production mean that the question of the extent of standard setting cannot be settled by means of economics alone.

Consequently, the setting of GAAP is as much a political process as it is an economic one.

Because information is such a complex commodity, even standard setters cannot calculate the

socially correct amount of information to require firms to produce.

Firms with good disclosure policies have great analyst following, improved share price, greater

institutional ownership, and lower bid-ask spreads.

Botosan (1997) showed that firms with superior disclosure enjoy lower cost of capital.

Dechow, Sloan, and Sweeney (1996) showed that firms that do not provide good disclosure are

penalized.

Explain why standards that allow some reporting flexibility can increase standards efficiency.

Regulation of a firm’s information production is viewed as a way to overcome the various market

failures in its production.

In accounting, much of this regulation is in the form of standards, collectively known as GAAP.

We do not know whether existing GAAP represent insufficient, exact, or too much information

production.

However, because the setting of, and monitoring compliance with, GAAP is costly, a fact not

emphasized by standard setters, there is a danger that GAAP may go beyond the socially correct

amount.

IFRS 8, which requires firms to report segment information on the same basis as the firm

segments its business, was designed to improve the efficiency of standard setting. It does this by

minimizing the cost to the firm of producing the information while attempting to provide the

segment information of greatest use to investors.

Even if you do not know what the extent of standard setting should be, you can still work to

improve the efficiency of standards.

The basis of segment disclosure has been decentralized because the same segmentation

management uses for internal control will presumably be the most useful for informing investors

about the performance of the firm’s segments.

This decentralized approach is beginning to appear in other standards.

ASC 825-10-15 of the FASB (not examinable) and IAS 39 provide a fair value option to firms,

allowing them to value an asset or liability at its fair value, even if it is not required to do so by current accounting standards.

Discuss the difficulty of determining the socially correct amount of information to produce

Several market forces encourage firms to produce information in the absence of standards (the

disclosure principle, for example).

Financial reporting horror stories like Enron and WorldCom create the view that additional

regulation is necessary.

Regulation comes with costs to implement and enforce.

Balancing the cost and the benefit is required; therefore, it is the extent of standard setting that

is important.

Increased attention to corporate governance reduces incentives of management to take risks,

thereby reducing return and potentially stifling innovation.

Political and economic issues must be assessed when creating new standards.

Module 10 summary: Standard setting: Political issues

This module considers the political aspects of standard setting, describing how constituencies affected by

standard setting appeal to a political process to resolve the conflicts between them. As you saw in Module 9, these conflicts cannot be solved strictly through economic analysis.

Compare the two theories of regulation — the public interest theory and the interest group theory.

The public interest theory of regulation assumes that regulators have the best interests of society at heart and do their best to maximize benefit to society.

The interest group theory of regulation assumes that the various constituencies affected by

standard setting (the two main ones being investors and managers) lobby the legislature, and/or

regulatory bodies created by the legislature, for their preferred nature and extent of accounting standards.

o The legislature gives the regulatory body (for example, AcSB, FASB) power to set accounting standards.

o The regulatory body is assumed to maximize its own welfare while balancing the demands of the various constituencies.

o The constituency that is most politically effective in its regulatory demands will receive most

of the benefits of regulation.

Describe the standard-setting processes in Canada, the United States, and internationally.

Canada

In Canada, accounting standards are set by the Accounting Standards Board (AcSB), as

authorized by the board of governors of the Canadian Institute of Chartered Accountants.

Standards relating to financial accounting and reporting are included in the IASB standards.

The Ontario Securities Commission (OSC) regulates all securities trading in Ontario. This includes

the Toronto Stock Exchange, the largest stock exchange in Canada. o The OSC accepts accounting standards as laid down by the CICA Handbook, although it also

issues its own standards, such as MD&A and Management Proxy Circulars, which do not affect the financial statements directly. Note that the standards laid down by the CICA Handbook now include a full set of IFRS in Part I.

o More recently, the Canadian Securities Administrators (CSA) was created to attempt to

harmonize securities regulation across Canada.

The United States

In the United States, financial accounting standards are set by the Financial Accounting

Standards Board (FASB).

The Securities and Exchange Commission (SEC) is a body established by the U.S. legislature to

regulate most securities trading in the United States. The SEC looks to the FASB to set financial

accounting standards.

As is also the case for the OSC and CSA, the SEC issues its own standards (for example, MD&A,

Regulation FD), which do not affect the financial statements proper.

International

The International Accounting Standards Board (IASB) publishes financial accounting standards

and promotes their worldwide acceptance.

The ultimate goal of international accounting standards setting is to develop a set of high-quality

accounting standards that all countries, including the United States, accept.

Comparability of the financial statements produced in different countries will lower firms’ and

investors’ costs and promote share trading across countries, thereby facilitating international

capital flows. However, even high-quality standards allow differences in accounting policy choice, earnings management, and professional judgment. Investors should be aware that reporting

quality can differ across countries even though they use IASB standards.

The structures of the AcSB, FASB, and IASB are characterized by representation of different

constituencies.

Unlike the AcSB, the structures of the FASB and IASB are foundation based. A foundation-based

structure may give the standard-setting body greater independence from the management

constituency. However, recent standards in Canada, such as CSA MI 52-110, reduce these concerns.

The processes of the AcSB and IASB require a supermajority to pass a new standard.

The deliberations leading up to a new standard feature due process, whereby all interested

constituencies have the opportunity to present their views.

The structure and process of the AcSB, FASB, and IASB are most consistent with the interest

group theory of regulation.

Scrutiny of the process of setting a new standard suggests that it is primarily one of conflict

resolution.

The final product is a standard that reflects a compromise between the wishes of the affected

constituencies.

Describe some ethical issues related to standard setting.

The accounting profession must develop strategies to be trustworthy, such as acting transparently.

Professionals must not impose their own values on the client. They have an obligation to act in

the client’s best interests.

Professionals must serve the public interest by acting with integrity. This includes conscientious

application of existing standards, rather than helping managers to circumvent the rules.

Implementation of rules-based accounting standards will particularly require accountants to be

trustworthy and serve the public interest when this conflicts with the client’s interest, as well as

to fully meet their own rules of professional conduct.

Evaluate the political aspects of some important standards.

New accounting standards frequently run into opposition from managers, who fear the economic consequences.

This requires compromise, since managers are an important constituency whose interests must

be traded off with those of investors.

Examples of compromise include

o IAS 39, despite containing several provisions to meet manager concerns about fair value

volatility, encountered severe opposition by European banks, to the point where the IASB

had to introduce additional compromises. o SFAS 130 created other comprehensive income to reduce management concerns about

earnings volatility. Subsequently, the IASB adopted a similar standard. o Regulation FD attempts to improve the fairness of the distribution of financial information\ by

requiring firms to release information to all, rather than to a select group of analysts.

Describe the criteria for a successful standard.

To be successful, an accounting standard must meet four criteria: o It must convey useful information to investors.

o It must reduce information asymmetry, so as to improve the operation of capital and managerial labour markets.

o The economic consequences must not be too great. It must not have too unfavourable an

effect on managerial compensation contracts, debt contracts, and firms’ political visibility. o It must attain a consensus such that even a constituency not in favour of a standard is willing

to go along with it. Attainment of such a consensus requires due process by the standard-setting body.