Accounting Question

Description

The purpose of this assignment is to apply concepts and theories discussed in the course to

practical issues.

You will be required to prepare a research paper The paper should include the theories or concepts discussed in the course. For example, you may relate theories discussed in class which either confirm or contradict or expand upon the material you find in the public domain. The total length for the paper should not exceed 4 pages doublespaced, minimum 11-point font.

Grading will be based on the following criteria:

 Identification of relevant theories

 Understanding of theory

 Appropriate application of theory to the company

 Conclusions

There is not set amount of theories that you need to include in your paper; however, you are required at a minimum to apply at least one theory from the material covered pre-midterm (Chapters 1 – 5), and at least one theory from the material covered post midterm (Chapters 6 – 11) Entity selected for Fall 2023 term: Walmart Inc. NYSE:WMT

Materials to use: you may use any information on the entity that is in the public domain, your text book, your notes from class. Hint: check out the company’s Investor Relations section of the company’s website Walmart Investor Relations – Financials Investor Relations > Financials. I suggest that you refer to the most recent annual report, which is included in their 2023 Annual Report (also referred to as 10-K Report); however you are not restricted to this information.

Unformatted Attachment Preview

Financial Accounting Theory
Eighth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial reporting
environment in a market economy
Copyright © 2015 Pearson Canada Inc.
1-1
Chapter 1
Introduction
Copyright © 2015 Pearson Canada Inc.
1-2
1.2 Some Historical Perspective
• Early development
• Great depression of 1930s reinforced historical cost accounting
• Alternatives to historical cost
• Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
• Mixed measurement model
Copyright © 2015 Pearson Canada Inc.
1-3
1.2 Collapse of the Stock Market Boom of Late
1990s
• Enron
• WorldCom
• Collapse of public confidence in capital markets
• Effects on financial reporting
• Increased regulation and corporate governance
• Sarbanes-Oxley Act
• Tighten rules re off-balance sheet entities
Copyright © 2015 Pearson Canada Inc.
1-4
1.3 Market Meltdowns, 2007-2008
• Terminology
• Securitization
• Financial instruments
• Asset-backed securities
• Collateralized debt obligations
• Asset-backed commercial paper
• Credit default swaps
• Expected loss notes
• Liquidity risk
• Liquidity pricing
• Counterparty risk
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-5
Market Meltdowns, 2007-2008 (continued)
• Financial accounting issues leading up to the market meltdowns
• Fair value accounting for financial instruments
• Liquidity pricing
• Fair value less than value-in-use
• Severe criticism of fair value accounting
• High leverage of financial institutions
• Off-balance sheet liabilities
• Use of expected loss notes to avoid consolidation of structured investment vehicles
• Was disclosure of off-balance sheet liabilities adequate?
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-6
Market Meltdowns, 2007-2008 (continued)
• Response of standard setters
• Stopgap measures in response to government pressure
• Fair value accounting guidance during liquidity pricing
• Increased use of internal estimates (value-in-use)
• Increased use of cost-based valuation
• New accounting standards
• Consolidation
• Derecognition
• Increased disclosure
• Response of standard setters considered in greater detail in Chapter 7
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-7
Market Meltdowns, 2007-2008 (continued)
• Response of other regulators
• Increased disclosure of managerial compensation
• Move transactions to security exchanges and clearing houses from shadow
banking system
• Increased capital reserves for financial institutions
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-8
Market Meltdowns, 2007-2008 (continued)
• Implications for accountants
• Need for transparency
• Value-in-use v. fair value accounting
• Full disclosure of off-balance sheet activities
• New accounting standards to help prevent future abuses?
Copyright © 2015 Pearson Canada Inc.
1-9
1.4 Efficient Contracting
• A different view of the purpose of financial reporting
than the current value orientation of standard setters
• Basic characteristics of efficient contracting view
• Emphasis on contracts. A firm can be defined by the
contracts it enters into
• E.g., debt contracts, compensation contracts…
• Emphasis on corporate governance
• Those firm policies that align the firm’s activities with the
interests of investors and society
Copyright © 2015 Pearson Canada Inc.
1 – 10
Efficient Contracts
• For good corporate governance, contracts should be
efficient
• Contracting parties must trust each other
• E.g., a firm can generate lenders’ trust by incorporating a covenant
into a borrowing contract. Covenants are a cost of contracting
• Lenders reward firm with lower interest rate. This is a benefit of
contracting
• An efficient contract is the best tradeoff between contracting
costs and benefits
>> Continued
Copyright © 2015 Pearson Canada Inc.
1 – 11
Efficient Contracts (continued)
• Efficient contracting emphasizes manager stewardship
• Compensation contracts should motivate managers to work in the best
interests of firm owners
• An efficient compensation contract does so at lowest compensation cost.
Copyright © 2015 Pearson Canada Inc.
1 – 12
Accounting Policy Implications of Efficient
Contracting
• Financial reporting should be reliable
• Reliable reporting generates investor trust
• Financial reporting should be conservative
• E.g., write assets down if current value less than book value. But, write
assets up only if can be done reliably.
• Rationale: encourages stewardship
• Prevents managers from increasing reputation and compensation by increasing
reported profits through non-reliable asset writeups
• These policies often conflict with current value accounting
• Current value accounting sacrifices reliability for relevance
Copyright © 2015 Pearson Canada Inc.
1 – 13
1.5 Ethical Behaviour by Accountants/Auditors
• Was accountant/auditor behaviour leading up to Enron, WorldCom,
and 2007-2008 market meltdowns episodes ethical?
• Serve the client (short run view) or serve society (long run view)?
• Why would you serve the client or serve society in similar
circumstances?
• Ethical principles require you to do the right thing
• Long run interests of profession require you to do the right thing
• But mindsets differ
Copyright © 2015 Pearson Canada Inc.
1 – 14
1.6 Rules-Based v. Principles-Based Accounting
Standards
• Do rules-based accounting standards work?
• Enron, WorldCom
• Expected loss notes
• Will more rules in new accounting standards work to prevent
abuse?
• Principles-based standards
• Important role of Conceptual Framework
• Relies on ethical accounting/auditing profession
Copyright © 2015 Pearson Canada Inc.
1 – 15
1.7 The Complexity of Information
• Individual reactions to same information may differ
• Reporting to investors v. reporting on stewardship complicates
reporting
• Current value v. efficient contracting views
• Information also affects how well markets work
Copyright © 2015 Pearson Canada Inc.
1 – 16
1.9 Information Asymmetry
• Adverse selection
• One or more parties to a business transaction have an information advantage
over other parties
• Affects operation of capital markets
• Moral hazard
• One of more parties to a contract can observe their actions but other parties
cannot
• Affects effectiveness of contracts
• Both types of information asymmetry affect efficient working of the
economy
9/8/2021
Copyright © 2015 Pearson Canada Inc.
1 – 17
Information Asymmetry (continued)
• Role of accounting information to control adverse selection
• Convert inside information into outside
• Supply useful information to investors
• Role of accounting information to control moral hazard
• Control manager shirking
• Improve corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 18
1.10 The Fundamental Problem Of Financial
Accounting Theory
• The best measure of net income to control adverse selection not the same
as the best measure to motivate manager performance
• Investors want information about future firm performance
• Current value accounting?
• Good corporate governance requires that managers “work hard”
• Does more reliable information and conservatism better reflect manager effort than current
value information?
Copyright © 2015 Pearson Canada Inc.
1 – 19
1.11 Regulation as a Reaction to the
Fundamental Problem of Standard Setting
• Standard setting is a form of regulation
• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces subject to failure
• Adverse selection
• Moral hazard
• Regulation steps in to try to correct market failures
• Regulation is costly
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 20
Regulation as a Reaction to the Fundamental
Problem of Standard Setting (continued)
• Standard setting mediates between conflicting interests of investors
and managers
• Investors want lots of useful information
• Managers may object to releasing all the information that investors desire
• Due process in standard setting mediates between investors’ and managers’
interests
• Representation of diverse constituencies
• Super-majority voting
• Exposure drafts
Copyright © 2015 Pearson Canada Inc.
1 – 21
1.12.5 The Process of Standard Setting
• Structure
• IASB
• International standards
• FASB
• United States standards
• Securities commissions
• Role in enforcing firms to follow standards
• May set standards themselves
• Why do they delegate most standard setting?
Copyright © 2015 Pearson Canada Inc.
1 – 22
Theories Relevant to Financial Accounting
• The rational investor
• A model of how an investor may use new information to revise beliefs about future
firm performance
• Rationality holds on average, not necessarily for each individual
• Efficient securities markets
• Efficiency is a matter of degree
• Share prices reasonably reflect all publicly available information
• Efficiency is relative to a stock of information
• Role of financial reporting in improving/expanding the stock of information
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 23
Theories Relevant to Financial Accounting
(continued)
• Behavioural theories
• Investors do not use all the information in financial statements → securi es
markets not fully efficient
• Agency theory
• Efficient contracts to motivate manager performance (stewardship) and
achieve good corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 24
Chapter 2 – Part 2
Present Value Accounting in the
real world
• The real world is not characterized by ideal
conditions; however, there are real world
examples of present value accounting.
• Consider Reserve Recognition Accounting
(RRA) for oil and gas companies.
• RRA provide sufficient information to prepare
a present value based income statement.
Reserve Recognition Accounting
• RRA requires supplemental disclosure of
present value, discounted at 10%, of a firm’s
proven oil and gas reserves.
– No IASB standard
– NI 51-101 (in Canada) requires supplemental
disclosure but not RRA
– ASC 932 (in the US) requires RRA disclosures
Reserve Recognition Accounting
• ASC 932
– Requires companies to provide values of proven reserves
based on discounted expected future cash flows at a fixed
rate of 10%.
– Advantages:
• Historic cost of these reserves may have little predictive value
• Avoids problems of full cost vs. successful efforts
– Intent: to provide investors with more relevant information
about future cash flows than that contained in
conventional historical cost-based financial statements.
The mechanics of RRA
• These things affect the • These things are shifts
between the reserve
reserve “asset” and
“asset” and other
total assets:
assets:
– Change in prices, costs,
timing, estimates,
taxes, quantities
– Extensions and
discoveries and
purchases of reserves
in place
– Accretion of discount
– Sales
– Development costs
incurred
Reserve Recognition Accounting
• To address concerns of subjectivity and uncertainty,
companies:
– Only look at proven reserves
– Use a prescribed discount rate of 10%
– Use prices and costs in effect at balance sheet date
• Nevertheless, substantial estimations and revisions
are necessary regarding:
– Quantities of reserves
– Timing of cash flows
– Revisions to prices and costs
Reserve Recognition Accounting
• Results in asset values and income that:
– Fluctuate substantially
– Are very different from historic cost counterparts
• Mixed evidence whether RRA is informative or not
(covered in Chapter 5)
Reserve Recognition Accounting
• Do oil and gas firms operate under ideal
conditions?
– What is the impact on present value accounting
under RRA requirements?
Reserve Recognition Accounting
• Without ideal conditions, complete relevance
and reliability are no longer jointly attainable.
One must be traded off against the other.
Why do I have to learn this?
• The mechanics of RRA are what accountants have to
do in general if we adopt asset valuations based on
present values (=revenue recognition at different
point). Accounting for asset retirement obligations
works similarly to this, for example
• Accounting also changes if we adopt asset valuations
based on market values
Current Value vs. Historical Costs
• we have seen that ideal conditions do not
hold resulting in volatility and reliability issues
(consider RRA discussion)
• Will current value accounting (eg. present
value accounting) replace historical cost
accounting?
Current Value vs. Historical Costs
• Relevance vs. Reliability
• Revenue Recognition
• Recognition Lag
• Matching of Costs and Revenues
Current Value vs. Historical Costs
• Relevance vs. Reliability
– Historical cost = reliable, not relevant
– PV = relevant, not reliable (unless ideal conditions
hold)
Current Value vs. Historical Costs
• Revenue recognition
– revenue is recognized earlier under current value
accounting vs. historical cost accounting
• Recognition Lag
– the extent to which timing of revenue recognition
lags behind changes in real economic value.
Current Value vs. Historical Costs
• Matching of costs and revenues
– matching is primarily associated with historical
cost accounting
– matching is accomplished by the use of accruals
(accounts receivable, accounts payable, allowance
for bad debts, amortization, etc.)
– Little matching under current value accounting
• What is the impact of matching on reliability
of historical cost financial accounting? …think
estimates…
Current Value vs. Historical Costs
• There are often several ways of accounting for
the same thing.
• Lack of well defined concept of net income
(should it be based on changes in current
values of assets and liabilities or on historical
costs and accruals?)
– Requires a great deal of judgement to value assets
and measure income … this is why we have an
accounting profession
Current Value vs. Historical Costs
• As there is value in both approaches to
financial accounting, the profession has
turned their efforts to making financial
statements more useful.
• Chapter 3 – The Decision Usefulness Approach
to Financial Reporting
Recap – Ideal Conditions
Recap – Ideal Conditions
• Ch. 2. Q7 – Explain why, under ideal
conditions, there is no need to make
estimates when calculating expected present
values?
Recap – Ideal Conditions
• Ch.2. Q10 – Explain why, under non-ideal
conditions, it is necessary to trade off
between relevance and reliability when
estimating future cash flows. Define relevance
and reliability as part of your answer.
Admin items
Recap Chapter 1
Chapter 2
Admin
• Slides
– before class I will post a PDF document of the
slides with certain slides removed for discussion
purposes
– after each class I will provide copies of the slides
used with my speaking notes
• Solutions to text book problems – at the end
of each chapter I will provide solutions to the
textbook problems – there are no questions in
Chapter 1
Admin
• What is the best way to study for this class?
– Read the chapter before class
– Attempt some of the problems that are at the end
of each chapter
– Read business section of newspaper/news
websites and relate to what has been covered in
class
Recap – Chapter 1
Recap – Chapter 1
• What is the “fundamental problem” of
financial accounting theory?
Recap – Chapter 1 cont.
• The best measure of net income to control
adverse selection not the same as the best
measure to motivate manager performance
– Investors want information about future firm
performance
• Current value accounting?
– Good corporate governance requires that
managers “work hard”
• Does more reliable information and conservatism
better reflect manager effort than current value
information?
Recap – Chapter 1 cont.
• What is the reaction to the fundamental
problem?
Recap – Chapter 1 cont.
• Reaction to the fundamental problem is
Standard setting:
– Accounting guidance from IASB, FASB, AcSB, etc.
– Regulation from securities commissions (SEC, OSC)
Recap – Chapter 1 cont.
• The market crash of 1929 reinforced historical
cost accounting, what are some alternatives to
historical cost accounting?
Recap – Chapter 1 cont.
• Alternatives to historical cost
– Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
– Mixed measurement model
Chapter 2
Accounting Under Ideal Conditions
Accounting under ideal conditions
• In a perfect world, accounting information would:
– be relevant;
– be a faithful representation of “reality”
– be understandable;
– be verifiable;
– be timely; and
– facilitate comparisons.
Under what conditions would this be achieved?
Accounting under ideal conditions
• Assume you have a situation where:
– the future cash flows of the firm are publicly known with
certainty (=$150 at end of year 1, $150 at end of year 2)
– the interest rate for the firm’s cash flows is publicly
known with certainty=10%
• Present value of the asset = $260.33
• =($150/1.10) + ($150/1.102) = $136.36 + $123.97
• Who would be willing to pay more for this asset?
• Who would be willing to sell this asset for less?
Accounting under ideal conditions
Balance Sheet of P.V. Ltd at time 0:
Capital asset
$ 260.33
Shareholders’ Equity $260.33
Accounting under ideal conditions
For period 1, the income statement shows:
Revenue
$150.00
Amortization Expense
123.97
Net income (260.33*10%)
26.03
The amortization expense represents the decline in
the asset’s service-rendering potential:
Service rendering potential, time 0:
$260.33
Service rendering potential, time 1:
136.36
Decline
123.97
Accounting under ideal conditions
Balance Sheet of P.V. Ltd at time 1:
Cash
$ 150.00
Capital asset 260.33
S/H equity, to $260.33
Less amort. 123.97
+ net income 26.03
$ 286.36
$ 286.36
• If there were only one share, it would be worth
$286.36
Accounting under ideal conditions
• For period 2, the income statement shows:
Revenue
$150.00
Interest income
15.00
Amortization Expense
136.36
Net income
28.64
The amortization expense represents the decline in the
asset’s service-rendering potential:
Service rendering potential, time 1:
$ 136.36
Service rendering potential, time 2:
0
Decline
136.36
Accounting under ideal conditions
• Balance Sheet of P.V. Ltd at time 2:
Cash
$ 315.00
Capital asset 136.36 S/H equity, t1 $ 286.36
Less amort.
136.36 + net income
28.64
$ 315.00
$ 315.00
• Is this information inclusive of the desirable
characteristics of relevance, representational
faithfulness (reliability), understandability,
verifiability, timely, and comparable?
Accounting under ideal conditions
• Why is the firm’s net income in the previous
example not considered in the valuation of
the firm?
– future cash flows are known and can be discounted to provide balance
sheet valuations. Net income is then perfectly predictable, being the
opening balance sheet multiplied by the interest rate.
– $260.33 x 10% = $26.03
A bit of help on the terminology
• Info is a “Faithful representation” of the realworld economic phenomena if the sub-criteria
of neutrality, completeness and freedom from
error are met
“Confirmatory Value” is the ability to confirm or
correct previous evaluations
• Verifiability implies that different knowledgeable
and independent observers would reach general
consensus, although not necessarily complete
agreement, either:
a. That the information represents the economic
phenomena that it purports to represent without
material error or bias (by direct verification); or
b. That the chosen recognition or measurement method
has been applied without material error or bias (by
indirect verification).
• Neutrality is the absence of bias intended to attain
a predetermined result or to induce a particular
behavior
Ideal conditions with uncertainty: Q17
• We now consider a situation with the following conditions:
– a given fixed interest rate (3%) for firm’s cash flows and
borrowings
– a complete and publicly known set of states
– asset yields publicly known state probabilities
Probability
annual cash flow
.30 (no snow)
$300
.70 (snow)
$900
– publicly observable state realization
– Equipment financed by bank loan of $500 and remainder by
issuing common shares
– Pays a dividend of $50 at end of each year of operation
• What is the present value of North Ltd.’s asset on August 1,
2015 (time 0) and July 31, 2016 (end of year 1)?
Q17 cont.
What is the present value of North Ltd.’s asset on August
1, 2015 (time 0) and July 31, 2016 (end of year 1)?
Q17 cont.
• What items would appear on North Ltd.’s
balance sheet?
Q17 cont.
Q17 cont.
• How do we calculate year one net income?
Q17 cont.
For 2016, with snowy (good) state realization, the income
statement shows:
Revenue
$900.00
Amortization expense
678.67
Interest expense
15.00
Net income
$206.33
The amortization expense represents the decline in the
asset’s service-rendering potential:
Service rendering potential, time 0:
$1,377.70
Service rendering potential, end of yr. 1:
699.03
Decline
$ 678.67
Q17 cont.
Alternatively, for 2016, with snowy (good) state
realization, the income statement could show:
Accretion of discount ($1,377.70 x .03) $ 41.33
Interest accrued on bank loan ($500x.03) (15.00)
Abnormal earnings (actual revenues of
$900 less expected revenues of $720)
180.00
Net income
$206.33
• Expected revenues (based on probabilities of
outcomes) of $720
= (.7 x $900) + (.3 x $300) = $630 + $90 = $720
Q17 cont.
• What would the net income be under
historical cost accounting?
• Assumptions:
– North Ltd. paid the present value of the
equipment at time 0 (calculated earlier)
– The equipment is amortized over 2 years on a
straight line basis
Q17 cont.
• Under the more realistic assumption that ideal
conditions do not hold, which measure of net
income, present value basis or historical cost
basis, is most relevant? Which is most
reliable? Why?
Don’t get lost in the mechanics:
• Investment on B/S = PV of expected future cash
flows
• Expected future cash flows = sum of (cash flow of
each realization * its probability)
Traditional Format income statement:
• Amortization = change in PV of asset
• Cash on hand earns interest
Alternative format income statement
• Opening asset value*discount
rate=accretion=expected income
• Difference between actual realizations and
expected = unexpected income
Financial Accounting Theory
Eighth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial reporting
environment in a market economy
Copyright © 2015 Pearson Canada Inc.
1-1
Chapter 1
Introduction
Copyright © 2015 Pearson Canada Inc.
1-2
1.2 Some Historical Perspective
• Early development
• Great depression of 1930s reinforced historical cost accounting
• Alternatives to historical cost
• Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
• Mixed measurement model
Copyright © 2015 Pearson Canada Inc.
1-3
1.2 Collapse of the Stock Market Boom of Late
1990s
• Enron
• WorldCom
• Collapse of public confidence in capital markets
• Effects on financial reporting
• Increased regulation and corporate governance
• Sarbanes-Oxley Act
• Tighten rules re off-balance sheet entities
Copyright © 2015 Pearson Canada Inc.
1-4
1.3 Market Meltdowns, 2007-2008
• Terminology
• Securitization
• Financial instruments
• Asset-backed securities
• Collateralized debt obligations
• Asset-backed commercial paper
• Credit default swaps
• Expected loss notes
• Liquidity risk
• Liquidity pricing
• Counterparty risk
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-5
Market Meltdowns, 2007-2008 (continued)
• Financial accounting issues leading up to the market meltdowns
• Fair value accounting for financial instruments
• Liquidity pricing
• Fair value less than value-in-use
• Severe criticism of fair value accounting
• High leverage of financial institutions
• Off-balance sheet liabilities
• Use of expected loss notes to avoid consolidation of structured investment vehicles
• Was disclosure of off-balance sheet liabilities adequate?
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-6
Market Meltdowns, 2007-2008 (continued)
• Response of standard setters
• Stopgap measures in response to government pressure
• Fair value accounting guidance during liquidity pricing
• Increased use of internal estimates (value-in-use)
• Increased use of cost-based valuation
• New accounting standards
• Consolidation
• Derecognition
• Increased disclosure
• Response of standard setters considered in greater detail in Chapter 7
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-7
Market Meltdowns, 2007-2008 (continued)
• Response of other regulators
• Increased disclosure of managerial compensation
• Move transactions to security exchanges and clearing houses from shadow
banking system
• Increased capital reserves for financial institutions
>> Continued
Copyright © 2015 Pearson Canada Inc.
1-8
Market Meltdowns, 2007-2008 (continued)
• Implications for accountants
• Need for transparency
• Value-in-use v. fair value accounting
• Full disclosure of off-balance sheet activities
• New accounting standards to help prevent future abuses?
Copyright © 2015 Pearson Canada Inc.
1-9
1.4 Efficient Contracting
• A different view of the purpose of financial reporting
than the current value orientation of standard setters
• Basic characteristics of efficient contracting view
• Emphasis on contracts. A firm can be defined by the
contracts it enters into
• E.g., debt contracts, compensation contracts…
• Emphasis on corporate governance
• Those firm policies that align the firm’s activities with the
interests of investors and society
Copyright © 2015 Pearson Canada Inc.
1 – 10
Efficient Contracts
• For good corporate governance, contracts should be
efficient
• Contracting parties must trust each other
• E.g., a firm can generate lenders’ trust by incorporating a covenant
into a borrowing contract. Covenants are a cost of contracting
• Lenders reward firm with lower interest rate. This is a benefit of
contracting
• An efficient contract is the best tradeoff between contracting
costs and benefits
>> Continued
Copyright © 2015 Pearson Canada Inc.
1 – 11
Efficient Contracts (continued)
• Efficient contracting emphasizes manager stewardship
• Compensation contracts should motivate managers to work in the best
interests of firm owners
• An efficient compensation contract does so at lowest compensation cost.
Copyright © 2015 Pearson Canada Inc.
1 – 12
Accounting Policy Implications of Efficient
Contracting
• Financial reporting should be reliable
• Reliable reporting generates investor trust
• Financial reporting should be conservative
• E.g., write assets down if current value less than book value. But, write
assets up only if can be done reliably.
• Rationale: encourages stewardship
• Prevents managers from increasing reputation and compensation by increasing
reported profits through non-reliable asset writeups
• These policies often conflict with current value accounting
• Current value accounting sacrifices reliability for relevance
Copyright © 2015 Pearson Canada Inc.
1 – 13
1.5 Ethical Behaviour by Accountants/Auditors
• Was accountant/auditor behaviour leading up to Enron, WorldCom,
and 2007-2008 market meltdowns episodes ethical?
• Serve the client (short run view) or serve society (long run view)?
• Why would you serve the client or serve society in similar
circumstances?
• Ethical principles require you to do the right thing
• Long run interests of profession require you to do the right thing
• But mindsets differ
Copyright © 2015 Pearson Canada Inc.
1 – 14
1.6 Rules-Based v. Principles-Based Accounting
Standards
• Do rules-based accounting standards work?
• Enron, WorldCom
• Expected loss notes
• Will more rules in new accounting standards work to prevent
abuse?
• Principles-based standards
• Important role of Conceptual Framework
• Relies on ethical accounting/auditing profession
Copyright © 2015 Pearson Canada Inc.
1 – 15
1.7 The Complexity of Information
• Individual reactions to same information may differ
• Reporting to investors v. reporting on stewardship complicates
reporting
• Current value v. efficient contracting views
• Information also affects how well markets work
Copyright © 2015 Pearson Canada Inc.
1 – 16
1.9 Information Asymmetry
• Adverse selection
• One or more parties to a business transaction have an information advantage
over other parties
• Affects operation of capital markets
• Moral hazard
• One of more parties to a contract can observe their actions but other parties
cannot
• Affects effectiveness of contracts
• Both types of information asymmetry affect efficient working of the
economy
9/8/2021
Copyright © 2015 Pearson Canada Inc.
1 – 17
Information Asymmetry (continued)
• Role of accounting information to control adverse selection
• Convert inside information into outside
• Supply useful information to investors
• Role of accounting information to control moral hazard
• Control manager shirking
• Improve corporate governance
Copyright © 2015 Pearson Canada Inc.
1 – 18
1.10 The Fundamental Problem Of Financial
Accounting Theory
• The best measure of net income to control adverse selection not the same
as the best measure to motivate manager performance
• Investors want information about future firm performance
• Current value accounting?
• Good corporate governance requires that managers “work hard”
• Does more reliable information and conservatism better reflect manager effort than current
value information?
Copyright © 2015 Pearson Canada Inc.
1 – 19
1.11 Regulation as a Reaction to the
Fundamental Problem of Standard Setting
• Standard setting is a form of regulation
• Is standard setting needed?
• Market forces motivate firms to produce information
• But market forces subject to failure
• Adverse selection
• Moral hazard
• Regulation steps in to try to correct market failures
• Regulation is costly
• Continued
Copyright © 2015 Pearson Canada Inc.
1 – 20
Regulation as a Reaction to the Fundamental
Problem of Standard Setting (continued)
• Standard setting mediates between conflicting interests of investors
and managers
• Investors want lots of useful information
• Managers may object to releasing all the information that investors desire
• Due process in standard setting mediates between investors’ and managers’
interests
• Representation of diverse constituencies
• Super-majority voting
• Exposure drafts
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1.12.5 The Process of Standard Setting
• Structure
• IASB
• International standards
• FASB
• United States standards
• Securities commissions
• Role in enforcing firms to follow standards
• May set standards themselves
• Why do they delegate most standard setting?
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Theories Relevant to Financial Accounting
• The rational investor
• A model of how an investor may use new information to revise beliefs about future
firm performance
• Rationality holds on average, not necessarily for each individual
• Efficient securities markets
• Efficiency is a matter of degree
• Share prices reasonably reflect all publicly available information
• Efficiency is relative to a stock of information
• Role of financial reporting in improving/expanding the stock of information
• Continued
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Theories Relevant to Financial Accounting
(continued)
• Behavioural theories
• Investors do not use all the information in financial statements → securi es
markets not fully efficient
• Agency theory
• Efficient contracts to motivate manager performance (stewardship) and
achieve good corporate governance
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• Chapter 6 – The Measurement Approach to
Decision Usefulness
Recap Chapter 5 – Value Relevance
• accounting information has “value relevance”
when security prices respond to the
information released.
• Ball & Brown study – Stock market reacts to
earnings information but anticipates the
information
• ERC – Does quality of earnings affect
magnitude of abnormal share return
Ball & Brown Findings
Chapter 6 – Measurement
Approach
Is the market efficient?
• Market efficiency relies on rational investors.
On an individual basis, lots of evidence that
people aren’t rational:
– People take credit for their successes, blame
nature for failures. So if stocks go up, people feel
they’re smart, buy more, causing momentum.
However, they don’t want to sell losers, resulting
in underreactions….
– Prospect Theory
Prospect Theory
• People are loss-averters, so they will hang on
to losers and sell winners
• Individuals also tend to overweight salient,
anecdotal and extreme evidence
– Underestimate probabilities of likely states
– Overestimate probabilities of unlikely states
What Is the Measurement
Approach?
• Greater use of current values in the financial
statements proper
• Recall two versions of current value
– Fair value: exit price
– Value-in-use: present value of