Course Schedule Course Modules Review and Practice Exam Preparation Resources

Introduction to Accounting Theory& Contemporary Issues

Print the introduction

Course purpose

This course has two main goals. The first is to describe and explore various theories that underlie financial
accounting and reporting. The second is to explain and illustrate the relevance of these theories in order to
understand the practice of financial accounting and reporting.

What are some of these underlying theories? You will find that some of these theories are based on economics
and finance. Economics underlies much of financial accounting and reporting. One of the earliest influences of
economics on accounting is the present value model. By discounting future cash flows to a common point in
time, the present value model enables a theoretically correct basis of asset and liability valuation and income
measurement assets and liabilities are valued at the present value of their future cash receipts and
payments, and income is the change in present value over time. Thus, the present value model provides a
benchmark to guide accounting practice. While it can be difficult to apply in the complex real-world
environment in which accountants operate, there is nevertheless increasing emphasis on the present value
model in financial reporting. Examples include fair value reporting for financial instruments, ceiling tests for
capital assets, and valuation of pension and other employee post-employment benefits.

Portfolio theory and efficient securities market theory are from finance. Portfolio theory is relevant to
accountants because it helps them understand how investors make rational investment decisions and how they
use financial accounting information to make their decisions. Accountants can then prepare financial statements
that are of greatest use to investors.

Efficient securities market theory also has important implications for financial accounting. An efficient securities
market is one in which securities prices always properly reflect all available information about securities traded
on that market. Since financial reports supply much (but not all) of the available information about firms,
accountants are now generally aware of the concept of efficient markets. For example, such awareness has led
to the principle of full disclosure, whereby accountants attempt to maximize the information content of financial
statements, including notes to the statements. Often, such full disclosure is not popular with management. Full
disclosure, however, reduces the amount of inside information and the resulting problem of insider trading.

A more recent influence of theory on accounting is that branch of economics called information economics
or the economics of imperfect information. Information economics formally recognizes information
asymmetry between different parties, suchas managers and shareholders of large companies. Managers
typically know more about the firms prospects than shareholders, which may give managers advantages.
Forexample, if managers know that future firm prospects are good, they may not work as hard on the
shareholders behalf and may take excessive perquisites for themselves instead. They may also be tempted to
profit from their inside information by insider trading, at the expense of investors. These problems complicate
the role of corporate governance in motivating and controlling manager behaviour. For example, a manager
may blame natural disasters for low profits when the actual cause is substandard performance, suchas lack of
effort or poor cost control. Shareholders, who cannot observe manager effort, have no way of knowing the real
reasons for the low profits.

Models have been developed in information economics to help us understand and predict the outcome of such
conflict situations. The shareholder-manager interaction just described can be facilitated by making a contract
between these two parties, which will spell out the obligations of each party and specify the compensation for
the manager.

The contractual nature of information economics has major implications for financial accounting and reporting.
One reason is that, directly or indirectly, compensation of top managers depends on reported net income.
Therefore, a precise and sensitive income measure that accurately reflects manager performance is essential.
This role of net income to assist in motivating managers by providing a reliable measure upon which profit-
sharing contracts can be based is quite different from its equally important role of providing information to
capital markets. It is not reasonable to expect that a measure of net income that is most useful for contracting
purposes will also be most useful for reporting to investors.

Another reason is that covenants in debt contracts often depend on accounting variables. Since debtholders will
suffer if the firm enters financial distress, they demand conservative accounting, such as lower-of-cost-or-
market and ceiling tests. These provide an early warning system so that debtholders can take steps to protect
their interests before it is too late.

Therefore, financial accounting theory now recognizes two major roles for net income contracting and
reporting.

Another effect of information economics is that it contains the concept of economic consequences.
Essentially, this concept asserts that accounting policies do matter. For example, a manager whose
compensation depends on reported net income will be interested in the accounting policies used to calculate
that income. Therefore, changes in accounting policies, suchas those laid down by new accounting standards,
can have major consequences, even if those changes have no effects on cash flows. A new accounting policy
that tends to lower reported net income (suchas the recording of deferred income taxes, post-employment
benefits, or the successful-efforts method for exploration costs of oil and gas companies) can affect the way
managers run the firm, as can accounting policies that increase net income volatility, such as fair value
accounting. Anticipating a decrease in their compensation or an increase in the volatility of the firms reported
net income, managers may change operating and investment strategies to compensate for the effect of the
change in accounting policy. This can influence the market value of the firms shares, thereby affecting
shareholder wealth.

The concept of economic consequences has led accountants to pay increased attention to the important and
difficult role of standard-setting bodies, suchas the Accounting Standards Board (AcSB) of the Canadian
Institute of Chartered Accountants (CICA, currently responsible for setting standards for private enterprises in
Canada), the Financial Accounting Standards Board (FASB) in the United States, and the International
Accounting Standards Board (IASB). These bodies face the formidable task of determining the economic
consequences of particular accounting policy pronouncements and of trading off the interests of constituencies
who may be affected differently by these pronouncements. In effect, the setting of accounting standards is as
much a political process as an economic one.

The second goal of this course is to explain and illustrate the relevance of the various theories mentioned
previously to financial accounting and reporting. This is accomplished in two main ways. First, the material
alternates between theory and application. For example, Module2 describes how investors make rational
investment decisions, and then demonstrates how the decision usefulness approach underlies the
pronouncements of the major accounting standard-setting bodies and how it is applied to financial accounting
and reporting. You will better understand and apply these pronouncements when you understand the reasoning
behind them. It is essential to realize that this alternation between theory and practice is designed to motivate
you to consider the theory seriously.

Another approach to illustrating the relevance of the course material is through the review questions and
assignments. A real attempt has been made to design and select material to illustrate the course concepts.

As you know, from 2011, financial reporting for publicly-traded firms in Canada is in accordance with
International Accounting Board (IASB) standards. This course includes coverage of IASB standards, in the
textbook, the modules, the assignments, and review material.

Coverage of certain United States standards is also included where these differ significantly from IASB
standards. Of course, differences are decreasing over time as these two bodies move towards a converged set
of standards.

All of this material is examinable unless specifically marked to the contrary.

In this course, material relating to specific accounting standards is largely (but not completely) at a conceptual
level. Fortunately, at this level, most standards in Canada, the United States, and internationally are broadly
similar, thereby reducing the amount of detail you will have to learn.
Course prerequisites

As an advanced financial accounting course, Accounting Theory & Contemporary Issues draws on knowledge
you have acquired from several other subjects, specifically financial accounting, economics, quantitative
methods, and finance. You can find course descriptions of the prerequisite courses in the CGA-Canada
Syllabus. You can also obtain a copy from your CGA regional office.

In the quantitative area, you should be able to calculate expected utilities, abnormal returns, accretion of
discount, standardized measure income statement and alternative statement, Bayes Theorem and Nash
equilibriums.

Hands-on computer work is not currently required in AT1 . Most of the questions are essay type.
Questions that do require computations can be done quickly by hand or by calculator. Of course, you are
welcome to use your knowledge of computer-based problem-solving techniques to solve any of the quantitative
questions.

An understanding of ethical principles and how the accounting profession addresses ethical issues is an
essential part of the CGA program of professional studies. The Ethics Readings Handbook [ERH] has been
developed as a study resource in this area and is provided electronically through the "Reference library" link
under the Resources tab.

In AT1 it is assumed that you have become familiar with Section A of the ERH . This section clarifies important
concepts and terms used throughout the ERH , and is necessary background knowledge for ERH readings
referenced in this and other courses.

When working with AT1 , you are expected to have acquired basic competence with Microsoft Windows. For
more information on how to work with software in this course, refer to How To/Use Software under the
Resources tab.

Structure and delivery

AT1 comprises 10 modules that can be studied over a 12-week period, one module per week followed by
preparation for the final examination. Each module should take between 15 and 20 hours to complete. The
modules are delivered online and can be saved to your hard drive and also printed.

Course materials

The textbook and reference materials for this course are

William R. Scott, Financial Accounting Theory,Fifth Edition (Toronto, Ontario: Pearson Education
Canada, 2009)
Canadian Institute of Chartered Accountants, CICA Handbook Accounting , updated to January
2011 release
Ethics Readings Handbook [ERH] , Fourth Edition (Vancouver, B.C.: CGA-Canada, 2011)

For a list of the required software for all CGA courses, see Technical Support/System requirements under the
Resources tab.

CICA Handbooks

Whether or not the CICA Handbook is required for your course, you can purchase access to an online
subscription. Be sure to subscribe to the correct Handbook (Accounting, Assurance, or Public Sector). Here are
the CGA courses in which the Handbooks are required:

CICA Handbook Accounting, required for Financial Accounting: Consolidations & Advanced
Issues [FA4], Accounting Theory & Contemporary Issues [AT1 ]
CICA Handbook Assurance, required for External Auditing [AU1 ], Advanced External Auditing
[AU2 ]
 CICA Handbook Public Sector Accounting, required for Public Sector Financial Management
[PF1 ]

The subscriptions expire at the end of the December following the academic year for which they are purchased.

Using the course materials

The module notes and text provide the structure for studying the various course topics. Additional required
readings have been selected to enhance your understanding of the topics.

This course includes a wide selection of learning materials from various sources: textbook, articles, financial
statements, and other materials. You should note:

Articles included as readings for a module: These are to be read and studied at the levels
of competence indicated in the related module notes. They are examinable at the level indicated
and would not be reproduced or provided with the examination paper.
Articles included as part of a review or an assignment question: These are to be read
and studied only for the purposes of answering the specific, related question(s) in that
assignment. You are not responsible for the content of such articles for examination purposes.
Articles included as part of an examination question: An examination question may
include, as part of its data, an article, statement, or similar source material. If this material is
part of the module notes (a reading), then it would not be provided on the examination. Any
other article will be attached to the examination paper.

Comparison of commonly used terms IFRS and pre-IFRS CICA Handbook

The Accounting Standards Board prepares the CICA Handbook and the International Accounting Standards
Board prepares IFRSs. Understandably, while the terminology used by these two bodies is similar in many
aspects, it does vary somewhat. A list of some of the more common differences follows. As these terms may
be used interchangeably in the CGA course materials, you need to be familiar with both versions.

IFRS CICA
at fair value through profit and loss held for trading
closing rate, closing exchange rate current rate, current exchange rate
deferred income tax future income tax
depreciation amortization
foreign currency transactions integrated foreign operation
foreign operation self-sustaining foreign operation
ordinary shares common shares
reserves accumulated other comprehensive income
statement of changes in equity statement of retained earnings
statement of financial position balance sheet
statement of profit and loss income statement
through profit or loss on the income statement

CICA IFRS
accumulated other comprehensive income reserves
amortization depreciation
balance sheet statement of financial position
common shares ordinary shares
current rate, current exchange rate closing rate, closing exchange rate
future income tax deferred income tax
held for trading at fair value through profit and loss
integrated foreign operation foreign currency transactions
income statement statement of profit and loss
on the income statement through profit or loss
self-sustaining foreign operation foreign operation
statement of retained earnings statement of changes in equity

Recommended study approach

The recommended study approach is to begin each module with the overview. The text frequently includes
such overviews. Use the introductions to begin thinking about the material, and skim through the text and
module notes. Then, review the text and related module note material in detail. The module notes are
designed to be studied after the text readings have been completed. Some reference materials are meant to
complement the module notes and should be read when indicated in the topic. A glossary is also provided,
which summarizes important terms used throughout the course. For each term, cross-references are
providedto one or more topics where the term is defined and described in either the module notes or the
required readings.

The review questions are taken mainly from the text. They are designed to further enhance your understanding
of the text and module notes and will often assist you in approaching the assignments. Work through the
questions and review their accompanying suggested solutions once you have finished the text and module note
material. Try to answer the review questions for yourself before looking at the suggested answer at the end of
the review material for that module.

To fully understand the course concepts, you should consider the various theories set forth in the text and
module notes and the applications described. Failure to understand course concepts is perhaps the main reason
for poor performance on examinations.

Course assessments

The assessments in this course consist of the following:

Five quizzes, one each in Modules 2, 4, 6, 8, and 10. These are in the form of multiple-choice
questions that you complete online and submit for marking. For instructions on accessing and
submitting quizzes, see your AT1 Assignment/Quiz submission area.

Assignment 1 (due at the end of week 5 see Course Schedule), Assignment 2 (due at the end
of week7), and Assignment 3 (due at the end of week 9). You prepare each assignment
response in Word and submit it to your marker using an electronic drop box.

Course examination: As with other foundation level CGA courses, the final examination is
threehours long.

Your final course mark will be the combined quiz/assignment mark and examination mark (30 for the
quiz/assignment mark and 70 for the examination). The five quizzes will be worth a combined maximum score
of 10 (each quiz has a maximum score of 2). Assignment 1 and Assignment 3 will be worth a maximum score
of 5 each.Assignment 2 will be worth a maximum score of 10. Your final examination will be graded out of
100, and your raw examination mark will be scaled into a mark out of 70. Your quiz/assignment mark (with a
maximum score of 30) will then be added to the scaled examination mark.

Several resources are available to help you prepare for the final examination:

two practice examinations, which show you the general form of the final examination, including
the types of questions you can expect

examination reviews, in the form of recorded lectures, available approximately two weeks before
the course examination

an examination blueprint, which outlines the primary content areas covered on the examination,
the related learning objectives, the proportion of marks assigned, and the weighting for different
types of questions
To access these resources, see the Exam Preparation tab in the course navigation.

Important reminder:

For CGA-Canada's policy regarding original work on assignments and discussions, check out the Academic
integrity policy in your AT1 Assignment /Quiz Submission area.

Boldfaced terms

Icons and boldfaced terms have been incorporated throughout the module notes to help you through the
course materials.

Words in bold type: When it is particularly important that you learn the meaning of a term (a key word or
phrase), that term will appear in bold at the first instance, suchas ideal conditions in Topic 1.1.

Copyright
Accounting Theory & Contemporary Issues

Fourth Edition
Author: William R. Scott, University of Waterloo

Curriculum Developer: Rita Leung and Alison Howard

Curriculum Editors: Chris Van Cauwenbergh and Patryce Kidd

Product Coordinator: Shuhan Lee

This course is produced in Canada by:

Certified General Accountants Association of Canada

100 4200 North Fraser Way
Burnaby, British Columbia
Canada V5J 5K7

CGA-Canada, 2011

All rights reserved. These materials or parts thereof may not be reproduced or used in any manner without the
prior written permission of the Certified General Accountants Association of Canada.

Every reasonable effort has been made to obtain permissions for all articles and data used in this edition. If
errors or omissions have occurred, they will be corrected in future editions, provided written notification has
been received by the publisher.

Both the curriculum and content of this course have been reviewed by the School of Commerce of
LaurentianUniversity, and have been found to meet acceptable standards.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 1: Accounting under ideal conditions

Texts

William R. Scott, Financial Accounting Theory, Fifth Edition (Toronto, Ontario: Pearson Education
Canada, 2009)

Canadian Institute of Chartered Accountants, CICA Handbook Accounting, updated to January

2011 release.

Ethics Readings Handbook [ERH] , Fourth Edition (Vancouver, BC: CGA-Canada, 2011)

Note:

For all modules, complete required readings before designated topics, unless instructed otherwise.

Overview

Required reading

Chapter 1; Chapter 2 Overview, Section 2.1, page 24

Because this is an accounting theory course, it will be different from most courses you have taken to date.
Some of the concepts raised, such as the matching principle, will be familiar to you, while others will be new
and challenging. Read Chapter 1 of the text, which provides a "roadmap" of how this course will unfold,
including descriptions of the standard setting processes in Canada, the United States, and internationally.

The essence of the course is to explain the tremendous importance of financial accounting in our economy.
You have no doubt heard of financial reporting disasters such as Enron and WorldCom. Both companies were
forced into bankruptcy after massive accounting frauds were revealed. The collapse of investor confidence in
financial reporting that followed was a major contributing factor to the economic recession of the early 2000s.
More recently, the collapse of the market for asset-backed securities and its repercussions leading to worldwide
recession contains serious accounting implications for fair value accounting and consolidation policy. Topic 1.2
describes these recent developments in greater detail. The course aims to give you a good balance of
theoretical and conceptual topics with practical and real world information to enable you to understand how
such unfortunate events can occur, how they can affect real business activity, and how accountants can reduce
the likelihood of them happening again.

After this introduction and overview, Module 1 looks at the present value model. This model is highly relevant
to financial statement users as it reports on the cash flows and profitability of the firm. The module will also
explain ideal conditions, a rather conceptual but essential element in understanding the relevance and reliability
of financial information. You will be introduced to a standard reserve recognition accounting (RRA) that
uses present value accounting in far-from-ideal conditions. It is interesting to note managements concerns with
RRA. The module will then revisit historical cost accounting and explain the tradeoffs between reliability and
relevance that the two accounting methods historical cost and present value represent.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics
1.1 Due process
1.2 Recent developments relevant to financial accounting
1.3 Present value accounting
1.4 Present value model under certainty
1.5 Present value model under uncertainty
1.6 Reserve recognition accounting
1.7 Historical cost accounting revisited
1.8 Conclusion

Learning objectives

Explain the concept of due process and understand how the structure of accounting standard
setting bodies attains due process. (Level 2)
Review recent development relevant to financial accounting. (Level 2)
Define the concept of ideal conditions and outline the necessary assumptions that underlie the
definition. (Level 1)
Explain and illustrate the following concepts: (Level1)
states of nature
probabilities of states of nature (objective and subjective)
expected value of an asset or liability
abnormal earnings
risk
Use the present value model, under conditions of certainty and uncertainty, to prepare an
articulated set of financial statements for a simple firm. (Level 1)
Critically evaluate reserve recognition accounting as an application of the present value model.
(Level 1)
Explain why relevance and reliability of accounting information have to be traded off. (Level 1)
Evaluate historical cost-based accounting in terms of relevance and reliability, revenue
recognition, recognition lag, and matching. (Level 1)

Module summary

Print this module

 Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.1 Due process

Required reading

Chapter 1

LEVEL 2

Chapter 1 lays out the organization of the course and explains many important course concepts. A careful
reading of this chapter will help you to see the course as a whole, and will assist in your understanding of the
material in later modules.

This course contains many references to accounting standards. To fully understand these standards, you need
to appreciate that they are designed so as to trade off the conflicting interests of constituencies affected by
these standards usually investors and managers. Standard setting bodies make these tradeoffs through due
process. That is, standards are set in consultation with major constituencies. Devices to achieve due process
include representation of major constituencies on the standard setting boards, super-majority voting, exposure
drafts, and public meetings. Be sure you are aware of these various ways to achieve due process. This will be
particularly helpful when you reach the topics of game theory and agency theory (Modules 7 and 8), and the
political aspects of standard setting (Module 10).

Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.2 Recent developments relevant to financial accounting

LEVEL 2

Section 1.2 of the text describes highlights of the development of financial reporting up to and including the
Enron and WorldCom scandals, leading to the introduction of the Sarbanes-Oxley Act in the United States.
However, you are no doubt aware of the meltdown of the markets for asset-backed securities in 2007, which
led to the subsequent collapse of stock markets and the threat of worldwide recession. These developments
took place as the 5th edition of the text was being written. Consequently, they are not included in Section 1.2.
This topic outlines these developments and some of their implications for accountants.

Although the following descriptions of these developments are quite detailed, the key objectives are to
illustrate that financial reporting must be transparent so that investors can properly value assets and liabilities;
that off-balance sheet activities should be fully reported in order to discourage management from excessive
risk-taking; and that there is a risk that fair value accounting could understate value-in-use when markets
collapse.

New standards for consolidation

Following the Enron fraud described in the text, standard setting bodies moved to tighten up standards for
consolidation, since Enrons failure to consolidate its Special Purpose Entities (SPEs) was at the heart of its
misreporting. In the United States, Financial Accounting Standards Board Interpretation No. 46 (FIN 46) (2003)
expanded requirements for consolidation of SPEs (called variable interest entities (VIEs) by FIN 46).
Consolidation under IASB standards is governed by Standing Interpretations Committee Interpretation 12, (SIC
12) Consolidation-Special Purpose Entities (1999). It was felt that by forcing VIE consolidation, thus bringing
their assets and liabilities onto their sponsors balance sheets, the financial reporting for financial institutions,
particularly with respect to their overall liquidity and capital adequacy, would be improved.

However, despite this tightening up of consolidation standards, the use of SPEs did not decline, particularly by
financial institutions, where they were frequently called structured investment vehicles (SIVs). These
vehicles were often created by banks, mortgage companies, and other financial institutions to securitize their
holdings of mortgages, credit card balances, auto loans, and other financial assets. That is, the institution
would transfer large pools of these assets to the SIVs it sponsors. The SIV would pool them into asset
backed securities (ABSs), that is, into tranches of similar credit quality. Thus, a particular ABS would be a
tranche of, say, residential mortgages (mortgage backed securities (MBSs)) of high quality, another ABS
would be of lower quality, etc. down to sub-prime mortgages of lowest quality. These various ABS tranches
would then be resold to investors or, particularly for the lowest quality tranche, retained by the SIV and its
sponsor. As mortgagors made payments, cash flowed to the SIV and on to the tranche holders, after deduction
of various fees. Holders of higher quality (i.e., lower risk) tranches received a lower return than holders of
lower quality tranches.

Prior to selling ABSs, they could be further repackaged and sold as collateralized debt obligations (CDOs),
which also consisted of tranches of similar quality mortgages or other financial assets. The difference was that
holders of ABSs had an interest in the underlying assets, whereas CDO holders had an interest only in the cash
flows generated by those assets. Also, unlike ABSs, CDOs tended to be arranged and sold privately, and often
consisted of riskier mortgages.

When it is not necessary to distinguish them, we will refer to these securities collectively as ABSs.

ABSs were highly popular with investors, since they offered higher returns than, say, bonds, and were viewed
as safe because of the diversification of credit risk created by the large underlying pools of mortgages or other
financial assets that backed them up. They also enabled investors to invest in tranches of the particular risk
and return that they desired.

As an alternative to selling the ABSs it acquired, SIVs could hold them. To pay the sponsor for ABSs transferred
to it, the SIVs typically borrowed money. Thus, SIVs were highly levered. Since the ABSs generated higher
returns than the cost of borrowed funds, the SIV became a money machine. Of course, this strategy was
risky. Despite the inherent diversification of ABSs, credit losses could still occur. Consequently, some form of
credit enhancement of ABSs was necessary if the SIV was to be able to borrow at a low interest rate. One
common way to accomplish this was for the sponsor to agree to buy back the SIVs asset-backed securities
should they become impaired. Also, SIVs could hedge their risk by purchasing credit default swaps (CDSs).
These were derivative financial instruments that would reimburse the SIV for all or part of credit losses on its
ABSs. To obtain this protection, the CDS purchaser paid a fee (called the spread) to the CDS issuer. The belief
that credit losses on the underlying ABSs were protected increased the confidence of lenders that their loans to
the SIV were low risk.

Note that if an SIV was consolidated into the financial statements of its sponsor, the high SIV leverage would
show up on the consolidated balance sheet. Now, sponsors will be penalized by the market if their leverage
gets too high, even given the apparent safety of ABSs, since investors react negatively to increased risk. This is
particularly so for financial institutions, many of which are subject to capital adequacy regulations.
Consequently, like Enron, firms that sponsored SIVs had an incentive to avoid consolidation of their SIVs into
their own financial statements. Then, leverage could be further exploited by remaining off-balance sheet. This
motivation would be reduced to the extent that the market looked through the lack of consolidation and valued
the sponsor and its VIEs as one entity. Landsman, Peasnell, and Shakespeare (2008) report evidence that the
market did do this. Even so, avoiding consolidation would be of crucial importance to financial institutions
facing capital adequacy regulations, since these are based on financial statements.

As described above, standard setters had moved to tighten up the rules for consolidation.

Crash of mortgage backed securities (MBSs)

Nevertheless, sponsors were able to avoid consolidation, by creating expected loss notes (ELNs). These
were securities sold by sponsors to outside parties under which the purchasers committed to absorb a majority
of a VIEs expected losses and receive a majority of expected net returns. Thus, the holder of the ELN became
the primary beneficiary under FIN 46, and consolidation would be with the financial statements of the ELN
holder, not with the sponsor. Freed from consolidation, the sponsor could then exploit VIE leverage as much as
it wanted. Presumably, the balance of net returns would go to the sponsor. In addition, sponsors received fees
for various services rendered to VIEs.

Beginning in 2007, this whole structure came crashing down, however. It had become increasingly apparent
that because of lax lending practices to stoke the demand for more and more MBSs to feed leverage profits,
many of the mortgages underlying MBSs were unlikely to be repaid. As a result, a major advantage of ABSs
from an investors perspective (diversification of credit risk across many similar assets) turned out to be their
greatest weakness: asset-backed securities lacked transparency . This was particularly so for CDOs, which
tended not to be publicly traded. As concern about mortgage defaults increased, investors were unable to (or
neglected to) determine how many mortgages associated with a specific ABS were likely to go bad. The rational
reaction to the difficulty of valuing specific ABSs is to not buy any of them. Thus, in July 2007, financial media
reported that two mutual funds of Bear Stearns (at the time, a large U.S. investment bank) were suffering
severe losses on their large holdings of ABSs. This was followed, in August 2007, with a suspension by BNP
Paribas, a large France-based bank, of subscriptions to and redemptions of several of its funds, on grounds
that the market values of its holdings of ABSs were impossible to determine. Other U.S. and European financial
institutions reported similar problems. In effect, the market for these securities collapsed.

Loss of confidence due to counterparty risk

There was another major contributing factor to the market collapse, however. Above, we mentioned that SIVs
could purchase CDSs to reimburse any losses suffered on their ABSs. If so, why did investors lose confidence?
The answer lies in counterparty risk. As mentioned, many SIVs purchased CDSs to reduce the credit risk of
their ABSs. However, as concern about mortgage defaults grew, concern also grew that CDS issuers (i.e.,
counterparties) would not be able to meet their obligations.

Counterparty risk was greatly enhanced, however, due to a significant feature of CDSs it was not necessary
for the purchaser of a CDS to own the underlying assets secured by that CDS. Anyone could buy a CDS that
protected against losses on specific reference ABSs. Such a CDS would protect an investor who did not own
that ABS but wanted to hedge against the possibility of, say, a downturn in the economy. If the economy
deteriorated, the value of the ABS would likely decline as well. A CDS that pays off if an ABS declines in value
would thus increase in value. CDSs also were a vehicle for speculators, since any event that lowered the value
of ABSs would raise the value of CDSs written on those securities.

The demand for CDSs became very high, and their issuance quickly spread from insurance companies to other
financial institutions, attracted by the spread that they generated. Indeed, CDSs were often packaged into
synthetic CDOs, that is, tranches of CDSs, for sale to investors. As a result, the face value of CDSs written on
specific asset-backed securities could be many times their value. Also, like CDOs, CDSs and synthetic CDOs
were not traded on an organized exchange, where regulations would be in place to protect the integrity of
trade transactions. Instead, they were bought and sold privately, making it difficult to know how many CDSs
were outstanding against specific ABSs. A major contributing factor to the ABS market collapse was that CDSs
did not protect ABSs in the eyes of investors, due to counterparty risk.

SIVs faced several problems simultaneously. They were unable to roll over maturing debt: No one would buy it
due to the collapse of their underlying security, their holdings of ABSs themselves were difficult or impossible
to sell, and the ability of CDS issuers to reimburse losses was doubtful. In the face of this collapse of liquidity
and severe counterparty risk, SIVs faced either insolvency or the necessity for their sponsors to buy back their
impaired assets. For example, the Financial Times (November 19, 2008) reported that Citigroup returned the
last $17.4 billion of assets of its sponsored SIVs to its balance sheet, recording a writedown of $1.1 billion in
the process.

Buybacks led to recession

These buybacks had severe consequences, however. Paying for them lowered sponsors liquidity, and required
writedowns of the toxic assets thus acquired. These writedowns were in addition to writedowns of CDSs, and
of asset-backed securities held directly by the sponsors. Further writedowns were frequently required as the
fair value of these assets continued to deteriorate. Many sponsors were rescued by governments, raised
additional capital at distressed prices, or failed outright, resulting in a major contraction of the financial system.
The resulting reduction in market liquidity spread to the real economy, leading to worldwide recession.

Failure to control risk

While blame for the initial collapse of the market for ABSs is usually laid at the feet of lax mortgage lending
practices, the lack of transparency of complex financial instruments created by the finance and investment
communities was also to blame. Of greater significance for accountants, however, was sponsors failure to
adequately control the risks of excessive leverage in the quest for leverage profits. Risk-taking was encouraged
since, as described above, financial accounting standards allowed sponsor firms to avoid SIV consolidation,
thereby encouraging them to take on large amounts of off-balance sheet leverage. Arguably, accountants and
auditors who allowed this avoidance were meeting the letter of FIN 46 while avoiding its intent.

Losses reported under fair value accounting

Another result of the meltdown was severe criticism of fair value accounting, particularly by financial
institutions. They claimed that the requirement to write down the carrying values of financial instruments made
matters worse, by creating huge losses that threatened their capital adequacy ratios and eroded investor
confidence. Writedowns were further criticized because inactive markets often meant that fair values had to be
estimated by other means. For example, fair value of asset-backed securities could be estimated from the
spreads charged by CDS issuers. Since these spreads became very high as underlying ABS values fell, the
resulting estimates, which reflected lack of liquidity in the market, were less than the value-in-use that the
institutions felt they would eventually realize if they held these assets to maturity. Historical cost accounting, or
at least allowing institutions to put their own valuations on these assets, it was claimed, would eliminate these
excess writedowns.

Accounting standard setters largely held their ground in the face of these criticisms. However, faced with
threats that governments would step in to override fair value accounting, they did relax some requirements. In
October 2008, the IASB and FASB issued similar guidance on how to determine fair value when markets are
inactive. The guidance was that when market values did not exist and could not be reliably inferred from values
of similar items, firms could determine fair value by using their own assumptions of future cash flows from the
assets/liabilities, discounted at a risk-adjusted interest rate (that is, value-in-use). Presumably, this would
overcome management criticisms that fair value writedowns were excessive. Also, the IASB relaxed somewhat
the extent of its fair value requirements, by allowing certain financial instruments to be reclassified from full
fair value to less volatile valuation bases, in a manner consistent with existing FASB standards. These changes
are described more fully in Topic 5.5.

In sum, three points relevant to accountants stand out from the events just described. First, financial reporting
must be transparent, so that investors can properly value assets and liabilities. Second, fair value accounting,
being based on market value or estimates thereof, may understate value-in-use when markets collapse due to
a severe decline in investor confidence. This leads to management objections. Finally, off-balance sheet
activities should be fully reported; otherwise, they can encourage excessive risk taking by management.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.3 Present value accounting

Required reading

Reread Chapter 1, Section 1.9.1, page 16 (Level 1)

LEVEL 1

This module approaches the presentation of accounting information from a basic and idealistic situation called
ideal conditions. Section 1.9.1 of the text briefly describes accounting under ideal conditions. Note the
following points in particular:

Under ideal conditions, accounting is done on the basis of present values of future cash flows,
which is a basic and idealistic way of accounting. Nevertheless, it provides a benchmark against
which actual accounting practice can be evaluated. Specifically, without the theoretical guidance
provided by accounting under ideal conditions, we have no way of judging whether an actual
accounting practice, such as historical cost accounting, is "good" or "bad." With the theorys
guidance, however, we can state that the closer an accounting practice comes to present value
(without sacrificing too much reliability), the better.

The text (page 4) introduces the term current value accounting. This is a general term used to refer to
departures from historical cost designed to increase relevance of financial information. One such departure is
present value accounting (also called value-in-use), as just mentioned. The other departure is fair value
accounting (also called exit value or opportunity cost). Fair value is the amount the firm could sell an
asset for or the cost to dispose of a liability, that is, market value. An implication of valuing assets and liabilities
at opportunity cost is that managements success is then evaluated by its ability to generate more profits from
retaining assets and liabilities and using them in the business than by taking the opportunity of selling them.

Under ideal conditions, present value and market value are equal. This module concentrates on present value
accounting, since this is the fundamental basis on which market values are determined. However, when ideal
conditions do not hold, the present value of an asset or liability may differ from its market value. Furthermore,
no market value exists for many assets and liabilities, such as specialized assets (for example, oil and gas
reserves, power dams, and steamships), intangibles, and illiquid asset and debt securities, which is a situation
called incomplete markets.
Course Schedule Course Modules Review and Practice Exam Preparation

1.4 Present value model under certainty

Required reading

Chapter 2, Sections 2.1 and 2.2, pages 24-29 (Level 1)

LEVEL 1

Example 2.1 of the text illustrates the present value accounting model under certainty, also known as
ideal conditions under certainty. Be sure you understand the mechanics of the example. Notice that the format
of the balance sheet is identical to conventional financial statements prepared under historical cost accounting.
What is different is that valuation of all assets and liabilities is now the basis of discounted present value. The
income statement is much simpler than under historical cost accounting. It contains only accretion of
discount, that is, interest on opening net assets. To understand accretion of discount, note the reference in
the text to interest on a bank savings account. If you have $1 in your account at the beginning of the year and
the account pays 3%, you will have $1.03 at year end. The 3 cents is your income for the year, that is,
accretion of discount. The term arises because as time passes, the balance in your account grows (that is, it
accretes) at the interest rate you receive.

It is instructive to also think of Example 2.1 in terms of revenue recognition. As you are aware, the usual point
in the operating cycle at which revenue is recognized is the point of sale. In present value accounting under
ideal conditions, the present value of all future revenues net of costs is recognized when productive capacity is
acquired (for example, plant and equipment is valued at the present value of its future net cash receipts at
date of acquisition). Then, income for the year is simply the accretion of discount on the opening present value.
That is, under ideal conditions, it is not necessary to wait until the realization of revenue is probable, since, by
definition, all future revenues are reliably known. While the text addresses this in terms of asset valuation, it is
useful to also evaluate the pros and cons of present value accounting in terms of revenue recognition. In
effect, asset valuation and revenue recognition are two sides of the same coin.

Notice that Example 2.1 includes only the first year of P.V. Ltd.s operations. In years beyond the first, there will
be opening cash-on-hand. Any such cash will be invested at the given interest rate. (It would not be rational
for the firm to let cash sit idle when it can be invested for a riskless return.) Then, accretion of discount in
subsequent years must be based on total assets including opening cash. Self-test Question1 illustrates this
point.

Note that even if the firm pays out all of its profits as dividends, there will be cash-on-hand equal to
accumulated amortization. This illustrates the point learned in introductory accounting courses that amortization
retains assets in the business.

The concept of dividend irrelevancy is mentioned on page 26 of the text. The basic idea is that when there
is only one interest rate in the economy, investors do not care about the firms dividend policy. If the firm
retains profits, it will earn a return at the given interest rate on earnings retained in the business. If it pays a
dividend, investors can invest it to earn the same return. The investors wealth is the same either way. If
investors wish to consume their shares of firm profits rather than invest them, they can simply spend any
dividends, or, if the firm does not pay dividends, borrow with the retained profits as security. Again, they are
equally well off whether the firm pays dividends or not.

To help you understand the process of preparing an income statement and balance sheet using present value
accounting, first set up your steps. As an example, the steps for preparing the balance sheet at the top of
page26 of the text are shown in Exhibit1-1, which follows.

Exhibit 1-1

Steps for preparing a balance sheet at end of year1

1.Determine cash $150

2.Determine current net present value of future cash flows $150 /1.10 = $136.36

3.Calculate shareholders' equity Opening value + net income dividends (if any)
$260.33 + 26.03 = $286.36

4. Arrive at total assets and shareholders equity $286.36

When all the items are set out for each statement, you can then construct your financial statements.

Finally, while the interest rate in Example 2.1 of the text is referred to as the risk-free interest rate in the
economy, this rate can also be interpreted as the firms cost of capital. In effect, under ideal conditions, all
firms costs of capital are equal, and equal to the investment and borrowing rates used by investors.
Ofcourse, under realistic conditions, firms that prepare present value estimates may use their own costs of
capital, which will typically differ from interest rates faced by investors.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.5 Present value model under uncertainty

Required reading

Chapter 2, Section 2.3, pages 29-35 (Level 1)

LEVEL 1

This topic proceeds to the present value model under uncertainty. The major change in moving from
certainty to uncertainty is that the cash flows may differ depending upon the states of nature, and each
possible cash flow is expected with a known probability.

Be sure you understand the mechanics of text Example 2.2 (page 29), which illustrates the present value model
under uncertainty. In many ways, present value accounting under uncertainty is a simple extension of
accounting under certainty.

Example 2.2 introduces several new concepts that are frequently drawn on throughout the course:

States of nature. States of nature are possible future events that will affect the outcome of a
decision. In Example 2.2, the states of nature are "economy is bad" and "economy is good." The
decision outcome this affects is whether the firm will use its asset (operate as a business) for the
next two years or sell it. Example 2.2 assumes the firm will continue to operate. However, under
ideal conditions the firm can always sell its net assets at their expected present values. For
example, if the firm sells out at the end of period 1 it will not face the prospect of the low state
in period 2 (nor will it enjoy the prospect of the high state). Several other types of decisions that
are also affected by states of nature will be illustrated in subsequent modules. For now, the
important point to realize is that, under ideal conditions, the set of states of nature comprise an
exhaustive list of events affecting the decision at hand that may happen in the future. Of course,
at the time a decision under uncertainty is taken we do not know which state will happen.
Nevertheless, whatever state does actually happen must be a member of the set of states.

Probabilities of states of nature. Under ideal conditions, these probabilities are known, similar
to the probability of obtaining heads or tails when tossing a coin that you know is fair. These are
called objective probabilities. This is the case in Example 2.2, where the probability of
"economy is good" is known to be 0.5. However, the example also introduces the concept of
subjective probabilities, where the probabilities are not known but must be assessed by the
firm or decision maker. (What is the probability of a head if you are not sure that the coin you
are about to flip is fair?) Subjective probabilities are more formally introduced in Module 2. For
now, the main points to realize are the difference between the two probability concepts and that
ideal conditions of uncertainty assume objective probabilities.

Expected value of an asset or liability. This concept should be familiar to you from earlier
courses. Be sure you are able to make expected value calculations. The mechanics of the
calculations are the same regardless of whether probabilities are objective or subjective.
However, the accuracy of the calculation may be much lower in the latter case.

Abnormal earnings. These are the difference between the expected value of earnings and their
actual realization. This is the main difference between income statements prepared under ideal
conditions of certainty and uncertainty. Note that expected earnings (that is, accretion of
discount) are the same in both Examples 2.1 and 2.2. Since, as a practical matter, almost every
firm operates under uncertainty, abnormal earnings are an important concept that will come up
again when you study investor reaction to firms reported earnings in Modules 3 to 6. For
example, investors seem to respond strongly to unexpected earnings. You have probably seen the
major effect on share price when a firm reports earnings higher or lower than the market had
expected. The Income Statements illustrated in Example 2.2 (see pages31 and 33) show how
 reported earnings consist of an expected and an unexpected component.

Risk. Most firms operate under considerable risk. As you will see in Module 5, accountants have
been giving increased attention to reporting on risk. Example 2.2 provides a conceptual basis for
thinking about and understanding the nature of risk under ideal conditions. Risk is the knowledge
that one of several different possible state realizations will occur, but it is not known for sure
which one it will be. When ideal conditions do not hold, additional risks appear. For example,
there may be realizations of states of nature during the year that were not anticipated at the
beginning of the year.

The present value model has one additional feature that is conceptually important to note. With respect to
revenue recognition, all future revenues are recognized (that is, their expected values are capitalized into the
carrying value of assets such as plant and equipment) as at the financial statement date. This is similar to the
case of ideal conditions under certainty. The only difference is that under uncertainty, that is, in uncertain
situations, expected revenues are recognized and capitalized.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.6 Reserve recognition accounting

Required reading

Chapter 2, Section 2.4, pages 35-41 (Level 1)

LEVEL 1

Note:

You may wonder why American standards are sometimes used for illustrative purposes rather than Canadian or
international standards. Also, why are the standards and articles in some cases quite dated?

The objective is to illustrate the concepts with the most developed illustration, whether it be Canadian,
American, or international. Since the three sets of standards are very similar in concept, any one of them can
usually serve the purpose acceptably. However, in some cases the standards differ. For example, at present the
FASB pensions standard is more advanced towards current value accounting than international standards. For
such cases, we will discuss the more advanced standard, with less attention to the others. The purpose is
always to select the standard that best illustrates course concepts. With respect to dating, the objective is to
explain or illustrate the concept with an appropriate release whether it be an earlier or more recent release. An
article or standard that is quite old in time can still be highly relevant to current practice.

With respect to reserve recognition accounting, Canada does have its own standard (described below).
However, we will see that most large Canadian oil and gas companies report under the United States standard.

This topic gives you some exposure to the mechanics of reserve recognition accounting (RRA), which
reports expected present value of proved oil and gas reserves as supplementary information. It is
interesting that, even though RRA is an American accounting standard, it shows up in the financial statements
of a major Canadian corporation (here, Suncor Energy, Inc.). One reason is that shares of many Canadian
corporations, such as Suncor, are traded in the United States. U.S. investors, and the SEC in the United States,
will expect RRA information. Another reason is that some large Canadian oil and gas companies are subsidiaries
of U.S. parents. Because of increasing integration of world economies, it is becoming more important for
Canadian accountants to be aware of financial reporting practices in other countries.

Under ideal conditions, the future cash flows of the firm are known, the interest rate in the economy is known
with certainty, and present value and market values are equal, as mentioned earlier. These conditions never
exist in the real world. The main purpose of this topic is to illustrate some of the difficulties that arise when
accountants attempt to apply the present value model under non-ideal conditions. A study of RRA helps us to
understand the problems that arise as accounting moves more towards the reporting of current values.

A major problem involves the reliability of the estimates. Reliability remains a concern for RRA despite attempts
in SFAS 69 to reduce the problem. Specifically, SFAS 69 mandates a 10% interest rate, applies only to proved
reserves, and requires that future receipts from oil and gas be priced at year-end levels rather than the more
"ideal" prices expected to be in effect when the oil and gas is actually sold. Another problem faced by RRA is
how to overcome management objections, as illustrated by the texts quotation from Suncors management on
page 38. While managements concerns are expressed in terms of low reliability, another problem from
management perspective is that present value accounting produces relatively (that is, relative to historical cost)
volatile asset values and earnings. Management often feels that this volatility produces financial statements
that do not properly reflect its performance. We postpone consideration of this concern to Module6 and
subsequent modules.

With respect to reliability, the serious consequences of unreliable RRA information are illustrated by the case of
RoyalDutch/Shell, outlined in the vignette on text page 41. While this company is European, not Canadian, it
too reported in accordance with SFAS 69. Canadian oil and gas firms should take note of Shell's experience.

In this regard, Canadian securities regulators have now introduced their own RRA standard, namely
NationalInstrument 51-101 of the Canadian Securities Administrators (CSA), a forum of 13 Canadian provincial
and territorial securities commissions. This standard goes beyond SFAS 69 in several ways:

The definition of proved reserves is tightened up. Under NI 51-101, these are reserves with at
least a 90% probability of recovery. The SFAS 69 definition requires only "reasonable certainty" of
recovery.
Probable reserves must also be reported. These are additional reserves such that there is a
greater than 50% probability that the sum of proved plus probable will be recovered.
Two present value estimates of future cash flows from reserves are required based on year-
end prices and costs (as in SFAS 69) and on forecasted prices and costs.
Discounting is required at several different discount rates, ranging from 0% to 20%. SFAS 69
requires only 10%. The use of different discount rates reflects the perceived risk of receipts.

Clearly, the Canadian requirements go beyond SFAS 69. Nevertheless, the same problems of reliability that the
text outlines for SFAS 69 remain.

It should be noted that Canadian firms can apply for exemption from NI 51-101 if they report under SFAS 69.
Most large Canadian oil and gas companies have secured this exemption. Consequently, despite the Canadian
standard, RRA as per SFAS 69 remains as an important disclosure standard in Canada. For example, Suncor
Energy, Inc. states in its 2006 Annual Report (page 035, not reproduced in textbook):

We are a Canadian issuer subject to Canadian reporting requirements, including rules in connection with
the reporting of our reserves. However, we have received an exemption from Canadian securities
administrators permitting us to report our reserves in accordance with U.S. disclosure requirements.

This exemption allows the Company to substitute United States Securities and Exchange Commission ("SEC")
requirements for certain disclosures required under NI 51-101.

Revenue recognition

Read the discussion of revenue recognition and asset valuation on pages 39-40 of the text with particular care.
Note that the revenue recognition criteria of RRA are somewhat different from those of ideal conditions, where
all future revenue is recognized as at the financial statement date. Under RRA, revenue is recognized, in effect,
when reserves are proved . While this is somewhat later in the operating cycle than under ideal conditions
(which could be when exploration rights are acquired), it is still substantially earlier than the conventional sale
basis of revenue recognition.

An understanding of the question of revenue recognition enables you to economize on the amount of material
you have to understand. This is because asset valuation and revenue recognition are two sides of the same
coin. The text discussion is primarily in terms of asset valuation (the debit side of the coin), concentrating on
the problems of estimating the value of proved reserves. However, the discussion on pages 39-40 is also in
terms of the timing of revenue recognition from oil and gas (the credit side). Note that early revenue
recognition, as in RRA, is relevant (early recognition helps investors evaluate the firms future cash receipts
from oil and gas) but less reliable (less precise and more subject to possible manager bias). Exactly the same
tradeoff between relevance and reliability is present as in the problem of asset valuation greater relevance
can be attained only by sacrificing reliability, and vice versa.

Many "real world" accounting problems are cast in terms of revenue recognition rather than asset valuation.
Indeed, when firms get into trouble over their financial reporting, the most common cause is their revenue
recognition practices. Question 22, on pages 52-53 of the text, illustrates this point. (Read the question only.
The solution is not required for this illustration.) Lucent restated its earnings for 2000 to reverse $679 million of
revenue that had been included in its earnings for that year. Note that instead of asking if Lucent should
recognize revenue when product is shipped to distribution partners, the problem could equivalently be
expressed as whether Lucents accounts receivable from distribution partners should be valued at selling price
(that is, the price charged by Lucent to its distribution partners) or at cost (that is, the cost to Lucent of
producing the products and services sold to distribution partners). (This latter treatment, in effect, regards the
items sold as part of Lucents inventory pending resale by the distribution partners.)

Be sure you realize that valuing accounts from distribution partners at selling price is not necessarily "bad." The
tradeoff between relevance and reliability applies here. Valuing accounts at selling price increases relevance,
because this is likely to be the amount received by Lucent when the distribution partners sell the product to
outside customers. However, this basis of valuation reduces reliability since the non-arm's length relationship
between Lucent and its distribution partners increases the possibility that Lucent will "stuff the channels" with
more product than the distribution partners can sell. Then, accounts receivable at selling price is overvalued.
Only if the decrease in reliability from valuing accounts at selling price outweighs the increase in relevance is
the reversal of revenue warranted in terms of decision usefulness.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.7 Historical cost accounting revisited

Required reading

Chapter 2, Section 2.5, pages 41-45 (Level 1)

LEVEL 1

Two of the most useful concepts in this course are relevance and reliability of financial accounting information.
These are recurring themes which are important to understanding many of the problems accountants face in
trying to increase the usefulness of financial reporting, particularly with respect to the implementation of
current value accounting.

Relevant financial information gives investors information about the firm's future economic prospects.
Reliable financial information faithfully represents without error and bias what it is intended to represent.
Be sure you understand why, except under ideal conditions, relevance and reliability must be traded off . This is
the main purpose of this topic. While the text concentrates on the relevance and reliability tradeoff of historical
cost accounting, there are different tradeoffs for other bases of accounting. For example, cash basis accounting
represents the trading off of a lot of relevance in order to attain high reliability. Conversely, current value
accounting represents the trading off of a lot of reliability in order to attain high relevance. Historical cost
accounting can then be thought of as a compromise between these two extremes.

Note: The joint IASB/FASB Conceptual Framework, introduced into the CICA Handbook in January, 2011, (to be
discussed in Topic 2.7) replaces the term reliability with representational faithfulness, where
representationally faithful information is complete, free from material error, and neutral (that is, unbiased). In
these notes, we will usually use the term reliability since it is well known, shorter, and conceptually quite
similar to representational faithfulness.

Increasing both relevance and reliability is extremely difficult to do. (Can you think of a financial accounting
product that does this?) The text suggests that the reporting of supplementary information (such as RRA)
enables increased relevance while retaining the reliability of historical cost in the financial statements proper.
Also, it may be that improved technology (for example, the use of large data bases and computer technology
to prepare more accurate estimates) could increase both relevance and reliability of employee pension
liabilities. Nevertheless, such examples are rare. The reasons should be apparent from the problems of RRA
increasing relevance requires better predictions of states of nature and their probabilities. However, predictions
require estimates, and since state probabilities are usually subjective, hence subject to error and possible
manager bias, the use of estimates reduces reliability.

Notice also that a discussion of historical cost accounting in terms of its relevance and reliability is equivalent to
discussing it in terms of revenue recognition, recognition lag, or matching. If under historical cost accounting,
the accountant waits until receipt of proceeds is probable before recognizing sales revenue, you can think of
this decision in terms of a reasonable tradeoff between relevance and reliability. You can also think of it in
terms of recognition lag, since waiting until receipt of proceeds is probable involves a lag from the main
economic event leading to the sale (which in most cases is the acquisition of goods available for sale or the
rendering of services). Recognizing revenue when goods are acquired or as service is rendered represents a
very short lag, whereas waiting until cash is actually collected represents a very long lag. Again, historical cost
accounting represents a tradeoff between short and long recognition lag. You can alternatively evaluate this
transaction in terms of matching. Under current value accounting, inventory is valued at fair value. There is
little matching since a sales transaction has not yet occurred. Nor is there much matching under cash flow
accounting since the sales transaction has occurred some time ago. Historical cost accounting involves
matching expected cash flow against costs of sale, again an intermediate position. In this course, we will use
these various terms interchangeably. For example, to say that current value accounting is low in reliability but
high in relevance is also to say that current value accounting recognizes revenue early, has little recognition
lag, and that the accountant does not wait to match cost and revenue.
Note that unless the basis of accounting is cash flow, accruals are required to anticipate future cash inflows
and outflows.

While historical cost accounting may seem like a reasonable tradeoff between desirable characteristics of
accounting information, and is still used for many important classes of assets and liabilities, actual practice has
been moving toward current value accounting for some years, as the text points out in Section 2.4.1 (page35).
Present day accounting is often called a mixed measurement model.
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

1.8 Conclusion

Required reading

Chapter 2, Sections 2.6 and 2.7, pages 45-47

It is interesting to consider the text's conclusion that "true" net income (one based on present value
accounting) does not exist, except in the idealistic and unattainable world of ideal conditions. However, this
does not mean that present value accounting should be abandoned on the grounds that it cannot be reliably
implemented. As argued in Topic 1.4, the present value model provides a "beacon" or standard against which
real-world accounting can be evaluated the closer we can come to present-value-based accounting, while
retaining reasonable reliability, the better. Indeed, financial reporting practice is moving strongly toward
increased use of current values. You will see several examples of this in later modules.

Recall that, under ideal conditions, present value and market value are equal. Indeed, many implementations
of current value accounting in practice are based on market values. However, you should realize that when
conditions are not ideal, market values do not resolve the question of non-existence of true net income. The
reason is simple market values do not exist for many assets and liabilities. When markets are incomplete,
financial statements cannot be fully prepared on a market value basis, which is another way of saying that true
net income does not exist.

Nevertheless, it may still be worthwhile to prepare financial statements for which individual assets and liabilities
are accounted for on a current value basis. Providing that reasonable reliability is maintained, accounting
theories tell us that financial statements are "better" when they more closely approach the present value ideal.
This is one reason for the movement of practice to a mixed measurement model. Other reasons for this
movement will be discussed in later modules.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 1 summary
Outline of the course and update on recent developments
This module begins with an outline of the course as given in Chapter 1, with particular attention to the
structure of accounting standard setting bodies and the concept of due process. You should be aware of the
structure of standard setting, since standard setting comes up many times in the course.

The module also provides an outline of important events leading up to the market meltdowns beginning in
2007, since these events have several important implications for accountants and are not discussed specifically
in Section 2.1 in the text.

Accounting under ideal conditions

This module defines the concepts of ideal conditions and illustrates preparation of financial statements when
ideal conditions hold. Balance sheet 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 tradeoff 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.

This module begins with an outline of the structure of the course (text, Chapter 1), with
particular attention to the concept of due process in standard setting. Due process is essential if
reasonable compromises between the interests of investors and managers in standard setting are
to be attained.

Review recent development relevant to financial accounting.

Implications for financial accounting of Enron and World.com scandals and the current market collapse:

Off-balance sheet 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

the future cash flows of the firm are publicly known with certainty
the single interest rate in the economy is given and publicly known
Ideal conditions are then extended to conditions of uncertainty in which
a complete and publicly known set of states of nature exists
 the probabilities of states of nature are objective and publicly known
the single interest rate in the economy is given and publicly known state realization
is publicly observable

Explain and illustrate the concepts of states of nature and the probabilities
of states of nature (both objective and subjective).

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.

Explain and illustrate the concepts of expected value of an asset or liability,

abnormal earnings, and risk.

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.

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

Financial statements are prepared on the basis of present value of future cash flow,
discounted at the given interest rate.
Assets and liabilities are valued at their present values.
Net income is equal to accretion of discount.

Use the present value model, under conditions of uncertainty, to prepare an

articulated set of financial statements for a simple firm.

Using the definition of ideal conditions extended to conditions of uncertainty

Financial statements are prepared on the basis of expected present value of future
cash flows, discounted at the given interest rate.
Assets and liabilities are valued at their expected present values.
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.
Most large Canadian oil and gas companies have received exemption from NI 51-101 providing
they disclose under the less detailed requirements of SFAS 69 of the Financial Accounting
Standards Board of the United States.
SFAS 69 requires affected firms to report supplementary information about the expected present
value, based on year-end prices, 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 proven 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 accuracy, and
about legal liability if reserves are overstated.

Explain why relevance and reliability of accounting information have to be

traded off.

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 firms 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.

Evaluate historical cost-based accounting in terms of relevance and

reliability, revenue recognition, recognition lag, and matching.

Historical cost accounting represents an intermediate tradeoff 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 tradeoff between these characteristics of accounting information.
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.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 2: Decision usefulness approach to financial

reporting
Overview

Read the Chapter Overview, Section 3.1, on pages 58-59.

This module reviews the theory of rational investment decision making and develops the concept of decision
usefulness. Financial statements are interpreted as an information system, relating current financial statement
information to the firms future prospects. To do this accurately is the essence of decision usefulness. The
effects of relevance and reliability of accounting information on the information system are shown. Relevance
and reliability are the fundamentals of decision usefulness. The conceptual framework of major accounting
standard-setting bodies is shown to be based on the decision theory framework. Decision usefulness
underscores all investor-oriented financial statement preparation decisions. How financial statement users
interpret and use the information contained in financial statements can have serious ethical consequences. A
good understanding of decision usefulness theory will enable you to better understand investors decisions and
enhance your ability to supply useful information.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

2.1 Decision usefulness approach

2.2 Single-person decision theory
2.3 The rational, risk-averse investor
2.4 Principle of portfolio diversification
2.5 Optimal investment decision ignoring transaction costs
2.6 The concept of beta risk
2.7 Professional accounting bodies and the decision usefulness approach
2.8 Ethical undertones of the usefulness criterion
2.9 Conclusion

Learning objectives

Define the concept of decision usefulness. (Level 1)

Perform calculations in accordance with the single-person theory of decision making under
uncertainty. (Level1)
Describe financial statements as an information system and give a precise definition of
information. (Level1)
Define the basic concepts of portfolio theory, including beta risk,and the optimal investment
decision. (Levels 2 and 3)
Calculate expected return and variance of a portfolio and its covariance with other portfolios.
(Level 2)
Relate decision theory to the conceptual framework for financial reporting. (Level 1)
Outline the ethical issues related to the usefulness criterion in financial statement preparation.
(Level 2)

Module summary

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.1 Decision usefulness approach

Required reading

Chapter 3, Section 3.2, pages 59-60 (Level 1)

LEVEL 1

In this course, you will study two main functions of financial accounting and reporting:

assisting investors in making good investment decisions

motivating managers to perform responsibly by providing a measure of theirperformance in
running the firm

Modules 1 to 5 deal with the first function, with this module providing the theory that underlies investor
decision making. Modules 6 to 8 will cover the second function.

Financial accounting and reporting is used to assist investors in making investment decisions it is not the
accountants responsibility to make the decisions for investors. If accountants are to provide useful information
to assist investors, they must know what information investors need. The single-person decision theory
(Topic 2.2) and its subset , the theory of the optimal investment decision (Topics 2.3 to 2.6), help accountants
to identify what these information needs are.

Firms and professionals who do not supply useful products and advice to customers will probably find
themselves in dire straits. The decision usefulness approach, then, simply asserts that, to survive and
prosper, financial accountants should supply information that is useful to investors.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.2 Single-person decision theory

Required reading

Chapter 3, Section 3.3, pages 60-68 (Level 1)

ERH , Unit A5 (ERH readings can be found under the course Resources tab)
Reread Chapter 1, page 5 re Possibility Theorem of Arrow, Section 1.3, and pages 15-16 re
regulation (Level 2)

LEVEL 1

This topic provides a general model for an individual to make a rational decision in the face of uncertainty.
While not claiming that all individuals make decisions this way, the theory does provide a formal way to do
what one would do intuitively when confronted with new evidence. For example, suppose you walk out the
door one morning and realize that the sky is dark and threatening. You would likely revise your probability of
rain and may decide to take your umbrella. The decision theory model parallels, in a more formal way, the
thought processes you go through when confronted with a decision. In particular, Bayes theorem provides a
recipe to revise your beliefs about the probability of rain, and the expected utility calculations summarize your
feelings about the benefits and costs of taking or not taking your umbrella. You would then do what you feel is
best that is, you make the decision that maximizes your expected utility.

The recipe for Bayes theorem, as shown in the text, is the following equation, which effectively adjusts your
prior probabilities for new information:

where:

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

P(H) = decision makers subjective prior probability of the high state, based on all information possessed by the
decision maker up to just prior to analyzing the financial statements.

P(L) = decision makers subjective prior probability of the low state. Note that the prior probabilities must sum
to 1.

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

Before proceeding to a typical investment decision, utility will first be defined. It is the economic term for the
satisfaction a specific individual receives from a circumstance or set of circumstances. When faced with two
alternative situations, an individual will most likely choose the one that affords the greatest satisfaction. The
question you may ask is How can you quantify satisfaction? Utility is a subjective measure, and if there is a
given scale of utilities, one can only guess at a numerical value of ones utility. However, in order to show the
reader that in the view of the individual one decision is better than another, numerical values are attached to
the alternatives, assuming that the one with the greatest value will give the greatest satisfaction (utility).

As discussed in ERH , Unit A5, a complete evaluation of the utility of an act requires the decision maker to
evaluate any impact the decision may have on others. Interpersonal comparisons of utility are very difficult,
however, as Unit A5 makes clear. At this point, you should reread the text, page 5, last full paragraph, on the
Possibility Theorem of Arrow, and Section 1.3 on ethical behaviour, including Note 10. The theory of decision
making that we develop here sidesteps the difficulty (impossibility?) of evaluating group utility in two
interrelated ways. First, you consider the decision of a single individual no aggregation of utilities across
others is attempted. The individuals decision process is an example of the Arrow satisfaction of preferences
approach.

Second, even at the single individual level, you evaluate the decision solely in terms of its effect on the
decision makers wealth. Thus, if act a1 provides greater expected utility of wealth than act a2, you assume
that the decision maker prefers a1. There is no reason (other than perhaps some of the difficult tradeoffs
posed in Unit A5) why a decision maker cannot adjust his/her utility to take account of any beneficial or
adverse effect of the decision on others, or on the environment. However, for the investment decisions studied
here, investors are assumed to buy or sell on markets sufficiently deep and liquid that their purchases and
sales do not affect market price, and hence have no effect on others. Since securities markets generally have
these deep and liquid characteristics for all but the largest of investors, this assumption is literally true in most
cases. Consequently, the text discussion of rational decision making is sufficient to help accountants understand
the decision needs of investors.

To look ahead a bit, Module 7 discusses the satisfaction of preferences approach by looking beyond individual
decisions to consider game theory and, in particular, agency theory as ways to simultaneously satisfy the
preferences of two persons. However, in the discussion about standard setting in Module 10, you will see that
the standard setter does face the evaluation of group utilities, since standards affect many different persons
and groups. Here the full complexity of evaluating group utility so well described and illustrated in Unit A5
becomes apparent. For a brief description of the complexity of standard setting, reread text, pages 15-16 on
regulation. Due process, as described in Module 1.1, is one way that accountants respond to this complexity.

Work through text Example 3.1 (pages 61-64), which shows a typical investment decision, and be sure that
you understand the logic. Notice that the investment decision involves a two-step process. The first step is to
set up the decision tree with the prior probabilities, which is a convenient way to visualize the decision problem.
The second step is to decide whether or not to obtain more information you can always decide to proceed
on the basis of your prior probabilities. However, you have the option to obtain more information. The text
assumes you exercise this option. Make sure you understand how financial accounting information, when
processed through Bayes theorem, leads to revision of the individuals (subjective) prior state probabilities,
with possible impact on the decision to buy or not to buy the firms shares. This is the essence of decision
usefulness if it leads to belief revision and possible effect on the investors decision, information is useful to
that investor. A good question accountants can ask themselves is "How useful is the information that I am
producing?"

The information system

While it is not hard to see that financial statement information can affect an investors beliefs about future firm
performance, a deeper question can be asked: "By how much are the investors beliefs affected?" Or, in terms
of the question asked at the end of the previous paragraph, " How useful is the accounting information?" The
answer is provided in the information system, which is one of the most useful concepts in financial
accounting theory (summarized in Section 3.3.2 and, in particular, Table 3.2 on page 65). For ease of
reference, Table 3.2 is reproduced in Exhibit 2-1:

Exhibit 2-1

Information system for decision theory (Table 3.2)

Current financial

statement evidence
GN BN

High 0.8 0.2
State
Low 0.1 0.9
The main diagonal runs from the top-left corner to the lower-right corner. The 0.8 and the 0.9 probabilities
constitute the main diagonal. The off-main diagonal involves the 0.1 and 0.2 probabilities. Note that the
probabilities add to 1 across , that is, if the true state is high, then there is a 0.8 probability that the financial
statements will show GN and a 0.2 probability that they will show BN. Similarly, if the true state is low, there is
a 0.9 probability that the financial statements will show BN and a 0.1 probability that they will show GN. In
statistics, these are called conditional probabilities, since they are conditional on which state is true. If this
information system was used in Bayes theorem given above, we would have P(GN/H) = 0.8 and P(GN/L) =
0.1.

Note that information system probabilities are objective, in contrast to the subjective prior and posterior
probabilities of the decision maker. That is, the information system probabilities are determined by the quality
of the financial statements and the accounting principles that underlie them. In this regard, read Note7 of
Chapter 3 on page95 of the text carefully. The higher the quality of the financial statements, the greater their
usefulness.

To maximize usefulness, accountants would want financial statements to have as much impact on the investor
as possible. In information system terms, the main diagonal probabilities should be as high as possible.
Equivalently, the information system should be as informative as possible. Highly informative information
systems are also called of high quality , transparent , and precise .

The concept of an information system is one of the most important in this course. It provides the link between
the current financial statements and the probabilities of future firm performance, which are of interest to the
investor. Furthermore, it ties in with the concepts of relevance and reliability introduced in Module 1. As
described in the text, suppose that a proposed new accounting standard, for example, one that requires
valuation of assets or liabilities at fair value, promises increased relevance. This will increase the main diagonal
probabilities of the information system, because fair values of assets and liabilities provide a better basis for
predicting future firm performance than their historical costs. However, the new standard may also decrease
reliability, which lowers the main diagonal probabilities. Then, whether the new standard offers greater
usefulness to investors depends on the relative magnitude of the two effects. Since most financial accounting
debates involve a tradeoff between relevance and reliability, the information system concept offers a unified
way to think about their effects on decision usefulness.

To understand the role of information in decision making, considerSelf-test Question 1 carefully. This question
looks at the two information system extremes perfect information and useless information. Note in particular
how Bayes theorem conforms to our intuition by producing posterior probabilities that perfectly predict the
state of nature (perfect information system) or that are unchanged from prior probabilities (useless information
system). While a perfect information system is beyond the reach of financial accounting (this would require
ideal conditions), careful consideration of the issues of relevance and reliability in the development of
accounting standards should produce financial statements that are sufficiently close to the perfect extreme for
investors to perceive them as useful.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.3 The rational, risk-averse investor

Required reading

Chapter 3, Section 3.4, pages 68-71 (Level 2)

Note:

You should note that the square root utility function is valid only where the payoff x is zero or positive. If
negative payoffs are possible, other functions, such as log (x), can be used. Of course, these functions are
approximations. Techniques to determine an individuals actual utility function are available, but are beyond our
scope. Nevertheless, these and other approximations are widely used in decision theory.

LEVEL 2

Accountants should be familiar with the concept of risk aversion. To the extent that investors are risk averse,
financial accounting has the role of providing investors with information about the riskiness of their investments
as well as expected returns. Recall from text Example2.2 that the source of firm risk arises from the concept of
states of nature at the beginning of the period, it is not known which state will happen. Here, the concept of
risk aversion shows how risk-averse investors react to risk for a given expected return, the expected utility of
an investment declines with its riskiness.

Example 3.1 (page 61) shows that Bill Cautious is risk averse. Specifically, his utility from a given payoff is
the square root of the amount of the payoff. In decision theory, this is an example of a utility function,
which is a convenient way of relating the dollar amount of a payoff to the amount of utility, or satisfaction, an
individual receives from that payoff. Bill Cautiouss utility function is shown diagrammatically in Figure 3.3 on
page 70. The fact that the utility function is concave from below tells us that Bill is risk averse. Intuitively, the
greater the spread between the high and low payoffs, holding the expected payoff constant, the lower is the
expected utility . If the utility function is a straight line, as shown in Figure 3.4 on page 70, the individual is said
to be risk neutral. Then, for a given expected payoff, expected utility is the same regardless of the spread.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.4 Principle of portfolio diversification

Required reading

Chapter 3, Section 3.5, pages 71-76 (Level 2)

LEVEL 2

Read carefully the comments on pages 74-75 regarding the factors that affect returns on shares. There are
economy-wide or market-wide factors, which affect all shares and over which individual firms have
virtually no control, such as changes in interest rates and the economic climate. There are also firm-specific
factors, which relate directly to a firm. These would include changes in firm management, strikes, changes in
pricing policies of competitors, and other items unique to that firm. Economy-wide factors relate to returns on
all shares and are referred to as systematic risk, while firm-specific factors relate to the return of one firm
only and are referred to as non-systematic risk.

The payoff probabilities shown in Tables 3.3 and 3.4 (pages 73 and 74 respectively) may need further
explanation. They are Tonis posterior state probabilities. The states are the various possible portfolio
returns. Toni would assess them in the same manner that Bill Cautious assessed his subjective probabilities in
Example 3.1. That is, Toni will use all her past experience and knowledge to assess her prior probabilities of the
possible portfolio returns. Then, using Bayes theorem, she will update her probabilities after studying the firms
financial statements. Since this procedure has been illustrated in Example3.1, it is not repeated in the text it
simply assumes a particular set of Tonis posterior probabilities. There are four possible state realizations in the
two-share portfolio in Table 3.4. These would be assessed in the same manner as just described, except that
Toni would also have to consider information about the state of the economy with particular care. Forexample,
if the economy is in a high state, the probability that both shares will enjoy a high return is greater than the
probabilities of each firm enjoying a high return, due to the presence of economy-wide factors that induce
correlation into firms share returns.

Examples 3.2 and 3.3 (pages 72 and 73 respectively) show how firm-specific risk can be reduced or eliminated
by a diversified investment strategy. This may come as a surprise to you, since the accountants role includes
informing investors about the riskiness of their investments. Presumably, the information about risk in financial
statements will be firm specific. How can this information be useful if risk is diversified away? As you will see,
however, the theory of optimal investment decision tells us that a stocks beta is its relevant risk measure.
(Beta will be more fully described in Topic 2.6.) It turns out that beta is correlated with financial
statement-based risk measures such as the ratio of debt-to-equity and operating leverage (to be covered in
Module 5 see Topic 5.7 and text pages 255-257). Thus, financial statements have a role in reporting on risk
by assisting investors to evaluate a stocks beta, even in the presence of diversified investment strategies.
Of course, if an investor is not almost fully diversified, reporting on firm-specific risk becomes even more
important.

Another type of utility function, called mean-variance utility, is introduced on page 71. This utility function is
slightly different from the square root utility function of Bill Cautious in Example 3.1. It expresses the decision
makers expected utility directly, rather than having to calculate expected utility as in Example 3.1, and
therefore, it is easier to work with. Nevertheless, the basic idea is the same. The risk-averse decision makers
expected utility increases with the expected value (that is, the mean) of the payoff and decreases as the risk of
the payoff (measured by the variance) increases, as in Bill Cautiouss case.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.5 Optimal investment decision ignoring transaction costs

Required reading

Chapter 3, Section 3.6, pages 76-78 (Level 3)

LEVEL 3

Transaction costs are defined broadly to include, in addition to brokerage and other out-of-pocket costs, the
time and effort incurred by the investor to make investment decisions. When transaction costs of buying and
selling securities are ignored, the optimal investment decision is to buy that combination of the market portfolio
and risk-free securities that gives the investor the best tradeoff between risk and expected return.

The text illustrates this decision by means of a two-step procedure. First, Toni buys the market portfolio,
thereby eliminating firm-specific risk. Notice again how the assumption that Toni has mean-variance utility
simplifies the calculation of her expected utility. Once the expected value and variance of a portfolio are
determined (in the calculations on page 77, the portfolio is the market portfolio), these two values can be
plugged directly into Tonis utility function to give the expected utility of that portfolio (0.1691).

Second, the text goes on to show that Toni can increase her expected utility still further by buying a
combination of the market portfolio and risk-free asset. By borrowing at the risk-free rate (4%) and using the
proceeds to buy more of the market portfolio (note that this increases her risk), she can tailor the amount of
risk she bears to her own degree of risk aversion.

To illustrate further, consider the calculations on page 78, where Toni borrows $100 and uses the proceeds to
increase her holding of the market portfolio. Tonis portfolio then consists of $300 of market portfolio and a
loan payable of $100. What are the mean and variance of this portfolio?

Mean return on the market portfolio = 0.0850 $300 = $25.50.

Interest payable on the loan = 0.04 $100 = $4.00.

Net return = $21.50.

Expressed as a rate of return on the $200 invested:

$21.50 200 = 0.1075, as shown in the text calculation on page 78.

For the portfolio variance, note first that the variance of the loan is zero, since, from Tonis perspective, the
loan interest has to be paid. Thus, the portfolio variance derives completely from its holding of the market
portfolio. Using the fact that

Var(kx) = k 2 Var(x)

where

x = the market portfolio

k = 300/200

then

a2 = (300/200) 2 0.0009 = 0.0020, as also shown in the text calculation on page 78.

This portfolio mean and variance raise Tonis utility to 0.2130.

The text states (on page 78) that Toni could increase her expected utility to as much as 2.33 in this manner.
This implies that Toni is relatively low risk averse. If she were more risk averse (for example, the second term
in her utility function might be 20 2 rather than 2 ), she might prefer to sell some of the market portfolio and
use the proceeds to buy the risk-free asset, thereby reducing the risk of her $200 investment below that of the
market portfolio alone.

The probabilities of 0.8 and 0.2 used in the calculations of expected return and variance of the market portfolio
on page77 are Tonis posterior probabilities (similar to those described in Topic 2.4). That is, after obtaining
current information (for example, from the financial press or her broker), Toni has used Bayestheorem to
revise her prior probabilities of future market performance. The result is that Toni feels the probability that the
TSE will rise by 10% over her decision horizon is 0.8, and so forth. In reality, there are many more possible
changes in the TSE index than +10% and +2%. Nevertheless, the simple two-state example is sufficient to
convey the idea.

In recent years, the availability of broadly based mutual funds, stock market index securities, investment trusts,
hedge funds, and international investment opportunities has enabled the investor to more closely approach
holding the market portfolio, at reasonable cost. Conceptually, however, the market portfolio consists of all
assets in the economy, not just stocks and bonds. Increasingly, the economy can be interpreted as the global
economy. Consequently, holding the full market portfolio remains a conceptual ideal.

This topic leads into the more realistic case where transaction costs are not ignored. As you will see, the
introduction of transaction costs leads directly to the concept of a stocks beta as the important measure of its
riskiness.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.6 The concept of beta risk

Required reading

Chapter 3, Section 3.7.1, pages 79-81 (Level 2); Sections 3.7.2 and 3.7.3,pages 81-83 (Level 3)

LEVEL 2

Rational, risk-averse investors require information to help them to assess the expected returns and riskiness of
individual securities. This risk is measured by beta, and information that enables investors to make an
assessment is useful.

Beta, as the term is used in the text, is also referred to as a stocks beta or equity beta. It measures the
co-movement or covariance between changes in the price of a security and changes in market value of the
market portfolio. It indicates the systematic risk encompassed in a security. Measuring the change in a firms
price against changes in the value of the market portfolio also indicates how the firms price will react to
systematic risk factors. For example, the beta of the market portfolio is 1.00. An airlines beta may be 1.8, so
in general terms, the airlines response to economy-wide factors would be 1.8 times that of the market
response. For example, if the market portfolio falls in value by 2% today, we would expect the airline shares to
fall in value by 3.6%, strictly because of market-wide (that is, systematic) factors. The share price of the airline
would be considered more volatile than the market. On the other hand, an electric utility may have a beta of
0.75, which would indicate that it is less responsive to economy-wide factors than the market portfolio its
shares would be expected to fall by only 1.5%. Note that the beta of a risk-free asset will be zero. The return
on the risk-free asset is a constant, and the covariance of a random variable with a constant is zero. Betas can
also be negative, which simply means that share price tends to move opposite to the market. Forexample,
gold stocks may have negative betas.

Here again, the text does not specifically mention or illustrate the use of Bayes theorem to revise probabilities.
Rather, as in Topic 2.5, the expected values and betas are to be interpreted as the posterior beliefs of the
investor, formed by the same Bayesian revision process illustrated in Topic 2.2. What this topic does is to refine
the states of nature to expected return and beta, rather than simply high or low earning power as was the
case in Example 3.1.

Make sure that you know how to calculate expected value, variance, and covariance. These are covered in
Topics 2.4 to 2.6.

In text Example 3.4 (page 79), you have a small portfolio of two shares. Your objective is to determine how
much systematic risk the two securities contribute to the portfolio. The beta is needed for each share. To
calculate the beta of share A, the covariance of share A and the market is required. This is then divided by the
variance of the market.

The values for the high and low returns on share A (0.15 and 0.10, respectively) in Table 3.6 are taken from
Table 3.3 on page 73. The high and low returns on the market and their probabilities (0.10 with probability 0.8
and 0.025 with probability 0.2, respectively) come from page 77. The return probabilities for share A are given
on page80. Note that these are conditional probabilities. For example, if the return on the market is high, the
probability of a high return on share A is 0.90. If the return on the market is low, this probability falls to 0.10.
This is due to the market-wide factors that induce correlation between the return on share A and the market:
Share A is more likely to earn its high return when the return on the market is high, and vice versa.

LEVEL 3

Once the betas are obtained, you can calculate the variance of the portfolio as shown on pages 81 and 82.
The variance of the portfolio is 0.0074. The third term in the equation is the systematic risk contribution of the
portfolio. In this example, it is 0.0017. This is approximately 23% (0.0017 0.0074), which is the percentage
the systematic risk contributes to the portfolio.
While this may seem a limited amount of systematic risk, if there are 10 stocks in a portfolio, there would be
45 covariance terms (A + B, A + C, and so on; B + C, B + D, and so on). Thus, the bulk of the portfolio risk
comes from systematic risk (the covariance terms). That is, the systematic risk cannot be diversified away
because the number of covariance terms goes up rapidly as more securities are added to the portfolio. Thus,
there is very little room for further diversification, even for only 10 stocks in the portfolio.

Using the formula n (n 1) 2, shown on page 82, you can calculate the number of covariance terms easily.
For example, assuming 15 shares in a portfolio, there would be 15 (15 1) 2 = 105 covariance terms.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.7 Professional accounting bodies and the decision usefulness

approach

Required reading

Reread text, Chapter 1, pages 7-8 regarding Enron and WorldCom (Level 1)
Chapter 3, Section 3.8.1, page 87 (Level 1)
CICA Handbook, the conceptual framework for financial reporting, January 2011 (Level 1)
IAS 1 and IAS 8 (Level 1)

LEVEL 1

The IASB and FASB Conceptual Frameworks outlined in Section 3.8 of the text have been replaced in part by a
joint IASB/FASB Framework. Chapters 1 and 3 of this Framework, which replace SFAC 1 and SFAC 3, were
added to the CICA Handbook in January 2011. While the consistency of the new Framework with the decision
theory model remains, the word rational included in the SFAC 1 basic objective of financial reporting (text,
page 83) has been removed. Presumably this is due to theory and evidence that some investor decisions may
not be as rational as the decision theory model suggests. (This will be further discussed in Topic 5.2.)
Nevertheless, the importance of rational decision theory remains since, to the extent that investors do not
make rational investment decisions, high-quality financial reporting can increase the rationality of these
decisions.

The second major change in the new Conceptual Framework is to replace the property of reliability with
representational faithfulness. For our purposes, we can regard reliability and representational faithfulness as
equivalent concepts, although, as you will see below, the definitions do differ. As explained in Topic 1.7, the
term reliability will continue to be used instead of representational faithfulness.

The new Framework also contains many changes in wording. To be consistent with the CICA Handbook, the
following discussion based on this new wording replaces text Section 3.8 on pages 83 to 86.

Major professional accounting bodies have adopted the decision usefulness approach. For example, according
to the IASB/FASB Conceptual Framework, the objective of financial statements is to provide financial
information that is useful to present and potential investors, lenders, and other creditors about providing
resources to the entity.

Note that this objective implies that it is the capital provider who makes the decision, and that the role of
financial reporting is to supply useful information for this purpose. This is the essence of the decision
usefulness approach outlined in the earlier sections of this module. In particular, the Framework implies that it
is not the accountants role to make individuals decisions for them.

A variety of constituencies are included in this most general objective, namely present and potential investors,
lenders, and other creditors. These constituencies are referred to in the Framework as primary users. Their
use of financial information is oriented to making investment decisions. By recognizing a responsibility to report
to all capital providers, the Framework adopts the entity view of financial reporting. That is, financial reports
reflect the perspective of all capital providers to the entity, rather than simply the perspective of the entitys
shareholders.

The question then arises, what types of information do capital providers need? The Framework states that the
primary user group needs information about the amount, timing, and uncertainty of the firms future cash
flows. This is consistent with the discussion of investor needs in this module. In particular, the reference to
uncertainty implies that investors are assumed to be risk averse if they were risk neutral they would not care
about uncertainty.

Thus, it is apparent that the primary decision addressed in the Framework is the investment decision in firms
shares or debt. Specifically, cash flows are payoffs, similar to those in the payoff table (Table 3.1 in text) of
text Example 3.1. These investment decisions apply to potential as well as current investors. This means that
financial statements must communicate useful information to the market, not just to existing investors in the
firm.

Note also that the information objective is future-oriented it calls for information about future payoffs from
investments. While the terms are somewhat different from those used in the earlier discussion of the
investment decision, the Framework clearly states that investors need future-oriented information. More
specifically, this is information that helps them to assess the expected returns and risk of their investments.

How can financial statements be useful in predicting future returns? For this, it is necessary to establish some
linkage between current firm performance and future prospects. Without such linkage, the decision-oriented
objectives of the Framework would not be attainable.

You can see the linkage clearly, however, by drawing on the decision theory model. In particular, refer to the
information system (Table 3.2 in text) for text Example 3.1. The table provides a probabilistic relationship
between current financial statement information (GN or BN) and the future-oriented states of nature (high or
low performance), which will determine future investment payoffs. In effect, current financial statement
information and future returns are linked via the conditional probabilities of the information system.

Consistent with the information system linkage, the Framework states (boldface added):

Consequently, existing and potential investors, lenders, and other creditors need information to
help them assess the prospects for future net cash inflows to an entity Information about a
reporting entity's past financial performance is usually helpful in predicting the entity's future
returns on its economic resources.

These arguments enable the Framework to maintain that even though the financial statements report on a
firms current financial position and performance, this information can be useful to forward-looking investors.

As we have discussed (text, page 3), under historical cost accounting the income statement is the primary
financial statement. The Framework takes a different view (comment in brackets added):

Both types of information (that is, balance sheet and income statement) provide useful input for
decisions about providing resources to an entity.

In this regard, the Framework envisages a different role for accruals from their matching role under historical
cost accounting:

Accrual accounting depicts the effects of transactions and other events and circumstances on a
reporting entity's economic resources and claims in the periods in which those effects occur, even if
the resulting cash receipts and payments occur in a different period.

In effect, the role of accruals is to record the effects of transactions on the firms financial statements in the
periods in which those effects occur, even if the resulting cash receipts and payments occur in a different
period. For example, consistent with both statements being equally decision useful, an account receivable (an
accrual) anticipates on the balance sheet the sales proceeds to be received next period, and current net
income includes this amount. Current cash flows (zero, for this particular sale) would not predict next periods
cash receipts from this sale very well.

The Framework also states that

information about a reporting entity's economic resources and claims and changes in its economic
resources and claims during a period provides a better basis for assessing the entity's past and
future performance than information solely about cash receipts and payments during that period.

In other words, the financial statements enable a better prediction of future cash flows than current cash flows
themselves. This may seem surprising. Nevertheless, several researchers, for example, Kim and Kross (2005),
support this statement empirically. For a large sample of U.S. firms over 19742000, they report that the ability
of current earnings to predict next periods operating cash flows exceeds that of current operating cash flows.
The Framework goes on to consider the characteristics that are necessary if financial statement information is
to be useful for investor decision making. This is another crucial and delicate aspect of the whole conceptual
framework how can financial statement information be presented so as to be of maximum use to investors
in predicting future returns? Once again, the answer lies in the concepts of relevance and reliability.

Chapter 2 defined relevant financial statements as those that give information to investors about the firms
future economic prospects. The Framework definition is consistent:

Relevant financial information is capable of making a difference in the decisions made by users

Clearly, if information helps investors to evaluate future economic prospects, it can make a difference in users
decisions. The definition is also consistent with the definition of information in decision theory. Recall that
information is that which has the potential to change individual decisions. In effect, evidence is not really
information unless it is capable of affecting user decisions. This role of information comes across with particular
clarity in Bayes theorem, which provides a vehicle for investors to update their prior beliefs about relevant
states of nature on the basis of new information.

Thus, under the ideal conditions of Chapter 2, relevant financial statement information consists of (the
discounted present values of) expected future payoffs. Under less-than-ideal conditions, relevant financial
statement information consists of information that helps investors form their own expectations of future
payoffs. By extending the definition of relevance to include information that can help investors form their own
payoff estimates, the scope for information to be relevant is greatly enlarged.

Reliability (that is, representational faithfulness) is another desirable information characteristic. In Topic 1.7,
reliable information was defined as information that faithfully represents without error or bias what it is
intended to represent. The Framework definition is equivalent:

To be useful, financial information must faithfully represent the phenomena that it purports to
represent.

The Framework goes on to point out that to be a faithful representation, information must be complete (that is,
nothing in the valuation or description of an item that affects its faithful representation is left out), free from
material error, and neutral, where neutral information is free from any bias which may affect its interpretation
by the user.

The Framework does not specifically state that relevance and reliability have to be traded off. Given the
conclusion in Topic 1.6 with respect to RRA that a tradeoff is necessary, this may seem surprising. However,
the Framework does state the following:

Information must be both relevant and faithfully represented if it is to be useful First, identify an
economic phenomenon that has the potential to be useful to users of the reporting entitys financial
information. Second, identify the type of information about that phenomenon that would be most
relevant if it is available and can be faithfully represented. Third, determine whether that
information is available and can be faithfully represented. If so, the process of satisfying the
fundamental qualitative characteristics ends at that point. If not, the process is repeated with the
next most relevant type of information.

This view implies a hurdle rate for reliability. If the hurdle is not met, relevance is reduced until faithful
representation can be attained. While this admits that a tradeoff is necessary, it leaves open the possibility that
more relevant information, combined with a level of representational faithfulness slightly less than the hurdle,
has greater decision usefulness than less relevant but faithfully represented information.

Now read the text summary, Section 3.8.1.

Since IFRSs are relatively new to Canada, the following are some provisions of two important standards that
relate to the Framework.

Paragraph 5 of IAS 8 clarifies what is meant by IFRS. Essentially, IFRS consists of International Financial
Reporting Standards, International Accounting Standards, and Interpretations developed by the International
Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC).

An interesting provision of paragraph 19 of IAS 1 is that it permits firms to deviate from IFRS if, in the opinion
of management, conformity would result in misleading financial statements. For example, a deviation could
result if, in managements opinion, conformity with an IFRS standard would conflict with the objectives of the
Framework. However, management must provide full disclosure about the reasons for and the nature and
effect of the deviation on the amounts recognized in the financial statements.

Paragraphs 10 to 12 of IAS 8 also addresses what to do when management faces accounting policy choice
issues not addressed by IFRS. Essentially, management should refer to available IFRS relating to similar issues
and apply the Framework. Management might also consider pronouncements by other standard setting bodies,
other accounting literature, and accepted industry practices.

Another important provision of IAS 1 (paragraph 15) is that financial statements should present fairly the firms
financial position, results of operations, cash flows, and whether or not the firm is a going concern, in
accordance with IFRS and the concepts laid down in the IASB Framework. Furthermore, fair presentation
(paragraph 17) requires providing sufficient information about significant transactions, including information in
notes, so that the effect of these transactions on the financial statements can be understood. This information
should be clear and understandable. Presumably, the intent of this standard is to reduce the ability of firms to
disguise the effects of important transactions by burying them in larger totals and/or by highly complex and
technical explanations.

The provisions of IAS 1 and IAS 8 address to some extent accounting "horror stories" such as WorldCom, Inc.
(now called MCI) and Enron Corp., discussed in the text on pages 7-8. The WorldCom scandal was relatively
straightforward, involving overstatement of reported earnings and operating cash flows, including capitalizing
billions of dollars of expenses that should have been charged to operations. Enron deceived investors by
establishing a complex web of associated companies that, in retrospect, should have been consolidated with
the parent company. By not consolidating them and compounding this omission by poor disclosure, Enron was
able to keep large amounts of debt off its balance sheet and substantially overstate its reported earnings. The
misleading financial statements issued by the two firms, once they were discovered, led to bankruptcy
protection for both firms and contributed to a massive loss of public confidence in financial reporting. By
formally laying down what constitutes GAAP, prohibiting departures from GAAP, specifying procedures to be
followed if the firm faces accounting policy choices not addressed by GAAP, and laying down what fair
presentation in accordance with GAAP means, IAS 1 and IAS 8 provide credibility to financial statements.

In recent years, many other major occurrences of fraud and untoward accounting have appeared in the
financial pages of newspapers. It is suggested that accountants should read one good financial newspaper daily
to keep abreast of accounting information and "horror stories."
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.8 Ethical undertones of the usefulness criterion

Required reading

Reread Chapter 1, Section 1.3, pages 10-11 (Level 1)

ERH , Units A2 and A4 (Level 2)
ERH , Unit C4, "Auditors and Deceptive Financial Statements: Assigning Responsibility and Blame,"
by James C. Gaa and Charles H. Smith (Level3, except for caseB, "Auditors are not responsible
for deception,"insection "The blameworthiness of auditors for deceptive financial statements"at
Level2)

LEVEL 2

This topic considers the strong ethical undertones of the usefulness criterion. The McMullin Plumbing case study
in ERH , Unit A2, shows that the usefulness of financial accounting information to the potential creditor (the
bank) would be severely misleading if Deepak Ramachan gave in to Bill McMullins requests. Indeed, if every
firm manipulated its financial statements in this manner, we would have the world without morality that
Hobbes contemplated (see ERH , Unit A4) and, in the extreme, banks would simply refuse to lend. It is
interesting to consider whether there is sufficient morality in the business world (and whether extreme self-
interest maximization like Bill McMullins is sufficiently rare) that banks would still be willing to lend. While most
people will behave ethically in most circumstances, they will be further encouraged to do so by generally
accepted accounting principles (GAAP), audits, penalties, and statements of principles such as the conceptual
frameworks reviewed here. For example, if accountants work toward representational faithfulness in financial
reporting, as urged in SFAC 2, this will increase investors perceptions of equity in financial reporting and
discourage behaviour such as Bills. This will then encourage investors, including banks, to lend and buy shares
in capital markets.

Nevertheless, accountants, including auditors, will still be faced with situations of extreme self-interest
maximization such as Bills. As evidenced by Deepaks dilemma, such behaviour raises difficult issues since, in
any specific situation, accountants and auditors must decide on the extent to which they will "go along" with
misleading financial reporting. Gaa and Smith, in ERH , Unit C4, discuss the extent to which auditors are
responsible for deceptive financial statements and the defences they may draw on if they are charged with
responsibility for such deception. While Deepak is not an auditor, he is a member of a professional accounting
body and thus bound by its ethical principles. Deepak faces many of the same issues as do auditors when
financial statements are deceptive.

Gaa and Smith point out that deception can be unintentional, if the accountant or auditor does not notice
managements manipulations. They also point out that financial statements can be deceptive even if they
conform to GAAP. For example, useful information may be buried in larger totals. (Hopefully, the IASB
Framework, IAS 1 and IAS 8, reduce this possibility.) In Deepaks case, it would be hard for him to argue that
any deception was unintentional, since Bills suggestions were stated directly to him. Furthermore, the potential
for deception is made even greater since the proposed accounting policies do not conform to GAAP.

Gaa and Smith make a statementthat deception is sometimes justifiable. In Deepaks case, perhaps Bills
suggestions are justified because, with the loan, Bill stays in business, Deepak keeps his job, and the bank
makes money on the loan. However, this is a very short-run viewpoint. Essentially, it is rationalization,
reminiscent of an excuse often made by war criminals that they were simply obeying orders. With this in mind,
consider carefully the point made in the last two paragraphs of the text on page 9. Clearly, Deepak is behaving
unethically if he goes along with deceptive financial statements. He fails to take into account the position of the
deceived. Both Bill and Deepak know full well that the bank will not lend them the money if they receive an
accurate GAAP-based statement of the companys assets and liabilities. It is very likely (indeed extremely
probable) that Bills and Deepaks hopes for success with the loan are based on a great deal of wishful thinking.
If it is not wishful thinking then they should be able to find another lender who is open to their style of
"creative accounting." In subsection B"Auditors are not responsible for deception,"Gaa and Smith discuss in
detail the defences that an auditor may use to avoid responsibility for deception. In any specific situation
involving deceptive financial reporting, the accountant should seriously consider whether these defences would
be sufficient to avoid a charge of unethical behaviour.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

2.9 Conclusion

Required reading

Chapter 3, Section 3.9, pages 87-88

A knowledge of decision theory and the theory of optimal investment decision is important to accountants,
because it helps them to understand investors decision needs, thereby enhancing the ability of accountants to
supply useful information. The theory also leads to a deeper appreciation of the IASB/FASB Conceptual
Framework.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

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 major professional accounting standard-setting bodies have adopted the theory 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.

Outline the single-person decision theory.

It 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 makers expected utility based on the
probabilities of the states of nature.

Explain prior probabilities of 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.

Explain posterior probabilities of states of nature.

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 investors buy/sell
investment decision.

Define Bayes theorem.

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

Define an information system.

It is a way of conceptualizing the information content of financial statements.

It is 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).

Define beta.

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.

Calculate expected return and variance of a portfolio, and its covariance

with other portfolios.

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 portfolio
The optimal investment decision

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 tradeoff 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.

Relate decision theory to the conceptual framework for financial reporting.

The IASB and FASB have accepted the decision theory model as a guide to the preparation of
useful financial statement information.
The IASB/FASB 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:
Helping them to assess the amounts, timing, and uncertainty of future cash flows
Enhancing relevance and reliability of accounting information

Ethical issues related to the usefulness criterion

CICA Handbook, section 1100

clarifies what is meant by Canadian GAAP
removes ability to depart from GAAP
purpose: to increase public confidence in GAAP and reduce misleading reporting
CICA Handbook, section 1400
financial statements must conform to GAAP and section 1000 concepts
full disclosure of significant transactions in an understandable manner

Ethical issues related to the usefulness criterion

The accountant/auditor is often caught between the demands of management and responsibility
for the interests of investors, including lenders.
If a managements demands involve unethical behaviour, the accountant must take into account
the perspective of the deceived.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 3: Efficient securities markets

Overview

Read the Chapter Overview, Section 4.1, on pages 98-99

Having discovered in the previous module how rational investors make decisions, you will now learn how
security prices reflect the information available to the investor. An efficient securities market, by definition,
is one where the prices of the securities traded "properly reflect" all information that is publicly known about
those securities. This has important implications for accountants as providers of information. Accountants, like
all other providers of goods and services, must ensure that what they provide is relevant, reliable, timely, and
cost effective. So this module will look at the following questions:

Can information released in footnotes and other supplementary disclosures be as effective as

information in the financial statements proper?

Since accountants are in competition with the news media, financial analysts, and other
information providers, can they compete effectively through the medium of financial statements?

Given that the market has a problem with information asymmetry, do financial statements
credibly communicate the required information to mitigate information asymmetry?

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

3.1 Efficient securities markets

3.2 Implications of efficient securities markets for financial reporting
3.3 Informativeness of price
3.4 A capital asset pricing model
3.5 Information asymmetry
3.6 Social significance of properly working securities markets
3.7 Examples of full disclosure
3.8 Conclusion

Learning objectives

Define an efficient securities market and explain how market prices reflect available information.
(Level1)
Explain the implications of securities market efficiency for financial accounting and reporting.
(Level1)
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. (Level2)
Explain the implications for securities pricing of the Sharpe-Lintner capital asset pricing model.
(Level1)
Explain the significance of information asymmetry and, in particular, the adverse selection
problem to financial accounting theory. (Level1)
Evaluate the social role of efficient securities markets in allocating capital resources in the
economy. (Level2)
Analyze the information content of management discussion and analysis. (Level1)
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.1 Efficient securities markets

Required reading

Chapter 4, Section 4.2, pages 99-104 (Level 1)

LEVEL 1

The theory of efficient securities markets has an important implication for financial accounting and reporting.
This is that financial accounting and reporting have a major role to play in improving the amount, timing, and
accuracy of the "stock" of information reflected in securities prices. This topic provides the background required
to understand this implication.

Page 100 of the text defines one form of the efficient securities market the semi-strong form, in which
prices of securities traded in the market will reflect all available public information at all times. This is the form
most often referred to in this course. Then, security returns (equivalently, security price changes) should
fluctuate randomly over time. In technical terms, such returns are serially uncorrelated. The reason is that,
based on all publicly known information, the market forms unbiased estimates of future firm performance.
According to the definition of an unbiased estimate, changes to estimates (hence changes in security prices)
from new information come along randomly. Such return behaviour is often called a random walk.

There are two other forms not mentioned in the text. One is the weak form, where all historical information is
reflected in the prices of the securities traded. Thus, one cannot learn anything useful about future price from
studying past prices.

The other form is referred to as the strong form, where the prices of the securities traded reflect all private
as well as public information. You can imagine that there is a lot of private information (also called inside
information) that is not publicly revealed to the market. How can securities prices reflect information that is
not public? One possibility is that the market watches closely the activities of those who have access to inside
information. This is done by monitoring insider trading activities, for example. However, there is not much
empirical evidence to suggest that the market is strong-form efficient, and the strong form remains a
theoretical ideal of efficiency. It does reveal, however, that inside information that is not available for public
consumption does exist. As evidence of this, consider news about claimed insider trading scandals that
frequently appears in the financial media. If the market was strong-form efficient, such insider trading profits
would not be made. Figure 4.2 on text page 117 shows strong form efficiency, although the text does not use
this term. If markets were strong form efficient, market price would equal fundamental value as shown on the
figure. That is, there would be no inside information.

Thus, it is important to understand that the semi-strong theory does not imply that the market price behaves
as if the market knows everything . If it did, there would not be much of a role left for financial reporting.
Rather, it is best to think of efficiency in relative terms, that is, security prices are efficient relative to an
amount, or "stock," of public information. Hopefully, financial reporting has a role to play in making publicly
available information as complete as possible. However, there will always be some inside information.

Section 4.2.2 of the text suggests a process for how market prices reflect available information, using the
forecast of the outcome of football games to illustrate. The example indicates that a consensus of opinions
outperforms individual forecast. While this does not necessarily mirror how security prices are determined, it
does suggest a similar process in the trading of securities that is, the consensus of purchases and sales of
securities is an averaging of the views of the market participants. Thus, with a number of participants in the
market holding various views and taking differing actions, the result is an average share price that is correct or
unbiased, since individual differences in reacting to new information are assumed to cancel out. Note, however,
the discussion on page103 of the text. For this unbiased characteristic of share price to hold, individual
investor reactions to new information must be independent. If, for example, investors see other investors
buying a particular stock, and react by buying it themselves simply for this reason, a "herd" mentality may
develop. This creates share price "momentum" and price behaviour will be biased upwards. Some have argued
that the extremely high prices of the shares of technology companies observed during the late 1990s resulted
from this type of investor behaviour, not to mention the high prices of oil and gas and other commodity firms
shares prior to the market collapse beginning in 2007. This collapse illustrates that the same "herd" mentality
can occur in the downside where investors see other investors selling, and a rout can occur, having serious
economic effects.

This reminds us that the efficient securities market model is just that a model of how the market works.
There is no guarantee that the model is completely accurate in capturing how investors behave. Indeed, the
efficient market model has come under increasing criticism in recent years. These criticisms are reviewed in
Module5. For now, suffice it to say that we conclude there, despite some evidence that securities markets may
not be fully efficient, that the efficiency model is still the most useful one to guide accountants in their full
disclosure decisions.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.2 Implications of efficient securities markets for financial

reporting

Required reading

Chapter 4, Section 4.3 pages104-107 (Level 1)

IAS 1, paragraphs 117-124 (Level 1)
ERH , Unit C1, "The marks of a profession" (Level 3)
Reading 3-1 (Level 3)

Read text Section 4.3 and paragraphs 117 to 124 of IAS 1 before proceeding with this topic. Read UnitC1,
"The marks of a profession" of the ERH and Reading 3-1 when indicated.

LEVEL 1

This topic considers the implications of efficient securities market theory for financial reporting. In Section4.3,
the text summarizes Beaver's 1973 classic article.

Beaver advances four important points:

Firms' accounting policies do not affect their security prices as long as these policies have no
differential cash flow effects, the policies are disclosed, and the reader is given sufficient
information to convert across different policies.

This is an important concept in this course. Firms sometimes make accounting policy changes
because of new accounting standards or to improve their "bottom line." The important question is
whether the policy changes will affect share price.

There should be full disclosure of information, provided the costs do not exceed the benefits to
be received by the investor.

Should firms be concerned with the naive investor? The conclusion is that there are
knowledgeable people available to help them. These naive investors are also "price-protected,"
because they can depend on the efficient market to determine share prices according to all
available public information. Thus, if they buy a share at its market price, they need not fear
paying too much (nor can they expect to make a "killing").

Accountants face competition in the provision of information, because other agencies and sources
may fill any gap left by the accounting profession. Thus, it is necessary for accountants to supply
cost-effective, timely information; otherwise, their function could decline as other sources take
over.

Beaver's article was written partly to tell practising accountants what they needed to do to survive in a world of
efficient markets. The main point inhis arguments is the importance of full disclosure. The reasoning is that
the efficient market is sufficiently sophisticated that it can digest information from any source, including
supplementary information in financial reports. That is, the financial statements proper supply only part of the
information content of the annual report. Certainly, financial accounting standard setters have adopted this
implication of the theory. Users of firms' annual reports realize that a lot of additional information is supplied by
management discussion and analysis, notes to the financial statements, and supplemental disclosure such as
RRA. That the efficient market is able to evaluate supplemental disclosure removes some of the pressure on
the financial statements proper to be relevant. The more reliable historical cost basis of accounting can
therefore be used in the financial statements, supplemented by more relevant information in notes and other
information. RRA is an example of this approach.

It should also be pointed out that full disclosure includes disclosure of the accounting policies used by the firm.
Under historical cost accounting, there are usually different ways of accounting for the same item or,
equivalently, there is no unique way to calculate accruals and match costs with revenues (see Sections 2.5.1
and 2.5.2 of the text). The reason for accounting policy disclosure is that if the efficient market is to be able to
adjust for different accounting policies used by different firms, the market must know which policies a firm is
using. Paragraphs 117 to 124 of IAS 1, which requires that accounting policies be disclosed, show that
accounting standard setters also follow this implication of the theory.

Remember that "true" net income does not exist (Section 2.6 of the text). Nothing in the theory of efficient
securities market requires a true net income. Rather, the market demands useful financial information. A great
deal of accounting judgment, aided by a good theoretical background, is needed to prepare useful information,
and it is good judgment that provides the basis for the profession of accounting. As Beaver points out, the
accounting profession has no inherent right of survival in the competitive marketplace for information.

LEVEL 3

Now read ERH , Unit C1, "The marks of a profession," and Reading 3-1, which provide valuable guidance as to
what a profession needs to be and to do in order to attain the public confidence that is essential to survival.

The ultimate responsibility of a profession is to society . In our context, this includes a responsibility to investors
to enhance their ability to make good investment decisions and, through this, to enhance their trust in the
proper operation of securities markets. Thus, Beaver's assertion that the accounting profession has no inherent
right of survival implies that it is in the long-run interests of the profession, as well as in society's interests, to
maintain public confidence. While it may be tempting for some professionals to abuse public trust for their
short-term gain, the profession should weed out and punish such individuals in order to preserve its reputation.
As proposed in Unit C1, this can be accomplished by high education standards, financial accounting standards
that promote useful information, encouragement of ethical behaviour, and enforcement of penalties for
delinquents.

Unfortunately, "horror stories," such as those surrounding Enron and WorldCom (see Section 1.2 of the text,
pages 6-8, and Topic 2.7), suggest that some accountants and auditors may have forgotten that their ultimate
responsibility is to society. Hopefully, accountants will continue to emphasize and strengthen the goals
proposed in Unit C1, so that public confidence is maintained. IAS 1 and IAS 8, (reviewed in Topic 2.7), which
clarify the meaning of financial reporting in accordance with IFRS, represent important moves in this direction.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.3Informativeness of price

Required reading

Chapter 4, Section 4.4, pages 107-110 (Level 2)

LEVEL 2

Section 4.4 is highly theoretical, but it contains an important implication for the usefulness of financial
accounting information. In the early years of the efficient securities market theory (Beaver's 1973 article was
written during this period), financial accounting information was sometimes accused by non-accountants of
being irrelevant. This is because the efficient securities market would already know the information upon which
the financial statements were based and would have incorporated this information into the market price of
shares well before the annual report was released. Examples of such information are sales, cost structure,
economic conditions in the industry and economy, and interest rates, which would typically be available from
other more timely sources. Therefore, investors would not bother to use financial statements because, by the
time of release, financial statements would be out of date and devoid of information content. More generally, if
the market price of a share always fully reflects everything publicly known about that share, there would be no
point in gathering information from any source. If these accusations were valid, the long-term survival of the
accounting profession and, indeed, the operation of the markets themselves,would be in doubt.

By introducing the concept of noise traders (liquidity traders), however, the efficient securities market theory
is extended to reconcile the concept of efficiency with the usefulness of financial accounting information.
Security prices are now recognized to contain "noise." Without noise, security prices properly reflect all publicly
available information they are fully informative. With noise, security prices are only partly informative
some random investment decision may have perturbed a securitys price away from its fully informative
value. Then, it is worthwhile for investors to search for mispriced securities. One way to do this is to study the
firm's annual report carefully. If mispriced securities could be identified, the annual report information would
indeed be useful, since it could form the basis of a profitable investment strategy.

Noise traders add another dimension to the picture of the market by injecting additional volatility into
pricesince as mentioned,price may be different from what it "should" be. Noise traders' decisions are random
and not based on a rational evaluation of relevant information. Nevertheless, the market is still efficient since
the expected value of the noise is zero. This is because, by definition, the information content of noise is zero.
Thus, when buying a share at its market price, an investor is still price protected in the sense that market price
is expected to equal its value based on all publicly available information. However, analysis of the financial
statements (and/or other available information) may reveal that it is mispriced. This creates an incentive to
carefully analyze financial statements, as in the case of Bill Cautious in Example3.1 of the text.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.4 A capital asset pricing model

Required reading

Chapter 4, Section 4.5, pages 110-114 (Level 1)

LEVEL 1

Given an efficient securities market, security prices always fully reflect (with noise) all publicly available
information. This raises the question "What should this price be?" The well-known Sharpe-Lintner capital
asset pricing model (CAPM) provides an answer. It states that a shares current market price will be such
that

expected return on the share E(R jt) = a constant R f (1 j ) +

expected return on market portfolio E(R Mt ) beta of the share j

Note: There is an error in Equation 4.1 on page 110 of the text. The second plus sign in the numerator of the
middle term should be a minus sign, as follows:

The text provides details on how to calculate the actual return and the expected return on a share, as well as
the CAPM formula (Equation4.3 on page111). You are expected to be able to do these calculations and
reproduce the CAPM formula.

Expected return E(R jt) is also interpreted as firm js cost of capital, since to say that the market demands a
return of, say, E(R jt) = 16% on the firms shares is the same as saying that capital costs the firm 16%. That
is, share price adjusts so that anyone who buys a share at that price expects to earn 16%.

Notice that the current share price is not given directly by the CAPM equation. Rather, the current price (P j, t1 )
appears in the denominator of the expected return (Equation 4.2). You can use the CAPM equation to
determine the expected return E(R jt). Then, as mentioned, the current share price in the numerator of
Equation 4.2 adjusts so that E(R jt) in that equation equals the value given by the CAPM equation.

Example 3-1 following illustrates how the current share price makes this adjustment, using the formulas for the
net rate of return (from text page110) and CAPM. This example also illustrates how share price has to fall if
bad news is received. If there is an expected return and bad news arrives, then the share price has to change
to maintain the expected return.

Example 3-1

You can look at returns in two ways look back from the year-end, which is referred to as ex post, and look
forward down the year, which is referred to as ex ante. While either one can be used for this illustration, the
ex ante formula will be used here.

The CAPM and net rate of return formulas are

CAPM = E(R jt) = R f (1 j ) + j E(R Mt )

Expected net rate of return = E(R jt) = [E(P jt + Djt) P j, t1 ] 1

Where the second formula is really just the definition of how one calculates expected return. Be sure you
realize that you are at time t 1 (that is, "now") in this discussion, looking ahead for one period. The terms
are defined as follows:

E(R jt ) = expected return for the security

R f = risk-free rate, such as the current rate on a government bond
j = beta for firm j
E(R Mt ) = expected market rate of return in the current period
P jt = price of the security at the end of period t
D jt = dividend paid by the firm during period t
P j, t1 = security price at the beginning of period t

Assume

Risk-free rate = 10%

Expected market return = 12%
Beta of firm j = 0.8
Dividend of firm j = $1.00
Share price at the beginning of the period (that is, "now") (P j, t1 ) = $20.00

Find the expected share price at the end of the period E(P jt) for the given expected value.

First, calculate the expected return on the firms shares from CAPM:

Expected return = Risk-free rate (1 Beta) + Beta (Expected market rate of return)
= 0.10 (1 0.8) + 0.8 (0.12)
= 0.02 + 0.096
= 11.6%

Then, from equation (4.2), calculate the ending price that supports an 11.6% expected return:

Expected return = [(Expected ending price + Expected dividend) Beginning price] 1

Substituting: 0.116 = [(P(end) + 1.00) 20.00] 1
1.116 = (P(end) + 1.00) 20.00
20.00 1.116 = P(end) + 1.00
22.32 = P(end) + 1.00
22.32 1 = P(end)
P(end) = $21.32

However, suppose bad earnings news about the firm arrives at the beginning of the year and drives E(P jt), the
expected ending price of the firm's shares down from $21.32 to $21.00. Then, E(R jt) in Equation (4.2)
becomes:

E(R jt ) = [(21.00 + 1.00) 20.00] 1

= 22.00 20.00 - 1
= .1.10 1
= .10

Therefore, something has to change to keep the expected return at 11.6%. Now the factors that make up the
CAPM are independent of earnings news: the fixed rate would come from treasury bills or government bonds;
beta is assumed constant; and the expected return on the market portfolio is independent of the firm, and so
does not change. The only place where change is possible is the beginning share price. What would it fall to?

0.116 = [(21.00 + 1.00) P(beg.)] 1

1.116P(beg) = 22.00
P(beg) = $19.71
To maintain the 11.6% expected return required by the CAPM formula, the share price at time t 1 will fall to
$19.71, and, if no other bad or good news arrives in the period, the share price at the end of the year would
be $21.00.

The example showed that to maintain the yield, the share price falls right away. Also, remember that the yield
of a security must be equivalent to other similar securities in the market. Otherwise, investment funds will be
placed elsewhere with the going yield.

Notice how the CAPM is consistent with the conclusions of the theory of the optimal investment decision
described in Topics 2.4 to 2.6 rational investors like Toni Difelice are constantly evaluating and re-evaluating
their expected return on the firms shares as new information comes along. If bad news causes Toni's expected
end-of-period share price to fall below $21.32, she will start to sell. Other rational investors will tend to do the
same. As Example 3-1 above showed, this will drive down the current price in Equation 4.2 until E(R jt) returns
to the value it should have according to the CAPM (11.6%). This is what produces the rapid price reaction to
new information in an efficient market.

From an accounting perspective, two important assumptions of the CAPM should be understood. First, it is
assumed that beta is known (that is, it is stationary). In Module 5, you will see arguments that beta can
change. If it does, then investors must estimate the new value, and we know that estimates are subject to
error. This introduces an additional source of risk into the investors decision, over and above the systematic
risk of a diversified portfolio, since errors in estimating beta will create errors in investment decisions. Topic5.7
outlines how accounting information may help investors to estimate beta.

The second assumption is that there is no inside information. Inside information imposes additional risk (thatis,
additional to beta) on investors since they do not know the extent of such information and the extent to which
insiders will take advantage of it. For example, investment decisions that may have been perfectly rational
given all publicly available information may result in a large abnormal loss if inside information is subsequently
revealed, especially if it also happens that insiders have traded on this information. Notice that this risk cannot
be diversified away, since it applies to all shares. As we will suggest in the next two topics, accountants have
an important role in controlling the effects of inside information.

The text (page 113) introduces the concept of estimation risk. Non-stationarity of beta and inside
information are important sources of this risk. However, estimation risk does not invalidate the CAPM. The
CAPM remains as an important conceptual device to understand how share prices and cost of capital are
determined on an efficient market, and is used by many firms and analysts to estimate cost of capital. The way
to think about estimation risk is that a firms actual cost of capital will be somewhat greater than that given by
the CAPM due to estimation risk, since investors will add on an additional required return to compensate them
for the fact that they may not be sure about the value of beta, and may be taken advantage of by persons
who possess inside information. Full disclosure by accountants reduces these investor concerns, reducing
estimation risk.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.5 Information asymmetry

Required reading

Chapter 4, Section 4.6, pages 114-117 (Level 1)

ERH , Unit B4, "Business Ethics," by Alexei Marcoux (Level3)
ERH, Unit B4, Finance Ethics (Level 3)
Reading 3-1 (Level 3)

Read text Section 4.6 before proceeding with this topic. Read UnitB4, "Business Ethics," of the ERH and
Reading 3-1 when instructed to do so.

Note: For the definition of "moral hazard," see pages 13-14.

LEVEL 1

This topic expands on the important concept of information asymmetry. If there is no information
asymmetry, share price would equal the firms fundamental value (defined in the text on page 116; see also
Figure 4.2) since all known information about the future of the firm would then be in the public domain. Under
more realistic conditions, however, all information is not publicly known. This results in the presence of inside
information, that is, information that is not publicly known. Then there is information asymmetry between
people who know and people who do not know the inside information. Examples of such information are
merger plans, unpublished forecasts, plans for new products, and intentional biases in the accounts known only
to managers. Recall that semi-strong securities market efficiency relates only to publicly available information.
There is no guarantee that inside information will be made public and be reflected in share price.

These incentives for people who possess inside information to take advantage of it create the adverse
selection problem. The nature of this problem and its consequences are more vividly described in the
"lemons" problem on page 115 of the text. The text also describes ways to alleviate the lemons problem, such
as safety certificates for used cars.

In addition, the "lemons" scenario can be alleviated by ethical behaviour on the part of buyers and sellers.

LEVEL 3

Read Reading 3-1, and ask yourself whether you would behave as the "lemons" model implies. For example,
would you misrepresent the quality of a used car that you were offering for sale? To the extent that you and
others would not do this, the operation of the market is enhanced, to the benefit of all buyers and sellers. If
you are tempted to misrepresent, read the outline of Kohlbergs stages of moral development in A Conceptual
Model of Corporate Development in ERH , Unit B4. Ask yourself whether you are at the fear of punishment or
desire for rewards stage (Stages 1 and 2) or have moved on to Stages 4, 5, or 6, where you recognize a
broader responsibility for your actions rather than acting simply in your own short-term interests.

Fortunately, as professionals, most accountants recognize that acting solely in their own short-term interests
can frequently harm both their own longer-term interests and the interests of the profession. In this regard,
read the Finance Ethics section of ERH , Unit B4. Note in particular the importance of trust in business
dealings. That is, in many business situations, transactions repeat over time. For example, instead of being a
one-time seller, you may be a used car dealer. Then, you might be even more likely to behave ethically, so as
to build a reputation for fair dealing. In an accounting context, you may be tempted to create, or support,
financial statement misrepresentations that are designed to mislead and harm investors and/or creditors. Such
misrepresentations are usually discovered (dont forget that accruals reverse), in which case the resulting
erosion of trust will affect your reputation and well-being, as well as those of the profession.

At this point, read Note 10 of text Chapter 1. Notice that many ethical dilemmas faced by accountants can be
thought of in a longer-term context. That is, even though ethical behaviour may cost you in the short term,
your long-term welfare will be increased. As Note 10 points out, however, there are two ways to think about
ethical behaviour. One way is through fear of punishment (that is, Stages 1 and 2 of the Kohlberg hierarchy).
Hopefully, however, you will progress to wanting to do the right thing, a point recognized long ago by Hobbes
(text, Section 1.3).

Unfortunately, there remain individuals who will take advantage of their inside information for short-term gain.
For example, The Globe and Mail (February 16, 2002, page B4) reported that the chief financial officer of Nortel
Networks Corp. had resigned. According to the article, he had engaged in personal Nortel stock trades just
ahead of corporate announcements that affected Nortel's stock price. These trades violated Nortel's "trading
window" policy. Many companies restrict the time periods during which insiders can trade in company stock, in
order to avoid damage to their reputations and share prices should insider trading in advance of important
announcements become publicly known. A common restriction is to ban such trading from the last day of the
quarter until two or three days after quarterly financial results are announced. As another illustration, the text
(page 116) refers to the Enron and WorldCom scandals as extreme examples of the effects of information
asymmetry, where the reputations of several senior officers were ruined.

These episodes suggest that while longer-term concerns about reputation may reduce information asymmetry
problems, they are unlikely to eliminate them. Information asymmetry has important implications for securities
markets, as you will see in the next topic.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.6 Social significance of properly working securities markets

Required reading

Chapter 4, Section 4.7, pages 118-119 (Level 2)

LEVEL 2

The significance of the "lemons" problem to accountants arises because securities markets are subject to a
similar problem of adverse selection. This problem opens up another dimension of the usefulness of financial
reporting. To this point, we have emphasized its role in providing useful information to enable individuals to
make good investment decisions. In addition, however, by moving information from inside the firm to outside,
full disclosure reduces the extent of inside information (even though, as pointed out in the previous topic, it
cannot eliminate it completely). This reduction of estimation risk increases investor confidence, and helps to
improve the operation of securities markets. This is a social benefit of financial accounting, since the allocation
of scarce capital in the economy is improved.

In this regard, it is worthwhile to note Regulation FD, implemented by the SEC in the United States in the fall
of 2000. Regulation FD prohibits senior officials of companies under SEC jurisdiction from disclosing inside
information to analysts without simultaneously disclosing it to all investors. This regulation was designed to
improve the operation of capital markets by reassuring investors that the market is a "level playing field." Prior
to Regulation FD, investors were concerned that analysts who received inside information first may use it for
their own benefit and for the benefit of certain select clients before releasing it to investors at large.

Interestingly, Canadian securities regulators claimed that Regulation FD is not needed in Canada, since
regulations already exist to prohibit selective disclosure.

One of the effects of Regulation FD is to increase the role of financial accounting and reporting since less
financial information is released prematurely.

In this regard, observe that the individual and social benefits of financial accounting and reporting can be
realized simultaneously. The link between them is the efficient securities market. As individual investors use
financial information in their investment decisions, security prices are driven to "properly reflect" this
information. Provided that accountants do a good job of communicating relevant and reliable information, this
means that a firms security price (equivalently, its cost of capital) is consistent with the firm's prospects. To
put this another way, full disclosure reduces estimation risk, so that the firms security price is closer to
fundamental value. The social benefit is that this improves the efficient allocation of scarce capital in society.

A further benefit of financial accounting and reporting is that reducing the extent of inside information
enhances investor confidence in the fairness of the market. More investors are then willing to enter the market,
with resulting improvement in market depth. Market depth benefits the economy since individual investors,
especially large ones, can buy and sell securities without affecting the market price. Then, individual investors
can concentrate on making rational investment decisions without having to worry, for example, that a decision
to sell may lower market price, hence the proceeds of their sale. See text, page 118, and Note 5, page 480.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.7 Examples of full disclosure

Required reading

Chapter 4, Section 4.8, pages 119-135 (Level 1)

Reading 3-2 (Level 1)
Management Commentary, a framework for presentation (IASB, December 2010)(Level 2)

LEVEL 1

Note that management discussion and analysis (MD&A) in the text is referred to as Management
Commentary by IASB. The discussion on this topic here is based on the 2010 IFRS Practice Statement,
Management Commentary, a framework for presentation , issued by the IASB . The purpose of covering
management discussion and analysis (MD&A) (or Management Commentary) is twofold. First, MD&A is
an example of how accounting standard-setting bodies have moved in recent years to further expand
disclosure in annual reports, consistent with the concept of decision usefulness. In particular, note that MD&A
encourages the provision of forward-looking information, thereby giving some coverage of management's
expectations for the future.

The second purpose is to present a specific example of superior financial reporting under the MD&A standard.
Read Canadian Tires disclosures (text, pages 122-134) in conjunction with the MD&A objectives summarized
on page 120. Note how the information presented about the firms operating strategies, growth prospects, and
risks goes beyond what can be learned from the financial statements.

The Management Commentary document lays down the principles that should underpin MD&A. For example,
one principle is that MD&A should be written from management's perspective. This seems highly desirable
since it is management that has the best information about the current and future state of the firm.
Consequently, the release of information that might otherwise remain inside is encouraged. Another principle
encourages a forward-looking orientation. Also, disclosure of risk exposures and the effectiveness of
managements strategies to control them are suggested. All of these principles are consistent with the decision
needs of users, who want to predict future firm performance. It should be noted that the Exposure Draft does
not envisage it to be another IFRS, and its application is voluntary. Nevertheless, its adoption by a firm
provides a vehicle for that firm to signal to the market its commitment to full disclosure.

The text speculates why Canadian Tire goes beyond the minimum requirements of disclosure. Presumably, the
firms management feels that a good disclosure reputation is consistent with ethical principles and, in the longer
run, will enhance its profitability through lower estimation risk, resulting in higher share price and lower cost of
capital. In addition, voluntary disclosure has an aura of credibility to it that is beyond the information content
of the disclosure itself. Many investors will feel that by choosing to reveal more than the minimum, the firm is
telling them that it has a confident view of its future. You will revisit the topic of voluntary disclosure in
Module9.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

3.8 Conclusion

Required reading

Chapter 4, Section 4.9, pages 135-137

This module has explained the efficient securities market theory in which a given security's price is said to
properly reflect all publicly known information about the security. You should remember that noise traders, that
is,liquidity traders, add a random component to the markets, preventing market price from being fully
informative with respect to publicly available information. This provides a motivation for rational investors to
use financial statement information to help find mispriced securities.

Since this theory deals with all publicly known information, it still allows for insider information and the
problems associated with information asymmetry. This is a source of estimation risk, and provides accountants
an opportunity to use full disclosure as a way to help investors to learn at least some of this inside information.
In so doing, investor confidence in securities markets is increased and share prices more closely reflect
fundamental value. In addition to improving investor decisions, this creates social benefits of better allocation
of scarce capital in the economy.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

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.

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
the policies used are fully disclosed
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.

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

Explain the implications for securities pricing of the Sharpe-Lintner capital

asset pricing model (CAPM).

CAPM specifies what the expected return of a share traded on an efficient securities market
 should be (equivalently, the firms 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 shares beta and the return on the risk-free asset.
Firm-specific risk is diversified away by rational investors and therefore does not affect the shares
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 as per CAPM.
The CAPM assumes beta is stationary, and that there is no information asymmetry. When these
are not so, estimation risk arises. This causes the firms actual cost of capital to be somewhat
greater than CAPM.

Explain the significance of information asymmetry.

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.

Define the adverse selection problem as it applies to securities markets.

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 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.

Explain the significance of the adverse selection problem to financial

accounting theory.

Adverse selection creates a problem for securities markets because inside information is a source
of estimation risk (that is, lemons problem).
Investors then demand higher return to compensate (that is, higher than the return given by the
CAPM), 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 since 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).

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:
Be written from managements perspective
Have a forward-looking orientation
 Discuss risks and uncertainties

By going beyond minimum disclosure requirements, management can:

Meet a high ethical standard

Create a reputation for full disclosure, which
Reduces estimation risk
Raises share price and lowers cost of capital
Convey to investors that management has a confident view of its future
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 4: Information approach to decision usefulness

Overview

Read the Chapter Overview, Section 5.1, on pages 143-144.

There are several problems associated withfinding empirical evidence on decision usefulness. A major concern
is in constructing the research model. Essentially, the researcher is trying to isolate the causes of changes in
stock prices. Given all the complexities of the modern stock market, it is difficult to say that a certain piece of
information, announced on a specific date, was responsible for a given change in stock price.Nevertheless, by
using both the efficient securities market theory and decision usefulness theory, researchers have found that
the evidence is consistent with the predictions.

The information approach to financial reporting, which recognizes investor responsibility for investment decision
making and the role of accountants in supplying useful information for this purpose, will be explained in this
module. You will look at the securities markets response to reported net income and RRA. However, it is
important to remember that while a market response to accounting information tells accountants that investors
find the information useful, the extent of the market response does not necessarily indicate the value to society
of the accounting policy that produced the information. Standard setters need to assess more than just market
response.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

4.1 Outline of the research problem

4.2 Ball and Brown study
4.3 Earnings response coefficients
4.4 Unusual, non-recurring, and extraordinary items
4.5 A caveat
4.6 Information content of other financial statement information
4.7 Conclusion

Learning objectives

Explain why a securities market responds to information that investors find useful, in light of the
efficient securities market and decision usefulness theories. (Level1)
Outline some of the difficulties of conducting empirical research to discover evidence of securities
market reaction to accounting information. (Level1)
Explain Ball and Browns research techniques and findings. (Level1)
Define the concept of an earnings response coefficient and identify the factors that explain its
magnitude. (Level1)
Apply the earnings response coefficient concept to accounting for unusual, non-recurring and
extraordinary items. (Level1)
Describe why an accounting policy that produces the greatest share price reaction may not be
the best for society. (Level2)
Evaluate the empirical evidence on securities market response to RRA. (Level2)

Module summary

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.1 Outline of the research problem

Required reading

Chapter 5, Section 5.2, pages 145-149 (Level 1)

LEVEL 1

This module deals with the information approach to decision usefulness. As defined in the text, equating
usefulness to information content is called the information approach to financial reporting. This approach
dominated financial accounting theory and research from 1968 until recently. While it is now yielding to a
measurement approach (to be discussed in Module 5), it continues to be an important component of practice.
The large amount of supplementary information in notes and MD&A is consistent with the information
approach, for example.

Investors want to make their own predictions, but they look to accountants to supply information. The
information approach (or perspective) can guide accountants as to what is perceived to be useful. Accountants
often rely on research about market reaction to financial statement information as a guide to what is useful or
not useful. While the accounting policy that produces the greatest market response is not always the best
accounting policy from a social perspective (Topic 4.5), accountants can still use market response as a guide to
which accounting policies and disclosures are perceived as useful by investors greater market response
implies greater usefulness.

There are many factors affecting share prices. Therefore, isolating the effects of accounting information is very
difficult. It is important for accountants to understand the significant relationship between accounting
information and share prices. Financial accounting information enables investors to make good decisions and,
by helping to control information asymmetry, promotes the proper operation of capital markets. The theory of
the investment decision identifies information that is useful to rational investors. You have already studied
Beavers analysis of the implications of efficient securities markets for financial reporting (Topic 3.2). Without
some assurance that investors do use financial accounting information to make investment decisions, as
predicted by the decision theory and the theory of efficient securities markets, the theories themselves become
suspect. It is difficult to take the theories seriously and to be guided by them if the predictions of these
theories are not supported empirically.

Fortunately, empirical accounting researchers have been quite successful in demonstrating that financial
accounting information is used much as the theories predict. In this topic, you begin to study some of this
research. This topic also explains some of the methodological challenges and how they have been overcome.

The research problem in Section 5.2 of the text outlines how accounting researchers have been guided by
theory. For example, efficient markets theory predicts that the market will evaluate accounting information
relative to what it expected since analysts forecasts of earnings, and sales statistics are publicly available
information that will be incorporated into the markets expectations of earnings as soon as they become
available. That is, investors constantly revise their beliefs about future firm performance as they receive this
information. Upon learning current earnings, they further revise their beliefs only to the extent that earnings
contain additional information. Thus, the GN (good news) or BN (bad news) in reported earnings, explained in
the single-person decision theory example in Topic 2.2, and which can affect investors buy and sell decisions,
is often interpreted net of expectations. A firms share price may fall after release of a high earnings figure if
the market had expected even higher earnings the market would interpret the high earnings as BN and
react accordingly. A similar but opposite effect of a rise in market price could follow the release of poor
earnings, if the market had expected even poorer earnings. For an actual example of a negative market
response when reported earnings were below expectations, see self-test question 5 in Module 3 regarding
General Electric Co.

Efficient markets theory also predicts that the market reacts quickly to new information. Thus, researchers
cannot wait until the firms annual report is released but must find the earlier date that the firm announces its
earnings. (Most large firms do this.) If the market does react to the GN or BN in earnings, it will do so at the
earlier date, and a researcher who looks for a securities market response to earnings on the annual report date
will be too late. (Of course, the market will react to other information in the annual report that was not
previously released, including non-earnings information.)

Predictions of investor behaviour

As the text outlines on page 145, one might predict investors actions somewhat along the following lines:

Investors have prior varied beliefs (that is, prior probabilities) about expected return and risk of a
firms shares and the firm's future performance, based on publicly available information.
Upon release of the current years net income, some people will analyze the net income and
compare it with what they expected.
In the light of their findings, they will revise their beliefs and will buy, sell, or make no change in
their share holdings, depending on how current years net income compares to what they
expected.
Thus, one would expect that the volume of shares traded would increase around the time the
firm announces its earnings. If most investors regard the earnings as good news, share price will
rise, and vice versa.

Finding the market response

It is interesting that in 1968, Beaver examined trading volume reaction and found a dramatic increase in the
volume of trading during the week of earnings announcements. As mentioned earlier, researchers cannot wait
until the firms annual report but must find that earlier date at which the market first becomes aware of the
earnings information. If the predictions are to be documented, researchers have to find that narrow window of
time surrounding the date of earnings release to study the reaction of investors. Figure 5.2 on page 147 of the
text uses a narrow window of one day. Often, however, researchers widen the window slightly to include a day
or two on each side of the date of earnings release. The efficient market may anticipate the amount of the
earnings release through analysts, "hints" by company officials, and possibly leakage through other insiders,
and hence may start to react early. The inclusion of a day or two beyond the earnings release date is because
even an efficient market may take a day or two to fully evaluate the earnings news. For example, the news
may be released late in the day, or may be difficult to interpret at first glance if it includes unusual or non-
recurring items. Whatever the width of the window, the returns on the market portfolio and on firm js shares
are evaluated over this interval of time. Indeed, earlier studies used the week, and even the month, of the
earnings release, since daily returns data were not readily available then.

Separating market-wide and firm-specific factors

Notice how the theory of the CAPM (itself based on efficient securities market theory) is used to separate the
return on the firms shares into market-wide and firm-specific components (Section 5.2.3). If the share return
on the day (or narrow window) of the firms earnings announcement is separated in this manner, it is
reasonable to regard the firm-specific portion of the share return as a reaction to the earnings GN/BN.

To understand the process of separating share return into market-wide and firm-specific components, see
Figure 5.2 on page 147 of the text, and recall that the market model formula (that is, the ex post version of
the CAPM on page 112) is

R jt = j + j R Mt + jt

The j + j R Mt portion indicates the market-wide or expected return for firm j shares for period t, and the jt
portion indicates the unexpected , also called firm-specific or abnormal return. Assume, as in Figure 5.2, that
the actual return on firm js shares for period t is 0.0015 or 0.15%. Period t is taken as the day the firm
announced its earnings, but the period could alternatively include a day or more on each side of day t. Our
objective is to separate the 0.0015 into expected (market-wide) and unexpected (firm-specific, abnormal)
components.

The CAPM line (the straight line) in Figure 5.2 is the market model for firm j, with j = 0.0001 and j = 0.80.
First, obtain the return on the market portfolio for day t (this is usually taken as the return on the Toronto
Stock Exchange or Dow Jones indices for that day). This return is 0.001 on the figure. Then, to determine
expected return, simply read up from 0.001 on the horizontal axis to the CAPM line and then across to the
vertical axis. The expected return is 0.0009. That is, based on the level of the market index on day t and on
the CAPM estimated for firm j, the return on firm js shares for day t should be 0.0009, calculated as follows:

j + j R Mt = 0.0009

Since the actual return for firm j is 0.0015, the abnormal return jt is 0.0006.

To understand the procedure, read Section 5.2.4 carefully. Although a number of points are raised, the
conclusion is that the procedure performs reasonably well and that the market reacts to earnings information as
the theory predicts.

For an actual abnormal return calculation for Imperial Oil Ltd., see Question 8 of the self-tests for this module
(text, Problem 18, page 173).
Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.2 Ball and Brown study

Required reading

Chapter 5, Section 5.3, pages 149-153 (Level 1)

LEVEL 1

The Ball and Brown study was the first to demonstrate a significant relationship between earnings information
and share price. The methodology that the study applied continues to be used today. The studys finding not
only encourages accountants that the information they prepare is useful to investors, it also feeds back to
support the theories on which their methodology is based.

The essence of Ball and Browns approach is to identify samples of firms that report GN and BN (relative to
expectations) in earnings and to compute the firm-specific component of share returns for each sample. Ball
and Brown took last years earnings as their measure of what investors expected this years earnings to be.
Thus, a GN firm is one that reports higher earnings than last year, and vice versa. If the market reacts to the
GN and BN, we would expect the firm-specific share returns, computed according to the procedure described in
the previous topic, to be positive and negative, respectively. As can be seen in Figure5.3 on page 151, this is
what they found.

While there was a positive and negative reaction for the month of release of the earnings announcement
(month0), most of the market reaction took place over the 12-month period leading up to the earnings
announcement date. This fact implies that the market began to "ferret out" the GN or BN in earnings as much
as a year in advance. In Section5.3.2, the text explains the reason for this impressive, and perhaps surprising,
ability of the market to anticipate good and bad earnings news. Over the course of the year, the market
constantly receives and evaluates information from a variety of sources about firm performance. This
information may include new patents, cost-cutting campaigns, write-offs, acquisitions, and discovery of natural
resources. It may even include information released by the firm itself, such as quarterly reports, speeches, and
announcements by company officials. As pointed out in Topic 4.1, investors will revise their expectations of
future firm performance as this information is received. Consequently, the market will quickly incorporate the
implications of this information into share price at that time. For firms that reported higher earnings than the
previous year (GN firms), we would expect that the stream of information about those firms over the year was
favourable (this is what drives the higher reported earnings), leading to positive abnormal returns on their
shares over the year. The opposite would occur for firms that reported lower earnings than the previous year
their shares should exhibit negative abnormal returns over the year.

This is what Ball and Brown found, as shown by the steadily rising and falling lines in Figure5.2. From an
accounting perspective, however, the most important result was that, despite the markets anticipation of much
of the GN and BN in reported earnings, there was a positive and negative abnormal share price reaction for the
month of release of the earnings announcement . This means that the market did not completely anticipate the
good news or bad news in earnings. That is, the earnings announcement added something to what the market
already knew about future firm performance, and investors revised their state probabilities accordingly. (One
possible explanation is that the market did not fully react to the good or bad news during the year until the
news was "validated" by earnings.) The markets quick processing of this good or bad earnings news led to the
abnormal share returns for month 0, as shown in Figure 5.3.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.3 Earnings response coefficients

Required reading

Chapter 5, Section 5.4, pages 153-162 (Level 1)

LEVEL 1

The text outlines some of the empirical research done after Ball and Brown. An important branch of this
research is earnings response coefficients (ERCs), which measure the amount of abnormal share return in
relation to the amount of the BN or GN in earnings. Ball and Brown only classified their sample firms as GN or
BN irrespective of the amount of the GN or BN and measured only the average abnormal share return of their
GN and BN samples. While their results are encouraging, an average can conceal wide variations about the
average. That is, some firms in the Ball and Brown sample may have had a much stronger market reaction to
their GN or BN in month 0 than others. Other firms may have had a much weaker reaction. ERC research asks
why .

ERCs are important to accountants because understanding why investors react more strongly to the GN/BN of
some firms than others enables you to identify which accounting and reporting policies investors find most
useful. A higher ERC means greater decision usefulness. That is, the more useful the information contained in
each given dollar of GN or BN, the stronger the investors response will be.

Read Section 5.4.1 carefully and be sure you understand the characteristics of the stocks that result in higher
ERCs, such as low beta, less levered capital structure, higher earnings quality (including higher earnings
persistence), growth opportunities, similarity of investor expectations, and the informativeness of price.
Forexample, a less levered capital structure means that more of the earnings GN or BN belongs to the
common shareholders, leading to a stronger share price response to a dollar of GN/BN. Note also that if
investors prior expectations of earnings are close together (that is, similar), they will react in the same way to
reported earnings. Similarity of expectations is likely to be the case if investors all base their earnings
expectations on analysts earnings forecasts, especially if these forecasts are precise.

(On page 158, the texts use of "precise" needs some explanation. Note first that when more than one analyst
follows the same firm, the average of their forecasts is called the consensus forecast (see text, page 160).
When the forecasts included in the consensus are close together, the forecasts are termed precise. The term
does not imply that the forecasts are necessarily accurate this is called "forecast accuracy." Given that
investors earnings expectations are based on analysts forecasts, and given that these forecasts are precise,
investors earnings expectations will be similar. Then you would expect share price to react quite strongly to
GN/BN. This is borne out in practice. One need only read the financial press to see that even very small
differences between reported earnings per share and analysts forecasts produce major changes in share price.
Such large swings are consistent with the point made above and in the text (top of page 161) that most
empirical studies of the information content of earnings now use analysts forecasts as a proxy for the markets
earnings expectations.

One of the most important characteristics that leads to a higher ERC is earnings persistence. Earnings
persistence is an important component of earnings quality. Recall that investors are interested in earnings not
just because of the GN/BN it may contain about current operations. They are also interested in the extent to
which current success, or lack of success, will continue (or persist) into the future, since it is future earning
power that will generate returns on their investments. Earnings persistence measures the extent to which
current GN or BN in earnings is expected to continue. Obviously, if current GN results from solid increases in
sales and market share and good cost control, the GN will likely persist longer than if the GN results from a
change in accounting policy or the reversal of a previous writeoff.

For accountants, the concept of earnings persistence reinforces the need for full disclosure, so that investors
can figure out the sources of current GN/BN. In the next topic, you will see that such disclosure issues concern
standard setters.
Summing up, ERC research has several implications for full disclosure. These include greater disclosure for
smaller firms, for highly levered firms, and for firms with growth opportunities. An example is the reporting of
segment information so that segments of the firm with and without growth potential can be identified, since we
expect that current GN for a growth firm will persist. Also, disclosure of components of net income assists in
the evaluation of persistent earnings.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.4 Unusual, non-recurring, and extraordinary items

Required reading

Chapter 5, Section 5.5, pages 162-164 (Level 2)

IAS 1 (Level 2)

LEVEL 2

The reporting of unusual, non-recurring and extraordinary items is one of the most important issues in current
financial accounting practice. It will be explained more fully in Module 8, where you will see how these items
are frequently used by management to increase future reported core earnings (core earnings are net income
before extraordinary, unusual and non-recurring items see the summary on page 163 of the text), operating
earnings (operating earnings are net income before extraordinary items), and management compensation.
Unusual, non-recurring and extraordinary items can increase future reported core and operating earnings
because they frequently involve the creation of loss provisions, which can be used in future periods to absorb
costs, such as employee training or layoff costs, that would otherwise be charged to earnings as they are
incurred. Also, they may involve the writeoff of capital assets, which can reduce future depreciation expense.
Excessive use of unusual, non-recurring and extraordinary charges is sometimes referred to as putting earnings
"in the bank."

Note that under IASB standards, IAS 1 prohibits the use of the term extraordinary item completely. Nor does
it use the terms unusual and non-recurring items. Consequently, since Canada has now adopted IASB
standards, Section 5.5 of the text is out of date. You need not learn the definition of an extraordinary item and
how it differs from unusual and non-recurring items. Instead, think in terms of persistence.

In this regard, note that IAS 1 does require separate disclosure in the income statement of low-persistence
items such as writedowns of inventory and property, plant and equipment, provisions for restructuring, and
gains and losses on disposals of investments and property, plant and equipment. Furthermore, IAS 1 contains
provisions that require fair presentation, including provision of sufficient information that the effects of
significant transactions can be understood. Consequently, the main message of text Section 5.5 remains: full
disclosure includes the provision of sufficient information so that investors can evaluate earnings persistence.

Also, as pointed out above, current writeoffs affect future operating earnings and the effects of past writeoffs
on operating earnings need not be disclosed. This is an important issue, because it is persistent earnings that
investors find most useful in revising their probabilities of future firm performance.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.5 A caveat

Required reading

Chapter 5, Section 5.6, pages 164-166 (Level 2)

LEVEL 2

During the years following the 1968 Ball and Brown study, it was sometimes suggested that earnings response
coefficient (ERC) methodology could help standard setters. The "best" standards would be those that produced
financial statements with the greatest effect on share price. For example, if net income based on declining-
balance depreciation of capital assets generated a greater share price response (or ERC) than net income
based on straight-line depreciation, then standard setters should require firms to use declining-balance
depreciation.

However, as the text explains, this argument is not valid. The reason is that accounting information has
characteristics of a public good. Hence you cannot rely on market forces, such as strength of investor
response, to drive the socially "right" accounting policies. If accounting policies are not socially right, then
investor response to different accounting policies cannot guide standard setters in choosing between policies.
Topic 3.6 emphasized the role of financial accounting information in promoting the proper operation of capital
markets and efficient allocation of scarce capital in the economy. Unfortunately, choosing accounting policies
that produce the greatest effect on share price does not further this role.

However, investor response can still guide accountants as to which accounting policies are most useful to
investors. If net income based on declining balance depreciation produces a greater ERC than net income
based on straight line, then the main diagonal probabilities of the information system must be higher under
declining balance depreciation than under straight line. This leads to a stronger effect on share price. Thus, the
argument that accountants should produce information that is of greatest help to investors is still valid.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.6 Information content of other financial statement

information

Required reading

Chapter 5, Section 5.7, pages 166-167 (Level 2)

LEVEL 2

This topic moves from describing the information content of historical-cost-based net income to considering
whether other financial statement information, such as information from the balance sheet and notes, is also
found useful by investors. The text uses reserve recognition accounting (RRA), which, as you know, is reported
as supplementary information, as an example. Does RRA have additional information content and therefore
greater usefulness for investors, compared with historical-cost-based net income?

The methodology used to empirically estimate the impact of financial statement information on share prices
can also be adapted to evaluate the usefulness of specific reporting policies, such as RRA. If investors find RRA
information useful, you should observe share price response to that information over and above any response
the market has already made to historical cost-based net income. The text refers to several research studies
that have investigated this question and concludes that it has been hard to find strong evidence of usefulness.
This conclusion provides a tentative answer to the question about the reliability of RRA information raised in
Topic 1.6. Perhaps the increased relevance of RRA is outweighed by its low reliability.

However, an alternative possibility is that investors do find RRA information useful but researchers cannot find
evidence to confirm this. For example, it is more difficult to identify the time the market first learned the RRA
information than it is to identify the time the market learns earnings information. Then, given market efficiency,
it is difficult to know when to look for a market response.

The methodology used by Lev and Thiagarajan, however, provides some evidence of the usefulness of balance
sheet information (as opposed to supplemental note information, as in RRA). These authors calculate a number
of ratios based on balance sheet information, such as change in inventories relative to sales. A higher ratio
suggests lower earnings quality. If so, the ERC for firms with high ratios should be lower than for firms with
low ratios, other things equal. Lev and Thiagarajan report empirical evidence consistent with this argument. It
may thus be the case that market response to balance sheet and supplementary information is routed through
the ERC.
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

4.7 Conclusion

Required reading

Chapter 5, Section 5.8, pages 167-168

It does seem that the empirical results support the rational investor and efficient securities market theories.
The results provide encouragement that at least net income information is found to be useful by investors.

However, it has been more difficult to find a market reaction to non-earnings accounting information.
Methodological difficulties of finding a direct reaction are a possible explanation. Researchers may be unable to
find just when the market first becomes aware of non-earnings information, or the market may learn much of
the other financial statement information from more timely sources. However, by routing the effect of balance
sheet information on share price through the ERC rather than looking for it directly, some encouragement that
the market finds other financial statement information useful is obtained.

The information approach to financial reporting is content to use historical costs in the financial statements
proper and make up the resulting reduced relevance with a lot of supplemental information. This puts the onus
on investors to ferret out all relevant information in the annual report. Perhaps accountants can further
increase the markets use of financial statement information by greater use of fair value accounting, thereby
increasing the relevance of the financial statements proper. This leads to the measurement approach to
financial reporting, which you will study in the next module.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

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.

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.

Outline some of the difficulties of conducting empirical research to discover

evidence of securities market reaction to accounting information.

Since efficient markets react quickly, the researcher must find the date on which the market first
became aware of the information.
For net income, the date the firm announces its earnings in the financial press is a
successful proxy.
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.
This is usually accomplished using the market model to predict expected share
returns.
The deviation of expected and actual share returns is taken as firm-specific return.

Explain Ball and Browns 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, BB expected to observe a positive firm-specific
return on the firms 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 for some firms than for others.
ERCs have been found to be higher for
 less risky firms (in a beta sense)
less levered firms
firms with higher earnings persistence
firms with higher earnings quality
growth firms
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 accounting for unusual,

non-recurring, and extraordinary items.

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.
To make matters worse, current low persistence items might increase future core earnings, and
these effects are not disclosed. This is a particular problem if the initial writeoffs are excessive.
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 on 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.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 5: Measurement approach to decision usefulness

Overview

This module introduces a new approach to decision usefulness. This is the measurement approach, in which
the accountant incorporates current values directly into the financial statements proper. Under the information
approach, fair value information could be incorporated into the financial statements notes but not necessarily in
the financial statements proper. This raises the question of how relevant information is most usefully disclosed.
While there has long been a debate over the reliability of fair value information, the trend is toward the
measurement approach. This trend is largely driven by several factors:

evidence that historical cost-based accounting information accounts for relatively little of the
changes in security prices
questions about the extent of securities market efficiency
availability of alternative theories
auditors legal liability

It seems that accountants believe that the recording of fair values in the financial statements proper will
further increase their usefulness for investor decision-making and reduce the possibility that investors are
misled when fair values are buried in extensive notes.

The module will outline several measurement-oriented standards in GAAP, including standards for derivative
instruments. The debate rages over whether or not the introduction of fair values increases the volatility of
reported earnings or just reports true volatility. This debate heightened further in 2007-2008 following the
huge writedowns reported by banks and other financial institutions. Managers claimed that the writedowns
were excessive. This debate leadsto looking at recent developments in reporting on risk.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

5.1 Measurement approach

5.2 Reasons for increased attention to measurement
5.3 Using clean surplus theory for firm valuation
5.4 Measurement-oriented standards in GAAP
5.5 Financial instruments
5.6 Accounting for intangibles
5.7 Reporting on risk
5.8 Conclusion

Learning objectives

Explain the measurement approach to financial reporting. (Level1)

Explain why financial reporting is moving in a measurement direction. (Level1)
Understand theory and evidence suggesting that securities markets may not be fully efficient.
(Level2)
Explain Ohlson's clean surplus theory and its role in firm valuation. (Level2)
Outline measurement-oriented accounting standards. (Level2)
Explain why auditor legal liability encourages conservative accounting. (Level2)
Evaluate the important concepts of derivative financial instruments. (Level1)
Describethe problems of accounting for intangibles. (Level1)
 Evaluate alternative approaches to reporting on risk. (Level 1)

Module summary

Reading 5-1

Reading 5-2

Reading 5-3

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.1 Measurement approach

Required reading

Chapter 6, Section 6.1, pages 177-178 (Level 1)

LEVEL 1

This module moves from the information approach to the measurement approach to decision usefulness.
The measurement approach incorporates the idea of accountants adding as much fair value material into the
financial statements proper as is feasible.

At this point, review text, page 4 and the discussion in Topic 1.3 concerning the difference between fair value
and value-in-use. Since standard setting bodies have, for the most part, decided that current value accounting
(that is, the measurement approach) shall be based on fair value, much of the discussion in this module is in
terms of fair value. However, as we shall see, value-in-use and historical cost alternatives are sometimes
allowed when fair values cannot be determined with sufficient reliability. Indeed, use of these alternatives for
certain financial instruments has increased following the 2007-2008 market meltdowns. See the discussion in
Topic 1.2.

In this course, consistent with the text, the term current value is used when referring generally to asset
and liability valuations that depart from historical cost. The term fair value is used to refer specifically to
measurements based on market value. Value-in-use refers to valuations based on discounted present
value. Recall from Topic 1.3 that fair value and value-in-use need not be the same when ideal conditions do
not exist.

It is important to understand the difference between the measurement and information approaches to financial
reporting. Both are oriented to decision usefulness for investors. However, the measurement approach brings
current values into the financial statements proper and, on occasion, includes unrealized changes in current
values in income. The information approach retains historical cost accounting in the financial statements proper
and relies on efficient securities market theory to justify providing additional value-relevant information as
notes and supplementary information, on the grounds that the efficient market will properly evaluate
information from any source.

In practice, the differences between these two approaches are a matter of degree. The information approach
has always had a measurement component, as in the lower-of-cost-or-market rule, for example. Also, the
measurement approach is unlikely to completely displace historical cost accounting, at least in the foreseeable
future it is unlikely that RRA will be used for the balance sheet valuation of oil and gas reserves, for
example. Also, the valuation of property, plant and equipment where the company decides to use historical cost
is subject to a ceiling test (see Topic 5.4). However, under international standards, a fair value revaluation
option is available. Despite the mixed measurement model of present-day accounting, the trend is toward
increasing use of measurement.

The measurement approach does not necessarily conflict with investor rationality and efficient securities market
theory. However, the text argues (Section 6.2.7) that if investors are not rational (that is, they do not make
investment decisions as described in Topics 2.2 and 2.3), greater use of measurement in the financial
statements proper will improve their investment decisions. Thus, the question is how relevant information can
most usefully be disclosed to investors. Under the measurement approach, the accountant assumes somewhat
greater responsibility for helping investors (who may not be fully rational). For example, under the information
approach, investors who are subject to limited attention may not bother to read current value information in
the notes. Fair value accounting may help such investors to predict future firm performance by conveying fair
values directly (that is, in the financial statements proper), rather than indirectly as supplementary information
in the notes. Other things equal, the best predictor of future values of assets and liabilities (and hence of the
firm) is their current values. Nevertheless, the ultimate onus to predict future firm performance is still on the
investor.
To be decision useful, however, current values should not be too unreliable. This is a potential problem with
the measurement approach. But, as you will see, many new markets have developed in recent years, such as
those for financial instruments. In addition, models have been developed to estimate what the value of assets
and liabilities should be. Models are particularly useful in valuing assets and liabilities that do not have market
values, such as non-traded stock options and other illiquid securities. If these markets and models work well,
they can provide reliable value measurements for many assets and liabilities.

Another reason for the measurement approach is that legal liability for firm failures may have motivated
accountants, including auditors, to trade off some reliability in favour of greater relevance.

If a market price for an asset or liability exists, this provides a readily-available fair value. If a market value is
not available, fair value may be estimated on the basis of recent market transactions for similar assets and
liabilities. Lacking these, models to estimate fair value can be used, as mentioned above. In extreme cases of
lack of market values, present value (that is, value-in-use) can be used to estimate fair value.

The text (page 229) uses the definition of fair value given in SFAS 157:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.

Under IASB standards, IAS 39 (paragraph 9) defines fair value as:

The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing
parties in an arms length transaction.

IAS 39 goes on to say (paragraph 48A): The best evidence of fair value is quoted prices in an active
market.

These definitions are basically the same. All of them equate fair value with market value. The text uses the
SFAS 157 definition since, at the time of writing, it was the clearest statement that standard setters regard fair
value as market value.

Note the text discussion of fair value on page 229. In particular, fair value measures the opportunity cost of
using an asset or liability in the business. That is, by retaining the asset/liability, management gives up the
opportunity to sell/pay off the item.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.2 Reasons for increased attention to measurement

Required reading

Chapter 6, Sections 6.2, 6.3, 6.4, and 6.6, pages 178-197 and 210-211 (Examples6.3 and 6.4
need not be read)(Level2, except Sections 6.2.6 and 6.2.7, pages 186-190, at Level1)

LEVEL 2

Are securities markets efficient?

Like any theory, the theory of efficient markets is constantly being tested. One way to test a theory is to
compare its predictions with what actually happens. For example, the efficient securities market theory predicts
that market prices should react very quickly to new information and should not be more volatile than the
volatility of expected dividends. To the extent that share prices do not behave in this way, the theory is called
into question. Further questions arise if

Share price increases develop a momentum of their own, increasing by more than is predicted by
investors rational use of new information.
It appears that investors do not use all of the information available in financial statements.

Prospect theory

Prospect theory attempts to explain some observed behaviour that is inconsistent with the theory of rational
decision making outlined in Topics 2.2 to 2.6 inclusive. To the extent that investors do not behave as rational
investment decision-makers, further questions are raised about market efficiency.

Prospect theory is based on behavioural science. Specifically, it is an implication of the psychological concept of
narrow framing whereby individuals attempt to simplify the decision problems they face. According to prospect
theory, investors will separately evaluate gains and losses on securities (rather than evaluating the overall
impact on their wealth) and will attach too much probability to rare events (that is, a higher probability than
would result from applying Bayes theorem to available evidence). Investors will then tend to act in ways that
deviate from a rational, decision-theory investment viewpoint. For example, they may hesitate to enter the
market or, once they do enter the market, they may hold on to "loser" securities when the rational thing to do
is to sell. For a diagram of a prospect theory utility function, see Figure 6.2 on page 181 in the text.
Implications of prospect theory can be seen by examining this utility function. For example, note the very steep
decline in the function for small losses. This implies that when a share declines in value, investors will tend to
hold on so as to avoid the severe psychological impact of realizing a small loss. This helps to explain the
tendency to hold "loser" securities mentioned above.

As the text points out, there are relatively few empirical tests of prospect theory. For the test by Burgstahler
and Dichev (1997) described in the text, the results are inconclusive. The results described in the Theory in
Practice vignette on page 182 of the text are also inconclusive, although it appears that as market participants
gain more experience, their behaviour moves away from the predictions of prospect theory towards the rational
decision theory. Thus, the extent to which prospect theory calls into question the rational decision theory that
underlies this course is unclear.

Beta can change over time

With respect to beta, Section 6.2.3 of the text asks, interestingly, if beta is dead. Various questions have been
raised about beta. Specifically, there is some evidence that beta does not explain share returns very well (recall
that the CAPM predicts that high-beta shares will have high returns over time and vice versa for low-beta
shares). However, other evidence suggests that it does.

There are two main approaches to resolving the question of whether beta is dead. One approach points out
that beta may change over time (this is called non-stationarity) and, if these changes are taken into account,
beta does explain share returns. This approach is consistent with securities market efficiency. The second
approach takes the view that there are two classes of investors. One class is assumed to be rational. The other
class is assumed to be subject to behavioural biases (overconfidence). When these two investor types are
stirred up together in the market, the result is that beta continues to be an important risk measure but that an
accounting-based risk measure (the debt-to-equity ratio) is also important. This possibility is of interest to
accountants because it implies that the financial statements have a role to play in reporting on risk as well as
helping investors to assess expected return. We will return to reporting on risk later in this module (Topic5.7).

For present purposes, the main point is that, regardless of which of the above two approaches best holds, beta
is not dead. The CAPM remains as the model that many analysts use as the place to start to estimate firms
costs of capital. As the text concludes, however, beta may change over time and may have to share its risk-
measuring role with accounting-based variables.

Stock market volatility

Another line of investigation of the question of securities market efficiency looks at the volatility of the market,
including the extreme case of volatility the bubble. It is now generally agreed that the tremendous run-up in
the share prices of technology companies during the late 1990s and early 2000s constituted a bubble. Indeed,
history will likely show that the run-up in prices of oil and gas and commodity shares during years prior to 2008
was also a bubble. Obviously, excess volatility and bubbles are not consistent with securities market efficiency.
Efficiency implies that volatility should not be greater than the volatility of underlying firm value, determined
fundamentally by changes in expected dividends. In this regard, it is interesting to note from text Section 6.2.4
that the evidence of excess market volatility is mixed.

LEVEL 1

Efficient securities market anomalies

Yet another way of investigating market efficiency is to inquire if the market uses all the available information
in financial statements. Text Section 6.2.6 describes two instances where anomalies have been observed in the
marketplace. The two anomalies are outlined as follows:

Post-announcement drift

For firms reporting good news in quarterly earnings, their positive abnormal security returns (reflecting a share
price increase), tend to drift upward for 60 days or more following the earnings announcement. Conversely, the
negative abnormal returns (reflecting a share price decrease), of firms reporting bad news tend to drift
downward for a similar period. If the market were fully efficient, share prices and returns should adjust
immediately to the good or bad news, so that there would be no drift. It seems that investors wait for further
information to validate the good or bad news. Post-announcement drift continues to exist, and remains as a
challenge to market efficiency.

Accruals

Sloan conducted a study in 1996 in which he separated net income into operating cash flow and net accruals.
Net accruals would include amortization and depreciation expense and net changes in such current
asset/liability accounts as accounts receivable, allowance for doubtful accounts, inventories, accounts payable,
and so on. It was argued that, other things equal, the market should respond more strongly to a dollar of
operating cash flow than a dollar of accruals since, generally, cash flow is more persistent (because accruals,
being largely based on estimates, are less reliable than cash from operations). Sloans study found that the
market did respond to good news and bad news but did not seem to take full account of the cash-accrual
situation. By designing an investment strategy that took account of the cash-accrual situation, Sloan achieved a
return 10.4% in excess of the market return. While Sloans study was published in 1996, it seems that, like
post-announcement drift, it continues to exist.

Discussion

Note that lack of full securities market efficiency does not threaten financial reporting. To the contrary, it
creates a second role for financial reporting to investors. This is illustrated by Figure 6.3 in text, page 190.
Compare this figure with Figure 4.2 on page 117, where the role of financial reporting if markets are fully
efficient is to move as much information as is cost-effective from inside into outside information. If markets are
not fully efficient, this role remains. But a second role for financial reporting is to make it easier for investors to
fully understand financial statement information and its implications for future firm performance, thereby
improving the working of the market by moving share price closer to its efficiency ideal. As the text suggests,
current value accounting may enhance this second role by incorporating fair values into the financial
statements proper.

In Section 6.2.8 (pages 191-194), the text asks why the efficient securities markets anomalies continue to
exist, since one would think that investors would rush to exploit the anomalies and earn excess returns such as
the 18% reported by Bernard and Thomas and the 10.4% reported by Sloan. The rush to exploit such a
money machine would quickly arbitrage the anomalies away.

Researchers continue to devote great effort to answer this question. It increasingly appears that cost and risk
considerations provide the explanation. An investment strategy to exploit the anomalies incurs considerable
costs. In addition to brokerage costs and costs of short-selling, costs to develop the required expertise and to
constantly monitor firms financial reports are considerable. Note the studies of Bartov, Radhakrishnan, and
Krinsky, and of Ke and Ramalingegowada (text, page 188), who report that financial institutions, who have
more expertise and economies of scale than ordinary investors, do earn arbitrage profits from
post-announcement drift but that, even for these investors, the amounts of profits earned are small.

Another reason why the anomalies continue is risk. Recall from Topics 2.4-2.6 that rational investors will
diversify away firm-specific risk. An investment strategy to exploit an anomaly involves a departure from full
diversification. Instead, the investor buys shares that he/she perceives as mispriced. It is quite likely that such
firms will be similar. For example, firms with high accruals may be concentrated in specific industries, such as
firms that sell on long-term credit. Also, firms subject to post-announcement drift may be complex and thus
difficult for investors to figure out, such as high-tech. In such cases, diversification will not be complete. The
firm-specific risk that remains is called idiosyncratic risk. Risk averse investors will not be willing to invest
large amounts in portfolios subject to idiosyncratic risk.

While cost and risk may explain why the anomalies persist, the text points out (page 193) that a more
fundamental question is why they appear in the first place. One possibility is that investors, on average, are
subject to the behavioural biases described in the text on pages 178-181. Thus investors who are subject to
limited attention, conservatism, and/or narrow framing may not extract all the information in the financial
statements. Instead, they may only become aware of it over time from future quarterly reports, media articles,
and so on. Then, share price will drift up or down over time as the full GN or BN in the financial statements
becomes apparent.

A second possibility, however, is that investors are, on average, rational, and wait for subsequent events to
fully validate, or invalidate, GN or BN financial statement information. The text argument on pages 193-194 is
not difficult to see. Suppose that the current financial statements show GN. For example, earnings may be up
strongly. The question then is, will these higher earnings persist? Investors will use Bayes theorem to increase
their probabilities of high future firm performance. However, since investors are not sure the GN will persist,
their probabilities of high future firm performance will not be as high as if they were sure. Consequently, share
price will not rise as much as it would otherwise. Investors will then watch for subsequent information to
confirm or deny that the increased earnings will persist. If high earnings do in fact persist, good news, such as
media reports of rising sales, will be observed and share price will rise over time. If the GN will not persist
(forexample, the GN could be due to a change in revenue recognition policy that is not fully disclosed), bad
news will be observed over time and share price will drift downwards. This produces a time pattern of share
price behaviour similar to the post-announcement drift or accruals anomalies.

The point is that we cannot be sure that efficient securities market anomalies are due to non-rational investors.
They could just as likely be due to rational investor behaviour. Note also that the cost and risk arguments
above are consistent with rationality.

Conclusions

In the face of these various arguments, the text concludes in Section 6.2.9 that securities markets are not fully
efficient. If they were fully efficient, you would not observe the anomalies. However, it also concludes that
markets are close enough to full efficiency that the implications of efficiency for financial reporting as laid out
by Beaver (Topic 3.2) remain. This conclusion is largely based on the impressive evidence consistent with
efficiency described in text, Chapter 5 and Topic 4.3. In other words, efficient market theory is still the best
available theory to help accountants understand the decision needs of investors, and hence to prepare useful
financial reports.

The text also concludes that it is an open question whether average investor behaviour is better described by
rational or behavioural theories. However, from an accounting standpoint, this may not matter since fair value
information in the financial statements proper should improve decision making regardless. For behaviourally
biased investors, fair value accounting in the financial statements proper improves decision making by reducing
the need to dig through masses of supplementary information. Alternatively, since market values are the best
predictors of future values, fair value accounting reduces the need for rational investors to evaluate financial
statement information by waiting for subsequent events.

LEVEL 2

Other reasons supporting the measurement approach

There are several other reasons why financial reporting is moving toward greater incorporation of fair values
into the financial statements proper. Section 6.3 of the text raises the question of the explanatory power of net
income. Lev, in a well-known 1989 research study, contends that, even after allowing for market-wide factors,
the markets response to good and bad news in reported earnings is quite small (see Section 6.4). He estimates
that earnings themselves only account for 2 to 5% of the variability of abnormal narrow-window security
returns around the date of release of earnings information. This explanatory power increases with a wider
window, but then other factors, apart from change of earnings, have a significant effect. Furthermore, some
subsequent research described in the text on pages 196-197 suggests that the explanatory power of net
income seems to be falling over time, while other research disputes this.

As the text points out on page 196, there is a difference between statistical significance and practical
significance. For example, a small ERC can indicate a statistically significant market response, even though in
practical terms, the market response is very small.

Note that recognition lag and conservatism are at least partly responsible for low value relevance. A good
example is the accounting for R&D. A firm that spends heavily on R&D will see its reported net income lowered
at the same time as its share price rises due to market anticipation of the fruits of the research small
wonder that net income does not explain share return! In the light of these findings, the text suggests that
value relevance could be improved by introducing a measurement approach into the financial statements,
provided it was not outweighed by decreased reliability. The possibility of using the measurement approach for
R&D is considered in Topic 5.6.

As the text suggests in Section 6.6, perhaps the most important reason for movement towards the
measurement approach is auditors' legal liability. The failures of numerous financial institutions in the United
States during the 1980s (collectively known as the Savings and Loans debacle), led to substantial settlements
by the auditing firms involved. Part of the problem was that the institutions failed to report fair values of assets
such as loans, thereby misleading investors. Typically, these fair values were less than book values, so that
many institutions, by retaining historical cost for major asset and liability items and failing to disclose their
(lower) fair values, were able to disguise for some time the fact that they were insolvent. When insolvency
became apparent, auditors were frequently found liable for major settlements, such as the proposed
$300million settlement of Deloitte and Touche mentioned on page 210 of the text.

Accountants reacted to these failures and resulting legal liabilities with standards imposing various ceiling and
impairment tests, to be described in Topics 5.4, 5.5, and 5.6, which require writedowns when current value is
less than book value. The text regards ceiling and impairment tests as one-sided versions of the measurement
approach. They can also be regarded as applications of conservative accounting. Conservative accounting
reduces the potential for legal liability since, if assets are written down to fair value when this has declined to
below historical cost, it is less likely that the accountant can be blamed for overvaluation if the firm
subsequently goes bankrupt. From a legal liability perspective, writing assets up to fair value when this is
greater than cost is not as crucial since undervaluation of assets seldom leads to bankruptcy and resulting
auditor liability.

At this point, reread text, page 9 (bottom paragraph) and page 10, where it is suggested that conservatism in
accounting is increasing.

You have no doubt heard of severe criticisms of fair value accounting by financial institutions who were forced
to take huge writedowns following the recent market meltdowns (if not, reread the account of them in
Topic 1.2). In effect, these institutions argued that fair value accounting was too conservative, since they
viewed the huge writedowns following the 2007-2008 market meltdowns as excessive. The Savings and Loans
debacle, however, suggests that historical cost accounting for financial instruments may be even worse, since it
enables firms to delay recognition of approaching insolvency until it is too late.

Note:

Examples 6.3 and 6.4 on pages 212-216 of the text are not examinable. These examples are designed to
show that conservative accounting can be supported by the decision theory described in Topics 2.2 and 2.3.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.3 Using clean surplus theory for firm valuation

Required reading

Chapter 6, Section 6.5, pages 198-210 (Level 2), with the exception of Section 6.5.2, pages 201-
203, which is not examinable.
Reading 5-1 (Level 3)

Read Section 6.5.3 in the text, and Reading 5-1 when instructed to do so.

LEVEL 2

The clean surplus theory shows how the balance sheet and income statement correlate to the firm value.
This, in turn, allows the investor to calculate an estimate of what share price should be. The theory works as
follows.

From the income statement:

Actual earnings are based on the clean surplus calculated by ensuring that all gains and losses
go through the income statement.
Goodwill is calculated as the discounted present value of abnormal earnings, where, consistent
with text example 6.2, abnormal earnings is the difference between actual earnings (calculated as
ROE times opening book value) and expected (or "normal") earnings (calculated as cost of capital
times opening book value). The firms cost of capital (estimated using the CAPM) is also used as
the discount rate.

From the balance sheet:

Actual earnings for each year looking ahead are calculated by multiplying opening shareholders'
equity (denoted by bv in the text) by the firm's ROE.
Normalearnings for each year looking ahead are calculated by multiplying opening shareholders'
equity by the firm's cost of capital (denoted by E(R j ).
Take the net worth of the firm and add the calculated estimate of the firm's goodwill (discounted
sum of actual minus expected earnings) to arrive at the firm's estimated value.
Then take the number of shares outstanding and divide it into the firm's estimated value to arrive
at an estimated share price.

This calculated share price is then compared to actual market price to determine how close the market value
represents the calculated value.

From a theoretical perspective, the significance of the clean surplus theory is that it demonstrates that firm
value, as calculated above, is identical to theoretically correct valuations obtained from discounted dividend and
cash flow models. Of course, no model can predict a firm's actual market value, since the real world is more
complex than any model can capture. However, as we shall discuss in a moment, model value may be helpful
in finding mispriced securities, since, in the presence of noise trading and possible market inefficiencies, actual
market price may not be correct either.

In this regard, the theory leads to a relatively simple procedure to estimate share value from financial
statement information. (If you have prepared a firm valuation based on discounted cash flows, you will
appreciate how difficult it can be to prepare cash flow estimates from a set of accrual-based financial
statements.)

Read now the article by Charles Lee in Reading 5-1, which describes this procedure. It is also illustrated in text
Section 6.5.3, Example 6.2.
Perhaps the most difficult aspect of the Lee procedure is to come up with a reasonable estimate, looking
ahead, of how long any abnormal earnings will continue. (Full disclosure will reduce this difficulty by, for
example, helping investors to evaluate earnings persistence.) For Canadian Tire in Example 6.2, the text
assumes seven years. It is difficult to assume a longer period, since forces of competition will tend to eliminate
abnormal earnings. Nevertheless, it seems that the market's estimate of the amounts and persistence of
Canadian Tire's future abnormal earnings substantially exceeded what the theory or model can justify. In the
Canadian Tire example, the calculated value is $46.06, whereas actual market price at the time was $74. The
text goes through considerable soul-searching to try to explain the discrepancy, but ends up concluding that a
value higher than $46.06 is not justified.

In December 2008, the market price of Canadian Tire shares in was in the range $42-$45.

The discrepancy between model and market valuation in the Canadian Tire example suggests that the clean
surplus approach may be useful as the basis of an investment strategy. This possibilitywas pursued by Frankel
and Lee. Their study is outlined on page 207. The higher the ratio of model value to market value, the better
the firm's future performance should be. The reason appears to be that the higher the ratio, the more the
firm's market value is backed up by formal balance sheet and goodwill valuations.

Finally, the clean surplus theory supports a measurement approach. There are two interrelated reasons for this.
First, by demonstrating an equivalence between financial statement variables and market value, financial
statements are shown to be firmly grounded in the theory of value.

Second, the more fair values that are included on the balance sheet, the "less" abnormal earnings need to be
predicted, leading to more accurate predictions and hence more useful financial statements. The reason why
there is less to predict is that current share value is based, directly or indirectly, on the markets expectations of
the present value of the firms expected future cash receipts. Under the measurement approach, expected
future cash receipts are capitalized on the balance sheet (either directly, as in value-in-use accounting, or via
market value as in fair value accounting), rather than having to be projected and included in goodwill as the
text does for Canadian Tire in Example 6.2. In theory, the same share value will be obtained whether or not a
measurement approach (unbiased accounting in clean surplus terminology) is applied (on this point, see the
biased accounting illustration on page 200 of the text). In practice, however, the firm's management can
probably prepare more accurate estimates of fair values than the outside investor, so that incorporating more
measurement into the balance sheet should produce better share value estimates than our Canadian Tire
procedure.

Read text Section 6.5 carefully (except Section 6.5.2) and make sure that you understand the process outlined
and the various uses to which the clean surplus theory can be applied.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.4 Measurement-oriented standards in GAAP

Required reading

Chapter 7, Sections 7.1 and 7.2, pages 228-235 (Level 2)

IAS 36 (Level 2)

Read text Sections 7.1 and 7.2before proceeding with this topic. Read IAS 36 when instructed to do so.

LEVEL 2

Lower-of-cost-or-market and ceiling tests

As you read the text and the IASB Standards, notice the various characteristics of these measurement
situations. For example, the lower-of-cost-or-market rule, described in text Section 7.2.3, is a one-sided or
asymmetric version of the measurement approach. Traditionally, asset values subject to this rule are written
down, but are not written up if current value rises above cost.

However, note that IAS 2 allows subsequent writeup of previously written down inventory, but not to above
original cost. Under United States standards, subsequent writeup is not allowed.

Text Section 7.2.5 describes the ceiling test. Under international standards, IAS 36 requires a writedown for
property, plant, and equipment (and various other long-lived assets, including intangibles to be discussed in
Topic 5.6) when the recoverable amount (fair value less costs to sell or value-in-use, whichever is greater) is
less than book value. Note that writedowns can be reversed (but not to above book value) if recoverable value
subsequently increases.

Section 7.2.5 also describes the two-step ceiling test under United States standards. First, it is determined if
capital assets are impaired. This is the case if the book value of the asset exceeds the sum of its
undiscounted expected direct cash flows. If the asset is deemed impaired, the second step is to determine its
fair value. Fair value can be measured by means of quoted market prices, if available. Otherwise, fair value can
be measured as the discounted expected present value of the assets direct future cash flows. The ceiling test,
however, is still one-sided. That is, assets are not written up if fair value is greater than book value.
Furthermore, subsequent write-up of impaired assets is not allowed if fair value rises (paragraph .06).

As you read IAS 36, note the difference between fair value less costs to sell as opposed to value in use.
Paragraphs 25 to 29 provide the definition of fair value, and sections 30 to 45 provide guidelines for calculating
value in use. Under paragraph 25, fair value is the price of the asset in a binding sale agreement in an arms
length transaction adjusted for incremental costs relating to the sale. If there is no binding sale agreement but
there is an active market for the asset, then fair value is the current bid price or the price of a recent
transaction, provided the economic circumstances have not changed. If neither a bid price nor a recent
transaction price is available, then fair value is the best estimate of the amount that the entity can obtain from
an arms length transaction. Costs to sell reflect such costs as legal costs, stamp duties, removal costs, and so
forth.

Value in use, on the other hand, involves estimating future cash inflows and outflows from continuing use of
the asset and applying an appropriate discount rate to future cash flows. Future cash flows estimates could be
based on reasonable assumptions or the most recent financial budgets/forecasts, if available. IAS 36
(paragraph 37) points out that caution should be used when utilizing historical growth rates over long periods
because competitors are likely to enter the market if conditions are favourable. This is one of the reasons why
the text (page 207) refuses to extend the persistence of Canadian Tires abnormal earnings beyond seven
years. Note also the similarities with RRA (Section 2.4 of the text). Under IAS 36, if future cash flows from the
asset are uncertain, the firm estimates annual future expected cash flows and discounts them using an
appropriate discount rate. (Recall that RRA uses 10%.) Increasing the interest rate for risk, of course, lowers
the expected value. The adjustment for risk arises because financial statement users are assumed to be risk
averse, similar to Bill Cautious in text Example 3.1.

It is also worth noting that under IFRS 6 (Exploration and Evaluation of Mineral Resources), the impairment
test also applies to the costs of oil and gas exploration (referred to in IFRS 6 as exploration and evaluation
assets or E&E assets ) when the carrying amount of an E&E asset is greater than its recoverable amount. The
impairment loss is to be calculated based on the methods described under IAS 36. It is interesting to note,
however, that while IFRS 6 does not mention either successful efforts accounting or full cost accounting, it
allows firms the choice of expensing or capitalizing E&E expenditures provided it is applied consistently.

Pensions and other post-employment benefits (OPEBs)

The accounting for pensions and OPEBs represents a major application of, and challenge for, the measurement
approach. The text, Section 7.2.6, describes United States pension standards, since these are more advanced
towards measurement than international standards. The most advanced standard is used here since the
purpose is to describe the measurement approach in action.

Note the definition of the projected benefit obligation (PBO) in text, page 233. This is the discounted
expected value of future expected pension payments, including for expected compensation increases (that is,
value-in-use). SFAS 158, effective in 2006, requires this liability to be shown on the balance sheet. Prior to
SFAS 158, and still under international standards, pension gains and losses such as actuarial adjustments due
to changing lifespans, changes in interest rates, and changes in plan benefits, could be off-balance sheet.

By bringing the PBO onto the balance sheet, SFAS 158 represents a major application of the measurement
approach. However, as the text points out on page 234, the application is not complete since some pension
gains and losses are included in other comprehensive income and amortized into net income over several
years. The reason, presumably, is to avoid extreme volatility of reported net income, since pension gains and
losses can be large and of low persistence.

Other comprehensive income, described in the text on page 234, consists of unrealized gains and losses that
are reported outside of net income. In addition to pension gains and losses, this category includes gains and
losses on various financial instruments, which you will study in Topic 5.5. A more extensive discussion of other
comprehensive income is included in Module 10. Other comprehensive income is allowed by IAS 1.

Employee benefits also include OPEBs. While measurement-oriented, the accounting for OPEBs does not go as
far in a measurement direction as pensions since it is the accumulated benefit obligation that is reported
on the balance sheet. This is similar to the projected benefit obligation except that expected future benefit
increases are not included. The reason, as pointed out in text Note 10 (page 271) is that OPEBs can be
withdrawn by the employer more easily than pension benefits. Thus, whether expected future increases are
really a liability can be questioned.

As the text points out on page 235, IAS 19, the international pension standard, is broadly similar to SFAS 87.
That is, pension gains and losses can be deferred off-balance sheet and amortized into net income. However,
IAS 19 allows firms to adopt alternative accounting for these gains and losses. One alternative is to recognize
them in current net income, including the offsetting debit or credit in the PBO on the balance sheet. The other
is similar to SFAS 158, namely include them in other comprehensive income, with the offsetting debit or credit
in the PBO. If the latter alternative is chosen, IAS 19 differs from SFAS 158 in that these gains or losses remain
in other comprehensive income, rather than being amortized into net income.

At present, the IASB is reconsidering IAS 19. In 2010, it issued an exposure draft (which is not examinable)
that proposes requiring the reporting of the full PBO liability (that is, including pension gains and losses) in the
financial statements proper. If so, this would represent a substantial move toward the measurement approach.
However, it is not known at the present time what the final standard will be.
Course Schedule Course Modules Review and Practice Exam Preparation

5.5 Financial instruments

Required reading

Chapter 7, Section 7.3, pages 235-248 (Level1)

IAS 39 (Level 2)
IFRS 7 (Level2)
Reading 5-2, "Controlling Financial Risk Exposure Part I" (Level3)
Reading 5-3, "Controlling Financial Risk Exposure Part II" (Level3)

Read Section 7.3 in the text before proceeding with this topic. Complete the remaining readings when
instructed to do so.

LEVEL 1

The text discussion of financial instruments is primarily oriented to IAS 39. This will be the main focus of our
discussion here. Our discussion of FASB financial instrument standards will be brief. However, since FASB
standards were the first in this area, some attention will be given, particularly where they differ from IASB.

Financial assets and liabilities are defined on pages 235-236 of the text. Notice that the definitions are rather
broad, including items such as accounts receivable and payable that at first glance might not be considered
financial items. Also included are derivative instruments. These broad definitions mean that, in practice,
accounting standards relating to financial instruments are quite wide-ranging.

IAS 39

Be sure you are familiar with the four IAS 39 categories of non-derivative financial assets and two of financial
liabilities described in the text, pages 236-237. Here are the significant points to note:

Important categories of financial instruments are fair valued, including available-for-sale financial
assets and held-for-trading financial assets and liabilities.

Unrealized gains and losses on available-for-sale financial assets are included in other
comprehensive income. Unrealized gains and losses on financial assets and liabilities held for
trading are included in net income.

Some financial instruments are valued at amortized cost, including loans and accounts receivable,
held-to-maturity financial assets and other financial liabilities.

Financial assets valued on this basis are subject to an impairment test, such as the lower-of-cost-
to-market and ceiling tests applied to inventories, other investments, and property, plant and
equipment described in Topic5.4. As is the case for these latter assets, written-down financial
instruments can be written back up again under IAS39 if fair value subsequently improves.

Note that a writedown is not required if market value (that is, fair value) falls below book value
(forexample, this could result from a rise in interest rates). That is, valuing the asset at its value-
in-use suggests that temporary declines in market value can be ignored providing the future
receipts from the asset do not fall significantly.

If the term valuing liabilities at cost seems strange to you, think in reverse about buying an
asset. The cost of an asset is typically the amount paid for it. The cost of a liability is typically the
amount received. For example, if a firm issues a $100 bond at par, the cost of this liability is
$100. If market value of this bond falls to, say, $90, this is its fair value but its cost remains at
$100.
 Fair valuing financial assets constrains gains trading. Gains trading is described on text page
237. Recall that the discussion at the end of Topic 5.2 mentioned the savings and loan debacle,
where by retaining assets at historical cost, savings and loan associations were able to hide their
increasing financial distress as these assets declined in value. Gains trading was a misuse of
historical cost accounting to hide deteriorating profitability. By selling assets that had appreciated
in value, realized gains were generated to increase the firms net income. But assets that had
deteriorated in value were retained on the books at cost on the grounds that they were intended
to be held to maturity. This strategy was effective in increasing reported net income, but made
little business sense, since it amounted to selling the winners and holding the losers. One of the
main purposes of new standards requiring fair valuing of financial assets was to eliminate gains
trading. On page 237, the text explains how fair value accounting for all financial assets does
this.

However, since all financial assets are not fair valued, IAS 39 has the potential to make gains
trading easier, not more difficult. To trigger a gain in net income, simply transfer securities from
available-for-sale to held-for-trading no actual sale of assets is needed! However, IAS 39
contains provisions to discourage this practice. Sale or reclassification of more than an
insignificant amount of held-to-maturity securities triggers a prohibition of using the held-to-
maturity category for two years, in which case all present held-to-maturity securities would have
to be transferred to another category.

Note: In October 2008, the IASB relaxed their restrictions on transfers somewhat. These are described in the
The 2007-2008 Market Meltdowns section later in this topic.

Reliability

Given the move toward increased measurement in general, and standard setters concerns about gains trading
in particular, you may wonder, and rightly so, why all financial assets and liabilities are not fair valued. There
are two main reasons. The first is reliability. As the text notes on page 238, some equity financial
instruments, such as shares that are not traded, are difficult to value reliably. Another example on the same
page is demand deposits received by a financial institution. Fair value of these financial liabilities requires also
valuing core deposit intangibles that accompany deposits that pay lower than market rates of interest.
However, it is difficult to value core deposit intangibles reliably. Thus, IAS 39 allows equity financial assets to
be valued at cost if fair value is not available, and prohibits fair valuing of deposit liabilities.

Earnings volatility

The second reason, equally important, is earnings volatility. Recall first that fair valuing financial assets and
liabilities generates unrealized gains and losses. Note also that fair values tend to be volatile, since market
values constantly change, sometimes by large amounts. If these gains and losses are included in net income,
the gains and losses will tend to cancel out. However, since all financial assets and liabilities are not fair valued,
it can happen that certain financial assets are fair valued while certain financial liabilities are retained at cost
(or vice versa). Also, unrealized gains and losses on available-for-sale financial assets go into other
comprehensive income. Then, net income gains and losses do not offset. This creates excess net income
volatility (also called mismatch), that is, volatility greater than the real volatility of the firm, where real
volatility is the volatility of the firms real operations, which depends on the net fair value of all of its assets
and liabilities. To illustrate, consider the text example on page 238. The firm in that example accounts for long-
term debt at cost (more generally, this would be at amortized cost, if the debt was originally issued at a
discount or premium). It holds fixed interest-bearing securities of similar amount and maturity. If interest rates
fall, the fair value of debt rises and the fair value of interest-bearing securities also rises. Thus the two
changes offset in their effect on real firm value. However, if the interest-bearing securities are fair valued, with
the unrealized gain included in net income, and the debt is valued at cost, the volatility of reported net income
exceeds the real volatility of the firms operations.

There are several ways to control this excess volatility:

Value the interest-bearing securities at cost. IAS 39 allows for this by means of the held-to-
maturity category, under which financial assets with a fixed term to maturity can be valued at
cost, providing the firm intends to hold them to maturity. This could well be the case in our
 example, since the firm may have acquired interest-bearing securities that mature at the same
time as its long-term debt, so as to have funds to repay the debt when it comes due. If so, the
firm has created a natural hedge. In addition to facilitating debt repayment, changes in fair
value offset during the term to maturity.

Note, however, that assets in the held-to-maturity category are subject to an impairment test.
Thus, if the discounted present value of future receipts of the fixed-term securities falls below
book value, they should be written down, with the loss included in net income. Consequently, this
strategy to reduce excess volatility works best on the upside.

Alternatively, if the firm did not intend to hold the interest-bearing securities until maturity, it may
classify them as available-for-sale. Then, unrealized gains and losses are included in other
comprehensive income. This excludes the gains and losses from net income as long as they
remain unrealized.

Use the fair value option to value the long-term debt at fair value. The resulting unrealized loss
will offset the unrealized gain from fair valuing the interest bearing securities. This reduces the
mismatch. Under IAS 39, the fair value option is generally limited to reducing a mismatch. The
fair value option can be implemented simply by reclassifying a financial asset into the held for
trading category or by reclassifying a financial liability into the at fair value through profit and
loss category.

Related U.S. standards

SFAS 115, a U.S. standard governing accounting for financial instruments, is described briefly on text page237
and following pages. As the text points out, it is basically similar to international standards in this area, except
that it applies only to financial assets. Issued in 1993, SFAS 115 was the pioneering standard for fair valuing
financial assets. Since the measurement approach was not as far advanced in 1993 as it is today, and in view
of the difficulties of fair valuing certain financial liabilities such as deposit liabilities, the U.S. standard setters
opted to exclude all financial liabilities from the standard.

For our purposes, SFAS 157, issued in 2006, is of greater current relevance to the measurement approach,
since it lays down a market value approach to determining fair value. This standard is mentioned briefly on
text, page229, and in Topic 5.1, where we pointed out that U.S. and international definitions of fair value are
quite similar. The significance of SFAS 157 is its detailed delineation of what to do when no market value is
available. Because of market incompleteness (Topic 1.3), market prices do not exist for all assets and liabilities.

When no market value is available, fair value accounting runs into significant difficulties. In the face of these
difficulties, SFAS 157 creates a fair value hierarchy, consisting of three levels:

Level 1
Assets and liabilities for which a reasonably well-working market price exists (for the concept of a
market that works well, see text, page 117).

Level 2
Assets and liabilities for which a market price can be inferred from the market prices of similar
items.

Level 3
Assets and liabilities for which a market value cannot be observed or inferred. Then, the firm shall
use its own assumptions about how a prospective purchaser of the asset or liability would value
the item.

IFRS 7 (paragraph 27A) adopts a similar hierarchy.

Under U.S. GAAP, the fair value option is laid down by SFAS 159 (see text, page 239). Unlike IAS 39, the
option is not confined to reducing a mismatch. On this point, see the Theory in Practice vignette on text page
243. It would have been interesting to see the effect on Blackstone Groups share price had it proceeded with
its original intentions to apply the fair value option.

Finally, it should be pointed out that IAS 39 and IFRS 7 (paragraph 27B) require extensive supplementary
disclosures to assist investors to evaluate the terms and risks of firms financial instruments. These
requirements are outlined later in this topic.

The 2007-2008 market meltdowns

Following the 2007-2008 market meltdowns, many firms reported huge fair value writedowns. Since markets
had collapsed, most of these were based on Level 3 valuation. Indeed, you have probably seen such
writedowns reported in media articles, which frequently referred to writedowns of toxic assets, that is,
impaired assets for which no market value was available. These writedowns led to serious criticisms of fair
value accounting. At this point, reread the Topic 1.2 discussion of criticisms of fair value accounting.

In response to these criticisms, standard setters introduced two modifications in 2008:

The IASB and the FASB issued similar guidance on how to determine fair value when markets are
inactive. The guidance is that when market values do not exist and cannot be reliably inferred
from values of similar items, firms can determine fair value by using their own assumptions of
future cash flows from the assets/liabilities, discounted at a risk-adjusted interest rate (that is,
value-in-use). Notice the subtle difference from the wording of Level 3 in the fair value hierarchy.
Instead of using assumptions about how a prospective purchaser would value a financial item,
firms can use their own assumptions about future cash flows from the item. That is, value-in-use
is allowed as a valuation technique when no market value is available or cannot be inferred from
sales of similar assets. Presumably, the intent of this modification is to reduce criticisms that such
writedowns are excessive due to lack of liquidity in the market, since many firms feel that if they
hold on to their financial assets they will eventually realize more than the value currently placed
on them by prospective purchasers. Of course, this relaxation reduces reliability, since it is
possible that managers may bias their value-in-use estimates for their own purposes. However,
the standard setters require extensive supplementary disclosure of how the estimated fair value is
determined.

The IASB revised their financial instruments measurement standards (that is, IAS 39) to allow
reclassification of certain financial assets. The intent is to make these standards more consistent
with SFAS 115, which allows reclassification out of the at fair value through profit and loss"
category (text, page 136) in rare circumstances. The market meltdowns of 2007-2008 were
such a circumstance.

Specifically, the revisions allow firms that hold non-derivative financial assets at fair value through
the profit and loss category (unless those assets had been classified into this category at original
recognition) to transfer them out of that category. The transfer can be to held-to-maturity if the
transferred assets have a fixed maturity date, in which case they are valued at amortized cost
(equal to fair value at date of transfer). Assets reclassified into held-to-maturity are still subject
to an impairment test, however. Alternatively, the transfer can be to available-for-sale, in which
case they are valued at fair value at date of transfer with subsequent unrealized gains and losses
included in other comprehensive income. A third alternative is to transfer loans and receivables
included in at fair value through profit or loss or available-for-sale categories into loans and
receivables. Here, they can be valued at cost, even though fair value is lower, as long as
expected future cash flows from the transferred assets are greater than cost.

Deutsche Bank, for example, was quick to take advantage of these revisions, in particular, the
third alternative just outlined. In its quarterly report for the period ending September 30, 2008, it
reported that it had reclassified 12.824 billion of loans and receivables from at fair value through
profit and loss, and 12.159 billion from available-for-sale, to loans and receivables category. At
September 30, 2008, these assets were valued in the quarterly financial statements on a cost
basis at 24.901 billion, whereas their fair value at this date was only 23.386 billion. However,
Deutsche Bank estimated the future cash flows from these assets at 26 billion. Since this was
greater than book value, no writedown was required under IAS 39 (see text, page 236). This
saving of a 1.515 billion writedown enabled Deutsche Bank to report a net income for the
 quarter of 414 million. Upon release of this news, the companys share price increased by
almost 18% on the Frankfurt exchange.

Subsequent to these stopgap measures, the FASB began a project to revise and simplify IAS 39. IFRS 9,
effective January 1, 2013, is the first outcome of this project. Under this standard, which amends some of the
provisions of IAS 39, all financial assets are to be recorded on a fair value basis at acquisition. Subsequent
valuation is also at fair value unless the objective of the firms business model is to hold the asset in order to
collect interest and principal. Then, the asset can be valued on an amortized cost basis, subject to the ceiling
test provisions of IAS 39. This reduces the four financial asset categories in IAS 39 to two.

The fair value option of IAS 39 continues at acquisition, the firm can designate financial assets into the fair
value category if this reduces a mismatch. Also, the impairment test provisions of IAS 39, under which a
writedown is required if fair value falls below book value, are continued. Gains and losses on financial assets
are generally included in net income.

Assets may be sold prior to maturity unless sales are so frequent as to question the business model assumption
of holding to collect interest and principal. Thus, the business model concept broadens the set of financial
instruments that can be accounted for on a cost basis and relaxes the IAS 39 rule (text, page 237) that the
held-to-maturity category cannot be used for two years if there are substantial sales of assets from this
category prior to maturity.

In effect, IFRS 9 backs off somewhat from fair value accounting for financial instruments in favour of amortized
cost. It should be noted that FASB standards do not specifically use the business model concept, and thus may
require fair value accounting for financial instruments to a greater extent than the IASB.

Note that since IFRS 9 is not effective until 2013, knowledge of IAS 39 is still needed.

Derivative instruments

SFAS 133

Sections 7.3.4 and 7.3.5 of the text describe another important component of financial instrument accounting,
the accounting for derivatives. IAS 39 and SFAS 133 use a similar approach to derivatives. These are the main
points to note about accounting for derivatives:

Derivative financial assets and liabilities are valued at fair value.

Reasons why firms acquire or issue financial instruments include hedging and speculation.

There are two basic types of hedges:

Fair value hedges. These are hedges of some asset owned by the firm. If the
hedge is outstanding at year-end, it is valued at fair value. To reduce excess net
income volatility, the hedged item is also fair valued. See text, pages 244-245 for
further discussion.

Cash flow hedges. These are hedges of price risk of the firms products. Their
purpose is to lock in a price for product not yet produced. Cash flow hedges are
valued at fair value at period-end. To reduce excess net income volatility,
unrealized gains and losses on cash flow hedges are included in other
comprehensive income. Next period, as the hedged product is produced and sold,
the unrealized hedging gains or losses are transferred from other comprehensive
income to net income, where they offset decreases or increases in product selling
prices. As a result, the firm receives net proceeds for its hedged product equal to
the price it locked in when the cash flow hedge was acquired.

Hedges must qualify if they are to receive the benefits of hedge accounting. (For a fair value
hedge, the benefit is to be able to fair value the hedged item. For a cash value hedge, the
benefit is to include unrealized gains and losses on the hedging instruments in other
 comprehensive income rather than net income). If the hedge does not qualify, unrealized hedging
gains and losses are included in net income, where they increase net income volatility. To qualify,
hedges must be designated as such by management and must be highly effective. See text,
pages 245-250 for further discussion. For an illustration of what can happen when a hedge does
not qualify, see the El Paso Corporation vignette on text page 246.

If derivatives are not held as hedges (that is, they may be speculative), they are classified into
the at fair value through profit and loss category. Like other financial instruments in this
category, they are valued at fair value, with unrealized gains and losses included in net income.

Differences between SFAS 133 and IAS 39

Two differences of IAS 39 from SFAS 133 are worthy of note. First, under IAS 39, hedging instruments (also
called hedging items) may include non-derivative financial assets and liabilities when designated as a hedge of
a foreign currency risk exposure (paragraph 72). Under SFAS 133, only derivatives can be designated as
hedges. For example, a Canadian financial firm may use securities (that is, non-derivative financial assets) to
hedge the risk of changing foreign exchange rates on liabilities payable in that foreign currency. The reason for
allowing this more generous treatment, according to the AcSB, is that when derivative markets are less liquid
than those in the United States, it could be quite costly for firms to hedge such risks using derivatives. To the
extent that higher hedging costs reduce the extent of hedging, reported net income without this provision
would be more volatile for Canadian and foreign firms than for similar U.S. firms.

Both standards require that to be eligible for hedge accounting, hedges must be "highly effective." SFAS 133
does not lay down rules to determine effectiveness. The second difference, however, is that IAS 39 specifically
mentions that effectiveness can be demonstrated (Appendix A, paragraph AG105), consistent with the texts
discussion on pages 245-246.

To understand how derivative instruments work to reduce risk, read the two articles, "Controlling Financial Risk
Exposure" parts I and II, by Marc-Andr Lapointe, reproduced in Readings 5-2 and 5-3. Both articles are an
excellent source of information for several basic types of derivatives.

Supplemental disclosures of financial instruments

Notice the discussion on text pages 247-248 of the Gigler, Kanodia, and Venegopulan (2007) model, which
demonstrates conditions under which historical cost accounting can be superior to fair value in alerting
investors that the firm has used derivatives to speculate rather than to control risk. While the model is technical
and, as the text points out, no model can capture all the complexity of the firms operations and environment,
the message of the model is clear. The message is not necessarily to abandon fair value accounting for
derivatives, but to give sufficient disclosure to enable investors to determine if the firm has suffered speculation
losses.

Accounting standards require considerable supplementary disclosure about financial instruments, including
derivatives. The text refers briefly to these standards (page 248). For, example, IFRS 7 contains many of these
disclosure requirements.

IFRS 7

The purpose of this standard is to enhance users understanding of the significance of financial instruments to
the firms financial position and performance. Paragraphs 1 to 6 of IFRS 7 provide general overviews of the
purpose and scope of the standard. Appendix B of the standard has some helpful definitions.

Paragraph 20 includes requirements for disclosure of gains and losses, including impairment losses, on the
various classes of financial instruments laid down in IAS 39. The fair values of each class must also be
disclosed. Paragraph 21 requires disclosure of the measurement bases used (for example, fair value). As
mentioned above, paragraph 27A lays down a fair value hierarchy similar to that of SFAS 157. Paragraph 27B
requires extensive supplementary disclosures about valuations under the hierarchy and transfers between
Levels, particularly for Level 3.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.6 Accounting for intangibles

Required reading

Chapter 7, Section 7.4, pages 248-255 (Level 1)

LEVEL 1

Goodwill exists if a firm can earn higher than a normal or expected rate of return (where expected rate of
return is determined, for example, by the CAPM) on its invested capital. The text points out many reasons for
the existence of goodwill, such as patents, location, and workforce. However, if these various intangible assets
are to have value, they must earn more than a normal rate of return. Collectively, we refer to their value as
goodwill.

There are two types of goodwill purchased and self-developed. Purchased goodwill arises from business
combinations when one firm purchases another. Usually, the acquiring firm pays more than the fair value of the
net tangible and identifiable intangible assets acquired. To be willing to do this, the rational firm must envisage
higher than normal earnings when the two firms combine their operations. That is, the acquiring firm is buying
abnormal earnings or, equivalently, goodwill.

Under traditional historical cost accounting, this purchased goodwill was capitalized and amortized over its
useful life, consistent with the treatment of other capital assets. However, IFRS 3 and SFAS 142 moved the
accounting for purchased goodwill toward the measurement approach. Specifically, under these standards,
goodwill need not be amortized, but remains on the balance sheet at its original value unless its estimated fair
value falls below this amount. Then, it must be written down. You will recognize this as a ceiling test applied to
goodwill. Note that if the fair value of written-down goodwill subsequently increases, it may not be written up
again under IAS 36.

With respect to self-developed goodwill, it is even more difficult to move in a measurement direction. No
standards exist at present to require fair value accounting for self-developed goodwill. Nevertheless, it is
interesting to consider the argument of Lev & Zarowin (1999) outlined on pages 253-254 of the text. The main
reason for the low and declining ability of net income to explain share returns (discussed in Topic 5.2) they
claim, is that writing off the costs of R&D as required by current GAAP creates a mismatch between the costs
of self-developed goodwill and the subsequent benefits. As Lev & Zarowin point out, the efficient market will
look through these costs and put its own valuation on them. If, as a result of looking through these costs, the
market reacts favourably to costs that reduce reported net income, the association between net income and
share returns (that is, R 2 ) is low.

To increase this low "market share" for net income in explaining share returns, accountants may wish to move
accounting for self-developed intangibles more toward the measurement approach. Lev and Zarowin propose
capitalizing the costs of R&D (a major intangible) if a feasibility test indicates that the R&D will be successful,
but this suggestion has not been adopted by standard setters. IAS 38 (not examinable), however, goes part
way towards Lev and Zarowins proposal since, under this standard, development costs can be capitalized.
Alternatively, the clean surplus valuation procedure for Canadian Tire Corp. outlined in Topic 5.3 and pages
204-207 of the text may provide a way to fair value goodwill. While this approach has obvious problems of
reliability, if the estimates are made by management, there is the potential to reveal management's
expectations regarding its future profitability. Furthermore, the model of Kanodia, Singh, and Spiro (2005)
suggests that concerns about reliability may be overstated. While their model is technical, the basic argument is
that if financial statement valuation of intangibles, such as R&D, is highly reliable, investors will overreact to
the firms intangibles investments. Hence management overinvests in intangibles, at least in the short run, to
capitalize on the favourable share price that results. Reduced reliability of intangibles valuation serves to
dampen the excessive market reaction.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.7 Reporting on risk

Required reading

Chapter 7, Section 7.5, pages 255-263 (Level 1)

LEVEL 1

When reporting on firm risk, remember that the theories of rational decision and efficient securities markets
imply that the only relevant firm risk measure is beta. Firm-specific risks are diversified away by the rational,
risk-averse investor. Since standard-setting bodies have implicitly accepted the theory of the investment
decision (see Topic 2.7), you may wonder why reporting on firm risk is an important component of financial
reporting, and one that involves the measurement approach. However, there are several such reasons.

Reasons for managing and reporting on risk

Given that investors can manage firm-specific risk by diversification, the question arises why firms also control
risk. Whatever the risk of the firm is, can investors not eliminate it by following the portfolio decision theory
described in Topics 2.4-2.6? While the answer to this question is yes, there are nevertheless reasons to
manage risk. The text gives several of these in Section 7.5.2. From managements perspective, perhaps the
most important reason is to ensure that sufficient cash is on hand to meet planned expenditures. It could be
quite costly to the firm if some unfortunate state realization, such as a sudden decline in the price of the firms
products, required capital projects to be delayed, or led to a need to raise expensive outside capital. A hedging
strategy helps prevent such costs, and also reduces the likelihood of a major fall in reported earnings, leading
to a fall in share price and the lawsuits that frequently follow such events. As the text points out (page 258),
investors can be diversified ex ante, but will still be upset ex post if a particular firm suffers financial distress.

From an investor perspective, reducing estimation risk by reporting on risk management strategies, and
enabling the detection of speculation, are important reasons why even diversified investors would support risk
management and reporting.

Ways to report on risk

There are many ways to report on risk. Interestingly, financial statements contain information to help assess
beta risk since various financial ratios are correlated with beta. The study of Beaver, Kettler, and Scholes
described on pages 256-257 is a classic in this area. Reporting of information to help estimate a stocks beta is
particularly important, because beta can change over time (see Topic 5.2). Financial statement information
may provide "early warning" of beta change. Otherwise, it would be necessary to wait for enough data on
security returns to re-estimate the market model, which is the usual approach to beta estimation. These
considerations suggest that full disclosure of liabilities, and separation of fixed and variable costs, are decision
useful to investors concerned with beta risk (see Section 7.5.1 in the text).

Other ways to report on risk include sensitivity analysis, illustrated and discussed on text pages 260-261,
and value at risk (pages 261-262). These techniques are consistent with the measurement approach.

Notice also that the market prices of firms shares, especially those of financial firms, respond to firm risk as we
would expect. For example, Hodder, Hopkins, and Whalen (2006) report that the overall volatility of income (a
measure of firm risk) is negatively related to share price (text, page 259). If diversified investors did not care
about firm specific risk, you would not see share price responding to this risk.

Canadian risk reporting requirements

Our discussion of MD&A in Topic 3.7 shows that MD&A is an important vehicle for reporting on risk, applying to
public companies across Canada. Indeed, MD&A reporting requirements now extend to quarterly reports,
review by the audit committee, and approval by the board of directors.
In addition, many Canadian firms provide measurement approach-oriented risk reports as part of MD&A, such
as the sensitivity analysis of Suncor Energy Inc. illustrated on text page 261.

With respect to financial instruments, paragraphs 31 to 42 of IFRS 7 require considerably expanded risk
information, including information about different types of risk, including credit risk. Note in particular that
quantitative risk disclosure is now required (paragraphs 34 and 35), consistent with a measurement approach.
Also of note is that this disclosure shall be based on the risk information provided internally to management.
Since management presumably has the best risk information and has the responsibility to control firm risk, this
requirement promises to be decision useful to investors since it helps them to evaluate risk through the eyes of
management. Note also that a sensitivity analysis is required. The text, Section 7.5.4, discusses and illustrates
sensitivity analysis and value at risk as separate quantitative risk disclosure techniques. Paragraph 41 of IFRS 7
views them as both sensitivity analyses. Nevertheless, either technique can be used, so the text discussion
continues to apply.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

5.8 Conclusion

Required reading

Chapter 6, Section 6.8, pages 216-217

Chapter 7, Section 7.6, pages 263

This module has shown that financial reporting practice is moving substantially in the direction of the
measurement approach. Despite the severe criticism of fair value accounting following the market meltdowns
of 2007-2008 (see Topic 1.2), it appears that the modifications allowed by standard setters described in Topic
5.5 will be sufficient to ensure that fair value accounting will survive.

The module completes a major segment of the course. You have studied the adverse selection problem and
how financial accounting information can control this problem by conveying useful information to investors.
However, management also has an interest in financial reporting standards, despite the implication of efficient
securities market theory that as long as policies used are fully disclosed, management should be indifferent to
them. Indeed, any accountant with experience in preparing or auditing financial statements will be aware of
managements interest.

In the next module, you will begin to study why management is fundamentally concerned about accounting
policy choice. As you will see, the answer lies in the moral hazard problem.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 5 summary
Measurement approach to decision usefulness
This module defines and illustrates the measurement approach on 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
and U.S. financial accounting standards. These include standards dealing with accounting for financial
instruments, such as derivative instruments, and in 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.

Explain why financial reporting is moving in a measurement direction.

Historical cost based earnings have a 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 questions efficient securities markets.
Auditor liability.
The development of clean surplus theory provides a theoretical framework that supports the
measurement approach.

Understand theory and evidence suggesting that securities markets may not
be fully efficient.

Efficient securities market theory has been questioned in recent years, for several reasons:
increasing attention to alternative theories of investor behaviour, such as prospect
theory
evidence of excess stock market volatility and bubbles
evidence of anomalies, that is, share price reactions to accounting information that
do not match those predicted by the efficient markets theory

Conclusions on securities market efficiency

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

Explain Ohlsons clean surplus theory and its role in firm evaluation.

Ohlsons clean surplus theory shows how market value of a firm can be determined from balance
sheet 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 balance sheet, expected earnings are calculated as shareholders equity multiplied by
the firms cost of capital.
Then, to determine the value of the firm, add the calculated goodwill to the book
value.
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 empirical
studies suggest 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 lower-of-cost-or-market rule.
Other measurement-oriented standards include
ceiling tests for property, plant and equipment (partial application)
pensions and other post-retirement benefits (present-value-based approaches)

Auditor legal liability encourages conservative accounting.

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.

Evaluate the important concepts of financial instruments.

There are two types of financial instruments:

primary including accounts and notes receivable, investments in debt and equity
securities
derivative contracts, the value of which depends on some underlying price,
interest rate, foreign exchange rate, or other variables; examples are options and
swaps

Detail the important concepts of accounting for financial instruments.

Under IAS 39 and IFRS 9 (which has amended several provisions of IAS 39), financial instruments are now
either accounted for at amortized cost or fair value. The business model of the entity carrying the financial
instruments is an important determinant of the choice of accounting policy. Moreover, re-classification of
financial instruments has been made more difficult than before.

To help control the volatility of unrealized gains and losses, SFAS 130 created the concept of
other comprehensive income. Similar international standards are now in place. These are the
important aspects of other comprehensive income:
Unrealized gains and losses from the fair-valuing of available-for-sale securities are
included in other comprehensive income.
Other comprehensive income also includes unrealized gains and losses on fair-
valuing of derivatives designated as hedges of anticipated future transactions.
Comprehensive income is the sum of net income and other comprehensive income.
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.

Accounting for intangibles

Goodwill is an important intangible asset for many firms.

There are two types of goodwill:
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
managements emphasis on pro-forma income.
Self-developed
This often arises from successful R&D.
Self-developed goodwill usually not recorded on the firms 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:

Price risk risk arising from changes in interest rates, commodity prices, and
foreign exchange rates
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:
Risk reporting reduces investors estimation risk. This risk is not included in the
CAPM.
Firms may wish to ensure availability of cash for future investment projects.
Risk reporting helps to control, or at least to inform investors about, possible
speculation by management.
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 by the SEC in the United States have moved risk reporting
in a measurement direction. These requirements include
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
sensitivity analysis the impact on earnings, cash flows, or fair values of various
price risk
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 6: Economic consequences

Overview

Read the Chapter Overview, Section 8.1, on pages 273-275.

In this module, you start to study managements interest in financial reporting. Efficient securities market
theory implies that managers need not be concerned with financial reporting as long as the market knows
which particular policies the firm is using. Yet management is concerned about the choice of accounting policies
used by the firm. Managements concerns may therefore seem to be another efficient securities market
anomaly at first glance. Yet this is not the case managements concerns can be supported by theory and in a
manner that is consistent with efficient securities markets.

To demonstrate why, the text proceeds in three stages. Sections 8.1 to 8.4 of Chapter 8 show that economic
consequences exist. That is, accounting policies matter to major constituencies of financial accounting such as
management and investors.

Chapter 8 then explains why this is the case by describing positive accounting theory (Section 8.5). This body
of accounting theory and research predicts that accounting policies matter to managers. (If they matter to
managers, they will also matter to investors.) Accounting policies matter because they affect compensation
contracts, debt covenants, and political reaction to excessive corporate profits. Compensation contracts and
debt covenants typically depend on financial statement variables, and accounting policy choice may reduce the
appearance of excessive profits.

Finally, Chapter 9 (Module 7) will show you why compensation contracts, debt covenants, and political reaction
depend on financial statement variables.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

6.1 Rise of economic consequences

6.2 Employee stock options
6.3 Efficient securities market theory and economic consequences
6.4 Positive theory of accounting
6.5 Opportunistic and efficient contracting form of positive accounting theory
6.6 Conclusion

Learning objectives

Explain the concept of economic consequences. (Level 2)

Apply the concept of economic consequences to accounting for employee stock options. (Level1)
Describe the concept of positive accounting theory and its predictions about manager reaction to
compensation contracts, debt covenants, and political pressures. (Level1)
Compare the opportunistic and efficient contracting versions of positive accounting theory.
(Level2)
Explainhow positive accounting theory contributes to economic consequences. (Level1)

Module summary

Reading 6-1

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.1 Rise of economic consequences

Required reading

Chapter 8, Section 8.2, pages 275-276 (Level 2)

LEVEL 2

This topic introduces the concept of economic consequences by describing a well-known article written by
Stephen Zeff in 1970. Zeff clearly points out how management does not hesitate to attack accounting standards
that are not favourable to them, by "intervening" in the standard-setting process. Zeff mentions nine instances
dating as far back as 1941 and up to 1970. These related to a variety of subjects of real concern to
management. All of these issues had economic consequences as far as management was concerned even
though the standard-setting bodies were endeavouring to improve reporting for investors. As a result, standard
setters cannot simply impose standards that benefit investors they must also take managers views into
account. The main point of this topic is that managements interests frequently conflict with those of investors.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.2 Employee stock options

Required reading

Chapter 8, Section 8.3, pages 277-283 (Level 1)

Reading 6-1, "Options to Expense" (Level 2)

Read Section 8.3 in the text before proceeding with this topic. Complete Reading 6-1 when instructed to do so.

LEVEL 1

For our purposes, an employee stock option is a contract (more specifically, a financial instrument) that gives
the employee the right to buy an underlying company share at a stated price during some specified period of
time. Many firms grant stock options to senior executives and, in some cases, to other key employees. We will
call these ESOs. The basic reason for granting ESOs is not hard to see. Employees, including senior executives,
who hold stock options have an interest in seeing the underlying company share price increase since the price
they pay under the option contract is given. Consequently, they have an incentive to "work hard," which
benefits the firm and its shareholders.

Of course, there are other ways to compensate employees, including salary, cash bonus, and the awarding of
company shares. The theory that explains why ESOs are, or at least have been until recently, such a popular
compensation device will be developed in Module8. Here, our interest is in how to account for ESOs.

First, we need to consider the sequence of dates relevant to ESOs and some related terminology:

The grant date. The date on which the option is granted to the employee. On this date, the
exercise price of the option is set. The intrinsic value of the option is the difference between
the exercise price and the market value of the underlying share. For example, if an employee can
exercise an option (that is, use the option to acquire the share) for $10, to acquire the underlying
share with a market value of $30 on the grant date, the intrinsic value of the option on this date
is $20.

To fully understand current accounting standards for ESOs, it is necessary to understand APB 25
of the APB (a predecessor body to the FASB in the United States), which, until recently, governed
the accounting for ESOs in the United States. Under this standard, ESO expense was set equal to
intrinsic value on the grant date. In the previous-paragraph example, the firm would have to
record compensation expense of $20 per ESO. In practice, to avoid having to record an expense,
most firms set the exercise price equal to the underlying share's market value on the grant date,
that is, $30 in the example above. Then, the intrinsic value is zero and no expense need be
recognized. There is still an incentive to work hard since the employee will benefit to the extent
the market value of the share increases above $30 following the grant date.

Note, however, that even though the intrinsic value is zero, the ESO has a fair value on the
grant date. This is because, as just mentioned, the underlying share may rise in value after the
ESO is granted. For example, if market value rises to $40 and the exercise price is $30, the
holder of the ESO is better off by $10. ESO fair value anticipates the possibility of share price
increases such as this.

The vesting date. The date on which the employee can first exercise the option. To increase
the motivation for employees to work hard, ESOs are usually not exercisable until some time after
the grant date. As the text mentions, vesting dates are usually one or two years following the
grant date. While not mentioned in the text, some vesting dates are much earlier say one
month following the grant. Nevertheless, the employee may not want to exercise the option on
the vesting date and may continue to hold it.
 The expiry date. The date that the option contract expires. If not exercised by this date, the
option becomes worthless.

The controversy over accounting for ESOs had its roots in the APB 25 intrinsic value approach. As mentioned,
most firms issued ESOs so that the intrinsic value was zero. It thus appeared that compensation by means of
ESOs is "free." Indeed, the firm pays out no cash and, in our example above, receives $10 upon exercise.

However, ESOs are not free. To explain why, note the example on page 278 of the text. By selling a share to
an employee for $10, the firm foregoes the opportunity to sell it to an investor for $30. The resulting
opportunity cost of $20 represents the dilution of the shareholders' equity. To see this, assume for simplicity
that the firm has one share outstanding, held by an outside investor, with a current market value of $30,
which is thus also the market value of the firm. Assume that two years ago the firm granted an ESO to its CEO
with an exercise price of $10, equal to the firm's share price at that time. Thus, the option now has an intrinsic
value of $20, being the increase in share price since the ESO was granted. Suppose that the CEO exercises the
option, paying $10. The market value of the firm is now $40, divided between two shares with a market value
of $20 each. Thus, each share has lost $10, being the reduction in market value from $30 to $20. In effect,
the value of the option at exercise ($20) equals the opportunity cost.

This example assumes that the market did not anticipate the share price decline to $20. If it did, the market
value of the share outstanding prior to the option exercise would be less than $30. While this is unlikely in our
example, large firms will typically have millions of shares outstanding. Then, the dilution will still be present,
but its amount per share will be negligible.

The above is an ex post scenario it has turned out that the option is worth $20 at the exercise date. Other
outcomes are possible. For example, if the underlying share price had declined to $8 by the expiry date, the
option value would be zero. To account for ESOs at the grant date, we need the fair value of the option at that
time . If we make some simplifying assumptions, the fair value of an ESO at the grant date is the expected
value of the value of the option at the exercise date (see pages 241-242 and Figure 7.2 in the text for an
example based on simplifying assumptions) or, equivalently, the expected opportunity cost. Under less
unrealistic assumptions, the Black/Scholes option pricing formula can be used to provide a fair value (see
page 242 in the text).

The question then is, consistent with the measurement approach, why not recognize an expense when an ESO
is granted, equal to its fair value? Recording zero expense, as allowed by APB 25, it was argued, understates
compensation expense and overstates net income. As just demonstrated, there is a dilution cost for ESOs.
Failure to recognize this cost constituted a serious defect in financial reporting or, at the very least, a clinging
to an outdated information approach.

However, the text describes the economic consequences that were threatened when the FASB attempted in
1993 to require ESO expense equal to fair value based on Black/Scholes. These claimed consequences even
went so far as to threaten the competitive position of U.S. industry! The furore that arose is all the more
impressive when we consider efficient securities market theory, which predicts, given full disclosure of the
details of ESOs, that share price should not be affected by expensing them since the act of expensing does not
affect cash flows.

Objections to the 1993 exposure draft were strengthened by concerns about reliability. Specifically, the
Black/Scholes formula may bias ESO expense upwards. This is because the Black/Scholes formula is designed
to value options that can be freely traded by the holder. Options issued as ESOs have restrictions on trading,
which reduce their fair value, especially if the holder is risk averse. Also, ESOs may be exercised prior to their
expiry date, while Black/Scholes assumes they will be exercised only at expiry. The text describes the research
of Huddart (1994), who showed that early exercise could also reduce the ESO expense relative to
Black/Scholes.

To get around concerns that Black/Scholes may bias ESO expense upwards, the 1993 exposure draft proposed
to use expected time to exercise rather than time to expiration when applying the Black/Scholes formula.
However, the text (page 280) refers to research suggesting that this can still result in overstating ESO fair
value.

The FASB was forced to withdraw its exposure draft. Instead, it settled for SFAS 123, which encouraged firms
to recognize ESO cost in the financial statements proper using the fair value method, but allowed the APB 25
intrinsic value method providing the firm gave supplementary disclosure of ESO fair value expense in the notes
to the financial statements (which goes back to the information perspective).

Almost all firms chose the supplementary disclosure option, reinforcing the point that they must have perceived
economic consequences if they recorded ESO expense in their income statements.

With the downturn in economic activity in the first few years of the twenty-first century, many accounting and
auditing "horror stories," such as Enron and WorldCom, have come to light. In retrospect, these horror stories
appear to have been driven, at least in part, by ESOs. It seems that many firms engaged in questionable
accounting practices to manage reported earnings upwards, with a resulting upwards impact on share price
(theory and techniques of earnings management are considered in Module9). This increased the value of their
ESOs, many of which were then cashed in with the proceeds reinvested elsewhere (reminiscent of Huddart's
second scenario described on page 279 of the text). Further abuses of ESOs by management are evidenced by
the studies of Bartov and Mohanran (2004) and Aboody and Kasznik (2000), described on page 281. For
example, Aboody and Kasznik document a tendency for CEOs to manipulate share price downwards prior to
scheduled ESO award dates, then manipulate share price upwards after the award, so that their ESOs become
deep-in-the-money.

One of the most serious and widespread abuses of ESOs, however, is the late timing scandal, under which
managers back-dated the grant date of ESOs to a time when share price was lower than at the actual grant
date, without disclosure. The result was to understate ESO expense and overstate net income, as explained on
text page 280. The serious consequences for managers involved are illustrated by Theory in Practice vignette
8.1 on page 282. Investigation of other late timing episodes is still going on in the United States and Canada.

As a result of episodes such as these, standard setting bodies overcame the management objections to
expensing that shot down the 1993 FASB exposure draft. IFRS 2, effective in 2004, requires that the fair value
of ESOs awarded be charged to expense over the period during which the services related to said ESOs are
rendered. In the United States, SFAS 123R implemented expensing in 2005.

Fair value of ESOs may be determined by means of Black/Scholes or another option pricing model, with
adjustments for ESO characteristics, such as early exercise, along the lines discussed above and in text
pages 278-280. While this introduces problems of reliability of the fair value estimates, as discussed above, the
standard setters must believe that these are outweighed by an increase in relevance.

The main source of increased relevance, it is argued, is a better measure of the firm's compensation cost since
the opportunity cost of ESOs is brought into the accounts, as explained above. Relevance is increased, because
existing shareholders will ultimately bear this cost through reduced cash flows from dividends since earnings are
spread over a larger number of shares. Lower reported net income from expensing ESOs anticipates these
lower dividends, helping investors to predict future cash flows from their investments.

Another argument is that expensing helps to control overuse of this method of compensation, thereby reducing
the pressure from CEOs to manipulate the financial statements for their own advantage.

Now read Reading 6-1, "Options to Expense." This article was written as part of the debate leading up to the
new standards to expense ESOs described above. The article describes concerns about comparability, and
dilution of shareholder interests, arising from failure to record ESO expense under SFAS 123. It also describes
reliability issues surrounding the use of Black/Scholes to value ESOs, and suggests an alternative approach,
namely to value ESOs at the value of the employee services received.

It will be interesting to see if adoption of ESO expensing will result in the economic consequences predicted by
business. Perhaps not, since many firms voluntarily decided to charge the cost of ESOs to expense prior to the
new standards. One such U.S. firm was General Motors. The Globe and Mail, August 7, 2002, page B8,
reported "GM will expense stock options." Apparently, General Motors felt that the increased public confidence
in its financial statements resulting from its move to the measurement perspective outweighed any economic
consequences. Perhaps GM accepts securities market efficiency after all!
Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.3 Efficient securities market theory and economic

consequences

Required reading

Chapter 8, Section 8.4, pages 283-284 (Level 1)

LEVEL 1

Section 8.4 sums up the Chapter 8 material to this point. It is clear that economic consequences exist, despite
the implications of efficient securities market theory. Unless we can find reasons for economic consequences
that are consistent with efficient markets theory, the theory of market efficiency embraced in this course is
jeopardized. As will be explained in the following topics, positive accounting theory provides some of the
reasons, by showing why accounting choice matters to managers.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.4 Positive theory of accounting

Required reading

Chapter 8, Sections 8.5.1, 8.5.2, and 8.5.3, pages 284-293 (Level 1)

LEVEL 1

The scientific methodology and the philosophy of science that underlie the word "positive" in positive
accounting theory are beyond the scope of this course. For the purposes of AT1 , positive accounting theory
(PAT) is using theory to make predictions about managers choices of accounting policies. The theory accepts
efficient securities markets. It also assumes that managers, like investors, are rational that is, managers
cannot be assumed to necessarily act in the best interests of the shareholders. Instead, managers are assumed
to act in their own best interests. This immediately leads to questions of corporate governance how can the
firm arrange its affairs so that managers will perceive it in their own best interests to act in the shareholders
best interests? This is called the problem of alignment, the subject of the remainder of this module as well as
Modules 7 and 8.

Three hypotheses

Positive accounting theory is largely organized around three hypotheses:

the bonus plan hypothesis

the debt covenant hypothesis
the political cost hypothesis

The hypotheses are easy to understand and are consistent with the managerial self-interest assumption of the
theory. In effect, accounting policy choice is part of the process of management managers choose
accounting policies to help them accomplish their objectives.

As the hypotheses imply, three important managerial objectives are to

maximize the utility of compensation

minimize problems with creditors
minimize political "heat"

The theory then predicts that managers will choose accounting policies to achieve these objectives.

It should be emphasized that fraudulent behaviour is not necessarily implicated here or even unethical
behaviour. Accounting and auditing horror stories such as Enron Corp., WorldCom, late timing, and the 2007-
2008 market collapse may seem to strain this argument. Indeed, such unethical behaviour may be regarded as
an extreme case of the bonus plan hypothesis. The above horror stories violated GAAP or, at the very least,
conformed to the letter of GAAP but violated its spirit. However, reforms to corporate governance, especially
the Sarbanes-Oxley Act in the United States and similar moves in Canada, have increased the pressure for
accounting policy choice to be firmly within GAAP. The Sarbanes-Oxley Act was passed by the U.S. Congress in
2002 to improve corporate governance and financial reporting following from Enron and other corporate
scandals. It recognizes that such scandals are ultimately due to poor corporate governance and places
increased responsibility on management and the board of directors, including the audit committee, to oversee
the financial statements.

Furthermore, post-Enron accounting standards reflect this pressure for better corporate governance.
Specifically, in Canada, CICA Handbook sections 1100 and 1400, reviewed in Topic 2.7, clarify the meaning of
GAAP and require that financial statements be consistent with it.

Nevertheless, as the text points out in Section 2.5, there is considerable room to manage reported net income
under historical cost accounting within GAAP. This can be done through choice of depreciation policy, choice of
full-cost versus successful-efforts for costs of oil and gas exploration, being conservative or optimistic about
provisions for warranties and bad debts, and so on. In effect, management can still choose accounting policies
pursuant to the three hypotheses of PAT without being fraudulent or unethical, particularly if the policies
chosen are responsible and clearly disclosed.

Unfortunately, however, it is still possible to produce misleading financial reports within GAAP. As mentioned,
GAAP requires that capital assets be depreciated and that provisions for warranties and bad debts be made.
However, it says little about how the amounts of these accruals are to be determined. Managers could manage
reported earnings upwards by providing very low amounts and still argue they were within GAAP. Since
managers have an ethical responsibility to act as loyal agents of owners and to act in the general public
interest, some countervailing pressures are needed if accounting policy choice, even within GAAP, is to be kept
within acceptable boundaries. IAS 1 (paragraph 2) lays down what conformance with GAAP means. In
particular, there should be sufficient clear and understandable disclosure that investors can figure out the
impacts of accounting policy choice. Also, as we will see in Topic 9.2, market forces supply additional pressure
and, in Topic 7.3, clever contract design further aligns the interests of managers and owners. Ultimately,
however, ethical behaviour by managers, reinforced by accountants who will object if management goes too
far, is necessary to fully rein in managerial self-interest. These matters are further discussed in Topic 6.6.

Regardless of managements motives, if the three hypotheses are accepted, it is obvious why financial
accounting policies have economic consequences. New standards, or the reduction of acceptable accounting
policy alternatives, may interfere with managements attainment of its objectives.

Much of the empirical positive accounting research is devoted to testing these hypotheses. Section 8.5.3 of the
text shows that the research has gathered considerable evidence that is consistent with the hypotheses. This
evidence has greatly increased our ability to predict which accounting policies managers will choose under
different circumstances. Thus, very large firms that may be suspected of monopoly pricing practices are
predicted to choose accounting policies to lower reported net income. At other times, firms that are close to
violating provisions of debt covenants may choose policies to increase reportedincome.

While considerable evidence consistent with the three hypotheses has been gathered, the research presents
some difficult issues of methodology. How can one establish that a manager whose firm is close to violating
debt covenants is in fact choosing accounting policies to maximize income? Certainly, the manager would be
unlikely to admit to this behaviour and, indeed, would probably try to hide evidence of it. A common research
approach is to examine carefully a firms accruals. If accruals are consistently chosen to increase reported net
income, this suggests that the manager may be engaging in a maximization strategy. Of course, not all
accruals are subject to manager discretion accrued bond interest, accounts payable for normal levels of
business activity, and depreciation expense where a clear policy is laid down are primarily non-discretionary.
Nevertheless, other accruals, such as allowance for bad debts, effects of changes in accounting policies,
warranty provisions, and manufacturing inventory in excess of normal requirements, may have a considerable
discretionary component. Unless some reasonable estimate of discretionary accruals can be obtained, we
would be unable to tell whether a given level of total accruals results from normal business activity or from
conscious manager choice as the hypotheses predict.

Study the procedure in Section 8.5.3 of the text developed by Jones to separate discretionary and non-
discretionary accruals. The Jones model, and adaptations of it, still represents the state of the art in estimating
managements discretionary accruals. This material will come up again in the topic of earnings management in
Module 8.

Given the importance of the Jones model in PAT research, some discussion of it beyond that given in the text is
warranted. Specifically, look at the equation of the model at the bottom of page 292 of the text. The logic
underlying this equation is that a firms total accruals for the year (left side of equation at bottom of page 292)
consist of two components non-discretionary and discretionary accruals (on the right side). Discretionary
accruals are determined by changes in the level of business activity (proxied by the change in sales for the
year) and the amount of capital assets (right side of equation). This seems reasonable since more sales
generate more accounts receivable, inventories, and other current assets and liabilities and depreciation of
capital assets is a major accrual for most firms. Discretionary accruals (the term on the right side) are then
the remaining accruals not explained by change in sales and capital assets.
Notice that the Jones model is in the form of a regression equation. Past data for a firms total accruals (TA jt),
changes in sales revenue (REV jt), and capital assets (PPE jt) are readily obtained from previous years financial
statements, and the regression equation is estimated to obtain the coefficients of the model: j , 1j , and 2j .
As the text points out, these betas have nothing to do with the betas of a firms shares. They are simply
constants that specify the relationship between changes in revenues, changes in capital assets, and total
accruals for the firm in question.

Once the regression equation is estimated, it is used to predict non-discretionary accruals for future years. This
is shown by the equation on page293. The expression in brackets ( j + 1j REV jp + 2j PPEjp ) is the
predicted accruals for next year (year p). This prediction is then compared with actual accruals for year p
(TA jp ). The difference between predicted and actual accruals is taken as an estimate of discretionary accruals
for year p (U jp ). For example, if next years accruals are predicted by the model as Dr. $100 and actual
accruals are Dr. $150, the model assumes that the $50 excess is due to managements recording of $50 of
discretionary accruals, with the objective of lowering reported net income by $50.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.5 Opportunistic and efficient contracting form of positive

accounting theory

Required reading

Chapter 8, Section 8.5.4, pages 294-296 (Level 2)

LEVEL 2

The three hypotheses of positive accounting theory have been judged by some people as presenting a cynical
view of manager behaviour. They feel that managements choice of accruals and other accounting policy
manipulations are "bad" and should be prevented. As the text points out, this opportunistic form of
management behaviour is a common interpretation of the hypotheses. As mentioned above, recent accounting
and auditing horror stories, as well as the Aboody and Kasznik (2000) and Bartov and Mohanram (2004)
studies referred to in Topic 6.2 (page 281 of the text), suggest that opportunism is common.

However, one can argue that there is a "good" side to managements abilities to choose accounting policies as
predicted by the three hypotheses. If we start with the proposition that the goal of the firm is to survive and
prosper in the long run, some ability of management to manage reported net income could contribute to this
goal. For example, suppose that standard setters impose a new standard that brings a major new liability onto
the balance sheet. (The recording of liability for pensions and other post-employment benefits, as required by
SFAS 158 of the FASB and IAS 19 , are such standards see Topic 5.4.) Suppose further that the resulting
increase in the firms debt-to-equity ratio brings the firm close to violation of a covenant in its long-term debt
contract, whereby the firm must maintain this ratio below a certain level. Violation would impose considerable
costs on the firm, involving renegotiation of the contracts and even possible foreclosure and bankruptcy.
However, if the firm can avoid these costs by choosing (within GAAP) accounting policies that decrease the
debt-to-equity ratio (for example, by increasing reported net income), the firm and, indeed, the bondholders
would benefit.

As another example, suppose a new standard is implemented requiringthat fair value accounting for financial
instruments with unrealized gains and losses be included in net income. Such a standard would greatly
increase the volatility of net income. Suppose also that the managers compensation is based on reported net
income. If the manager were risk averse, the resulting increased compensation volatility would reduce utility.
The firm would probably have to increase the managers salary to compensate. However, if instead the
manager could reduce the earnings volatility by appropriate choice of (within GAAP) discretionary accruals so
that a higher salary level was unnecessary, the firm would be better off.

This view of the hypotheses is called the efficient contracting form of positive accounting theory. If the
firm arranges its contracts (in the previous examples, these are debt contracts and compensation contracts) to
allow the manager some flexibility to choose different accounting policies in order to work around the impact of
unanticipated events, all parties to the contracts will benefit.

Ethical issues

The efficient contracting form of PAT may be somewhat naive, just as the opportunistic form may be cynical.
The truth is likely to be somewhere in between, which raises some ethical issues. Extreme opportunistic choice
of accounting policies and accruals to benefit the manager at the expense of other stakeholders seems clearly
unethical, and ethical behaviour on the part of management, and accountants, serves to restrain such
practices.

However, it is less clear that management of reported earnings is unethical under the efficient contracting form.
One could argue that a risk-averse manager should have some ability to control the amounts and timing of
bonuses dependent on net income, since net income is affected by random state realizations beyond the
managers control. This is particularly so if the board of directors anticipated a reasonable amount of earnings
management when it was negotiating the managers compensation contract in the first place. Similarly, the firm
and its stakeholders, including the bondholders, will benefit if the manager has some ability to choose
accounting policies in order to reduce the likelihood of violation of debt covenants. Even the manager of a large
firm who manages net income to reduce political "heat" could be interpreted as acting ethically to the extent
that this provides stability and employment to the regions in which the firm is located. Of course, there can
also be unethical reasons for reducing political heat, such as concealing information about public health and
safety.

As a result, the question of which form is closer to the truth is of considerable interest since important issues of
managers social responsibility are involved. The text describes some of the research into this question. Despite
recent events, there seems to be considerable empirical support for the efficient contracting form.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

6.6 Conclusion

Required reading

Chapter 8, Section 8.6, pages 296-297

It seems that firms choices of accounting policies have economic consequences, despite efficient securities
market theory. An awareness of economic consequences is important to accountants since it alerts them to the
pressures that managers often bring to bear on them. These pressures are valid up to a point since managers
do have a legitimate interest in how the accountant measures their performance. However, if they go too far,
they may threaten the accountants ethical responsibilities to other constituencies.

You can begin to see why these consequences occur by considering the positive accounting theory, which
suggests reasons why managers, governments, and possibly investors, are concerned about accounting policy
choice. These reasons stem from the contracts that firms enter into, particularly compensation and debt
contracts, and the political environment in which firms operate. As the text points out, however, these issues
raise deeper questions of why important firm contracts depend on accounting variables. Module 7 will
investigate these questions and, in conclusion, will complete the explanation of how economic consequences
and efficient securities markets can be reconciled.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

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, 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 is a concept that 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
expected value of ESO on exercise date (under very simplifying assumptions)
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 be 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 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:
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.
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.
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.

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 the ones that are best for
the firms shareholders.
Managers that choose accounting policies for their own benefit and at the expense of
shareholders and lenders are said to be behaving opportunistically (unethically).
By 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.

Understand how positive accounting theory contributes to economic

consequences.

Positive accounting theory shows how accounting policies can have economic consequences:
Even without cash flow effects, accounting policies matter because they affect the
provisions of contracts based on financial statement variables and can affect the
firms political environment.
Thus, accounting policies matter to managers they have economic consequences.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 7: An analysis of conflict

Overview

Read the Chapter Overview, Section 9.1, on pages 304-305.

This module explains the concept of conflict by means of some game and agency theory models. Interest in
these theories arises because many aspects of accounting are affected by conflict between parties with
different interests in financial reporting. The study of economic consequences and the positive theory of
accounting alerts us to situations where conflict occurs. The most basic conflict is between the interests of
investors and managers managers cannot be assumed to necessarily go along with accounting standards
that are designed to provide the most useful information for investors. This was apparent in the employee
stock options (ESO) episode described in Topic 6.2. Other areas of conflict arise between managers and the
firm with respect to compensation, between manager and lenders, and between large firms and government
agencies (Topic 6.5).

Game theory and agency theory provide insight into how such conflicts may be resolved and enhance your
understanding of firms' choices of accounting policies. When making choices or recommendations regarding
which accounting policies to use, it is important to include management concerns as well as investor concerns.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

7.1 Understanding game theory

7.2 A non-cooperative game theory model of manager-investor conflict
7.3 Agency theory
7.4 Implications of agency theory for accounting
7.5 Reconciliation of efficient securities market theory with economic consequences
7.6 Conclusion

Learning objectives

Explain the basic principles of non-cooperative game. (Level1)

Explain and be able to determine the Nash equilibrium. (Level2)
Explain the basic principles of the cooperative solution to a non-cooperative game. (Level2)
Provide a game theoretic argument for constrained as opposed to unconstrained maximization.
(Level2)
Explain the basic principles of agency theory, including the concepts of
reservation utility
fixed versus moving support
first-best versus second-best contracts (Levels 1 and 2)
Analyze the important implications of agency theory for financial accounting. (Level1)
Describethe properties net income needs to compete as a performance measure with share
price. (Level1)
Explain how agency theory serves to reconcile efficient securities market theory and economic
consequences. (Level1)

Module summary

Print this module

 Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.1 Understanding game theory

Required reading

Chapter 9, Section 9.2, pages 305-306 (Level 1)

Read Section 9.2 in the text before proceeding with this topic.

LEVEL 1

Game theory involves the study of interactions between two or more parties, each of whom is rational (in the
sense of maximizing expected utility) and takes the actions of the other parties in the game into account.
Decision theory and the theory of rational investment decision (Topics 2.2 to 2.6) can also be thought of as
games, but of a somewhat different kind, namely a game between a decision-maker and an impersonal other
player called nature. Since the other player (nature) does not "think," nature's possible actions can be
expressed in terms of state probabilities.

Thinking of a decision problem as a game against nature is fine when there is a large number of other players.
In Example 3.1 in the text, it is implicitly assumed that there is a large number of other investors also buying
and selling shares of XLtd. The action of any one player does not affect the outcome (payoff from the
investment) of the game. As a result, it is not necessary to bring the other investors into the model. A similar
interpretation applies to the investment decision explained in Sections 3.5 to 3.7 in the text. Despite the
relative simplicity of the decision theory model, it has proven to be useful to accountants. In Modules2 to 6,
you learned a lot about useful financial statement information from studying the decision needs of the player in
the investment game.

However, the decision theory approach breaks down when playing against a small number of other players.
Each player must then take the actions of the other players into account that is, the action of any player
does affect the outcome of the game. This complicates the way the player determines the optimal action, but
greatly extends the use of the rational decision theory by enabling it to address conflict situations.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.2 A non-cooperative game theory model of manager-investor

conflict

Required reading

Chapter 9, Section 9.3, pages 306-312 (Level 2)

ERH , Unit B3, "Making a Moral Corporation: Artificial Morality Applied" by Peter Danielson (Level
2)

Read text Section 9.3 before proceeding with this topic. Read ERH , UnitB3, "Making a Moral Corporation:
Artificial Morality Applied" by Peter Danielson when instructed to do so.

LEVEL 2

The Nash equilibrium

There are two main points to note from the text illustration of a prisoner's dilemma-type game. The first is the
logic of the Nash equilibrium solution concept. This is the strategy pair such that, given the strategy choice
(that is, the chosen act) of the other party, neither party has an incentive to change strategies. In Example 9.1
of the text, the Nash equilibrium is the strategy pair RD. For example, the manager can give honest statements
(H) by maintaining a good internal control system and good accounting practices, or distort (D) by maintaining
a poor control system and poor accounting practices. The investor can invest (B) or refuse to invest (R). The
utilities of each player are shown in Table 9.1. The investor's utility is on the left of each set of numbers and
the manager's utility on the right.

Notice that the manager always works horizontally across the table in respect of his utilities, and the investor
works vertically in respect of her utilities. Keep the two processes separate, and it will be easy to determine the
Nash equilibrium.

Note:

Example 9.1 in the text is called a "prisoners' dilemma" type of game. This is because it can be applied to the
problem faced by two prisoners who are jointly charged with a crime, kept in separate cells, and cannot
communicate with each other. The jailer tells each prisoner that the payoff for a confession will be a shorter
sentence. The cooperative solution is for neither prisoner to confess, but the Nash equilibrium is that they both
confess. In this interpretation of the game, the payoffs are specified in terms of time in jail, in which case less
time is better. In the text example, and in the Danielson article in ERH , the payoffs are specified in terms of
utilities, in which case, more is better. Keep this in mind as you study these examples.

Prisoners dilemma type games described here are one-shot games. That is, they are played only once. If the
same game is repeated many times, the players may realize that it is in their joint interests to cooperate. If so,
the cooperative solution is attained and they are both better off than in the Nash equilibrium. This possibility is
discussed below. The interesting aspect of the Danielson article, also discussed below, is that Danielson
suggests conditions under which the cooperative solution can be attained in a single play of the game.

Assuming the manager decides to distort the accounting process, his utility would be 80, as compared to 40 if
he were honest in his presentation. But BD, the strategy pair where 80 is located, would not be the Nash
equilibrium, because the investor would have a greater utility from refusing to buy if the accounting system
were distorted. She would move vertically from BD to RD to avoid the situation where the manager has an
incentive to cheat by distorting the accounting process. If the investor refuses to buy, you must now work
across the table to see what the manager would do. He could remain in RD because by remaining at distort,
his utility would be 30 rather than 20, as it would be if he were in strategy pair RH. The investor would be
willing to move from RH to BH if the statements were honest, but this is not an option because the statements
are distorted.

All three strategy pairs BH, BD, and RH would be vacated by one player or the other, leaving RD as the
place where both would remain. Thus, RD is the Nash equilibrium.

This outcome is unfortunate because both parties would be better off by choosing BH. However, this is not a
Nash equilibrium because, as just explained, the manager has an incentive to cheat on the investor. The
investor realizes this, so to avoid a payoff of 20, she chooses R. Thus, the outcome of the game is driven to
the Nash equilibrium.

While this game model is a relatively simple one, it is interesting that it can be interpreted into financial
reporting scandals such as Enron and WorldCom (text, page 309). Note also that attempts by regulators to
restore investor confidence in financial reporting (text, pages 309-310) can be interpreted as changes in the
payoffs of the game. As mentioned in the text, an important component of restoring investor confidence is the
creation of oversight bodies such as the Canadian Public Accountability Board, and the Public Company
Accounting Oversight Board in the United States. These bodies can bring pressure to bear on accountants and
auditors who go too far in catering to opportunistic manager behaviour. Potential penalties and damage to
reputation resulting from these bodies' investigations should better motivate accountants to stand up to
manager distortion demands, thereby increasing and decreasing the payoffs of investors and managers,
respectively.

The second point is that if the game were to be repeated many times, the parties may realize that it is to their
mutual advantage to cooperate. In Example 9.1, the manager would soon realize that yielding to the
temptation to distort does not result in a payoff of 80, since the investor responds by refusing to buy. After
observing the manager playing honestly several times, the investor gains confidence in the manager, and
continues to buy. Thus both players are better off than if they continually play the Nash equilibrium. However,
the cases of Enron and WorldCom make it clear that even if the game is repeated many times (think of each
annual report as a separate play of the game), the cooperative outcome will not always be achieved since
some managers may unilaterally decide to abandon cooperative play. Presumably, this is because they perceive
that the potential short run gains from distorting exceed the longer run gains from continuing to play
cooperatively.

The Danielson article is, in a sense, the opposite of the Enron and WorldCom misfortunes. Even in a single play
of the game, ethical principles may avoid, or at least reduce, the incidence of the distort strategy choice, with
resulting Enron-like horror stories.

Analysis of "Making a Moral Corporation: Artificial Morality Applied"

At this point, read ERH , Unit B3, "Making a Moral Corporation: Artificial Morality Applied" by Peter Danielson. In
his article, Danielson describes how there might be sufficient trust between the conflicting parties that they
would both be willing to choose the BH strategy pair in a single play, that is, to choose BH in Example 9.1 of
the text.

While the payoffs differ somewhat, Example 9.1 in the text and Figures1 and 2 in the Danielson article are
quite similar. The main difference is that, in Figure2, player I moves first, whereas in Example9.1 in the text,
the investor (analogous to Danielson's player I) and manager move simultaneously. Sequential play gives player
II the advantage of knowing which strategy player I has chosen. However, player I knows that if she chooses
C, player II will be better off choosing D, resulting in a payoff of 0 for player I. Thus, player I will not choose C.
Instead, she chooses D since she knows that this way she will get a payoff of 1 (because if she chooses D
player II will also choose D). As a result, both players end up at the Nash equilibrium (1,1). This is the same
result as with the simultaneous play in Example 9.1 that is, the thought processes of each player are much
the same.

Straightforward maximization

Danielson calls this choice of non-cooperative RD Nash solution straightforward maximization. The
essential reason why the players end up in RD is that the manager cannot commit to playing honest. (By
definition, in a non-cooperative game, the manager cannot enter into a binding agreement, and the investor
knows that if she invests, the manager has an incentive to renege on a promise to play honest).

However, Danielson argues that moral principles can be applied to enable the manager to reject
straightforward maximization, that is, to commit to choose H, even in a "one-shot" play of the game. If the
manager could commit in this way, the investor would choose B, and the cooperative solution BH results.

Consider carefully how the commitment needed for this cooperative solution is achieved. In part, it is because
players would only be willing to play with "responsive" parties who feel the same way about cooperation as
they do. Such players must be transparent in their willingness to forego the short-run benefits that would
result from reneging on the commitment of the players to choose the cooperative solution. These players are
also resolute choosers who won't renege on their commitment to cooperation. That is, they are not just
creating the appearance of cooperative behaviour (trustworthiness) to fool other players. They really have
become cooperative players who are thoroughly trustworthy. For example, an ethical manager in Example 9.1
of the text may not adopt the short-run strategy of moving from BH to BD, thereby foregoing a short-run
increase of payoff of 40 (80 - 40). If the investor is convinced of this, she would invest, as mentioned.
Pursuant to the Enron/WorldCom discussion on page 309, a firm management that, for example, publicly
adopts improved corporate governance procedures can be interpreted as responsive. Such procedures would
include steps like appointing directors to the board who are independent of management and giving increased
powers and responsibilities to the Audit Committee of the board. Danielson calls such players constrained
maximizers. The result is that the long-run perspective on the game, where the manager may establish a
reputation for always taking H, is achieved.

How can a player in the situation described in the article by Danielson know that the other players are
genuinely trustworthy co-operators? One possibility is that the other players are transparent each player can
literally "see through" the behaviour and motivations of other players. In real-life situations, transparency is
rare and we usually have to be content with less than perfect transparency call this "translucence" or
partial awareness of the motives and actions of others. Another way in which a player could be sure that other
players were really trustworthy would be if a player made irrevocable choices such that they are no longer able
to defect and act uncooperatively. In real-life, this is sometimes accomplished by posting bonds or agreeing to
binding mediation by a neutral third party if conflicts arise. Reputation is also taken as a useful though not
infallible indicator of a players true character. It is worth noting that in real-life it can take considerable
practice and skill to accurately determine how trustworthy other players are.

Constrained maximization

How is constrained maximization attained? It is interesting that Danielson argues that firms are suitable
candidates for constrained maximizing behaviour, although individuals might not be. This view may seem to
conflict with the assumption throughout this course that firm managers are rational, expected utility-maximizing
individuals. Why should the manager in Example 9.1 of the text voluntarily give up 40 of additional payoff? The
answer is that by being "transparent," the other player will be willing to continue playing (that is, to invest).
Indeed, additional investors will also be willing to join the game, so that the firm reaps the benefits of
cooperative behaviour. This, in turn, increases the manager's utility to an amount greater than the Nash
equilibrium. Thus, Danielson's argument is not really inconsistent with the view of manager rationality. He
points out that firms are models of adaptable rational agents and that they are driven by market forces to
maximize their profits this is how they survive in the long run. From here, it is a short step to argue that
managers of these firms are forced to recognize the benefits of constrained maximization. Danielson reinforces
this argument by showing how managers are committed by the Principle of the Hanko not to defect from the
cooperative solution. In effect, in the longer run, the concept of rational expected utility maximization and
Danielsons concept of the moral corporation come together. The text anticipates this argument in Section 1.3,
pages 10-11. You may wish to reread this section now.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.3 Agency theory

Required reading

Chapter 9, Sections 9.4, 9.5, 9.6, and 9.7, pages 313-335 (Levels1, 2, and 3)

LEVEL 1

Section 9.4 explores some models of cooperative game theory. Many areas of accounting exhibit cooperative
behaviour as participants enter into agreements that they perceive as binding on both parties. These are often
called contracts. Many contracts undertaken have accounting implications, which signals the importance of the
accounting process.

Two major types of contracts are covered in text Chapter 9:

employment contracts, made between the firm (shareholder or owner) and the top manager
(such as the CEO)
lending contracts, made between the firm manager and the bondholder or lending institution

In these contract situations, one party is the principal and the other the agent. In the employment contract,
the firm would be the principal, the CEO the agent. In the case of the lending arrangement, the bondholder
would be the principal and the firm manager the agent. The study of this type of contracting is referred to as
agency theory, which is a branch of game theory. A definition of agency theory is given on page313 of the
text.

While these contract situations are referred to as cooperative, there are both cooperative and non-cooperative
aspects to them. There are certain provisions in the contracts that the parties agree to, but the parties can
choose to act non-cooperatively. However, as they are committed to the contract, they are expected to adhere
to the provisions of the contract and also, when carrying out the contract, to "play by the rules," that is, to act
within the contract provisions. An agent who embezzled the total firm proceeds and departed to a foreign
jurisdiction, for example, would hardly be playing by the rules.

Agency theory is as important as efficient securities market theory in financial accounting. Decision theory and
efficient securities markets underlie the study of investor behaviour and guide the accountant in the
preparation of useful financial statement information. Agency theory underlies the study of manager behaviour
and guides the accountant in the preparation of financial statement information to motivate and monitor
manager performance. This performance-monitoring role enables more efficient employment contracts to be
made between the firm and its managers. It also assists the managerial labour market to properly assess the
manager's ability and motivation. Motivation of manager performance is just as important to the efficient
operation of the economy as the supplying of useful information to investors.

Owner-manager agency problem

Section 9.4.2 covers a number of owner-manager conflict situations in an agency context. The main point is
that in almost all realistic situations, the manager's effort cannot be observed by the firm owner. This is an
example of moral hazard the second major case of information asymmetry that underlies this course
(adverse selection is the other). Because of moral hazard, indirect measures of manager effort, such as net
income, become necessary. The higher the correlation between the manager's effort and the resulting reported
net income (that is, the better that net income reflects the results of the manager's performance), the more
efficient is an employment contract that bases the managers compensation on net income.

Example 9.2 develops the basic conflict between owner and manager, namely, that when managers are paid a
salary, they will be less inclined to work as hard as the owner would like. This result is derived by calculating
the expected utilities of owner and manager under the "work hard" and "shirk" action alternatives. Since both
parties are assumed to be rational, they will each prefer the manager to act so as to give them their respective
highest expected utilities. Thus, the owner prefers the manager to work hard, because the expected utility to
the owner when the manager works hard is 57, greater than the expected utility of 48 when the manager
shirks. Conversely, the manager prefers to shirk, since the utility to the manager from receiving a salary of 25
is 5 regardless, where the managers utility is assumed to be the square root of cash received. However, the
extra effort of working hard reduces the managers total utility from 3.29 to 3 (page 317).

Be sure you understand the timing issues in agency theory. These are shown in Figure 9.2, page 316, of the
text. Notice first that the owner/manager contract is for one period (think of it as one year). Actual employment
contracts are typically multi-period, of course. However, modelling a multi-period contract increases complexity
without substantially increasing the insights we can gain about the role of net income in motivating manager
performance. Consequently, in this module we look primarily at single-period contracts.

Notice also that the owners ultimate interest is in the firms cash flow, since this is the payoff to the owner
from his/her ownership. However, the full cash flow resulting from the managers effort is not realized until
after the single-period contract has expired. In Figure 9.2, this realization is assumed to take place at the end
of the next period. But, the manager must be compensated at the end of period 1, so compensation cannot be
based on the cash flow. Instead, manager compensation must be based on a performance measure. In
agency theory, net income is viewed as a performance measure which tells the owner something (that is, it is
informative) about the managers performance. The question is, how good a job does net income do in
measuring the results of the managers first-period effort or, equivalently, predicting the future cash flow? This
is an important question for accountants since, as argued above, motivation of managers is just as important a
role as informing investors.

It should be clear why the full payoff from manager effort is not known at the end of period 1. The full
consequences of this effort often take considerable time. This is easy to see in the case of R&D, for example. It
may take considerable time, if ever, before current research generates cash.

The calculation of expected utility for each party is similar to the calculation of the rational investors expected
utility in Module2. The only differences are that, here, it is assumed that the owner is risk neutral (this is to
simplify the calculations and is not a necessary assumption) and that the manager's expected utility of money
is reduced by the disutility of working. Disutility of working is assumed to increase with manager effort; that is,
shirking creates a disutility of 1.71 in the example (the manager still exerts some effort), while working hard
increases the disutility to 2.

The problem for the owner is what to do about this undesirable state of affairs. The text outlines several
alternatives on pages 318-321, summarized as follows.

Suggested Contract 1

Hire the manager and accept a2 . This would mean the owner's utility would be 48 rather than 57. The owner
can do better than this.

Suggested Contract 2

If the manager could be directly monitored without cost, a salary of $25 would be paid if act a1 were taken
and, say, $12 if a2 were taken. The managers utility of taking a2 would diminish to 1.75, in which case the
rational manager would take a1 , since its utility is 3.

This is called the first-best contract. If a1 were achieved, the owner would receive expected utility of 57 and
the manager would receive reservation utility of 3. (The manager must receive an expected utility of at least 3
in order to be willing to work for the owner.) No contract could be better in the given circumstances. Notice the
risk-sharing situation under this contract. The manager does not bear any risk because he/she receives a $25
salary regardless of the payoff. The owner, who is risk neutral, bears the risk and does not mind doing so.

Unfortunately, it is difficult to monitor manager effort, and this first-best contract is usually unavailable. This is
because information asymmetry exists as to whether the manager was working hard.

Suggested Contract 3
Indirect monitoring of the manager could occur. That is, it may be possible to figure out the manager's effort
even if it is not directly observable. Refer to Table 9.3 on page319. In this case, the low payoff is lower ($40
compared to $55 in Table 9.2) if the manager chooses to "shirk" than if he works hard. This is the case of
moving support, as opposed to fixed support in the two previous suggested contracts. If the manager
chooses a2 and the low payoff happens, the $40 payoff makes it apparent to the owner that the manager
shirked. Then, the salary would be reduced from $25 to, say, $12. You will see by the calculation on page319
that a1 would yield higher expected utility to the manager.

It is difficult to rely on this approach since moving support may not hold. For example, if the payoff can be any
positive number (as would be the case if the payoff is in terms of net income) instead of only high or low as in
the text example, we are back to a case of fixed support. Then, one cannot be certain whether a low payoff is
due to the managers actions or some exogenous factor. Also, there could be some other factors in the
community to prevent lowering the wage. Consequently, in the next two suggested contracts, we return to the
fixed support case.

Suggested Contract 4

The owner could rent the firm to the manager for a suggested rent of $51. The owner would receive this rent
regardless of the payoff, and the manager bears all the risk. This is called internalizing the problem for the
manager. The owners utility would be reduced to 51 from 57, a drop of 6, in order to enable the risk-averse
manager to achieve his reservation utility of 3. This 6 reduction in the owners utility from first-best is called an
agency cost.

Suggested Contract 5

Give the manager a share of the performance measure (for example, net income). This is often the most
efficient arrangement if the first-best contract cannot be achieved. This brings us to Example 9.3, text pages
321-323. The manager is offered a 32.37% share of net income, which motivates the manager to choose a1 .
The 32.37% share is chosen so that the manager just achieves reservation utility of 3. Go over the calculations
of Example 9.3 to be sure you can reproduce them. Although a bit more complex, they are similar in nature to
the expected utility calculations for a risk averse investor in modules 2.2 and 2.3. In particular, note that the
probabilities always go outside the square root signs. A common calculation error is to place them inside.

The owner's and manager's interests are said to be aligned since both parties want a1 to be chosen.

The owner's utility is now 55.4566. The agency cost of this contract is 1.5434, which is considerably less than
the agency cost of the rental contract (6). That is, this contract is more efficient in generating utility for the
owner while still motivating the agent to work hard. (Do not confuse this use of the term "efficient" with its use
in efficient securities market theory.) When the first-best contract cannot be achieved, the most efficient
contract that can be achieved is termed second-best.

Now work through Example 9.4. The calculations here are similar to those of Example 9.3, except that net
income does a less noisy job of predicting the ultimate cash payoff. Note that the resulting contract is more
efficient than that of Example 9.3. That is, the manager can attain reservation utility with a profit share of
31.85%, down from 32.37% in Example 9.3. To put this another way, the manager bears less compensation
risk, since the profit-sharing percentage is lower. This greater contract efficiency is measured by the lower
agency cost to the owner (1.1171, down from 1.5434).

In Examples 9.3 and 9.4, net income is assumed to be unbiased . That is, the expected misstatement of
ultimate cashflow is zero. In Example 9.3, If the cashflow is going to be $100, net income could be either $115
(in which case cashflow is overstated by $15) with probability 0.8, or $40 (cashflow understated by $60) with
probability 0.2. The expected misstatement in net income is thus

Expected misstatement (Cashflow = $100) = 0.8 15 + 0.2 -60 = 0

If ultimate cashflow is going to be $55, the analogous calculation is

Expected misstatement (Cashflow = $55) = 0.2 60 + 0.8 -15 = 0

The text suggests reasons why net income may be noisy but unbiased. Net income will overstate the payoff if
legal or environmental liabilities resulting from the manager's current activities are understated. This would
happen if, for example, these liabilities are regarded as contingent at the end of the period. Then, while they
may be disclosed as supplemental information, they will not be reflected in net income. If the contingent
liabilities materialize, future cash flows will be overstated.

Net income will understate the payoff if the firm engages in R&D. While current research costs may generate
future cashflows, these costs are expensed as incurred. Since many firms are exposed to both of these, and
many other, recognition lags, their net effects may tend to cancel out.

Unbiasedness captures some aspects of accounting practice. Thus, to retain reasonable reliability, accountants
do not record legal or environmental expense if these liabilities are too difficult to estimate. Similarly, research
costs are not capitalized since the future benefits are too difficult to measure reliably. The important point to
note here is that these measurement errors do not result from manager actions. Rather, they are characteristics
of an accounting system that must trade off some relevance so as to attain reasonable reliability. Examples 9.3
and 9.4 assume that these measurement errors are equal but opposite hence the unbiasedness. Of course,
accountants can still strive to reduce noise through better measurement, as illustrated in Example 9.4.

Manager's Information Advantage (pages 325-327)

LEVEL 2

Examples 9.3 and 9.4 omit an important characteristic of reported earnings earnings may be biased by the
manager. This is called earnings management. That is, reported earnings (and hence compensation) may be
manipulated by the manager so as to overstate or understate expected future cash flow. Our study of positive
accounting theory in Module6.5, for example, suggests that earnings management may well occur.
Consequently, we now extend the agency theory to consider earnings management.

Earnings management is possible since the manager controls the firm's accounting system. When net income is
the performance measure, the owner can only observe an earnings number reported by the manager, which
may differ from the earnings number resulting from application of accounting policies that best inform
investors.

Work through Example 9.5 on pages 326-327 of the text, to be sure you understand the calculations. This
example is admittedly rather artificial. Would/could the manager really report the highest possible net income
regardless of the level of unmanaged earnings? Probably not, since ethical and legal considerations, along with
GAAP, would likely deter most managers from misleading reporting of this magnitude. The important point to
realize here, however, is that in a single-period contract (in which case there is no scope for earnings
management behaviour today to come back to "haunt" the manager tomorrow), this is exactly what a rational
manager would do the higher is reported net income, the higher is compensation. Ethical and legal
considerations become more important when the manager has a multi-period horizon. Some aspects of
multi-period behaviour are considered in Module8. For now, realize that the main purpose of Example 9.5 is to
set the stage for Examples 9.6 and 9.7, to be discussed next.

The Revelation Principle (pages 327-329)

LEVEL 3

In Example 9.6, the text outlines a very simple compensation contract under which the manager will not
manage earnings opportunistically. That is, the manager will tell the truth about net income. Note that the
contract has a very similar outcome to the contract of example 9.5 both parties receive the same utility and
the manager still shirks. The only difference is that the manager does not bias reported earnings because, in
effect, he/she is "bribed" by the same compensation for telling the truth as would be received by managing
earnings as in Example 9.4. This is an illustration of the revelation principle.

The revelation principle is of considerable theoretical interest. However, as the text explains on pages 328-329,
it often does not apply. Indeed, we already know that managers do not always "tell the truth," as witnessed
the Enron and WorldCom reporting scandals, for example. Consequently, this material can be read at level3.
Limiting the Bias in Net Income (pages 329-331)

LEVEL 1

Now work through Example 9.7, being sure that you understand the reasoning and calculations. Again, the
calculations are lengthy, but straightforward and consistent with earlier examples. There aretwo main points to
see from this example. First, this contract is more efficient than that of Example 9.5, since the manager now
works hard. The owner's utility has increased to 55.4981 from 50.8165.

Second, the contract does allow for some earnings management. For example, if unmanaged earnings fall in
the $111-$116 range, the manager manages it up to $116. As the text points out on page 331, we can regard
earnings management here as "good," since the contract is more efficient than that of Example 9.6, where
there was no earnings management. In terms of positive accounting theory, Example 9.7 expands on the
bonus plan hypothesis. In particular, the example is consistent with the efficient contracting version of that
hypothesis rather than the opportunistic version.

Understanding earnings management is of great importance to accountants, since they quickly become caught
up in the reputational consequences, and the legal liabilities, resulting from opportunistic manager behaviour.
Furthermore, the accountant should realize that under some conditions earnings management can be efficient,
rather than opportunistic. We shall return to earnings management in Module8. For now, the important point
to realize is that if it is used responsibly, and in moderation, some earnings management is not necessarily
opportunistic.

Discussion and Summary

The discussion and summary on text pages 331-332 provide a recap of the reasoning and implications of
agency theory applied to compensation. An understanding by accountants of how manager behaviour is
affected by compensation is important, since a manager whose livelihood is affected by the bottom line will
obviously be interested in the accounting policies leading to that bottom line. That is, accounting policies have
economic consequences. Accountants must steer a fine line between recognizing managers' legitimate interests
in financial reporting and recognizing the possibility that managers may operate opportunistically.

Agency theory also expands our understanding of the role and importance of GAAP. In addition to providing
useful information to investors, GAAP has a role to play in motivating manager effort and contributing to
efficient compensation contracting. Both of these roles are necessary for the productive operation of our
economy.

Lender-manager agency problem

A second source of the moral hazard problem is that creditors, such as bondholders, cannot observe the
manager's effort in preserving the security of their loans. Thus, managers may do things not in the creditors'
best interests, such as paying excessive dividends or diluting creditors' security by issuing additional debt. To
protect against this situation, many debt contracts impose covenants based on financial accounting variables,
such as maintenance of a specified amount of working capital or a specified interest coverage ratio.

Example 9.8 presents an interesting scenario to illustrate the lender-manager agency problem. A lender can
invest $100 in a government bond for 10% or lend the $100 to the firm for 12%. If no dividends are paid (a1 ),
there is a 1% chance of bankruptcy for the firm. If high dividends are paid (a2 ), there is a 10% chance of
bankruptcy. The lender assigns a 50/50 chance to each possibility of low dividends and high dividends.

Incorporating the figures into the formula for the lender's expected total return (ETR) on page334, an
expected total return of only 5.84% is generated when the bankruptcy possibilities are considered. The lender
would not be rational to lend to the firm, given the government bond alternative.

Given the same data and a required return of 10%, equivalent to the bond return, the necessary interest rate
on the loan to yield the investor an expected return of 10% is calculated as 16.40%. This would seem to be
high to the manager, and no doubt an attempt would be made to write covenants into the lending contract
that would result in the lender accepting the lower interest rate of 12%. For example, the manager could agree
to pay no dividends if interest coverage is below a certain level and/or if a stipulated current ratio or amount of
working capital is not met.

Now, instead of assessing the probability of 50/50 for each act, the example assumes that the lender assesses
a probability of 1.00 to the no dividend act. (That is, the lender is now sure that the effect of the covenants will
be to prevent the manager from paying high dividends.) This gives the lender an expected return of 10.88%.
Thus, the effect of incorporating the covenants is to lower the required lending rate to the firm.

Summary of lender-manager agency problem

The contract just described provides an additional illustration of how cooperation makes both parties better off.
In the bondholder-manager game, the creditors react to the greater security offered by covenants by lowering
the interest cost to the firm.

It should be clear how this contracting scenario feeds into the debt covenant hypotheses of positive accounting
theory (Topic 6.5). Since managers' freedom to manoeuvre under debt covenants depends on reported
accounting numbers, they have an incentive to manage these numbers by their choice of accounting policies.
This managerial incentive is another source of economic consequences.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.4 Implications of agency theory for accounting

Required reading

Chapter 9, Section 9.8, pages335-340 (Levels 1 and 3)

LEVEL 1

Holmstrm's agency model

Holmstrm's 1979 analysis is a classic in the theory of agency. Holmstrm assumed that the payoff from the
manager's current effort was fully observable at the end of the period. As explained in Module7.3, this is
unlikely when the contract is based on net income, due to recognition lag. However, this payoff-observable
simplification doesn't really matter for our purposes here, since the implications of Holmstrm's analysis carry
over to the more realistic case of payoff not observable until later.

LEVEL 3

Example 9.9 illustrates Holmstrm's argument. There are now two performance measures, namely net income
and share price, in place of the single net income measure of previous examples. There are now four possible
performance measure combinations (for example, both performance measures high, one high the other low,
etc., as given in Table 9.5). As the example illustrates, the owners utility is now 55.5520, up from 55.4566 in
the single-performance measure of Example 9.3. Thus, the two-measure contract is more efficient, consistent
with Holmstrm's analysis. Since Example 9.9 involves lengthy but straightforward calculations, this example
can be read at Level 3.

LEVEL 1

A main point to realize from Example 9.9 is that there are other performance measures than net income, in
particular share price. Holmstrm shows that a requirement for contract efficiency to be increased by adding a
second performance measure is that the second measure adds to the information about manager effort
contained in the first measure. Share price on an efficient market meets this condition, since it is based on a
broader set of information than net income. Example 9.9 is consistent with this requirement.

Thus net income competes for importance in motivating and monitoring effort. This leads to the question of
what properties net income needs to be a good performance measure. One property is sensitivity. That is, as
the manager works harder in the current period, net income and/or share price for the period should also
increase. Since a performance measure is more sensitive (to effort), the greater the expected increase in the
performance measure for a given increase in effort. High sensitivity of net income increases the efficiency of
compensation contracts, since a better prediction of the ultimate cash flow payoff (which also depends on
current manager effort) is incorporated into end-of-period net income.

Obviously, net income is not completely sensitive, however. For example, as the manager works harder at R&D,
net income goes down, not up. Nevertheless, accountants can increase sensitivity. As the text points out, fair
value accounting and RRA (if incorporated into net income rather than just as supplementary information)
increase sensitivity. This is because there is less recognition lag between the manager's effort and the results of
that effort appearing in net income. As another example, management of the firm's long-term investments is a
component of manager effort. If the manager works hard to increase the value of the portfolio, the results
will show up in net income under current cost accounting but not under historical cost accounting. Fair value
accounting for R&D, as discussed in Module5.6, would also increase sensitivity.

The second property is precision. This is the reciprocal of the variance of the noise in net income less
variance of noise means greater precision. Less noise increases compensation contract efficiency because it
results in less risk imposed on the (risk averse) manager. This means that his/her reservation utility can be
attained with a lower share of net income. Example9.4 illustrated the benefits of increased precision.
Note that sensitivity and precision have to be traded off. This tradeoff is clear with respect to current value
accounting. Thus, if the manager works hard to increase the value of an investment portfolio, value may still
decrease due to factors that are not the manager's fault, such as an increase in interest rates. While it is less
sensitive, historical cost accounting for long-term investments is less subject to uncontrollable changes in fair
value, hence more precise. A similar tradeoff exists with respect to fair value accounting for R&D, since it is
difficult to accurately measure future R&D payoffs.

Note that the tradeoff here is reminiscent to the tradeoff between relevance and reliability introduced in
Module1. The concepts are different, however, since they apply to the properties of net income as a manager
performance measure, not to its properties in informing investors.

You consider sensitivity and precision again in your study of executive compensation in Topic 8.3.

Rigidity of contracts

The second implication of agency theory follows from the rigidity of contracts once they are signed. If a
manager could avoid the implications of changes in accounting policies imposed by standard setters by simply
renegotiating affected contracts, we would be back to the efficient markets argument that accounting policies
should not matter. Thus, contract rigidity is crucial to the economic consequence implications of agency theory.

Read the text coverage of both of these implications carefully, because they are important for understanding
the applications in Module8. In particular, note that in practice, contracts are incomplete, unlike the
contracts illustrated in Chapter 9. If all possible state realizations could be anticipated, provision to deal with
them can be incorporated into the contract, in which case it is complete. However, it is effectively impossible
to anticipate all states of nature whose realization may affect the contract, particularly when contracts extend
over several periods. For our purposes, the best example of incompleteness is changes in accounting standards
during the contract term. These changes affect earnings and balance sheet amounts, and thereforeaffect
compensation and debt covenants. When combined with contract rigidity, accounting policy matters to
managers. The combination of contract incompleteness and rigidity is what drives many of the economic
consequences and positive theory hypotheses studied in Module 6.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.5 Reconciliation of efficient securities market theory with

economic consequences

Required reading

Chapter 9, Section 9.9, page341 (Level 1)

LEVEL 1

Section 9.9 of the text deals with a crucial point regarding efficient securities markets and economic
consequences: "Are these two theories inconsistent? Do they contradict one another?" Your study of economic
consequences showed that management has some real concerns about the effects of accounting policies and
changes on lending agreements and employment contracts. However, efficient securities market theory and
economic consequences are not inconsistent, as supported by the text arguments. This reconciliation means
that accountants should not concentrate only on the provision of useful information to investors managers'
legitimate interests in the financial statements also need to be taken into account.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

7.6 Conclusion

Required reading

Chapter 9, Section 9.10, pages 341-343

Modules 8 and 9 make it apparent why accounting policies have economic consequences. Accounting policies
affect the bottom line. Thus they matter to rational managers, since the bottom line affects incomplete and
rigid compensation and debt contracts.

It should also be apparent why manager and investor interests conflict. Investors' interests are best served by
earnings information that represents a useful tradeoff between relevance and reliability. Managers' (and
owners') legitimate interests are best served by earnings information that represents an efficient tradeoff
between sensitivity and precision. There is no reason why the earnings information that best meets investor
interests also best meets manager and owner interests. For example, fair value accounting may be more useful
to investors in predicting future firm performance if its relevance outweighs its lower reliability, but less useful
for compensation contracts if its low precision outweighs its high sensitivity. Indeed, this is the fundamental
problem of financial accounting theory, first introduced in text section1.7 (pages 14-15). You should reread
this section now.

Agency theory also helps us to understand earnings management. Despite recent financial reporting scandals,
earnings management is not necessarily bad if it is used responsibly. This is because a contract that allows
some earnings management can be more efficient than one that does not.

Theory tells us that contracting efficiency can be increased by use of more than one performance measure.
Accountants should appreciate the role of net income and GAAP in efficient contracting since if net income does
not have reasonable sensitivity and precision it will be squeezed out of efficient contracts. This would be
unfortunate, since a major opportunity for accountants to contribute to the efficient operation of our economy
would be lost.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 7 summary
An analysis of conflict
This module models 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, with economic consequences, which predicts that accounting policies
matter.

Explain the basic principles of non-cooperative game.

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 the Nash equilibrium of a non-cooperative game.

The Nash equilibrium is the strategy pair such that, 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.

Explain the basic principles of the cooperative solution to a non-cooperative

game.

The cooperative solution to a non-cooperative game is the strategy pair such that 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.

Provide a game theoretic argument for constrained as opposed to

unconstrained maximization.

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.

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 effort devoted by the manager to running the firm usually cannot be
observed by the principal (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 that is based on firm payoff (that is, the cash flow resulting from the
managers effort in running the firm).
However, payoff is usually not observable until after the compensation contract has ended,
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 the performance measure just enough 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.
However, net income may be biased by the manager. 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.

Explain 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.

Explain fixed and moving support.

Fixed support is the situation where 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 is where the set of performance measure realizations is different depending on
the action taken. When moving support holds, manager effort may be inferred and the first-best
contract can be attained.

Explain 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 managers effort can be directly
observed, or inferred.
Agency cost is the reduction in the principals 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
managers 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 managements interest in
 accounting policy choice and why accounting policies can have economic consequences.

Understand the properties net income needs to compete as a performance

measure with share price.

For compensation contracts, when more than one performance measure is available, both of
which contain incremental information about the managers 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 tradeoff between sensitivity and precision.

Explain how agency theory serves to reconcile efficient securities market

theory and economic consequences.

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.
Consequently, accounting policies have economic consequences.
Nothing in this argument conflicts with securities market efficiency.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 8: Conflict between contracting parties

Overview

Read the Chapter Overviews, Sections 10.1 and 11.1, on pages 356-357 and 402-404.

In this module, you will learn two major applications of the agency theory studied in Module 7. The first
application is executive compensation. The focus is on the effects of performance measures such as net
income and share price in motivating manager effort. You will see that real incentive plans are consistent with
agency theory predictions but are more complex because they involve a mix of incentive, risk, and decision
horizon considerations. Executive compensation plans are important to accountants, because they introduce a
second major role of financial reporting, distinct from the communication of useful information to investors.
This role is to motivate and monitor manager effort. To the extent that net income is informative about
manager effort, it improves the operation of managerial labour markets and motivates productivity. Arguably,
this function of financial reporting is equally as important as improving the operation of capital markets and the
efficient allocation of scarce capital in the economy.

The second application is earnings management, that is, managers' selection of accounting policies and
disclosures so as to influence reported net income in a desired manner. Earnings management is an application
of agency theory, because this theory predicts that firms will compensate managers by means of an incentive
contract, and will lower borrowing costs by means of debt covenants. Both types of contracts are typically
based at least in part on earnings, or financial ratios that are affected by earnings such as interest coverage.
Consequently, earnings matter to managers, so that managing earnings becomes a function of management.

Earnings management has the potential to relieve some of the effects of rigid and incomplete contracts and to
communicate useful information to investors. You will consider these possibilities in the light of the
opportunistic versus efficient contracting form of positive accounting theory introduced in Topic 6.6.
Accountants should understand the incentives for, and effects of, managing reported earnings and the forms
that such management takes since they are frequently involved in earnings management decisions and are
affected when opportunistic earnings management is revealed.

Both of these applications involve conflict between contracting parties. It is important to understand the nature
and sources of this conflict because its resolution revolves around financial statements and the GAAP that
underlie them. As guardian of the integrity of financial reporting, you, as an accountant, need to understand
the favourable and unfavourable aspects of earnings management. This understanding will in turn help you to
understand the standard-setting process and the pressures brought on standard setters by various
constituencies. Standard setting will be the subject of Modules 9 and 10.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

8.1 Are incentive contracts necessary?

8.2 A typical managerial compensation plan
8.3 Executive compensation: theory and evidence
8.4 Politics of executive compensation
8.5 The power theory of executive compensation
8.6 Conclusion re executive compensation
8.7 Patterns of earnings management
8.8 Evidence of earnings management for bonus purposes
8.9 Other motivations for earnings management
8.10 Is earnings management "good" or "bad"?
8.11 Do managers accept securities market efficiency?
8.12 Conclusion

Learning objectives

Explain why incentive contracts are necessary. (Level 2)

Describe how an incentive plan can align the interests of the manager with those of
shareholders. (Level2)
Comment on the theory and evidence pertaining to executive compensation. (Level 1)
Identify devices to control compensation risk. (Level1)
Explain the political ramifications of executive compensation. (Level2)
Evaluate the power theory of executive compensation in relation to efficient contracting theory.
(Level 2)
Explain the various motivations for earnings management. (Level1)
Identify patterns of earnings management. (Level1)
Distinguish between earnings management that reveals inside information to the market and
earnings management that attempts to deceive the market. (Level 1)
Explain the significance of the "iron law" of accruals. (Level 1)
Evaluate whether or not managers accept securities market efficiency. (Level 1)

Module summary

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.1 Are incentive contracts necessary?

Required reading

Chapter 10, Section 10.2, pages 357-360 (Level 2)

LEVEL 2

When students are first introduced to the agency model, a common reaction is that managers do not need to
be motivated by a performance measure. You would expect managers to want to work hard, because
otherwise, they will not get ahead in the organization and will lose earning power by destroying their
reputation. This is the reaction expressed by Fama, an influential finance academic at the University of Chicago
(see Section 10.2).

However, if the predictions of the agency model are to be taken seriously, such reactions need to be
countered. Analytical work done by Arya, Fellingham, and Glover (1997) and empirical work done by Wolfson
(1985) both suggest that while organizational and reputation considerations help to control moral hazard, they
do not do so completely an incentive contract is still needed.

An example closer to home helps to explain why. Suppose you are not required to take the AT1 examination.
Completing the assignments is sufficient to obtain a pass mark. Would you still work as hard? Most people
would answer no. No one questions your motivation, and, presumably, a good knowledge of the course
material will help you do well in the accounting world. Consequently, you would put some effort into learning
the module material but not as much as if you were under the pressure and risk of a final examination. Since
your effort in studying the course material cannot be directly observed, a moral hazard problem is present. It
seems that the incentive device of an examination is still needed. Designers of compensation plans tend to
agree. As you will see in the next topic, the design of such plans is consistent with the agency model.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.2 A typical managerial compensation plan

Required reading

Chapter 10, Section 10.3, pages 360-371 (Level 2)

LEVEL 2

The text outlines some of the characteristics of the BCE Inc. compensation plan. The plan is largely consistent
with the predictions of the agency model. It contains several different incentives, based on net income, share
price, and individual contribution such as creativity and initiative.

The incentive compensation plans of many firms extend well down into the organization. The BCE plan, for
example, applies to its officers and other key employees. This contrasts with the development of the agency
model (Topic 7.3, text Section 9.4.2), which uses a single manager and a single owner, who are proxies for a
larger number of investors and managers. Although the simple two-person model reveals a lot about the
accounting implications of incentive compensation plans, this model has its limitations. Consequently, it is
necessary to consider an interesting and important problem that arises when the compensation plan extends
down into the organization.

The problem is that it becomes more difficult to measure individual contribution to net income and share price
at lower organizational levels. Certainly, the firm's CEO is responsible for these performance measures. But, at
lower levels, it is difficult or impossible to determine the portion of net income and share performance
generated by the lower-level executives. The problem arises from jointness of responsibility lower-level
executives' contribution to firm performance is generated in cooperation with other organization members.
Note how the BCE plan deals with this problem (pages 362-364). The plan provides that annual short-term
incentive awards are based in part on an individual performance factor, derived from creativity and initiative,
succession planning, and management development. The total short-term incentive award for an officer is then
determined by the product of a target award, a corporate performance factor, and individual contribution. This
allows BCE to award higher bonus to key employees who have exhibited superior individual performance.

The BCE plan also has a longer-term component, in particular, stock options. Note that these are awarded as a
multiple of base salary. Presumably, BCE feels that the higher an executive's position, the more important it is
to motivate performance by stock price. Note, however, that the multiple also depends on individual
performance. Again, this allows higher awards to key employees who have exhibited superior individual
performance.

The complexity and sophistication of the BCE plan is consistent with Holmstrm's prediction that real
compensation plans will include several different incentives (Topic 7.4 and text Section 9.8.1).

It is interesting that BCE reduced its usage of ESOs in 2003 and forward into 2004, replacing ESOs with other
compensation components, such as higher short-term incentive bonuses and the introduction of a 2-year stock-
based performance award. Presumably, this reduction was due in part to abuses of ESOs such as those pointed
out in Topic 6.2, which have raised serious questions about ESOs' incentive value. Indeed, concerns about the
incentive effects of ESOs have continued post-Enron. The late timing scandal (Topic 6.2) and the 2007
meltdown of the market for asset-backed securities (blamed in part on excessive manager risk-taking) further
illustrate the dysfunctional effects that ESO-based compensation can contribute to.

Another explanation for the shortening of the decision horizon is that BCE wanted to shorten the decision
horizons of its executives, since it appears that not all short-term corporate objectives were attained in 2003.
Shortening the decision horizon by means of increased weight on 1-year bonuses would have created the
possibility of short-term opportunistic manager behaviour such as deferral of maintenance, underinvestment in
R&D, and so on. However, the 2-year performance award seems designed to avoid, or at least reduce, such
consequences.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.3 Executive compensation: theory and evidence

Required reading

Chapter 10, Sections 10.4 and 10.5, pages 372-383 (Levels 1 and 3)

LEVEL 1

Having established that compensation plans contain a mix of accounting-based, market-based, and
individual-performance measures, you now consider factors that affect the proportion of accounting-based
measures in the plan. This is important to financial accountants because their competitive position as suppliers
of information is improved as this proportion increases. Unfortunately, as noted in our discussion of the
BCEplan, excessive reliance on net income to motivate performance may encourage short-term policies such
as cutting advertising and R&D, to increase reported net income in the short run. Consequently, identifying
which financial statement characteristics increase the informativeness of reported net income about responsible
manager effort will enable accountants to improve the ability of their product to motivate executive
performance.

To further explore the factors that affect the proportion of accounting-based measures in compensation plans,
the text returns to the concepts of sensitivity and precision of a performance measure introduced in
Topic7.4. While sensitivity and precision both increase the informativeness of the performance measure about
manager effort, they generally have to be traded off.

Note the text's suggestions to increase earnings sensitivity. One possibility is to adopt fair value accounting,
since many of the results of current manager effort then show up sooner in earnings. Full disclosure also
increases sensitivity, by enabling the compensation committee to better evaluate earnings persistence. Then, it
is more difficult for a manager to disguise poor performance by means of opportunistic behaviour, such as
shirking and covering up by, for example, "one-time" transactions such as unusual, non-recurring, and
extraordinary gains, or reduced advertising and maintenance, and so on.

Low sensitivity of net income is an argument for using share price performance rather than net income in the
compensation contract. For example, the efficient securities market will look through the cutting of advertising
and R&D as devices to increase reported net income in the short run and will penalize the firms share price to
the extent this goes against the firm's longer-term interests. In effect, share price is a more sensitive
performance measure than net income.

Greater sensitivity of share price does not necessarily mean that net income should be dropped from
compensation contracts, however. This is because share price is low in precision (fair value accounting is
subject to the same problem). To see this, recall first that in addition to being affected by manager effort, a
performance measure is affected by random state realization. A precise performance measure is one where the
influence of manager effort is "high" and of random state realization is "low" that is, if net income is high,
the more precise is net income, the greater the probability that the high reading results from manager effort
rather than from favourable state realization. Thus, when we say that share price is low in precision, we mean
that a high share price is relatively more likely driven by factors such as interest rate changes (a state
realization), than by manager effort. The text points this out at the top of page373.

The real question, therefore, is not one of using either accounting-based or market-based measures of
performance but, rather, one of the relative proportions of each in the contract. Indeed, there may be times
when a short-run decision horizon is in the firm owners' best interests, as during times of financial distress or
when cost cutting is imperative. Recall that BCE shortened its decision horizon somewhat beginning in 2004.
More formally, the analysis of Bushman and Indjejikian (1993) referred to on page 373 shows that the relative
proportions of net income-based and share-based incentives can control the length of managers' decision
horizons.

Short-run and long-run effort

LEVEL 3

In Section 10.4.2, the text looks more closely at short-run and long-run effort (we used the equivalent term
short-run and long-run decision horizon above). This section extends the agency model to include both types
of effort, and formally considers how the compensation contract can be designed to motivate the type of effort
desired by the owner. We see in the BCE compensation plan that this is a critical issue. As mentioned, BCE
amended its plan in 2004 to motivate more short/medium-term effort. For our purposes, however, it is
sufficient to be aware of the concepts of short-run and long-term manager decision horizon and how the
relative proportions of earnings-based and share-price-based performance measures affect this horizon.
Consequently, text Section 10.4.2 can be read at Level3.

Risk-reducing approaches to executive compensation

LEVEL 1

As noted in Section 10.4.3 of the text, managers are assumed to be risk averse. Further, they cannot diversify
as can the shareholder. While agency theory tells us that managers should bear some risk, it may be desirable
to control that risk. This is because the manager that is exposed to too much risk may underinvest in risky
projects that are worthwhile from the standpoint of diversified shareholders. Also, the manager may shed risk
through excessive hedging, which could lead to shirking. Note how the board of Suncor (text, page 381)
restricts this possibility.

Some risk-controlling approaches include

having more than one performance measure

adding a bogey or cap in the bonus plan
limiting the extent to which the manager is allowed to hedge
having a compensation committee for the review of compensation for the manager
using relative performance evaluation (RPE)

With respect to the role of more than one performance measure in controlling risk, the basic idea is that if one
performance measure is low, implying low compensation, another may be high. In this regard, note the
argument of Sloan (text, page 378). Consistent with our discussion, Sloan argues that share price is less
precise than net income, that is, it is relatively more affected than net income by economy-wide risks. Thus, if
share price is low due to some unfortunate state realization, net income may well be high, since it may take
some time before net income reflects the economy-wide events that drive share price down (recognition lag).
For example, share price may fall immediately if the market suspects a rise in interest rates, but it will likely be
some time before increased interest rates affect items such as sales and expenses.

With respect to the bogey in the bonus plan, this reduces risk by exempting the manager from paying the firm
if it should suffer a loss. Since losses could be very large, the possibility of a negative bonus would constitute a
major source of risk for the manager, leading to avoidance of risky projects. By eliminating any bonus for net
income below the bogey, this possibility is reduced.

RPE is a process of setting bonuses or other incentive awards in relation to the average performance of other
firms in the industry. With this approach, the systematic and common industry risk (which is not very
informative about the managers effort) is filtered out of the incentive plan. The larger the number of firms
involved, the better the filtering process, and the lower the risk for the manager.

If so, you should observe that when the average performance in the industry is high (that is, good times), a
specific firms managerial compensation should be low, since high current performance of the firm in question
is then less impressive. That is, with RPE, manager compensation should be negatively associated with other
firms performance.

However, as the text points out on pages 378-379, there is no strong empirical evidence in support of RPE.
The text suggests two reasons, First, Aggarwal and Samwick (1999) (text pages 378-379) argue that manager
compensation should be positively associated with other firms performance, rather than negatively associated
as it would be under RPE. Their analysis is consistent with the BCE plan, since when the performance of the
comparator group is high, BCE's compensation will also be high, and vice versa.Second, as mentioned above,
Sloan arguesthat net income as a performance measure in addition to share price helps shield the manager's
compensation from systematic or economy-wide risk. Thisnegates the necessity for RPE.

The ability of ESOs to control risk is ambiguous. On the one hand, since the lowest an ESO can be worth is
zero, ESOs operate like a contract bogey to eliminate downside risk. However, since ESOs can be very valuable
if share price "takes off," they may contribute to excessive risk-taking, conceivably leading the firm into
financial distress. For example, it is argued that the high leverage of many financial institutions leading up to
the 2007-2008 market meltdowns (Topic 1.2) was encouraged by the stock option component of managerial
compensation plans.

The theory of executive compensation also explains why managers dislike accounting policies that increase the
volatility of net income. One reason is that the more volatile the net income, the lower is the expected utility of
the risk-averse manager's stream of future bonuses, other things equal. Given contract incompleteness and
rigidity, it is unlikely that the manager could compensate for increased volatility by negotiating a higher share
of net income.

Another reason is that more volatile net income increases the probability of violation of debt covenants. Again,
contract incompleteness and rigidity make it difficult to renegotiate debt contracts. Consequently, if new
accounting standards come along while the contracts are in force, the theory predicts strong manager
opposition to such standards.

Empirical compensation research

Finally, note the empirical evidence on compensation contract design given in text section 10.5. As was shown
in Module4, empirical research on the reaction of share price to financial accounting information is largely
consistent with underlying decision and capital market theories. The research outlined in section 10.5 suggests
that actual compensation contract design is consistent with the underlying theory of agency.

On pages 381-383, the text describes the research results of Lambert and Larcker (1987), who found that the
relative proportions of accounting-based and share-based compensation vary as the theory predicts. Note also
the results of Baber, Kang, and Kumar (1999). It seems that compensation committees do value persistent
earnings more highly than low-persistence earnings when setting manager compensation. As mentioned above,
persistent earnings (for example, core earnings) are more precise than net income to the extent net income
contains unusual, non-recurring, and extraordinary items. Of particular interest are the results of Indjejikian
and Nanda (2002), who found that when firm risk is low, the firms in their sample tended to award higher
bonuses relative to base salary. This is consistent with the theory since when risk is low the incentive effects of
a bonus can be attained while loading relatively low risk on the manager. This enables managers to attain their
reservation utility with lower total compensation expense than would be the case if risk is high. It seems that
compensation committees recognize this, and design their compensation schemes accordingly.
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.4 Politics of executive compensation

Required reading

Chapter 10, Section 10.6, pages 383-386 (Level 1)

LEVEL 2

The text describes arguments and evidence for and against the popular belief that managers are overpaid.
While the amounts of senior executive compensation are large, they may not be as large as they seem, due to
manager risk aversion and restrictions on disposal of shares and options received as part of the compensation
package. The effect of risk aversion on the value of stock-based compensation to the manager was studied by
Hall and Murphy (2002) (text, page 386), ranging up to a 55% reduction for a highly risk averse individual.

Note that there are reasons for the low pay-performance relationship documented by Jensen and Murphy
(1990). These include the sheer size of some corporations and the fact that compensation plans tend to avoid
putting too much downside risk on the manager. Topic8.3 also brings out the reason why it may be desirable
to exclude low-persistence non-recurring and extraordinary items from earnings when determining manager
compensation, as seems to be the case for BCE. The BCE stranded costs vignette on page 384 is consistent
with the Babar, Kang, and Kumar (1999) results referred to in Topic8.3. For present purposes, the point to
note is that to the extent that unusual, non-recurring, and extraordinary items are excluded for compensation
purposes, a low relationship between pay and net income is to be expected.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.5 The power theory of executive compensation

Required reading

Chapter 10, Section 10.7, pages 386-389 (Level 2)

LEVEL 2

Module 5.2 discussed some theories and evidence from behavioural science that question securities market
efficiency, despite the impressive evidence in favour of efficiency discussed in Topics 4.2 and 4.3. It is
interesting that similar questions arise about the efficient contracting view of executive compensation. An
alternative view is known as the power theory of executive compensation. This theory suggests that
executive compensation contracts are more consistent with the opportunistic version of positive accounting
theory than with efficient contracting. Essentially, the theory predicts that managers use their power in their
organization to secure more than their reservation utility. They do so by influencing the Board of Directors,
camouflaging their excess compensation through compensation consultants, setting compensation in
comparison with peer groups, and, generally, through poor corporate governance (evidenced by, for example,
late timing of ESO grants, as noted in text page 388).

The question then arises, to the extent the power theory applies, how can accountants assist in controlling
excess compensation? As the text points out (page 388), expensing of ESOs is one step, since expensing helps
to control some of the ESO abuses described in Topic 6.2. Also, full disclosure makes it more difficult for
managers to cover up excess compensation.

While you do not need to take a stand on the issue of whether managers are overpaid, you should be aware
that securities commissions recognize the importance of full disclosure of compensation. Indeed, the
description of the BCE plan in Topic8.2 is taken from compensation disclosure requirements in effect in Canada
in 2004. Similar SEC requirements were in effect in the United States. If the managerial labour market is to
work properly to hold managers to their reservation utility levels, an obvious minimal requirement is that the
market knows how much compensation the manager is receiving.

Compensation disclosure requirements were extended by the SEC in 2006 to include a Compensation
Discussion and Analysis, a clear statement of total compensation received by five senior officers, and extensive
disclosure of share-based compensation, including the amount charged to expense during the year for stock
options. Disclosure of "golden parachutes" is also required (see text, page 385 re GlaxoSmithKline). In Canada,
new disclosure requirements are in effect under Canadian Securities Administrators (see text, page20) Form
51-102F6, effective December31,2008. These requirements are substantially similar to the 2006 SEC
requirements. It is interesting that these disclosures seem to be having an effect, according to Lo (2003),
discussed in the text on pages388-389. Compensation disclosures were further extended by the SEC in 2010
to include, for example, disclosure of the relationship between compensation policy and risk management, so
that investors can better detect management risk-taking incentives. Similar proposals were announced by the
Canadian Securities regulators in November 2010.
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.6 Conclusion re executive compensation

Required reading

Chapter 10, Sections 10.8 and 10.9, pages 389-390 (Level 2)

LEVEL 2

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.

To serve as an informative input into managerial compensation contracts, accounting earnings should be
sensitive measures of manager effort, subject to reasonable precision. Full disclosure is an important vehicle for
informativeness. In addition to full disclosure of compensation components and amounts, full disclosure of non-
recurring gains and losses assists compensation committees and investors to evaluate core earnings and
control possible manager efforts to obtain excessive compensation. In this way, financial reporting contributes
to efficient contracting. More efficient contracting benefits the firm and its shareholders. In so doing, the
operation of the managerial labour market is improved, with resulting improvements in productivity and social
welfare for the economy.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.7 Patterns of earnings management

Required reading

Chapter 11, Sections 11.1 and 11.2, pages 402-405 (Level 1)

LEVEL 1

You now come to the second subject of this module earnings management. This is the selection of
accounting policies and disclosures in order to affect net income so as to obtain some specific earnings
objective. Earnings management can be accomplished through manipulation of real variables (for example,
cutting R&D) or by accruals. Obviously, manipulating real variables can have dysfunctional consequences for
the firms longer-run viability. Accruals do not have this same effect but, since they reverse, accruals can also
have severe longer-term consequences.

While a natural tendency is to view earnings management as bad (opportunistic), the text argues that if used
responsibly, earnings management can be good. For example, it may increase contracting efficiency by
reducing the likelihood of debt covenant violation when unforeseen events occur, or may communicate
information about persistent earning power.

The text describes four patterns of earnings management, summarized as follows:

Taking a bath If the reported net income is expected to be below the bogey (that is, that
level of earnings below which no bonus is paid), go all the way so that future cost may be lower
and higher net income may be reported in the following year, with a brighter future for bonus
prospects.

Income minimization This is a reduction of income but not as severe as taking a bath.
Management may choose this pattern if it expects to exceed the cap (that is, that level of
earnings beyond which no bonus is paid) of the bonus plan.

Income maximization This may be chosen if the firm is between the bogey and the cap. It
may also be chosen to avoid violation of debt covenants.

Income smoothing This is the use of earnings management to smooth income in order to
avoid excessive volatility in reported net income. This may be chosen to receive relatively
constant compensation or to smooth covenant ratios over time.

If a clear pattern of earnings management can be discerned, this gives the accountant clues as to whether the
earnings management is good or bad. For example, a pattern of income smoothing may enable management to
reveal its expectations of its longer-term (that is, persistent) earning power. It would be unwise for a rational
manager who expects to remain with the firm to report earnings this year that cannot be sustained in future
years. (It is far easier to explain steady or increasing profits than to explain why profits have fallen.) To avoid
being in this situation, one can manage current earnings to a level that can be sustained. The beneficial effect
of such management, provided that it is done responsibly, is to help investors predict future firm performance
or to help managers manage debt covenant ratios to reduce the likelihood of debt covenant violation.
Alternatively, a pattern of earnings maximization may be due to a manager opportunistically maximizing his/her
compensation.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.8 Evidence of earnings management for bonus purposes

Required reading

Chapter 11, Section 11.3, pages 406-411 (Level 2)

Level 1

Evidence of use of accruals to manage earnings for bonus purposes is illustrated in a study by Healy, described
in Section 11.3. While the study is quite old now, it is a seminal paper in earnings management and occupies a
place comparable to the Ball and Brown paper (Topic 4.2) in the literature of securities market response to
accounting information.

There are three main points about Healy's study:

First, the study is a test of the bonus plan hypothesis of positive accounting theory. It is perhaps
remarkable that Healy was able to find significant statistical evidence of earnings management
consistent with this hypothesis. If management were asked whether they engaged in earnings
management of this nature, they would probably deny it. Thus, Healy had to use actual financial
statement data and overcome substantial methodological problems in order to find what he was
looking for. His results constitute an important example of the predictive ability of agency theory.

Second, you should be aware of some of the methodological procedures in this area of research
since this will improve your ability to understand and interpret financial statements. Many of
these problems involve obtaining a good estimate of discretionary accruals. The distinction
between discretionary and non-discretionary accruals was introduced in Topic 6.5. You may wish
to review that topic at this time.

Third, it is easy to determine the net total accruals, as shown in the following formula:

Net income = cash flow from operations net accruals

Operating cash flow can be obtained from the statement of cash flows. Net accruals are then the
difference between this amount and net income. Note that net accruals are the difference
between total income-increasing and total income-decreasing accruals. This equation is easy to
apply, and can be helpful to give the accountant/auditor, and the investor, a quick reading on
earnings quality. Recall that persistence is an important component of earnings quality (Topic
4.3), and that Sloans finding (Topic 5.2) was that accruals are less persistent on average than
cash flows.

A second way to obtain net total accruals is to proceed item by item. This approach is illustrated in the text on
pages 407-408. You will recognize that this approach is similar to the preparation of the operating section of
the statement of cash flows, where a common procedure (called the indirect method) is to start with net
income and then adjust for the various accruals.

As indicated in the text on page 407, the previous formula can be extended as follows:

Net income = cash flow from operations net non-discretionary accruals net discretionary accruals

Separating discretionary from non-discretionary accruals

While it is straightforward to determine total accruals, the separation of total accruals into non-discretionary
and discretionary components is far from straightforward. The different approaches are as follows:

Use the item-by-item approach to determine total accruals, using information from the balance
 sheet and statement of cash flows to the extent possible. Then, analyze each accrual in turn to
evaluate its discretionary component. This approach is illustrated in the text, pages 407-408.

Use total accruals as a proxy for discretionary accruals, on the grounds that if discretionary
accruals are high (that is, income-increasing), so will be total accruals, and vice versa. This was
the approach used by Healy. Even though estimating discretionary accruals in this way introduces
noise into the estimate, it seems that it is sufficiently accurate, on average, that Healy found what
he was looking for.

Don't estimate total discretionary accruals, but instead, pick a specific account for which it is
relatively easy to estimate the discretionary portion, such as net accounts receivable. This
approach was used by McNichols and Wilson (1988), described on page 410 of the text. The
assumption is that if evidence of earnings management is discovered in one account, managers
are probably doing the same thing in other accounts as well.

More recent studies of earnings management, however, use the Jones model, described in the
text in Section 8.5.3 and referred to in Topic 6.5. Jones took the difference between operating
cash flows and net income to determine total accruals for the period. Then, in order to separate
discretionary from non-discretionary accruals, Jones used a regression equation (see text page
292) to extract the non-discretionary portion while taking into account the effects of changes in
the level of business activity and the firm's investment in property, plant and equipment. You
should review the additional description of the Jones model given in Topic 6.5 at this time.

As described in the text on pages 409-410, Healys results support the bonus plan hypothesis. Specifically,
Table 3 implies that managers use discretionary accruals to manage earnings upwards when earnings are
between the bogey and cap. Outside of these two limits, average accruals were negative (earnings decreasing),
consistent with his argument that when earnings are below the bogey or above the cap, the rational manager
will want to decrease earnings, not increase them.

It is interesting to note that Healy's results, by and large, stand up to the more sophisticated way of separating
discretionary and non-discretionary accruals provided by the Jones model. See, in particular, the Holthausen,
Larcker, and Sloan (1995) study outlined in the text (pages 410-411).
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.9 Other motivations for earnings management

Required reading

Chapter 11, Section 11.4, pages 411-415 (Level 1)

LEVEL 1

Section 11.4 of the text describes several other motivations for earnings management and outlines evidence
consistent with managers managing earnings for these reasons. Additional reasons include

avoiding debt covenant violation

meeting investors' earnings expectations
initial public offerings

Note that the first reason, as for compensation, constitutes a contracting motivation for earnings management.
The second and third reasons derive from capital markets. Specifically, they are attempts to affect share price
(although, if the managers compensation includes shares and/or ESOs, a contracting motivation creeps in here
too). The second motivation is one of the strongest. The text (page 414) describes the consequences for
managers who fail to meet analysts' earnings forecasts.

As suggested previously, an awareness of the methodological issues surrounding discretionary accruals would
help you to understand and interpret financial statements. Thus, by examining discretionary accruals carefully,
you may find "clues" revealing inside information that management has.

For example, if a firm seems to be using discretionary accruals to maximize current reported net income, this
may suggest that management is concerned about meeting earnings forecasts, about events such as violation
of debt covenants, or may be planning an initial public offering. While further investigation may be needed to
pinpoint the cause, you are alerted to where to look. Conversely, minimization of reported net income may
suggest that management foresees a period of reduced earnings and may be trying to move earnings from
current to future periods. Of course, your ability to glean such inside information depends crucially on how well
you can estimate discretionary accruals.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.10 Is earnings management "good" or "bad"?

Required reading

Chapter 11, Section 11.5 and 11.6.1, pages 415-425 (Level 1), Problem 9 (pages 431-432) and
Problem 10 (pages 432-438) (Level 1)

LEVEL 1

There are two sets of reasons why earnings management can be good or bad. One set is related to the
opportunistic versus efficient contracting forms of positive accounting theory (Topic 6.6). In Section 11.4.1 (see
Topic 8.9), the text points out that earnings management can help avoid violation of debt covenants. If the
manager does this simply to hide the fact that the firm is insolvent, this is opportunistic (bad) earnings
management. However, if the manager does it to work around the effects of an unanticipated change in GAAP,
this may be a low-cost way to protect the firm and the creditors from technical violation. Unanticipated
changes are a consequence of contract incompleteness (Topic 7.4). In this case, earnings management can
give a solvent firm some flexibility to work around the technical violation. If so, the earnings management is
efficient (good).

The second set of reasons relates to the capital market. Here, earnings management is usually looked on with
suspicion. Indeed, horror stories such as Enron and WorldCom have increased this suspicion to the point that
even the slightest indication that a firm may be managing its earnings leads to a precipitous drop in its share
price. Consequently, the possibility that earnings management can be good is intriguing. Review the discussion
of text Example9.7 in Topic7.3. A more general reason why earnings management can be good from a capital
markets perspective is given in the text on pages415-416. Essentially, the reason is that earnings management
enables the manager to credibly convey (that is, "unblock") inside information to the market.

Problems 9 and 10 of Chapter 11 are mini-cases that illustrate the good and bad sides of this second type of
earnings management, respectively. In Problem 9, reasonable arguments can be made that General Electric
conveys inside information about its persistent earning power by means of responsible use of earnings
management by managing reported earnings to an amount the company feels it can maintain. The case also
illustrates the formidable array of earnings management techniques that are available to a large and complex
firm. Problem 10 illustrates a "horror story" about earnings management. It appears in retrospect that
Sunbeams 1997 reported earnings were almost entirely manufactured by means of discretionary accruals. As
widely reported in the financial media when this became known, Sunbeams CEO, "Chainsaw Al" Dunlap, was
quickly dismissed by the board, and the original 1997 financial statements were withdrawn. As a result,
Sunbeams auditors have been drawn into lawsuits from this financial disaster.

An analysis of these two cases follows. Points (a) to (d) correspond to the "Required" in the problems.

Problem 9, General Electric Co.

a. Restructuring charges are an effective earnings management device. They are an unusual and
non-recurring item, and therefore of low persistence. As a result, they may be ignored by
investors in evaluating operating earnings, and by compensation committees for bonus purposes.
Also, restructuring charges serve the dual role of reducing current reported earnings and
"banking" future earnings. Banking is accomplished since future costs can be charged to the
restructuring allowance rather than to operations.

This is the focus of Hanna (1999) (text, page 423), who argues that management may overstate
restructuring charges, thereby putting excess future core earnings in the bank. These future
earnings increases are difficult to detect, since they become buried in lower depreciation and
used to absorb costs that would otherwise be charged to future core earnings. Thus management
can have it both wayslittle penalty when the charge is reported, and reward for increased future
core earnings. In effect, Hannas argument is that restructuring charges are too effective an
 earnings management device since they create temptations for opportunistic manager behaviour.
The Nortel Theory in Practice vignette 11.1 provides a dramatic example of Hannas argument in
action.

b. Securities market efficiency requires that prices "properly reflect" all publicly available information.
If analysts cannot track all of GEs activities, the amount of publicly available information about
GE will be low relative to inside information. While the efficient market price of GE shares may
properly reflect what is known about GE, there is a lot of inside information not included in price,
so that the market price may not properly reflect the "real" GE. If even analysts cannot ferret out
such information, responsible use of earnings management by GE can serve as an important
substitute.

c. The answer follows from part b. It seems that GE is using earnings management responsibly to
convey inside information about expected earning power. The company does this by using a
variety of earnings management devices to report a smooth, increasing net income series. This
differs from Hannas approach, which involves only the use of unusual and non-recurring charges
to opportunistically minimize, then maximize, reported earnings.

GEs earnings management strategy stands in for the difficulty analysts and investors face in fully
evaluating all available information themselves. As a result, GEs share price should reasonably
reflect its future performance. In this case, GEs earnings management is good.

Note: GE reported a further increase of net income to $22,208 for 2007. Given the recession
following the 2007-2008 market meltdowns, it will be interesting to see if the firm can continue
to maintain its record of steadily increasing earnings.

Problem 10, Sunbeam Corp.

a. Effect of the decline in prepaid expenses on net income

Laing reports a $23.2 million drop in prepaid expenses in 1997. The offsetting debit in 1997 was,
presumably, to Expense (Dr. Expense $23.2, Cr. Prepaid expense $23.2). If so, the drop has
decreased 1997 net income, not increased it as Laing asserts.

Laing notes that 1996 was "a lost year anyway," so the company "prepaid everything it could." Of
course, as any accountant knows, if the company charged the prepaid items to a prepaid expense
account (which it should have done since they were prepaid), this would not affect 1996 net
income. However, Mr. Laing may have been speaking loosely, meaning to say that the company
charged as much to expense in 1996 as it could, including paying for and expensing items that
properly belonged to 1997. This would have the effect of lowering 1996 reported earnings and
raising 1997 reported earnings by the amount of the prepayments. Then, if very few items were
prepaid at the end of 1997 (possibly to preserve cash), this could account for the decrease in
prepaid expenses. However, the fact remains, as pointed out in the preceding paragraph, that if
prepaid expenses decreased in 1997 this operates to decrease 1997 reported earnings, not
increase them.

To conclude, Laings analysis that the decrease in prepaid expenses in 1997 increased 1997 net
income by $23.2 million (before tax) is incorrect.

b. List of impacts on 1997 net income of the various earnings management devices (amounts are
estimated net of tax)

Effect on 1997 Net Income

($millions)

Increase Decrease

Inventory written down to zero in 1996, sold at 50 on the dollar in 1997 $ 36.5
Decline in prepaid expense from $40.4 in 1996 to $17.2 in 1997 (opposite
$ 15
 to Laings assertion see parta.)

Decrease in other current liabilities ($18.1) and other long-term liabilities

$ 25
($19), attributed mainly to reduction in product warranty provisions
Reduction in 1997 depreciation, due to 1996 writedown of property, plant
$ 6
and equipment, and trademarks
Capitalization of product development, advertising, and so on into
$ 10
property, plant and equipment in 1997
Decrease in allowance for doubtful accounts from $23.4 to $8.4 during
$ 10
1997

Manufacturing for stock in 1997, evidenced by 40% increase in

$ 10
inventories

"Early buy" and "bill and hold" sales of $50 $8

$ 105.5 $ 15

15
Net discretionary accruals $ 90.5

Net accruals can be determined as the difference between net income and operating cash flow:

$109.4 ($8.2) = $117.6

We can conclude that $90.5 million of the net accruals of $117.6 million were discretionary,
income-increasing. It thus appears, on the basis of Laings analysis, that Sunbeams 1997
reported earnings were largely manufactured.

c. How restructuring charges give the company plenty of fodder

The article implies that the restructuring charges of $390 million were excessive. This puts
earnings in the bank, which can be drawn down in future years through reduced depreciation
and charging of operating costs to the restructuring reserves.

d. Explaining the substantial first-quarter loss using the "iron law" of accruals reversal

Sunbeams reported first-quarter earnings for 1998 were a loss of $44.6 million, compared with a
profit of $6.9 million for the first quarter of 1996.

Sales were reported as $244.5 million, a decrease of $9 million from the first quarter of 1996.
While a decline in actual sales may be at least partly responsible for the first-quarter loss, the
reported sales would have been pulled down by the reversal of the $50 million of "early buy"
sales accruals recorded in 1997. It appears that the efforts to "pump up" first-quarter sales
(additional "buy now, pay later" sales, extending the quarter by three days) fell short of
overcoming the reversal of the sales prematurely recorded in 1997.

With respect to expenses, some of the expense reductions, such as depreciation, noted for 1997
would continue in 1998. However, many others would reverse, such as warranty expense,
allowance for doubtful accounts, and manufacturing for stock (which would lower 1998
production, hence the amounts of absorbed overhead).

In sum, the early recording of sales in 1997, together with the reversal of discretionary, income-
increasing 1997 accruals, seems to have "come home to roost" in 1998, consistent with the "iron
law" of accruals reversal.

Note:

Numerous articles (not examinable) related to Sunbeams accounting problems appeared in the financial
media. Their titles alone reveal subsequent developments. Some of these articles are
 "Troubled Sunbeam ousts CEO Al Dunlap," The Globe and Mail, June 15, 1998, p. B6
"Teary-eyed Chainsaw Al defends record at Sunbeam," The Globe and Mail, July 10, 1998, p. B8
"Sunbeam audit finds mirage, no turnaround," The Globe and Mail, October 20, 1998, p. B15
"Despite Recovery Efforts, Sunbeam Files for Chapter 11," The New York Times , February 7, 2001
"S.E.C. Accuses Former Sunbeam Official of Fraud," The New York Times , May 16, 2001
"Sunbeams ex-CEO settles SEC probe," The Globe and Mail, September 5, 2002, p. B6

These articles are not required reading. Their titles are listed solely to illustrate subsequent developments.

Despite theoretical arguments, and specific cases of good earnings management, it is clear from the Sunbeam
case that bad earnings management does exist. On pages 422-423, the text gives additional evidence of the
bad side of earnings management. Some of this bad management arises from opportunistic behaviour with
respect to contracts (that is, the first type of earnings management incentives mentioned above). For example,
Dechow, Sloan, and Sweeney (1996) found that many firms charged in the United States by the SEC with
violations of GAAP (suggesting bad earnings management) were close to debt covenant constraints.

Other instances of earnings management arise from managers attempts to deceive the stock market. The
tactics described by Hanna (1999) were described in our discussion of Problem 9. As noted there, managers
whose compensation is based on core earnings have an incentive to record large non-recurring charges,
thereby forcing down current reported net income. This low net income does not adversely affect the manager,
however, to the extent that compensation committees, and the market, base their evaluations on persistent,
core, earnings. The important point is that excessive non-recurring charges increase future core earnings (that
is, putting earnings in the bank), on which the manager is evaluated. Managers can get away with such bad
earnings management because accountants do not report separately the effect of past writeoffs on current core
earnings. Thus, there is a danger that the manager is overcompensated and enjoys a higher-than-deserved
reputation in the capital and managerial labour markets.

Given the increasing adoption of IASB standards worldwide, it is interesting to note the results reported by
Leuz, Nanda, and Wysocki (2003) (text, pages 423-425). It seems that earnings management extends to other
countries as well as the United States and Canada. In effect, IASB standards are no more immune to
opportunistic earnings management than FASB and AcSB standards.

The two examples of earnings management in Topic 8.10 represent extreme cases. They raise the question of
whether, on average, earnings management is used responsibly or irresponsibly by managers. That is, does
good or bad earnings management predominate?

The study of Subramanyam (1996), whose research is described in the text on pages 419-420, provides
evidence in favour of good earnings management. Subramanyam finds that share prices of the firms in his
sample respond positively, on average, to discretionary accruals. That is, if good news in reported earnings is
the result of income-increasing discretionary accruals, the market responds favourably to the good news, and
vice versa. If these accruals were being used to manage earnings irresponsibly, as in the case of Sunbeam
Corp., you would hardly expect a positive market response. However, the evidence of Xie (2001), described in
the text, page 420, suggests that the market appears to overvalue discretionary accruals, opening up the
possibility that Subramanyams results are driven by securities market inefficiency rather than by positive
market response to discretionary accruals.

It should be noted that these conflicting findings depend crucially on the ability of the Jones model to
accurately separate accruals into discretionary and non-discretionary components. This suggests that other
approaches to evaluating market response to earnings management are desirable. For example, Elliott and
Hanna (1996), (text page 423), supports market efficiency. They find that the ERC for core earnings is lower
for firms that have frequently recorded large, unusual, and non-recurring charges. Since such charges put
earnings in the bank, it appears that the market, lacking direct information about the effect of past writeoffs
on core earnings, uses the frequency of past writeoffs as an indicator of bad earnings management. Such a
sophisticated response would be unlikely in the absence of market efficiency.

Other evidence, using a variety of techniques, is described in the text on pages 420-422. The studies of Tucker
and Zarowin (2006), Liu, Ryan, and Whalen (1997), Barth, Elliott, and Finn (1999), Callen and Segal (2004),
and Francis, LaFond, Olsson, and Schipper (2005) all support good earnings management and securities
market efficiency.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.11 Do managers accept securities market efficiency?

Required reading

Chapter 11, Sections11.6.2 and 11.6.3, pages425-427 (Level 1)

LEVEL 1

While the theorists you studied generally support market efficiency, their findings relate primarily to investor
reaction to earnings management. The question immediately arises as to whether managers accept securities
market efficiency. On the one hand, despite evidence to the contrary, managers may feel that the market will
be "fooled" by their earnings management. On the other hand, they may accept efficiency, so that if earnings
management is to be effective, it must be buried by poor disclosure. If the latter, what can accountants do
about it?

Whatever the reason behind bad earnings management, the antidote is full disclosure. Hopefully, IAS 1 and
IAS 8 (see Topics2.7 and 4.4) represent steps in this direction. These standards, by requiring disclosure of
important transactions, especially those that have low persistence, such as writedowns of inventory and
property, plant and equipment, provisions for restructuring and so on, as well as changes in estimates and
accounting policies, earnings management is made more difficult. Nevertheless, there seems to be no
requirement to disclose the effect of these items on future core earnings. If there was, the securities market,
and compensation committees, would quickly penalize managers for bad earnings management. To the extent
that managers suffer the consequences of their own actions, bad earnings management will decrease.
 Course Schedule Course Modules Review and Practice Exam Preparation Resources

8.12 Conclusion

Required reading

Chapter 11, Section 11.7 (pages 427-428)

Financial accounting theory plays an important role in helping us to understand both executive compensation
and earnings management. The motivation and monitoring of responsible manager performance and the
promotion of properly working securities markets are equally important in a market economy. It is encouraging
to see that net income plays a role in executive compensation contracts, consistent with the agency theory.

Earnings management, which, at first glance, may seem to be undesirable, has the potential to reveal inside
firm information. However, while there is considerable theory and evidence that earnings management does
play such a role, other theory and evidence suggests that earnings management is used opportunistically. The
likelihood of opportunism is bolstered by horror stories, such as Sunbeam, Enron, and WorldCom, and the
markets rejection of the shares of firms who are suspected of bad earnings management. To restore and
maintain the role of financial accounting in promoting proper operation of the managerial labour market and
securities market, accountants need to further improve disclosure to ensure that managers bear the full
consequences of their earnings management practices.

Course Schedule Course Modules Review and Practice Exam Preparation Resources

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 managements inside information about future earning power, or bad,
as when management behaves opportunistically to maximize bonus 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 managers compensation on one or more performance measures, that
is, measures that predict the payoff from the managers effort in operating the firm.

Describe how an incentive plan can align the interests of the manager with
those of the shareholders.

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 controls the length of the managers
decision horizon.

Comment on the theory and evidence pertaining to executive compensation.

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 managers decision horizon.
Lambert and Larcker (1987), found that the relative proportions of accounting-based and share-
based compensation vary as the theory predicts:
 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-persistent 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.

Identify devices to control compensation risk.

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
compensation based on more than one performance measure
a bogey in the compensation plan
compensation committee
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

The power theory predicts that executives 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.

Identify patterns of earnings management.

There are four main patterns of earnings management:

taking a bath If expected earnings are below the bogey, go all the way with
writeoffs, and so on.
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.
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.
income smoothing This is used to avoid excessive volatility of earnings.

Explain the various motivations for earnings management.

Earnings management is a managers 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 the following objectives.

Identify the objectives of earnings management.

The objectives of earnings management are to

maximize bonuses
meet investors earnings expectations
avoid the consequences of violation of debt covenants
increase the proceeds of initial public offerings
reduce political visibility
influence government policy
communicate blocked inside information to investors

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

Distinguish between 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.
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 bonus are an example.
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 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 income-
decreasing discretionary accruals such as unusual, non-recurring, and extraordinary items.
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.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 9: Standard setting: Economic issues

Overview

Read the Chapter Overview, Section 12.1, on pages 443-444.

A major building block of this course is the fundamental problem of financial accounting theory, introduced in
Section 1.7 of the text that is, the best accounting system for reporting to investors is not necessarily the
best system for motivating manager performance. In other words, investors and managers interests in
financial reporting do not coincide. To understand the process of standard setting in financial accounting, it is
essential to recognize this fundamental problem.

Standard setting is the subject of this module and the next. This module explains the economics of regulation.
Financial accounting and reporting is a highly regulated activity. Since there has been substantial deregulation
of many industries in our economy over the past few years, you may ask, "Why not in accounting?" In other
words, how much standard setting is desirable from societys perspective? While accounting standards provide
benefits, they also impose a cost. The considerable bureaucracy needed to design, implement, and enforce
accounting standards is only one of these costs.

The question of how much standard setting is desirable from societys perspective cannot be determined from
economics alone. Because information is such a complex commodity and the two major constituencies involved
in financial reporting (investors and managers) have fundamentally different interests, it is not possible to
measure all the benefits and costs of information production. Consequently, the process of standard setting is
as much a political one as an economic one. The political aspects of this process will be explained in Module
10.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

9.1 Regulation of economic activity

9.2 Private incentives for information production
9.3 Sources of market failure
9.4 How much information is enough?
9.5 Decentralized regulation
9.6 Conclusion

Learning objectives

Distinguish between proprietary and non-proprietary information. (Level2)

Explain the regulatory implications of IFRS 8 on segment reporting. (Levels1 and 2)
Outline private incentives for information production, including private information search.
(Levels1 and 2)
Identify and explain sources of market failure in the private production of information. (Level1)
Outline the complexity of measuring the costs and benefits of information to society. (Level2)
Explain the regulatory implications of section 1701 of the CICA Handbook on segment reporting.
(Level2)

Module summary

Reading 9-1

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.1 Regulation of economic activity

Required reading

Chapter 12, Sections 12.1 and 12.2, pages 443-445 (Level 2)

LEVEL 2

Most regulation in accounting is justified because information asymmetry exists that is, the adverse selection
and moral hazard problems create information advantage for managers and other insiders. Regulation of firms
information production is an attempt to protect investors and creditors from the consequences of this
information asymmetry, thereby improving the operation of capital and managerial labour markets. In this
module, regulation of economic activity refers specifically to the regulation of firms external information by
some central authority.

A number of regulators are involved in the regulatory process in accounting, ranging from government
agencies to the standard-setting body of the CICA in Canada (the AcSB), the FASB in the United States, and
the IASB internationally. These regulatory bodies are referred to as central authorities. The text defines
standard setting as "the regulation of firms external information production decisions by some central
authority." While, strictly speaking, the AcSB, FASB, and IASB are private sector bodies, their ability to set
standards is delegated by the government through the various securities commissions and corporations acts.
Consequently, they are treated as regulators, and they issue standards known collectively as GAAP.

It is important to distinguish between proprietary and non-proprietary information (see page 445). Because
the costs to firms of releasing proprietary information can be high, it is more difficult to implement and enforce
regulations to require firms to release proprietary information, as opposed to non-proprietary information.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.2 Private incentives for information production

Required reading

Chapter 12, Sections 12.3, 12.4, and 12.5, pages 446-461 (Levels 1 and 2)

Read text Sections 12.3, 12.4, and 12.5 before proceeding with this topic.

LEVEL 1

This topic deals with private incentives to encourage the production of information; that is, reasons why
firms would produce information even if not required to. It is perhaps surprising that there are so many
incentives for firms to release information, even in the absence of regulations. As a result, the possibility of
reducing the extent of such regulations is worthy of debate. Accountants should not take for granted that more
accounting standards are necessarily desirable. Standard setters are not known for pointing out that standards
impose a cost on firms, and hence on society. If private incentives succeed in motivating firms to produce
sufficient information in the absence of such standards, society will benefit because standards that are not cost
effective may be eliminated.

Three ways to characterize information production

The text describes different ways of thinking about the quantity of information. To evaluate how much
information should be produced, you need to think in cost-benefit terms. This requires measuring the amount
of information involved, as well as its costs and benefits. Since information is such a complex commodity, three
quantity measures can be defined:

finer information provides more detail than normally required for historical cost statements

additional information adds new accounting information that was not formerly disclosed

credibility of information information is credible because the reader knows that the supplier
has an incentive to disclose truthfully

The text provides a fuller explanation of each measure, with examples, on pages 446-447. They are collectively
referred to as information production. In this module, a new accounting standard is interpreted as the
production of a greater quantity of information, regardless of whether it is finer, additional, or credible
information. The question is, do the benefits of that quantity outweigh the costs?

Contractual incentives for information production

There are a number of private contractual incentives that result in information production. Common
examples pointed out in text Section 12.4.1 include contractual incentives to produce information to monitor
debt covenants in lending agreements and to motivate and monitor managerial performance in a large variety
of situations. Such contracts are drawn up every day between lenders and borrowers and between firms and
managers. In the contract, the contractual parties can agree on the ratios or the performance measures to be
used.

Unfortunately, the larger the number of parties to a contract, the more difficult it is to agree on, and enforce,
provisions about information production. Consequently, many contracts simply provide that financial statements
prepared in accordance with GAAP will be used for contract purposes. This is fine, unless there are unforeseen
changes to GAAP while the contract is in force. It is such changes that produce many of the economic
consequences described in Module 6. In effect, one of the costs of a new accounting standard is its impact on
contracts in force.

Market-based incentives for information production

It is apparent, then, that contractual forces do not fully solve the problem of the extent of information
production in society. However, there are also market-based forces at work. These market-based forces
include three market systems that are responsible for the production of a large amount of information. Briefly,
they are

The managerial labour market, which constantly evaluates managerial performance. For
proper evaluation, firms need to produce information that provides a useful tradeoff between
sensitivity and precision (See Topics 7.4 and 8.3 to review these two concepts). Managers
reputations on the market reflect their abilities. The desire to establish and maintain a good
reputation motivates manager performance, and reduces the need for an incentive contract
(although not completely recall the study of Wolfson (1985), Topic 8.1 and text, page 359).

The capital market, which motivates managers to release full information to investors in order
to create a reputation for full information release, thereby lowering the firms cost of capital.

The takeover market, which motivates managers to maximize the value of the firm. (Takeover
is the taking over of one firm by another by means of a friendly or hostile bid for a controlling
interest in the firms shares.) A reputation for full information release will enhance firm value by
increasing investor confidence, thereby raising share price and lowering cost of capital. The
greater the value of the firm, other things equal, the lower the chances that the firm will be
taken over.

These are all noncontractual sources of information production. They can be very effective in bringing forth
information for the financial statement reader.

Section 12.4.2 of the text outlines several theories predicting that firms (and thus their managers) benefit from
superior reporting. Superior reporting reduces information asymmetry, thereby lowering investors estimation
risk and increasing their demand for shares. This increases market liquidity (see Note 5 on page 480) and
lowers cost of capital.

The importance of market liquidity is dramatically illustrated by the 2007-2008 meltdown of markets for asset-
backed and related securities (Topic 1.2). Investor concern about lack of transparency of these securities
reached a point where investors refused to buy them, and the market collapsed. In terms of this topics
discussion, the market lost liquidity due to lack of information production about these securities, leading to
very high estimation risk.

In Section 12.4.3 of the text, several empirical studies are described that support the theoretical arguments
that firms benefit from releasing information. It appears that firms with good disclosure policies (as measured
by financial analysts) have greater analyst following, improved share price, greater institutional ownership and
lower bid-ask spreads (see again Note 5 on page480, which explains that lower bid-ask spreads contribute to
market liquidity). A more direct relationship between disclosure quality and cost of equity capital is
demonstrated by Botosan and Plumlee (2002). They empirically showed that firms with superior disclosure
enjoy lower cost of capital. A similar result for cost of debt capital was demonstrated by Sengupta (1998).
Obviously, a measurable reduction in the cost of equity and debt capital provides an important incentive for
firms to produce information even in the absence of regulation.

To reinforce these findings, it is worthwhile to consider what happens to firms that do not provide good
disclosure. They are severely penalized by the capital market when their poor disclosure becomes known. The
cases of Enron Corp. and WorldCom Inc. provideextreme examples. As the text comments, their costs of
capital effectively became infinite. The recent market meltdowns for asset-backed securities provide an even
more dramatic example.

Other information production incentives

LEVEL 2

The text continues to describe other private forces where the firms costs of capital can be affected by their
information production policies. These forces are
 the disclosure principle
signalling
private information search

Disclosure principle

The disclosure principle provides an interesting general argument that firms will release information in the
absence of regulation. According to this principle, if a firm does not disclose information, the efficient market
will immediately wonder why and will assume that the firm must have something to hide. The resulting
negative share price effect will motivate all firms (except the one with the worst information) to disclose, in
order to separate themselves from firms with worse information.

While it has a certain logic to it, the disclosure principle does not imply that all information production problems
can be resolved by market forces. The text outlines several reasons why it can fail. One of these is cost of
disclosure the disclosure principle assumes that disclosure costs are zero. However, if there is a disclosure
cost, for example, when the information is proprietary, a disclosure threshold exists. That is, only firms with
sufficiently good news information will disclose, since the favourable impact on their costs of capital will
outweigh the disclosure costs. Firms with bad news information will not disclose, and the market cannot tell if
their failure to disclose is due to bad news or to news that is good, but not good enough to outweigh the
disclosure costs.

Even if there are no disclosure costs, as may be the case for non-proprietary information, the disclosure
principle may not motivate all firms to release information. This can happen if there is a cost to obtain (as
opposed to release) the information. Pae (2005) (page 453) shows that in this case there are also disclosure
thresholds. If the information in question (such as a financial forecast) is below the threshold, the market does
not know whether failure to disclose results from the manager not obtaining the information because it is too
costly, or whether the manager has obtained the information but it is sufficiently bad news as to be below the
threshold. Then, the disclosure principle fails because, again, only firms with relatively good news information
will disclose.

The text provides an interesting example of this phenomenon: Marks Work Wearhouse did not issue a bad
news forecast in 1992, a year in which it was expecting a loss. Marks must have felt that reporting a loss was
below its disclosure threshold.

The text outlines further examples of the breakdown of this principle. Thus, while the disclosure principle
undoubtedly encourages firms to release information under certain conditions, it seems that it cannot ensure
that market forces alone will drive adequate information production in society.

Signalling

Signalling is a related vehicle for private information production. The text defines a signal and gives numerous
examples. Three points are particularly important about signalling. First is the concept of type. This is an
underlying characteristic of the manager or firm. Simple examples of type include the following:

The firm manager may be hard working or may be a shirker. You can then think of firm
managers as consisting of two types high type (hard working) and low type (shirking).

The firm may have good future earnings prospects or poor future earnings prospects. You can
then think of firms as consisting of two types high type (good earnings prospects) and low
type (poor earnings prospects).

Of course, there can be more than two types. For example, the firm may have good earnings prospects, fair
prospects, poor prospects, and so on. However, two types is sufficient to convey the idea.

In each case, investors will be interested in which type the firm or its manager is. Also, the high types would
like investors to know that they are in fact high types, in which case they are said to want to separate
themselves from the low types. How can high types do this? A simple announcement that they are high types
would not be credible to investors, due to the danger that an unethical low type would falsely claim to be a
high type, in which case the low type is said to mimic the high type.

Signals provide a way for high types to credibly separate themselves from low types. A simple example of a
signal available to the hard working manager would be to buy more shares in the company. If a shirking
manager intends to continue to shirk, buying shares would be foolish (that is, more costly to the manager)
since the company is likely to do poorly as a result of the shirking. Thus, the market would interpret the buying
of shares as credible information that the manager is a high type.

The example of buying shares illustrates the most important point about signals: it must be less costly for a
high-type firm or manager to signal. Consider another example of a signal, namely a voluntary financial
forecast. It is less costly for the manager to release a forecast of high future earnings if the firm is in fact a
high type than if the same forecast was released by a low-type firm. The reason, of course, is that the low-type
firm is much less likely to meet the high forecast. If it does not, there will be costs in terms of possible
lawsuits, reduced manager and firm reputation, and lower share price. Thus, the low-type firm manager would
be foolish to mimic by releasing a high-type forecast. The market realizes this, and hence accepts a high
forecast as a credible signal of a high-type firm. Note thatthe act of signalling has information content over
and above the information in the forecast itself. The fact that the firm is willing to make a forecast adds
credibility to the markets belief that the firm is high type, over and above the news contained in the forecast
itself.

This leads to another point that, for a forecast or any other signal to be credible, the manager must have a
choice whether or not to release the information. Thus, if all firms were required by regulation to issue financial
forecasts, there may be information in the forecasts themselves, but firms ability to signal their type by
voluntarily releasing a forecast would be eliminated.

Private information search

Finally, private information search undoubtedly leads to much information production. In this case, the
information is generated by investors, rather than by firm managers. Nevertheless, the effect is much the same
the information available to the market is increased.

It should be apparent that private information search is not inconsistent with efficient securities markets. This is
because noise traders can cause share prices to diverge from their fully efficient levels (see Topic 3.3). Private
information search helps to push prices back to these levels. While the prospect of profiting from
self-discovered information undoubtedly drives much information production, such activities tend toward cost-
ineffectiveness from societys standpoint, because many individuals incur costs to obtain similar information.

Despite thevariety of private information production forces, the text concludes that there is no guarantee that
private forces will necessarily drive the "right" amount of information production. In the next topic, you will
consider some of the reasons for this conclusion.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.3 Sources of market failure

Required reading

Chapter 12, Section 12.6, pages462-465 (Level 1)

Reading 9-1 (Level 1)

Read Section 12.6 in the text before proceeding with this topic. When indicated, read Reading 9-1.

LEVEL 1

What is market failure? On page 443, the text defines the socially "right" amount of information production as
that amount which equates the marginal social benefits of information to the marginal social costs (see also
Note 1 on page 480 of the text). If these do not equate, there is market failure.

This is a purely economic definition. As Note 1 explains, the marginal social benefits and costs of information
production are aggregated across all individuals and firms in society. Thus, the definition ignores the
distribution of the benefits and costs. To illustrate, hold total information production constant at a level that
satisfies the definition and consider two scenarios. First, 90% of the benefits of the information go to the
wealthiest 10% of investors. Second, the benefits are equally distributed across all investors. The economic
definition is satisfied in each case, but most people would not feel that the two scenarios are equivalent.
Instead, they would likely feel that the second was "fairer." Thus, there is a strong ethical dimension to the
distribution of the net benefits of production.

The reason why most economists tend to define the socially right amount of production as they do is that they
feel that their primary role is to maximize efficiency to produce the largest possible "pie" of goods and
services in the economy. (Equating marginal total benefits with marginal total costs does this.) They feel that
they have little comparative advantage in advising how the pie should be distributed this is left to political
and ethical debate.

However, this line of questioning of the definition ignores the public-good nature of information and the role of
financial accounting in producing it. Recall from Topic 4.5 and pages 164-165 of the text that the use of
financial accounting information by one individual does not destroy it for use by another, and that financial
accounting information is available to all individuals. Thus, a benefit of producing information by means of
financial accounting is that it works in favour of a fair distribution of the benefits of information. These benefits
are available directly to investors who are willing and able to use the information (as in the case of Bill Cautious
in Example 3.1 of the text), or indirectly to other investors through the price protection mechanism of efficient
securities markets (Topic 3.2, and page 164 in the text). Consequently, to the extent that accountants behave
ethically by encouraging firms to producehigh qualityinformation (and by encouraging them to release it
simultaneously to all investors, not just a select group of analysts), society enjoys a fair distribution of the
benefits.

Unfortunately, while it may work toward these desirable goals, financial accounting information does not fully
lead to the socially right amount of information production or to a completely fair distribution of its benefits. As
mentioned, this is called market failure. Now consider reasons why market forces alone are unlikely to produce
the socially right result.

Externalities and free-riding

The first reason is a standard one used to justify government regulation. Public goods, including information,
are subject to the problems of externalities and free-riding. This means that you cannot rely on private
forces of supply and demand to generate the right amount of production. Recall that the use of accounting
information by one person does not destroy it for use by another. Another public-good aspect of accounting
information is that accounting information released by one firm often reveals information about another
(page462). In each case, it is difficult for firms to charge investors for the value of the information they
produce. In accordance with the text definition on page 462, firms actions to produce information create an
externality for investors, since the firms do not receive revenue for the information that they produce. Investors
enjoy a free ride because of this externality. However, because they do not get paid, firms produce less
information than is socially optimal. Thus, there is a role for government to regulate firms to produce more
information.

Adverse selection

Two other reasons derive from the specific nature of information. These are the by-now-familiar concepts of
adverse selection and moral hazard. It is relatively easy to see how the adverse selection problem constitutes a
failure in the production of information, as evidenced by a managers failure to release bad news, or the release
of news intended to deceive, for example. According to the disclosure principle, this should not happen.
However, there are opportunities for the manager, or other insiders, to make a quick profit by selling shares
before the bad news becomes publicly known. For some insiders, the short-run temptation of a quick profit
outweighs the longer-run adverse effects on share price and reputation. If a manager fails to release bad news,
you can hardly say that the socially right amount of information is being released, particularly since this feeds
back to outside investors, causing them to lose faith in the market. Thus, while the disclosure principle
undoubtedly operates in some cases, it does not provide a guarantee that the amount of information released
is in any way socially optimal.

At this point, take some time to review the article reproduced in Reading 9-1. This article illustrates the
existence of market failure and how such failure can lead to calls for increased regulation. In his role as
minister of finance, former Prime Minister Paul Martin was clearly concerned about the problem, leading to
suggestions for a national regulatory system for securities trading and for increased enforcement of insider
trading regulations, which are still being debated in Canada). Note also the comments of Professor Craig
Dunbar, who points out, as we have many times in this course,that market irregularities undermine investors
confidence that the market is a level playing field.

Moral hazard

To see how moral hazard also leads to market failure, revisit Problem 10 of Chapter 11 (Topic 8.10). Following
the release of its first-quarter 1998 results, it became apparent that Sunbeam CEO Dunlap had not been
"working hard" in 1997 (that is, not working effectively to turn Sunbeam Corp. around). Instead, Dunlap
attempted to cover up his shirking by means of earnings management. Again, you see that Dunlap's perception
of the short-run benefits of reporting a high profit for 1997 outweighed the expected longer-run costs to
Dunlap of loss of job and reputation (as it turned out, he was wrong in this perception, but nevertheless it
must have held in 1997). In effect, while the private forces of the managerial labour market undoubtedly
motivate much information release (as seems to be the case for General Electric in Problem 9 of Chapter11 in
Topic 8.10), they are subject to failures arising from the moral hazard problem.

Lack of unanimity

The final source of market failure, lack of unanimity, arises from the failures already described. The presence
of externalities and free-riding, adverse selection, and moral hazard means that securities and managerial
labour markets do not work properly to motivate information production. Specifically, share prices of all firms
will be slightly lower than their real worth because firms produce less information than is socially optimal and
investors are afraid of adverse selection and moral hazard.

Even if a manager does engage in full release of information so as to maximize the firms share price, this
maximization is with respect to a share price that is "too low." Thus, shareholders would prefer even more
information release. Therefore, shareholders and managers are not unanimous in the amount of information
the firm should produce. The text also gives a slightly different explanation if the audit shows that the
manager does engage in insider trading or shirking, the shareholders may be able to recover damages. Hence,
shareholders demand more information than the manager wants to release. The two explanations are
essentially the same.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.4 How much information is enough?

Required reading

Chapter 12, Section 12.7, pages 466-468 (Level 1)

LEVEL 1

By now, the texts argument that you simply do not know if market forces drive the socially right extent of
standard setting should be apparent. While there are several market forces that encourage firms to produce
information in the absence of standards, these forces are subject to failure. Whether these failures are
sufficiently serious that standards are necessary to control them is not yet known. It seems, however, that
financial reporting horror stories, such as Enron and WorldCom, have created a view that further regulation is
necessary. We have already discussed the joint IASB/FASB Framework, IAS 1, and IAS 8 (Topic 2.7), designed
to strengthen the application of GAAP. As discussed in Topic 6.2, accounting standard setters now require
expensing of employee stock options. This can be viewed as a reaction to excessive use of this compensation
device, which seems to have motivated some managers to misstate financial reports so as to opportunistically
increase share price. Also, the Sarbanes-Oxley Act in the United States (Topic 6.5) imposes major new
regulations on firms, designed to improve corporate governance. Similar requirements for improved corporate
governance are now in place in Canada, for example, The Canadian Public Accounting Board fulfils a role similar
to the Public Company Accounting Oversight Board in the United States. Also, MI 52-110 of the Canadian
Securities Administrators (see text, pages 20-21 for a brief description of this body) increases the role of audit
committees in adding credibility to financial reporting, and MI 52-109 requires the CEO and CFO to certify
financial statements and MD&A.

Note: The contents of MI 52-110 and MI 52-109 are not examinable.

These financial reporting horror stories, and the reaction of regulators to them, reinforce the text's suggestion
that complete deregulation of firms' financial reporting decisions would lead to chaos. What is less clear,
however, is whether standard setters should continue to impose more standards. The findings of Ely and
Waymire (1999) (text, page 467) suggest caution. Furthermore, the Theory in Practice vignette 12.2 (text,
pages 467-468) suggests that private market forces can be surprisingly strong in motivating managers' ethical
behaviour.

In other words, the extent of standard setting is the real issue, because standards impose costs on firms and
society. For example, are improvements in corporate governance following from Sarbanes-Oxley worth the
costs to firms to conform to this complex new regulation? Interestingly, the SEC announced some relaxation of
Sarbanes-Oxley requirements in 2007. Self-test Question 12 discusses this relaxation.

Another issue is whether increased attention to corporate governance will reduce the incentives of management
to take risks and to respond to needed changes in a rapidly changing world. No one really knows the answer.
Increased regulation of the corporate governance of financial institutions, particularly in the United States, is a
likely result of the 2007-2008 market meltdowns (Topic 1.2). These meltdowns are largely blamed on excessive
risk-taking by managers (aided by accounting standards that allowed much of this risk-taking to remain off the
balance sheet). The danger is that increased regulation will go too far, and stifle innovation by future financial
institution managers.

The main point is that you need to be aware of the costs of regulation, as described in the text, as well as the
benefits since standard setters are unlikely to bring these costs to your attention. Ignoring regulatory costs can
lead to over-regulation, the adverse social consequences of which can take considerable time, if ever, to be
reversed.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.5 Decentralized regulation

Required reading

Chapter 12, Section 12.8, pages 468-469 (Level 2)

LEVEL 2

The text makes an interesting argument that even if you do not know what the extent of standard setting
should be, you can still work to improve the efficiency of standards. That is, can standards be designed to
generate more information with no increase in costs, the same amount of information at less cost, or both?
Interestingly, IFRS 8 (not examinable), which requires firms to disclose segment information, has some
potential in this regard. The basis of segment disclosure is no longer specified by regulation but has been
decentralized, thereby revealing more information. This is because segmentation on the same basis that
management uses for internal control will presumably also be the most useful basis for informing investors
about the performance of the firms segments. Furthermore, since the firm already prepares segment
information on this basis, costs of conforming to the standard should be low.

It is interesting that this decentralized approach is beginning to appear in other standards. Thus, IFRS 7
requires that quantitative risk information be provided to investors on the same basis as it is provided to
management (see Topic 5.5). More recently, as also discussed in Topic 5.5, SFAS 159 of the FASB (not
examinable) and IAS 39 provide a fair value option to firms. Under this option, a firm may be able to value
an asset or liability at its fair value, even if it is not required to do so by current accounting standards.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

9.6 Conclusion

Required reading

Chapter 12, Section 12.9, pages 469-470

It seems, then, that the process of standard setting requires more than simply consulting an economist to
advise on the costs and benefits of proposed new standards. Since these costs and benefits cannot be
measured precisely, some other approach to standard setting is needed. As the text suggests, the politics, as
well as the economics, of new standards need to be taken into account. This means that standard setting is
more a process of conflict resolution than a process of calculation. This implication is pursued in the next
module.

Nevertheless, it is still important for accountants to be familiar with the economic costs and benefits of
standard setting. Accountants should not take for granted that more standards are necessarily desirable. This
module should alert you to the fact that standards have a cost and there are still lots of jobs for accountants in
the absence of regulation. Indeed, competent and ethical judgment about full and fair disclosure is even more
necessary when standards do not completely prescribe how to report.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

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 accountants 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.

Distinguish between proprietary and non-proprietary information.

Information can be categorized as proprietary or non-proprietary.

The release of proprietary information will directly affect the firms 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 difficult to require firms to release proprietary information.

Explain the concept of information as a commodity that has value and can
be produced by firms at a cost.

Information can be produced in several ways:

finer information more detail
additional information
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.

Outline private incentives for information production.

Contractual incentives to produce information arise from the contracts firms enter into.
Examples are managerial compensation contracts and debt contracts.
These contracts usually depend on financial accounting variables.
They are only effective when a few parties are involved.
Market-based incentives to produce information arise from securities markets and managerial
labour markets.
They encourage managers to produce information so as to create and maintain
reputation for full disclosure.
Such a reputation benefits the firm and manager through lower cost of capital and
higher reservation utility.
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.
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.
Signals are actions taken by a high-type manager that would not be rational if that
manager was a 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 for a low-type manager.
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 societys standpoint
because many individuals expend resources to discover similar
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.

Describe externalities, free-riding, adverse selection, moral hazard, and

lack of unanimity.

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 failure, or delay, of managers to release all
information.
As a result, investors do not perceive the securities market as a level playing field.
They may withdraw from the market, in which case the market loses liquidity.
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, by
opportunistic earnings management.
Such earnings management distorts the firms 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.
This can happen even if the manager produces information to the point of
maximizing the firms 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.
Outline the complexity of measuring the costs and benefits of information
to society.

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.

Explain the regulatory implications of IFRS 8 on segment reporting.

Regulation of a firms 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 minimize the cost to the firm of producing the
information while attempting to provide segment information that is of greatest use to investors.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 10: Standard setting: Political issues

Overview

Read the Chapter Overview, Section 13.1, on pages 483-484.

This module returns to the topics of conflict and conflict resolution introduced in Module7. Given the
conclusion in Module9 that the extent of standard setting cannot be calculated strictly in terms of economic
cost/benefit, this raises the further question of how the extent of standard setting is determined. As you will
see, the process of standard setting seems to be most consistent with a political process, where conflict
between affected constituencies may be resolved by means of due process, debate, and compromise. The
structure of standard-setting bodies seems consistent with this view.

This module also looks at ethical considerations for standard setters. Whenever there are conflicting
constituencies, there is the potential for ethical problems. The process of attaining a reasonable compromise
between the various groups through debate and due process results in the development of criteria for
successful standards.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topics

10.1 Two theories of regulation

10.2 Standard setting in Canada, the UnitedStates, and internationally
10.3 An ethical perspective on standard setting
10.4 Conflict and compromise
10.5 Criteria for standard setting
10.6 Conclusion

Learning objectives

Compare the two theories of regulation the public interest theory and the interest group
theory. (Level1)
Describe the standard setting processes in Canada, the United States, and internationally.
(Level 2)
Describe the ethical issues related to standard setting. (Level2)
Evaluate the political aspects of some important standards. (Level1)
Assess the criteria for a successful standard. (Level1)

Module summary

Print this module

Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.1 Two theories of regulation

Required reading

Chapter 13, Section 13.2, pages 484-486 (Level 1)

LEVEL 1

The two theories of regulation explained in Chapter13 are the public interest theory and the interest group
theory. The public interest theory suggests that the public authority or the central regulatory authority is
assumed to have the best interest of the society at heart in setting out regulations. It does its best to
maximize social benefits in the form of a fair distribution of information available to investors, and improved
operation of markets. This theory represents an ideal state of affairs where the regulator tries to follow the
cost/benefit approach to determine the extent of regulation, as described in Module9. However, it is effectively
impossible to do this for regulation in accounting, due to the complex nature of information.

This issue raises the question of how accounting regulators behave in practice. The interest group theory
provides one answer. This theory embodies the concept that there are many interest groups in society and they
lobby the legislature for various amounts and types of regulation. These interest groups can be considered as
demanders of regulation. Furthermore, the political authority itself can be thought of as an interest group that
has the power to supply regulation, including the creation of agencies such as securities commissions and other
standard setting bodies. The political authority has an interest in retaining power and will expect its agencies to
supply regulation to those groups that will assist it to retain its power. The standard setting agency is thus
caught "in between" the demands of the various interest groups affected by its standards.

Note that in this theory, the regulator attempts to maximize his/her own utility, much like the investor and the
manager. Thus, the regulator will prescribe regulations to please those interest groups who are most effective
in demanding them, and will attempt to trade off the interests of competing groups so as to minimize the
"heat" that results. In our context, the two main competing interest groups are investors and management.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.2 Standard setting in Canada, the UnitedStates, and

internationally

Required reading

Reread Chapter 1, Section 1.9.5, pages 18-21 (Level 2)

Text, Section 13.6, pages 496-503 (Level 2)

LEVEL 2

Canada and the United States

You should be familiar with the structure of standard setting in Canada and the United States, as described in
text Section 1.9.5.

Now that Canada has adopted international accounting standards, you will be operating in the IASB regulatory
environment for public companies. Note the basic difference between standard-setting activities in Canada, in
the United States, and internationally. In Canada, it is a professional body, namely the Board of Governors of
the Canadian Institute of Chartered Accountants, that has primary responsibility in this area, although it
delegates responsibility for standard setting to the Accounting Standards Board (AcSB). In the United States,
standard setting is foundation-based; that is, accounting standards are set by a body (the FASB) that is
independent of the professional accounting body (the AICPA). The IASB structure is also foundation-based.
When, as in Canada prior to 2011, standards are the responsibility of a professional body whose members also
implement those standards, concerns arise that the tradeoff between investor/manager interests may favour
managers.

It should be noted, however, that Multilateral Instrument 52-110 of the Canadian Securities Administrators,
effective March 30, 2004, (not examinable) gives audit committees the responsibility to recommend external
auditors and their compensation, and to oversee their work. This should reduce concerns that Canadian
standard setting is not foundation-based, since MI 52-110 also requires that members of the audit committee
be independent of management.

International standard setting

International standard setting is of increased importance to Canadian accountants in view of Canadas adoption
of international standards. With respect to international standard-setting, the text, pages 18-19, describes the
objectives and structure of the International Accounting Standards Board (IASB). Potential benefits of a
set of international accounting standards include lower cost of capital for firms because they can tap broader
sources of capital, especially sources in the United States. Lower costs to investors of comparing and
interpreting financial statements of firms in different countries further contribute to lower costs of capital and,
as described in the text on pages 500-501, it appears that the economies of adopting countries benefit from
better working securities markets and greater foreign investment.

However, it is still the case that investors, including Canadian investors, in foreign companies need to be
careful when they make investment decisions based on financial statements prepared under IASB standards. A
major reason is that a countrys legal, customs, and contracting environments, as well as the degree of
government involvement in the economy, affect the quality of financial reporting. Thus, the studies of Ball,
Kothari, & Robin (2000), Ball, Robin, & Wu (2003), and Bushman & Piotroski (2006), discussed in the text,
pages 497-499, found that timeliness of reporting and extent of conservative accounting differed across
countries. While this suggests that financial reporting quality is lower in some countries than others, even
under IASB standards, lower quality reporting is not necessarily opportunistic, since even high quality
accounting standards leave considerable room for accounting policy choice, earnings management, and
professional judgment. As a result, investors could be misled if they are unaware of these quality differences.

It is also clear that standards must be enforced if they are to be followed in practice. Enforcement may differ
across countries due to differences in legal systems, securities regulations, protections for minority
shareholders, and auditor liability. Guedhami & Pittman (2006) (text, page 500) found that countries with weak
auditor liability laws had higher share ownership concentration. This suggests that auditors in such countries
allowed relatively poor disclosure. Poor disclosure discriminates against small investors since majority
shareholders are more likely to be already aware of inside information. Then, small investors are less likely to
invest since they are concerned about being disadvantaged by the majority. It seems that even auditors are not
immune to differences in enforcement. Again, investors in companies in such countries should be aware of
these differences when making investment decisions.

In Section 13.6.5, the text discusses the interesting possibility of competition between standard setters. This is
already the case on a German stock exchange (the New Market), which allows firms listed on that exchange to
use either IASB or FASB standards. Indeed, a similar situation may develop in the United States. As the text
mentions on page 501, the SEC now allows foreign companies with shares traded in the United States to
report, without reconciliation, under either FASB or IASB standards, and is actively considering extension of this
option to United States companies. While, as the text discusses on pages 501-502 the possibility that
competition could increase costs of analysis for investors, and even lead to lower quality standards, a more
probable outcome is that firms would use their choice of accounting standards to signal their commitment to
quality disclosure. Also, it would be less likely that standard setters would push standards beyond their socially
desirable level, a possibility hinted at in text Section 12.2. See also Topic 9.4, which points out that the
Sarbanes/Oxley regulations may have gone too far. It will be interesting to see if the 2007-2008 market
meltdowns discussed in Topic 1.2 produce a flurry of possibly excessive new regulations, particularly with
respect to financial institutions. You should reread Topic 1.2 at this point.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.3 An ethical perspective on standard setting

Required reading

Chapter 13, Section 13.4, page 492

ERH , Unit C1, "Professionalism and responsibility in the technological society," by Conrad Brunk
(Level 2)
ERH , Unit C1, "Accounting as a Profession," by Duska and Duska (Level 2)
ERH , Unit C3, "Code of ethical principles and rules of conduct" (You are only required to read the
introductory commentary and the preamble to CEPROC.) (Level2)

LEVEL 2

Hobbes' theory

To begin this topic, refer back to ERH , Unit A4, assigned in Topic2.8 of Module2. The commentary on that
ethics reading describes Hobbes' theory of what would happen in society with no regulation at all, which is not
a desirable state of affairs. This scenario is a "mega" version of the text's assertion (Section12.7 and
Topic9.4) that markets would cease to function if all regulations of information production were withdrawn.

It is interesting to note Hobbes' argument that, in such a state, people would realize that it was in their
interests to cooperate. The argument here is similar to that in Topic 7.2 and Example 9.1 on pages 307-308.
Players will perceive that it is in their interests to achieve the cooperative solution of the game. Note that
Hobbes suggests two sources of motivation for cooperative behaviour. External motivation is a "stick"
approach. It requires an enforcement authority such as a regulator. Another source is internal motivation.
This is a "carrot" approach people will want to cooperate by keeping promises, honouring contracts, and,
generally, playing within the rules laid down by the regulator. In effect, ethical considerations suggest an
outcome similar to the conclusion of Topic9.4 the real issue is the extent of regulation. Recall from
Module9 that regulation is only needed to the extent that private forces for information production fail. As a
result, if people behave ethically, the extent of regulation can be reduced. Conversely, you would expect the
extent of regulation to increase following market failures and revelations of unethical behaviour, such as the
2007-2008 market meltdowns (Topic 1.2). It seems that lax mortgage lending practices that, in retrospect,
were clearly unethical, were major contributing sources of the market collapse that followed.

One way of getting an insight into how the extent of regulation can change is to think about what would
happen if professions and professionals always put their interests ahead of the interests of clients and the
general public or, alternatively, put client interests ahead of the public interest. Over time, clients and the
public would grow to be suspicious. They would act to restrict the powers and privileges that professionals
have. In short, professionals would be seen as untrustworthy agents whose every action had to be scrutinized.
In this situation, all parties lose. Professionals lose because they are highly restricted. Clients and the public
lose because they have to pay the increased costs of scrutinizing the behaviour of professionals, as well as the
economic costs that can follow. For example, as described in Topic 1.2, the failure of accounting standards,
and thus accounting professionals, to require consolidation of all off-balance sheet entities encouraged
excessive risk taking, which was another cause of the 2007-2008 market meltdowns. This failure will
undoubtedly lead to new accounting regulations to further tighten consolidation requirements and, indeed, will
likely lead to substantial lawsuits against the accounting firms involved.

An ethical win-win situation can be created if professionals can be relied upon to act in a trustworthy way. But
this takes more than the adoption of codes of ethical behaviour. It takes action as well. It is essential for
professionals individually and collectively to take effective steps to become trustworthy. That is, professionals
must develop strategies to offset the natural tendency to put their own interests and/or client interests ahead
of the interests of the general public. One strategy is to act in a transparent manner. For example, a profession
could invite the participation of members of the public in its regulatory bodies. Another strategy is for
professionals to be honest about their own self-interested tendencies. Too often in discussions of professional
and business ethics, people talk as if self-interest does not exist. This disables them from "naming the
problem" and proposing regulatory schemes that actually will work.

The process of standard setting and ethics

Given that some extent of regulation will always be needed, you now consider the process of standard setting
from an ethical perspective. Like all professions, the accounting/auditing profession faces significant ethical
issues, which are obviously important to its long-run survival and prosperity. "The marks of a profession" in
Unit C1 of ERH (assigned in Topic3.2 of Module3) describes the characteristics of a profession, points out the
imbalance of power between professional and client, and describes some of the ethical issues in professional-
client relationships. For example, while accountants must exercise sound professional judgment based on their
superior accounting knowledge, they should not impose their own values on the client, nor harm the public to
please the client. This important point also appears in the Duska and Duska reading, "Accounting as a
Profession" (ERH , Unit C1).

Professions also have substantial legal powers, such as those described toward the end of "The marks of a
profession" in ERH , Unit C1. In this module, our primary interest is in only one of these powers, namely,
"development and promotion of policies relating to professional practice." In accounting, this relates to the role
of standard setting. In this role, the accountant is serving as a regulator. Note that the two theories of
regulation described in Topic10.1 can be cast in an ethical perspective. Should the accounting profession act
in the best interests of the client and the public, or should it act as an interest group to secure as much power
and prestige for itself as possible?

The answer comes across clearly in Duska and Duska. They argue that the profession has an obligation to
"look out for the best interests of the client, avoiding the temptation to take advantage of the client"; this
quotation implies the public interest theory. Despite the difficulties of implementing the public interest theory
summarized in Section 12.7 of the text and Topic 9.4, accountants and standard setters should do their best to
serve the client and the public rather than serving themselves, should these goals conflict. That is, when there
is a tradeoff between the public interest and the professions interest, the accountant and standard setter
should adopt the public interest.

This tradeoff between the client/public interest and the profession's own interest is related to the "ethical
isolationism" that concerns Professor Conrad Brunk in his paper "Professionalism and responsibility in the
technological society" (ERH , Unit C1). After reviewing a number of rationalizations under which professionals
can ignore the social implications of their actions, Professor Brunk argues for an "Ethic of Conscious
Professionalism," under which the professional recognizes "the implications for good or ill of the technology or
skill he/she practices." When translated into a standard-setting context, his argument suggests that when there
are problems in accounting practice, the solution does not necessarily lie in new standards but in the
responsible, conscientious application of existing GAAP. For example, would a new standard to further regulate
consolidation of off-balance sheet activities be necessary if accountants and auditors had applied existing GAAP
conscientiously to prevent such a practice? Client firms always had the option of consolidating, even if the
regulations allowed them a loophole and, if they did not, auditors could have applied pressure to consolidate if
they felt that excessive off-balance sheet risk was being concealed.

Conflicting interests between managers and the investing public

The ethical issues facing the accounting profession in its standard-setting role are further complicated because
the interests of clients who are the managers of companies often conflict with those of the public. Thus, Duska
and Duska point out a third obligation, namely "to serve the public interest." (Usually, the public interest is
formally represented by a securities commission, such as the OSC or the SEC, but this does not change the
argument.)

According to Duska and Duska, the accountant and regulator can reconcile these two obligations by acting with
integrity. They argue that there is really no conflict because acting in the publics interest is also acting in the
clients best interests.

To understand this argument, it is helpful to consider the short run and longer run consequences of ones
actions. Clearly, the 2007-2008 market meltdowns and ensuing worldwide recession (Topic 1.2) illustrate the
serious longer run consequences of short-term thinking that allowed off-balance sheet liabilities to be
concealed. As additional examples, consider the cases of Enron, WorldCom, and the late timing scandal
described in Topic 6.2. In this case, management managed reported earnings upwards, or managed the timing
of option awards, to increase the value of its ESOs, thereby benefiting management at the expense of
shareholders. It seems that opportunistic earnings were allowed by accounting standards at the time and by
the accounting profession going along with practices that may have met the letter but not the spirit of the
standards. It is now apparent that such behaviour was not in the interests of the client or the public. In
retrospect, auditors appear to have considered only the very short-run interests of their clients, enabling the
firms and their managers to temporarily enjoy increased share price and high compensation. These actions
were not in the longer run interests of investors, the client, and the accounting profession. In effect, in the
longer run, the publics interests and the clients interests merge.

You should now carefully read the commentary in ERH , Unit C3, "Code of ethical principles and rules of ethical
conduct," as well as the preamble to CEPROC. You will see that these principles and rules of behaviour are fully
in accord with the various ethical principles outlined above.

It is important to consider these ethical considerations in relation to the debate between rules-based and
principles-based accounting standards described in text Section 13.4. Financial reporting failures, such as
Enron, have highlighted this debate, since it seems that the opportunistic policies used by Enron were, strictly
speaking, within the rules of GAAP. Yet, as argued above, these policies clearly were not in accordance with
the public interest, nor the long-run interests of the accounting profession. It is significant that the FASB is
working to implement a more principles-based approach to financial reporting. For such an approach to
succeed, accountants must pay close attention to the arguments of Brunk and Duska & Duska, as well as their
own rules of conduct.

While not mentioned in the text, IASB standards are regarded as more principles-based than United States
standards. Now that Canada has adopted IASB standards, the same comment applies to Canada. As the text
points out, principles-based standards increase the need for professional judgment. Consequently, the ethical
bases of judgment will become even more important.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.4 Conflict and compromise

Required reading

Chapter 13, Section 13.3, pages 486-492 (Level 1)

LEVEL 1

The text describes two interesting standards that illustrate the conflict and compromise aspects of standard
setting. The first is IAS 39, which applies to investments in debt and equity securities. This standard was
introduced in Section7.3.2 and Topic 5.5, where it served as an illustration of the measurement perspective.
(You may wish to review this material at this time.) This topic discusses the conflict aspects of IAS 39.

Note first that banks tend to dislike fair value accounting for financial instruments. Reasons are given on text
page 487. Essentially, they dislike the volatility that fair value accounting creates. While not stated explicitly, it
is likely that they also dislike the reduced ability to manage earnings that results from fair value accounting.

As a result, IAS 39 contained several compromises to reduce management concerns. One compromise is to
allow inclusion of unrealized gains and losses on available-for-sale financial instruments and fair value hedges
in other comprehensive income (other comprehensive income is discussed below). Another is to allow
cost-based accounting for held-to-maturity financial instruments. The fair value option represents another
compromise. Recall our discussion of mismatch in Topic 5.5, where firms may value financial instruments,
such as long-term debt at fair value even if not required to do so, thereby reducing the excessive volatility if
the debt is offset by a natural hedge consisting of financial assets that must be fair valued.

Despite, or perhaps because of, these compromises, European banks objected strongly to IAS 39, to the point
that they convinced the European Union regulators to intervene. Note that one concern expressed was a fear
that banks could disguise deteriorating credit risk by recording a gain from fair valuing financial liabilities
downwards (one might ask if the banks really believed this concern, or if it was just a smokescreen to disguise
their real concerns about earnings and capital volatility and reduced ability to manage earnings). Another
concern, perhaps of greater credibility, was the strict provisions for documenting hedges (see text, page 245),
which were claimed to be cumbersome and costly for firms that were heavily involved in hedging activity.

As a result of these expressed concerns, the European Union suspended the fair value option and strict hedging
documentation components of IAS 39 for companies under its jurisdiction. The IASB compromised by restricting
the fair value option to mismatch situations (unlike SFAS 133, which does not contain such a restriction; see
Theory in Practice vignette 7.1 on text page 243). The IASB further compromised by allowing macro-hedging,
as described on text page 247.

Other comprehensive income (OCI) represents another compromise in the setting of accounting standards.
First introduced in 1997 by SFAS 130, OCI was adopted in Canada in 2007 and by the IASB in 2009.

OCI gives management a choice of where to include other comprehensive income in the financial statements.
The most logical location would seem to be on the income statement, below net income, to arrive at
comprehensive income. However, SFAS 130 allows an alternative presentation, in a separate statement of
changes in shareholders' equity (IAS 1 does not allow this alternative). It seems that, given a choice,
management usually prefers the second alternative. For example, see the Theory in Practice 13.1 vignette on
text pages 490-491. The results of Lee, Petroni, and Shen (2004), who studied U.S. companies, strongly
suggest that managers of firms that were heavy gains traders overwhelmingly chose to report other
comprehensive income in a separate statement. Of course, if securities markets are reasonably efficient, it will
not matter where other comprehensive income is disclosed. However, the managers of the firms that chose the
separate statement may not fully accept efficiency (see Topic 8.11).

Though not discussed in the text, the 2007-2008 market meltdowns described in Topic 1.2 provide a more
recent example of political aspects. Concerns of managers of financial institutions led to threats by
governments against fair value, to the point where standard setters relaxed some of the fair value accounting
requirements.

Thus, you see again that crucial compromises have been made by standard setters in the design of accounting
standards. These compromises are particularly apparent in the accounting for financial instruments, where
bank management is very concerned and willing to apply political pressure. Also, OCI allows other types of
unrealized gains and losses to be excluded from net income, in addition to those arising under financial
instruments accounting. These include unrealized gains and losses arising from consolidation of foreign
subsidiaries, from certain pension gains and losses, and from fair value accounting for cash flow hedges. These
are also sources of earnings volatility. Also, an alternative presentation of other comprehensive income was
allowed (except under IAS1) that placed it away from the income statement. In each case, standard setters
have backed off somewhat from their preferred treatment (which, arguably, is to include all unrealized gains
and losses in net income) in order to gain management acceptance.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.5 Criteria for standard setting

Required reading

Chapter 13, Section 13.5, pages 493-496 (Level 1)

LEVEL 1

As concluded in Module 9, and as questioned again in Topic10.3, it seems unlikely that standard setters can
calculate the "socially correct" extent of standard setting. The question then is, what is needed if a standard is
to succeed?

The text suggests four needed characteristics for a successful standard. The first two are oriented to investors:

Decision usefulness for a new standard to be successful, it should be decision useful for the
investor.

Reduction of information asymmetry every effort should be made to reduce information

asymmetry, which arises from adverse selection and moral hazard.

One characteristic is oriented to managers:

Economic consequences the economic consequences that arise from manager reaction must
not be too great; the standard is likely to fail if the two investor-oriented characteristics are
pressed too strongly in the standard.

The fourth characteristic, which is perhaps better described as reasonable compromise rather than the texts
term of political aspects, relates to a more general point of view and is created from the previous three:

Reasonable compromise there should be a reasonable compromise between the interests of

investors and managers.

Attaining a reasonable compromise requires due process and debate between the various interest groups
affected by the standard. Therefore, the interest group theory, wherein each constituency bargains for the best
deal it can get, better describes standard setting than the public interest theory. Standard setters, on the other
hand, unquestionably believe that the welfare of society embodied in the public interest theory is the prime
objective of their standard-setting process. The structure of standard-setting bodies, however, seems
consistent with the interest group theory.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

10.6 Conclusion

Required reading

Chapter 13, Section 13.7, pages 503-504

In Section 13.7, the text provides some useful conclusions about the course as a whole. In the Overview of
Module 1, Chapter1 of the text was referred to as a "roadmap." Now that you have been over the "road," the
course structure should be clearer than it was at the beginning. For examination purposes, it is important for
you to see the course as a whole and to understand how the various concepts and theories fit in to this whole.
Rereading Chapter1 will assist you in this regard.
Course Schedule Course Modules Review and Practice Exam Preparation Resources

Module 10 summary
Standard setting: Political issues
This module considers the political aspects of standard setting, describing how constituencies that are 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 createdby the legislature,for their preferred nature and extent of accounting
standards.
The regulatory body (for example, AcSB, FASB) is supplied with power to set
accounting standards by the legislature.
The regulatory body is assumed to maximize its own welfare while balancing the
demands of the various constituencies.
The constituency that is most politically effective in its regulatory demands will
receive most of the benefits of regulation.

Outline the standard-setting processes in 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.
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 those laid
down by the CICA Handbook now include a full set of IFRS in Part I.
More recently, the Canadian Securities Administrators (CSA) was created to attempt
to harmonize securities regulation across Canada.

Outline the standard-setting processes in 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),
which do not affect the financial statements proper.

Outline the standard-setting processes internationally.

The International Accounting Standards Board (IASB) publishes financial accounting standards
and promotes their world-wide 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.

Compare and contrast standard-setting processes in Canada, the United

States, and internationally.

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 super-majority to pass a new standard.
The deliberations leading up to a new standard feature due process, whereby all interested
constituencies have the opportunity of presenting 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.

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 clients 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 clients 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:
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.
SFAS 130 created Other Comprehensive Income, to reduce management concerns
about earnings volatility. Subsequently, the IASB adopted a similar standard.

Assess the criteria for a successful standard.

To be successful, an accounting standard must meet four criteria:

It must convey useful information to investors.
It must reduce information asymmetry, so as to improve the operation of capital
and managerial labour markets.
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.
It must attain a consensus such that even a constituency that is 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.