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financial accounting theory

fifth edition William R. Scott
UNIVERSITY OF WATERLOO QUEENS UNIVERSITY

Toronto

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Waseda Library and Archives Canada Cataloguing in Publication Scott, William R. (William Robert), 1931 Financial accounting theory / William R. Scott. 5th ed. Includes bibliographical references and index. ISBN 978-0-13-207286-1 C2008-900661-5 1. AccountingTextbooks. I. Title. 657.044 HF5635.S36 2009 Copyright 2009, 2006, 2003, 2000, 1997 Pearson Education Canada, a division of Pearson Canada Inc., Toronto, Ontario. Pearson Prentice Hall. All rights reserved. This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission, write to the Permissions Department. ISBN-13: 978-0-13-207286-1 ISBN-10: 0-13-207286-6 Vice President, Editorial Director: Gary Bennett Executive Editor: Samantha Scully Executive Marketing Manager: Cas Shields Developmental Editors: Megan Dunkley and Rema Celio Production Editor: Imee Salumbides Copy Editor: Melissa Hajek Proofreader: Laurel Sparrow Production Coordinator: Deborah Starks Compositor: Hermia Chung Permissions Researcher: Amanda McCormick Art Director: Julia Hall Cover Designer: Miguel Acevedo Cover Image: Masterfile, Andrew Olney For permission to reproduce copyrighted material, the publisher gratefully acknowledges the copyright holders listed under articles, exhibits, and tables, which are considered an extension of this copyright page. Section 1000 (in part), Section 1505.04, and Section 3480.02 are reprinted with permission from CICA Handbook Accounting (Toronto, Canada: The Canadian Institute of Chartered Accountants, 2007). Any changes to the original material are the sole responsibility of the author (and/or publisher) and have not been reviewed or endorsed by the CICA. Portions of FASB documents, copyright by the Financial Accounting Standards Boards, 401 Merrit 7, PO Box 5116, Norwalk, CT 06856-5116, USA, are reprinted with permission. Complete copies of those documents are available from the FASB. 12345 h 12 11 10 09 08

Printed and bound in the United States of America.

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To Mary Ann, Julie, Martha, Kathy, Paul, and Cary

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Contents
Preface xi Acknowledgments 2.2.1 xiii Summary 28

2.3

The Present Value Model Under Uncertainty 29

2.3.1 Summary 35

1
1.1 1.2 1.3 1.4

Introduction

1
2.4

1.5 1.6 1.7 1.8 1.9

The Objective of This Book 1 Some Historical Perspective 1 A Note on Ethical Behaviour 10 The Complexity of Information in Financial Accounting and Reporting 11 The Role of Accounting Research 12 The Importance of Information Asymmetry 13 The Fundamental Problem of Financial Accounting Theory 14 Regulation as a Reaction to the Fundamental Problem 15 The Organization of This Book 16
1.9.1 1.9.2 1.9.3 1.9.4 1.9.5 Ideal Conditions 16 Adverse Selection 16 Moral Hazard 17 Standard Setting 18 The Process of Standard Setting 18

Reserve Recognition Accounting (RRA) 35

2.4.1 2.4.2 2.4.3 2.4.4 An Example of RRA 35 Summary 38 Critique of RRA 38 Summary 41

2.5

Historical Cost Accounting Revisited 41

2.5.1 2.5.2 2.5.3 Comparison of Different Measurement Bases 41 Accruals 43 Summary 45

2.6 2.7

The Non-Existence of True Net Income 45 Conclusion to Accounting Under Ideal Conditions 47

3 The Decision Usefulness Approach to Financial Reporting 58

3.1 3.2 Overview 58 The Decision Usefulness Approach 59
3.2.1 Summary 60

1.10 Relevance of Financial Accounting Theory to Accounting Practice 21

2 Accounting Under Ideal Conditions 24

2.1 2.2 Overview 24 The Present Value Model Under Certainty 25

3.3

Single-Person Decision Theory 60

3.3.1 3.3.2 3.3.3 3.3.4 Decision Theory Applied 61 The Information System 64 Information Defined 68 Summary 68

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3.4 3.5

The Rational, Risk-Averse Investor 68 The Principle of Portfolio Diversification 71

3.5.1 Summary 76

4.5 4.6

A Capital Asset Pricing Model 110 Information Asymmetry

4.6.1 4.6.2

114

3.6

The Optimal Investment Decision 76

3.6.1 Summary 78

A Closer Look at Information Asymmetry 114 Summary 117

4.7

3.7

Portfolio Risk
3.7.1 3.7.2 3.7.3 3.7.4

79 4.8

Calculating and Interpreting Beta 79 Portfolio Expected Value and Variance 81 Portfolio Risk as the Number of Securities Increases 82 Summary 83

The Social Significance of Securities Markets that Work Well 118 An Example of Full Disclosure 119
4.8.1 4.8.2 Introduction 119 Management Discussion and Analysis 119

4.9

Conclusions on Efficient Securities Markets 135

3.8

The Reaction of Professional Accounting Bodies to the Decision Usefulness Approach 83

3.8.1 Summary 87

5 The Information Approach to Decision Usefulness 143

5.1 5.2 Overview 143 Outline of the Research Problem 145
5.2.1 5.2.2 Reasons for Market Response 145 Finding the Market Response 146 Separating Market-Wide and Firm-Specific Factors 146 Comparing Returns and Income 148

3.9

Conclusions on Decision Usefulness 87

4 Efficient Securities Markets

4.1 4.2 Overview 98 Efficient Securities Markets
4.2.1 4.2.2

98
99

4.2.3

The Meaning of Efficiency 99 How Do Market Prices Fully Reflect All Available Information? 101 Summary 104

5.2.3 5.2.4

5.3

The Ball and Brown Study

149

4.3

Implications of Efficient Securities Markets for Financial Reporting 104

4.3.1 4.3.2 Implications 104 Summary 106

5.3.1 Methodology and Findings 149 5.3.2 Causation Versus Association 151 5.3.3 Outcomes of the BB Study 153

5.4 107
107

4.4

The Informativeness of Price

4.4.1 4.4.2 A Logical Inconsistency Summary 110

Earnings Response Coefficients 153

5.4.1 Reasons for Differential Market Response 154

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5.4.2 5.4.3 5.4.4

Implications of ERC Research 159 Measuring Investors Earnings Expectations 159 Summary 161

6.4 6.5

The Value Relevance of Financial Statement Information 196 Ohlsons Clean Surplus Theory 198
6.5.1 6.5.2 6.5.3 6.5.4 6.5.5 Three Formulae for Firm Value 198 Earnings Persistence 201 Estimating Firm Value 204 Empirical Studies of the Clean Surplus Model 208 Summary 209

5.5 5.6 5.7

5.8

Unusual, Non-recurring, and Extraordinary Items 162 A Caveat about the Best Accounting Policy 164 The Information Content of Other Financial Statement Information 166 Conclusions on the Information Approach 167

6.6 6.7 6.8

6 The Measurement Approach to Decision Usefulness 177

6.1 6.2 Overview 177 Are Securities Markets Fully Efficient? 178
6.2.1 6.2.2 6.2.3 6.2.4 6.2.5 6.2.6 6.2.7 Introduction 178 Prospect Theory 180 Is Beta Dead? 183 Excess Stock Market Volatility 185 Stock Market Bubbles 186 Efficient Securities Market Anomalies 186 Implications of Securities Market Inefficiency for Financial Reporting 189 Discussion of Market Efficiency Versus Behavioural Finance 191 Conclusions About Securities Market Efficiency 195

Auditors Legal Liability 210 Asymmetry of Investor Losses 212 Conclusions on the Measurement Approach to Decision Usefulness 216

7 Measurement Applications
7.1 7.2 Overview 228 Longstanding Measurement Examples 230
7.2.1

228

6.2.8

Accounts Receivable and Payable 230 7.2.2 Cash Flows Fixed by Contract 231 7.2.3 The Lower-of-Cost-or-Market Rule 231 7.2.4 Revaluation Option for Property, Plant, and Equipment 232 7.2.5 Ceiling Test for Property, Plant, and Equipment 232 7.2.6 Pensions and Other PostEmployment Benefits 233 7.2.7 Summary 235

6.2.9

7.3

Financial Instruments
7.3.1 7.3.2

235

6.3

Other Reasons Supporting a Measurement Approach 195

Introduction 235 Valuation of Debt and Equity Securities 236

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7.3.3 7.3.4 7.3.5 7.3.6

Conclusion 239 Derivative Instruments 239 Hedge Accounting 243 Conclusion 248

8.5.2

7.4

Accounting for Intangibles

7.4.1 7.4.2 7.4.3 7.4.4 7.4.5

248

8.5.3 8.5.4

Introduction 248 Accounting for Purchased Goodwill 249 Self-Developed Goodwill 252 The Clean Surplus Model Revisited 254 Summary 255

The Three Hypotheses of Positive Accounting Theory 287 Empirical PAT Research 290 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT 294

8.6

Conclusions on Economic Consequences and Positive Accounting Theory 296

7.5

Reporting on Risk
7.5.1 7.5.2 7.5.3 7.5.4 7.5.5

255

9 An Analysis of Conflict
9.1 9.2 9.3

304

Beta Risk 255 Why Do Firms Manage FirmSpecific Risk? 257 Stock Market Reaction to Other Risks 258 A Measurement Approach to Risk Reporting 260 Summary 262

Overview 304 Understanding Game Theory 305 A Non-Cooperative Game Model of ManagerInvestor Conflict 306
9.3.1 Summary 312

7.6

Conclusions on Measurement Applications 263

9.4

Some Models of Cooperative Game Theory 313

9.4.1 9.4.2 Introduction 313 Agency Theory: An Employment Contract Between Firm Owner and Manager 313

8 Economic Consequences and Positive Accounting Theory 273

8.1 8.2 Overview 273 The Rise of Economic Consequences 275
8.2.1 Summary 276

9.5

Managers Information Advantage 325

9.5.1 9.5.2 Earnings Management Controlling Earnings Management 329 325

8.3 8.4

8.5

Employee Stock Options 277 The Relationship between Efficient Securities Market Theory and Economic Consequences 283 The Positive Theory of Accounting 284
8.5.1 Outline of Positive Accounting Theory 284

9.6 9.7

Discussion and Summary 331 Agency Theory: A Bondholder Manager Lending Contract 332
9.7.1 Summary 335

9.8

Implications of Agency Theory for Accounting 335

9.8.1 Is Two Better Than One? 335 9.8.2 Rigidity of Contracts 339

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9.9

Reconciliation of Efficient Securities Market Theory with Economic Consequences 341 9.10 Conclusions on the Analysis of Conflict 341

11.3 Evidence of Earnings Management for Bonus Purposes 406 11.4 Other Motivations for Earnings Management 411
11.4.1 Other Contracting Motivations 411 11.4.2 To Meet Investors Earnings Expectations and Maintain Reputation 413 11.4.3 Initial Public Offerings 414

10 Executive Compensation
10.1 Overview 356 10.2 Are Incentive Contracts Necessary? 357 10.3 A Managerial Compensation Plan 360 10.4 The Theory of Executive Compensation 372

356

11.5 The Good Side of Earnings Management 415

11.5.1 Blocked Communication 415 11.5.2 Theory and Empirical Evidence of Good Earnings Management 416

10.4.1 The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance 372 10.4.2 Short-Run and Long-Run Effort 374 10.4.3 The Role of Risk in Executive Compensation 377

11.6 The Bad Side of Earnings Management 422

11.6.1 Opportunistic Earnings Management 422 11.6.2 Do Managers Accept Securities Market Efficiency? 425 11.6.3 Implications for Accountants 426

10.5 Empirical Compensation Research 381 10.6 The Politics of Executive Compensation 383 10.7 The Power Theory of Executive Compensation 386 10.8 The Social Significance of Managerial Labour Markets that Work Well 389 10.9 Conclusions on Executive Compensation 389

11.7 Conclusions on Earnings Management 427

12 Standard Setting: Economic Issues 443

12.1 Overview 443 12.2 Regulation of Economic Activity 444 12.3 Ways to Characterize Information Production 446 12.4 Private Incentives for Information Production 447
12.4.1 Contractual Incentives for Information Production 447

11 Earnings Management
11.1 Overview 402 11.2 Patterns of Earnings Management 405

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12.4.2 Market-Based Incentives for Information Production 449 12.4.3 Securities Market Response to Full Disclosure 450

13.3 Conflict and Compromise

486

12.5 A Closer Look at Market-Based Incentives 452

12.5.1 The Disclosure Principle 12.5.2 Signalling 456 12.5.3 Financial Policy as a Signal 459 12.5.4 Private Information Search 460 12.5.5 Summary 461 452

13.3.1 An Example of Constituency Conflict 486 13.3.2 Comprehensive Income 489 13.3.3 Conclusions Regarding Comprehensive Income 491

13.4 Rules-Based versus PrinciplesBased Accounting Standards 492 13.5 Criteria for Standard Setting 493
13.5.1 Decision Usefulness 493 13.5.2 Reduction of Information Asymmetry 493 13.5.3 Economic Consequences of New Standards 494 13.5.4 The Political Aspects of Standard Setting 495 13.5.5 Summary 496

12.6 Sources of Market Failure

12.6.1 Externalities and Free-Riding 462 12.6.2 The Adverse Selection Problem 463 12.6.3 The Moral Hazard Problem 464 12.6.4 Unanimity 465 12.6.5 Summary 465

462

13.6 International Integration of Capital Markets 496

13.6.1 Convergence of Accounting Standards 496 13.6.2 Effects of Customs and Institutions on Financial Reporting 497 13.6.3 Enforcement of Accounting Standards 499 13.6.4 Benefits of Adopting High Quality Accounting Standards 500 13.6.5 Should Standard Setters Compete? 501 13.6.6 Summary of Accounting for International Capital Markets Integration 502

12.7 How Much Information Is Enough? 466 12.8 Decentralized Regulation 468 12.9 Conclusions on Standard Setting Related to Economic Issues 469

13 Standard Setting: Political Issues 483

13.1 Overview 483 13.2 Two Theories of Regulation
13.2.1 The Public Interest Theory 484 13.2.2 The Interest Group Theory 485 13.2.3 Which Theory of Regulation Applies to Standard Setting? 486

484

13.7 Conclusions and Summing Up 503

Biblography Index 531 513

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Preface
This book began as a series of lesson notes for a financial accounting theory course of the Certified General Accountants Association of Canada (CGA). The lesson notes grew out of a conviction that we have learned a great deal about the role of financial accounting and reporting in our society from securities markets and information economicsbased research conducted over many years, and that financial accounting theory comes into its own when we formally recognize the information asymmetries that pervade business relationships. The challenge was to organize this large body of research into a unifying framework and to explain it in such a manner that professionally oriented students would both understand and accept it as relevant to the financial accounting environment and ultimately to their own professional careers. This book seems to have achieved its goals. In addition to being part of the CGA program of professional studies for a number of years, it has been extensively used in financial accounting theory courses at the University of Waterloo, Queens University, and numerous other universities, both at the senior undergraduate and professional Masters levels. I am encouraged by the fact that, by and large, students comprehend the material and, indeed, are likely to object if the instructor follows it too closely in class. This frees up class time to expand coverage of areas of interest to individual instructors and/or to motivate particular topics by means of articles from the financial press and professional and academic literature. Despite its theoretical orientation, the book does not ignore the institutional structure of financial accounting and standard setting. It features considerable coverage of financial accounting standards. Many important standards, such as reserve recognition accounting, management discussion and analysis, employee stock options, post-employment benefits, financial instruments, ceiling tests, hedge accounting, and comprehensive income are described and critically evaluated. The structure of standard-setting bodies is also described, and the role of structure in helping to engineer the consent necessary for a successful standard is evaluated. While the text discussion concentrates on relating standards to the theoretical framework of the book, the coverage provides students with the occasion to learn the contents of the standards themselves. I have also used this material in Ph.D. seminars. Here, I concentrate on the research articles that underlie the text discussion. Nevertheless, the students appreciate the framework of the book as a way of putting specific research papers into perspective. Indeed, the book proceeds in large part by selecting important research papers for description and commentary, and provides extensive references to other research papers underlying the text discussion. Assignment of the research papers themselves could be especially useful for instructors who wish to dig into methodological issues that, with some exceptions, are downplayed in the book itself. A major change in this fifth edition is to orient the coverage of accounting standards to those of the International Accounting Standards Board (IASB), in place of Canadian

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standards in the CICA Handbook. This is because of the planned adoption in 2011 of IASB standards for public companies by the Canadian Accounting Standards Board. This change does not affect the approach and structure of the book. While there are numerous differences in detail, international and Canadian accounting standards are already similar at a conceptual level, and are continuing to move closer together. Consequently, prior to 2011, Canadian readers can accept IASB standards as roughly equivalent to those in Canada. Of course, this change to IASB standards should appeal to the numerous users of this book in other countries that have adopted IASB standards. As in previous editions, coverage of major U.S. accounting standards is included, particularly where these differ from, or are in advance of, international and Canadian standards. Other changes include expanded coverage of financial reporting issues arising from global integration of capital markets, and improvements to the discussion and presentation of agency theory. I have updated references and discussion of recent research articles, revised the exposition as a result of comments received and experience in teaching from earlier editions, and added new problem material. I have also expanded the number of optional sections for those who do not wish to delve too deeply into certain topics. This edition now accepts that securities markets are not fully efficient, although it continues to argue that markets are close enough to full efficiency that the efficient market model provides useful guidance to theory and practice. In part, this continuing acceptance of the efficient market model reflects my perception from the academic literature that the efficiency model is recovering somewhat from the onslaught of behavioural finance. More fundamentally, however, research suggests that departures from full efficiency can be just as well explained by rational investor behaviour as by non-rational behavioural characteristics. Consequently, this edition retains its acceptance of the rational Bayesian decision theory model of the average investor.

SUPPLEMENTS
Instructors Resource CD-ROM (ISBN 978-0-13-604110-8)
This resource CD includes the following instructor supplements:

Instructors Manual The Instructors Manual includes suggested solutions to all the end-of-chapter Questions and Problems. It also offers learning objectives for each chapter and suggests teaching approaches that could be used. In addition, it comments on other issues for consideration, suggests supplementary references, and contains some additional problem material. PowerPoint Lecture Slides PowerPoint presentations offer a comprehensive selection of slides covering theories and examples presented in the text. They are designed to organize the delivery of content to students and stimulate classroom discussion.

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Acknowledgments
I have received a lot of assistance in writing this book. First, I thank CGA Canada for their encouragement and support over the past years. Much of the material in the questions and problems has been reprinted or adapted from the Accounting Theory I course and examinations of the Certified General Accountants Association of Canada. These are acknowledged where used. I acknowledge the financial assistance of the Ontario Chartered Accountants Chair in Accounting at the University of Waterloo, which enabled teaching relief and other support in the preparation of the original manuscript. Financial support of the School of Business of Queens University is also gratefully acknowledged. I extend my thanks and appreciation to the following instructors who provided formal reviews for this fifth edition: Granville Ansong (Saint Marys University) Sati P. Bandyopadhyay (University of Waterloo) Paul Berry (Mount Allison University) Kate Bewley (York University) Carla Carnaghan (University of Lethbridge) James C. Gaa (University of Alberta) Maureen P. Gowing (University of Windsor) Irene M. Gordon (Simon Fraser University) Mary Oxner (St. Francis Xavier University)

I also thank numerous colleagues and students for advice and feedback. These include Sati Bandyopadhyay, Phelim Boyle, Dennis Chung, Len Eckel, Haim Falk, Steve Fortin, Irene Gordon, Jennifer Kao, David Manry, Patricia OBrien, Bill Richardson, Gordon Richardson, Dean Smith, Dan Thornton, and Mike Welker. Special thanks to Alex Milburn for invaluable assistance in understanding IASB standards, and to Dick VanOfferen for helpful comments and support on all editions of this work. I thank the large number of researchers whose work underlies this book. As previously mentioned, numerous research papers are described and referenced. However, there are many other worthy papers that I have not referenced. This implies no disrespect or lack of appreciation for the contributions of these authors to financial accounting theory. Rather, it has been simply impossible to include them all, both for reasons of space and the boundaries of my own knowledge. I am grateful to Carolyn Holden for skilful, timely, and cheerful typing of the original manuscript in the face of numerous revisions, and to Jill Nucci for research assistance. At Pearson Education Canada I would like to thank Samantha Scully, Gary Bennett, Cas Shields, Megan Dunkley, Imee Salumbides, Melissa Hajek, Laurel Sparrow, Leanne Rancourt, Deborah Starks, Hermia Chung, and Miguel Acevedo. Finally, I thank my wife and family who, in many ways, have been involved in the learning process leading to this book. William Scott

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