CHAPTER 1: Introduction

The purpose of financial accounting theory is to create an awareness and understanding of the financial reporting
environment in a market economy

Some Historical Perspective

1.Early development
- Before companies issued shares: reports were internal
- After shares were issued: reports for external purposes as well
2.Accounting was unregulated until the Great depression of 1930s
- Creation of SEC
- Strengthening of historical cost accounting
3.Alternatives to historical cost
- Current value accounting
 Value-in-use
 Fair value (also called exit price, opportunity cost)
4.Mixed measurement model

Collapse of the Stock Market Boom of Late 1990s

Enron  In order to raise capital without taking on debt, they:

- Created Special Purpose Entities (SPE’s)
- Sold Enron’s shares to the SPE for notes
- Then SPE took on debt with Enron’s shares as collateral
- Debt was used by SPE to pay Enron for the shares

Also
- Enron owned the SPE, and SPE held Enron stock
- When Enron’s share price inc., SPE recorded investment income
- Then Enron recorded its share of the SPE’s income (since Enron owned the SPE)
- SO Enron recorded an income on the inc. in its shares

Consolidation would have prevented this!

- Also, Enron’s Auditors had approved their annual reports

- WorldCom (overstated earnings by $11 Billion)
- Collapse of public confidence in:
1) capital markets
2) financial reporting
3) auditors

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 - To boost confidence: Improve financial reporting
1) Increased regulation and corporate governance
2) Sarbanes-Oxley Act
 Audit committee on BOD
 Enhancement to audit standards
3) Tighten rules re off-balance sheet entities

Additional Details of 2007-2008 Market Crash

- ABS were not transparent, so Investors didn’t know what was in those securities
- CDO and CDS were traded privately
- Lenders knew they would sell mortgages, so they stopped caring about quality of debtors and started giving
out mortgages left and right
- People began taking on too many mortgages
- Too many ABS’s (which are mortgages) began failing because they were bad debts
- So credit default swaps had to be paid, i.e Insurance companies began to fail

Causes of Market Crash:

1.Inadequate regulation
 Lack of transparency
 Relaxed mortgage lending policies
2.Lack of ethics from banks
 Manipulating securities markets to sell toxic loans

2007- 2008 Market Meltdown Implications for Accountants

1. Need for transparency in reporting
2. Value-in-use v. fair value accounting
- Allow the use of firm estimates when markets are illiquid (liquidity pricing)
3. Full disclosure of off-balance sheet activities

Efficient Contracting

- It is a different view of the purpose of financial reporting

- Basic characteristics of efficient contracting view
- Emphasis on contracts to generate trust and accountability.
- A firm can be defined by the contracts it enters into
 Debt contracts,
 Compensation contracts
- For good corporate governance, contracts should be efficient
 E.g., a firm can generate lenders’ trust by incorporating a covenant into a borrowing contract.
 Covenants are a cost of contracting
 Lenders reward firm with lower interest rate. This is a benefit of contracting
- An efficient contract is the best tradeoff between contracting costs and benefits
- Efficient contracting emphasizes manager stewardship
 Compensation contracts should motivate managers to work in the best interests of firm owners
 An efficient compensation contract does so at lowest compensation cost.
- Policy Implications of Efficient Contracts:
 Financial reporting should be reliable
 Reliable reporting generates investor trust
- Financial reporting should be conservative
 Prevents managers from increasing profits through non-reliable asset write-ups or unrealized sales

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Ethical Behavior by Accountants/Auditors

- Was accountant/auditor behavior leading up to Enron, WorldCom, and 2007-2008 market meltdowns
episodes ethical?
- Serve the client (short run view) or serve society (long run view)?

- Why should you behave ethically as an accountant/auditor?

Rules-Based v. Principles-Based Accounting Standards

- Do rules-based accounting standards work?

 Enron, WorldCom, 2007-2008 crisis…
 Expected loss notes
 Will more rules in new accounting standards work to prevent abuse?
- Principles-based standards?
 Important role of Conceptual Framework
 Relies on ethical accounting/auditing profession

The Complexity of Information

- Individual reactions to same information may differ
 Investors (Short-term vs. long-term)
 Creditors
- Information also affects how well markets work
 Securities markets
 Managerial Labor Market

Information Asymmetry

- What is Information Asymmetry?

- 2 Problems for a market economy:
1. Adverse selection problem
• Ex: buying second hand products?
2. Moral hazard problem
• Ex: you hire an employee in your coffee shop or depanneur
- Role of accounting information to control adverse selection
 Communicate inside information to outsiders
 Supply useful information to investors and creditors
- Role of accounting information to control moral hazard
 Control manager shirking
 Improve corporate governance

The Fundamental Problem Of Financial Accounting Theory

The best measure of net income to control adverse selection is not the same as the best measure to motivate
manager performance (moral hazard)
- Investors want information about future firm performance
 Current value accounting?
- Good corporate governance requires that managers “work hard”
 Does more reliable information and conservatism (historical cost accounting) better
reflect manager effort than current value information?

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CHAPTER 2: Accounting Under Ideal Conditions

Relevant financial information gives information to investors about the firm’s future economic prospects (future
cash flows). It makes a difference in decision making.
Reliable financial information faithfully represents the firm’s financial position ad results of operations.

Under ideal conditions, future cash flows are known with certainty and there is a given interest rate in the
economy. It is possible to prepare completely relevant and reliable financial statements. The market value of the
firm is then the value of its net financial assets plus the value of its capital assets (less liabilities).

Ideal Conditions of Certainty

- Assumptions include that future cash receipts are known and there is a given interest rate
- Information is reliable; cash flows and interest rates are known
- Present value (or market value) is used as basis of accounting.
- Future cash flows are known with certainty and risk-free rates are given. PV of assets/liabilities will equal their
FMV. Future cash flows can be discounted; B/S contains all relevant information while the I/S contains none.
- Income is recognized as changes in present value occur. Thus it has no role in firm valuation since it is
predictable. Investors can calculate themselves. There is therefore no need for accounting under such
conditions because the investor can calculate everything himself (no income statement either)
- Dividend irrelevancy: as long as investors can invest any dividends they receive at the same rate of return as the
firm earns on cash flows, the PV of an investor’s overall interest in the firm is independent of the timing of
dividends.

Ideal Conditions of Uncertainty

- Assumptions are that states of nature are publically known (state realization is publicly observable) as well as
probabilities, and given interest rate
- The interest rate is given at which the firm’s future cash flows are discounted
- A complete and publicly known set of states of nature are given. States of the economy are called the states of
nature, which is either good or bad. We assume that the states of nature are objective and publicly known,
along with their probabilities of occurring.
- Future cash flows are known conditionally on the states of nature.
- Expected present value is used as a basis of accounting.
- Income is recognized as changes in expected present value occur i.e. at the end-of-period after we observe the
outcome. PVs depend on which state is realized: there is volatility with B/S values and net income. There is no
need for an income statement under these conditions because it has no information content when abnormal

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 earnings do not persist. Investors have sufficient information to calculate for themselves what realized net
income would be once they know the current year’s state of realization.

If the state probabilities are subjective, so are the resulting expected values. Thus, the value of the firm is also
subjective. Since investors know that their predictions are subject to error, they will be alert for information sources
that enable them to revise their probability assessments. The I/S is one source. When state probabilities are
subjective, investors will assign probabilities themselves based on the information available for them.

Therefore, ideal conditions are NOT realistic. Outcomes are not known to everyone (subjective vs. objective
outcomes), everyone has a different risk assessment (risk averse, etc.) and interest rates are not always known. Due
to the lack of ideal conditions, greater relevance requires more estimates but more estimates decrease reliability.

We aim for value relevance, which is a mix of relevance and reliability  they must be traded off.

Reserve Recognition Accounting

- An application of present value accounting when ideal conditions do not exist governed by SFAS 69 of FASB
- Applies to proved reserves only, discounted at mandatary rate of 10%, revenue is recognized as reserves are
proved and uses average oil and gas price for the period.
- This method is not reliable and not relevant: what if oil prices change, outcomes are not predicted, why doesn’t
the rate change, state probabilities are not objective… This leads to the critique of RRA.
- Estimates are subject to error and bias but this method requires estimates of quantities, timing of extraction and
prices
- RRA is therefore not reliable so it must be disclosed in notes

Historical Cost Accounting

- More reliable because cost has already occurred therefore it is verifiable and less subject to bias and errors of
estimation.
- Less relevant because cost isn’t allocated over the years and in reality, these values change over time.
- More recognition lag: revenue is not recognized until sales are realized (revenue recognition).
- Costs and revenues are better matched: Net income is a result of the matching of realized revenues with the
costs of earning them. This is accomplished through accruals.

Fair Value Accounting

- More relevant because in a constantly changing environment, the current values of assets/liabilities better
reflect future prospects.
- Less reliable because it requires the need for estimates when conditions are not ideal.
- Less recognition lag: changes in economic value are recognized as they occur.
- Earlier revenue recognition than historical cost
- Little matching of costs and revenues since net income is an explanation of how current values of assets and
liabilities have changed during the period. Matching is not required for this since value changes in assets and
liabilities are driven by market forces and then firm’s response to these forces.

The Non Existence of True Net Income

- There is a lack of objective states of nature probabilities

- Theory of incomplete markets (for use of FMV) due to thin markets (oil and gas reserves) and information
asymmetry

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 - If there is no market value, we cannot use market value as proxy for present value
- If we have to estimate present value, then true net income does NOT exist
Fundamental Roles of Accounting

- Accountants are not needed if true net income did exist

- Judgement is required to estimate net income (judgement differs across individuals due to many reasons).
Judgement is an essence of profession
- Protect the equity of claimants to the assets and income of an entity
- Provide information for decision makings
- Accountants must aim for the closest representation of income

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CHAPTER 3: The Decision Usefulness Approach to Financial Reporting

Accountants agree that financial statements should be useful. Decision usefulness is the ability of financial
accounting information to help users make good decisions.

The Decision Useful Approach

- Takes the view that “if we can’t prepare theoretically correct financial statements, at least we can try to make
financial statements more useful” i.e. make them reliable and relevant
- The users of financial statements are categorized into broad groups called constituencies: equity and debt
investors, managers, unions, government and standard setters. By taking in the information needs of these
users, accountants can better prepare financial statements to lead to improved decision-making

Single-Person Decision Theory (The Rational Decision Theory Model)

- Takes the viewpoint of an individual who must make a decision under conditions of uncertainty.
- State probabilities are now subjective as they are under ideal conditions and sets out formal procedures
whereby an individual can make the best decision by selecting from a set of alternative actions.
- By obtaining additional information, the individual can revise his assessment of probabilities of what might
happen after the decision is made (probabilities of states of nature)
- Investors make decisions in a variety of ways. This theory claims to capture the decision process of the average
investor not an individual investor. Investor decisions are rational; they make decisions to maximize their
expected utility.
- The rational decision theory model does not claim to capture the decision process of an individual investor
- It claims to capture the decision process of the average investor, that is:
 Investor decisions are, on average, rational
 A rational investor makes decisions to maximize his/her expected utility
- It is important to note that this theory doesn’t claim that all investors are rational. It assumes that investors are
usually risk averse. Risk-averse investor trades off risk and return. If risk increases, there is a higher demand
for higher return.

Bayes’ Theorem
- A device to revise state probabilities upon receipt of new evidence
- Calculates the expected probability of the state of nature
- Difficult to use because it is subjective and people don’t measure utility with numbers on a regular basis.

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 - It is unreliable, how will you know everyone’s beliefs? Additional information is needed from financial
statements, notes, company website to help predict future outcomes

The Information System

- All conditional probabilities are called an information system
- For information to be useful, it must help predict future investment returns. Financial statements will still be
useful to investors to the extent that the good or bad news they contain will persist into the future. The lack of
ideal conditions gives the financial statements their information content.
- Highly informative financial statements are also called: transparent, precise, high quality
- Even though probabilities are subjective, we can still improve our probability estimates by more useful, relevant
and reliable information and information we find useful
- Information is evidence that has potential to affect and individual’s decision. Information benefit should
outweigh the costs. The costs related to information are those that incur to produce or check it. Financial
statements are information.
- Overall, information is a powerful commodity because it can affect the actions taken by investors. It is important
that accountants understand this

The Rational, Risk-Averse Investor

- The decision theory is a model of the average investor. It does not claim that all investors are rational.
- Investors are usually assumed risk-averse
- Risk-averse investor trades off risk and return

Portfolio Diversification

- Investors can increase their utility by adopting a strategy of portfolio diversification (diversify investments by
investing in different companies)
- There are two types of events that affect the returns on firm’s market share.
1. Market wide factors: if the return on one share is high, it is more likely that the returns on most other
companies’ shares in the economy will also be high. However this is not always the case due to firm specific
factors; one firm can experience high return while another experiences low return.
2. Firm specific factors: affect the return of one firm only. Examples include quality of a firm’s management,
new patents, strikes, machine breakdowns, etc.
- If diversification increases, then risk decreases. You cannot completely eliminate risk because you cannot take
out market wide factors. A fully diversified portfolio is one where firm-specific factors tend to cancel out
leaving only undiversifiable market wide factors to affect returns.

Increasing the Decision Usefulness of Financial Reporting

Management discussion and analysis (MD&A) is a standard that requires firms to provide a narrative
explanation of company operations to assist investors to interpret the firm’s financial statements. The standard also
provides an important illustration of how the amount of useful information in the public domain can be increased.
Its objectives include:
 Help current and prospective investors understand the financial statements
 Discuss information not fully reflected in financial statement
 Discuss important trends and risk
 Provide information about the quality, and potential variability, of earnings and cash flow, to help investors
determine if past performance is indicative of future performance
 Provide information about credit ratings

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MD&A standard has a forward-looking orientation and is consistent with rational decision making (more
information provides better future predictions). It can be more relevant than financial statements depending on
what is said. For instance, management can explain to users what happened exactly and give a better idea of
forecasts and the risks approaching the firm.

Current research reports evidence that MD&A is decision useful. However, further studies are needed to determine
whether this decision usefulness is declining over time. In addition, MD&A suffers from low timeliness, since by the
time the firm’s annual report becomes publicly available, much financial statement information has already been
released.

The Reaction of Professional Accounting Bodies

The Conceptual Framework

- Major professional accounting bodies have adopted the decision useful approach because it is oriented to
primary users’ decisions. Financial statements provide information that is useful about the amount, timing, and
uncertainty of future cash flows. The decision usefulness and investor risk aversion is implied.
- In addition, information system is implied since information system links current and future performance. This
suggests that investors use current performance to update their probabilities of future firm performance.
- Overall, the approach is reasonably consistent with the decision theory
- The role of accruals is to include the effects of transactions on the firm’s balance sheet in the periods in which
those effects occur, even if the resulting cash receipts and payments occur in a different period
- The framework considers the characteristic that are necessary for financial statement information to be useful
for investor decision making: relevance, reliability, timeliness, comparability, verifiability, understandability

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CHAPTER 4: Efficient Securities Market

In this chapter, we consider the implications of rational investor behavior for securities markets. The theory of
efficient securities markets predicts that the security prices that result have some appealing properties. These
prices fully reflect the collective knowledge and information-processing expertise of investors. This theory leads
directly to the concept of full disclosure.

Accounting can be viewed as a mechanism to enable communication of useful information from inside the firm to
the outside world. Accounting will survive only if it is relevant, reliable, timely and cost effective relative to other
sources (analysts, media, share price etc). We can therefore say that accounting is in competition with other sources
of information.
 Under ideal conditions, information of state of economy, dividends and future cash flows is publicly
observable and free.
 Under non-ideal conditions, investors have different levels of expertise and information acquired. Each
investor must decide how much accounting expertise and information to acquire and then form their own
subjective estimates of firms’ future performance. These estimates will need revision as new information
comes along. Each investor then faces a cost-benefit tradeoff with respect to how much information to
gather. A major source of cost-effective information is careful analysis of quarterly/annual reports.

Efficient Securities Market

An efficient securities market is one where the prices of securities traded on the market at all times fully reflect all
information that is publicly known about those securities. Semi-strong form

- Market prices are efficient with respect to publicly known information. Thus, the definition does not rule out the
possibility of inside information. People with insider information know more than the market and are at an
advantage to earn excess profits on their investments at the expense of outsiders.
- The market is efficient relative to a stock of publicly available information.
- Investing is a fair game if the market is efficient. Investors cannot expect to earn excess returns on a security, or
portfolio of securities, over and above the normal expected return on that security
- A security’s market price should fluctuate randomly over time. There should be no serial correlation of share
return. For example, if a firm reports good news today, its share price should rise to reflect this news the same
day. The reason is that anything about firm value that can be expected, such as seasonal nature of its business
or expected profit from a new contract, will be fully reflected in its security price by the efficient market
- Once new or corrected information becomes publicly available, the market price will quickly adjust to it. This
adjustment occurs because rational investors will scramble to revise their beliefs about future performance as
soon as new information becomes known.
- Different investors will react to the same information differently, even though they all proceed rationally. This is
because of different beliefs or interpretations of the same information. Each investor has his own estimates.
We can think of these differences as averaging out so that the market price has superior quality to the quality

10
 of the information processing of the individuals. It is assumed that the investors evaluate new information
independently.
- If information for a stock is incomplete due to inside information (or errors), security prices will be wrong.
Therefore, market efficiency does not guarantee that security prices fully reflect real firm value. It does
however, suggest that prices are unbiased relative to publicly available information and will react quickly to
new or revised information.

Implication of Securities Market Efficiency for Financial Reporting

- Accounting policies adopted by firms do not affect their security prices, as long as these policies have no
differential cash flow effects, the particular policies used are disclosed, and sufficient information is given so
that the reader can convert across different policies. The market can see through the ultimate cash flow and
dividend implications regardless of which accounting policy is used for reporting. The efficient market is not
“fooled” by differing account policies when comparing different firm’s securities.
- Efficient securities markets go hand in hand with full disclosure. Managers should disclose information about
the firm as long as the benefits to investors exceed the costs. Investors will use all available information as tjeu
strive to improve their predictions of future returns and the more information a firm discloses about itself, the
greater is the investors’ confidence in the working of securities market.
- Firms should not be overly concerned about the naïve investor – financial statement information need not be
presented in a manner so simple that everyone understands it. According to Fama, if enough informed
investors engage in the action of buy/sell based on the information publicly available the market price of
securities will reach efficient level. Naïve investors can hire other professionals and can imitate informed
investors; they are price protected.
- Financial statements aren’t the only source of information. So, accountants now face competition with financial
institutions, websites and other media, and disclosures by management.

The Informativeness of Price - A Logical Inconsistency

The actions of informed investors who are always striving to obtain and process information to make good buy/sell
decisions are the reasons why prices fully reflect publicly available information. We can say that the price is fully
informative. The logical inconsistency is that if prices fully reflect information available, there is no motivation for
investors to acquire information and they rely on market price as indicator of future security concerns; hence prices
will not fully reflect available information. No one would bother to gather information, since they can't beat the
market (fair game). If no one gathers information, share prices will not reflect all publically available information. If
share prices do not reflect all publically available information, investors will gather information and share prices
will quickly become fully informative. Then no one would bother to gather information, etc… hence a logical
inconsistency.

A common way out of the inconsistency is to recognize that there are other sources of demand and supply for
securities than the buy/sell decisions of rational/informed investors. For example, noise traders buy shares not
based on rational evaluation of information. Share prices are partially informative in presence of noise trading so
share price may deviate from its efficient value. This restores incentive of investors to gather information. If further
investigation shows the firm is undervalue, rational investor will buy. The rational investor correctly figures out
how much weight to put on the possibility that the share price reflects noise trading and how much on the
possibility that other investors have better information

We might expect that price will be more informative for large firms, since they are more ‘’in the news’’ than small
firms, hence their market price will incorporate considerable information. This reduces the ability of financial
statements to add to what is already known about such firms. Thus, security prices respond less to financial
statement information for large firms than for small firms.

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Capital Asset Pricing Model

E(Rjt) = Rf(1 - βj) + βjE(RMt)

Market sets share price so that expected return E(Rjt) (i.e., firm’s cost of capital) is given by right side of equation
Note that only firm-specific component is ßj. Beta measures the covariance of security’s return j with market
portfolio return. It measures risk contributed by a security to a fully diversified portfolio. Var(M) is the variance of
the market portfolio (a standardization device so that betas from securities traded on different markets can be
compared).

Information Asymmetry

Information asymmetry occurs when one party has an advantage on information over the other party. It is an
important reason for market incompleteness. There are two types:
1. Adverse Selection: occurs in situations where two parties have an imbalance of information
2. Moral Hazard: when one side of the party’s actions are unobservable which creates the possibility that one
may lack in effort
These two types of information asymmetry create additional sources of estimation risk for the investor. With
adverse selection, the unknown parameter is the honesty of the insider. With moral hazard, the unknown
parameter is the extent of manager shirking,

- Lemon Problem: In the used car market, the owner of the car will know more about its true condition,
and hence its future stream of benefits, than would a potential buyer. This creates an adverse selection
problem, since the owner may try to take advantage of this inside information by bringing a ‘’lemon’’ to
market, hoping to get more than it is worth. However, buyers will be aware of this temptation and since they
don’t have the information to distinguish between lemons and good cars, they will lower the price they are
willing to pay for any used car. As a result, the good cars will have a market value that is less than the real
value of their future stream of benefits. Thus, owners of good cars are less likely to bring them to market. To
reduce lemon problem, voluntary signals can be used to show that the product is good quality. For example,
warranties & safety certifications for cars and medical exams for life insurance.
- Securities markets are subject to information asymmetry problems, such as insider information and
insider trading. Insiders might take advantage of their inside information to earn excess profits by delaying or
withholding its public release while they buy/sell shares on the basis of this information (adverse selection
problem). There is therefore market incompleteness with shares since investors cannot be sure of buying a
security with the exact expected return and risk that they want.

Effect of Estimation Risk on Share Prices

- Efficient market price includes a “discount” for expected estimation risk (i.e., for expected losses at the hands of
insider trading). In effect, investors demand a higher return
- Then, CAPM may understate cost of capital, since ignores estimation risk. To some extent, estimation risk may be
diversified away, but, since outside investors more likely to lose than gain from insider trading, some discount
will remain
- Controlling estimation risk involves insider trading laws and financial reporting. The role of financial reporting is
to convert inside information into outside, thereby reducing estimation risk.
- Markets that "work well" have low estimation risk, and share prices as close to fundamental value as is cost
effective

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Fundamental Value

The fundamental value of a share is the value it would have in an efficient market if there is no inside information. That
is, all information about the share is publicly available.

Under ideal conditions, the firm’s market value fully reflects all information. When conditions are not ideal, market
value fully reflects all publicly available information. Security prices do not fully reflect the fundamental value in the
presence of inside information. Investors will recognize that this is unfair, so they will either withdraw from the
market or lower the amount they are willing to pay for any security. As a result, firms with high-quality investment
projects will not receive a high price for their securities, and they will underinvest

Agencies create/enforce regulations to, for example, set accounting standards, control insider trading and promote
timely disclosure of significant events, with penalties for violation. This could reduce the estimation risk related to
inside information. Inside information creates a lemons problem that raises firms cost of capital.

A firm with credible policy of full disclosure beyond the regulatory minimum set by agencies may enjoy higher
share prices and lower cost of capital. This is because full disclosure reduces investors’ concerns about inside
information (for example: via MD&A). In addition, reporting quality is also important to fight information
asymmetry. Through MD&A, the management can discuss about trends and risks, which tightens up the current
information with the future performance of the firm. Superior disclosure signals a confident and well-planned
management approach, suggesting that good performance in the face of risks and uncertainties will continue.

Efficient Markets Theory states that supplementary information in F/S notes or elsewhere is just as useful as
information. Informative financial reporting has a role to play in improving the amount, timing and accuracy of
information, which helps capital markets to work better and improve operations of the economy. Better information
enables more informed buy/sell decisions.

Market price aggregates the collective information processing and decision-making expertise of investors. Therefore
market price itself has considerably information content, which individuals may use as input into their decisions.
However, not all information is in the public domain (inside information). We also need to consider noise trading
that affects the share price, which does not have any relation to the fundamental value of a firm.

Social Significance of Markets that Work Well

- In a capitalist economy, allocation of scarce capital to competing demands is accomplished by market price.
Firms with productive capital projects should be rewarded with high share prices (low cost of capital)
- Capital allocation is most efficient if share prices reflect fundamental value. Society is better off the closer are
share prices to fundamental value (i.e., if markets work well)
- The social role of financial reporting is to help markets work well. It maximizes amount of publically available
information and is subject to a cost-benefit constraint.
- The social role of financial reporting is enhanced by securities market efficiency. Then, the market fully uses
financial accounting information.

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 CHAPTER 5: Information Approach to Decision Usefulness

When security market prices respond to accounting information, accounting information has value relevance.
Information is useful if it leads investors to change their beliefs and actions. The degree of usefulness for investors
can be measured by the extent of volume or price change following release of the information. This takes the view
that investors want to make their own predictions of future security returns.

The information approach to decision usefulness is an approach to financial reporting that recognizes individual
responsibility for predicting future firm performance and that concentrates on providing useful information for this
purpose. The approach assumes securities market efficiency, recognizing that the market will react to useful
information from any source. It also implies that empirical research can help accountants to further increase
usefulness by letting market response guide them as to what information is and is not valued by investors. Investors
are responsible for predicting future firm performance, therefore role of financial reporting is to provide useful
information. Usefulness of financial statement information is evaluated by magnitude of security price response to
that information. This helps accountants to evaluate decision usefulness of different accounting policies.

Information is a commodity and its private and social values are not the same. Financial statement users do not
generally pay directly for this information so they may find information useful even though it costs society more
(in the form of higher product prices to help firms pay for generating and issuing the information) than the
increased usefulness is worth. Accountants cannot claim that the best accounting policy is the one that produces the
greatest market response due to the fact of these costs. Securities market will work better to allocate scarce
capital if security prices provide good indicators of investment opportunities and fundamental firm value.

The Research Problem

Reasons for Market Response to Financial Statement Information

1) Investors have prior beliefs about a firm’s future performance (dividends, cash flows & earnings), which affects
the expected returns and risk of the firm’s stock price. These prior beliefs are based on available information
(including market price) up to just before the release of the firm’s current net income. These prior beliefs are
different depending on the investor.
2) If net income results are higher than expected, it may be good news so investors will revise upward their
beliefs about future firm performance. Other investors, who perhaps had overly high prior beliefs of what current
net income should be, might interpret the same net income number as bad news.
3) Those who revised their beliefs upward will tend to buy more shares of the firm and vice versa for those who
revised their beliefs downward. They do this to restore the risk-return tradeoffs in their portfolios to desired levels.
4) It is expected that there will be an increase in volume of shares traded when the firm reports its net income.
The greater the differences in investor’s prior beliefs, the greater the volume of shares. If those who interpret the

14
 newly reported net income as good news outweigh those who see it as bad news, the share price will increase. The
price change can be due to other factors (political, wide-economy, stock split, dividends, etc.)

Abnormal Share Return

- Most value relevance studies examine effect of earnings information on return on firms’ common shares
- Total share return = return due to market-wide factors ± abnormal return due to firm-specific factors
- Abnormal share return can be attributed to financial accounting information
- If good news in financial statements leads to positive abnormal share returns (and vice versa), conclude financial
statement information is useful.
- To reach such a conclusion, need to separate market-wide and firm-specific share return

Finding the Market Response

1) Efficient markets theory implies that the market will react quickly to new information.
2) The good or bad news is usually evaluated relative to what investors expected. If the reported net income were
what investors expected it to be, there wouldn’t be much information content in that reported net income; if net
income reported is higher than what was expected, it would trigger rapid belief revision about the future
performance of the firm signifying good news.
3) It is important to separate the impacts of market wide and firm specific factors on share returns. There are
many events taking place that can affect firm’s share volume and price. For example, on the same day a firm reports
its current year’s net income, the government announced a substantial increase in the deficit. This government
announcement would affect prices of all securities on the market. This could create abnormal returns (= the
difference between actual and expected returns, the rate of return after removing the influence of market wide
factors)

Unexpected Earnings
- Investors have expectations of current earnings
- Investors’ expectations are built into share price prior to release of current earnings. Assumes market efficiency
- When current earnings released, investors will react only to unexpected component
- Investors’ earnings expectations are unobservable

Estimation of investors’ earnings expectations

- Time series approach: Based on earnings in prior years
- Analysts’ earnings forecasts: Available for most large firms. Now the most common approach

Ball & Brown Study

They began a tradition of empirical capital markets research. They were the first to provide convincing scientific
evidence that firm’s share returns respond to the information content of financial statements. This type of research
is called an event study, since it studies the securities market reaction to a specific event. In this case, the specific
event would be the firm’s release of current net income.

They analyzed a sample of 261 New York Stock Exchange (NYSE) companies over a period of 9 years. They
concentrated on the information content of earnings to the exclusion of other potentially informative financial
statement components such as solvency and capital structure. They performed two tasks:
1) Measure the information content: whether the reported earnings were better than expected (good news) or
less than expected (bad news). They used the prior year’s earnings as benchmark; anything higher was good
news and anything lower was bad news.
2) Evaluate the market return on the shares of the sample firms near the time of the each earnings
announcement (over a month-long return window). This was done according to the abnormal returns
procedure as described above.

15
 They discovered:
- The average abnormal return in the month of earnings release was strongly positive for firms that had
GN and vice versa for those who had BN. The market began to anticipate the GN and BN before the
announcement of the current net income and the share price continue to go higher/lower.
- During a narrow window study (1 month), there are relatively few firm specific-events other than net
income to affect share returns. Thus, it can be argued that the accounting information is the cause of the
market reaction. Narrow window studies suggest that accounting disclosures are the source of new
information to investors.
- In the wide window study, it cannot be claimed that reported net income caused the abnormal returns
during the 11 months leading up to the month where the income was reported. This is because during that
time frame, there might be additional GN or BN that contributed to the share price. As the market learns
information from sources such as quarterly reports or media, the share price would begin to adjust
accordingly. Thus, firms that in a real sense are doing well should have much of the effect on their share prices
anticipated by the market before the GN appears in the annual financial statements. BB estimated that most of
the information in annual earnings was already built into share price by the time annual earnings were
announced.

Earnings Response Coefficient (ERC)

An earnings response coefficient measures the extent of a security’s abnormal market return in response to the
unexpected component of reported earnings of the firm issuing that security. This identifies and explains differential
market response to earnings information.

Reasons for Differential Market Response: Why might the market respond more strongly to the good or bad news in
earnings for some firms than for others?

1) Beta: The riskier these future returns are, the lower investors’ reactions to a given amount of unexpected
earnings will be. If the future expected returns are riskier, the lower it will be its value to a risk-averse investor.
Thus, if better increases, portfolio risk increases and acts as a brake on the investor’s demand.

2) Capital Structure: An increase in earnings adds strength and safety to bonds and other outstanding debt, so that
much of the good news in earnings goes to the debtholders rather than the shareholders. ERC of a firm will be lower
since most earnings go to debtholders.

3) Earnings Quality (Informativeness): The quality of earnings is defined by the magnitude of the main diagonal
probabilities of the associated information system. The higher these probabilities, the higher we would expected the
ERC to be since investors are better able to infer future firm performance from current performance.
Earnings persistence: ERCs are higher when the persistence of unexpected current earnings changes since
current earnings provide a better indication of future firm performance. For example, if the good news is due to
successful R&D/marketing, then ERC should be higher than if good news is due to an unanticipated gain from the
disposal of plant and equipment. The gain on the plant and equipment is less likely to reoccur compared the
probability of the management gain because this is a reflection of management’s inside information about the
firm’s longer-term earnings prospects. (A rational manager will only invest capital and labour in positive
expected value projects. Exceptions: a company can write-off its R&D costs, which can produce bad news in
current earnings. However, to the extent the market perceives the research costs as having future value, it would
react positively to this bad news so that persistence is negative.
Accruals quality: Dechow and Dichev pointed out that net income is composed of cash flow from operations
and net accruals, where net accruals include changes in non-cash working capital accounts such as receivables,

16
 AFDA, inventories, accounts payable. A manager has considerable control over these accounts; if the manager
uses this control over accruals to influence the amount of reported net income, they are called discretionary
accruals. The greater the discretionary accruals are relative to cash flows, the more likely it is that those
accruals contain a substantial discretionary component, leading to lower earnings quality. The earnings quality
depends primarily on the quality of working capital accruals, since cash flow from operations is relatively less
subject to errors and manager bias, and therefore is of reasonably high quality to start with.

4) Growth Opportunities: If good/bad news suggests future growth then higher ERC. Growth opportunities may
stem from the fact that future profits can increase the firm’s assets and that success with current projects may
suggest to the market that this is firm is also capable of identifying and implementing additional successful projects
in the future.

5) Similarity of Investors’ Expectations: To the extent that investors’ earnings expectations were closer together,
they will put the same interpretation on the news. The more similar the earnings expectations, the greater the effect
of a dollar of abnormal earnings on the share price. The more precise analysts’ forecasts are, the more similar are
investors’ earnings expectations and the greater the ERC.

6) Informativeness of Price: Market price can be partially informative about the firm’s future value. Market price
aggregates all publicly known information about the firm. Accordingly, the study in B&B shows that share returns
anticipated the GN or BN in earnings beginning as much as 12 months before earnings were released. Consequently,
the more informative is price, the less will be the information content of current accounting earnings, so lower ERC.
This is because most of information would have been already reflected in the price, so there will be less unexpected
information
Researchers must obtain a proxy for expected earnings, since the market will react to only that portion of an
earnings announcement that it did not expect. If there were no information content in net income, there would
be no belief revision, buy/sell decisions and no price changes.

Implications of ERC Research

Improved understanding of market response suggests ways that accountants can further improve the decision
usefulness of financial statements. Examples:
- Positive relationship between earnings quality and ERC suggests higher earnings quality is valued by
investors
- Growth opportunities suggests the desirability of disclosure of segment information since profitability
information by segments would better enable investors to isolate the profitable and unprofitable operations
- Lots of detail and supplemental information in the income statement and balance sheet helps investors
interpret the persistence of the current earnings number. This enhances the importance of earnings
persistence and to the ERC means that the disclosure of the components of net income is useful for investors.
- If ERCs are lower for highly levered firms then firms should expand disclosure of the nature and
magnitude of financial instruments.

Measuring Investors’ Earnings Expectations

Researchers must obtain a proxy for expected earnings, since an efficient market will react to only that portion of an
earnings announcement that it did not expect. If a reasonable proxy is not obtained, the researcher may fail to
identify a market reaction when one exists.

*According to BB study, if information is completely persistent, expected earnings for the current year are just
last’s year earnings; if the earnings are zero persistent, there is no information in last year’s earnings about future
earnings and all of current earnings are unexpected.

17
A Caveat About the Best Accounting Policy

Market response is a measure of usefulness to investors. However, we cannot say that the best accounting policy is
the one that provides the greatest market response. Accountants may be better off to the extent that they provide
useful information to investors but it does not follow that society will necessarily be better off. This is because:
- Information has characteristics of a public good (consumption by one person does not destroy is for use
by another). Information, such as annual reports, is available to the public, thus suppliers might have a hard time
charging for them. If a firm tried to charge for annual reports, it would not be effective since once produced, it
can be downloaded and shared to others.
- Production of annual reports is costly as the costs include possible disclosure of valuable information to
competitors and revealing too much about managers’ plans.
- Although investors perceive information as free, they will eventually have to pay for these costs through
higher product process or lower share prices.
- Since information is perceived as ‘’free’’, investors will consume more of it. As a result, investors may
perceive accounting information as useful even though from society’s standpoint the costs of this information
outweigh the benefits to investors.
- The social value of such information depends on both the benefits to potential investors and
competitors and on the costs to managers and shareholders. It is very difficult to assess those cost-benefits
tradeoffs. However, accountants can still be guided by market response to improve their competitive position as
suppliers of information. It is important to remember that accounting is in competition with other sources of
information.

Other Financial Information

The greater the additional information in the notes is relative to the information in net income, the more likely
analysts are to issue revised target share prices and the larger these revisions are.
Note information is decision useful to investors and analysts forecast revisions are a vehicle whereby note
information becomes incorporated into share prices.

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CHAPTER 6: Measurement Approach to Decision Usefulness

The measurement approach to decision usefulness is an approach to financial reporting under which accountants
undertake a responsibility to incorporate current values into the financial statements proper, providing that this can
be done with reasonable reliability, thereby recognizing an increased obligation to investors to predict firm
performance and value.

The intent of this approach is to enable better predictions of this performance by means of a more informative
information system. If a measurement approach is to be useful to investors, increased relevance must outweigh any
reduction in reliability. Why would we evaluate possible reasons underlying increased emphasis on current value?
- Recent years have shown evidence suggesting that securities markets may not be as efficient as
originally believed and investors are not collectively rational
- Beta is the only relevant risk measure according to the CAPM. Other risk measures should be considered
such as firm size that can significantly affect share return
- Market efficiency should be based on whether securities reflect publicly available information, not
whether they affect fundamental value

Are Securities Markets Fully Efficient?

The average investor behavior may not correspond to the rational decision theory and investment models outlined in
chapter 3, why?
- Individuals may have limited attention. They may not have the time, inclination or ability to process all
information. They will focus on the information that is readily available (“bottom line”) and ignore information
in the notes of annual reports.
- Investors may be biased in their reaction to the information. Evidence shows that individuals are
conservative in their reaction to new evidence; they retain excess weigh on prior beliefs.
- Investors may be overconfident by overestimating the precision of information they collect themselves.
They will underreact to the new information that is not self-collected.
- Individuals may assign too much weight on evidence that is consistent with the individual’s impressions
of the population from which the evidence is drawn, known as representativeness. For example, an investor
categorizes a firm with strong profit growth over the past years into a growth firm category. But, true growth
firms are a rare event in economy (i.e. the base rate of growth firms in the population is low). If many investors
react this way, the share price will overreact to the reported growth in earnings.
- Individuals may experience self-attribution bias, where they feel that good decision outcomes are due
to their abilities and that bad outcomes are not their fault and are due to the states of nature. If many investors
act this way, share price momentum can develop.

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- Individuals may experience motivated reasoning, where investors accept information that is consistent
with their preferences (good news) and discard information if it is inconsistent with their preferences (bad
news)

Prospect Theory (Kahneman and Tversky 1979)

- This theory provides a behavioral-based alternative to rational decision theory described in chapter 3.
Investors considering a risky investment (a “prospect”) will separately evaluate prospective gains and losses.
The decision theory states investors evaluate their decision in terms of their effects on their total wealth.
- The Prospect Theory can lead to narrow framing, where investors analyze problems in isolated
manners which can then lead to limited attention.
- An individual’s utility in Prospect Theory is defined over deviations from zero rather than over total
wealth.
- This theory assumes loss aversion, where individuals dislike even the small losses. Therefore, the
utility for losses is greater than the rate of utility increase for a gain in value. This leads to disposition effect,
whereby the investor holds on to losers and sell winners because they do not want to sell at loss.
- When individuals calculate the expected value of a prospect, they under- or overweight their
probabilities. Underweighting is a sign of overconfidence: information not generated by the investor will be
underweighted relative to other evidence. Overweighting is a sign of representativeness: current evidence,
for example, a stock’s value is about to take off, is overweighed even though realization of the state “taking off”
is a rare event.
- The combination of separate evaluation of gains and losses and weighting of probabilities can lead to
irrational behaviors:
 Fear of losses may cause investors to stay out of the market.
 Underreacting related to bad news by holding on ‘’losers’’ to avoid losses.
- Rate at which utility decreases for small losses is greater than the rate at which it increases for small
gains. Managers of firms that would otherwise report a small loss thus have an incentive to avoid this negative
investor reaction by managing reported earnings upwards.

Is Beta Dead?
- CAPM implicates that a stock’s beta is the sole firm-specific determinant of the expected return on that
stock.
- In a large sample of firms traded on major US stock exchanges, Fama and French (1992) found that beta
has little ability to explain stock returns, and is not an important risk measure. Instead, there is a significant
correlation to book-to-market value (ratio of book value of common equity to market value) and firm size.
Thus, the market acts as if firm risk increases with book-to-market and decreases with firm size.
- Different results are reported according to Kothari, Shanken and Sloan (1995) who argued beta is a
significant predictor return and the B/M is a weak predictor of return
- Behavioral finance argues that CAPM is evidence of market inefficiency.
- Conclusion: beta is not dead, however it may change over time and may to have “move over” to share its
status as a risk measure with accounting based variables

Excess Stock Market Volatility and Market Bubbles

Inefficiency in behavioral factors creates additional volatility in the market. For example, there are investors that
buy shares when it goes up or vice versa when it declines to take advantage of price run-ups, which creates excess
volatility. This can lead to market bubbles, where the share prices rise far above fundamental values. During
bubbles, it can be questioned whether the share price fully reflected information available to investors that could
have helped in diagnosing the riskiness. It can be argued that some information was not available to the public
(inside information).

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Fama pointed out that theory and evidence of overreaction of share prices to information is about as common as
underreaction. According to Barberis, SHkeifer abd Vishny, underreaction occurs when new evidence such as sharply
increased earnings this period, comes along on a one-time basis (representativeness). Overreaction occurs when a
longer-term sequence of increased earnings causes investors to assume that growth will continue (conservative).

Efficient Securities Market Anomalies (Market Inefficiency Involving Financial Accounting Information)

The market may not respond to accounting information exactly as the efficiency theory predicts.
- Share prices may not fully react to financial statement information right away so abnormal security
returns continue for some time following the released on information
- Market may not extract all the information content from financial statements
These are called efficient security market anomalies. There are two such anomalies and other reasons called limits
to arbitrage:

1) Post-Announcement Drift: Once a firm’s current earnings become known, the information content should be
quickly digested by investors and incorporated into the market price. However, for firms that report good news
in quarterly earnings, their abnormal security returns tend to drift upwards for some time after earnings
announcement; vice versa for bad news. Abnormal share returns drift upward or downward for some time
following the month of release of good news and bad news, respectively. Quarterly seasonal earnings
changes mean the difference between current quarterly reported earnings and those of the same quarter last
year. The assumption is that investor’s expectations of current quarterly earnings are based on those of the
same quarter of the previous year.
Explanation Investors take considerable time to figure out the good news or bad news. There is also the
explanation of limited attention, under which investors do not exert the time and effort needed to fully
understand the serial correlation of quarterly earnings changes. Other evidence suggests that instead of
anticipating the effects of inflation on future earnings growth, investors seem to wait until the increased or
decreased earnings actually show up. SO investors underestimate the implications of current earnings for future
earnings and they also ignore earnings volatility (the more earnings volatility ism the more earnings change
over time leading to lower persistence and correlation).
 Investors have limited attention
 Conservative financial reporting relates to it
 It is believed that investors take their time to process inflation
 Lack of timeliness of forecast revisions
 Lack confidence in management forecasts: biased, errors?
 So is it really an anomaly or it just how the market works?

2) Market Response to Accruals: Sloan (1996) concluded net income= cash flow from operations +/- net accruals.
He included changes in non-cash working capital accounts such as receivables, AFDA, inventories, accounts
payable and amortization expense in net accruals analysis. Accruals are more subject to errors of estimation
and possible manager bias than cash flows and this lower reliability should reduce the association between
current accruals and next period’s net income. Operating cash flows from continuing operations are less likely
to reverse and are less subject to error and bias.
Explanation  Accruals are less reliable than cash flows and thus tend to reverse quickly, the good or back
news they contain in the current period is less likely to continue into the next period than good or bad news in
cash flows. So, the cash flow component is more persistent than the accrual component. Sloan found that next
year’s reported income was more highly associated with the operating cash flow component of the current
year’s income than with the accrual component. Low reliability accruals are more subject to manager
manipulation; investors do not fully take the responsibility of earnings management into account.
 Accruals are less persistent that cash flows
Accruals are there boost or lower income

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 Low persistence of low accruals would be ignored by investors
 Investors and their behavioral characteristics

Anomalies still exist but are not completely there

3) Limits to Arbitrage: These are costs incurred by investors that limit their ability to fully exploit an anomaly and
thereby arbitrage it away. We consider two limits: transaction costs and risk. Persistence of the anomalies
because of limits to arbitrage is consistent with average investor rationality. Regardless of whether their
persistence is due to behavioral biases or limits to arbitrage, securities markets are not fully efficient. Is this lack
of efficiency due to behaviorally biased investors?
- Transaction costs include brokerage commissions, bid-ask spread, short selling costs, time and effort.
Transaction costs at least partially constrain investors’ abilities to exploit the accruals anomaly.
- Idiosyncratic risk remains to limit the arbitrage of rational, risk-averse investors. The higher the risk, the
higher the return demanded by risk-averse investors, thereby putting a brake on arbitrage investing.
- Large institutional investors, with low transaction costs and, arguably sophisticated risk management systems,
have increased over time their exploitation of PAD and accrual anomalies to an extent that the anomalies, net of
costs, seem to have largely disappeared.

*To the extent that securities markets are not fully efficient, this can only increase the importance of financial
reporting.

*Improved financial reporting, by giving investors more help in predicting firm performance, will speed up share
price response to the full information content of financial statements. When there is good or bad news, there will be
noise trading so the price will not reflect fundamental value of the firm. Examples of improved reporting include
full disclosure of low-persistence components of earnings, high-quality MD&A, and moving current value
information into the financial statements properly. Indeed, by reducing the costs of rational analysis, better
reporting may reduce the extent of investors’ behavioral biases.

*Market inefficiency can be created by limited attention. The market underreacts to supplemental information
because it focuses too much on bottom line. Since investors with limited ability to process information focuses on
bottom line, instead of the price fully reacting right away, it will drift downwards as the bad news about negative
disclosures become apparent over time. Accounting can provide help in this by providing current value accounting
for disclosures such as reserves, which helps in speeding up market reaction. For example, disclosing on the balance
sheet rather than in the notes could help.

*Investors tend to follow and rely on analysts rather than use accounting information themselves.

Auditor’s Legal Liability

During the 1980’s, over 1000 financial institutions failed because they couldn’t keep up with interest rates. So their
short term liabilities were increasing and the money they earned from mortgages couldn’t pay off their obligations.
These companies failed to disclose of these loans into their balance sheets. Consequently, net earnings and assets
were overstated in financial statements. This was when auditors began to feel pressured from management to bend
GAAP so that performance targets can be met.

If hidden information becomes known, it can lead to:

- Possible lawsuits
- Reduced reputation
- Reduced public confidence
- Loss of business because loss of present and future clients

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Auditors can protect themselves by acting ethically. Reinforced with conservative accounting to resist the pressure:
 Conditional conservatism: standard setters implemented impairment tests for capital assets and goodwill
 Unconditional conservatism: risky assets are valued at less than current value even though an economic
gain or loss has not yet taken place.

Conclusions

Assume a firm has reported substantial increase in earnings. We need to ask ourselves if the earnings power of the
firm really increased or it is simply some low-persistence earnings. While careful analysis of financial statements
may help, the rational investor is unlikely to know the answer with complete accuracy because of inside information
and possibly poor disclosure. The investor therefore faces estimation risk. In the face of estimation risk, the
investor will place some probability on each possibility regarding future performance of the firm. His estimate of
future earnings will increase but by less than the increase in current earnings. The additional demand will trigger an
immediate share price increase. This increase will be less than it would be if investors were 100% certain of the
increase in expected earnings power.

*To reduce estimation risk, investors will watch for additional information. For each information item, investors will
revise their expected earnings power estimate and will buy additional shares (if this information conveys news
regarding persistent earnings power). The firm’s share price will drift upwards. It takes time for investors to
confirm whether the earnings are persistent or not, so the price will not adjust perfectly right away. Same thing
applies to bad news regarding earnings. Investors need to find evidence to confirm the shift that will contribute in
the share price going even lower or higher.

*We can therefore say that failure of share prices to fully reflect accounting information in a timely manner is due to
behavioral characteristics such as conservatism and representativeness, which leads to overreaction or
underreaction. Failure of prices to completely reflect information is also due to uncertainty of rational investors
(estimation risk above) since they are not sure if the earnings are persistent or not. This is because of the possibility
of inside information not disclosed or poor accounting disclosure in financial statements. Accounting can help in
both of these problems.

*Reducing the costs and risks of rational investing, by bringing current values into the financial statements proper,
will increase decision usefulness. Helping investors overcome behavioral biases by bringing current values into the
F/S will increase decision usefulness. However, people might question the reliability of those current values (even
if it increases relevance). The decision usefulness of current value-based financial statements will be compromised if
too much reliability is sacrificed for greater relevance.

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CHAPTER 7: Measurement Applications

Three obstacles:
1. The decision usefulness of current value-based financial statements will be compromised if too much reliability
is sacrificed for greater relevance
2. Management’s skepticism about reserve recognition accounting (RRA) carries over current value accounting.
3. Managers, investors and auditors may prefer conservative accounting to current value accounting in some
circumstances. Conservative accounting can contribute to investor decision making and reduction of auditor
liability (as discussed in chapter 6)
This chapter reviews and evaluates important current value-based standards and sees how the measurement
approach extends into reporting risk.

Current Value Accounting

VALUE IN USE - measured by the discounted present value of cash expected to be received or paid with respect to
the use of the asset of liability.
-Present value accounting is based on value in use
-High in relevance since it measures the expected cash flows to or from the firm
-Low in reliability since future cash flows have to be estimated and managers may change its intended use
-Recognizes revenues before they are realized

FAIR VALUE - currently governed by IFRS 13 which defines it as 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
-The basis of valuation is also termed exit price which measures the opportunity cost to the firm of the intended
use of its assets and liabilities
-Ideally, fair value is based on the selling price in a well-working market
-Due to market incompleteness, these prices do not exist for many assets and liabilities. So, standards create a fair
value hierarchy consisting of three levels: *Reliability decreases the higher the level*
1: Assets/Liabilities for which a reasonably well-working market price exists
2: Assets/Liabilities for which a market price can be inferred from the market prices of similar items
3: Assets/Liabilities for which a market value cannot be observed or inferred. Then, the firm shall use the best
available information to value the items. This requires the firm to envisage such a prospective purchaser and
estimate how much the purchaser would be willing to pay, mostly based on expected future cash flows of the asset.
-Recognizes gains and losses as changes in fair value occur  represents an effect to increase the forward looking
nature of the income statement, reducing recognition lag and increasing decision usefulness
-Changes the nature of the income statement; assumes greater important of the balance sheet
-Improves the ability of net income to report on a manager stewardship

Both offer increased relevance relative to historical cost accounting & problems of reliability remain

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Longstanding Measurement Examples

Accounts Receivable and Payable

-valued at expected amount of cash to be received or paid

Cash Flows Fixed by Contract

-Amortized cost accounting is a version of value in use, discounted at the effective rate rather than the firm’s
cost of capital. For example,
Long term debt valued at present value of future interest and principle payments discounted at the effective
interest rate. If borrowing rate does not change, book value = value in use.
Finance lease contracts value at the lower of fair value or the present value of minimum lease payments using the
rate implicit in the lease or the lessee’s incremental borrowing rate and applied amortized cost accounting.

The Lower-of-Cost-or-Market Rule

-Inventories valuation justified in terms of conditional conservatism
-Example of a partial measurement approach

Revaluation Option for Property, Plant, and Equipment

-Can be valued at fair value, providing this can be done reliably
-Fair value must be kept up to date, so as not to differ materially from fair value at the balance sheet date

Impairment Test for Property, Plant and Equipment

-IAS: recognize impairment loss when recoverable amount < book value (conditional conservatism)
-FASB: recognize impairment loss when undiscounted expected future net cash flows < book value

Financial Instruments Defined

A financial instrument is a contract that creates a financial asset of one firm and a financial liability or equity
instrument of another firm.

Primary Financial Instruments

The 2007-2008 meltdowns led firms to write down their assets to fair value. Write downs are huge because the
market suffered from low liquidity pricing and credit default swaps. Standard setters introduced some modifications
for the reporting of assets at fair value.

Short Run Changes:

-IASB and FASB: When markets are not working well, firms are allowed to make their own assumptions about
future cash flows from the item. This is reduced reliability; however extensive supplementary disclosure of
how estimated fair value was determined is required. A risk-adjusted discount rate would be used, lowering
present value estimates
-FASB: Certain debt and equity securities do not need to be written down to fair values with losses included in net
income if the decline in value was only temporary
-IASB: Reclassification of certain financial assets is allowed to allow greater consistency with FASB standards. For
example, loans and receivables could be valued at cost even though fair value was lower.

Longer Run Changes:

-IFRS 9 replaces IAS 39 (previous standard for financial assets and liabilities)
-Financial assets and liabilities are to be recorded on fair value basis at acquisition

25
 -Subsequent valuation of most liabilities will be at amortized cost
-Subsequent valuation of financial assets is at fair value except for financial assets that pay interest and principal.
If the objective of the firm’s business model is to hold the asset in order to collect this interest and principle,
the asset is valued on an amortized cost basis.
-If the asset becomes impaired it must be written down to its new expected PV with the loss included in net
income
-Changes in the business model are rare, so standard makes it more difficult for management to influence the
present value input into amortized costs
-For financial assets that are equity investments the firm may elect at acquisition to include unrealized fair value
gains and losses in OCI unless asset intended for resale (net income).
-IFRS 13 also requires expanded supplementary disclosures
-FASB imposes a three part classification for financial assets:
1. Trading: Securities acquired for intention of reselling. Valued at FV with unrealized gains and losses included
in net income.
2. Held to Maturity: These securities are acquired with intention that they be held to maturity. They are valued
at amortized cost. If FV falls below amortized cost securities written down to FV. Sales before maturity of
securities intended to be held to maturity cause all remaining securities to be classified as held for sale.
3. Available Sale: Securities valued at FV, with unrealized gains and losses included in OCI

Fair Value Option

IFRS 9: at acquisition, the firm can irrevocably designate financial assets/liabilities that would normally be valued at
amortized cost into the fair value category if this reduces a mismatch, where a mismatch is earnings volatility in
excess of the real volatility facing the firm. Changes in FV of assets and liabilities are included in net income.
*Mismatches arise when some assets/liabilities are fair valued but related assets/liabilities are not. To solve:
 The firm can adopt the fair value option for its long term debt so that both sides of the natural hedge are fair
valued, with gains and losses on both included in net income under IFRS 9
 The fair value of a firm’s debt can also be changed due to changes in its own credit risk even without a change in
market interest rates

Reporting Liquidity Risk and Financial Reporting Quality

-Liquidity risk is the uncertainty about what the buying or selling cost will be.
-More transparent financial reporting reduces information asymmetry, making firm’s share prices less sensitive
to changes in market volatility (i.e. investors are more confident in transparent firms). So, more transparency
leads to lower liquidity risk.
-Liquidity risk can be a significant contributor to cost of capital and quality financial reporting can help reduce the
adverse effects of liquidity risk on the cost of capital.

Derecognition and Consolidation

Derecognition: Removing an asset from the balance sheet and revenue recognized on the resulting sale. Firms do
not retain their Accounts Receivables; they are rather securitized and transferred to another entity. Firms have an
incentive to derecognize these assets since this can improve their leverage ratios. This happened in the 2007-2008
market meltdown.

IASB and FASB restricted the use of derecognition to avoid further abuse; IFRS 10 requires consolidation when
there is control. There are two dimensions of control: power and risk.
Power: direct important activities of another entity
Risks: share profits or losses

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 Accounting for Intangibles

Intangible assets are capital assets that do not have physical substance (patents, trademarks, franchises, goodwill).
-If they are purchased or self-developed, they are valued at cost and amortized over their useful lives
-If they are acquired in a business combination and fair value can be determined reliably, their cost is equal to
their fair value at acquisition
*Value is hard to establish reliably, particularly if they are self-developed, because their cost spreads over many
years. Therefore, severe reliability problems are created.
*They are subject to impairment tests: written down if the asset’s recoverable amount < book value
*Research cost does not appear on the balance sheet and are charged to expense as incurred
*Even if they are not on the balance sheet, they appear through the income statement

Purchased Goodwill
- The difference between the net amount of fair values and the total purchase price paid by the acquiring
company. Exists if the firm earns more than its cost of capital on its net asset, including any separately
identified intangibles
- Issue: Net income drops after an acquisition  Solution:
Pooling of interest : the balance sheets of the merged entities were simply added together
Pro-forma income (cash income): net income before goodwill amortizations, restructuring charges, and
other items

Self-Developed Goodwill
- No identifiable transactions exist to determine the cost of self-developed goodwill
- Costs that may create goodwill, such as R&D, are mostly written off as incurred
- IAS 38 : prohibits the capitalization of internally generated goodwill
- Recognition lag occurs when goodwill shows up as abnormal earnings in subsequent income statement
- The study of Lev and Zarowin (1999) explain that transparency is important part of self-developed Goodwill
because it indicates a firms future profitability for the investors and also possibility of over investment in
R&D by firms
- Self-developed goodwill have reliability problem, thus standard setters are concerned

Conclusions

*Using the measurement approach, accountants undertake the responsibility to incorporate current values into the
financial statements, provided this can be done with reasonable reliability. It recognizes an increased obligation,
beyond that of the information approach, to assist investors in predicting future firm performance.
*Partial applications of current value have the potential to be decision useful to the extent they reveal a material
change in the firm’s financial position and prospects.

Why is financial reporting moving towards current values?

- Historical cost based earnings have low ability to explain abnormal returns (low value relevance)
- Investors need more help in predicting future securities returns (do efficient securities markets really
exist)
- Auditor liability

Efficient securities market theory has been questioned in recent years because:
- Increasing attention to alternative theories of investor behavior such as prospect theory
- Evidence of excess stock market volatility and bubbles caused by irrational behaviors

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- Evidence of anomalies such as share price reactions to accounting information that do not match those
predicted by efficient markets theory (post-announcement drift)

Auditor Legal liability encourages conservative accounting:

- The auditor is more likely to be held liable for overstatements of assets and earnings than
understatements
- This leads to conservative accounting such as ceiling tests (for capital assets and goodwill write-downs)
since conservative accounting reduces the likelihood of overstatements.
- Current value accounting requires more estimates and judgments, but because of legal liability for
auditors, the relevance/reliability tradeoff may have shifted towards greater relevance.

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 CHAPTER 8: The Efficient Contracting Approach to Decision
Usefulness

This chapter begins our study of financial reporting from a management’s perspective.

Efficient Contracting Theory

- The efficient contracting theory studies the role of financial accounting information in moderating information
asymmetry between contracting parties, thereby contributing to efficient contracting and stewardship and
efficient corporate governance.
- It takes the view that firms organize themselves in the most efficient manner, so as to maximize their prospects
for survival.
- Its objective is to understand and predict managerial accounting policy choice in different circumstances across
different firms and how financial accounting can contribute to contract efficiency.
- Efficient contracting is a significant component of efficient corporate governance – a firm can be largely defined
by the contracts it enters into. Therefore these contracts must be efficient by balancing contract benefits and
costs. Efficient contracting naturally leads to the stewardship role of financial reporting - an efficient contract
minimizes costs of moral hazard by motivating the manager to act in shareholders’ best interests.
- The most efficient form of corporate governance depends on factors such as:
 Legal and institutional environment
 Technology
 Degree of competition in industry
- Firms enter into contracts such as executive compensation contracts and debt contracts with customers,
suppliers, management, other employees and lenders. These contracts are frequently based on financial
accounting variables, such as net income or various measures of liquidity. Since accounting policies affect the
values of these variables, and since management is responsible for the firm’s contracts, it is natural that
management be concerned about accounting policy choice  e.g. management compensation usually depends on
reported earnings
- The theory assumes that managers are rational: managers cannot be assumed to maximize firm profits and act
in the best interests of the investors, they will do so only if they perceive such behavior to be in their own interests.
In other words, managers choose accounting policies to maximize their own expected utility relative to their given
remuneration and debt contracts. Consequently, the interests of managers, lenders and shareholders conflict.
Efficient contracting will study how this conflict is resolved.

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  It predicts how managers will react to new accounting standards
 It helps us understand why managers often object to new standards
 It enables us to appreciate how efficient contract design can help to align the interests of managers with
those of lenders and shareholders
- The theory also envisages implicit contracts which arise from continuing business relationships e.g. if a firm
builds and maintains a reputation for high quality financial reporting, it generates the trust of customers and can
then charge higher product prices.
- The theory also believes in markets: demands for financial accounting information should be met by market
forces, with the role of standard setting being to provide general principles within which accounting practices can
develop based on laws of supply and demand.

Sources of Efficient Contracting Demand For Financial Accounting Information

1. Lenders
- Concerned about information asymmetry for debt contracts: management may hide performance that
threatens lender interests
- Face payoff asymmetry because they stand to lose if the firm performs poorly

2. Shareholders
- Protect themselves from exploitation by management by basing manager compensation on some measure
of manager performance such as net income
- If managers overstate their inside information during the year, share price can be overvalued

Accounting Policies for Efficient Contracting

Reliability
- Accounting information for efficient contracting should be based on realized market transactions
(transactions that have already occurred) and be verifiable by third parties. Unrealized increases in fair
value are subject to error and possible manager bias.
- Fair values can be determined with reasonable reliability; the contract theory supports fair value only when
this value can be determined reliably
- The best financial statements to inform lenders and protect against manager opportunism are not the same
as the best ones to inform equity investors: equity investors may find unrealized gains to be decision useful

Conservatism
- Lender’s demand for information is higher for unrealized losses than gains because unrealized losses are
better predictors of financial distress
- Conditional conservatism provides lenders with a lower bound on net assets to help them evaluate their
loan security
- Conditional conservatism is demanded by equity holders for stewardship purposes, since it is then more
difficult for managers, who may wish to enhance their reputations and compensation, to include unrealized
income-increasing gains in earnings and to cover up overstatements, such as optimistic forecasts

Employee Stock Options (ESO)

Economic Consequences: Despite the implications of efficient securities market theory, accounting policy choice
can affect firm value.
- Changes in policy matter are based on the notion of economic consequences; managers may change the
actual operation of their firms due to changes in accounting policies. For example, managers may cut maintenance
and R&D to compensate for a new accounting policy that lowers the bottom line.

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- According to the economic consequences doctrine, the accounting policy change will matter, despite the
lack of cash flow effects. Under efficient markets theory, the change will not matter because future cash flows, hence
the market value of the firm are not directly affected. For example, a change in amortization policy will not affect
cash flow but will affect income.

- Accounting for employee stock options (ESO) is an example of economic consequence, whereby
managers express extreme concerns about an accounting policy that does not directly affect cash flows. Managers
use opportunistic tactics to increase compensation by manipulating stock price so as to increase the value of their
ESOs. Expensing of ESOs can then be viewed as a way to increase compensation contract efficiency.
- We need to expense ESOs at their fair market value; expensing ESOs avoids excessive usage and
increases relevance. Firms have argued that this can create a shortage of managerial talent and reduces the bottom
line.
 Failure to record an expense understates the firm’s compensation cost and overstates its net income
 Until 2005, ESOs were valued at intrinsic value

Distinguishing Efficiency and Opportunism in Contracting

- Given the importance of efficient contracting to corporate governance, the question arises whether
actual debt and compensation contracts are efficient or whether they bear evidence of manager opportunistic
behavior. This has received considerable empirical research, much of which suggests that on average, contracts are
efficient.
- Another question arises on whether securities prices behave as predicted by rational investor theory
and efficient capital markets. While the two concepts of efficiency are different, there is substantial empirical
support for the respective theories. This leads into the argument that even though managers care about accounting
policy choice even if it does not affect cash flow (contrary to market efficiency theory), the two theories are not
inconsistent.
However, empirical evidence and the ESO saga suggest that manager opportunism (i.e., inefficient contracts) is
mixed in with the efficient contracts. Accountants have a responsibility to reduce the extent of manager
opportunism by ethical behavior leading to high quality financial reporting.
- It is costly for the firm to completely specify the policies that they will use. The optimal set of accounting
policies for the firm then represents a compromise. On one hand, tightly prescribing accounting policies beforehand
will minimize opportunistic accounting policy choice by managers but will incur costs of lack of accounting
flexibility to meet changing circumstances, such as new accounting standards that affect net income. On the other
hand, allowing the manager to choose from a broad array of accounting policies will reduce costs of accounting
inflexibility, but expose the firm to the costs of opportunistic manager behavior. Ultimately, the objective of PAT is
to predict managerial accounting policy choice in different circumstances and across different firms.

Conclusion

- Reporting to lenders and reporting on managers stewardship are important sources of demand for
financial accounting information as a protection against managers’ inside information advantage and possible
shirking
- Accounting policy choice is part of the firm’s overall need to attain efficient contracting and corporate
governance. It is part of the firm’s overall need to minimize its cost of capital and other contracting costs. The
theory does not imply that a firm’s accounting policy choice should be uniquely specified; it is usually more
efficient to have a set of accounting policies from which management may choose. Given some flexibility, it is not
hard to see why accounting policies can have economic consequences:
- From an efficient contracting perspective, a large set of available policies enables the firm to respond
efficiently to unforeseen events that affect existing contracts.

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 - From an opportunistic perspective, a large set of available policies gives management the ability to
select accounting policies for its own advantage.
- Either way, changes in the set of available policies will matter to management.
- The more a new standard interferes with existing contracts or reduces accounting policy choice, the
stronger is the likely manager reaction (reason why we witnessed a strong reaction towards expensing
ESOs since it negatively affected net income)
- While there is evidence of manager opportunism, there is also evidence of efficient contracting. This
suggests that it is possible to align managers’ interests with those of shareholders.
- To attain efficient contracting, financial information should be reliable and conditionally conservative
- A significant implication of efficient contracting theory is that accounting policies have economic
consequences; they matter to managers. Managers have flexibility to choose accounting policies to offset the
effect of new accounting standards on debt and compensation contracts. Too little flexibility leads to contract
inefficiency when accounting standards change; too much flexibility opens up the possibility of manager
opportunism. So a reasonable compromise is to allow managers to choose accounting policies within GAAP.

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CHAPTER 9: An Analysis of Conflict

The Agency Theory

The game theory attempts to model and predict the outcome of conflict between rational individuals.
The agency theory is a version of game theory that models the process of contracting between two or more
persons, where a rational agent acts on behalf of a principal. Since each party to a contract attempts to get the best
deal for himself, agency theory also involves conflict. Business firms enter into:

1. Employment contracts - between firm and its management

2. Lending contracts - between the firm and its lenders

Agency Contracts between Firm Owner and Manager

Timeline:
1. Manager hired, manager exerts effort
2. Manager paid, based on performance measures e.g. net income
3. Cash flow from manager’s first period effort fully realized by the owner

The owner is the principal and the manager is agent

- Manager’s goal is to maximize overall utilities (in line with decision theory)
- Firm’s goal is to maximize expected payoff, where payoff is the cash flows resulting from the manager’s
activities

Manager has a choice between two courses of action:

1. Work hard
2. Shirk

Manager’s action affects overall probabilities of payoffs:

High manager effort exerted  higher probability of high payoff/utility  lower probability of low payoff/utility

It is possible for the manager to work hard and exert maximum effort and for the payoff to be low. Full payoff is not
observable until after the current compensation contract has expired, creating an unbiased message about the
payoff. This is because net income as is not fully informative, known as noisy net income:
- cost control, employee morale and advertising affect net income with a lag
- corporate governance, for example weak internal controls allow random error or bias
- recognition lag, not all manager effort fully pays off in the current period such as R&D costs
- accruals anticipate some of the cash flows pertaining to current manager performance

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 - environment and legal liabilities that are not known until the next period
- despite hard work, bad economic times may result in low payoff; good times may rescue the one who
shirks

PROBLEMS
1. The firm faces payoff risk resulting from the manager’s activities for the time employed
2. The firm faces compensation risk from noisy net income.

Owner’s Standpoint Manager’s Standpoint

- Loss of control over actions taken by manager hired
to operate the firm
- Owner would want the manager to work hard as it
yields the higher expected utility
1. Risk- averse
- If manager is willing to work for owner, compensation
offered must be fairly large
- Expected utility should at least be equal to the
opportunity cost of the utility that could be attained in
case of next best job = concept of reservation utility

2. Effort- averse
- He/she dislikes effort
- Most people would prefer to exert least amount of effort
- Tendency of agent to shirt = clear example of moral
hazard

To deal with these issues, owners can design a contract to control moral hazard:

1. Hire the manager and put up with the chance of lower expected utility

2. Direct monitoring of the manager’s chosen act

 A first best contract: gives owner maximum utility, while giving manager reservation utility
 The owner observes the manager’s actions, but this can to be too costly
 Manager’s salary amended to his/her effort (i.e. if low effort observed, manager’s salary will decrease).
Manager will choose to work hard as this gives a higher utility
 Unattainable in real life: unlikely that an owner could monitor a manager’s action and assess his/her
level of effort

3. Indirect monitoring
 A first best contract
 Manager’s effort can be determined from payoff of firm.
 But, performance of firm cannot only be imputed to manager, it is also affected by economic conditions,
laws and government policies, consumer trends
 Difficult for owner to collect penalty from manager after one-year contract has expired

4. Owner rents firm to the manager

 Rent firm to manager for fixed amount
 Owner no longer cares if manager works hard
 Manager is worse off: he or she receives a lower utility
 Owner who is risk neutral bears no risk; manager who is risk averse bears all the risk

5. Give the manager a share of the profits

 Most efficient alternative since first best contracts are not attainable

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  Impose the minimum compensation risk needed to motivate the manager to work hard.
 Manager must be paid at the end of current period; firm’s performance is not known until next period
 An indicator of the manager’s hard work is net income but it is not fully informative as discussed above

Overall,
- The nature of the most efficient contract depends on what can be observed; if the agent’s effort can be
observed, a fixed salary is the most efficient. This is the first-best contract. There are no agency costs and effort is
the performance measure. BUT since the payoff from the current period’s manager effort can only be observed until
after the end of the current period, the manager must be paid periodically and not based on payoff.
- If the agent’s payoff cannot be observed, but net income can, the most efficient contract may give the
agent a share of net income. However net income is a risky performance measure for the manager, because it is
subjected to noise. The second-best contract is the contract that imposes the lowest amount of risk on the manager
while maintaining the manager’s incentive to work hard. Accountants can improve the efficiency of compensation
contracts by improving the precision of net income as a payoff predictor (by reducing ‘’noise’’).
- If effort, payoff and net income are all unobservable, the optimal contract is a rental contract, whereby
the principal rents the firm to the manager for a fixed rental fee, thus internalizing the agent’s effort decision. Such
contracts are inefficient because they impose all of the firm’s risk on the manager, resulting in maximum agency
cost. Here there is no performance measure.

When net income is the performance measure, the manager has further information advantage over the owner; he
will therefore tend to perform earnings management.
Pre-contract advantage: information prior to contract signing
Pre-decision advantage: information prior to decision, post-contract signing
Post-decision advantage: information obtained post-decision, but prior to reporting to firm owner

It is unlikely that the owner can monitor all the actions of the manager so the manager has a tendency to shirk. This
creates a moral hazard/information asymmetry problem: the manager knows the effort level, but not the owner.

To control earnings management

- Hire external auditors to sit on firm’s Board of directors to ensure objectivity and neutrality
- Apply GAAP principles to limit the amount by which earnings are managed
- Strengthen corporate governance

Agency Contracts between Firm and Lender

Moral hazard problem: the possibility that the managers may act opportunistically against the best interests of
the lenders, thereby benefitting him/herself and/or the shareholders at lender’s expense. Managers may:
1. Pay excessive dividends
2. Undertake additional borrowing
3. Undertake excessively risky projects, particularly if the firm is approaching financial distress

Rational lenders will anticipate this behavior and raise interest rates they demand for their loans so that managers
have less of an incentive to act against the lender’s interests. This can be done by inserting covenants into the
lending agreement whereby the manager agrees to limit dividends or additional borrowing while the loan is
outstanding. Consequently, the firm is able to borrow at lower rates.

Covenants assure more security on their return. However, due to external factors, covenants cannot guarantee
lender protection. This leads to the issue of earnings management. The optimal solution is to offer debt and equity
awards (require a manager to hold company debt) which make managers take more cautious in their actions since

35
they now have something to lose. This reduces the agency problem as it motivates managers to have the best
interests of both parties. Shares lender position while satisfying shareholders through lower interest rates.

Implications of Agency Theory for Accounting

Contracts can be made more efficient with two performance measures. Conditions for increased efficiency:
- Performance measures and share prices must be observable
- The second measure must add information about manager performance that first one does not. For
instance, share price reacts quicker to unobservable payoff than the accounting system. For example,
they reflect expected R&D benefits. It doesn’t matter how noisy the second measure is
Performance measures must have sensitivity and precision as characteristics.
- Sensitivity is the rate at which expected value of a performance measure increases as managerial effort
increases. One unit of managerial effort is equal to one unit of payoff. It strengthens the connection
between effort and output. Mixed measurement model decreases sensitivity.
- Precision is the measurement of the variance of the noise in the performance measure. If measure is
precise, there is low chance that effort used will not be reflected in the payoff. It reduces manager’s
compensation risk and increases the change of effort recognition.
- Current value accounting increases sensitivity but decreases precision. Accountants must find a balance
between precision and sensitivity.

In the real world, contracts are incomplete and do not anticipate all state realizations. There are too many possible
outcomes and it is impossible to create a contract that considers all of them. It is not possible for contracts to be
renegotiable as it lessens the incentive for managers to work hard. Therefore contracts are rigid.

Under efficient securities market theory, only accounting policies that affect expected cash flows create economic
consequences. Managers have incentive to maximize performance and therefore maximizing payoff. Compensation
based on performance measures that are affected by accounting policies do not affect expected cash flows.
Therefore, economic consequences and efficient securities markets are not necessarily inconsistent. Nothing in the
theory of efficient securities market theory conflicts with managerial concern about accounting policies. Instead,
both theories help us to see that managers may well intervene in accounting policies, even though those policies
would improve the decision usefulness of financial statements to investors.

Application of Game Theory:

Investors will desire a useful tradeoff between relevant and reliable financial statement information to assist in
assessing the expected values and risks of their investments. Managers, however, may not want to reveal all the
information that investors want. By omitting some liabilities from the balance sheet, they might be able to raise
capitals. Also, they might not want to reveal all accounting policies being used in order to have room to manage
reported profits through accruals or changes of accounting policy. Finally, management may fear that releasing too
much information will benefit their competition. The investor of course, will be aware of this possibility that the
management might want to present their company in the best light by biasing/managing the financial statements
for efficient contracting and will take it into account when making investment decisions. The management, in turn,
will be aware of possible investor reaction when preparing financial statements. This is a good example of game
theory (each party tries to predict each other’s moves). It should be noted that reported net income has the role to
predict the ultimate payoff from current manager activities. This monitors and motivates manager performance.

By modeling this conflict situation as a game, we can understand the problems surrounding policy choice more
clearly. In particular, we can see that depending on the payoffs of the game, it may indeed be in a manager’s own
interests to distort the financial statements at least in the short run (if the manager has more utility in doing so).
Thus, any accounting body concerned about implementing a new policy must consider the payoffs to both investors

36
and management. To ensure a smooth implementation, we need to ensure that the payoffs to management are such
that management will accept the new policy.
CHAPTER 10: Executive Compensation

Executive Compensation Plan

Definition: An agency contract between the firm and its manager that attempts to align the interests of owners and
manager by basing the manager’s compensation on one or more measures of the manager’s performance in
operating the firm.

Many compensation plans are based on two performance measures:

1. Share price
2. Net income
* Thus, the amounts cash bonus, shares options, and other components of executive pay that are awarded in a
particular year depend on both net income and share price performance.

Are they necessary?

Fama 1980 concluded that incentive contracts are not necessary because the managerial labour market efficiently
controls moral hazard.
- If a manager can establish a reputation for creating high payoffs for owners, that manager’s market
value will increase. He can therefore command higher compensation.
- A manager who shirks, thus reporting lower payoffs on average, will suffer a decline in market value.
The present value of reduced future compensation will be equal to or greater than the immediate benefits of
shirking. This reduces the incentive for managers to shirk.
- For lower level managers, any shirking will be detected and reported by managers below them who
want to get ahead. A process of internal monitoring operates to discipline managers who may be less
subject to the discipline of the managerial labour market itself.
- These arguments do not consider that the manager may be able to disguise the effects of shirking by
managing the release of information. The manager may try to fool the market by opportunistically managing
earnings to cover up shirking.

AFG 1997 designed two period model with one owner and two risk averse managers instead of a one period model
in chapter 9.
- In the single period model, the owner knows which action the manager will in take thus this model does not
reveal any information about manager effort and ability. The manager’s market value enters only through a
reservation utility constraint- the utility of the compensation of the next-best available position, taken as a
constant.
- The two period model produces a joint, observable payoff in each period. The owner cannot observe either
manager, but each manager knows the effort of the other. Since the payoff is joint, shirking by either manager

37
 will reduce the payoff for both. This is more efficient because it imposes less risk than a sequence of two
single period contracts. Managers can attain their reservation utility with lower expected compensation.

While internal and market forces may help control managers’ tendencies to shirk, they do not eliminate them.

The Theory of Executive Compensation

The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance
- The efficiency of compensation contract may be increased if it is based on two or more performance
measures.
- Motivation of manager performance is an important social goal. If financial reporting is to contribute to
the attainment of this goal, it must successfully complement other performance measures
Banker and Datar 1989 demonstrated conditions under which the linear mix of performance measures depends on
the product of the sensitivity and precision of those measures. The lower the noise in net income or the greater its
sensitivity to manager effort, the greater should be the proportion of net income to share price in determining the
manager’s overall performance.
- A way to increase sensitivity to management performance is for accountants move to current value
accounting to reduce recognition lag. Reduced recognition lag increases sensitivity since more of the payoffs
from the manager effort show up in current net income. However, current accounting tends to reduce
precision and reliability.
- Another approach to increase sensitivity of net income to managerial performance is through full
disclosure, particularly for low-persistent items. Full disclosure increases sensitivity by enabling the
compensation committee to better evaluate manager effort and ability. Share price is not really precise in
determining managerial effort, because it can be affected by economy-wide factors such as the fluctuation in
interest rates. Noise trading and market inefficiencies can affect the share price, which distorts the evaluation
of managerial effort.
- Efficient compensation plan design adjust the relative proportions of earnings-based and share price-
based compensation to exploit the fact that current net income aggregates the payoffs from only some
manager activities in the current period.

The Role of Risk in Executive Compensation

- In the presence of moral hazard, the manager must bear some compensation risk if effort is to be
motivated. Since managers are rational and trade off risk and return, the more risk they bear, the higher must
be the expected compensation if reservation utility is to be attained. If no risk is imposed; the firm will suffer
from low managerial effort because they will have nothing to lose. If too much risk is imposed, the manager
might underinvest in a project even if it would benefit the shareholders.
- To control compensation risk, Baiman, Demski and Holmstrom (1982) developed relative performance
evaluation (RPE). Here, instead of measuring performance by net income and/or share price, it is measured
by the difference between the firm’s net income and/or share price performance and the average
performance of a peer group of similar firms.
1. The common or systematic risks that the industry faces will be filtered out of the incentive plan,
especially if the number of firms in the peer group is large.
2. Under this theory, it is possible for a manager to do well even if the firm reports a loss and/or
share price is down, providing the losses are lower than those of the average peer group firm.
3. If this theory is valid, we expect to observe manager compensation negatively related to average
economy or industry performance. For example, when industry performance is low, high earnings
and/or share price performance for the firm in question is more impressive since it overcomes
negative factors affecting the whole industry.
- Another way to control compensation risk is through the bogey of the compensation plan. That is,
incentive compensation does not kick-in until some level of financial performance is reached. The effect is

38
 that if the bogey is not attained, the contract does not award any incentive compensation. However, the
manager does not have to pay the firm if there is a loss.
1. If downside risk is limited, it seems reasonable for upside risk to be limited too; otherwise the
manager would have everything to gain and little to lose which could encourage excessive risk taking.
Thus, many plans impose a cap, whereby incentive compensation ceases beyond a certain level.
2. Conservative accounting also controls upside risk by delaying recognition of unrealized gains
and discouraging premature revenue recognition. It promotes contract efficiency by constraining the
manager’s ability to inflate current earnings and hence compensation, by realized gains. However, it
gives the manager little incentive to invest in risky projects (no compensation will be received unless a
project starts to generate realized profits).
3. The use of employee stock options reduces downside risk and promotes risk-taking activities. If
they succeed they can become very valuable.
- A mix of performance measures is desirable. Compensation in the form of ESOs and/or company shares
encourages upside risk and a longer-run decision horizon, while net income-based compensation (use of
bogey) imposes some downside risk that discourages the excessive risk taking that pure share-based
compensations may create. Also, restricted stocks might be better alternatives.

The Politics of Executive Compensation

Jensen and Murphy conducted studies to determine whether CEO’s were overpaid and concluded that although not
overpaid, the correlation between a CEO’s performance and compensation was very low. JM’s explanation was that
CEO’s did not have enough risk embedded in their compensation plans in order to motivate their behaviors.

Overall, managements’ performance is positively correlated with compensation in the real world; empirical
evidence shows that the correlation is very low.

The Power Theory of Executive Compensation

The power theory suggests that executive compensation in practice is driven by manager opportunism, not
efficient contracting; it therefore questions the efficient operation of the managerial labour market.
Managers have sufficient power to influence their own compensation, and they use this power to generate excessive
pay, at the expense of the shareholder value.
*Regulators and accountants have responded to the political pressures that result when managers exercise
excessive power by expanding the information available to shareholders and others, on the assumption that they
will take action to eliminate inefficient plans, or the managers and firms that have them.

Conclusions

It is important to note that labor markets are subject to adverse selection problems such as earnings management to
disguise shirking. To properly align the interests of managers and shareholders, an efficient contract needs to
achieve a high level of motivation while controlling compensation risk. Too little risk discourages manager effort,
while too much risk leads to avoidance of risky projects, which can slow down the growth of the firm. To attain
proper alignment, incentive plans usually feature a combination of salary, bonus and stocks or options.

Financial reporting has an important role in motivating executive performance and controlling manager power. This
role includes full disclosures so that the compensation committee and investors can better relate pay to
performance. It also includes expensing ESOs to help control their abuse and encourage more efficient
compensation vehicles. As a result, responsible manager performance is motivated. This improves the operation of
the managerial labor market.

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Managers are generally risk-averse because the compensation that they receive is dependent on only one incentive
compensation plan as they only work for one employer. They cannot diversify their risk by working at 25 different
jobs, as this would be unrealistic.

Eliminating the upside limit of management compensation plans, while keeping the downside limits, will cause the
manager to take on risky projects all the time because they would have everything to gain, but nothing to lose.
Eliminating the downside limit while keeping the upside limits would create an extremely risk averse manager as
they would have everything to lose, but nothing to gain.
Eliminating both the downside and upside risk, in the context of diminishing utility, the manager would be very
scared to experience any type of losses, because the losses would be limitless and could imply personal bankruptcy.
Therefore, the manager would probably be very risk averse because there utility would have a greater decrease for
a decrease in loss than an increase in a gain.
Advantages and Disadvantages of Performance Measures:

Net Income Share Price

- More reliable (based on
- Takes into consideration
historical cost
prospective payoffs from current
- Less volatile to uncontrollable
Advantages manager activities
economic events
- Properly reflects publicly
- Influences managers to partake
available information
in earnings management
- Doesn’t reflect private
- Lacks timeliness
information
Disadvantages - May not reflect all activities
- Volatile (influenced by external
- Can be eliminated
factors)

By combining share price, which better reflects long-run payoffs, and net income, which better reflects short-run
payoffs of current managers’ actions to determine a compensation plan, managers are concerned with both the
short-term well-being and long-term success of the firm.

Although share price by nature takes net income into account, research has shown that compensation plans are
better if both are used when noise is present in the market.

Manipulating the proportions of each can change the decision horizon and risk tolerances to the desired level.

40
CHAPTER 11: Earnings Management

From a financial reporting perspective, managers may use earnings management to meet analysts’ forecasts,
thereby avoiding the reputation damage and strong negative share price reaction that quickly follows a failure to
meet investor expectations. They may also record excessive write offs or emphasize earnings constructs other than
net income. Some of these tactics suggest that managers do not fully accept securities market efficiency.
Management may also use earnings management to report a stream of smooth and growing earnings over time.
Given securities market efficiency, this requires management to draw on inside information. Thus, earnings
management can be a vehicle for the communication of management’s inside information to investors.

From a contracting perspective, earnings management can be used as a way to protect the firm from the
consequences of unforeseen events when contracts are rigid and incomplete. Too much earnings management,
however, can reduce the usefulness of financial reports for investors, especially if it is not disclosed. Earnings
management affects the manager’s motivation to exert effort because managers can use it to smooth their
compensation over time, thereby reducing compensation risk. But managers need to bear some risk if they are to
work hard.

Managers can perform earnings management by choosing accounting policies that help them meet their objectives
and by taking real actions affecting their earnings such as R&D. Their choices are motivated either by efficient
markets and contracts, or by opportunism and rejection of market efficiency. So this gives the definition:

Earnings management is the choice by a manager of accounting policies, or real actions, affecting earnings so as to
achieve some specific reported earnings objective.

Accounting Policy Choices

1. Accounting policies per se such as amortization method or policies for revenue recognition
2. Discretionary accruals such as provisions for credit losses, warranty costs, inventory values, and timing and
amounts of low-persistence special items. There is an “iron law” regarding accruals reverse: if a manager
manages earnings upwards to an amount greater than can be sustained, he will find that the reversal of these
accruals in future periods will force earnings downward. So even more earnings management is needed if the
reporting of losses is to be further postponed.

Real Actions
Manage earnings by means of real variables such as through advertising, R&D, timing of purchases and disposals of
capital assets. These may be costly since they directly affect the firm’s longer run interests.

41
Patterns of Earnings Management

1. Taking a Bath: Occurs during periods of organizational stress or restructuring. If a firm must report a loss,
management may feel it might as well report a large one, since there is little to lose. It could perform large
write-offs of assets.
2. Income Minimization: Similar to taking a bath, but less extreme. It is characterized by policies that induce rapid
write-offs of capital assets and expensing of advertising and R&D expenditures.
3. Income Maximization: Engage in a pattern of maximization of reported net income for bonus purposes.
4. Income Smoothing: From a contracting perspective, risk-averse managers prefer a less variable bonus stream.
Managers therefore may smooth reported earnings over time as to receive a relatively constant compensation.
Income smoothing reduces the likelihood of reporting low earnings. If used responsibly, smoothing can convey
inside information to the market by enabling the firm to communicate its expected persistent earning power.

Earnings Management for Bonus Purposes

Managers have inside information on the firm’s net income before earnings management. Managers would manage
net income so as to maximize their bonuses under their firms’ compensation plans. This was studied by Healy. His
study was confined to firms whose compensation plans are based on current reported net income only. These are
called bonus schemes.
- If net income is low (that is, below the bogey), the manager has an incentive to lower it even further that is, to
take a bath. If no bonus is to be received anyway, the manager might as well adopt accounting policies to
further reduce reported net income. In doing so, the probability of receiving a bonus in the following year is
increased since current write-offs will reduce future amortization.
- If net income is high (above the cap), there is motivation to adopt income minimization policies, because
bonus is permanently lost on reported net income greater than the cap. If net income is between the bogey and
the cap, the manager is motivated to adopt accounting policies to increase reported net income.
- Healy assumed managers use accruals to manage net income: net income = cash flow from operations +/- net
accruals = cash flow from operations +/- net non-discretionary accruals +/- net discretionary accruals.
*Discretionary accruals are accruals over which the manager can exercise some control.

Other Motivations for Earnings Management

Other Contracting Motivations

- Debt contracts typically depend on accounting variables, arising from moral hazard problem between
manager and lender. To control this problem, long term lending contracts contain covenants to protect against
actions by managers that are against the lenders’ best interests such as excessive dividends, additional
borrowing, or letting working capital or shareholder’s equity fall below specified levels, all of which dilute the
security of existing lenders.
- Covenant violations can impose heavy costs such as high interest rates and reduced future ability to
raise financing.
- Thus, earnings management can arise as a device to reduce the probability of covenant violation in debt
contracts.
- Discretion is provided in GAAP to allow the fairest representation of a company’s operations and
financial position. Discretion also allows for earnings management. The problem is that we cannot see the
actual motivation for the choices made; we cannot always distinguish fair representation from earnings
management.

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To Meet Investor’s Earnings Expectations
- Firms that report earnings greater than expected have enjoyed a share price increase, as investors revise
upward their probabilities of future performance. Conversely, firms with a negative earnings surprise suffer a
significant share price decrease.
- As a result, managers have a strong incentive to ensure that earnings expectations are met, particularly
if their hold ESOs or other share-related compensation.
- One way to do this is to manage earnings upward but rational investors are aware of this incentive so it
makes meeting expectations all the more important for managers. If these are not met, the market will reason
that if the manager could not find enough earnings management to avoid the shortfall, the firm’s earnings can
outlook must be bleak and the firm is not well managed since it cannot predict its own future.
- Management can change multiple policies in order to manage earnings such as policies regarding
amortization (they can change estimates of useful life) and accounts receivable (include earlier revenue
recognition and a more generous credit policy). Managers can also time their capital gains/losses to manage
earnings.
- Rather than report a net income substantially higher than what is expected to persist in the long run,
managers will decide to report earnings that they feel could persist in the future. So there is sometimes no use
in reporting very high income.

Stock Offerings
- When a firm plans to issue new or additional shares to the public, management faces a temptation to
manage earnings upward, so as to maximize the amount received from the share issue.
- Cohen and Zarowin reported that firms used real earnings management techniques to increase reported
earnings. These were speeding up of sales recognition, overproduction and reduction of discretionary
expenses such as R&D and advertising.
- If the market is fooled by the earnings management, we would expect abnormal share returns to fall in
periods following the new issue as investors realize, from lower profitability, that they have overpaid.
- Another assumption is that if the market is not fooled, then the managers can go ahead and manage
earnings since the market will expect it. Then there will be no abnormal negative share returns in subsequent
periods.
- It is important to note that investors do not always fully anticipate IPO earnings management.

The Good Side of Earnings Management

Arguments in favor are based on the blocked communication concept of Demski and Sappington (DSI).
- Agents obtain specialized information as part of their expertise, and this information can be
prohibitively costly to communicate to the principal.
- DSI showed that the presence of blocked communication can reduce the efficiency of agency contracts,
since the agent may shirk on information acquisition and compensate by taking an act that, from the principal’s
standpoint, is sub-optimal. If so, the principal has an incentive to try to eliminate or reduce the blocked
communication.
- Earnings management can be a device to reduce blockage. The unblocking of the manager’s inside
information by means of large discretionary accruals to produce a desired result has credibility. The market
knows that a manager would be foolish to report higher earnings that can be sustained.
- The credibility of unblocking is reinforced by the confirmatory role net income plays, which is that it
confirms inside information released by the manager during the period, thereby encouraging its honest
communication.
- Management typically has additional information about future firm performance such as new firm
strategies, planned restructurings, changes in firm characteristics, or changes in market conditions.

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The Bad Side of Earnings Management

Opportunistic Earnings Management

- Bad earnings management can result from opportunistic behavior.
- Higher quality disclosure helps investors evaluate financial statements, thereby reducing their
susceptibility to behavioral biases and reducing managers’ incentive to exploit poor corporate governance and
market inefficiencies. For example, clear reporting of revenue recognition policies, and detailed descriptions of
low-persistence items and major discretionary accruals such as write-downs and provisions, will bring bad
earnings management into the open, reducing manager’s ability to manipulate and bias the financial
statements for their own advantage.

Conclusion

Earnings management is made possible by the fact that true net income does not exist. Furthermore, GAAP do not
completely constrain managers’ choices of accounting policies and procedures. Such choices are much more
complex and challenging than simply selecting those policies and procedures that best inform investors. Rather,
manager’s accounting policy choices are often motivated by strategic considerations, such as meeting earnings
expectations, new share issues, discouraging potential competition and unblocking inside information. As a result,
accountants need to be aware of the legitimate needs of management, as well as of investors, while at the same time
being alert to opportunistic management strategies. Actual financial reporting represents a compromise between
the needs and strategies of these two major constituencies.

Earnings management can serve as vehicle for the credible communication of inside information to investors.
Nevertheless, some managers may abuse the communications potential of GAAP by pushing earnings management
too far, with the result that persistent earnings power is overstated, at least temporarily. Accountants can reduce the
extent of bad earnings management by bringing it out into the open. This can be accomplished by improved
disclosure of low-persistence items and reporting the effect of previous write-offs on current earnings. In addition
to assisting share prices to more closely reflect fundamental firm value, improved disclosure assists corporate
governance because compensation committees and the managerial labor market can better reward good manager
performance and discipline managers who shirk. This results in better allocation of scarce investment capital and
firm productivity to potentially increase social welfare.

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CHAPTER 12: Standard Setting & Economic Issues

Standard setting is the regulation of firms’ information production decisions by a regulator that is ultimately the
responsibility of a country’s government or legislature. Regulators are agencies delegated to set accounting
standards e.g. IASB and FASB. They act as a mediator between conflicting interests of investors and managers and
ensure the right amount of information is in financial statements.

The fundamental problem is how to combine the financial reporting and efficient contracting roles of accounting
information or, how to determine the socially “right” amount of information.

The socially right amount of information is when marginal social benefits equal marginal social costs. This is referred
to as the first-best amount of information production. This is impossible to attain by market forces alone due to
market complexities such as information asymmetry.

Regulation of Economic Activity

Regulation protects individuals who are at an information disadvantage due to information asymmetry. If
managerial actions and inside information were freely observable by all, there would be no need to protect
individuals from the costs of information disadvantage. Thus, it improves markets by enhancing public confidence.

Externalities and information asymmetry are frequently used to justify regulations to protect investors. In addition
to GAAP, we have insider-trading rules, MD&A, executive compensation disclosures, public access to conference
calls and regulations of full disclosure. In this chapter, our primary concerns are the regulation of minimum
disclosure requirements, generally accepted accounting and auditing standards, and the requirement that public
companies have audits.

There are two types of information that a manager may possess:

1. Proprietary information: Information that, if released, would directly affect future cash flows of the firm
(patent information, etc)
2. Non-proprietary information: Information, if released, does not affect future cash flows. These include
earnings forecast and financial statement information.

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 Information Production

Production of information is used for two reasons:

1. We want to think that information is a commodity that can be produced and sold
2. We want a consistent/unified way of thinking about the various ways of information production can be
accomplished

Quantity of Information
1. Finer information: A finer reporting system adds more detail to the existing financial statements e.g. expanded
note disclosure, additional line items on the financial statements, segment reporting. Finer information
production means a better ability to discriminate between realizations of the states of nature. Think of how a
thermometer enables a finer reading of temperature.
2. Additional information: This means the introduction of new information systems to report on matters not
currently included. Examples include informative extensions of current value accounting to additional assets
and liabilities, future-orientated financial information included in MD&A, and expanded disclosure of firm risk.
This implies an expansion of relevant states of nature. Adding a barometer to the thermometer will report
temperature and atmospheric pressure.
3. Credibility: The receiver knows that the supplier of information has an incentive to disclose truthfully. The
purchaser of the thermometer knows that the manufacturer must produce an accurate product in order to stay
in business and thus the thermometer is a credible representation of the temperature.

All these ways to produce information are considered information production.

Benefits and Costs of Information Production (Firs-best Information Production)

Benefits Costs
- - Better-informed investment decisions - - Direct costs of preparing and releasing
- - Lower cost of capital for firms producing the information
information - - Possible release of proprietary of information
- - Better working markets due to greater to competitors
investor confidence resulting from lower adverse - - Increased contracting costs
selection
- and moral hazard.
- - Reduction of monopoly power
- - Timely recognition of firm failure
- - Potential information release about other
firms

Market Failures Preventing First-based Information Production

An externality is an action taken by a firm or individual that imposes costs or benefits on other firms or individuals
for which the entity creating the externality is not charged or does not receive revenue.

Free-riding is the receipt by a firm or individual of a benefit from an externality.

The perception of these costs and benefits differs between the firm and society. Due to the public-good nature of
accounting information, its use by one individual does not destroy it for use by another. Then, other investors can
‘’free ride’’ on this information. Since all investors will realize this, no one has an incentive to pay for this
information. As a result, it is difficult for the firm to charge for producing accounting information. Thus, it will
produce less information than is socially desirable.

46
The effects of externalities and free riding are that since the firm cannot generate revenue or other benefits from all
of its information production, it will produce less than it would otherwise. The regulator then steps in to try to
restore the socially correct amount of production.

Contractual Incentives for Information Production

Despite the inability of regulation and/or market forces to generate first-best information production, there is a
surprising number of incentives whereby firms want to produce information. Some examples include:
- Information is required to monitor compliance with contracts
- If manager effort is unobservable, manager compensation is based on some observable measure of the
firm’s operations
- When a firm issues debt, it usually includes covenants whereby information is needed about the various
ratios on which the covenants are based
- When a private firm goes public, there is increased possibility of shirking. Investors become aware of
this shirking and as a result, share prices decline. So management needs incentives to reduce shirking:
contracts include forecasts, there is increase financial reporting and there is an overall increase in information
production.

The Coase Theorem showed conditions under which the problem of externalities can be internalized, thereby
reducing the need for regulation. He did this by using an illustration of two farms, side by side.
- There are two farms: one raises a cattle and the other grows crops. The cattle roams into the crops
damaging its value. There are two solutions: regulate the two farms with fencing or the farmers can bargain.
Assume the property rights belong to the crop farmer, the damages are repaid by cattle farmer and cattle
farmer puts up a fence. The socially desirable option is that a fence should be built since the cost of the fence is
less than the damage without it.
- In an accounting context, a firm has information that, if released, will cost it $100. This information will
benefit an investor who values it at $150. Suppose that the investor has the right to demand that the
information be released. The firm will release the information without regulation since it incurs a smaller cost
than reimbursing the investor for damages if the information is not released.

Market-Based Incentives for Information Production

1. The managerial labor market evaluates manager performance. As a result, managers who release false,
incomplete or biased information will suffer damage to their reputations. While reputation considerations do
not completely remove the need for incentive contracts, they do reduce the amount of incentives needed.
2. In capital markets, managers are motivated by reputation and contracting considerations to increase firm value.
This creates an incentive to release information to the market. The reason is that more information, by reducing
concerns about adverse selection and estimation risk, increases investor confidence in the firm. So market
prices of firms’ shares increase or equivalently cost of capital ill fall, increased compensation and higher firm
profitability and value.
3. In the takeover market (market for corporate control), if the manager does not increase firm value, the firm may
be subject to a takeover bid, which mostly means that the manager will be replaced. This increases the incentive
for managers to increase firm value and issue more information.

The Disclosure Principle suggests that managers will release all information whether it’s good or bad. If rational
investors know that the manager has some decision-useful information, by do not know what it is, they will assume
that if it was favorable the manager would release it. So, if investors do not observe the manager releasing it, they
will assume the worst and bid down the market value of the firm’s shares accordingly. Therefore managers should
release ALL information or they risk decreasing firm value. This creates an incentive to keep share price from falling.

47
However, the disclosure principle does NOT always work. Verrechia(1983) concluded that managers may not fully
disclose at all times. Manager will disclose information if it exceeds the threshold, thus the disclosure principle fails.
The lower the disclosure cost, the lower the threshold and if disclosure cost is zero, the disclosure principle is
reinstated.

Signaling

It frequently happens that firms differ in quality. How can a manager credibly reveal the firm’s type, as these
underlying quality differences are called, without incurring the excessive costs? A signal is an action taken by a
high-type manager that would not be rational if that manager was low type. 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; it is irrational for low-type to
mimic high-type. Some signals include:
- Proportion of retained equity: It would not be rational for a bad news manager to retain high equity
position in the firm (ownership retention) while making an IPO. This would be too costly for low-type to do.
- Audit quality: This can be a signal of the value of a new securities issue. High quality auditors are costly
for low type.
- Forecast: It is less costly for a high-type firm to release a high quality, good-news forecast. In MD&A
about future prospects is required (to go beyond minimal requirements). The firm’s willingness to choose high-
quality disclosure reveals inside information that management has a confident and well-planned view of its
future. This adds credibility to the forecast.
- Firm’s capital structure: For example when the issuance of new shares causes existing shares to drop
in value. High-type firm would likely find other sources of financing such as bonds and internal financing.
- Dividends policy: A high payout ratio signals that a firm has confidence in its future performance.
- Accounting policy choice: Adopting conservative policies signals a manager’s confident view about the
firm’s future. A good firm can do this and still report profits, while a bad firm would report losses.

Firms may use multiple signals. For signals to be applicable, the manager must have a choice. For example, if a
regulator imposed a uniform level of audit quality on all firms, audit quality would not be available as a signal.
Furthermore, reducing the flexibility to choose the forecasting quality in MD&A would reduce its signaling content.
Consequently, standards to enforce uniform accounting destroy managers’ ability to signal.

Signaling is effective, because firms that are not able to back up their signals will suffer consequences. To the extent
that firms’ choices of accounting policies signal credible information about those firms, diversity of reporting
practices is desirable. Some earnings management can be good since it can serve as a vehicle for the release of inside
information. Obviously, earnings management by means of accounting policy choice is feasible only if there is a
sufficiently rich set of accounting policies within GAAP from which to choose.

Private Information Search

The onus is on the manager to release information. This implies that investors are passive; they react to whatever
information the manager releases in deciding on their demand for the firm’s securities. Investors may conduct
private information search. It encourages investors to produce information in the search for mispriced securities.
If they are successful, information can quickly go public. This can be quite costly from society’s perspective since
more than one investor incurs costs to discover the same information.

Theory of Superior Disclosure

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If market forces are to motivate superior disclosure, firms should benefit through higher share price and lower cost
of capital. It may also positively affect the firm’s future investment and production decisions. There are several ways
to benefit:
1. To improve the ability of investors to diversify – if the firm can increase the size of its subset of investors by
superior disclosure, its cost of capital will fall, its market value will rise and idiosyncratic risk will decrease.
2. To improve liquidity – credible voluntary disclosure reduces information asymmetry between the firm and the
market, thereby increasing liquidity of trading in its shares.
3. To reduce investor estimation risk – investors demand a higher expected return the greater the ratio of inside
information to outside. Insiders can make better investor decisions than outsiders due to their information
advantage. Outsiders are unable to fully from share price due to noise trading. So investors demand a higher
expected return to compensate. So, firms can reduce their costs of capital and increase market value by reducing
inside information.

If a firm reduces information asymmetry about itself though higher quality disclosure, its share price then reflects
more information about itself relative to the effects of economy wide events. As a result, investor’s assessment of its
share price covariance with other firms in the market falls.

The theory is relatively unproven and many researchers still disagree. It is difficult to measure cost of capital, there
are too many varieties of investor risk and information system probabilities are unobservable so researchers have
to develop proxies for disclosure quality.

Decentralized Regulation

Even though market failures in information production are sufficiently serious that some extent of regulation is
needed, efficiency of regulation can be improved. This is called the flexible approach decentralized regulation.
- It gives management some flexibility in reporting, reduces comparability across firms and improves the
relevance of reporting since it is adapted to the particular firm’s circumstances.
- Reliability must be controlled since management would have to change a firms’ internal organization to
exploit flexibility.

Examples include:
1. Segment reporting - Information about firm segments is potentially useful to investors, since, in evaluating the
performance of large and complex firms, relevant information, such as differing risks, rates of return, and
opportunities for growth, may be buried in consolidated totals. It is harder to disguise poor performance.
Segment reporting increases relevance but threatens reliability since management may act opportunistically in
choosing the basis and degree of aggregation of segment reporting. There are two motives: reporting on
segment performance may reveal information to competitors, thus incurring propriety costs and management
wants to cover up poor performance by including poorly performing segments in larger totals.
It is regulated by IFRS 8 which requires reporting on same basis as internally. Flexibility results in useful
information to investors.
2. Standards allowing fair value – Decentralized since management is given a choice. It gives management the
ability to signal through its choice of reporting methods.

How Much Information is Enough?

Complete regulation is too costly:

 Direct costs such as bureaucracy to establish and administer regulations and compliance costs to firm
 Indirect costs such as reduction in management opportunity to signal and costs of wrong amounts of information
because the regulator is unable to calculate the socially optimal amount of information to require

49
 Complete deregulation is not socially desirable. Uncontrolled impacts of externalities, adverse selection and moral
hazard would be extremely serious and markets would probably cease to function.

The range of regulation is based on the theory of second-best. The Sarbanes-Oxley Act showed net positive effect to
investors, but reduced utilities of insiders, and lowered the number of firms offering securities. It can’t infer the
social benefits are positive. The extent of standards is a complex and important question for market economy.
Standard setting boils down to a cost-benefit trade-off but this trade-off may never be fully known. A method for
dealing with this uncertainty is to give firms flexibility in meeting reporting standards.
CHAPTER 13: Standard Setting

Information asymmetry, which creates the demand for information production by firms, also creates a demand for
regulation of that information production. The amount of information that firms would privately produce is in
general not equal to the amount that investors want. As a result, investors may push for regulation for more
information production. In setting standards, the interests of managers, small investors and large investors must be
traded off.

Standard setting is political, not just economical. Information asymmetry (moral hazard and adverse selection)
creates demand for information and because the information that firms would produce privately will not equal the
demand of investors, information asymmetry creates demand for the regulation of information. Due to problem of
unanimity- the amount of information that firms would privately produce do not need to and in general will not
equal to the amount that investors want. Thus, the regulation of information is a political process.
- Regulatory complication: (Ignored in Chapter 12) faces information asymmetry since the manager has the best
knowledge of the firm's own costs, sources of demand, and information environment.

Challenges to financial reporting and standard setting result from global integration of capital markets and
international convergence of accounting standards.

It should be noted that while decision usefulness and reduction of information asymmetry are necessary for any
standard, much more is needed. Specifically, the standard must be acceptable to its various constituencies. This
often requires a careful attention to due process by the standard setter.

Two Theories of Regulation:

1. Public Interest Theory:

This theory suggests that regulation is a response to public demand for correction of market failures. It does its best
to maximize social welfare. Consequently, regulation is thought of as a tradeoff between its costs and its social
benefits in the form of improved operations of markets. There is, however, a problem in deciding the right amount

50
of regulation. As chapter 12 mentioned, it is impossible to please everyone. Under public interest theory,
implementing a new standard requires only the regulator to evaluate its social costs and benefits.

- Regulator is assumed to have the best interests of society at heart.

- Does its best to maximize welfare; attain first-best amount of information production
- Problems arise from:

1. Deciding on the correct amount of regulation

2. Moral hazard problem exists where there is a possibility that the regulator will operate on its own behalf rather
than on behalf of the public
Regulator faces fewer constraints on shrinking since there is no capital market to help motivate his or her actions

We simply do not know how to calculate the best tradeoff between conflicting uses of information by
investors and managers that is required by the public interest theory of regulation. This is why the choice of
accounting standards is better regarded as a conflict between constituencies.

2. Interest Group Theory:

Introduced by Stigler (1971); Posner (1924), Peltzman (1976), and Becker (1983). An industry operates in the
presence of a number of interest groups (or constituencies). These various interest groups will lobby the regulator
for various amounts and types of regulation. Customers, in turn, may form groups to lobby for quality standards or
price controls. These various constituencies can be thought of as demanders of regulation. In addition,
constituencies may also lobby against regulation.

The outcome depends on which group is relatively most effective in applying pressure on the regulator. Pressure
can take forms such as forming a lobbying organization and promoting the group’s position in the media. Interest
groups are assumed rational so they will not put pressure/efforts on something they don’t believe will work.

Activities subject to market failure are more likely to be regulated due to demand from groups adversely affected.
Market failure increases the potential benefits of regulation for investors.

Standard setters are players in a complex game where affected constituencies choose strategies of lobbying for or
against a proposed new standard. Also, there are due process provisions for public hearings, exposure drafts and
generally, for openness, as well as requirements for super-majority votes in favour before new standards are issued.
These considerations suggest that the interest group theory of regulation is a better predictor of new standards than
the public interest theory, since the interest group theory formally recognizes the existence of conflicting
constituencies.

Interest group theory makes the following predictions:

- Creation of standard-setting bodies: Communication and organization costs, as well as fund raising and
overcoming a tendency for many investors to free-ride are involved in order for investors to support creation of
standard-setting bodies.
- Activities subject to market failure: Market failures in the production of information are common, due to
adverse selection and moral hazard. Market failures increase the potential benefits of regulation for investors.
- Due process: Management is expected to be involved in standards development such as reaction to exposure
drafts, and standards board representation.
Public interest theory does not make any of these predictions, it only requires that the regulator evaluate its social
costs and benefits.

* The interest group theory is a better indicator of how regulation is made, since it formally recognizes the existence
of conflicting constituencies.

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Decision Usefulness:
Information is useful if security prices respond to that accounting information. This suggests that a necessary
condition for the success of a new standard is that it be decision useful. Thus, the incorporation of current values
into financial reporting will increase investor decision usefulness to the extent that this tightens up the linkage
between current and future performance. However, since investors do not directly pay for accounting information,
they may ‘’overuse’’ it. Thus, a standard could appear to be decision useful, yet society would be worse off because
the costs of producing the information were not taken into account.

Reduction of Information Asymmetry

Market forces alone cannot ensure that the right amount of information is produced. This is because of information
asymmetry. Consequently, standard setters should use reduction of information asymmetry in capital and
managerial labor markets as a criterion for new standards. Reduction of information asymmetry improves the
operation of markets, since investors will perceive investors as more of a level playing field. This will reduce the
estimation risk and the ‘’lemons’’ phenomenon, reduce the big-ask spread and expand market liquidity.

Standard setters should weigh the possible economic consequences of new standards as an important source of cost
that will affect both the need for the standard and the willingness for the constituencies to accept it.

Political Aspect of Standard Setting:

Standard setters must engineer a consensus sufficiently strong that even a constituency that does not like a new
standard will nevertheless go along with it. Thus, the structure and due process of standard-setting bodies is
designed to encourage such a consensus. However, if constituency conflict is severe, even due process cannot always
bring up such consensus. For example in 1993, the exposure draft to expense ESOs met with such resistance that it
had to be withdrawn. While careful attention to due process may be time-consuming, such attention seems essential
if costly retractions are to be minimized.

Conclusion:

Accounting standard setters can be guided by decision usefulness and reduction of information asymmetry,
however, while these criteria are necessary, they are not sufficient to ensure successful standard setting. It is also
necessary to consider the legitimate interests of management and other constituencies and to pay careful attention
to due process.

- Under ideal conditions one can question whether financial accounting is needed at all since everything is
known and we can simply calculate the PV of future cash flows.
- Adverse Selection: the accounting challenge here is to convey information from the inside to outside of
the firm, thereby improving investor decision-making, limiting the ability of insiders to exploit their
information advantage and enhance operations in capital markets.
- Moral hazard: the effort exerted by a manager is unobservable to shareholders. The accounting
challenge here is to provide an informative measure of managerial performance. This enables incentive
contracts to motivate manager effort, protect lenders, and inform the managerial labor market.
- Investors need decision-relevant information to help them predict future firm performance. This implies
current value-based information. However, problems of volatility and possible low reliability of fair values
reduce the Informativeness of net income about manager performance. To the extent that historical cost
accounting is less subject to problems of measuring manager performance, it can be argued that it better meets
the challenge of enabling efficient contracts.

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- Investors, including securities commissions acting on their behalf, push for additional information,
including current value information. Management pushes the other way when they perceive that proposed
standards will affect their flexibility under the contracts they have entered into, inhibit their ability to credibly
communicate with the market through accounting policy choice, or reduce their ability to hide poor
performance through opportunistic earnings management. As mentioned, the standard setter must then seek a
compromise between these conflicting interests. The structure of standard-setting bodies is designed to
facilitate such compromise (due process and super-majority votes)

Efficient Securities Market Theory Efficient Contracting Theory

- Predicts that there is no price reaction to accounting
policy changes that do not impact underlying
profitability and cash flows.
- Implies the importance of full disclosure so investors
can adjust, based on the disclosed accounting policies.
So it doesn’t matter which policy the firms use.
- Concerned with predicting actions as the choices
of accounting policies by firm managers and how
managers will respond to proposed new accounting
standards.
- Believes firms organize themselves in the most
efficient manner to maximize their prospects for survival.
- Assumes that managers are rational and will
choose accounting policies in their own best interest

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