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 7.11.4 The Residual Income 8.9 Summary of Efficient
Model Revisited 289 Contracting for Debt
7.11.5 Summary 290 and Stewardship 337
7.12 Reporting on Risk 290 8.10 Implicit Contracts 338
7.12.1 Beta Risk 290 8.10.1 Definition and Empirical
7.12.2 Why Do Investors Care Evidence 338
about Firm-specific 8.10.2 A Single-period Non-
Risk? 292 cooperative Game 339
7.12.3 Stock Market Reaction 8.10.3 A Trust-Based Multi-period
to Other Risks 292 Game 343
7.12.4 A Valuation Approach 8.10.4 Summary of Implicit
to Risk Reporting 294 Contracting 348
7.12.5 Summary 297 8.11 Summary of Efficient
7.13 Conclusions on Valuation Contracting 348
Applications 298
9 An Analysis
8 Efficient Contracting of Conflict 361
Theory and
9.1 Overview 361
Accounting 312
9.2 Agency Theory 362
8.1 Overview 312 9.2.1 Introduction 362
8.2 Efficient Contracting Theory 9.2.2 Agency Contracts Between
and Accounting 314 Firm Owner and
8.3 Sources of Efficient Contracting Manager 363
Demand for Financial 9.3 Manager’s Information
Accounting Information 315 Advantage 373
8.3.1 Lenders 315 9.3.1 Earnings
8.3.2 Shareholders 316 Management 373
8.4 Accounting Policies 9.3.2 The Revelation
for Efficient Contracting 316 Principle 374
8.4.1 Reliability 316 9.3.3 Controlling Earnings
8.4.2 Conservatism 317 Management 376
8.5 Contract Rigidity 321 9.3.4 Agency Theory with
8.6 Employee Stock Options 325 Psychological Norms 378
8.7 Discussion and Summary 9.4 Discussion and Summary 381
of ESO Expensing 332 9.5 Protecting Lenders from
8.8 Distinguishing Efficiency Manager Information
and Opportunism Advantage 382
in Contracting 333

Contents xi
 9.6 Implications of Agency Theory 10.9 Conclusions on Executive
for Accounting 386 Compensation 435
9.6.1 Are Two Better Than
One? 386 11 Earnings Management 447
9.6.2 Rigidity of Contracts 390
11.1 Overview 447
9.7 Reconciliation of Efficient
Securities Market Theory 11.2 Patterns of Earnings
with Economic Management 450
Consequences 391 11.3 Evidence of Earnings
9.8 Conclusions on the Analysis Management for Bonus
of Conflict 392 Purposes 451
11.4 Other Motivations
for Earnings
10 Executive
Management 457
Compensation 406 11.4.1 Other Contracting
10.1 Overview 406 Motivations 457
10.2 Are Incentive Contracts 11.4.2 Meeting Investors’ Earnings
Necessary? 407 Expectations 459
10.3 A Managerial Compensation 11.4.3 Stock Offerings 460
Plan 410 11.4.4 To Hide Behind Error
10.4 The Theory of Executive “Camouflage” 462
Compensation 412 11.5 The Good Side of Earnings
10.4.1 The Relative Proportions Management 463
of Net Income and Share 11.5.1 Blocked
Price in Evaluating Communication 463
Manager Performance 412 11.5.2 Empirical Evidence
10.4.2 Short-run Effort of Good Earnings
and Long-run Effort 415 Management 466
10.4.3 The Role of Risk 11.6 The Bad Side of Earnings
in Executive Management 469
Compensation 418 11.6.1 Opportunistic Earnings
10.5 Empirical Compensation Management 469
Research 423 11.6.2 Empirical Evidence
10.6 The Politics of Executive of Bad Earnings
Compensation 425 Management 471
10.7 The Power Theory 11.6.3 Do Managers Accept
of Executive Securities Market
Compensation 430 Efficiency? 472
10.8 The Social Significance 11.6.4 Analyzing Managers’
of Managerial Labour Markets Speech to Detect Bad
that Work Well 435 Earnings Management 475

xii Contents
 11.6.5 Management Choices
Among Earnings
Management Methods 476
11.6.6 Implications for
Accountants 477
11.7 Conclusions on Earnings
Management 477
12 Standard Setting:
Economic Issues 492
12.1 Overview 492
12.2 Regulation of Economic
Activity 494
12.3 Ways to Characterize
Information Production 495
12.4 First-Best Information
Production 496
12.5 Market Failures
in the Production
of Information 496
12.5.1 Externalities and Free-
Riding 497
12.5.2 The Adverse Selection
Problem 497
12.5.3 The Moral Hazard
Problem 498
12.5.4 Unanimity 498
12.6 Contractual Incentives
for Information
Production 499
12.6.1 Examples of Contractual
Incentives 499
12.6.2 The Coase Theorem 500
12.7 Market-Based Incentives
for Information
Production 502
12.8 A Closer Look at Market-
Based Incentives 502
12.8.1 The Disclosure
Principle 502
12.8.2 Signalling 505
12.8.3 Private Information
Search 508
12.9 Are Firms Rewarded
for Superior Disclosure? 509
12.9.1 Theory 509
12.9.2 Empirical Tests
of Reporting Quality 512
12.9.3 Is Estimation Risk
Diversifiable? 515
12.10 Decentralized
Regulation 518
12.11 How Much Information
Is Enough? 520
12.12 Conclusions on Standard
Setting Related to Economic
Issues 525
13 Standard Setting: Political
Issues 537
13.1 Overview 537
13.2 Two Theories
of Regulation 539
13.2.1 The Public Interest
Theory 539
13.2.2 The Interest Group
Theory 539
13.2.3 Which Theory
of Regulation Applies
to Standard setting? 542
13.3 Conflict and Compromise:
An Example of Constituency
Conflict 542
13.4 Distribution of the Benefits
of Information, Regulation
FD 543
13.5 Criteria for Standard
Setting 546
13.5.1 Decision Usefulness 546
Contents xiii
 13.5.2 Reduction of Information
Asymmetry 547
13.5.3 Economic Consequences
of New Standards 548
13.5.4 Consensus 548
13.5.5 Summary 549
13.6 The Regulator’s Information
Asymmetry 549
13.7 International Integration of
Capital Markets 554
13.7.1 Convergence of
Accounting Standards 554
13.7.2 Effects of Customs and
Institutions on Financial
Reporting 556
13.7.3 The Role of Auditing in
Protecting Small Investors
in Developing
Economies 558
13.7.4 Does Adopting High
Quality Accounting
Standards Improve Financial
Reporting Quality? 560
xiv Contents
13.7.5 Does Adopting High
Quality Accounting
Standards Improve
Financial Statement
Comparability? 563
13.7.6 Effects of IFRS Adoption
on Contract
Efficiency 564
13.7.7 Conclusion on the Benefits
of IFRS Adoption 565
13.8 Should the United States
Adopt IASB Standards? 565
13.9 Summary of Accounting for
International Capital Markets
Integration 567
13.10 Conclusions and Summing
Up 568
Bibliography 583
Index 607
Preface

This book began as a series of lesson notes for a financial accounting theory course of the
Certified General Accountants’ Association of Canada (CGA). The lesson notes grew out
of a conviction that we have learned a great deal about the role of financial accounting
and reporting in our society from securities markets and information economics-based
research conducted over many years, and that financial accounting theory comes into its
own when we formally recognize the information asymmetries that pervade business
­relationships.
The challenge was to organize this large body of research into a unifying framework
and to explain it in such a manner that professionally oriented students would both under-
stand and accept it as relevant to the financial accounting environment and, ultimately,
to their own professional careers.
This book seems to have largely achieved its goals. In addition to being part of the
CGA program of professional studies for a number of years, it has been extensively used in
financial accounting theory courses at the University of Waterloo, Queen’s University, and
numerous other national and international universities, both at the senior undergraduate
and professional master’s levels. We are encouraged by the fact that, by and large, students
accept the material, and may object if the instructor follows it too closely in class. This
frees up class time to expand coverage of areas of interest to individual instructors and/or
to motivate interest in particular topics by means of articles from the financial press and
professional and academic literature.
Despite its theoretical orientation, the book does not ignore the institutional structure
of financial accounting and standard-setting. It features considerable coverage and critical
evaluation of financial accounting standards and regulations, such as fair value accounting,
financial instruments, reserve recognition accounting, management discussion and analy-
sis, employee stock options, impairment tests, hedge accounting, derecognition, consolida-
tion, and comprehensive income. The structure of standard-setting bodies is also described,
and the role of structure in helping to engineer the consent necessary for a successful
standard is evaluated. While the text discussion concentrates on relating standards to the
theoretical framework of the book, the coverage provides students with exposure to the
main features of the standards themselves.
This material has also been successfully used in Ph.D. seminars, concentrating on the
research articles that underlie the text discussion. Students appreciate the framework of
the book as a way of putting specific research papers into perspective. Indeed, the book
proceeds in large part by selecting important research papers for description and commen-
tary and provides extensive references to other research papers underlying the text discus-
sion. Assignment of the research papers themselves could be especially useful for instructors
 who wish to dig into methodological issues that, with some exceptions, are downplayed in
the book itself.
This edition continues to orient the coverage of accounting standards to those of the
International Accounting Standards Board (IASB). As in previous editions, some coverage
of major U.S. accounting standards is also included.
We have retained the outline of the events leading up to the 2007–2008 securities-
market meltdowns since these events raised significant questions about the validity of many
economic models and continue to have significant accounting implications. Ramifications
of these events are interwoven throughout the book. For example, one outcome of the
meltdowns is severe criticism of the efficient market hypothesis. Nevertheless, we continue
to maintain that investors are, on average, rational and that securities markets in developed
economies, while not fully (semi-strong) efficient, are sufficiently close to efficiency (except
during periods of bubble and subsequent liquidity pricing) that the implications of the
theory continue to be relevant to financial reporting. Critical evaluation of these various
criticisms and arguments is given.
The 2018 IASB Conceptual Framework is an important component of this book. Over
time, it will be an important aspect of the financial accounting environment. Its relation-
ships to the theory developed here are critically evaluated. While we retain extensive
discussion of alternate theories of investor behaviour, this book continues to regard the
theory of rational investors as important to helping accountants prepare useful financial
statement information.
The book continues to maintain that motivating responsible manager behaviour and
improving the working of managerial labour markets is an equally important role for finan-
cial reporting in a markets-oriented economy as enabling good investment decisions and
improving the working of securities markets.
We have updated references and discussion of recent research articles, revised the
exposition as a result of comments received about earlier editions, and added some new
problem material. We also continue to suggest optional sections for those who do not wish
to delve too deeply into certain topics.

What’s New
Below is a comprehensive list of major changes made to the eighth edition of Financial
Accounting Theory:
■■ The text reviews recent academic accounting research, with updated explanations and
discussion of important papers added throughout the text. The text represents the
current state of accounting-related theories, as published in major research journals up
to about mid-2018.

xvi Preface
■■ We have revised all chapters to improve the understandability of the exposition, dis-
carding some redundant material, and further clarifying the discussion of numerous
topics.
■■ The coverage of the Conceptual Framework (Chapter 3) has been updated to the 2018
IASB version, with references to it incorporated throughout the text. We have also
updated references to new accounting standards (Chapter 7), several of which were at
the exposure draft stage in the seventh edition.
■■ We have added numerous real-world examples to illustrate the theory. These are
mostly Theory in Practice vignettes with some related problem material. They include
Toshiba Corp. (Chapter 1), Home Capital Group (Chapters 3, 4, 6), vulture funds
(Chapter 3), SEC EDGAR (Chapter 4), Inco. Ltd. (Chapter 7), Broadwind Energy
Inc. (Chapter 7), Health South Corp. (Chapter 10), Barrick Gold Corp. (Chapter 10),
Valeant Pharmaceuticals (Chapter 11).
■■ Theory in Practice vignette 3.2, regarding evidence that tone of MD&A predicts
future earnings, is rewritten to bring out artificial intelligence implications. Additional
examples of computerized textual analysis are added, including of analyst written
reports (Chapter 5), effects of tone and sentiment on attribute framing (Chapter 6),
and qualitative statements in earnings announcements (Chapter 12).
■■ We have updated problem material, changed numerical solutions, and added new
problems.
■■ The discussion and illustration of reserve recognition accounting (Chapter 2),
management discussion and analysis (Chapter 3), and the RBC compensation plan
(Chapter 10) are updated.
Users of previous editions should take note that we have updated some terminology,
adopting wording that we believe will be more easily understood. The most important is
the change from “measurement approach” to “valuation approach,” when referring to the
standard-setting approach that emphasizes current values (Chapter 7). In addition, we
previously used the term “clean surplus” to describe both Ohlson’s (1995) theoretical model
and various valuation techniques that derive from it (Chapter 6). In this edition, we use
“residual income” for the valuation techniques. We have also replaced the term “late tim-
ing” with “backdating” in relation to employee stock options (Chapter 8).

Preface xvii
 FEATURES
■■ Theory in Practice: These vignettes provide real-world cases that illustrate the
­theoretical concepts. Some are pursued further in end-of-chapter Questions and
Problems.
■■ Examples: Numerical examples with detailed commentary about the method of
­solution make the theory more concrete, reinforcing students’ learning.
■■ Figures: Each chapter begins with a schematic figure. The figure at the start of
Chapter 1 shows the design of the book, and each subsequent chapter starts with a
figure showing the design of that chapter.
■■ Questions and Problems: Each chapter except Chapter 1 ends with questions and
problems that allow students to test, and sometime extend, their understanding of
the chapter’s contents.

xviii Preface
Acknowledgments

We have received a lot of assistance in writing this book. We thank CGA Canada (now
part of CPA Canada) for its encouragement and support over the past years. Bill
­acknowledges the financial assistance of the Ontario Chartered Accountants’ Chair in
Accounting at the University of Waterloo, which enabled teaching relief and other
­support in the preparation of the original manuscript, as well as financial support of the
School of Business of Queen’s University and the EY professorship at the University of
Waterloo. Pat acknowledges funding from The University of Waterloo School of
­Accounting and Finance.
We extend our thanks and appreciation to the following instructors, who provided
formal reviews for this eighth edition:
Hilary Becker
Carleton University

Harjinder Deol
Mount Royal University
University of Lethbridge
Southern Alberta Institute of Technology
Irene M. Gordon
Simon Fraser University
Duane Kennedy
University of Waterloo
Camillo Lento
Lakehead University
Janet Morrill
University of Manitoba
Mary Oxner
St. Francis Xavier University
Barbara Wyntjes
Kwantlen Polytechnic University
Jenny Zhang
Dalhousie University
We also thank numerous colleagues and students for advice and feedback. These
include Sati Bandyopadhyay, Jean-Etienne De Bettignies, Phelim Boyle, Kareen Brown,
 Dennis Chung, Len Eckel, Haim Falk, Steve Fortin, Irene Gordon, Jennifer Kao, James
A. Largay, David Manry, Bill Richardson, Gordon Richardson, Dean Smith, Dan T ­ hornton,
Kevin Veenstra, and Mike Welker. Enduring thanks to (the late) Alex Milburn for invalu-
able assistance in understanding IASB standards, and to Dick Van Offeren for helpful
comments and support on previous editions of this work.
We thank the large number of researchers whose work underlies this book in our
descriptions and discussions of research papers. We have not referenced many other worthy
papers. This implies no disrespect or lack of appreciation for the contributions of these
authors to financial accounting theory. Rather, it is simply impossible to include them all,
both for reasons of space and the boundaries of our own knowledge.
Bill remains grateful to Carolyn Holden for skilful, timely, and cheerful typing of the
original manuscript in the face of numerous revisions, and to Jill Nucci for very valuable
assistance on previous editions.
At Pearson Canada, we would like to thank Anne Williams, Vice-President, Editorial
Director; Keara Emmett, Portfolio Managers; Madhu Ranadive, Content Manager; Cheryl
Finch, Content Developer; Ainsley Somerville, Project Manager; and Darcy Pepper,
­Marketing Manager.
Finally, we thank our families, who, in many ways, have been involved in the learning
process leading to this book.
William Scott
Patricia O’Brien

xx Acknowledgments
About the Authors

William Scott received his B. Comm. from Carleton University, and his M.B.A and
Ph.D. from the School of Business, University of Chicago. He is a Fellow of Chartered
Professional Accountants Ontario. His research has been published in the Journal of
Accounting Research, Contemporary Accounting Research, Journal of Business Finance &
Accounting, and several other academic journals. He has served on the editorial boards
of Journal of Accounting Research, Contemporary Accounting Research, and The ­Accounting
Review; and served a term as Editor of Contemporary Accounting Research. Professor Scott
received the 1988 CAAA Award for Distinguished Contribution to Accounting Thought
and the CAAA 2005 L.S. Rosen Award for Outstanding Contribution to Canadian
Accounting Education. He has taught at Carleton University, University of Chicago,
Queen’s University at Kingston, University of British Columbia, and University of
Waterloo and is now Distinguished Emeritus Professor at University of Waterloo.

Patricia C. O’Brien is the EY Professor at the School of Accounting & Finance, U

­ niversity
of Waterloo. Her research, on topics concerning financial analysts, financial reporting
standards, and information in capital markets, is published in many of the premier
accounting journals. In 2009, Professor O’Brien received the CAAA Haim Falk Award
for Distinguished Contribution to Accounting Thought. She currently serves on the
Academic Advisory Council to C ­ anada’s Accounting Standards Board. She has served as
Editor-in-Chief of Contemporary Accounting Research (CAR), and on the editorial boards
of CAR, the Journal of Accounting Research, The Accounting Review, and the Journal of
Accounting and Public Policy. She holds an A.B. degree cum laude in mathematics from
Cornell University, and earned her M.B.A. and Ph.D. degrees at the University of Chicago.
Prior to joining Waterloo, P­ rofessor O’Brien was a faculty member at the University of
Rochester, Massachusetts Institute of Technology, the University of Michigan, London
Business School, and York University. She has held visiting appointments at the Helsinki
School of Economics, the University of Chicago, Stanford University, and the University
of Amsterdam, as well as in the Office of the Chief Economist of the Ontario Securities
Commission.
Chapter 1
Introduction

Figure 1.1 Organization of the Book

Ideal Information User Decision Accounting
Conditions Asymmetry Problem Reaction Mediation

Adverse Rational Decision

selection investment usefulness,
(inside information) decision full disclosure

Current
Standard
value-based
setting
accounting

Motivate
Moral Precise versus
and evaluate
hazard sensitive
manager
(manager effort) information
performance

1.1 THE OBJECTIVE OF THIS BOOK

This book is about the theory of accounting, not about how to account. It argues that
accounting students, having been exposed to the methodology and practice of accounting,
now need to examine the broader implications of financial accounting for the fair and
efficient working of our economy. Our objective is to give the reader a critical awareness
of the current financial accounting and reporting environment, taking into consideration
the diverse interests of both external users and management.

1.2 SOME HISTORICAL PERSPECTIVE

Accounting has a long history. Our perspective begins with the double entry bookkeeping
system. The first complete description of this system appeared in 1494, authored by Luca
Paciolo, an Italian monk/mathematician.1 Paciolo did not invent this system—it had
 developed over a long period of time. Segments that developed first included, for example,
the collection of an account receivable. “Both sides” of such a transaction were easy to see,
since cash and accounts receivable have a physical and/or legal existence, and the increase
in cash was equal to the decrease in accounts receivable. The recording of other types of
transactions, such as the sale of goods or the incurring of expenses, however, took longer
to develop. In the case of a sale, it was obvious that cash or accounts receivable increased,
and that goods on hand decreased. But, what about the difference between the selling price
and the cost of the goods sold? Profit has no physical or legal representation, and so it was
necessary to create abstract concepts of income and capital. By Paciolo’s time these concepts
had developed, and a complete double entry system-quite similar to the one in use today-
was in place. The abstract nature of this system, including the properties of capital as the
accumulation of income, and income as the rate of change of capital,2 attracted the atten-
tion of mathematicians of the time. The “method of Venice,” as Paciolo’s system was called,
was frequently included in mathematics texts in subsequent years.
Following 1494 the double entry system spread throughout Europe, where another
sequence of important accounting developments took place. The Dutch East India
Company, established in 1602, was the first company to issue shares with limited liability
for all its shareholders. Shares were transferable and could be traded on the Amsterdam
Stock Exchange, also established in 1602. In subsequent years the concept of a joint stock
company with permanent existence, limited liability, and shares traded on a stock exchange,
became an important form of business organization.
Obviously, investors needed financial information about the firms whose shares they
were trading. Thus began a long transition for financial accounting, from a system to enable
merchants to control their own operations to a system to inform investors who were not
involved in the day-to-day operations of the firm. To serve the joint interests of the firm
and investors, financial information provided by the firm needed to be trustworthy. This
laid the groundwork for developing an auditing profession and government regulation of
financial reporting.
In this regard, the English Joint Stock Companies Act of 1844 was notable. This Act
introduced into law the concept of providing an audited balance sheet to shareholders,
although this requirement was dropped in subsequent years3 and not reinstated until the early
1900s. During the interval, companies commonly provided information voluntarily, but the
effectiveness of such reporting was hampered by a lack of accounting principles. For example,
controversy arose over whether or not amortization of capital assets must be deducted in
determining income available for dividends. (The English courts ruled that it need not.)
In the twentieth century, major developments in financial accounting shifted to the
United States, which was growing rapidly in economic power. The introduction of a cor-
porate income tax in the United States in 1909 provided a major impetus to income
measurement and, as noted by Hatfield (1927, p. 140), was influential in persuading busi-
ness managers to accept amortization as a deduction from income.
Nevertheless, accounting in the United States continued to be relatively unregulated,
with both financial reporting and auditing largely voluntary. However, the stock market

2 Chapter 1
crash of 1929 and resulting Great Depression led to major changes by the U.S. government.
The most noteworthy was the creation of the Securities and Exchange Commission (SEC)
by the Securities Exchange Act of 1934, with a focus on protecting investors by means of
a disclosure-based structure. The Act regulates dealing in the securities of firms that meet
certain size tests and whose securities are traded in more than one state. As part of its
mandate, the SEC has the responsibility to ensure that firms supply investors with adequate
information.
Merino and Neimark (1982; MN) examine the conditions leading up to the creation
of the SEC. In the process, they report on securities market practices of the 1920s and prior.
Apparently, voluntary disclosure was widespread, as also noted by Benston (1973).
However, MN claim that such disclosure was motivated by big business’s desire to avoid
disclosure regulations that would reduce its monopoly power.
Regulations to enforce disclosure would reduce monopoly power by better enabling
potential entrants to identify high-profit industries. Presumably, if voluntary disclosure
were adequate, the government would feel no need to regulate disclosure. Thus, investors
were “protected” by a “two-tiered” market structure whereby prices were set by knowledge-
able insiders, subject to a self-imposed “moral regulation” to avoid government regulation
by controlling misleading reporting. Unfortunately, moral regulation was not always effec-
tive. MN refer to numerous instances of manipulative financial reporting and other abuses,
which were widely believed to be major contributing factors to the 1929 crash.
The 1934 securities legislation, then, can be regarded as a movement away from an
avoidance-of-regulation rationale for voluntary disclosure toward one of supplying investors
with better-quality information as a way to control manipulative financial practices.4
One accounting practice of the 1920s that received criticism was appraisal valuation
resulting in overstatement of capital assets, the values of which came crashing down in
1929.5 A major lesson learned by accountants as a result of the Great Depression was that
values are fleeting. The outcome was a strengthening of historical cost accounting, based
on completed transactions. This basis received its highest expression in the famous Paton
and Littleton (1940) monograph An Introduction to Corporate Accounting Standards. This
document elegantly and persuasively set forth the case for historical cost accounting, based
on the concept of the firm as a going concern. The going-concern concept justifies impor-
tant attributes of historical cost accounting, such as waiting to recognize revenue until
objective evidence of realization is available, the use of accruals to match realized revenues
and the costs of earning those revenues, and the deferral of unrealized gains and losses on
the balance sheet until the time comes to match them with revenues. In this view of
accounting, the income statement shows the current “instalment” of the firm’s ongoing
earning power. The income statement replaced the balance sheet as the primary focus of
financial reporting.
Some claim that the Paton and Littleton monograph was too persuasive, in that it shut
out exploration of alternative bases of accounting. However, alternative valuation bases
have become more common over the years, to the point where we now have a mixed
measurement system. Historical cost is still the primary basis of accounting for important

Introduction 3
 asset and liability classes, such as capital assets, inventories, and long-term debt.6 However,
impairment tests (also called ceiling tests) for capital assets and the lower-of-cost-or-market
rule for inventories, for example, introduce current valuations into historical cost. Under
International Accounting Standards Board (IASB) standards, capital assets can sometimes
be written up over cost. Since the 1970s, standard setters have generally moved toward
current value alternatives to historical cost accounting.
Two main current value alternatives to historical cost for assets and liabilities are
value in use, such as discounted present value of future cash flows, and fair value, also
called exit price or opportunity cost, the hypothetical amount that would be received or
paid should the firm dispose of the asset or liability. We discuss these valuation bases in
Chapter 7. When we do not need to distinguish between them, we shall refer to valuations
that depart from historical cost as current values.
While standard setters may be in the process of forgetting the historical cost lesson
learned by accountants from the Great Depression, another lesson remains: how to survive
in a disclosure-regulated environment. In the United States, for example, the SEC has
authority to establish the accounting standards and procedures used by firms under its
jurisdiction. However, the SEC usually has chosen to delegate standard setting to the
accounting profession. If the SEC chose to exercise its power, this would greatly erode the
prestige and influence of the accounting profession, by eliminating professional judgment
and giving accountants little influence over accounting standards.7 To retain this delegated
authority, however, the accounting profession must retain the SEC’s confidence, by creat-
ing and maintaining a financial reporting environment that protects and informs investors
and encourages well-working capital markets. By “well-working,” we mean markets where
the market values of assets and liabilities equal, or reasonably approximate, their real under-
lying fundamental values. We explore this in greater detail in Chapter 4.
Thus began the search for basic accounting concepts, those underlying truths on which
the practice of accounting is, or should be, based. The accounting profession saw this as a way
to convince regulators that private-sector standard-setting bodies could produce high quality
accounting standards. It was also felt that identification of concepts would improve practice,
by reducing inconsistencies in the choice of accounting policies across firms, and enabling
accountants to deduce the accounting for new reporting challenges from basic principles,
rather than developing accounting methods in an ad hoc and inconsistent way.8 Despite great
effort, however, accountants have never agreed on a set of accounting concepts.9
As a result of the lack of concepts, up to the late 1960s accounting theory and research
consisted largely of a priori reasoning about which accounting concepts and practices were
“best.” For example, should we account for the effects of changing prices and inflation on
financial statements, and if so, how? This debate can be traced back at least as far as the
1920s. Some accountants argued that firms should recognize the current values of specific
assets and liabilities, and include the resulting unrealized holding gains and losses in net
income.10 Others argued that inflation-induced changes in the purchasing power of money
should be recognized. During a period of inflation, the firm suffers a purchasing power loss
on monetary assets such as cash and accounts receivable, since the amounts of goods and

4 Chapter 1
services that can be obtained when they are collected and spent is less than the amounts
that could have been obtained when they were created. Conversely, the firm enjoys a
purchasing power gain on monetary liabilities such as accounts payable and long-term debt.
Separate reporting of these gains and losses would better reflect real firm performance, it
was argued. Still other accountants argued that firms should account for the effects of both
specific and inflation-induced changes in prices. Others, however, often including firm
management, resisted these suggestions. One argument, based in part on experience from
the Great Depression, was that measuring inflation is problematic and current values are
volatile, so that taking them into account would not necessarily improve the measurement
of the firm’s (and the manager’s) performance.
Nevertheless, standard setters in numerous countries did require some disclosures of
the effects of changing prices. For example, after a period of high inflation in the United
States, Financial Accounting Standards Board (FASB) Statement of Financial Accounting
Standards No. 33 (1979) required supplementary disclosure of the effects on earnings of
specific and general price level changes for property, plant and equipment, and inventories.
This standard was subsequently withdrawn. However, this withdrawal was due more to a
reduction of its cost-effectiveness as inflation declined in later years, than to the debate
having been settled.
The basic problem with debates such as how to account for changing prices was that
we have no sound theoretical basis for choosing among the various alternatives, particularly
since, as mentioned, accountants could not agree on a set of basic accounting concepts.
During this period, however, major developments were taking place in other dis-
ciplines. In particular, a theory of rational decision-making under uncertainty devel-
oped as a branch of statistics. This theory prescribes how individuals may revise their
beliefs upon receipt of new information. The theory of efficient securities markets
developed in economics and finance, with major implications for the role of informa-
tion in capital markets.
Another development was the Possibility Theorem of Arrow (1963), which demon-
strated that, in general, it is not possible to combine differing preferences of individual
members of society into a social preference ordering that satisfies reasonable conditions.
This implies that there is no such thing as perfect or true accounting concepts. For exam-
ple, suppose that a standard setter is debating asset valuation, where historical cost, value
in use, and fair value are alternatives, from which one is to be chosen. Different managers
and investors will have different preferences for these alternatives. Arrow’s theorem dem-
onstrates that in general across the population of investors and managers no “winner”
concept can emerge that meets the conditions for a socially most preferred alternative.11
Instead, concepts must be hammered out strategically through negotiation and compromise
to the point where investors and managers are willing to accept them even though they
are not perfectly satisfactory to all individuals.12 The difficulties that accountants have had
in agreeing on basic concepts are thus not surprising. Without a complete set of basic
concepts, accounting standards, which, ideally, are derived from the concepts, are subject
to the same challenges.

Introduction 5
 These theories, which began to show up in accounting theory in the latter half of the
1960s, generated the concept of decision-useful (in place of true) financial statement
information. This view of the role of financial reporting first appeared in the American
Accounting Association (AAA)13 monograph A Statement of Basic Accounting Theory, in
1966. The most recent statement of basic accounting concepts, the IASB’s Conceptual
Framework of Financial Reporting, issued in 2018, is based on decision usefulness. It states
that the objective of financial statements is to provide information to assist investors and
creditors in making investment decisions. Henceforth, we will usually refer to this docu-
ment as the Conceptual Framework, or, if the context is clear, the Framework. We discuss
it in some detail in Section 3.7.
Equally important was the development of the economics of imperfect information,
based on a theory of rational decision-making. The theory recognizes that some individu-
als have an information advantage over others. This led to the development of the theory
of agency, which has greatly increased our understanding of the legitimate interests of
business management in financial reporting and standard setting.
These theories suggest that we might decide the issue of accounting for changing prices
outlined above by examining how different accounting choices lead to good investment
decisions. Furthermore, any resolution would have to consider the concerns of manage-
ment, as well as investors.
In Canada, the development of financial accounting and reporting has proceeded dif-
ferently, although the end result is similar to that just described. Financial reporting
requirements in Canada were laid down in federal and provincial corporations acts, along
the lines of the English corporations acts referred to above. The ultimate power to regulate
financial reporting rests with the legislatures concerned. However, in 1946, the Committee
on Accounting and Auditing Research, now the Accounting Standards Board (AcSB) of
the Canadian Institute of Chartered Accountants (CICA) (now, Chartered Professional
Accountants Canada, or CPAC),14 began to issue bulletins on financial accounting issues.
These were intended to guide Canadian accountants as to best practices, and did not have
force of law. In 1968, these were formalized into the CICA Handbook.15 At first, adherence
to these provisions was voluntary but, given their prestigious source, they were difficult to
ignore. Over time, the Handbook gained recognition as the authoritative statement of
Generally Accepted Accounting Principles (GAAP) in Canada. Ultimately, provincial
securities commissions and the corporations acts formally recognized this authority. For
example, in 1975, for federally regulated companies, the Canada Business Corporations
Act required adherence to the CICA Handbook to satisfy reporting requirements under the
Act. The end result, then, is similar to that in the United States and many other countries,
in that the body with ultimate authority to set accounting standards has delegated this
function to a private professional body.16
Subsequently, several notable events had a major impact on financial accounting
and reporting. One such set of events followed from the stock market boom in the late
1990s and its collapse in the early 2000s. During the collapse, share prices of many firms,
especially those in “hi-tech” industries, fell precipitously. For example, while the share

6 Chapter 1
price of General Electric Corp., a large U.S. conglomerate firm, fell from a high of about
US$55 in August 2000 to a low of about US$21 in October 2002, that of telecommuni-
cations firm Nortel Networks fell from a high of about US$82 to a low of 44 cents over
the same period.
A contributing factor to the market collapse was the revelation of numerous finan-
cial reporting irregularities. Frequently, these involved revenue recognition, which has
long been a problem in accounting theory and practice. During the boom of the late
1990s, many firms, especially newly established ones with little or no history of profits,
attempted to impress investors and enhance their stock prices by reporting a rapidly
growing stream of revenue. Subsequently, when the boom collapsed, much recognized
revenue proved to be premature and had to be reversed. In a study of 492 U.S. corpora-
tions that reported restatements of prior years’ incomes during 1995–1999, Palmrose
and Scholz (2004) reported that revenue restatements were the single most common
type of restatement in their sample. Eight years later, Badertscher, Collins, and Lys
(2012) reported a similar result for their sample of firms reporting restatements of their
annual reports.
Accounting principles tend to be vague, and their application requires judgment;
this can contribute to reporting problems. For example, under International Accounting
Standard 18 (IAS 18),17 the standard in effect at the time of the above evidence, revenue
from the sale of goods would be recognized when the significant risks and rewards of
ownership had been transferred to the buyer, the seller had lost control over the items,
the revenue and related costs could be measured reliably,18 and collection was reasonably
assured. Revenue recognition criteria in the United States were broadly consistent with
those in IAS 18. In 2018, International Financial Reporting Standard 15 (IFRS 15)
replaced IAS 18, with the intention of reducing ambiguity. This standard is converged
with Accounting Standards Codification (ASC) 606 of the FASB.19 The core principles
of these standards are that there must be a contract between firm and customer, and that
revenue should be recognized as the entity satisfies the performance obligations con-
tained in the contract (e.g., a contract to sell merchandise to a customer is satisfied as
the customer obtains control of that merchandise). However, it must also be the case
that collection is probable.
Sales contracts that involve more than one performance obligation have often been
subject to revenue recognition abuses. A common example of such contracts involves sale
of a product plus an obligation to maintain the product for a period of time. IAS 18 and
ASC 606 require separation of the two performance obligations, with the contract price
allocated to each based on their stand-alone prices (or an estimate thereof if such prices
are not available). It must also be possible to reasonably measure progress over time in
satisfying each obligation, so that revenue recognized during the period is consistent with
the physical maintenance effort exerted during the period. No revenue would be recognized
until the maintenance term expires, if progress is not reasonably measurable.
Theory in Practice 1.1 illustrates some of the revenue recognition problems that the new
standards confront. Time will tell whether they reduce the frequency of misreported revenue.

Introduction 7
Another random document with
no related content on Scribd:
 So it came to pass that the little motherless boy, weeping for the
mother he was never to see again, was now Sir Henry Alden of
Aldenmere.
At first all was confusion and dismay, but after a time Mr. Eyrle
took the reins of government and restored something like order.
When the news began to spread there were callers innumerable.
The country that night supped full of horrors. Sir Ronald Alden had
died abroad and the shock of his death had killed the beautiful,
lovely wife, so devoted to him.
They robed her in white, as they had done the first Lady Alden;
they covered her with flowers, they laid them on the silent breast, in
the white hands, and crowned with them the golden head. So fair,
and still, and silent she lay when Lord Lorriston and Kenelm Eyrle
between them led the unhappy mother into the room. No words
could tell her grief. Did there flash across her a memory of that
evening so long ago when she had taken Sir Ronald into the sunlit
garden to renew his friendship with Lady Hermione and Miss
Severn?
It was not until she had gone away and the two gentlemen stood
in the death chamber alone, that Lord Lorriston remembered the
packet.
He spoke of it to Mr. Eyrle.
“Will you fetch it, Kenelm?” he said, “and I will read it here in her
presence. I have a conviction that there we shall find the key to the
mystery.”
Kenelm went in search of it. It lay on the table in the room where
she died. He brought it at once to the earl, who took it from him.
“Before I read what may be her justification, Kenelm,” said Lord
Lorriston, “look at her face. Was anything ever so fair, so noble, so
true? That face is but the index of a soul more fair, more noble, and
truer still. Nor murder, nor jealousy, nor unholy hate ever marred the
perfect beauty of that soul, or ever found a home there. That is the
temple of a pure spirit—how could you so misjudge her?”
 “Only from her own words; and those I heard against my own
will.”
Lord Lorriston bent down and kissed that white brow.
“There was no justification necessary, in my eyes,” he said; “still I
will read what is written here.”
 CHAPTER LII.
SIR RONALD’S CONFESSION.

“Not to be opened until after my death,” was written on the outer

cover of the packet in Sir Ronald’s bold, clear hand, “and then to be
read by no one save my wife. Should she die first, under penalty of
my curse I forbid this to be opened, and command it to be
destroyed.”
When Lord Lorriston had read that he showed it to Mr. Eyrle.
“Will it be honorable for us to read the contents?” he asked.
“Yes,” replied Mr. Eyrle, “a sudden idea has occurred to me, and
in your daughter’s name, I think that paper should be read.”
Lord Lorriston read it aloud, kneeling by the side of the beautiful
dead woman, whose love had proved so fatal to herself and to him
who loved her. It began:
“My Dearest Hermione—I am going abroad in an expedition
that may be attended with some danger, although I have every hope
of returning in safety; yet I write this because against the accidents
of life we cannot take precaution. I know not what may happen,
therefore I write this; no one but you will read it—oh, wife of my heart
—and I lay my soul bare before you. Hermione, what has been the
life of my life, the soul of my actions? What has been the source of
all my virtues, all my few good deeds, all that is noblest and best in
me?—my love for you. What drove me mad?—my love for you. Men
have loved before, and men will love again, but I do not believe that
ever one loved a woman so entirely, so devotedly, so wholly as I
loved you.
“My darling, my wife, that love was no ordinary passion, common
words will not tell it. Do you know what dew is to thirsty flowers,
sunshine to birds, light and warmth to fair spring blossoms? that you
are to me. The light of my soul, my one hope and treasure. Ah,
sweet wife of mine, go out in the woods and count the leaves on
each tree; go to the shore and count each grain of sand; look up at
the bright heavens and count each pale, pure star; you could do that
more easily than I can tell you how deeply, how dearly, how well I
love you. The world does not hold your peer, my love. Looking back,
I cannot remember the time when I did not love you with the same
passionate love. When we were children I worshiped the ground you
stood upon, and my love grew with my growth. When I came back to
Aldenmere and found all the promise of your beautiful youth fulfilled,
and you yourself lovelier than dream of poet ever was, I swore to
myself that if any man living could win you I would be that man. My
darling, you know how I tried. I loved you, I sought you, I was never
happy out of your presence, or away from you. My very life was so
wrapped in yours that I had no existence away from you. I can
remember when I first began to hope that you would care for me. I
can remember every faint token of preference you ever gave me, all
your pretty shy, sweet, maidenly ways. Hermione, sweet, true wife,
do you remember the evening out among the flowers when I spoke
to you of love and you did not send me from you? I went home that
night with my heart on fire, resolved to ask you at once to be my
wife, for I could brook delay no longer; my love was eating my very
life away. Darling, was it a sweet, maidenly whim to make me still
more eager, or was it that you were really engrossed? For one whole
week I went every day to Leeholme, but could not contrive to spend
one solitary five minutes with you. Oh, love, my love, had it been
otherwise the story of my life would have been different.
“At last, when I could bear the silence and suspense no longer, I
wrote to you and asked you to be my wife. You remember what
followed. I received a letter, written apparently by you, refusing me
with few words. Hermione, I went mad; my love had been so mighty,
so powerful, so strong, I could not bear the shock of seeing it all
scattered to the winds. I could not bear the refusal. God keep any
other man from suffering what I did then! I could not tell you, darling,
even if I tried. I do not believe any man suffered so much and lived.
A thousand times each day I was tempted to end my own life, but the
Alden pride, so strong in the men of my race, forbade me to die
because a woman was fair and false. Ah, me! what I suffered! I
hated my life; I loathed myself. I tried to drown all memory of my
most fatal love in the whirl of fashion, the pursuit of study. My darling,
I might as well have taught myself to fly as to forget you. Then there
came a time when the sneers of men, the sarcasm of women
aroused all the pride of my nature; it should never be said that I was
wasting away for the love of one who never loved me. I heard that
you were going to marry Kenelm, and I, reckless, despairing, half
mad and wholly wicked, married poor Clarice.
“I should have been true to you, my love—the sweet, pure love of
my youth—I should have been true to you, even though you had
never cared for me. When I married Clarice I meant most royally to
do my duty, to be kind to her, to make her happy, to indulge her, and
I succeeded. I never loved her, but I cannot tell if she found that out.
All went on calmly, if not happily, until the day when I met you in the
woods. You remember it, Hermione, then my heart leaped up like a
burning flame, devouring all before it, and then I learned that most
fatal truth, that you had never received my letter and, what was of
still more importance, you had not answered it, therefore had never
rejected me. Then I learned that you loved me. I wonder that I ever
recovered my senses when I remember the madness of my love.
You remember our farewell. With your last words ringing in my ears
—with your last gentle look haunting me—I swore to myself, like the
reckless madman that I was, to find out who had trapped me, who
had lured me to destruction, who had taken the letter I wrote to you,
and had answered it—imitating your writing and signing your name.
“How was I to find out? I swore that I would move heaven and
earth but that I would unravel the mystery in the end. I need not tell
you all my efforts. For long they seemed in vain, utterly, helplessly in
vain. At last, my attention was called to a strange fact, and that was
that my wife’s maid, Mary Thorne, seemed to be entirely mistress of
her. If Clarice ordered her to do anything she did it if she liked, if not
it was neglected. I found, too, that Clarice had given her at different
times large sums of money. I remonstrated with her, but you
remember her pretty, bewitching, caressing ways. She only smiled
and told me that she had always spoiled Mary Thorne. But,
Hermione, underneath that smile I detected fear, real fear, and I
wondered how it was. One day, going quite unexpectedly into my
wife’s dressing-room, I heard her ask Mary Thorne to do something
and the girl insolently refused. I could not bear that. I spoke sharply
and insisted on her instant dismissal, but to my surprise Clarice grew
pale with fear. ‘I do not think my mistress will allow me to leave, Sir
Ronald,’ said the woman, and she was right. Clarice hung weeping
round my neck and begged me not to send away a maid to whom
she was much attached, and who was most valuable to her. I yielded
to her wish, but from that moment a certain conviction came over me
that Mary Thorne knew some secret she was keeping from me. I
dare not think the secret concerned that letter, though instinct told
me so. I sent for my groom—the one who had taken the letter—and
what I discovered was this: The letter was safely delivered, and
placed on your toilet-table by your own maid. Mary Thorne, who was
engaged in doing something for you at the time, my darling, saw it
placed there. Mary was working in your room, she told me, on the
day that letter was delivered. You were out, and she sat sewing in
your room. While she was there Clarice went in to speak to her, and
bending over the toilet-table, saw the letter in my handwriting
addressed to you.
“Mary told me that she saw Clarice deliberately take up that letter,
place it in the pocket of her dress and then quit the room. She
returned in half an hour and placed upon the table another envelope,
the exact counterpart of the one she had taken away.”
 CHAPTER LIII.
THE SLAVE OF PASSION.

They paused in the reading of that confession, and Lord

Lorriston, looking at Kenelm, said to him:
“This is worse than my darkest dreams ever foreshadowed.”
But Kenelm made no reply. He was thinking of the two fair
women he had seen lying here dead, both slain by the fatal love of
one man. Then they read on:
“I was determined,” said Sir Ronald, “to solve the mystery, to
know who had taken my letter and who had written that false
missive. No one ever knew the pains I took over it, the enormous
expense! But I would have spent the last shilling I have in the world
rather than have failed. For many long months I had detectives
employed secretly, but the mystery seemed so great they could not
fathom it. At last I heard it, as I have said, through Mary Thorne, who
had been Clarice’s maid. She told me this story: On the day of that
visit to Thringston, she was sitting helping in some work in Lady
Hermione’s room, when she saw her mistress start in, and after
looking earnestly at the address of the letter, put it in the pocket of
her dress and go out of the room quietly as she entered it. In half an
hour she returned and placed an envelope there so exactly similar
no one could tell them apart. That little circumstance struck Mary
Thorne as being very peculiar. Most maids make themselves
mistresses of their mistress’ secrets. Mary knew that of poor Clarice.
She knew that Clarice loved me. She knew, also, in common with the
rest of the world, that I loved Lady Hermione. Most things, even our
nearest and dearest secrets that we hesitate almost in telling each
other, are known and discussed in the servants’ hall. There is no
doubt that all this had been told there.
 “So Mary Thorne watched her young mistress. It is not pleasant
to have to write of the treachery of those we have trusted. Clarice
trusted this girl implicitly, and she, in return, betrayed her, read her
letters, watched all she did, and made herself mistress even of the
poor lady’s hidden faults. Clarice stole my letter—the one I had
written to you—stole it, read it, and destroyed it by tearing it into
minute pieces. These pieces, Mary Thorne, with infinite patience and
perseverance worthy of a better cause, put together, and managed
to read sufficient of it to know that it was an offer of marriage from
me to my dearest Hermione.
“When she told me, my first impulse was to raise my hand and
slay. One moment’s reflection showed me that it was, after all, the
fault of her class—that want of honor, that morbid desire to pry into
the secrets of others, all come from the loose, imperfect method of
training.
“I pass it over now, as I did when I heard it. My eyes fell once
more on that letter—the letter that has proved the curse of my life. I
read again the words I had written when full of hope, as a spring
morning is of beauty. They seemed to raise living heads like
poisonous adders and sting me. No further proof was wanting to me.
Mary Thorne had evidently thought some day or other, to make her
price of these fragments of a letter. She had carefully preserved
them—she had gathered them from a fireplace in Clarice’s room.
Then she watched her mistress. Clarice, under pretext of a violent
headache, shut herself up in her room, and spent many hours in
practicing writing. Pieces of paper that the girl had preserved
showed that she had been imitating your handwriting. Should
Kenelm Eyrle ever read this story, or hear of it, he will remember that
we had often in our childish days been astonished by the facility with
which Clarice imitated different handwritings.
“Shut up in her room, she forged that letter in your name to me.
Deliberately, wickedly, cruelly, falsely forged the words that cut me
off from the world of men, blighted my life, marred every hope and
plan, brought curse and ruin upon me, the words that have lost me
this world, and, I fear, oh! I fear, will lose me the next. Mary Thorne
watched her young mistress dress herself and steal unobserved
from the house to post the letter that was my death warrant. And
then she waited and watched, thinking that when I recovered from
your dismissal I should turn with my whole heart to her. I did not do
so. I have never loved any woman but you, my Hermione. I never
could. I tried, but it was not in my power. You are soul of my soul, life
of my life, my heart has never beat for any love but yours. So, my
wife, I heard this tale of treachery, of the cruel and wicked wrong
done to me. Mary Thorne had saved all these fragments of papers
and lived in the hope of some day making money of them. She was
in love with James Conyers, the groom who had taken the letter, and
whose assistance I had sought. The bribe I offered proved sufficient
for her. It was a large sum of money to be paid on the spot, and a
promise that James Conyers should have the farm called ‘The
Willows’ when the lease of the then tenant had expired. One
morning, a beautiful bright morning, when the world was full of
melody, she told me this. We were standing under a grove of tall,
stately oak trees, and, Hermione, as the words dropped slowly from
her lips they maddened me. I can remember watching the sunlight
as it came filtering through the great green boughs. I can remember
listening to the sweet song of a little bird, while mad anger and
fierce, wild passion ran riot in my veins. Ah, my darling! a man
commits a great crime, and his excuse is, ‘I was mad!’ People cry
him down. They say, ‘This is but an excuse; he was sane enough!’
Ah! my wife, I know that madness comes in swift, keen darts of
flame, in a fiery surging of hot blood through heart and brain, in a
sudden impulse that calls in a mighty voice for the deed to be done
—and it is done. As I stood under the trees, Hermione, the sunlight
grew blood-red. The girl, in her weak, shrill voice, finished her tale.
She had given me every detail of the forgery and the fraud. When
her voice ceased, it was as though some cord had snapped
suddenly in my brain, and I turned away. ‘You will not forget your
promises, Sir Ronald?’ she said. ‘No; I will not forget them.’ And as I
walked from the oak trees I kept repeating to myself those words, ‘I
will not forget them!’
“Was I mad? Only God knows. I can remember that every beat of
my pulse sent a burning thrill through me, that the beating of my
heart seemed to come to me as a hot, heavy sound. Hermione, do
you remember? Oh! sweet wife, how it pains me to look across the
gulf of years, the sweet, sinless happy years; do you remember that
one evening at Leeholme Park? You showed some curiosities that
your cousin had brought from abroad with him. Amongst them was a
small, sharp, bright, pointed Grecian dagger, an antique of great
value, with a jeweled handle—one which Grecian ladies wore as a
toy, which had, without doubt, been used in many a deathblow. I took
it up in my hands to admire it, and you gave it to me, asking me with
a smile never to let your cousin know, or he would be jealous.
“It must have been fate that led me that morning to the little
drawer, where I kept all my souvenirs of you. This lay amongst them,
and I saw that one of the rubies was missing from the handle. I had
some intention of going over to Leeholme that day, so I put it in my
pocket, thinking that I would call at a jeweler’s and have it replaced. I
wish it had not been so, Hermione. Had not that weapon been in my
hands, the deed would not have been done. I walked on with the
same hot surging through heart and brain, this same dull roaring, as
of distant cannon in my ears, and the sunlight was all red. It came to
me like a picture in a red frame. I saw a lake—clear, cool, deep, dark
water—with green boughs bending over it. One bough was swinging
to and fro in the wind, and on it sat a little bird singing sweet, jubilant
notes. Clarice sat underneath the tree. She looked so white and cool
in the midst of the hot sunlight, and the mad, red wildfire that danced
before my eyes. She was smiling—looking at the water and smiling
as though her thoughts were happy ones.
“Hermione, how far was I guilty? Standing within the pure
presence of the great God, I swear to you I do not know. I was not
master of myself. The red flame seemed to leap about me and to
mock me! Hisses of laughter sounded in my ears! Oh! my darling,
when I saw her sitting there, so bright, so beautiful, so happy—when
I remembered that her fraud had parted me forever from you, I went
mad! It all returns to me as the memory of a scene in which I had no
share—as though I had stood by and seen some other person do it. I
remember taking out the dagger and creeping silently behind her
chair, she neither saw nor heard me. She was singing in a soft, low
voice to herself. I saw the rings of golden hair on her white neck. A
fury of murderous hate came over me. She had parted me from you.
“A thousand mocking devils seemed to be mocking around me as
I plunged that dagger right into her heart. She uttered no cry, no
sound, but fell with her face foremost into the lake, and I ran away.
“I remember how the green bough was swaying and the little
birds singing when I turned round to see, and there was a gleam of
golden hair in the cool, dark water. Hermione, I am making no false
excuses to you—I am not seeking to clear myself from blame—but
sure as I am now living and writing the words, so sure was I mad
when I murdered the unhappy girl, whose only fault had been loving
me too well and forging a letter that she thought would bring me to
her feet. I was mad! God knows it! Believe me, sweet wife!”
 CHAPTER LIV.
A DREAM AND THE AWAKENING.

Lord Lorriston’s voice died away in a low sob as he read the

words.
“It is terrible,” said Kenelm, “that Ronald is right. When he did that
deed he was mad. What a fearful love his was.”
Then Lord Lorriston read on:
“There came to me, Hermione, a curious instinct of self-
preservation the moment that terrible deed was done. The red flame,
the mocking devils, the hissing flame all vanished. I was cold, sick,
faint, shuddering with awful, unknown dread. I went straight home
into the library. I opened some paper, took a pen in my hand and
waited.
“How long did I wait? Oh, my God! when I remember the agony
of those bright, sunny, cruel hours—how the sun shone, how the
flowers bloomed, how the bees and butterflies flitted past the roses
in the window, how the birds sang, how warm gusts of sweet odor
came floating into the room, and I sat motionless, silent, mute and
dumb with horror, waiting till some one should come and tell me what
was the matter in the woods. Waiting with a soul so full of horror I
wonder that I did not die. Waiting with such sick dread as no words
can realize—every golden gleam of sunlight bringing to my mind the
fair hair floating in the dark water. Waiting until it seemed to me the
whole world was still in one awful pause—the sunbeams never
moved, the listening air was still—the deep, brooding silence grew
so awful, so terrible that I tried to cry out, but could not.
“Then it came—the rush of many feet, the murmur of many
voices, all crying for Sir Ronald—Sir Ronald—for my lady was
drowned in the wood!
 “Mary Thorne had found her, and she was the first to tell me the
tale. There was no suspicion in her mind. I saw at once she never in
the least suspected me of having caused the lady’s death. Oh!
Hermione, I cannot tell you all the horrors. I do not know how I bore
it. A thousand times each day the impulse came to me to own myself
guilty and to put an end to my tortures. I made all kinds of pretexts
and excuses to throw people off their guard, to give them a false
clue, a false step, yet longed that they should turn round suddenly
and find me guilty.
“People talk of remorse. Ah! my darling; the remorseless sting of
that terrible pain never left me. It seemed to eat my very heart away,
to prey upon my mind. It robbed me of health, of strength, of peace. I
suffered terribly—God knows—most terribly for my sin! I could never
tell you how much. Perhaps the most bitter hour of all was when I
stood with Kenelm by the body of Clarice and heard the story of his
love for her. How cruel Fate was! I loved you! Kenelm loved Clarice,
and we were parted.
“Can you imagine what a long, dark, dull brooding dream is,
Hermione? That was mine after she was buried. A man who commits
a murder is hung for the crime; his lot is merciful compared to that of
the man who repents and lives on. I have wept tears of blood for
mine. I would have given my life over and over again ten thousand
times never to have done the deed. I would have suffered the
extremity of torture for the power to undo it.
“But remorse and repentance were all in vain; nothing could bring
my wife back to me. She was gone forever. Nothing could undo my
crime. Its record was written in the Book of God. Who could tear out
the page? Hermione, I wore myself to a shadow. I neither slept, nor
ate, nor rested. My nights and days were one long agony. I used to
lie on my face for long hours together praying God to pardon me—to
pity me—but peace and rest were all over in this world. I only
remember that time as a hideous darkness in which there came no
gleam of light.
“Until, like a white dove over troubled waters, like a sunbeam in
deepest night, like a soft, sweet strain or harmony amongst terrible
discord, came your little note, Hermione, and then, like snow before
the sun, my sorrow seemed dispelled. I dared to raise my head, I
dared to hope that God had pardoned me. I dared to hope white-
winged peace might hover over me once more.
“You know the rest, sweet wife. For a short time I was happy
because my love for you was so mighty there was no room for
anything else in my heart, but after a time the fear, the shame, the
remorse, the unutterable dread, the terrible anguish, all came over
me again, and I knew that in the end they would kill me. Ah! my wife,
what words will thank you for your love and care? Yet the more
noble, the more true I found you, the deeper and more intolerable
grew my remorse.
“Then my little children were born, and I looked in the sweet,
innocent faces. My pain was martyrdom, and as they grew and
began to talk to me, to love me, I loathed myself with the deepest
loathing. Were my red hands such as holy lips should cover with
tender kisses?
“Hermione, I can bear it no longer, so I am going away. It is at my
own instigation that this offer has been made to me. I can bear the
sweetness, the brightness, the purity of your presence, the
tenderness of your love, the affection of my children, no longer. I go
out like Cain, with the red brand upon my brow.
“I shall never return, love. Something tells me that death awaits
me in that far-off land, that I am unworthy to sleep where the heroes
of my race rest. I who married a woman and slew her. I have asked
you, on my return, to meet me under our favorite tree. I shall never
see you there, but go, my love, sometimes, when the wind whispers
in the leaves, and it will tell how dearly I loved you. The great God is
very merciful and He knows what I have suffered. It may be that my
restless spirit will sigh among the branches. Go there, sweet wife,
when the dew falls, and remember that I loved you with a love
exceeding that of all other men.
“You will come, in time, to think of my life as a short one of
tragedy—a love story that ended in madness and murder—a dream
that had a most terrible awakening.
 “You may ask me why—when I have tried so hard to elude all
suspicion, and have succeeded—why have I preserved the dagger—
why have I written this? I cannot tell you, Hermione. There is an old
saying, ‘Murder will out.’ I feel compelled to write this confession.
The idea is strong upon me that if I do not, harm and evil will come to
you, and, my wife—life of my life, soul of my soul—we shall meet no
more. You may never read this; it may be lost, it may be
undiscovered, but if ever it comes to light, in reading it, judge me
mercifully, for I was mad when I took the life of the woman I had
sworn to love and cherish. I pray God in His mercy to pardon me,
and I pray Him to keep from all men a love so terrible as mine.”
And there the manuscript ended. Lord Lorriston laid it down, and,
kneeling by the side of his dead daughter, he wept aloud. It was a
terrible story—a story of love so mighty in its wild passion it had
blighted their lives.
Kenelm Eyrle listened to the deep sobs of the strong man, then
he laid his hand reverently in the folded hands of the dead lady.
“It seems to me,” he said, “that she was born the victim. Clarice
betrayed her, and Ronald’s love has brought her nothing but misery.”
Then they discussed the story of her self-sacrifice. Kenelm
understood it. He told Lord Lorriston how they had opened the box to
find the document, and had found there the dagger.
“This confession must have been lying near it, and Hermione
took it without my knowing. She had read it and declared herself
guilty in order to save him.”
“She loved him well, poor child,” said Lord Lorriston.
“She would have died for him,” continued Kenelm. “She would
have gone, for his sake, to prison, and from the prison to the
scaffold, if by doing so she might have saved him.”
“She loved him dearly. His death has broken her heart,” said Lord
Lorriston. “In her case death is far more merciful than life—she
would have been wretched, knowing his guilt, and wretched,
knowing his death. It is better as it is.”
 Even the father who had loved her so dearly kissed her face and
murmured the same words, “It is better as it is.”
The story of that last hour of her life is known to none. The doctor
said she died of disease of the heart; it might be so—but those who
loved her knew her heart was broken. She had taken out that
strange, sad confession of his, so mingled with love of her in order to
destroy it, and she died with it in her hands.
What passed between her soul and God, who shall tell? Her
terrible sorrow, her shame, her despair—she had to suffer it all
alone; there was no one to help her bear it in that terrible hour; no
one to soothe her agony; she struggled with it and died alone. The
merit of the grand, self-sacrifice she would so willingly have
accomplished was all her own; she had taken upon herself the
burden of his guilt and been willing to suffer for it. All her sweet
woman’s nature rose in rebellion against it—her true and loyal
nature, that had in it no taint of anything mean or false—her delicate,
sensitive, spiritual nature, that loved right and hated wrong, but she
had trampled all under foot, and by reason of her great love had
been willing to die the most shameful of deaths for his sake.
They thought a great deal of it at the time, but in after years they
thought still more. How dearly she had loved him! How great was the
sacrifice she would have made for him, when for his sake she was
willing to die on the scaffold to shelter his sin!
The whole country round was grieved at the intelligence. People
said, with tears in their eyes, they were not surprised; they would not
believe in the doctor’s fable of disease of the heart—that she died
because she loved Sir Ronald so well; she could not live without him.
Gloom and mourning spread from place to place, for she had been
loved as dearly in the cottages of the poor as in the halls of the rich.
 CHAPTER LV.
THE REST IS PEACE.

“There must have been a spell in Aldenmere,” so people said.

This was the second fair young wife who had been carried from
there to the grave; the second who had met with a tragical death.
What would become of the place? Who would take care of the
children? These and a hundred other questions they asked, but no
one answered them.
They did not bury Lady Hermione by Clarice’s side. Lord
Lorriston, knowing all, could not endure the thought of it. She was
taken thence, and the grave is on the western side of Leeholme
churchyard, a warm, lovely, sunny spot, where the sun shines and
the dew falls, where birds sing sweetest music and flowers yield
richest perfume. The story of her deep, true love and unutterable
sorrow, of her grief and heroic self-sacrifice, are buried with her.
The little Harry was heir to Aldenmere, but Lord Lorriston said the
associations connected with the place were all so sad, that the
children should not live there; they should make their home at
Leeholme until the young heir was of age, and then he could please
himself about returning there. The servants were all paid off; they
were not sorry to leave a place rendered gloomy by two such
tragedies. Some of them declared that long as they lived they should
never regain their natural spirits.
Aldenmere was closed. The head gamekeeper and his wife were
put in charge of the place. The state apartments, the magnificent
guests’ chambers, the superb reception-rooms, were all closed and
left to solitary desolation. Lord Lorriston declared that he never even
wished to see the place again—it was so full of sorrowful memories
for him.
 The little orphan children were taken home to Leeholme, where,
under the loving care of Lord and Lady Lorriston, they grew in
strength, beauty and goodness. The after life of Sir Henry Alden, of
Aldenmere, was eventful, but his story has been told by pens more
eloquent than mine. The little child whom Sir Ronald kissed and
blessed before he went on that long voyage from which he was
never to return, made his name famous all over Europe. There was
one thing he never knew, and that was the true history of his father’s
life. Nor was that secret ever known.
Kenelm Eyrle found some means of pacifying the detectives he
had so hastily summoned. They never heard one word of the truth,
nor was it ever told; Lord Lorriston never even told his wife, and the
secret of the first Lady Alden’s death remains a secret still.
Lord and Lady Lorriston found comfort after a time in the children
they had adopted. Baby Maud grew up the exact picture of her
mother, the same sweet face and tender eyes. There were times
when, as Lorriston grew older, he would forget the tragedy at
Aldenmere, and, seeing the golden head, would call her Hermione.
There were times, too, when he longed to take the child on his knee
and tell her how nobly her mother had kept her vow. But he never did
so. The children grew up with no other knowledge save that their
parents had both died when they were very young.
There were times, too, when Kenelm Eyrle regretted his
sternness, his lost desire for vengeance, his long years of search for
the criminal whom he afterward found in his dearest friend. If he had
been less vigorous, less exact, Lady Hermione might have lived. He
was very lonely; the great purpose of his life was accomplished; he
had found out who murdered Clarice, but in making that discovery he
made many others. Clarice was not what he had thought her. He had
believed her one of the noblest and truest of women; now he found
out that she had committed the most dishonorable of all frauds. The
whole of the sad tragedy at Aldenmere was the consequence of her
fault. If she had not stolen that letter and forged another there would
have been no wrong, no suffering, no murder; after all, she had but
reaped what she had sown—lo, that while his pity for her never grew
less, his love, the intense passionate worship he had felt for her
during life and for her memory after death, decreased. He had
believed her an angel—she was but a faulty woman; he had believed
her a goddess—she was but an ordinary fellow-creature, with more
faults and imperfections than fell to the lot of most people.
The very consciousness of this made him more lonely than ever.
He had so fitted his life with a reverential and worshiping love of her,
that now that love had changed its character, his life seemed empty.
He had not been to the Dower House for some time, because he felt
that it was not kind nor wise to add to the perplexities of Lady
Pelham.
One morning a messenger came with a note for him. It said
simply: “You have been so kind to me that I cannot help writing to tell
you that my husband lies even now on his deathbed and has sent for
me. He has promised to do me justice and to clear my good name
before the world.”
A few days afterward he read in the papers that Sir Alfred
Pelham was dead, and before his death he had exonerated his wife
from all blame. He had sworn to her innocence, and had withdrawn
the charges brought against her after begging her to pardon him.
Kenelm Eyrle read it with pleasure. He read long articles in which
the law, as it exists, enabling a man to wrong his wife in so deadly a
fashion, was reprobated as it deserved to be.
He often found himself wondering whether she would return to
the Dower House or not; he found his thoughts returning continually
to her. Her beautiful face haunted him. He remembered her indignant
appeals to Heaven for the justice she was not likely to obtain from
man. It was a source of keen pleasure to him when she wrote to say
that she intended to return to the Dower House, the only place where
she had ever known either peace or happiness. She did return. It
would be long to tell how their friendship ripened into love—how
gradually the living love replaced the dead one in Kenelm Eyrle’s
breast.
He is not so confident now over matters; time was when he would
have laughed to scorn any one who had hinted that Clarice could be
not only replaced but surpassed. Now he was not so violent in his
opinions nor so apt to rush into extremes. The first impetuous love of
his youth was lavished on Clarice Severn; the love of his sadder,
wiser manhood was given to Juliet Payton. They were married some
time afterward and lived happily enough at “The Towers.” Mrs. Eyrle
is very kind to Sir Ronald’s orphan children, for long after Lady
Hermione’s death, Kenelm never saw them without tears in his eyes.
Children of his own make “The Towers” merry with their happy
laughter; life is made up of sunshine and shade. He had suffered
much, but peace and rest came to him after long years. There is one
duty he never omits, and that is visiting the graves of the fair women
who lost their lives through an unhappy love.

THE END.