1 Introduction 1
1.1 The Objective of This Book 1
1.2 Some Historical Perspective 1
1.3 A Note on Ethical Behaviour 10
1.4 The Complexity of Information in Financial Accounting and Reporting 11
1.5 The Role of Accounting Research 12
1.6 The Importance of Information Asymmetry 13
1.7 The Fundamental Problem of Financial Accounting Theory 14
1.8 Regulation as a Reaction to the Fundamental Problem 15
1.9 The Organization of This Book 16
1.9.1 Ideal Conditions 16
1.9.2 Adverse Selection 16
1.9.3 Moral Hazard 17
1.9.4 Standard Setting 18
1.9.5 The Process of Standard Setting 18
1.10 Relevance of Financial Accounting Theory to Accounting Practice 21
2 Accounting Under Ideal Conditions 24
2.1 Overview 24
2.2 The Present Value Model Under Certainty 25
2.2.1 Summary 28
2.3 The Present Value Model Under Uncertainty 29
2.3.1 Summary 35
2.4 Reserve Recognition Accounting(RRA) 35
2.4.1 An Example of RRA 35
2.4.2 Summary 38
2.4.3 Critique of RRA 38
2.4.4 Summary 41
2.5 Historical Cost Accounting Revisited 41
2.5.1 Comparison of Different Measurement Bases 41
2.5.2 Accruals 43
2.5.3 Summary 45
2.6 The Non-Existence of True Net Income 45
2.7 Conclusion to Accounting Under Ideal Conditions 47
3 The Decision Usefulness Approach to Financial Reporting 58
3.1 Overview 58
3.2 The Decision Usefulness Approach 59
3.2.1 Summary 60
3.3 Single-Person Decision Theory 60
3.3.1 Decision Theory Applied 61
3.3.2 The Information System 64
3.3.3 Information Defined 68
3.3.4 Summary 68
3.4 The Rational,Risk-Averse Investor 68
3.5 The Principle of Portfolio Diversification 71
3.5.1 Summary 76
3.6 The Optimal Investment Decision 76
3.6.1 Summary 78
3.7 Portfolio Risk 79
3.7.1 Calculating and Interpreting Beta 79
3.7.2 Portfolio Expected Value and Variance 81
3.7.3 Portfolio Risk as the Number of Securities Increases 82
3.7.4 Summary 83
3.8 The Reaction of Professional Accounting Bodies to the Decision Usefulness Approach 83
3.8.1 Summary 87
3.9 Conclusions on Decision Usefulness 87
4 Efficient Securities Markets 98
4.1 Overview 98
4.2 Efficient Securities Markets 99
4.2.1 The Meaning of Efficiency 99
4.2.2 How Do Market Prices Fully Reflect All Available Information? 101
4.2.3 Summary 104
4.3 Implications of Efficient Securities Markets for Financial Reporting 104
4.3.1 Implications 104
4.3.2 Summary 106
4.4 The Informativeness of Price 107
4.4.1 A Logical Inconsistency 107
4.4.2 Summary 110
4.5 A Capital Asset Pricing Model 110
4.6 Information Asymmetry 114
4.6.1 A Closer Look at Information Asymmetry 114
4.6.2 Summary 117
4.7 The Social Significance of Securities Markets that Work Well 118
4.8 An Example of Full Disclosure 119
4.8.1 Introduction 119
4.8.2 Management Discussion and Analysis 119
4.9 Conclusions on Efficient Securities Markets 135
5 The Information Approach to Decision Usefulness 143
5.1 Overview 143
5.2 Outline of the Research Problem 145
5.2.1 Reasons for Market Response 145
5.2.2 Finding the Market Response 146
5.2.3 Separating Market-Wide and Firm-Specific Factors 146
5.2.4 Comparing Returns and Income 148
5.3 The Ball and Brown Study 149
5.3.1 Methodology and Findings 149
5.3.2 Causation Versus Association 151
5.3.3 Outcomes ofthe BB Study 153
5.4 Earnings Response Coefficients 153
5.4.1 Reasons for Differential Market Response 154
5.4.2 Implications of ERC Research 159
5.4.3 Measuring Investors'Earnings Expectations 159
5.4.4 Summary 161
5.5 Unusual,Non-recurring,and Extraordinary Items 162
5.6 A Caveat about the"Best"Accounting Policy 164
5.7 The Information Content of Other Financial Statement Information 166
5.8 Conclusions on the Information Approach 167
6 The Measurement Approach to Decision Usefulness 177
6.1 Overview 177
6.2 Are Securities Markets Fully Efficient? 178
6.2.1 Introduction 178
6.2.2 Prospect Theory 180
6.2.3 Is Beta Dead? 183
6.2.4 Excess Stock Market Volatility 185
6.2.5 Stock Market Bubbles 186
6.2.6 Efficient Securities Market Anomalies 186
6.2.7 Implications of Securities Market Inefficiency for Financial Reporting 189
6.2.8 Discussion of Market Efficiency Versus Behavioural Finance 191
6.2.9 Conclusions About Securities Market Efficiency 195
6.3 Other Reasons Supporting a Measurement Approach 195
6.4 The Value Relevance of Financial Statement Information 196
6.5 Ohlson's Clean Surplus Theory 198
6.5.1 Three Formulae for Firm Value 198
6.5.2 Earnings Persistence 201
6.5.3 Estimating Firm Value 204
6.5.4 Empirical Studies of the Clean Surplus Model 208
6.5.5 Summary 209
6.6 Auditors'Legal Liability 210
6.7 Asymmetry of Investor Losses 212
6.8 Conclusions on the Measurement Approach to Decision Usefulness 216
7 Measurement Applications 228
7.1 Overview 228
7.2 Longstanding Measurement Examples 230
7.2.1 Accounts Receivable and Payable 230
7.2.2 Cash Flows Fixed by Contract 231
7.2.3 The Lower-of-Cost-or-Market Rule 231
7.2.4 Revaluation Option for Property,Plant,and Equipment 232
7.2.5 Ceiling Test for Property,Plant,and Equipment 232
7.2.6 Pensions and Other Post-Employment Benefits 233
7.2.7 Summary 235
7.3 Financial Instruments 235
7.3.1 Introduction 235
7.3.2 Valuation of Debt and Equity Securities 236
7.3.3 Conclusion 239
7.3.4 Derivative Instruments 239
7.3.5 Hedge Accounting 243
7.3.6 Conclusion 248
7.4 Accounting for Intangibles 248
7.4.1 Introduction 248
7.4.2 Accounting for Purchased Goodwill 249
7.4.3 Self-Developed Goodwill 252
7.4.4 The Clean Surplus Model Revisited 254
7.4.5 Summary 255
7.5 Reporting on Risk 255
7.5.1 Beta Risk 255
7.5.2 Why Do Firms Manage Firm-Specific Risk? 257
7.5.3 Stock Market Reaction to Other Risks 258
7.5.4 A Measurement Approach to Risk Reporting 260
7.5.5 Summary 262
7.6 Conclusions on Measurement Applications 263
8 Economic Consequences and Positive Accounting Theory 273
8.1 Overview 273
8.2 The Rise of Economic Consequences 275
8.2.1 Summary 276
8.3 Employee Stock Options 277
8.4 The Relationship between Efficient Securities Market Theory and Economic Consequences 283
8.5 The Positive Theory of Accounting 284
8.5.1 Outline of Positive Accounting Theory 284
8.5.2 The Three Hypotheses of Positive Accounting Theory 287
8.5.3 Empirical PAT Research 290
8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT 294
8.6 Conclusions on Economic Consequences and Positive Accounting Theory 296
9 An Analysis of Conflict 304
9.1 Overview 304
9.2 Understanding Game Theory 305
9.3 A Non-Cooperative Game Model of Manager-Investor Conflict 306
9.3.1 Summary 312
9.4 Some Models of Cooperative Game Theory 313
9.4.1 Introduction 313
9.4.2 Agency Theory:An Employment Contract Between Firm Owner and Manager 313
9.5 Manager's Information Advantage 325
9.5.1 Earnings Management 325
9.5.2 Controlling Earnings Management 329
9.6 Discussion and Summary 331
9.7 Agency Theory:A Bondholder-Manager Lending Contract 332
9.7.1 Summary 335
9.8 Implications of Agency Theory for Accounting 335
9.8.1 Is Two Better Than One? 335
9.8.2 Rigidity of Contracts 339
9.9 Reconciliation of Efficient Securities Market Theory with Economic Consequences 341
9.10 Conclusions on the Analysis of Conflict 341
10 Executive Compensation 356
10.1 Overview 356
10.2 Are Incentive Contracts Necessary? 357
10.3 A Managerial Compensation Plan 360
10.4 The Theory of Executive Compensation 372
10.4.1 The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance 372
10.4.2 Short-Run and Long-Run Effort 374
10.4.3 The Role of Risk in Executive Compensation 377
10.5 Empirical Compensation Research 381
10.6 The Politics of Executive Compensation 383
10.7 The Power Theory of Executive Compensation 386
10.8 The Social Significance of Managerial Labour Markets that Work Well 389
10.9 Conclusions on Executive Compensation 389
11 Earnings Management 402
11.1 Overview 402
11.2 Patterns of Earnings Management 405
11.3 Evidence of Earnings Management for Bonus Purposes 406
11.4 Other Motivations for Earnings Management 411
11.4.1 Other Contracting Motivations 411
11.4.2 To Meet Investors'Earnings Expectations and Maintain Reputation 413
11.4.3 Initial Public Offerings 414
11.5 The Good Side of Earnings Management 415
11.5.1 Blocked Communication 415
11.5.2 Theory and Empirical Evidence of Good Earnings Management 416
11.6 The Bad Side of Earnings Management 422
11.6.1 Opportunistic Earnings Management 422
11.6.2 Do Managers Accept Securities Market Efficiency? 425
11.6.3 Implications for Accountants 426
11.7 Conclusions on Earnings Management 427
12 Standard Setting:Economic Issues 443
12.1 Overview 443
12.2 Regulation of Economic Activity 444
12.3 Ways to Characterize Information Production 446
12.4 Private Incentives for Information Production 447
12.4.1 Contractual Incentives for Information Production 447
12.4.2 Market-Based Incentives for Information Production 449
12.4.3 Securities Market Response to Full Disclosure 450
12.5 A Closer Look at Market-Based Incentives 452
12.5.1 The Disclosure Principle 452
12.5.2 Signalling 456
12.5.3 Financial Policy as a Signal 459
12.5.4 Private Information Search 460
12.5.5 Summary 461
12.6 Sources of Market Failure 462
12.6.1 Externalities and Free-Riding 462
12.6.2 The Adverse Selection Problem 463
12.6.3 The Moral Hazard Problem 464
12.6.4 Unanimity 465
12.6.5 Summary 465
12.7 How Much Information Is Enough? 466
12.8 Decentralized Regulation 468
12.9 Conclusions on Standard Setting Related to Economic Issues 469
13 Standard Setting:Political Issues 483
13.1 Overview 483
13.2 Two Theories of Regulation 484
13.2.1 The Public Interest Theory 484
13.2.2 The Interest Group Theory 485
13.2.3 Which Theory of Regulation Applies to Standard Setting? 486
13.3 Conflict and Compromise 486
13.3.1 An Example of Constituency Conflict 486
13.3.2 Comprehensive Income 489
13.3.3 Conclusions Regarding Comprehensive Income 491
13.4 Rules-Based versus Principles-Based Accounting Standards 492
13.5 Criteria for Standard Setting 493
13.5.1 Decision Usefulness 493
13.5.2 Reduction of Information Asymmetry 493
13.5.3 Economic Consequences of New Standards 494
13.5.4 The Political Aspects of Standard Setting 495
13.5.5 Summary 496
13.6 International Integration of Capital Markets 496
13.6.1 Convergence of Accounting Standards 496
13.6.2 Effects of Customs and Institutions on Financial Reporting 497
13.6.3 Enforcement of Accounting Standards 499
13.6.4 Benefits of Adopting High Quality Accounting Standards 500
13.6.5 Should Standard Setters Compete? 501
13.6.6 Summary of Accounting for International Capital Markets Integration 502
13.7 Conclusions and Summing Up 503
Biblography 513
Index 531