Chapter 6 - Measurement Approach

An approach to financial reporting which incorporate current values

into the financial statements, providing that this can be done with
reasonable reliability, thereby recognizing an increased obligation to
assist investors to predict firm performance and value
o Greater use of current values in the FS
Two versions of current value
Fair value exit price
Value-in-use PV of future cash receipts/payments
o Goal increase decision usefulness by increasing FS relevance
o Still is the investors job to make their own predictions, but this
approach enables better predictions by means of a more
informative system
Why are accountants moving towards the measurement approach?
o The average investor is not fully rational
o Securities markets are not fully efficient
o A measurement perspective may improve decision-making and
market efficiency
o Increased market efficiency = increased rational decisionmaking by investors
o Evidence that certain accounting variables used in these
approaches do a better job than beta in CAPM at predicting
share return
o Evidence that net income explains very little share price
variation; better measurement may increase accounting market
share in explaining share price changes
o Reduce auditor liability when firms become financially distressed
o Ohlsons Clean Surplus Theory supports a measurement
approach
Theoretical framework supportive of a measurement
approach
Expresses value of firm in terms of accounting variables
Three formulae to calculate firm value:
Firm value = net assets present value of
future abnormal earnings (Goodwill)
o This is the clean surplus approach
Firm value = PV of expected future dividends
Firm value = PV of expected future cash flows
Significance of clean surplus theory:
Alternative approach to estimating firm value
o Theoretically sound, uses accounting
variables, easier to apply than DCF
Increased emphasis on predicting net income
Supports measurement approach
Are Securities Markets Fully Efficient
Questions have been raised about investor rationality and securities
market efficiency

Evidence that shares are often mispriced relative to their deficient market
values
If shares are mispriced, improved financial reporting maybe helpful in
reducing inefficiencies
Average investor behavior may not correspond with rational decision
theory
Various behavioral characteristics are inconsistent with securities market
efficiency and rational decision theory
o Limited attention
Investors may not have time or ability to process all available
information
Investors look for the bottom-line
Investors may be biased
o Conservatism
Investors may be conservative in their reaction to new evidence
More emphasis on their individual prior beliefs
o Overconfidence
Investors overestimate the precision of information which they
collect
The overconfident investor will under-react to new information
that is not self collected, relative to information that is self
collected
o Representativeness
The investor assigns too much wait to evidence that is
consistent with their impressions of the population from which
the evidence is drawn
The investor takes the evidence of the few years of growth and
earnings as a representative of a growth firm, ignoring the fact
that it is quite likely that earnings will revert to normal in the
future
o Self-attribution bias
Good decision outcomes are due to their abilities; vs bad
decision outcomes are due to unfortunate realizations of states
of nature (not their fault)
Share price momentum can develop; reinforced confidence
following a rise in share price leads to the purchase of more
shares, and share price rises further
o Motivated reasoning
Investors accept at face value information that is consistent with
their preferences
If the information is inconsistent with their preferences, it is
received with skepticism and the investor will attempt to
discredit it
Contrasts with decisions theory (decision-maker accepts the
objective probabilities of the information)
Behavioral finance: the study of behavioral based securities market
inefficiencies

Prospect Theory
Alternate theory of decision making
Separate evaluation of gains and losses (narrow
framing)
Weighing of probabilities
o Overconfidence: event probs
underweighted
o Representativeness: event probs
overweighted
Prospect theory utility function
o Leads to a disposition effect
o Leads to earnings management to avoid reporting small losses
Is Beta dead?
Empirical results are weak and mixed that beta explains stock returns
(assuming CAPM is valid)
Other risk variables that explain stock returns:
o Book-to-market ratio
o Firm size
Answer = yes non-stationarity of beta
Answer = no behavioral finance - share returns driven by investor
overconfidence, not by beta
Conclusion beta isnt dead but other risk variables also explain share
returns
o Increased role of reporting on risk needed
Efficient Securities Market Anomalies
Post-announcement Drift (PAD)
o Abnormal share returns drift upwards or downwards for several
months following GN or BN in quarterly earnings
o Efficient securities market theory predicts immediate response
to GN or BN in reported earnings
o Reasons for PAD
Investors limited attention
Conservative financial reporting
Effects of inflation on financial statements
Lack of timeliness of analyst forecast revisions
Investors lack of confidence in management forecasts
o Recent evidence that PAD has almost disappeared
Accruals anomaly
o Net income = OCF +/- net accruals
o Accruals have lower persistence than cash flows
ERC should be greater the higher the proportion of OCF
relative to accruals
Evidence is that this isnt the case and ERD does not
reflect the proportion of OCF to accruals
o Reasons for accrual anomaly

Low persistence, low reliability accruals may be ignored

by investors
Investors may ignore possibility of lower future returns for
growth companies

Conclusions on Measurement Approach

Assuming reasonable reliability, current value accounting can increase
decision usefulness relative to historical cost accounting
Increased use of current value accounting (including impairment tests)
in financial reporting
o Suggested reasons
Markets not fully efficient
Low explanatory power of net income for share returns
Ohlsn clean surplus theory
Auditor liability
Decision usefulness for investors may be further increased by
conservative accounting

Chapter 7 Measurement Applications

Current Value Accounting
Value in Use
o Valued at discounted present value of future receipts
o Relevance: high
o Reliability:
Error and possible bias in estimating
Management may opportunistically change intended use
to increase present value or avoid impairment write-down
Fair value
o 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
o Measures opportunity cost of retaining asset/liability in firm
o Market price doesnt always exist fair value hierarchy:
Level 1: market price exists
Level 2: market price of similar asset exists
Level 3: no market price, fair value must be estimated
Revenue Recognition
o Value-in-use: changes in value recognized as present value
changes
o Fair value: changes in value recognized as value changes occur
o Recognition is sooner than under historical cost
Longstanding Measurement Examples
Accounts receivable and payable
o Approximates value-in-use if time is short
Cash flows fixed by contract
o E.g., long-term debt, leases
o Amortized cost valuation
I.e., present value, using effective interest rate
Lower-of-cost-or-market rule
o E.g., inventories
o Rule is example of conservativism, also a partial application of
current value accounting
Revaluation option for property, plant & equipment, IAS 16
o Option to value at fair value
o Not available under FASB standards
Impairment tests
o E.g., property, plant & equipment
Valued at recoverable amount if less than book value
An example of conservatism, also a partial application of
current value accounting
The Fair Value Option
IFRS 9 assets and liabilities must be recorded at fair value at
acquisition

After acquisition, assets with unrealized gains/losses are

included in OCI
o Unless objective of firm is to hold asset to collect
interest/principal
Then value is at amortized cost (value-in-use)
Under IFRS 9, firm may designate financial assets/liabilities at
acquisition as valued at fair value to reduce a mismatch.
o Applies to assets/liabilities otherwise valued at amortized cost
o Mismatch: Accounting volatility greater than real volatility
E.g., loans receivable valued at fair value
Bonds payable hedge the loans, valued at amortized cost
Unrealized gains/losses on loans included in net income
No offsetting loss/gain recorded on bonds
If bonds fair valued, losses/gains on bonds offset
gains/losses on loans
Accounting for changes in own credit risk
o Firm has opted under IFRS 9 to fair value debt outstanding
o Firms debt receives a credit downgrade
o Market value of debt falls
o Firm writes debt down to fair value, records a gain
o IFRS 9 requires own credit risk gains/losses to be included in OCI
o

Liquidity Risk
Investor uncertainty over what buying and selling prices of securities
will be
No liquidity risk on a liquid market CAPM assumes perfect liquidity
Undermines securities market efficiency can call prices to fall below
fundamental value
Can accounting reduce liquidity risk?
o Empirical evidence suggests high quality reporting associated
with lower liquidity risk
Derecognition and Consolidation
The purpose of new standards are to reduce abuses leading up to the
2008 meltdown
Derecognition
o When can a firm remove assets from its books?
o Can derecognize when substantially all risks and rewards of
ownership are transferred
o No derecognizing if control retained
Consolidation
o Required when one entity controls another
o Control exists when one firm has power over another and bears
risk of return on its investment
Derivative Financial Instruments
Financial instrument that is a contract where the value depends on
some underlying factor

May or may not require an initial cash outlay

Valued at fair value
Unrealized gains and losses are included in net income, except some
hedging contracts
Hedge accounting
o Purpose of hedge accounting is to manage risk
Price risks (e.g., commodity prices, interest and foreign
exchange rates), credit risks (credit default swaps)
o Fair value hedges
Gains and losses on the hedging instrument included in
net income
o Cash flow hedges
Gains and losses on the hedging instrument included in
OCI, until the future transaction affects net income
o Benefits of hedge accounting
Reduces earnings volatility
Offset gains/losses by fair valuing hedged item (fair
value hedge)
Delay gain/loss recognition by including in OCI until
realized (cash flow hedge)
Hedging may avoid the impairment test
To obtain benefits:
Hedges must qualify
o Must be highly effective
o High negative correlation with hedged item
Hedges must be designated
o To reduce temptation to speculate
o Requires elaborate procedure and
documentation

Accounting for Intangibles

Many intangibles are not on the balance sheet
o Unless they are purchased (goodwill)
o Accounted for at cost, no amortization
Self developed intangibles (ie. From R&D)
o Hard to reliably determine fair value
o Research costs are written off as incurred
o Development costs capitalized
o Recognition lag instead of valuation on the balance sheet,
goodwill value from R&D show up over time on income
statement
Some argue the recognition lag is responsible for low
ability of net income to explain stock returns
Lev & Zarowin say that accounting for intangibles is inadequate
o How to improve?
o Capitalize successful intangibles after a trigger point is
attained

Amortize over useful life

Like successful efforts accounting in oil and gas
Amounts capitalized and amortized may reveal inside
information to investors, since it is management that has
best knowledge of R&D value

Reporting on Risk
Some reasons for managing firm-specific risk, even though investors
can diversify it away
o Reduce investor estimation risk
o Cash availability for planned capital expenditures
o Control speculation by managers
o Reduce likelihood of major losses, which often lead to lawsuits
Beta risk
o Relevant to rational, diversified investor
Beta an input into investment decisions
o Accounting variables are correlated with beta
May help investors to estimate beta
Some reasons why reporting on other (firm-specific) risks also relevant
to investors
o Risk information may reduce estimation risk
o Hedging may prevent losses, reducing auditor & firm legal
liability
o Risk reporting may control manager speculation
Conclusions
Standard setters continue to favour current value measurements in
financial statements
o Conceptual framework emphasizes balance sheet approach
o Some current value measurements are one-sided
Lower-of-cost-or-market, ceiling tests
o Some backing off from fair value post 2007- 2008 market
meltdowns
E.g., IFRS 9 business model concept allows increased use
of amortized cost
Accountants are recognizing an increased obligation to measure and
report on firm risk

Chapter 8 Efficient Contracting Approach to Decision Usefulness

What is efficient contracting theory?
o Focus on role of financial accounting information in moderating
information asymmetry between contracting parties
Debt contracts and managerial compensation contracts
Lenders interests and managers interests may conflict
with interests of shareholders
An efficient contract generates trust between these
conflicting interests at lowest cost to firm.
Contracts may be formal written documents or implicit
Implicit contracts arise from continuing business
relationships
Implicit contracts can be modeled as noncooperative games
Sources of Contracting Demand for Financial Accounting Theory
Lenders
o Lenders face payoff asymmetry
o Lose heavily if firm does poorly, but dont benefit if firm does
well
o As a result, they demand early warning of financial distress
Shareholders
o Managers assumed rational and will act in their on interest
which may conflict with shareholders interest
o As a result, shareholders demand information to encourage
responsible manager effort and limit opportunistic actions
Reliability
o Lenders demand reliable information to help protect against
opportunistic manager policies that hide losses and record
unrealized gains
Conservatism
o Lenders demand conservative information to help predict
financial distress
Reporting unrealized losses helps predict financial distress
o Shareholders demand conservative information for stewardship
purposes
Conservatism makes it difficult for manager to increase
reported earnings, and compensation, by recognizing
unrealized gains
Efficient contracting demand for reliable and conservative information
conflicts with Conceptual Framework
o Framework more oriented to future-oriented (i.e., relevant)
information (fair value accounting)
Reliability downgraded to an enhancing characteristic
o Framework more oriented to information needs of investors than
to stewardship
Framework does state that investors need information
about manager stewardship, but ignores the fundamental

problem that best information for investor decision

making and for stewardship evaluation need not be the
same
Contract Rigidity
Many contracts depend on accounting variables
o Debt contracts contain accounting-based covenants
o Manager compensation contracts depend on net income
Both types of contract tend to be long-term
o Accounting standards often change during contract term,
affecting net income and debt covenants
Probability of debt covenant violation may increase
Manager compensation may be affected
Since contracts are hard to change (rigid), unlikely that contracts can
be renegotiated to allow for changes in GAAP
As a result, managers are concerned about changes in accounting
standards and policies, even if no effects on cash flows
o May lobby against proposed accounting standards
o May exploit the flexibility of GAAP to change accounting policies
to offset effects of changes in accounting standards on contracts
(e.g., increase net income by lengthening useful life of capital
assets)
o May change operating policies (e.g., R&D, extent of hedging)
A new accounting standard has economic consequences if it motivates
managers to change accounting and/or operating policies
Employee Stock Options
Until 2005 no expense recorded for ESOs
Why ESOs are an expense
o Dilution
o Opportunity cost
Measuring ESO expense
o Black scholes option pricing formula
Black scholes overstates ESO because it assumes that
they are held until expiry date, but sometimes they are
exercised early
o Accountants answer:
Use expected exercise date, not end date
Managers abuse of ESOs
Since no effect on net income, firms overdosed on ESO
compensation
Managers motivated to increase reported net
income in short run so as to increase ESO values
Pump and dump
Manipulate share price down prior to scheduled ESO grant
dates
Spring loading

 Late timing
This increased level of abuse led to the pressures to expense
ESOs even though managers resisted the change
Why management resistance?
o No effect on cash lfows
o ESO expense already reported as supplementary information
o Possible reasons:
May lead to reduced use of ESOs as compensation
Resulting reduced scope to abuse ESO value?
Concerns about reliability of Black/Scholes?
Lower reported net income?
Rejection of market efficiency?
o

Distinguishing Efficiency and Opportunism in Contacting

A basic question in contract theory:

Are managers accounting policy choices driven by

o Opportunism: manager benefits at expense of investors
o Efficiency: manager chooses accounting policies to maximize
contract efficiency (i.e., good corporate governance)
Opportunistic view
o Managers choose accounting policies to maximize their own
expected utility
Efficient contracting view
o Managers choose accounting policies to attain efficient
contracting
8-14 talks about some research done about contracting efficiency
o Conclusion: while significant evidence for efficiency version, also
evidence for opportunistic accounting policy choice

Conclusions
Contract theory argues that the role of financial reporting is to
generate trust between contracting parties
o Debt and managerial compensation contracts emphasized
Contract theory conflicts somewhat with Conceptual Framework
o Supports increased emphasis on reliability and conditional
conservatism
Managers have accounting policy choice
o Is this flexibility consistent with efficient contracting or with
manager opportunism?
Empirical evidence is mixed.

Chapter 9 Analysis of Conflict

Game Theory
Models a conflict situation between rational players
Types of games
o Cooperative (e.g. agency theory)
Binding agreement
o Non-cooperative (chapter 8)
No binding agreement
Implicit contracts
Agency Theory
Principal and agent are assumed rational. Agent is assumed riskaverse. Principal may be risk-averse, but assume risk-neutral for
simplicity
Principal wants agent to work hard
o But, agent is effort-averse
Moral hazard problem of information asymmetry
o Principal cannot observe manager effort - call it a
o Call managers disutility of effort V(a)
More effort ---> greater disutility
o Effort aversion implies manager may shirk on effort
E.g., if paid a fixed salary, how hard will the manager
work?
A problem arises if manager paid a share of payoff
o Firm payoff usually not known until after contract expires (single
period contract).
o Some manager effort does not pay of in current period
e.g., R&D, contingencies
o Manager has to be paid at contract expiry (i.e., end of single
period)
A solution
o Base manager compensation on a performance measure which
is available at period end
o Performance measure must be jointly observable and correlated
with payoff
Net income as a performance measure
o To motivate manager effort, an efficient contract may offer the
manager compensation based on a share of firm net income
o Higher net income suggests higher payoff (but with noise)
Will manager be willing to accept contract?
o Concept of reservation utility, call it R
If manager is to work for owner, must receive expected
utility of at least R
Level of R depends on manager reputation
R treated as fixed in a single-period contract
Managers Information Advantage

It is assumed manager could not control accounting system

A more realistic assumption is that manager can control accounting
system
o Owner cannot observe unmanaged net income, only net income
reported by manager
o Manager may then use this information advantage to bias (i.e.,
manage) reported net income
In a single-period contract, rational manager will shirk and
report highest possible net income
Owner utility falls
Result of these problems is that it may be more efficient to allow some
upwards earnings management
But manager will then overdose on earnings management
o A solution: restrict earnings management through GAAP

Implications of Agency Theory for Accounting

Holmstroms agency model
o To maintain market share in compensation contracts, net income
must be informative about manager effort
o To be informative, net income must have
Sensitivity & Precision
o These two desirable qualities usually have to be traded off
E.g., fair value accounting may be more sensitive than
historical cost, but less precise. Why?
Contract incompleteness
o Realistically, contracts cannot anticipate all possible state
realizations
E.g., new accounting standards may arise during contract
term
Managers net-income-based comp may be affected
Debt covenant ratios and probability of covenant
violation may be affected
o Contract rigidity (Section 8.5)
Contract rigidity prevents simply revising the contract
when an unforeseen state realization occurs
o Result: agency theory implies economic consequences
New accounting standards matter to managers since they
can affect contracts, motivating managers to change
accounting and/or operating policies to avoid effects of a
new standard on reported net income and/or debt
covenants
Conclusions
Accounting policies (even without cash flow effects) can have
economic consequences but securities markets can still be efficient
Role of net income in monitoring and motivating manager performance
equally important as informing investors
Net income competes with share price as a performance measure

Role of GAAP in controlling earnings management

Chapter 10 Executive Compensation

Are incentive contract necessary?
o No: (Fama)
Forces of reputation on managerial labour market enough
to motivate manager to work hard
Assumes managerial labour market works well
o Yes (Wolfson)
Forces of reputation help to motivate manager, but
incentive contract still needed
Suggests managerial labour markets do not work fully
well
Theory of Executive Compensation
Desired properties of a performance measure:
o Sensitivity and precision
Share price as a performance measure
o High in sensitivity, low in precision
Net income as a performance measure
o Low in sensitivity, high in precision
How to increase sensitivity of net income
o Reduce recognition lag
Net income waits until many aspects of manager effort
are realized
R&D, advertising, legal & environmental liabilities
Capital investment programs
Current value accounting reduces recognition lag
But decreases precision
o Full disclosure
More difficult for manager to disguise shirking by earnings
management
Enables compensation committee to better evaluate
earnings persistence
o Congruency of a performance measure
If performance measure (e.g., net income) is congruent to
payoff, mix of short-run and long-run effort does not
matter to firm owner (investor)
If net income not congruent to payoff (more likely), effort
mix does matter
Then, firm owner can control managers effort mix
(i.e., length of managers decision horizon) through
proportion of net income v. share price-based comp
The Role of Risk in Exec Comp
Recall manager must bear some compensation risk to motivate effort
Risk goes both ways
o Downside risk: Compensation may be less than expected
o Upside risk: Compensation may be more than expected
Lower performance measure precision higher compensation risk

Too little compensation risk

o Reduces effort incentive
Too much compensation risk
o Manager avoids risky projects
o Excessive hedging
Goal is to control compensation risk, not eliminate it
Controlling compensation risk
o Relative Performance Evaluation
Fine in theory, but hard to find in practice
May depend on firm size (Albuquerque (2009))
o Bogey of compensation plan
Controls downside risk
o Cap of compensation plan
Controls upside risk
o Board and comp committee have role in controlling comp risk
o Conditionally conservative acct also has role in controlling comp
risk

Empirical Compensation Research

Research suggesting efficient contracting
o Lambert & Larcker (1987)
Cash compensation (salary + bonus) more highly
correlated with ROE than with return on shares
Correlation higher as noise in NI lower
Correlation lower for growth firms
Higher weight on ROE in compensation plan when
correlation between ROE and return on shares low, and
vice versa
o Indjejikian & Nanda (2002)
Lower firm risk, higher target bonus
o Bushman, Indjejikian & Smith (1996)
For growth firms, more CEO compensation based on
individual performance measures
o Baber, Kang & Kumar (1999)
More persistent earnings changes have greater effect on
comp
Politics of Executive Compensation
Is exec compensation too high?
o Not too high, but managers do not bear enough compensation
risk they need to hold more stock
Do golden parachutes reduce effort incentive?
o A source of criticism of efficient contracting since may seem to
reward poor performance
Value of shares and ESOs to manager less than expense to firm
o Manager compensation not as high as some believe
Manager risk averse, cannot diversify share holdings

Ability to sell shares and ESOs usually restricted

Therefore, shares and ESOs worth less manager than their
expense to firm

Power Theory of Executive Compensation

Disputes efficient contracting
o Manager uses power in firm opportunistically to earn more than
reservation utility
Opportunism limited by outrage
Devices to camouflage excessive compensation and outrage
o Compensation consultants
o Peer groups
o Late timing of ESO awards
Controlling excessive manager power over compensation
o Good corporate governance needed
o Corporate governance helped by full disclosure
Reduces ability of mgr to cover up shirking by earnings
mgmt
Helps identify persistent earnings
Enables comp committee to better tie pay to performance
Limits excessive compensation by full disclosure of
compensation amounts to investors
o Disclosure regulation
Compensation discussion and analysis
Increased disclosures of risk management
Limit tax deductibility of compensation?
Despite these controls, power theory seems to have some validity
o Brown & Lee (2010)
Negative relationship between excess grants of equitybased compensation to managers and corporate
governance quality
Greater cutbacks in manager excess equity-based comp
post Enron for firms with weak corporate governance preEnron
Conclusions
Financial reporting plays two important roles in motivating manager
effort
o Provides an informative performance measure input into
compensation contracts
helps compensation committees tie pay to performance,
control manager power, and increase contract efficiency
o Improves working of managerial labour markets
Full disclosure helps labour market evaluate manager
performance and establish reputation
Role of financial reporting in motivating manager performance and
improving the working of managerial labour markets equally important
to social welfare as improving operation of capital markets

Chapter 11 Earnings Management

Earnings management is the choice by a manager of accounting
policies (accruals), or real actions, that affect earnings so as to achieve
some specific reported earnings objective
o Real actions to manage earnings include, for example, cutting or
increasing R&D and advertising; manufacturing for stock
o Accrual-based earnings management includes, for example,
managing the allowance for bad debts, changing amortization
policy
Here, we concentrate primarily on the role of accruals in earnings
management
o Note the iron law of accruals reversal: if accruals increase
earnings this period, their reversal lowers earnings in future
periods
Two types of accruals
o Non-discretionary: management has little discretion to control
amounts
o Discretionary: management has discretion to control amounts
o To discover role of accruals in earnings management, accountant
needs to separate these two types
Jones model usually used for this seperation
Patterns of Earnings Management
Bath
Income minimization
Income maximization
Income smooth
Evidence of Earnings Management for Bonus Purposes