Scott, 6th EditionFinancial Accounting Theory

The theory of rational decisionmaking under uncertainty describes how individuals may
revise theirbeliefs upon receipt of new information. Possibility Theorem of Arrow: in general it is not
possible to combine differing preferences into asocial preference ordering. This implies that there is
no such a thing as perfect or true accountingconcepts. This creates the concept of decision
usefulness (instead of true) financial information. This conceptstates that the objective of financial
statements is to provide information to assist investors to makeinvestment decisions. So, when
considering which type of standard must be used, it helps to reflectto what extent it leads investors
to make good investment decisions. Rulesbased standards attempt to lay down detailed rules for
how to account. An alternative is to laydown general principles only, and rely on auditor professional
judgment to ensure that application ofthe standards is not misleading. The product of accounting is
information, so this book is based on information economics.Information economics or the
economics of information is a branch of microeconomic theory thatstudies how information and
information systems affect an economy and economic decisions. Thestarting point for economic
analysis is the observation that information has economic value becauseit allows individuals to make
choices that yield higher expected payoffs or expected utility than theywould obtain from choices
made in the absence of information. As some parties have an information advantage over others,
there is information asymmetry. Twotypes: Adverse selection: some individuals will know more
about the current conditions and futureprospects of the firm than outside investors. Actions taken
by managers could be adverse to

the interests of investors.

To understand how financial accounting can help to control the adverse selection problem, it is
desirable to have an appreciation of how investors make decisions. Assumption in this book:
investors are rational on average: the average investor makes decisions soas to maximize his/her
expected utility, or satisfaction, from wealth. The reporting of informationthat is useful to rational
investors is called the decision usefulness approach. Moral hazard: this occurs as a consequence of
the separation of ownership and control. Onetype of the party can observe their actions in
fulfillment of the transaction, but the otherparty cannot. So this problem arises from the un
observability of the managers effort inrunning the firm. The user decision problem is hence how to
design financial reporting tomotivate and evaluate manager performance. To be informative about
performance, NI

should be a precise and sensitive measure of this performance.

Fundamental problem of financial accounting theory is how to design and implement concepts
andstandards that best combine the investorsinforming and manager performanceevaluating roles
foraccounting information (p. 23). There are two versions of decision usefulness (related to adverse
selection) Information approach (chapter 5): form of disclosure doesnt matter it can be in notes,
orin supplementary disclosures such as RRA, in addition to the financial statements proper.Investors
are assumed to be sufficient sophisticated on average that they can digest the
implications of public information of any source. Measurement approach (chapter 6): accountants
expand their approach by taking moreresponsibility for incorporating measures of current assets and
liabilities info the financialstatements proper (p. 26)

Standard setters:IASB: global accounting standardsFASB: US standardsThese standards must

conform to GAAP. Securities commissions are one of the most important enforcers of accounting
standards, e.g. SEC.SEC also issues accounting standards, mainly for disclosures outside of the
financial statement (e.g.RRA).
 Chapter 2
Relevant information in this context is information about the firms future economic prospects,
whilereliable information faithfully represents the firms financial position and results of operations.
According to the IASB, relevant information is capable of making a difference in the decisions
madeby users. Information is capable of making a difference in the decisions made by users if it
haspredictive value, confirmatory value or both. Accretion of discount: The increase in the value of a
discounted instrument as time passes and itapproaches maturity. The value of the instrument will
accrete (grow) at the interest rate implied bythe discounted issuance price, the value at maturity
and the term to maturity.PV under uncertainty: expected NI and realized NI ned not be the same
under uncertainty. Thisdeviation is described as Abnormal earnings in the income statement.
Nevertheless, financial statements based on expected PV continues to be both relevant and reliable.
However, the PV model encounters serious reliability problems when we try to apply it without
idealconditions. To illustrate this, the current value standard of reserve recognition accounting
isconsidered (RRA = PV accounting applied to oil and gas reserves)SFAS 69 requires the disclosure of
the estimated PV of future receipts (supplementary disclosure). This calculation resembles the PV
model under uncertainty. SFAS 69 requires that reserves are valuedby using yearend prices. SFAS
69 contains several provisions to mitigate reliability concerns. Only proved reserves areincluded,
periodend prices are used rather than prices expected when the reserves are lifted andsold, and the
interest is specified as a fixed amount. However, this reduces relevance. Also reliabilityproblems
remain (it is not a complete representation). This doesnt mean that it does not provideuseful
information to investors! Compared with historical costs, revenues are sooner recognized andassets
are different valuated, so this creates differences in earnings. What is the best predictor for future
performance? Historical costs vs current value accounting
 Chapter 3: The decision usefulness approach for
financial reporting
Adverse selection

Despite the current value approach or historical cost accounting, accountants agree that
statementsmust be useful. Group users of financial statements: constituencies. Accountants have
decided that investors are themain constituency of users (IASB, 2010).Singleperson theory of
decision: theory that explains how individuals may make decisions underuncertainty. It recognizes
that state probabilities are no longer objective, but are subjectivelydetermined by the investor. By
examining these theories, accountant try to understand how financialaccounting can help to control
this adverse selection problem, so what information is necessary forinvestors.The decision theory
tells that an investor would choose the act with the highest expected utility. The investor can also
try to obtain more information. This leads to the possibility that he canestimate the probability that
the financial statement shows GN/BN, while it is in a low/high state.He can use Bayes theorem to
calculate his posterior state probabilities. The theorem provides a way to revise existing predictions
or theories given new or additionalevidence. This posterior probability can change the investors
preferences.

Information system

Information helps to update subjective beliefs about future payoffs from investors decisions. An
information system reflects the conditional probabilities. It is a table giving (conditional on eachstate
of nature), the objective probability of each possible financial statement evidence item. Information
can be defined as the evidence that has the potential to affect an individuals decisionIn decision
theory, it is assumed that investors choose the act that has the highest expected utility.Besides, it is
assumed that they are riskaverse. This gives rise to a riskaverse utility function (e.g. asquare root
function, depicting expected payoff on the Xaxis and U(x) on the Yaxis)Portfolio diversification can
reduce risk, because realizations of firmspecific states of nature tend tocancel out across securities,
leaving economicwide factors (systematic risk) as the main contributorsto portfolio risk. When
transaction costs are ignored, a riskaverse investors optimal investment decision is to buythat
combination of market portfolio and riskfree asset that yields the best tradeoff betweenexpected
return and risk (individual specific). The principle of diversification leads to the beta, which
measures the comovement betweenchanges in the price of a security and changes in the market
value of the market portfolio. Itmeasures how strong A varies as the market varies. So, it shows the
sensitivity of economicconditions.When transaction costs are not ignored, a riskaverse investors
optimal decision is to buy relativelyfew securities, rather than the market portfolio. By doing this,
most of the benefits of diversificationcan be attained. Essence of the decision usefulness approach:
it is the investor that makes the investment decisionsand the role of financial reporting is to supply
useful information for this purpose.
 Chapter 4: Efficient Security Markets (ESM)
The theory of ESM predicts that the security prices that result have some appealing properties.
Inessence, these prices fully reflect the collective knowledge and informationprocessing expertise
ofinvestors. Efficiency implies that it is the information content of disclosure, not the form of
disclosureitself, what is valued by the market. ESM alerts us to the primary reason of the existence
of accounting, namely information asymmetry.Accounting is thereby in competition with other
forms of information. When a sufficient number of investors behave quickly upon receipt of new
information, the market

becomes efficient. An ESM is one where the prices of securities traded on that market at all times

fully reflect all information that is publicity known about those securities (semistrong). The only
reason that prices will change is if some relevant but unexpected information comes along. Even
while the definition states that the prices fully reflect all information, this does not mean
thatsecurity prices are fully informative with respect to available information at all points in
time.Partially information is due to noise traders and the unability of investors to identify
mispricedsecurities. How can market prices fully reflect all available information?On average, the
market uses all informationImplications of ESM for financial reporting Choice of accounting policy
doesnt matter as long as it does not influence cash flows (the

market sees through the information, so type doesnt matter) ESM goes hand in hand with full
disclosure: as long as the information is not available viaother sources and the benefits outweigh the
costs, managers should disclose information(because then there is less inside information affecting
the share price) Financial statements do not have to be presented such that everyone understands
it

Capital asset pricing model

This formula formalizes the relationship between the efficient market price of a security, its risk,
andthe expected rate of return on a security. CAPM specifies what the expected return of a share
traded on an efficient securities market shouldbe (equivalently, the firms cost of capital)Equation
4.3 shows the sum of a riskfree asset + the expected return on the market portfolio todetermine
the expected return of share j. The capital asset pricing model (CAPM) is used to determine a
theoretically appropriate required rateof return of an asset, if that asset is to be added to an already
welldiversified portfolio, given thatasset's nondiversifiable risk. The model takes into account the
asset's sensitivity to nondiversifiablerisk (also known as systematic risk or market risk), often
represented by the quantity beta () in thefinancial industry, as well as the expected return of the
market and the expected return of atheoretical riskfree asset. CAPM suggests that an investors
cost of equity capital is determined bybeta.The general idea behind CAPM is that investors need to
be compensated in two ways: time value ofmoney and risk. The time value of money is represented
by the riskfree (rf) rate in the formula andcompensates the investors for placing money in any
investment over a period of time. The other halfof the formula represents risk and calculates the
amount of compensation the investor needs fortaking on additional risk. This is calculated by taking
a risk measure (beta) that compares the returnsof the asset to the market over a period of time and
to the market premium (Rmrf).The CAPM says that the expected return of a security or a portfolio
equals the rate on a riskfreesecurity plus a risk premium. If this expected return does not meet or
beat the required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM forall different risks (betas).The formula brings out how share prices
depend on investors expectations of future share pricesMarket version of the CAPM states that the
realized return is the sum of the beginning of the periodexpected return and the unexpected or
abnormal earnings return. This market model provides aconvenient way for researchers and analysts
to estimate a stocks beta by regression analysis. So, the CAPM provides a useful way to model the
market expectations of a shares returns and afirms cost of capital, and that the model depends
crucially on ESM. It is a model that describes therelationship between risk and expected return.Even
if security market prices fully reflect all the publicly available information, it is still likely thatinsiders
know more than outsides about the true state of the firm. As there is an estimation riskresulting
from adverse selection (and insider trading as mentioned), security prices do not fullyreflect
fundamental value in the presence of inside information. To solve this, firms might issue highquality
reporting. So, full disclosure has an important role to play in financial accounting theory byreducing
the extent of inside information and estimation risk.An example of full disclosure: Management
discussion & analysis (MD&A). This standard requiresfirms to provide a narrative explanation of
company operations, to assist investors to interpret thefirms financial statements.
Chapter 5: the information approach to decision usefulness
Accounting information does have content. It is useful if it leads investors to change their beliefs
andactions. The degree of usefulness can be measured by the extent of volume or price change
followingrelease of the information. The information approach takes the view that investors want to
make their own predictions of futuresecurity returns and are capable of gobbling up all useful
information in this regard. The information approach to decision usefulness is an approach to
financial reporting that recognizesindividual responsibility for predicting future performance and
that concentrates on providing usefulinformation for this purpose. The approach assumes securities
market efficiency, recognizing that themarket will react to useful information from any source,
including financial statements. This approach (to financial accounting theory) equates the extent of
security price change withinformation content and hence with decision usefulness.Predictions about
investor behavior in response to financial statement information: p. 154It is expected that the
volume of shares traded increases when the firm reports its net income. Thisvolume should be
greater the greater are the differences in investors prior beliefs and in theirinterpretations of the
current financial information.

ERC: the coefficient measures the extent of a securitys abnormal market return in response to
theunexpected component of reported earnings of the firm issuing that security. It is the stock
marketreaction (the change in stock price) for one unit of unexpected earnings.Reasons for
differential market responses: Beta: the demand for GN firms shares will be lower the higher is its
beta (high beta = more

portfolio risk). This results in a lower ERC. Capital structure: ERC for a highly leverage firms is lower
than that of a firm with little or nodebt (earnings will go to debtholders instead of shareholders)
Earnings quality: the higher the earnings quality, the higher the ERC will be. Growth opportunities:
higher ERC for firms whose the market sees as having growth

opportunities Similarity of investor expectations: the more similar, the greater the effect (so the
greaterthe ERC) The informativeness of price: the more informative the price, the lower the ERC.

Researchers must obtain a proxy for expected earnings, since the market will react only to
thatportion of an earnings announcement that it did not expect. So, estimating earnings
expectations is acrucial component of information approach research. The information content of
reported NI can be measured by the extent of security price change or bythe magnitude of the
securitys abnormal market return, around the time the market learns thecurrent NI. This is because
rational, informed investors will revise their expectations about futurefirm performance and share
returns on the basis of current earnings information. So, this chapter states that security market
response is a measure of usefulness of investors. Thereason is that ESM states that all publicly
information is already incorporated in the share price, so afinancial report is useful when it provides
new information, which causes investors to revise theirbeliefs.
 Chapter 6: The measurement approach to decision usefulness

The measurement approach is an approach to financial reporting under which

accountantsundertake a responsibility to incorporate current values into the financial statement
paper, providingthat this can be done with reasonable reliability, hereby recognizing an increased
obligation to assistinvestors to predict firm performance and value. It enables to provide better
predictions of this performance by means of a more informativeinformation system. A
measurement approach could be only useful for investors when increased relevance outweigh
anyreduction in reliability. Purpose of this chapter is to suggest and evaluate possible reasons
underlying increased emphasis oncurrent value. One such reason involves investors rationality and
ESM it may be not that efficientas is claimed.Basic premise: average investor behavior may not
correspond with the rational decision theory andinvestment model outlined in chapter 3. For
example, individuals have limited attention (ignoreinformation in notes), conservative (they revise
their beliefs less than Bayes theorem implies),overconfident of their estimation capacity,
representativeness (assigns too much weight toinformation that is in line with the individuals
thoughts), they have a selfattribution bias (good newsis due to our capacity, while bad news is due
to realizations of states of nature) and motivatedreasoning Behavioral finance. These
characteristics are inconsistent with security market efficiency. This produces a wide variety ofshare
price behavior over time. The prospect theory provides a behavioralbased alternative to the
rational decision theorydescribed in 3.3. According to prospect theory, an investor considering a
risky investment will
separately evaluate gains and losses. This contrasts with decision theory where investors
evaluatedecisions in terms of their effects on total wealth. So, the rate at which investor utility
decreases for small losses is greater than the rate at which itincreases for small gains. Share return
behavior inconsistent with the CAPM is viewed as evidence of market inefficiency. Alsoexcess stock
market volatility could be a consequence of behavioral efficiency. Security market anomalies show
evidence of market inefficiency: Postannouncement drift (PAD): It seems that investors
underestimate the implications of

current earnings for future earnings. Market response to accruals: NI = cash flows + accruals, but
accruals are less reliable (theyare estimated). If this is the case, we would expect an efficient market
would respond morestrongly to the GN or BN in earnings the greater is the cash flow component
relative to theaccrual component in that GN or BN, and vice versa. Sloan suggests that this does
nothappen. Implications of SME for financial reportingImproved financial reporting will speed up
share price response to the full information content offinancial statements. Figure 6.3 adds another
inner circle, referring to the inefficient market price of the firm, besides thedifference between
fundamental value and the efficient security market price due to insideinformation. Why can limits
to arbitrage not eliminated? Transaction costs Idiosyncratic factorsWe conclude that while
securities prices can at times depart significantly from fundamental value,securities markets are
generally close enough to full efficiency that accountants can be guided by thetheory. However, to
the extent that full efficiency does not hold, some movement of information,such as current values,
into the financial statements proper may improve decision usefulness. What is the value relevance
of financial information, if most of the information is already built intoshare price prior to its
announcement date?The clean surplus theory of Ohlson (also called the residual income model)
shows that the marketvalue of the firm can be expressed in terms of income statement and balance
sheet variables. Itdemonstrates that firm value depends on fundamental accounting variables, so it
is consistent withthe measurement approach. It can be applied at any point in time to vale the firm
for which financial statements are available. Why does the theory support the measurement
approach? It makes use of current value accounting for PV assets, so it reduces the extent of biased
accounting. http://en.wikipedia.org/wiki/Clean_surplus_accountingThe clean surplus model can be
used to estimate the value of a firm shares. This can then becompared to the actual market value, to
indicate possible over or undervaluation by the market. The market value of a firm = net book value
of the firms net assets + present value of futureabnormal earnings (goodwill). This allows reading
the firm's value directly from the balance sheet.Conditional conservatism: recognition of unrealized
losses, but not of unrealized gains
 Chapter 7: Measurement Applications
This chapter is the last chapter about adverse selection (> chapter 8 is moral hazard).Information is
relevant when it informs the investor about the firms future economic prospects. Obstacle of
current value accounting is reliability. This chapter discusses some measurementapplications, so the
use of current value. There are two main current cost alternatives to historical cost for assets and
liabilities: Value in use (such as discounted PV) Fair value (exit price / opportunity cost). There are
three levels of fair value measuresValueinuse recognizes revenues before they are realized, since
anticipated future revenues arecapitalized into asset values. Fair value accounting recognizes gains
and losses as changes in valueoccur. Even though financial statements are based on a mixed
measurement model, they contain asubstantial current value component. Some examples of
currentvalue based measures: Accounts receivable and payable: valued at the expected amount
of cash to be received or

paid. Cash flows fixed by contract (longterm debt is valued at PV, given an interest rate: this
iscalled amortized cost accounting) Example of a partial measurement approach: lowerofcostor
marketruleWhen the net realizable value of inventory falls below cost, it is written down to the
lower value. IfNRV subsequently increases, the inventory may be written up, but not above costs:
IAS 2. This can bejustified in terms of conservatism. Revaluation option for property, plant and
equipment Standard setters have imposed a ceiling test for capital assets, such as property, plant,
and

equipment. Example is IAS 36.

(Other) Current valueoriented accounting standards: Financial instruments: a financial asset of one
firm and a financial liability or equityinstrument of another firm (IAS 39 or IFRS 9). There are four
categories:1) Availableforsale: Valued at fair value, with unrealized gains and losses in OCI. Upon

disposition, there are transferred to NI2) Loss and receivables: Valued at amortized costs, subject to
an impairment test.Unrealized loss is included in NI. A writtenup cant come above current book
value3) Held to maturity: Similar as loss and receivables, but writedown may be reversed
undercertain conditions4) Financial assets at fair value through profit and loss: includes all
derivatives. Derivative instruments: contracts whereby the value of depends on some underlying
price,interest rate, foreign exchange rate or other variable. They help to reduce
marketincompleteness, since they enable the firm to purchase protection against risks that
wouldotherwise be difficult to control. Example: options. IAS 39: all derivatives must be measuredat
fair value. Hedge accounting: Gains and losses on fair value are included in current NI (same
inavailableforsale)Concluding, fair value accounting for Financial Instruments is a prominent
example of standardsetters movement towards fair value accounting. However, it became under
pressure due toconcerns about huge writeoffs of financial assets triggered by falling market prices
and, lack ofexistence of prices due to inactive markets. The BlackScholes model is used to calculate
the theoretical price of European put and call options. Another example of the measurement
application is accounting for intangibles (patents, trademarks,goodwill..)Goodwill: (mainly here are
some problems with reliability) Purchased goodwill: assets and liabilities are valued at their fair
values after a businessacquisition, thereby calculating goodwill. This goodwill is amortized over its
useful life, whichgive rise to management complaints. In response, they try to circumvent
goodwillamortization by the poolingofinterest accounting (balance sheets are simply be
puttogether) and proforma income (NI before amortization: this is shown obvious in theincome
statement). In response, IAS 36 eliminated the amortization of purchased goodwilland prescribes
that goodwill is retained on the balance sheet at its value established at timeof purchase, unless
there is evidence of impairment, in which case a ceiling test is applied to

write goodwill down to fair value. Selfdeveloped goodwill (e.g. R&D): costs that create goodwill,
are mostly written off asincurred. Proposal LZ: capitalize goodwill. Another approach to valuing self
developedgoodwill: clean surplus model. Why do firms manage firmspecific risk? In other words, if
investors diversify their portfolios, isinformation about firmspecific risk decision useful, since
investors can manage this risk forthemselves? However, several reasons for managing and reporting
on firmspecific risk can besuggested:1. CAPM model does not include estimation risk, so reporting
on the firms risk managementstrategies may reduce investor concerns about estimation risk
resulting from adverse

selection. 2. For large capital expenditures, firms want to ensure that cash is available when
needed3. Derivatives used to speculate, so full disclosure is crucial. 4. Hedging may prevent large
lossesSo, this are several reasons why firms may wish to manage and report on firmspecific risk
despitethe theory underlying the CAPM and beta. A measurement approach to risk reporting:
Disclosures discussed in 7.9.3 are primarily oriented to the information approach: they involve
thecommunication of information to enable investors to make their own risk evaluations. However,
likevaluations of assets and liabilities, reporting on risk is also moving towards increased
measurement. Two quantitative measurement techniques are of interest: Sensitivity analysis,
showing the impact on earnings, cash flows etc. resulting from changes in

relevant commodity prices, interest rates and foreign exchanges rates. Value at risk: loss in
earnings, cash flows or fair values resulting from future price changessufficiently large that they have
a specified low probability of occurring. Conclusions: It appears that decision usefulness is moving
more and more into the arena of measurement.Reasons include the low value relevance of historical
costbased net income, reactions to theory andevidence that securities markets may not be as fully
efficient as originally believed, and auditor legalliability.

Carrying amount = book valueRecoverable amount: Accounting principles require companies to

record on their balance sheet instances where thecarrying amount of an asset exceeds the
recoverable amount. For example, if the company hasreason to believe an asset's value may be
impaired, it's required to perform a formal estimate of therecoverable amount. This approach is
similar to the concept of lower of cost or market value, whichapplies to inventory. IAS 36 provides
accountants with guidance on this topic, stating: If the asset's fair value less the cost of disposal
cannot be determined, the recoverable

amount is equal to its value in use. If the company intends to sell the asset, the recoverable
amount is equal to its fair value lessthe cost of disposal.Note: If the fair value of an asset less its cost
of disposal, or the asset's value in use is greater than itscarrying amount, then calculating a
recoverable amount is not necessary since the asset is notimpaired.IAS 36 Impairment of Assets
seeks to ensure that an entity's assets are not carried at more than theirrecoverable amount (i.e. the
higher of fair value less costs of disposal and value in use). With theexception of goodwill and certain
intangible assets for which an annual impairment test is required,entities are required to conduct
impairment tests where there is an indication of impairment of anasset, and the test may be
conducted for a 'cashgenerating unit' where an asset does not generatecash inflows that are largely
independent of those from other assets.Capital asset pricing model (CAPM):Het Capital Asset Pricing
Model (CAPM) is een financile beleggingstheorie om de rendementseis tebepalen, waarbij deze eis
is opgebouwd uit een zogenaamd risicovrij rendement en een risicoopslagwaarin het marktrisico
besloten ligt.In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriaterequired rate of return of an asset, if that asset is to be added to an already well
diversified portfolio,given that asset's nondiversifiable risk. The model takes into account the asset's
sensitivity to nondiversifiable risk (also known as systematic risk or market risk), often represented
by the quantitybeta () in the financial industry, as well as the expected return of the market and the
expectedreturn of a theoretical riskfree asset. CAPM suggests that an investors cost of equity
capital isdetermined by beta.
 Chapter 8:

Economic Consequences and Positive Accounting TheoryThe motivation of responsible

manager performance (providing information to evaluate managerstewardship) is as equally
important a role of financial accounting as the provision of usefulinformation to investors. The
stewardship role differs sharply from the investor decisionbased and efficient market
orientedtheories discussed earlier. Economic consequences is a concept that asserts (beweert) that,
despite the implications of ESMtheory, accounting policy choice can affect firm value (ESM states
that accounting policy choicedoesnt matter, only if the firms cash flows change, as investors would
see through the NI). Thisimplies that if they matter to management, they also matter for investors.
Example: the shift from decliningbalance to straightline amortization will not affect the firms
cashflows, but it will affect reported NI. Thus according to economic consequences, the accounting
policychange will matter, despite the lack of cash flow effects.The presence of economic
consequences raises the question of why they exist. To answer thisquestion, we begin with Positive
Accounting Theory. PAT attempts to predict what accountingpolicies managers will chose in order
to maximize the firms interest relative to contracts firms enter. Important paper about the
existence of economic consequences: Zeff (1978). He defines economicconsequences as the impact
of accounting reports on the decisionmaking behavior of business,government and creditors. The
essence is that accounting reports can affect the real decisions madeby managers and other, rather
than simply reflecting the results of these decisions.

So, despite the implications of ESMtheory, it appears that accounting policy choices haveeconomic
consequences for the various constituencies of financial statement users, even if thesepolicies do
not directly affect firm cash flows. Economic consequences complicate the setting ofaccounting
standards, which require delicate balancing of accounting and political considerations.

Example where economic consequences have been particularly apparent: employee stock
options(ESO). This is the accounting for stock options issued to management giving them the right to
buycompany stock over some time period. Until recently, APB 25 required to record an expense
equal to the difference between the marketvalue on the grantdate (toekenningsdatum) and the
exercise, or strike price, of the option. Thisdifference is called the intrinsic value of the option. Most
firms set the exercise price equal to thegrant date market value, so that the intrinsic value was zero
(and no expenses were recorded). Firmswere motivated to award with ESO, since this form of
compensation was free. Consequently, the FASB issued a draft that propose that firms record
compensation expense basedon the fair value at the grant date. This fair value can be determined by
the Black/Scholes model. Thiscreated a lot of opposition. Concerns were mainly expressed about the
economic consequences ofthe lower profits that would result.

The fair value of the ESO, hence the exante cost to the firm, is the expected present value of the ex

post costs. Recognizing these costs increases relevance, since future dividends per share will
bereduced to the extent dividends are diluted (verdund) over a number of shares. Problem: it is
verydifficult to measure these ESO expenses reliable. In order to know the fair value, you should
knowthe optimal strategy of an investor. Conclusion: ESO fair value estimates may be unreliable,
due both to upward bias and possible errorand bias in estimating the timing of employees early
exercise decisions in the face of wide variabilityof these decisions. The draft was dropped and a new
proposal suggested supplementary disclosure.
Manager tactics related to ESO: pump and dump, so increase share price and exercise your options
(and sell the shares)

before they drop again. Late timing, the backdating of ESO awards to a date when share price was
lower than at theactual ESO grant date. The common theme of these tactics is to increase the
likelihood that ESOs will be deepinthemoney. Now IFRS 2 requires expensing of ex ante ESO cost.
As expected, an economic consequence of ESOexpensing has been to greatly reduce the usage of
ESOs as a compensation device. Above example isa prime illustration that thirdparty intervention
greatly complicates the setting of accountingstandards.

The relationship between ESMtheory and economic consequences

(p. 303) ESM predicts no price reaction to accounting policy changes that do not impact
underlyingprofitability and cash flows. So, ESM implies the importance of full disclosure, including
disclosure ofaccounting policies. However, once full disclosure is made, the market will interpret the
value of thefirms securities in the light of the policies used and will not be fooled by variations in
reported netincome that arise solely from differences in accounting policies. The ESOexample
shows that accounting policy choice can matter, even in the absence of cash floweffects. Question:
does the existence of economic consequences reinforce the theory and evidencethat SM are not
fully efficient? Hence, more general theory that includes the existing theory but thatalso has the
potential to explain the inconsistent observations: Positive accounting theory (PAT). Positive refers
to a theory that attempts to make good predictions of realworld events.

PAT is concerned with predicting such actions as the choices of accounting policies by firmmanagers
and how managers will respond to proposed new accounting standards.

PAT takes the view that firms organize themselves in the most efficient manner so as to
maximizetheir prospects for survival. A firm can be viewed as a nexus of contracts, which all involve
accountingvariables (e.g. promotion may be based on NI, lenders look to liquidity etc.). So,
accounting choicedepends on the relating efficiency. PAT assumes that managers are rational (like
investors) and will choose accounting policies in theirown interest if able to do so. That is, managers
maximize their own expected utility. This leads to a tradeoff: on the one hand, tightly prescribing
accounting policies will minimizeopportunistic accounting policy by managers but incur costs of lack
of accounting flexibility to Meet changing circumstances; on the other hand, allowing the manager
to choose will reduce costsof accounting inflexibility but expose the firm to the costs of
opportunistic behavior. So, tradeoff between costs of accounting inflexibility and costs of
opportunistic behavior (efficiencyperspective and opportunistic
perspective).http://en.wikipedia.org/wiki/Positive_accountingThree hypotheses of PAT: 1) Bonus
plan hypothesis: managers of firms with bonus plans are more likely to chooseaccounting
procedures that shift reported earnings from future periods to the current

period. 2) The debt covenant (agreement) hypothesis: The closer a firm is to violation of accounting
based debtcovenants, the more likely the manager is to choose accounting procedures thatshift
reported earnings from future periods to the current period. 3) Political cost hypothesis: the greater
the political costs faced by a firm, the more likely themanager is to choose accounting procedures
that defer reported earnings from currentperiods to future periods. Conservatism leads to more
efficient debt contracting, but the extent to which is does is unclear.
Empirical PATresearch: much has been devoted to testing the implications of the three
hypotheses.Example: Healy (1985), who found evidence that managers of firms with bonus plans
based onreported NI systematically adopt their accrual policies so as to maximize their expected
bonuses. An effective way to reduce reported earnings in a hardtodetect manner is to manipulate
accounting

policies relating to accruals, mainly the discretionary accruals.

Total accruals can be determined by subtracting NI and operating cash flows. However, the
problemis to separate total accruals in discretionary and nondiscretionary components. P. 313:
example offormula to determine discretionary components. The three hypotheses above have been
stated in opportunistic form: that is, they assume thatmanagers choose accounting policies to
maximize their own expected utility relative to their givenremuneration and debt contract and
political costs. These hypotheses can also be stated in efficiency form. The hypotheses hereby are
still the same, soit is difficult to tell whether firms observed accounting policy choices are driven by
opportunism orefficiency.

To understand managements interests in financial reporting, it is necessary to appreciate

theconcept of economic consequences, namely that accounting policies do matter, and the role
ofpositive accounting theory (PAT) in explaining why they matter. PAT attempts to understand and
predict firms accounting policy choices.

Economic consequences: accounting policy choice affects firm value!

 Chapter 9: An analysis of conflict
Game theory can help us understand how managers, investors, and other affected parties
canrationally deal with the economic consequences of financial reporting. It attempts to model
andpredict the outcome of conflict between rational individuals. Two types of games: cooperative
and noncooperative

Noncooperative:

Conflicts between constituencies can be modelled as a game, since the decision needs of
differentconstituencies may not coincide. Nashequilibrium: p. 331

Cooperative:

Players in a conflict situation can enter into agreements that they perceive as binding: contracts.
Thissection discusses two types of contracts: employment contracts and lending contracts. Both are
forms of the agency theory. Agency theory is a branch of game theory that studies the design of
contracts to motivate a rationalagent to act on behalf of a principal when the agents interests
would otherwise conflict with thoseof the principal. Reservation utility: The minimum level of utility
that must be guaranteed by a contract to make itacceptable to an agent.In game theory, each player
chooses the act that maximizes his or her own expected utility(consistent with PAT). So, if a manager
chooses the same as the owner should do, it must be becauseof the managers expected utility is at
least as great for a1 as for a2. Besides, the manager is effortaverse. This means that the manager
dislikes effort and that thegreater the level of effort the greater the dislike. This is subtracted from
the utility of remuneration.

Designing a contract to control moral hazard

Direct monitoring: Pay 25 if a1 is taken, so that both the principal and the manager have
thehighest utility. However, due to information asymmetry, managerial effort is not directly

observable. Hence, this is not feasible Indirect monitoring Owner rents firm to the manager:
managers can hold the profit and only has to pay a fixedamount to the owner. This is referred to as
internalizing the managers decision problem. Give the manager a share of the profits: this is often
the most efficient alternative if the firstbest contract is not attainable. However, NI as a
performance indicator does not tell the fullstory about current manager performance (it is noisy).
Managers information advantage:Agents do have an information advantage over principals: pre
contract information, predecisioninformation and postdecision information
 Chapter 10: Executive compensation
An executive compensation plan is an agency contract between the firm and its manager
thatattempts to align the interests of owners and manager by basing the managers compensation
onone or more measures of the managers performance in operating the firm. Most used: NI and
share priceIt has a multiperiod orientation instead of a singleperiod as described in chapter 9.
Fama: managers have a reputation and the efficient manager labour market can properly value
thisreputation, so the manager will not shirk. Besides, there is internal control of lowerlevel
managers. A twoperiod contract with two riskaverse managers is more efficient then two single
periods. Thisis because when a manager can observe the others effort, shirking by either manager
will reduce thepayoff for both. Then each managers threatens the other that he/she will shirk in the
second periodif the other shirks in the first. However, while this ability to monitor each other reduce
agency costs, it cannot eliminate them, soincentive contracts are still needed. With respect to the
ability of manager reputation to control moral hazard, Famas argument does notconsider that the
manager may be able to disguise (vermommen) the effects of shirking, at least inthe short run, by
managing the release of information. So, the managerial labour market is stillsubject to adverse
selection as well as moral hazard. We conclude that while internal and market forces may help
control managers tendencies to shirk,they do not eliminate them. RBCcompensation: Short term
incentive awards, based on earnings and individual achievement Longterm stock options whose
value depends on share price performance Midterm awards whose value depends on bothAnalysis
of Holtstrom predicts that the efficiency of a compensation contract may be increased if it isbased
on two or more performance measures. Sensitivity (the rate at which the expected value of the
measure responds to manager effort) can beincreased by reduce the recognition lag (more of the
payoffs from manager effort show up in currentNI) or by full disclosure. NI creates shortterm
incentives, while share prices creates longterm incentives to invest in the firm.In this manner, you
can influence the managers decision horizon. This decision horizon must be traded off with the
sensitivity and precision of performance measures. If NI is congruent to the payoff, an increase of
E(NI) (= expected NI) will increase the expected payoff by X regardless of whether the increase in
expected NI comes from LR or SR or any combinationof the two. If this is the case, the owner can
design a contract that compensates the manager on thebasis of reported NI for the first period
without worrying about how the manager allocates effortbetween SR and LR. However, congruency
is unlikely to be the case (for example, due to recognition lag). How to commit to a multiperiod
contract? Replace NI with a more congruent performance measure (p. 395) such as share price.

However, share price is less precise than NI, so tradeoff

 Commit to a multiperiod contract ending on a fixed dateRisk has an important role in
compensation contract, as managers tradeoff risk and return. There are several ways to control
compensation risk, whereby the most important is relativeperformance evaluation (RPE). Instead of
measuring NI or share price, performance is measured bythe difference between the firms NI or
share price and a peer group. By doing this, the systematic /common risks that the industry faces
will be filtered out. Conservative accounting also controls upside risk by delaying unrealized gains.
To conclude, a mix of performance measures is desirable. ESO and companys share
encourageupsiderisk, while compensation based on NI downsides risk to discourage excessive risk
taking.

The politics of executive compensation

Are top managers overpaid?

It may be less than it seems at first glance

The power theory of executive compensation

This theory suggests that executive compensation in practice is driven by managerial

opportunism,not efficient contracting. Managers have enough power to influence their own
compensation andthey use this power to generate excessive pay at the expense of shareholder
value. The power theory predicts that executives use their power in the organization to
opportunisticallyincrease their compensation above competitive levels, thereby attaining more than
reservationutility.To reduce outrage at this behaviour, managers use a variety of devices, such as
hiring of outsideconsultants and comparison with peer groups, to camouflage their high
compensation.Regulators' mandating of increased disclosure of executive compensation helps to
counteractexcessive compensation.Example of power in action: backdating of ESO (there were in
themoney on the grant date)
 Chapter 12: standard setting economic issues
Standard setting is the regulation of firms external information production decisions by a
regulator.It is the establishment of various rules and regulations. Two types of information that a
manager may possess: Proprietary information: information that if it is released, it would directly
affect future cash

flows of the firms (technical information) Nonproprietary information: this does not directly affect
firms cash flowsQuantity of information produced can be strengthened by different ways of
information: Finer information (more details). In terms of the decision theory (chapter 3),
finerinformation means a better ability to discriminate between realizations of the states ofnature.
We can also think of the information approach to decision usefulness, as implyingfiner information
encourages elaboration of the financial statements proper by means of

MD&A and notes. Additional information: this can produce greater relevance (e.g. also include a
barometerinstead of just a thermometer) Credibility: the receiver knows that the supplier of
information has an incentive to disclosuretruthfully. Market failures that prevent firstbest
information production:1) Externalities and freeriding: crucial aspects is that the costs and benefits
of informationproduction as perceived by the firm differ from the costs and benefits to society. 2)
Adverse selection problem: insider trading (due to opportunistic behavior)