CONTENTS
1Introduction 1
1.1 The Objective of This Book 1
1.2 Some Historical Perspective 1
1.3 The 2007-2008 Market Meldowns 10
1.4 Efficient Contracting 16
1.5 A Note on Ethical Behaviour 18
1.6 Rules-Based versus Principles-Based Accounting Standards 20
1.7 The Complexity of Information in Financial Accounting and Reporting 21
1.8 The Role of Accounting Reasearch 21
1.9 The Importance of Information Asymmetry 22
1.10 The Fundamental Problem of Financial Accounting Theory 24
1.11 Regulation as a Reaction to the Fundamental Problem 26
1.12 The Organization of this Book 27
1.12.1 Ideal Conditions 27
1.12.2 Adverse Selection 27
1.12.3 Moral Hazard 28
1.12.4 Standard Setting 28
1.12.5 The Process of Stnadard Setting 29
1.13 Relevance of Financial Accounting Theory to Accounting Practice 32
2 Accounting Under Ideal Conditions 37
2.1 Overview 37
2.2 The Present Value Model Under Certainty 38
2.2.1 Summary 41
2.3 The Present Value Model Under Uncertainty 41
2.3.1 Summary 47
2.4 Examples of Present Value Accounting 48
2.4.1 Embedded Value 48
2.4.2 Reserve Recognition Accointing 49
2.4.3 Critique of RRA 52
2.4.4 Summary of RRA 56
2.5 Historical Cost Accointing Revisited 56
2.5.1 Comparison of Different Measurement Bases 56
2.5.2 Conclusion 58
2.6 The Non-Existence of True Net Income 58
2.7 Conclusion to Accointing Under Ideal Conditions 59
3 The Decision Usefulness Approach to Financial Reporting 72
3.1 Overvie 72
3.2 The Decision Usefulness Approach 73
3.2.1 Summary 74
3.3 Single-Person Decision Theory 74
3.3.1 Decision Theory Applied 74
3.3.2 The Information System 78
3.3.3 Information Defined 82
3.3.4 Summary 83
3.4 The Rational, Risk-Averse Investor 83
3.5 The Principle of Usefulness Diversification 85
3.6 Increasing the Desicion Usefulness of financial Reporting 87
3.6.1 Introduction 87
3.6.2 Objectives of Management Discussion and Analysis 88
3.6.3 An Example of MD&A Disclosure 89
3.6.4 Is MD&A Decision Useful? 99
3.6.5 Conclusion 101
3.7 The Reaction of Professional Accounting Bodies to the Desicion Usefulness Appoach 102
3.7.1 The Conceptual Framework 102
3.7.2 Summary 107
3.8 Conclusions on Desicion Usefulness 107
4 Efficient Securities Markets 120
4.1 Overview 120
4.2 Efficient Securities Markets 121
4.2.1 The Meaning of Efficiency 121
4.2.2 How Do Market Prices Fully Reflect All Available Information? 124
4.2.3 summary 126
4.3 Implications of Efficient Securities Markets for Financial Reporting 127
4.3.1 Implications 127
4.3.2 Summary 128
4.4 The Informativeness of Price 129
4.4.1 A Logical Inconsistency 129
4.4.2 Summary 132
4.5 A Model of Cost of Capital 132
4.5.1 A Capital Asset Pricing Model 132
4.5.2 Critique of the Capital Asset Pricing Model 135
4.5.3 Summary 137
4.6 Information Asymmetry 137
4.6.1 A Closer Look at Information Asymmetry 137
4.6.2 Fundamental Value 140
4.6.3 Summary 142
4.7 The Social Significante of Securities Markets that Work Well 143
4.8 Conclusions on Efficient Securities Markets 145
5 The Value Relevance od Accounting Information 153
5.1 Overiew 153
5.2 Outline of the Research Problem 154
5.2.1 Reasons for Market Response 154
5.2.2 Finding the Market Response 156
5.2.3 Separating Market-Wide and Firm-Specific Factors 156
5.2.4 Comparing Returns and Income 157
5.3 The Ball and Brown Study 159
5.3.1 Methodology and Findings 159
5.3.2 Causation Versus Association 160
5.3.3 Outcomes of the BB Study 162
5.4 Earnings Response Coefficients 163
5.4.1 Reasons for Differential Market Responce 163
5.4.2 Implications of ERC Research 169
5.4.3 Measuring Investors´ Earnings Expectations 170
5.4.4 Summary 172
5.5 A Caveat about the "Best" Accounting Policy 173
5.6 The Value Relevance of Other Financial Statement Information 174
5.7 Conclusions on Value Relevance 176
6 The Measurement Approach to Decision Usefulness 189
6.1 Overiew 189
6.2 Are Securities Markets Fully Efficient? 191
6.2.1 Introduction 191
6.2.2 Prospect Theory 194
6.2.3 Is Beta Dead? 197
6.2.4 Excess Stock Market Volatility 199
6.2.5 Stock Market Bubbles 200
6.2.6 Discussion of Securities Market Efficiency Versus Behavioural Finances 200
6.3 Efficient Securities Market Anomalies 202
6.4 Limits to Arbitrage 206
6.5 A Defence of Average Investor Rationality 209
6.5.1 Dropping Rational Expectations 209
6.5.2 Dropping Cmmon Knowledg 211
6.6 Summary re Securities Market Inefficiencies 215
6.7 Conclusions About Securities Martek Efficiency and Investor Rationality 216
6.8 Other Reasons Suppoting a Measurement Approach 219
6.9 The Low Value Relevance of Financial Statement Information 219
6.10 Ohlson´s Clean Surplus Theory 221
6.10.1 Three Formulae for Firm Value 221
6.10.2 Earnings Persistence 225}
6.10.3 Estimating Firm Value 227
6.10.4 Empirical Studies of the Clean Surplus Model 230
6.10.5 Summary 233
6.11 Auditors´ Legal Liability 233
6.12 Asymmetry of Investor Losses 236
6.13 Conclusions on the Measurement Approach to Decision Usefulness 241
7 Measurement Applications 252
7.1 Overview 252
7.2 Current Value Accounting 253
7.2.1 Two Versions of Current Value Accounting 253
7.2.2 Current Value Accounting and the Income Statement 255
7.2.3 Summary 256
7.3 Longstanding Measurement Examples 256
7.3.1 Accounts Receivable and Payable 256
7.3.2 Cash Flows Fixed by Contract 256
7.3.3 The Lower-of-Cost-or-Market Rule 257
7.3.4 Revaluation Option for Property, Plant, and Equipment 258
7.3.5 Impairment Test for Property, Plant, and Equipment 258
7.3.6 Summary 259.
7.4 Financial Instruments Defined 259
7.5 Primary Financial Instruments 259
7.5.1 Standard Setters Back Down Somewhat on Fair Value Accounting 259
7.5.2 Longer-Run Changes to Fair Value Accounting 261
7.5.3 The Fair Value Option 262
7.5.4 Loan Loss Provisioning 264
7.5.5 Summary and Conclusions 266
7.6 Fair Value Versus Historical Cost 267
7.7 Liquidity Risk and Financial Reporting Quality 270
7.8 Derecognition and Consolidation 271
7.9 Derivative Financial Instruments 275
7.9.1 Characteristics of Derivatives 275
7.92 Hedge Accounting 278
7.10 Conclusions on Accounting for Financial Instruments 281
7.11 Accounting for Intangibles 282
7.11.1 Introduction 282
7.11.2 Accounting for Purchased Goodwill 283
7.11.3 Self-Developed Goodwill 287
7.11.4 The Clean Surplus Model
Revisited 289
7.11.5 Summary 289
7.12 Reporting on Risk 290
7.12.1 Beta Risk 290
7.12.2 Why Do Firms Manage Firm- Specific Risk? 291
7.12.3 Stock Market Reaction to Other Risks 292
7.12.4 A Measurement Approach to Risk Reporting 294
7.12.5 Summary 297
7.13 Conclusions on Measurement Applications 297
8 The Efficient Contracting Approach to Decision Usefulness 311
8.1 Overview 311
8.2 What Is Efficient Contracting Theory? 313
8.3 Sources of Efficient Contracting Demand for Financial Accounting Information 314
8.3.1 Lenders 314
8.3.2 Shareholders 314
8.4 Accounting Policies for Efficient Contracting 315
8.4.1 Reliability 315
8.4.2 Conservatism 316
8.5 Contract Rigidity 318
8.6 Employee Stock Options 322
8.7 Discussion and Summary of ESO Expensing 329
8.8 Distinguishing Efficiency and Opportunism in Contracting 330
8.9 Summary of Efficient Contracting for Debt and Stewardship 334
8.10 Implicit Contracts 335
8.10.1 Definition and Empirical Evidence 335
8.10.2 A Single-Period Non- Cooperative Game 336
8.10.3 A Trust-Based Multi-Period Game 340
8.10.4 Summary of Implicit Contracting 344
8.11 Summary of Efficient Contracting 344
9 An Analysis of Conflict 357
9.1 Overview 357
9.2 Agency Theory 358
9.2.1 Introduction 358
9.2.2 Agency Contracts Between Firm Owner and Manager 359
9.3 Manager's Information Advantage 369
9.3.1 Earnings Management 369
9.3.2 The Revelation Principle 371
9.3.3 Controlling Earnings Management 373
9.3.4 Agency Theory with Psychological Norms 375
9.4 Discussion and Summary 378
9.5 Protecting Lenders from Manager Information Advantage 379
9.6 Implications of Agency Theory for Accounting 383
9.6.1 Is Two Better Than One? 383
9.6.2 Rigidity of Contracts 387
9.7 Reconciliation of Efficient Securities Market Theory with Economic Consequences 388
9.8 Conclusions on the Analysis of Conflict 389
10 Executive Compensation 403
10.1 Overview 403
10.2 Are Incentive Contracts Necessary! 404
10.3 A Managerial Compensation Plan 407
10.4 The Theory of Executive Compensation 409
10.4.1 The Relative Proportions of Net Income and Share Price in Evaluating Manager Performance 409
10.4.2 Short-Run Effort and Long- Run Effort 412
10.4.3 The Role of Risk in Executive Compensation 415
10.5 Empirical Compensation Research 420
10.6 The Politics of Executive Compensation 422
10.7 The Power Theory of Executive Compensation 428
10.8 The Social Significance of Managerial Labour Markets that Work Well 431
10.9 Conclusions on Executive Compensation 432
11 Earnings Management 444
11.1 Overview 444
11.2 Patterns of Earnings Management 447
11.3 Evidence of Earnings Management for Bonus Purposes 448
11.4 Other Motivations for Earnings Management 454
11.4.1 Other Contracting Motivations 454
11.4.2 To Meet Investors' Earnings Expectations 455
11.4.3 Stock Offerings 457
11.5 The Good Side of Earnings Management 458
11.5.1 Blocked Communication 459
11.5.2 Empirical Evidence of Good Earnings Management 461
11.6 The Bad Side of Earnings Management 465
11.6.1 Opportunistic Earnings Management 465
11.6.2 Do Managers Accept Securities Market Efficiency? 469
11.6.3 Analyzing Managers' Speech to Detect Bad Earnings Management 471
11.6.4 Implications for Accountants 472
11.7 Conclusions on Earnings Management 472
12 Standard Setting: Economic Issues 487
12.1 Overview 487
12.2 Regulation of Economic Activity 489
12.3 Ways to Characterize Information Production 490
12.4 First-Best Information Production 491
12.5 Market Failures in the Production of Information 492
12.5.1 Externalities and Free-Riding 492
12.5.2 The Adverse Selection Problem 493
12.5.3 The Moral Hazard Problem 493
12.5.4 Unanimity 493
12.6 Contractual Incentives for Information Production 494
12.6.1 Examples of Contractual Incentives 494
12.6.2 The Coase Theorem 495
12.7 Market-Based Incentives for Information Production 497
12.8 A Closer Look at Market-Based Incentives 497
12.8.1 The Disclosure Principle 497
12.8.2 Empirical Disclosure Principle Research 499
12.8.3 Signalling 503
12.8.4 Private Information: Search 505
12.9 Are Firms Rewarded for Superior Disclosure? 506
12.9.1 Theory 506
12.9.2 Empirical Tests of Measures of Reporting Quality 509
12.9.3 Is Estimation Risk Diversifiable? 511
12.9.4 Conclusions 513
12.10 Decentralized Regulation 514
12.11 How Much Information Is Enough? 516
12.12 Conclusions on Standard Setting Related to Economic Issues 519
13 Standard Setting: Political Issues 530
13.1 Overview 530
13.2 Two Theories of Regulation 532
13.2.1 The Public Interest Theory 532
13.2.2 The Interest Group Theory 532
13.2.3 Which Theory of Regulation Applies to Standard Stting? 535
13.3 Confict and Compromise:an Example of Constituency Conflic 535
13.4 Distribution of the Benefits of Information,Regulation FD 536
13.5 Criteria for Standard Setting 538
13.5.1 Desicion Usefulness 538
13.5.2 Reduction of Information Asymmetry 539
13.5.3 Economic Consequences of New Standards 540
13.5.4 Consensus 540
13.5.5 Summary 541
13.6 The Regulator´s Information Asymmetry 541
13.7 Standard Setting: Political Issues 530
13.7.1 Convergence of Accounting Standards 546
13.7.2 Effects of Customs and Institutions on Financial Reporting 548
13.7.3 Enforcement of Accounting Stadards 550
13.7.4 Benefits of Adopting High-Quality Accounting Standards 551
13.7.5 The Realative Quality of IASB and FASB GAAP 554
13.7.6 Should Standard Setters Compete? 55
13.7.7 Sholud the Unite States Adopt IASB Standards? 556
13.7.8 Summary of Accounting for International Capital Markets Intregration 558
13.8 Conclusions and Summing Up 558