Financial Accounting Theory (PDF)

Brief Contents 1 Introduction 1 2 Accounting Under Ideal Conditions 38 3 The Decision-usefulness Approach to Financial Reporting 73 4 Efficient Securities Markets 120 5 The Value Relevance of Accounting Information 153 6 The Valuation Approach to Decision Usefulness 190 7 Valuation...

Brief Contents 1 Introduction 1 2 Accounting Under Ideal Conditions 38 3 The Decision-usefulness Approach to Financial Reporting 73 4 Efficient Securities Markets 120 5 The Value Relevance of Accounting Information 153 6 The Valuation Approach to Decision Usefulness 190 7 Valuation Applications 253 8 Efficient Contracting Theory and Accounting 312 9 An Analysis of Conflict 361 10  Executive Compensation 406 11 Earnings Management 447 12 Standard Setting: Economic Issues 492 13 Standard Setting: Political Issues 537 Contents Preface xv 1.12.4 Standard Setting 28 Acknowledgments xix 1.12.5 The Process of Standard About the Authors xxi Setting 29 1.13 Relevance of Financial 1 Introduction 1 Accounting Theory 1.1 The Objective of This Book 1 to Accounting Practice 32 1.2 Some Historical Perspective 1 1.3 The 2007–2008 Market 2 Accounting Under Ideal Meltdowns 11 Conditions 38 1.4 Efficient Contracting 16 2.1 Overview 38 1.5 A Note on Ethical Behaviour 19 2.2 The Present Value Model Under Certainty 39 1.6 Rules-Based Versus Principles-Based Accounting 2.2.1 Summary 42 Standards 20 2.3 The Present Value Model 1.7 The Complexity of Under Uncertainty 42 Information in Financial 2.3.1 Summary 48 Accounting and 2.4 Examples of Present Value Reporting 21 Accounting 49 1.8 The Role of Accounting 2.4.1 Embedded Value 49 Research 22 2.4.2 Reserve Recognition 1.9 The Importance of Accounting 50 Information Asymmetry 23 2.4.3 Critique of RRA 54 1.10 The Fundamental Problem 2.4.4 Summary of RRA 57 of Financial Accounting 2.5 Historical Cost Accounting Theory 24 Revisited 57 1.11 Regulation as a Reaction to 2.5.1 Comparison of Different the Fundamental Problem 26 Measurement Bases 57 1.12 The Organization of This 2.5.2 Conclusion 59 Book 27 2.6 The Non-existence of True 1.12.1 Ideal Conditions 27 Net Income 59 1.12.2 Adverse Selection 28 2.7 Conclusion to Accounting 1.12.3 Moral Hazard 28 Under Ideal Conditions 60  3 The Decision-usefulness 3.8 Conclusions on Decision Approach to Financial Usefulness 106 Reporting 73 3.1 Overview 73 4 Efficient Securities 3.2 The Decision-usefulness Markets 120 Approach 74 4.1 Overview 120 3.2.1 Summary 75 4.2 Efficient Securities 3.3 Single-person Decision Markets 121 Theory 75 4.2.1 The Meaning 3.3.1 Decision Theory of Efficiency 121 Applied 75 4.2.2 How Do Market Prices 3.3.2 The Information Fully Reflect All Available System 79 Information? 124 3.3.3 Information Defined 83 4.2.3 Summary 127 3.3.4 Summary 84 4.3 Implications of Efficient 3.4 The Rational, Risk-averse Securities Markets Investor 84 for Financial Reporting 127 3.5 The Principle of Portfolio 4.3.1 Implications 127 Diversification 86 4.3.2 Summary 129 3.6 Increasing the Decision- 4.4 The Informativeness usefulness of Financial of Price 130 Reporting 88 4.4.1 A Logical 3.6.1 Introduction 88 Inconsistency 130 3.6.2 Objectives of Management 4.4.2 Summary 132 Discussion and 4.5 A Model of Cost Analysis 88 of Capital 133 3.6.3 An Example of MD&A 4.5.1 A Capital Asset Pricing Disclosure 90 Model 133 3.6.4 Is MD&A Decision- 4.5.2 Critique of the Capital useful? 97 Asset Pricing Model 136 3.6.5 Conclusion 99 4.5.3 Summary 137 3.7 The Reaction of Professional 4.6 Information Asymmetry 137 Accounting Bodies to the 4.6.1 A Closer Look Decision-usefulness at Information Approach 99 Asymmetry 137 3.7.1 The Conceptual 4.6.2 Fundamental Value 140 Framework 99 4.6.3 Summary 142 3.7.2 Summary 106 viii Contents 4.7 The Social Significance of 5.6 The Value Relevance of Other Securities Markets that Work Financial Statement Well 142 Information 176 4.8 Conclusions on Efficient 5.7 Conclusions on Value Securities Markets 144 Relevance 177 5 The Value Relevance of 6 The Valuation Approach to Accounting Information 153 Decision Usefulness 190 5.1 Overview 153 6.1 Overview 190 5.2 Outline of the Research 6.2 Behavioural Finance v. Market Problem 154 Efficiency and Investor 5.2.1 Reasons for Market Rationality 192 Response 154 6.2.1 Introduction to 5.2.2 Finding the Market Behavioural Finance 192 Response 156 6.2.2 Prospect Theory 195 5.2.3 Separating Market-wide 6.2.3 Validity of Beta as the Sole and Firm-specific Risk Measure 198 Factors 157 6.2.4 Excess Stock Market 5.2.4 Comparing Returns Volatility 199 and Income 158 6.2.5 Stock Market Bubbles 200 5.3 The Ball and Brown 6.2.6 Summary 201 Study 159 6.3 Efficient Securities Market 5.3.1 Methodology Anomalies 201 and Findings 159 6.4 Limits to Arbitrage 205 5.3.2 Causation Versus 6.5 A Defence of Average Investor Association 160 Rationality 208 5.3.3 Outcomes of the BB 6.5.1 Dropping Rational Study 162 Expectations 208 5.4 Earnings Response 6.5.2 Dropping Common Coefficients 163 Knowledge 210 5.4.1 Reasons for Differential 6.6 Summary of Challenges Market Response 163 to Securities Market 5.4.2 Implications of ERC Efficiency 213 Research 169 6.7 Conclusions About Securities 5.4.3 Measuring Investors’ Market Efficiency and Investor Earnings Expectations 170 Rationality 215 5.4.4 Summary 174 6.8 The Low Value-Relevance 5.5 A Caveat about the “Best” of Financial Statement Accounting Policy 174 Information 218 Contents ix  6.9 Ohlson’s Clean Surplus 7.3.5 Impairment Test Theory 220 for Property, Plant, 6.9.1 Three Formulae for Firm and Equipment 259 Value 220 7.3.6 Summary 261 6.9.2 Earnings Persistence 224 7.4 Financial Instruments 6.9.3 Estimating Firm Defined 261 Value 226 7.5 Primary Financial 6.9.4 Empirical Studies Instruments 261 of the Residual 7.5.1 Standard Setters Back Income Model 229 Down Somewhat on Fair 6.9.5 Summary 231 Value Accounting 261 6.10 Auditors’ Legal Liability 231 7.5.2 Longer-run Changes to 6.11 Demand for Conditional Fair Value and Unconditional Accounting 262 Conservatism 234 7.5.3 The Fair Value Option 264 6.12 Conclusions on the Valuation 7.5.4 Loan Loss Approach to Decision Provisioning 266 Usefulness 240 7.5.5 Summary and Conclusions 267 7 Valuation Applications 253 7.6 Fair Value Versus Historical Cost 268 7.1 Overview 253 7.7 Liquidity Risk and Financial 7.2 Current Value Reporting Quality 272 Accounting 254 7.8 Derecognition 7.2.1 Two Versions of Current and Consolidation 273 Value Accounting 254 7.9 Derivative Financial 7.2.2 Current Value Accounting Instruments 276 and the Income 7.9.1 Characteristics Statement 256 of Derivatives 276 7.2.3 Summary 257 7.9.2 Hedge Accounting 279 7.3 Longstanding Valuation Examples 257 7.10 Conclusions on Accounting for Financial 7.3.1 Accounts Receivable Instruments 283 and Payable 257 7.11 Accounting for 7.3.2 Cash Flows Fixed Intangibles 283 by Contract 257 7.11.1 Introduction 283 7.3.3 The Lower-of-Cost-or- 7.11.2 Accounting for Purchased Market Rule 258 Goodwill 284 7.3.4 Revaluation Option 7.11.3 Self-developed for Property, Plant, Goodwill 287 and Equipment 258 x Contents  7.11.4 The Residual Income 8.9 Summary of Efficient Model Revisited 289 Contracting for Debt 7.11.5 Summary 290 and Stewardship 337 7.12 Reporting on Risk 290 8.10 Implicit Contracts 338 7.12.1 Beta Risk 290 8.10.1 Definition and Empirical 7.12.2 Why Do Investors Care Evidence 338 about Firm-specific 8.10.2 A Single-period Non- Risk? 292 cooperative Game 339 7.12.3 Stock Market Reaction 8.10.3 A Trust-Based Multi-period to Other Risks 292 Game 343 7.12.4 A Valuation Approach 8.10.4 Summary of Implicit to Risk Reporting 294 Contracting 348 7.12.5 Summary 297 8.11 Summary of Efficient 7.13 Conclusions on Valuation Contracting 348 Applications 298 9 An Analysis 8 Efficient Contracting of Conflict 361 Theory and 9.1 Overview 361 Accounting 312 9.2 Agency Theory 362 8.1 Overview 312 9.2.1 Introduction 362 8.2 Efficient Contracting Theory 9.2.2 Agency Contracts Between and Accounting 314 Firm Owner and 8.3 Sources of Efficient Contracting Manager 363 Demand for Financial 9.3 Manager’s Information Accounting Information 315 Advantage 373 8.3.1 Lenders 315 9.3.1 Earnings 8.3.2 Shareholders 316 Management 373 8.4 Accounting Policies 9.3.2 The Revelation for Efficient Contracting 316 Principle 374 8.4.1 Reliability 316 9.3.3 Controlling Earnings 8.4.2 Conservatism 317 Management 376 8.5 Contract Rigidity 321 9.3.4 Agency Theory with 8.6 Employee Stock Options 325 Psychological Norms 378 8.7 Discussion and Summary 9.4 Discussion and Summary 381 of ESO Expensing 332 9.5 Protecting Lenders from 8.8 Distinguishing Efficiency Manager Information and Opportunism Advantage 382 in Contracting 333 Contents xi  9.6 Implications of Agency Theory 10.9 Conclusions on Executive for Accounting 386 Compensation 435 9.6.1 Are Two Better Than One? 386 11 Earnings Management 447 9.6.2 Rigidity of Contracts 390 11.1 Overview 447 9.7 Reconciliation of Efficient Securities Market Theory 11.2 Patterns of Earnings with Economic Management 450 Consequences 391 11.3 Evidence of Earnings 9.8 Conclusions on the Analysis Management for Bonus of Conflict 392 Purposes 451 11.4 Other Motivations for Earnings 10 Executive Management 457 Compensation 406 11.4.1 Other Contracting 10.1 Overview 406 Motivations 457 10.2 Are Incentive Contracts 11.4.2 Meeting Investors’ Earnings Necessary? 407 Expectations 459 10.3 A Managerial Compensation 11.4.3 Stock Offerings 460 Plan 410 11.4.4 To Hide Behind Error 10.4 The Theory of Executive “Camouflage” 462 Compensation 412 11.5 The Good Side of Earnings 10.4.1 The Relative Proportions Management 463 of Net Income and Share 11.5.1 Blocked Price in Evaluating Communication 463 Manager Performance 412 11.5.2 Empirical Evidence 10.4.2 Short-run Effort of Good Earnings and Long-run Effort 415 Management 466 10.4.3 The Role of Risk 11.6 The Bad Side of Earnings in Executive Management 469 Compensation 418 11.6.1 Opportunistic Earnings 10.5 Empirical Compensation Management 469 Research 423 11.6.2 Empirical Evidence 10.6 The Politics of Executive of Bad Earnings Compensation 425 Management 471 10.7 The Power Theory 11.6.3 Do Managers Accept of Executive Securities Market Compensation 430 Efficiency? 472 10.8 The Social Significance 11.6.4 Analyzing Managers’ of Managerial Labour Markets Speech to Detect Bad that Work Well 435 Earnings Management 475 xii Contents  11.6.5 Management Choices 12.8.2 Signalling 505 Among Earnings 12.8.3 Private Information Management Methods 476 Search 508 11.6.6 Implications for 12.9 Are Firms Rewarded Accountants 477 for Superior Disclosure? 509 11.7 Conclusions on Earnings 12.9.1 Theory 509 Management 477 12.9.2 Empirical Tests of Reporting Quality 512 12 Standard Setting: 12.9.3 Is Estimation Risk Economic Issues 492 Diversifiable? 515 12.10 Decentralized 12.1 Overview 492 Regulation 518 12.2 Regulation of Economic 12.11 How Much Information Activity 494 Is Enough? 520 12.3 Ways to Characterize 12.12 Conclusions on Standard Information Production 495 Setting Related to Economic 12.4 First-Best Information Issues 525 Production 496 12.5 Market Failures in the Production 13 Standard Setting: Political of Information 496 Issues 537 12.5.1 Externalities and Free- 13.1 Overview 537 Riding 497 13.2 Two Theories 12.5.2 The Adverse Selection of Regulation 539 Problem 497 13.2.1 The Public Interest 12.5.3 The Moral Hazard Theory 539 Problem 498 13.2.2 The Interest Group 12.5.4 Unanimity 498 Theory 539 12.6 Contractual Incentives 13.2.3 Which Theory for Information of Regulation Applies Production 499 to Standard setting? 542 12.6.1 Examples of Contractual 13.3 Conflict and Compromise: Incentives 499 An Example of Constituency 12.6.2 The Coase Theorem 500 Conflict 542 12.7 Market-Based Incentives 13.4 Distribution of the Benefits for Information of Information, Regulation Production 502 FD 543 12.8 A Closer Look at Market- 13.5 Criteria for Standard Based Incentives 502 Setting 546 12.8.1 The Disclosure 13.5.1 Decision Usefulness 546 Principle 502 Contents xiii  13.5.2 Reduction of Information 13.7.5 Does Adopting High Asymmetry 547 Quality Accounting 13.5.3 Economic Consequences Standards Improve of New Standards 548 Financial Statement 13.5.4 Consensus 548 Comparability? 563 13.5.5 Summary 549 13.7.6 Effects of IFRS Adoption 13.6 The Regulator’s Information on Contract Asymmetry 549 Efficiency 564 13.7 International Integration of 13.7.7 Conclusion on the Benefits Capital Markets 554 of IFRS Adoption 565 13.7.1 Convergence of 13.8 Should the United States Accounting Standards 554 Adopt IASB Standards? 565 13.7.2 Effects of Customs and 13.9 Summary of Accounting for Institutions on Financial International Capital Markets Reporting 556 Integration 567 13.7.3 The Role of Auditing in 13.10 Conclusions and Summing Protecting Small Investors Up 568 in Developing Economies 558 13.7.4 Does Adopting High Bibliography 583 Quality Accounting Index 607 Standards Improve Financial Reporting Quality? 560 xiv Contents Preface This book began as a series of lesson notes for a financial accounting theory course of the Certified General Accountants’ Association of Canada (CGA). The lesson notes grew out of a conviction that we have learned a great deal about the role of financial accounting and reporting in our society from securities markets and information economics-based research conducted over many years, and that financial accounting theory comes into its own when we formally recognize the information asymmetries that pervade business ­relationships. The challenge was to organize this large body of research into a unifying framework and to explain it in such a manner that professionally oriented students would both under- stand and accept it as relevant to the financial accounting environment and, ultimately, to their own professional careers. This book seems to have largely achieved its goals. In addition to being part of the CGA program of professional studies for a number of years, it has been extensively used in financial accounting theory courses at the University of Waterloo, Queen’s University, and numerous other national and international universities, both at the senior undergraduate and professional master’s levels. We are encouraged by the fact that, by and large, students accept the material, and may object if the instructor follows it too closely in class. This frees up class time to expand coverage of areas of interest to individual instructors and/or to motivate interest in particular topics by means of articles from the financial press and professional and academic literature. Despite its theoretical orientation, the book does not ignore the institutional structure of financial accounting and standard-setting. It features considerable coverage and critical evaluation of financial accounting standards and regulations, such as fair value accounting, financial instruments, reserve recognition accounting, management discussion and analy- sis, employee stock options, impairment tests, hedge accounting, derecognition, consolida- tion, and comprehensive income. The structure of standard-setting bodies is also described, and the role of structure in helping to engineer the consent necessary for a successful standard is evaluated. While the text discussion concentrates on relating standards to the theoretical framework of the book, the coverage provides students with exposure to the main features of the standards themselves. This material has also been successfully used in Ph.D. seminars, concentrating on the research articles that underlie the text discussion. Students appreciate the framework of the book as a way of putting specific research papers into perspective. Indeed, the book proceeds in large part by selecting important research papers for description and commen- tary and provides extensive references to other research papers underlying the text discus- sion. Assignment of the research papers themselves could be especially useful for instructors  who wish to dig into methodological issues that, with some exceptions, are downplayed in the book itself. This edition continues to orient the coverage of accounting standards to those of the International Accounting Standards Board (IASB). As in previous editions, some coverage of major U.S. accounting standards is also included. We have retained the outline of the events leading up to the 2007–2008 securities- market meltdowns since these events raised significant questions about the validity of many economic models and continue to have significant accounting implications. Ramifications of these events are interwoven throughout the book. For example, one outcome of the meltdowns is severe criticism of the efficient market hypothesis. Nevertheless, we continue to maintain that investors are, on average, rational and that securities markets in developed economies, while not fully (semi-strong) efficient, are sufficiently close to efficiency (except during periods of bubble and subsequent liquidity pricing) that the implications of the theory continue to be relevant to financial reporting. Critical evaluation of these various criticisms and arguments is given. The 2018 IASB Conceptual Framework is an important component of this book. Over time, it will be an important aspect of the financial accounting environment. Its relation- ships to the theory developed here are critically evaluated. While we retain extensive discussion of alternate theories of investor behaviour, this book continues to regard the theory of rational investors as important to helping accountants prepare useful financial statement information. The book continues to maintain that motivating responsible manager behaviour and improving the working of managerial labour markets is an equally important role for finan- cial reporting in a markets-oriented economy as enabling good investment decisions and improving the working of securities markets. We have updated references and discussion of recent research articles, revised the exposition as a result of comments received about earlier editions, and added some new problem material. We also continue to suggest optional sections for those who do not wish to delve too deeply into certain topics. What’s New Below is a comprehensive list of major changes made to the eighth edition of Financial Accounting Theory: The text reviews recent academic accounting research, with updated explanations and discussion of important papers added throughout the text. The text represents the current state of accounting-related theories, as published in major research journals up to about mid-2018. xvi Preface  We have revised all chapters to improve the understandability of the exposition, dis- carding some redundant material, and further clarifying the discussion of numerous topics. The coverage of the Conceptual Framework (Chapter 3) has been updated to the 2018 IASB version, with references to it incorporated throughout the text. We have also updated references to new accounting standards (Chapter 7), several of which were at the exposure draft stage in the seventh edition. We have added numerous real-world examples to illustrate the theory. These are mostly Theory in Practice vignettes with some related problem material. They include Toshiba Corp. (Chapter 1), Home Capital Group (Chapters 3, 4, 6), vulture funds (Chapter 3), SEC EDGAR (Chapter 4), Inco. Ltd. (Chapter 7), Broadwind Energy Inc. (Chapter 7), Health South Corp. (Chapter 10), Barrick Gold Corp. (Chapter 10), Valeant Pharmaceuticals (Chapter 11). Theory in Practice vignette 3.2, regarding evidence that tone of MD&A predicts future earnings, is rewritten to bring out artificial intelligence implications. Additional examples of computerized textual analysis are added, including of analyst written reports (Chapter 5), effects of tone and sentiment on attribute framing (Chapter 6), and qualitative statements in earnings announcements (Chapter 12). We have updated problem material, changed numerical solutions, and added new problems. The discussion and illustration of reserve recognition accounting (Chapter 2), management discussion and analysis (Chapter 3), and the RBC compensation plan (Chapter 10) are updated. Users of previous editions should take note that we have updated some terminology, adopting wording that we believe will be more easily understood. The most important is the change from “measurement approach” to “valuation approach,” when referring to the standard-setting approach that emphasizes current values (Chapter 7). In addition, we previously used the term “clean surplus” to describe both Ohlson’s (1995) theoretical model and various valuation techniques that derive from it (Chapter 6). In this edition, we use “residual income” for the valuation techniques. We have also replaced the term “late tim- ing” with “backdating” in relation to employee stock options (Chapter 8). Preface xvii  FEATURES Theory in Practice: These vignettes provide real-world cases that illustrate the ­theoretical concepts. Some are pursued further in end-of-chapter Questions and Problems. Examples: Numerical examples with detailed commentary about the method of ­solution make the theory more concrete, reinforcing students’ learning. Figures: Each chapter begins with a schematic figure. The figure at the start of Chapter 1 shows the design of the book, and each subsequent chapter starts with a figure showing the design of that chapter. Questions and Problems: Each chapter except Chapter 1 ends with questions and problems that allow students to test, and sometime extend, their understanding of the chapter’s contents. xviii Preface Acknowledgments We have received a lot of assistance in writing this book. We thank CGA Canada (now part of CPA Canada) for its encouragement and support over the past years. Bill ­acknowledges the financial assistance of the Ontario Chartered Accountants’ Chair in Accounting at the University of Waterloo, which enabled teaching relief and other ­support in the preparation of the original manuscript, as well as financial support of the School of Business of Queen’s University and the EY professorship at the University of Waterloo. Pat acknowledges funding from The University of Waterloo School of ­Accounting and Finance. We extend our thanks and appreciation to the following instructors, who provided formal reviews for this eighth edition: Hilary Becker Carleton University Harjinder Deol Mount Royal University University of Lethbridge Southern Alberta Institute of Technology Irene M. Gordon Simon Fraser University Duane Kennedy University of Waterloo Camillo Lento Lakehead University Janet Morrill University of Manitoba Mary Oxner St. Francis Xavier University Barbara Wyntjes Kwantlen Polytechnic University Jenny Zhang Dalhousie University We also thank numerous colleagues and students for advice and feedback. These include Sati Bandyopadhyay, Jean-Etienne De Bettignies, Phelim Boyle, Kareen Brown,  Dennis Chung, Len Eckel, Haim Falk, Steve Fortin, Irene Gordon, Jennifer Kao, James A. Largay, David Manry, Bill Richardson, Gordon Richardson, Dean Smith, Dan T ­ hornton, Kevin Veenstra, and Mike Welker. Enduring thanks to (the late) Alex Milburn for invalu- able assistance in understanding IASB standards, and to Dick Van Offeren for helpful comments and support on previous editions of this work. We thank the large number of researchers whose work underlies this book in our descriptions and discussions of research papers. We have not referenced many other worthy papers. This implies no disrespect or lack of appreciation for the contributions of these authors to financial accounting theory. Rather, it is simply impossible to include them all, both for reasons of space and the boundaries of our own knowledge. Bill remains grateful to Carolyn Holden for skilful, timely, and cheerful typing of the original manuscript in the face of numerous revisions, and to Jill Nucci for very valuable assistance on previous editions. At Pearson Canada, we would like to thank Anne Williams, Vice-President, Editorial Director; Keara Emmett, Portfolio Managers; Madhu Ranadive, Content Manager; Cheryl Finch, Content Developer; Ainsley Somerville, Project Manager; and Darcy Pepper, ­Marketing Manager. Finally, we thank our families, who, in many ways, have been involved in the learning process leading to this book. William Scott Patricia O’Brien xx Acknowledgments About the Authors William Scott received his B. Comm. from Carleton University, and his M.B.A and Ph.D. from the School of Business, University of Chicago. He is a Fellow of Chartered Professional Accountants Ontario. His research has been published in the Journal of Accounting Research, Contemporary Accounting Research, Journal of Business Finance & Accounting, and several other academic journals. He has served on the editorial boards of Journal of Accounting Research, Contemporary Accounting Research, and The ­Accounting Review; and served a term as Editor of Contemporary Accounting Research. Professor Scott received the 1988 CAAA Award for Distinguished Contribution to Accounting Thought and the CAAA 2005 L.S. Rosen Award for Outstanding Contribution to Canadian Accounting Education. He has taught at Carleton University, University of Chicago, Queen’s University at Kingston, University of British Columbia, and University of Waterloo and is now Distinguished Emeritus Professor at University of Waterloo. Patricia C. O’Brien is the EY Professor at the School of Accounting & Finance, U ­ niversity of Waterloo. Her research, on topics concerning financial analysts, financial reporting standards, and information in capital markets, is published in many of the premier accounting journals. In 2009, Professor O’Brien received the CAAA Haim Falk Award for Distinguished Contribution to Accounting Thought. She currently serves on the Academic Advisory Council to C ­ anada’s Accounting Standards Board. She has served as Editor-in-Chief of Contemporary Accounting Research (CAR), and on the editorial boards of CAR, the Journal of Accounting Research, The Accounting Review, and the Journal of Accounting and Public Policy. She holds an A.B. degree cum laude in mathematics from Cornell University, and earned her M.B.A. and Ph.D. degrees at the University of Chicago. Prior to joining Waterloo, P­ rofessor O’Brien was a faculty member at the University of Rochester, Massachusetts Institute of Technology, the University of Michigan, London Business School, and York University. She has held visiting appointments at the Helsinki School of Economics, the University of Chicago, Stanford University, and the University of Amsterdam, as well as in the Office of the Chief Economist of the Ontario Securities Commission. Chapter 1 Introduction Figure 1.1 Organization of the Book Ideal Information User Decision Accounting Conditions Asymmetry Problem Reaction Mediation Adverse Rational Decision selection investment usefulness, (inside information) decision full disclosure Current Standard value-based setting accounting Motivate Moral Precise versus and evaluate hazard sensitive manager (manager effort) information performance 1.1 THE OBJECTIVE OF THIS BOOK This book is about the theory of accounting, not about how to account. It argues that accounting students, having been exposed to the methodology and practice of accounting, now need to examine the broader implications of financial accounting for the fair and efficient working of our economy. Our objective is to give the reader a critical awareness of the current financial accounting and reporting environment, taking into consideration the diverse interests of both external users and management. 1.2 SOME HISTORICAL PERSPECTIVE Accounting has a long history. Our perspective begins with the double entry bookkeeping system. The first complete description of this system appeared in 1494, authored by Luca Paciolo, an Italian monk/mathematician.1 Paciolo did not invent this system—it had  developed over a long period of time. Segments that developed first included, for example, the collection of an account receivable. “Both sides” of such a transaction were easy to see, since cash and accounts receivable have a physical and/or legal existence, and the increase in cash was equal to the decrease in accounts receivable. The recording of other types of transactions, such as the sale of goods or the incurring of expenses, however, took longer to develop. In the case of a sale, it was obvious that cash or accounts receivable increased, and that goods on hand decreased. But, what about the difference between the selling price and the cost of the goods sold? Profit has no physical or legal representation, and so it was necessary to create abstract concepts of income and capital. By Paciolo’s time these concepts had developed, and a complete double entry system-quite similar to the one in use today- was in place. The abstract nature of this system, including the properties of capital as the accumulation of income, and income as the rate of change of capital,2 attracted the atten- tion of mathematicians of the time. The “method of Venice,” as Paciolo’s system was called, was frequently included in mathematics texts in subsequent years. Following 1494 the double entry system spread throughout Europe, where another sequence of important accounting developments took place. The Dutch East India Company, established in 1602, was the first company to issue shares with limited liability for all its shareholders. Shares were transferable and could be traded on the Amsterdam Stock Exchange, also established in 1602. In subsequent years the concept of a joint stock company with permanent existence, limited liability, and shares traded on a stock exchange, became an important form of business organization. Obviously, investors needed financial information about the firms whose shares they were trading. Thus began a long transition for financial accounting, from a system to enable merchants to control their own operations to a system to inform investors who were not involved in the day-to-day operations of the firm. To serve the joint interests of the firm and investors, financial information provided by the firm needed to be trustworthy. This laid the groundwork for developing an auditing profession and government regulation of financial reporting. In this regard, the English Joint Stock Companies Act of 1844 was notable. This Act introduced into law the concept of providing an audited balance sheet to shareholders, although this requirement was dropped in subsequent years3 and not reinstated until the early 1900s. During the interval, companies commonly provided information voluntarily, but the effectiveness of such reporting was hampered by a lack of accounting principles. For example, controversy arose over whether or not amortization of capital assets must be deducted in determining income available for dividends. (The English courts ruled that it need not.) In the twentieth century, major developments in financial accounting shifted to the United States, which was growing rapidly in economic power. The introduction of a cor- porate income tax in the United States in 1909 provided a major impetus to income measurement and, as noted by Hatfield (1927, p. 140), was influential in persuading busi- ness managers to accept amortization as a deduction from income. Nevertheless, accounting in the United States continued to be relatively unregulated, with both financial reporting and auditing largely voluntary. However, the stock market 2 Chapter 1 crash of 1929 and resulting Great Depression led to major changes by the U.S. government. The most noteworthy was the creation of the Securities and Exchange Commission (SEC) by the Securities Exchange Act of 1934, with a focus on protecting investors by means of a disclosure-based structure. The Act regulates dealing in the securities of firms that meet certain size tests and whose securities are traded in more than one state. As part of its mandate, the SEC has the responsibility to ensure that firms supply investors with adequate information. Merino and Neimark (1982; MN) examine the conditions leading up to the creation of the SEC. In the process, they report on securities market practices of the 1920s and prior. Apparently, voluntary disclosure was widespread, as also noted by Benston (1973). However, MN claim that such disclosure was motivated by big business’s desire to avoid disclosure regulations that would reduce its monopoly power. Regulations to enforce disclosure would reduce monopoly power by better enabling potential entrants to identify high-profit industries. Presumably, if voluntary disclosure were adequate, the government would feel no need to regulate disclosure. Thus, investors were “protected” by a “two-tiered” market structure whereby prices were set by knowledge- able insiders, subject to a self-imposed “moral regulation” to avoid government regulation by controlling misleading reporting. Unfortunately, moral regulation was not always effec- tive. MN refer to numerous instances of manipulative financial reporting and other abuses, which were widely believed to be major contributing factors to the 1929 crash. The 1934 securities legislation, then, can be regarded as a movement away from an avoidance-of-regulation rationale for voluntary disclosure toward one of supplying investors with better-quality information as a way to control manipulative financial practices.4 One accounting practice of the 1920s that received criticism was appraisal valuation resulting in overstatement of capital assets, the values of which came crashing down in 1929.5 A major lesson learned by accountants as a result of the Great Depression was that values are fleeting. The outcome was a strengthening of historical cost accounting, based on completed transactions. This basis received its highest expression in the famous Paton and Littleton (1940) monograph An Introduction to Corporate Accounting Standards. This document elegantly and persuasively set forth the case for historical cost accounting, based on the concept of the firm as a going concern. The going-concern concept justifies impor- tant attributes of historical cost accounting, such as waiting to recognize revenue until objective evidence of realization is available, the use of accruals to match realized revenues and the costs of earning those revenues, and the deferral of unrealized gains and losses on the balance sheet until the time comes to match them with revenues. In this view of accounting, the income statement shows the current “instalment” of the firm’s ongoing earning power. The income statement replaced the balance sheet as the primary focus of financial reporting. Some claim that the Paton and Littleton monograph was too persuasive, in that it shut out exploration of alternative bases of accounting. However, alternative valuation bases have become more common over the years, to the point where we now have a mixed measurement system. Historical cost is still the primary basis of accounting for important Introduction 3  asset and liability classes, such as capital assets, inventories, and long-term debt.6 However, impairment tests (also called ceiling tests) for capital assets and the lower-of-cost-or-market rule for inventories, for example, introduce current valuations into historical cost. Under International Accounting Standards Board (IASB) standards, capital assets can sometimes be written up over cost. Since the 1970s, standard setters have generally moved toward current value alternatives to historical cost accounting. Two main current value alternatives to historical cost for assets and liabilities are value in use, such as discounted present value of future cash flows, and fair value, also called exit price or opportunity cost, the hypothetical amount that would be received or paid should the firm dispose of the asset or liability. We discuss these valuation bases in Chapter 7. When we do not need to distinguish between them, we shall refer to valuations that depart from historical cost as current values. While standard setters may be in the process of forgetting the historical cost lesson learned by accountants from the Great Depression, another lesson remains: how to survive in a disclosure-regulated environment. In the United States, for example, the SEC has authority to establish the accounting standards and procedures used by firms under its jurisdiction. However, the SEC usually has chosen to delegate standard setting to the accounting profession. If the SEC chose to exercise its power, this would greatly erode the prestige and influence of the accounting profession, by eliminating professional judgment and giving accountants little influence over accounting standards.7 To retain this delegated authority, however, the accounting profession must retain the SEC’s confidence, by creat- ing and maintaining a financial reporting environment that protects and informs investors and encourages well-working capital markets. By “well-working,” we mean markets where the market values of assets and liabilities equal, or reasonably approximate, their real under- lying fundamental values. We explore this in greater detail in Chapter 4. Thus began the search for basic accounting concepts, those underlying truths on which the practice of accounting is, or should be, based. The accounting profession saw this as a way to convince regulators that private-sector standard-setting bodies could produce high quality accounting standards. It was also felt that identification of concepts would improve practice, by reducing inconsistencies in the choice of accounting policies across firms, and enabling accountants to deduce the accounting for new reporting challenges from basic principles, rather than developing accounting methods in an ad hoc and inconsistent way.8 Despite great effort, however, accountants have never agreed on a set of accounting concepts.9 As a result of the lack of concepts, up to the late 1960s accounting theory and research consisted largely of a priori reasoning about which accounting concepts and practices were “best.” For example, should we account for the effects of changing prices and inflation on financial statements, and if so, how? This debate can be traced back at least as far as the 1920s. Some accountants argued that firms should recognize the current values of specific assets and liabilities, and include the resulting unrealized holding gains and losses in net income.10 Others argued that inflation-induced changes in the purchasing power of money should be recognized. During a period of inflation, the firm suffers a purchasing power loss on monetary assets such as cash and accounts receivable, since the amounts of goods and 4 Chapter 1 services that can be obtained when they are collected and spent is less than the amounts that could have been obtained when they were created. Conversely, the firm enjoys a purchasing power gain on monetary liabilities such as accounts payable and long-term debt. Separate reporting of these gains and losses would better reflect real firm performance, it was argued. Still other accountants argued that firms should account for the effects of both specific and inflation-induced changes in prices. Others, however, often including firm management, resisted these suggestions. One argument, based in part on experience from the Great Depression, was that measuring inflation is problematic and current values are volatile, so that taking them into account would not necessarily improve the measurement of the firm’s (and the manager’s) performance. Nevertheless, standard setters in numerous countries did require some disclosures of the effects of changing prices. For example, after a period of high inflation in the United States, Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 33 (1979) required supplementary disclosure of the effects on earnings of specific and general price level changes for property, plant and equipment, and inventories. This standard was subsequently withdrawn. However, this withdrawal was due more to a reduction of its cost-effectiveness as inflation declined in later years, than to the debate having been settled. The basic problem with debates such as how to account for changing prices was that we have no sound theoretical basis for choosing among the various alternatives, particularly since, as mentioned, accountants could not agree on a set of basic accounting concepts. During this period, however, major developments were taking place in other dis- ciplines. In particular, a theory of rational decision-making under uncertainty devel- oped as a branch of statistics. This theory prescribes how individuals may revise their beliefs upon receipt of new information. The theory of efficient securities markets developed in economics and finance, with major implications for the role of informa- tion in capital markets. Another development was the Possibility Theorem of Arrow (1963), which demon- strated that, in general, it is not possible to combine differing preferences of individual members of society into a social preference ordering that satisfies reasonable conditions. This implies that there is no such thing as perfect or true accounting concepts. For exam- ple, suppose that a standard setter is debating asset valuation, where historical cost, value in use, and fair value are alternatives, from which one is to be chosen. Different managers and investors will have different preferences for these alternatives. Arrow’s theorem dem- onstrates that in general across the population of investors and managers no “winner” concept can emerge that meets the conditions for a socially most preferred alternative.11 Instead, concepts must be hammered out strategically through negotiation and compromise to the point where investors and managers are willing to accept them even though they are not perfectly satisfactory to all individuals.12 The difficulties that accountants have had in agreeing on basic concepts are thus not surprising. Without a complete set of basic concepts, accounting standards, which, ideally, are derived from the concepts, are subject to the same challenges. Introduction 5  These theories, which began to show up in accounting theory in the latter half of the 1960s, generated the concept of decision-useful (in place of true) financial statement information. This view of the role of financial reporting first appeared in the American Accounting Association (AAA)13 monograph A Statement of Basic Accounting Theory, in 1966. The most recent statement of basic accounting concepts, the IASB’s Conceptual Framework of Financial Reporting, issued in 2018, is based on decision usefulness. It states that the objective of financial statements is to provide information to assist investors and creditors in making investment decisions. Henceforth, we will usually refer to this docu- ment as the Conceptual Framework, or, if the context is clear, the Framework. We discuss it in some detail in Section 3.7. Equally important was the development of the economics of imperfect information, based on a theory of rational decision-making. The theory recognizes that some individu- als have an information advantage over others. This led to the development of the theory of agency, which has greatly increased our understanding of the legitimate interests of business management in financial reporting and standard setting. These theories suggest that we might decide the issue of accounting for changing prices outlined above by examining how different accounting choices lead to good investment decisions. Furthermore, any resolution would have to consider the concerns of manage- ment, as well as investors. In Canada, the development of financial accounting and reporting has proceeded dif- ferently, although the end result is similar to that just described. Financial reporting requirements in Canada were laid down in federal and provincial corporations acts, along the lines of the English corporations acts referred to above. The ultimate power to regulate financial reporting rests with the legislatures concerned. However, in 1946, the Committee on Accounting and Auditing Research, now the Accounting Standards Board (AcSB) of the Canadian Institute of Chartered Accountants (CICA) (now, Chartered Professional Accountants Canada, or CPAC),14 began to issue bulletins on financial accounting issues. These were intended to guide Canadian accountants as to best practices, and did not have force of law. In 1968, these were formalized into the CICA Handbook.15 At first, adherence to these provisions was voluntary but, given their prestigious source, they were difficult to ignore. Over time, the Handbook gained recognition as the authoritative statement of Generally Accepted Accounting Principles (GAAP) in Canada. Ultimately, provincial securities commissions and the corporations acts formally recognized this authority. For example, in 1975, for federally regulated companies, the Canada Business Corporations Act required adherence to the CICA Handbook to satisfy reporting requirements under the Act. The end result, then, is similar to that in the United States and many other countries, in that the body with ultimate authority to set accounting standards has delegated this function to a private professional body.16 Subsequently, several notable events had a major impact on financial accounting and reporting. One such set of events followed from the stock market boom in the late 1990s and its collapse in the early 2000s. During the collapse, share prices of many firms, especially those in “hi-tech” industries, fell precipitously. For example, while the share 6 Chapter 1 price of General Electric Corp., a large U.S. conglomerate firm, fell from a high of about US$55 in August 2000 to a low of about US$21 in October 2002, that of telecommuni- cations firm Nortel Networks fell from a high of about US$82 to a low of 44 cents over the same period. A contributing factor to the market collapse was the revelation of numerous finan- cial reporting irregularities. Frequently, these involved revenue recognition, which has long been a problem in accounting theory and practice. During the boom of the late 1990s, many firms, especially newly established ones with little or no history of profits, attempted to impress investors and enhance their stock prices by reporting a rapidly growing stream of revenue. Subsequently, when the boom collapsed, much recognized revenue proved to be premature and had to be reversed. In a study of 492 U.S. corpora- tions that reported restatements of prior years’ incomes during 1995–1999, Palmrose and Scholz (2004) reported that revenue restatements were the single most common type of restatement in their sample. Eight years later, Badertscher, Collins, and Lys (2012) reported a similar result for their sample of firms reporting restatements of their annual reports. Accounting principles tend to be vague, and their application requires judgment; this can contribute to reporting problems. For example, under International Accounting Standard 18 (IAS 18),17 the standard in effect at the time of the above evidence, revenue from the sale of goods would be recognized when the significant risks and rewards of ownership had been transferred to the buyer, the seller had lost control over the items, the revenue and related costs could be measured reliably,18 and collection was reasonably assured. Revenue recognition criteria in the United States were broadly consistent with those in IAS 18. In 2018, International Financial Reporting Standard 15 (IFRS 15) replaced IAS 18, with the intention of reducing ambiguity. This standard is converged with Accounting Standards Codification (ASC) 606 of the FASB.19 The core principles of these standards are that there must be a contract between firm and customer, and that revenue should be recognized as the entity satisfies the performance obligations con- tained in the contract (e.g., a contract to sell merchandise to a customer is satisfied as the customer obtains control of that merchandise). However, it must also be the case that collection is probable. Sales contracts that involve more than one performance obligation have often been subject to revenue recognition abuses. A common example of such contracts involves sale of a product plus an obligation to maintain the product for a period of time. IAS 18 and ASC 606 require separation of the two performance obligations, with the contract price allocated to each based on their stand-alone prices (or an estimate thereof if such prices are not available). It must also be possible to reasonably measure progress over time in satisfying each obligation, so that revenue recognized during the period is consistent with the physical maintenance effort exerted during the period. No revenue would be recognized until the maintenance term expires, if progress is not reasonably measurable. Theory in Practice 1.1 illustrates some of the revenue recognition problems that the new standards confront. Time will tell whether they reduce the frequency of misreported revenue. Introduction 7 Theory in Practice 1.1 In July 2002, Qwest Communications International services at cost, putting all profit into the equip- Inc., a large provider of Internet-based communi- ment component, which, as just mentioned, was cations services, announced that it was under immediately recognized as revenue, despite a con- investigation by the SEC. Its share price immedi- tinuing obligation to protect the customer from ately fell by 32 percent. In February 2003, the SEC risk of obsolescence on the equipment “sold.” Yet announced fraud charges against several senior another tactic was to recognize revenue from the Qwest executives, alleging that they had inflated sale of fibre-optic cable despite an ability of the revenues during 2000 and 2001 in order to meet purchaser to exchange the cable at a later date. In revenue and earnings projections. retrospect, Qwest’s revenue recognition practices One tactic used was to separate long-term were premature, to say the least. sales of equipment and services into two compo- In June 2004, the SEC announced settlements nents. Full revenue was immediately recognized with some of the officers charged. One officer, for on the equipment component despite the obliga- example, repaid $200,000 of “ill-gotten gains,” tion to honour the service component over an plus a penalty of $150,000, and agreed to “cease extended period. A related tactic was to price and desist” from any future violations. Of the many serious failures of financial reporting that came to light following the boom of the 1990s, two are particularly notable. Enron Corp. was a large U.S. corporation with initial interests in natural gas distribution. Following substantial deregulation of the natural gas market in the United States during the 1980s, Enron successfully expanded its operations to become an intermediary between natural gas producers and users, thereby enabling them to manage their exposures to fluctuating natural gas prices. For example, it offered long-term fixed-price contracts to public utilities and natural gas producers. Subsequently, Enron extended this business model to a variety of other trading activities, including steel, natural gas, electricity, and weather futures. Its stock market performance was dramatic, rising from US$20 in early 1998 to a high of about US$90 per share in September 2000. To finance this rapid expansion, and support its share price, Enron needed both large amounts of capital and steadily increasing earnings. Meeting these needs was complicated by the fact that its forays into new markets were not always profitable, creat- ing a temptation to disguise losses.20 In the face of these challenges, Enron resorted to devious tactics. One tactic was to create various special purpose entities (SPEs). These were limited partnerships formed for specific purposes, and effectively controlled by senior Enron officers. These SPEs were financed largely by Enron’s contributions of its own common stock, in return for notes receivable from the SPE. The SPE could then borrow money using the Enron stock as security, and use the borrowed cash to repay its note payable to Enron. In this manner, much of Enron’s debt did not appear on its balance sheet—it appeared on the books of the SPEs instead. 8 Chapter 1  In addition, Enron received fees for management and other services supplied to its SPEs, and also investment income. The investment income is particularly noteworthy. By applying current value accounting to its holdings of Enron stock, the SPE included increases in the value of this stock in its income. As an owner of the SPE, Enron included its share of the SPE’s income in its own earnings. In effect, Enron included increases in the value of its own stock in its reported earnings! Financial media reported that $85 million of Enron’s 2000 reported operating earnings of $979 million came from this source, and also that Enron’s chief accounting officer received a five-and-a-half-year jail sentence for his part in the Enron fraud. Of course, if the SPEs had been consolidated with Enron’s financial statements, as they should have been, the effects of these tactics would disappear. The SPE debt would then have shown on Enron’s consolidated balance sheet, fees billed would have been offset against the corresponding expense recorded by the SPE, and Enron’s investment in its SPEs would have been deducted from its shareholders’ equity. However, the SPEs were not consolidated, seemingly with the agreement of Enron’s auditor. But, in late 2001, Enron announced that it would now consolidate, apparently in response to an inquiry from the SEC. This resulted in an increase in its reported debt of some $628 million, a decrease in its shareholders’ equity of $1.1 billion, and large reduc- tions in previously reported earnings. Investors quickly lost all confidence in the company. Its share price fell to almost zero, and it filed for bankruptcy protection in 2001. A second major abuse involved WorldCom Inc., a large U.S. telecommunications carrier. During the years 1999 to 2002, the company overstated its earnings by about $11 billion. Almost $4 billion of this amount arose from capitalization of network maintenance and other costs that should have been charged to expense as incurred—a tactic that overstated both reported earnings and operating cash flow. Another $3.3 billion of overstatement arose from reductions in the allowance for doubtful accounts. Again, when these abuses came to light, investor confidence collapsed and WorldCom applied for bankruptcy protection in 2002. These, and numerous other, reporting abuses took place regardless of the fact that the financial statements of the companies involved were audited and certified as being in accordance with GAAP. As a result, public confidence in financial reporting and the work- ing of capital markets was severely shaken. One result of the reduction of public confidence was increased regulation. The most notable example is the Sarbanes-Oxley Act (SOX), passed by the U.S. Congress in 2002. This wide-ranging Act was designed to restore confidence by reducing the probability of accounting horror stories such as those just described. In this regard, the Act strengthened the audit function, thereby improving corporate governance. By corporate governance we mean policies that align the firm’s activities with the interests of its investors and society. For example, a goal of SOX was to improve corporate governance by giving the audit com- mittee of the Board of Directors greater powers. The audit committee must be composed of directors independent of management. The auditor now reports directly to the commit- tee, and can bring concerns about the manager’s operation of the firm’s accounting and reporting system to the committee rather than to management. Introduction 9  To further improve corporate governance, a major SOX provision created the Public Company Accounting Oversight Board (PCAOB). This agency has the power to set audit- ing standards and to inspect and discipline auditors of U.S. public companies. In Canada, the Canadian Public Accountability Board (CPAB), created in 2003 by federal legislation, has a similar role. The Act also restricts several non-audit services previously offered by auditing firms to their clients, such as information systems and valuation services. Other SOX provisions include a requirement that firms’ financial reports shall include “all material correcting adjustments” and disclose all material off-balance-sheet loans and other relations with “unconsolidated entities.” Furthermore, the CEO and Chief Financial Officer (CFO) must certify that the financial statements present fairly the company’s results of operations and financial position. The Act required these two officers, and an independent Theory in Practice 1.2 Corporate governance is important, since severe inventory overstatements, delayed impairment consequences can result when it is lacking. For writedowns, and stuffing the channels.22 example, consider Toshiba Corporation, a large Toshiba’s investigation committee pointed out Japan-based multinational company headquar- several reasons for this fraudulent behavior. One tered in Tokyo. Its products range from industrial reason originated in the global recession that arose power and energy systems and information tech- following the securities market meltdowns of nology to home appliances and computers. Its 2007–2008 (see Section 1.3), which made it difficult shares are traded on the Tokyo and Nagoya stock to maintain past performance. Perhaps the major rea- exchanges. son, however, was the corporate culture of Toshiba, In 2015, following a report order from Japan’s which demanded complete obedience to superiors in Securities and Exchange Surveillance Commission the organization. This culture also included a “chal- (SESC), Toshiba established an Independent lenge” policy, under which sales and profit targets Investigation Committee. Its report documented were set higher than what could reasonably be widespread accounting fraud during 2008–2014. achieved. Lower-level managers knew that there was Over this period, Toshiba overstated its pre-tax no point in submitting results lower than target, since profits by ¥151.8 billion ($US 1.22 billion). This higher-level managers would reject them. This cre- triggered the resignation from the company of its ated intense pressure to meet the targets, including, current and two former Chief Executive Officers if necessary, by fraudulent accounting. (CEOs) and 6 directors. Toshiba’s share price fell The investigation committee made several rec- by 32 percent. Other consequences included ommendations to improve corporate governance. multiple lawsuits from investors, banks, and One was to change the mindset of top manage- pension funds. Also, in 2017, Toshiba agreed ment, including adopting a longer-term manage- to pay a fine of ¥1.37 billion ($US 60 million) to rial perspective, dropping the expectation of the SESC. complete obedience, and dropping the challenge There were many sources of overstatement. A policy. Other recommendations included improved major source was the overstatement of profits to internal controls, adopting a whistleblower sys- date on long-term contracts.21 Others included tem, rotation of personnel, and including more delayed recognition of operating expenses, outside directors on the company board. 10 Chapter 1 auditor, to certify in each annual report the proper operation of the company’s internal con- trols over financial reporting, with deficiencies, and their remediation, publicly reported. (These requirements were relaxed somewhat in 2007, particularly for smaller companies.) Similar regulations are in place in several other countries, although in the European Union, the U.K. and Canada, officers’ certification of internal controls need not receive attestation by an independent auditor. Accounting standard setters also moved to restore public confidence. As we discuss later, one move was to tighten the rules surrounding SPEs, so that it was more difficult to avoid their consolidation with the financial statements of the parent entity. 1.3 THE 2007–2008 MARKET MELTDOWNS Despite these new regulations and standards, however, the use of SPEs did not decline, par- ticularly by financial institutions, where they were frequently called structured investment vehicles (SIVs). Banks, mortgage companies, and other financial institutions created SIVs to securitize their holdings of mortgages, credit card balances, auto loans, and other financial assets. That is, the institution would transfer large pools of these assets to the SIVs it spon- sored. The SIV would then issue asset-backed securities (ABSs), often separated into tranches of different credit quality.23 A first-tranche ABS might, for example, be promised the first rights to cash flows, and hence be regarded as very low risk. A second-tranche ABS would be somewhat riskier and therefore of lower quality, and so forth. The various ABS tranches would be sold to investors, and the proceeds used to pay the sponsor for the assets. Generally, the tranches that were sold to investors were marketed as having very low risk, to maximize the proceeds. Often, the SIV or its sponsor would retain the riskiest tranche, to help convince investors that the firm stood behind the investments it sold. As mortgagors made payments, cash flowed to the SIV and on to the tranche holders, after deduction of various fees. ABSs were highly popular with investors, including many financial institutions, because they offered higher returns and appeared to be no riskier than, say, bonds. As it turned out, this perception of low risk was mistaken. In part, the perception of ABS safety was fuelled by a belief that house prices, the ultimate security underlying mortgages, would continue to rise. Perceived safety was also enhanced because of the apparent diversification of credit risk, where credit risk is the risk that a party to a financial contract, such as a mortgage, will be unable to meet its financial obligations. This diversification was created by pooling together many mortgages or other financial assets: while some mortgages may go bad, it was felt that these would be a small proportion, and that these losses would be absorbed either by insurers or by the riskiest tranches. High ratings from investment rating agencies aided this perception of low risk. Furthermore, investors could customize their investments by buying tranches of the particular risk and return that they desired. ABSs were frequently further securitized as collateralized debt obligations (CDOs), which consisted of tranches of various ABS tranches, a procedure that further increased both diversification and leverage. Unlike ABSs, CDOs tended to be arranged and sold privately, and often consisted of riskier mortgages or other assets. Introduction 11  To increase the perceived safety, SIVs often added various credit enhancements, which amounted to purchased insurance against losses. Financial institutions subject to capital adequacy regulations found it attractive to issue enhancements on their SIVs, since enhancements had little effect on capital adequacy—the regulations put low weight on such off-balance sheet obligations when calculating adequacy ratios. In addition to adding leverage to the SIV, this further layer of CDO securitization diminished the reputational benefit of having the sponsor hold the riskier tranches of the SIV, and made it difficult to establish a clear priority of claims within the SIV. Issuing multiple tranches of debt securities meant that SIVs were usually highly levered. Compounding the risk-increasing property of leverage, the borrowing was often short-term asset-backed commercial paper (ABCP). Investors usually perceive commer- cial paper to be lower risk than long-term loans to the same entity, because they receive their payoff sooner; they therefore would demand a lower interest rate to hold the secu- rities. For the issuing SIVs, however, this meant the timing of borrowing and lending were “out of sync.” For example, if the SIV securitized home mortgages with ABCP, it would receive cash flows from mortgagors gradually over periods up to 30 years, but be obliged to meet ABCP within one year. Despite rising house prices and the inherent diversification of ABSs, some credit losses could still occur, leaving the SIV refinancing risk in the maturing ABCP. Note that if an SIV were consolidated into the financial statements of its sponsor, the high SIV leverage would show up on the sponsor’s consolidated balance sheet. The spon- sor’s equity investors would demand a higher return to compensate for the leverage risk. Since most financial institutions are subject to capital adequacy regulations that cap their leverage, firms that sponsored had an incentive to avoid consolidating the SIVs into their own financial statements.24 Post-Enron, standard setters had moved to tighten up the rules for consolidation of off-balance sheet vehicles. In the United States, FASB Interpretation No. 46(R) (2003; FIN 46) expanded requirements for consolidation of a particular form of SIVs, called variable interest entities (VIEs), and required additional supplementary disclosures by firms with significant interests in VIEs.25 Variable interests are those that absorb the expected losses and gains of the VIE—that is, they bear the risks. As noted above, VIEs tend to be very thinly capitalized, so that often the lower tiers of debt would bear significant risk of loss. FIN 46 changed the criterion for consolidation from control - the previous definition - to beneficial ownership. The primary beneficiary of the VIE, the entity that absorbed a majority of the VIE’s expected losses and received a majority of its expected gains, must consolidate it. It was felt that mandating consolidation when a sponsor’s exposure to their VIEs’ risks and returns was significant would improve the financial reporting for financial institutions, particularly with respect to their overall solvency and capital adequacy. Nevertheless, many sponsors avoided consolidation by creating new securities such as expected loss notes (ELNs). These were securities sold by sponsors to an outside party, under which that party contracted to absorb a majority of a VIE’s expected losses and receive a majority of expected net returns, thereby becoming the primary beneficiary under FIN 46. 12 Chapter 1 Freed from consolidation, the sponsor could then continue to exploit off-balance sheet VIE leverage. In addition, sponsors often received fees for various services rendered to VIEs. Beginning in 2007, this whole structure came crashing down. It had become increas- ingly apparent that because of lax lending practices to stoke the demand for more and more ABSs to feed leveraged profits, many of the mortgages underlying ABSs were unlikely to be repaid. It seems that when mortgage lenders knew that the mortgages they originated would be securitized and sold, they were less careful about evaluating borrowers’ credit quality than they would have been if they had intended to retain the mortgages. Further, the complex repackaging that allowed diversification of credit risk also created a lack of transparency, so that investors in a particular tranche did not know what these instruments contained, or who else had claims to the same underlying asset pool. As concern about mortgage defaults and housing prices increased, investors were unable to (or neglected to) determine likely default rates associated with a specific ABS. Valuation models based on market variables from well-working underlying markets were not available for ABSs. Instead, valuations were based on projected interest rates and historical default rates, which did not anticipate the high default rates that began to appear. The rational reaction to growing suspicion about the value of a security is to lower the price offered, or not to buy at all, leading to further declines in market value. The risk of a continuing decline in demand due to skeptical investors’ lack of buying is an example of liquidity risk.26 Note that liquidity risk can result in a market value less than value in use. Illustrating the effects of liquidity risk, financial media reported in July 2007 that two mutual funds of Bear Stearns (at the time, a large U.S. investment bank) suffered severe losses on their large holdings of ABSs. In August 2007, BNP Paribas, a large bank based in France, temporarily suspended subscriptions to and redemptions of several of its investment funds, on grounds that market values of their holdings of ABSs were impossible to deter- mine. Other U.S. and European financial institutions reported similar problems. In effect, the market for these securities collapsed. Another major contributing factor to the market collapse was counterparty risk. Above, we mentioned that SIVs purchase credit enhancements to insure any losses suffered on their ABSs. Credit enhancement contracts, of which the dominant type was credit default swaps (CDSs), were privately arranged and traded. The lack of an organized exchange or clearing house, where regulations would be in place to standardize, publicize, and protect the integrity of transactions, made it difficult to know how many contracts were outstanding against specific ABSs, or who held them. Counterparty risk was greatly compounded due to a significant CDS feature—it was not necessary for the purchaser of a CDS to own the underlying assets securing that CDS. Anyone could buy and sell a so-called “naked” CDS that protected against losses on a specific reference ABS. Thus, naked CDSs became a vehicle for speculators wishing to bet on a downturn in the housing market. The CDS market grew to immense size, meaning that if a reference ABS were to decline in value, insurance payouts could be huge. As housing prices fell in many U.S. cities and mortgage defaults increased, it became apparent that American International Group, Inc. (AIG), a major U.S. issuer of CDS Introduction 13  contracts, was unable to meet its obligations, which reportedly reached $85 billion. AIG suffered rapid declines in solvency, credit rating, and share price. In 2008, the U.S. govern- ment rescued AIG to prevent a complete collapse of the financial system. In sum, coun- terparty risk was a major contributing factor to the ABS market collapse. SIVs faced several problems simultaneously. Their holdings of ABSs themselves were difficult or impossible to value or sell. The ability of CDS issuers such as AIG to reimburse losses was doubtful. The ABCP market weakened as investors became wary, and SIVs were unable to roll over maturing ABCP using the proceeds of a fresh issue of ABCP. In the face of this market collapse and severe counterparty risk, SIVs faced either insolvency or the necessity for their sponsors to buy back their impaired assets. For example, the Financial Times (November 19, 2008) reported that Citigroup returned the last $17.4 billion of assets of its sponsored SIVs to its balance sheet, recording a writedown of $1.1 billion in the process. These buybacks had severe consequences. Paying for them lowered sponsors’ solvency and required writedowns of the “toxic” assets thus acquired. These writedowns were in addition to writedowns of CDSs, and of asset-backed securities held directly by the spon- sors. Weakness in the sponsors caused further deterioration in markets for these assets, necessitating further writedowns. Many sponsors failed, raised additional capital at dis- tressed prices, or were rescued by governments, resulting in a major contraction of the financial system. The resulting security market collapse spread to the real economy, leading to worldwide recession, including drastic falls in share prices. The underlying causes of these catastrophic events are rooted in both wealth inequality and global imbalances in consumption, trade, and foreign exchange markets. Economists and politicians will debate these issues for years. However, many blame the initial collapse of the market for asset-backed securities on lax mortgage lending practices, inadequate regulation, and the lack of transparency of the complex financial instruments created by parties in this market. Of greater significance for accountants, however, was the failure of sponsors to ade- quately control the risks of excessive leverage in the quest for securitization profits. Firm managers were encouraged/enabled to take on excessive risk because, as described above, financial accounting standards allowed sponsor firms to avoid SIV consolidation, resulting in large amounts of off-balance sheet leverage. Accountants and auditors who allowed this avoidance were arguably meeting the letter of FIN 46, while avoiding its intent. Another result of the meltdown was severe criticism of fair value accounting, since accounting standards required fair valuation for many financial instruments. Much of this criticism came from financial institutions. They claimed that the requirement to write down the carrying values of financial instruments as fair values fell created huge losses that threatened their capital adequacy ratios and eroded investor confidence. In effect, fair value accounting was claimed to be procyclical—it made the recession worse by contributing to a downward spiral. Writedowns were further criticized because inactive markets often meant that fair values had to be estimated by other means. For example, fair value of asset- backed securities could be estimated from the spreads charged by CDS issuers. Since these spreads became very high as underlying ABS values fell, the resulting fair value estimates reflected liquidity pricing in the market. Liquidity pricing is an outcome of liquidity risk 14 Chapter 1 (see Note 26), under which market value is less than the value in use that the institutions felt they would eventually realize if they held these assets to maturity. Management’s concerns about excessive writedowns had some validity. As mentioned above, ABSs lacked transparency. Because investors could not separate the good from the bad, all such securities became suspect, and all became valued as if they were bad. In Chapter 4, we will discuss this sort of market failure, which arises from severe information asymmetry. In the aftermath of the financial crisis, some believed that allowing institutions to value these assets using their own internal estimates would eliminate excessive write- downs. Of course, allowing managers to use their own internal valuations creates the pos- sibility of manager bias. Accounting standard setters attempted to hold their ground in the face of these criti- cisms of fair value. However, faced with threats that governments would step in to override fair value accounting, they relaxed requirements. For example, in October 2008, the IASB and FASB issued similar guidance on how to determine fair value when markets are inac- tive (i.e., melted down). Specifically, when market values did not exist and could not be reliably inferred from values of similar items, firms could determine fair value based on value in use. Collectively, the events described above raise fundamental questions about the role of regulation in a markets-based economy. It seems that relatively unregulated capital markets (e.g., the CDS market described above) are subject to catastrophic market failure. This came as a shock to many economists and politicians, who believed that markets would always properly price assets, so that regulation could be confined to maintaining an orderly marketplace. Furthermore, it was felt that, in addition to imposing a costly bureaucracy, regulators were inferior to markets in determining what market price should be, and that the consequences of failures by regulators could prove more costly to society than some of the excesses of unfettered markets. These theories, based on underlying economic models of rational investor behaviour and asset pricing, have come under intense criticism follow- ing their failure to predict the market meltdowns. Some of these criticisms, and possible responses to them, are discussed in Chapter 12. Market failures have in the past typically led to increased regulation. The question then is how and to what extent should regulation be increased as a result of failures? This question is heightened in recent years by the globalization of capital markets, which causes the effects of failures to quickly spread worldwide, while regulation remains at the national or sub-national level. Regulators, economists, and politicians continue to debate responses to the 2007–08 market failure. One response was to increase global banking regulation, such as requiring financial institutions to hold more capital reserves. Many U.S. financial institutions paid large fines for their part in leading investors to invest so heavily in mortgage-based securi- ties. Of more direct interest in this book were several new or expanded accounting and disclosure standards, some of which we outline in Section 7.5. Another regulatory response was to require increased compensation disclosures, and more shareholder participation in management compensation. Suspicion arose that Introduction 15  existing compensation practices, including large amounts of stock options, contributed to the meltdowns by encouraging managers to indulge in excessive off-balance sheet leverage. This leverage increased current profits of sponsoring institutions but also increased their risk. For whatever reason, the market did not fully appreciate this risk, bid up share prices of financial institutions, thus increasing the value of executive stock options for those institutions. To the extent that stock-based compensation practices encouraged short-run, risk-taking behaviour, this effect was opposite to their intended purpose, which was to align manager and shareholder interests by encouraging managers’ longer-run decision horizons. New regulations, such as the Dodd-Frank Act in the United States, include increased disclosure and explanation of how companies determine manager compensation, so that investors can see for themselves the extent to which managers may be tempted to repeat the activities leading up to the recession. We discuss this further in Section 10.6. Nevertheless, the question of the socially desirable amount of additional regulation remains unresolved. Regulation is costly and is itself subject to failure. Over time, objec- tions by bankers and others to the costs of the new regulations may lead to their gradual relaxation. We hope, however, that the lessons learned from the great recession will not be completely forgotten. In sum, four points relevant to accountants stand out from the events just described. First, financial reporting must be transparent, so that investors can properly value assets and liabilities, and the firms that possess them. With respect to complex financial assets and liabilities, transparency includes full reporting of models used to determine value, disclosure of all related obligations or enhancements, and explanations of risk exposures and risk-management strategies. Second, because fair value accounting is based on market value or estimates thereof, it may understate value in use when markets collapse due to liquidity pricing, as discussed above. This leads to management, and even government, objections to fair value accounting. It also creates a need for research into the causes of liquidity pricing and how financial reporting may help to control it. Third, off-balance sheet activities should be fully reported, even if not consolidated, since they can encourage excessive risk-taking by management. Finally, substantial changes to accounting standards and other regulations, including increased disclosures of manager compensation, have taken place. 1.4 EFFICIENT CONTRACTING Many standard setters apparently feel that fair value accounting is the best way to imple- ment the decision-usefulness concept that, as described in Section 1.2, originated during the 1960s. For example, we mentioned in Section 1.3 that many financial instruments are valued at fair value. However, the severe criticisms of fair value accounting arising from the security market meltdowns have strengthened an alternative view of financial report- ing, namely the efficient contracting approach to financial reporting. Efficient contracting argues that the contracts that firms enter into (e.g., debt contracts and managerial compensation contracts) create a primary source of demand for accounting information. 16 Chapter 1 In this view, the role of accounting information is to help maximize contract efficiency or, more generally, to aid in efficient corporate governance. Debt and compensation contracts are discussed in later chapters. For now, it is sufficient to note that these contracts usually depend on accounting variables, such as net income. The role of financial reporting for debt and compensation contract purposes is to generate trust. Trust is needed if lenders are to be willing to lend to the firm and if shareholders (represented by Boards of Directors) are to be willing to delegate managerial responsibilities to managers. An efficient contract generates this trust at lowest cost. Thus, covenants in debt contracts, which, for example, restrict the borrowing firm from paying dividends if its working capital falls below a specified level, increase lender trust in the security of their loans. Basing manager compensation on net income increases investor trust by helping to align manager and shareholder interests. That is, net income can be used as a measure of manager performance. Alignment of manager and investor interests is the stewardship role of financial reporting, one of the oldest concepts in accounting. Efficient contracting emphasizes trustworthiness in accounting numbers, especially those used in contracts. In contrast, the valuation approach emphasizes timeliness in accounting information conveyed to investors. This difference in emphasis leads to some major accounting policy differences between these approaches. One difference is an increased emphasis, relative to current value accounting, on reliability of accounting infor- mation. Reliability of accounting information benefits lenders by increasing their trust that the firm manager will not take actions that harm their interests (e.g., disguising deteriorat- ing earnings). Reliability also benefits compensation contracting by increasing share­ holders’ trust that managers cannot cover up poor performance by opportunistically manipulating reported net income and balance sheet values upwards. A second major difference between the contracting and valuation approaches is the role of conservatism in financial reporting. Under conservatism, unrealized losses from declines in value are recognized promptly, but gains from increases in value are not recog- nized until they are realized. Accounting standards include numerous instances of conser- vatism, such as lower-of-cost-or-market for inventories, and impairment tests for capital assets and many financial instruments. While most adherents to both the valuation and the efficient contracting views rec- ognize that some conservatism is desirable, they differ in the reasons why. Arguably, the valuation view is that conservatism reduces the probability of lawsuits that invariably result when firms report major unexpected losses. The contracting view is that conservatism improves contract efficiency by providing investors, particularly debt investors, with an “early warning system” of financial distress. It also serves a stewardship role by preventing managers from overstating their performance and compensation through unrealized gains. In this book, we view the valuation and efficient contracting roles of financial reporting as equally important. Although, as just mentioned, valuation adherents (including many standard setters) see a role for conservatism, they would point out that fair value accounting is, in effect, conservative when fair values fall, but can also serve a useful investor-informing role when fair values rise. Contract theory adherents, however, are willing to accept low Introduction 17 Theory in Practice 1.3 New Century Financial Corp. illustrates the serious However, through error or design, New Century consequences that can result from lack of conser- seriously underestimated the extent of its mortgage vatism. Formed in 1995, New Century became the buybacks and resulting credit losses. Of $40 billion second-largest sub-prime mortgage lender in the of mortgages granted in the first three quarters of United States. Its lending was in large part based 2006, it provided only $13.9 million for repurchases. on automated credit-granting programs, and As the number of subprime mortgages in default reflected a belief that house prices would continue increased greatly in the fourth quarter of 2006, New to rise. Many of these mortgages were securitized Century should have revalued its retained interests, and transferred to invest