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financial fifth edition

accounting
theory
William R. Scott
UNIVERSITY OF WATERLOO
QUEEN’S UNIVERSITY

Toronto
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Library and Archives Canada Cataloguing in Publication

Scott, William R. (William Robert), 1931–
Financial accounting theory / William R. Scott. — 5th ed.
Includes bibliographical references and index.
ISBN 978-0-13-207286-1
1. Accounting—Textbooks. I. Title.
HF5635.S36 2009 657’.044 C2008-900661-5

Copyright © 2009, 2006, 2003, 2000, 1997 Pearson Education Canada, a division of
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or likewise. For information regarding permission, write to the Permissions Department.
ISBN-13: 978-0-13-207286-1
ISBN-10: 0-13-207286-6
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Section 1000 (in part), Section 1505.04, and Section 3480.02 are reprinted with permission
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h
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To Mary Ann, Julie, Martha, Kathy, Paul, and Cary

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Contents

Preface xi 2.2.1 Summary 28

Acknowledgments xiii 2.3 The Present Value Model Under
Uncertainty 29
1 Introduction 1 2.3.1 Summary 35
2.4 Reserve Recognition Accounting
1.1 The Objective of This Book 1
(RRA) 35
1.2 Some Historical Perspective 1
2.4.1 An Example of RRA 35
1.3 A Note on Ethical Behaviour 10
2.4.2 Summary 38
1.4 The Complexity of Information
2.4.3 Critique of RRA 38
in Financial Accounting and
2.4.4 Summary 41
Reporting 11
1.5 The Role of Accounting 2.5 Historical Cost Accounting
Research 12 Revisited 41
2.5.1 Comparison of Different
1.6 The Importance of Information
Measurement Bases 41
Asymmetry 13
2.5.2 Accruals 43
1.7 The Fundamental Problem of
Financial Accounting Theory 14 2.5.3 Summary 45
1.8 Regulation as a Reaction to 2.6 The Non-Existence of True Net
the Fundamental Problem 15 Income 45
1.9 The Organization of This 2.7 Conclusion to Accounting Under
Book 16 Ideal Conditions 47
1.9.1 Ideal Conditions 16
1.9.2 Adverse Selection 16 3 The Decision Usefulness
1.9.3 Moral Hazard 17 Approach to Financial
1.9.4 Standard Setting 18 Reporting 58
1.9.5 The Process of Standard
3.1 Overview 58
Setting 18
3.2 The Decision Usefulness
1.10 Relevance of Financial Accounting
Approach 59
Theory to Accounting Practice 21
3.2.1 Summary 60
3.3 Single-Person Decision
2 Accounting Under Ideal Theory 60
Conditions 24 3.3.1 Decision Theory Applied 61
2.1 Overview 24 3.3.2 The Information System 64
2.2 The Present Value Model Under 3.3.3 Information Defined 68
Certainty 25 3.3.4 Summary 68
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3.4 The Rational, Risk-Averse 4.5 A Capital Asset Pricing

Investor 68 Model 110
3.5 The Principle of Portfolio 4.6 Information Asymmetry 114
Diversification 71 4.6.1 A Closer Look at Information
3.5.1 Summary 76 Asymmetry 114
3.6 The Optimal Investment 4.6.2 Summary 117
Decision 76 4.7 The Social Significance of
3.6.1 Summary 78 Securities Markets that Work
3.7 Portfolio Risk 79 Well 118
3.7.1 Calculating and Interpreting 4.8 An Example of Full
Beta 79 Disclosure 119
3.7.2 Portfolio Expected Value and 4.8.1 Introduction 119
Variance 81 4.8.2 Management Discussion and
3.7.3 Portfolio Risk as the Number Analysis 119
of Securities Increases 82 4.9 Conclusions on Efficient
3.7.4 Summary 83 Securities Markets 135
3.8 The Reaction of Professional
Accounting Bodies to the Decision 5 The Information Approach to
Usefulness Approach 83 Decision Usefulness 143
3.8.1 Summary 87
3.9 Conclusions on Decision 5.1 Overview 143
Usefulness 87 5.2 Outline of the Research
Problem 145
5.2.1 Reasons for Market
4 Efficient Securities Markets 98
Response 145
4.1 Overview 98 5.2.2 Finding the Market
4.2 Efficient Securities Markets 99 Response 146
4.2.1 The Meaning of Efficiency 99 5.2.3 Separating Market-Wide and
4.2.2 How Do Market Prices Fully Firm-Specific Factors 146
Reflect All Available 5.2.4 Comparing Returns and
Information? 101 Income 148
4.2.3 Summary 104 5.3 The Ball and Brown Study 149
4.3 Implications of Efficient 5.3.1 Methodology and Findings 149
Securities Markets for 5.3.2 Causation Versus
Financial Reporting 104 Association 151
4.3.1 Implications 104 5.3.3 Outcomes of the BB Study 153
4.3.2 Summary 106 5.4 Earnings Response
4.4 The Informativeness of Price 107 Coefficients 153
4.4.1 A Logical Inconsistency 107 5.4.1 Reasons for Differential Market
4.4.2 Summary 110 Response 154

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5.4.2 Implications of 6.4 The Value Relevance of Financial

ERC Research 159 Statement Information 196
5.4.3 Measuring Investors’ Earnings 6.5 Ohlson’s Clean Surplus
Expectations 159 Theory 198
5.4.4 Summary 161 6.5.1 Three Formulae for
5.5 Unusual, Non-recurring, and Firm Value 198
Extraordinary Items 162 6.5.2 Earnings Persistence 201
5.6 A Caveat about the “Best” 6.5.3 Estimating Firm Value 204
Accounting Policy 164 6.5.4 Empirical Studies of the Clean
5.7 The Information Content of Surplus Model 208
Other Financial Statement 6.5.5 Summary 209
Information 166 6.6 Auditors’ Legal Liability 210
5.8 Conclusions on the Information 6.7 Asymmetry of Investor
Approach 167 Losses 212
6.8 Conclusions on the
6 The Measurement Measurement Approach to
Approach to Decision Decision Usefulness 216
Usefulness 177
7 Measurement Applications 228
6.1 Overview 177
6.2 Are Securities Markets Fully 7.1 Overview 228
Efficient? 178 7.2 Longstanding Measurement
6.2.1 Introduction 178 Examples 230
6.2.2 Prospect Theory 180 7.2.1 Accounts Receivable and
6.2.3 Is Beta Dead? 183 Payable 230
6.2.4 Excess Stock Market 7.2.2 Cash Flows Fixed by
Volatility 185 Contract 231
6.2.5 Stock Market Bubbles 186 7.2.3 The Lower-of-Cost-or-Market
6.2.6 Efficient Securities Market Rule 231
Anomalies 186 7.2.4 Revaluation Option for Property,
6.2.7 Implications of Securities Plant, and Equipment 232
Market Inefficiency for 7.2.5 Ceiling Test for Property,
Financial Reporting 189 Plant, and Equipment 232
6.2.8 Discussion of Market 7.2.6 Pensions and Other Post-
Efficiency Versus Behavioural Employment Benefits 233
Finance 191 7.2.7 Summary 235
6.2.9 Conclusions About Securities 7.3 Financial Instruments 235
Market Efficiency 195 7.3.1 Introduction 235
6.3 Other Reasons Supporting a 7.3.2 Valuation of Debt and Equity
Measurement Approach 195 Securities 236

Contents vii
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7.3.3 Conclusion 239 8.5.2 The Three Hypotheses of

7.3.4 Derivative Instruments 239 Positive Accounting
7.3.5 Hedge Accounting 243 Theory 287
7.3.6 Conclusion 248 8.5.3 Empirical PAT Research 290
7.4 Accounting for Intangibles 248 8.5.4 Distinguishing the
7.4.1 Introduction 248 Opportunistic and Efficient
7.4.2 Accounting for Purchased Contracting Versions of
Goodwill 249 PAT 294
7.4.3 Self-Developed Goodwill 252 8.6 Conclusions on Economic
7.4.4 The Clean Surplus Model
Consequences and Positive
Revisited 254
Accounting Theory 296
7.4.5 Summary 255
7.5 Reporting on Risk 255 9 An Analysis of Conflict 304
7.5.1 Beta Risk 255
9.1 Overview 304
7.5.2 Why Do Firms Manage Firm-
9.2 Understanding Game
Specific Risk? 257
Theory 305
7.5.3 Stock Market Reaction to
9.3 A Non-Cooperative Game
Other Risks 258
Model of Manager–Investor
7.5.4 A Measurement Approach to Conflict 306
Risk Reporting 260
9.3.1 Summary 312
7.5.5 Summary 262
9.4 Some Models of Cooperative
7.6 Conclusions on Measurement Game Theory 313
Applications 263
9.4.1 Introduction 313
9.4.2 Agency Theory: An
8 Economic Consequences and Employment Contract Between
Positive Accounting Firm Owner and Manager 313
Theory 273 9.5 Manager’s Information
Advantage 325
8.1 Overview 273
9.5.1 Earnings Management 325
8.2 The Rise of Economic
Consequences 275 9.5.2 Controlling Earnings
Management 329
8.2.1 Summary 276
8.3 Employee Stock Options 277 9.6 Discussion and Summary 331
8.4 The Relationship between Efficient 9.7 Agency Theory: A Bondholder–
Securities Market Theory and Manager Lending Contract 332
Economic Consequences 283 9.7.1 Summary 335
8.5 The Positive Theory of 9.8 Implications of Agency Theory
Accounting 284 for Accounting 335
8.5.1 Outline of Positive Accounting 9.8.1 Is Two Better Than One? 335
Theory 284 9.8.2 Rigidity of Contracts 339

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9.9 Reconciliation of Efficient
Securities Market Theory with
Economic Consequences 341
9.10 Conclusions on the Analysis of
Conflict 341
10 Executive Compensation
10.1 Overview 356
10.2 Are Incentive Contracts
Necessary? 357
10.3 A Managerial Compensation
Plan 360
10.4 The Theory of Executive
Compensation 372
10.4.1 The Relative Proportions of
Net Income and Share Price
in Evaluating Manager
Performance 372
10.4.2 Short-Run and Long-Run
Effort 374
10.4.3 The Role of Risk in Executive
Compensation 377
10.5 Empirical Compensation
Research 381
10.6 The Politics of Executive
Compensation 383
10.7 The Power Theory of Executive
Compensation 386
10.8 The Social Significance of
Managerial Labour Markets that
Work Well 389
10.9 Conclusions on Executive
Compensation 389
11 Earnings Management
11.1 Overview 402
11.2 Patterns of Earnings
Management 405
11.3 Evidence of Earnings
Management for Bonus
Purposes 406
11.4 Other Motivations for Earnings
Management 411
11.4.1 Other Contracting
356 Motivations 411
11.4.2 To Meet Investors’ Earnings
Expectations and Maintain
Reputation 413
11.4.3 Initial Public Offerings 414
11.5 The Good Side of Earnings
Management 415
11.5.1 Blocked Communication 415
11.5.2 Theory and Empirical
Evidence of Good Earnings
Management 416
11.6 The Bad Side of Earnings
Management 422
11.6.1 Opportunistic Earnings
Management 422
11.6.2 Do Managers Accept Securities
Market Efficiency? 425
11.6.3 Implications for
Accountants 426
11.7 Conclusions on Earnings
Management 427
12 Standard Setting:
Economic Issues 443
12.1 Overview 443
12.2 Regulation of Economic
Activity 444
12.3 Ways to Characterize Information
Production 446
402
12.4 Private Incentives for
Information Production 447
12.4.1 Contractual Incentives for
Information Production 447
Contents ix
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12.4.2 Market-Based Incentives for
Information Production 449
12.4.3 Securities Market Response to
Full Disclosure 450
12.5 A Closer Look at Market-Based
Incentives 452
12.5.1 The Disclosure Principle
12.5.2 Signalling 456
12.5.3 Financial Policy as a
Signal 459
12.5.4 Private Information
Search 460
12.5.5 Summary 461
12.6 Sources of Market Failure
12.6.1 Externalities and
Free-Riding 462
12.6.2 The Adverse Selection
Problem 463
12.6.3 The Moral Hazard
Problem 464
12.6.4 Unanimity 465
12.6.5 Summary 465
12.7 How Much Information Is
Enough? 466
12.8 Decentralized Regulation 468
12.9 Conclusions on Standard Setting
Related to Economic Issues 469
13 Standard Setting:
Political Issues 483
13.1 Overview 483
13.2 Two Theories of Regulation
13.2.1 The Public Interest
Theory 484
13.2.2 The Interest Group
Theory 485
13.2.3 Which Theory of
Regulation Applies to
Standard Setting? 486
x Contents
13.3 Conflict and Compromise 486
13.3.1 An Example of Constituency
Conflict 486
13.3.2 Comprehensive Income 489
13.3.3 Conclusions Regarding
Comprehensive Income 491
452 13.4 Rules-Based versus Principles-
Based Accounting Standards 492
13.5 Criteria for Standard Setting 493
13.5.1 Decision Usefulness 493
13.5.2 Reduction of Information
Asymmetry 493
13.5.3 Economic Consequences of
462 New Standards 494
13.5.4 The Political Aspects of
Standard Setting 495
13.5.5 Summary 496
13.6 International Integration of
Capital Markets 496
13.6.1 Convergence of Accounting
Standards 496
13.6.2 Effects of Customs and
Institutions on Financial
Reporting 497
13.6.3 Enforcement of Accounting
Standards 499
13.6.4 Benefits of Adopting
High Quality Accounting
Standards 500
13.6.5 Should Standard Setters
Compete? 501
13.6.6 Summary of Accounting for
484 International Capital Markets
Integration 502
13.7 Conclusions and
Summing Up 503
Biblography 513
Index 531
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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 account-
ing 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 rela-
tionships.
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
understand and accept it as relevant to the financial accounting environment and ulti-
mately to their own professional careers.
This book seems to have achieved its goals. In addition to being part of the CGA pro-
gram of professional studies for a number of years, it has been extensively used in finan-
cial accounting theory courses at the University of Waterloo, Queen’s University, and
numerous other universities, both at the senior undergraduate and professional Master’s
levels. I am encouraged by the fact that, by and large, students comprehend the material
and, indeed, are likely to 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 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 struc-
ture of financial accounting and standard setting. It features considerable coverage of
financial accounting standards. Many important standards, such as reserve recognition
accounting, management discussion and analysis, employee stock options, post-employ-
ment benefits, financial instruments, ceiling tests, hedge accounting, and comprehensive
income are described and critically evaluated. 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 stan-
dards to the theoretical framework of the book, the coverage provides students with the
occasion to learn the contents of the standards themselves.
I have also used this material in Ph.D. seminars. Here, I concentrate on the research
articles that underlie the text discussion. Nevertheless, the students appreciate the frame-
work 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
commentary, and provides extensive references to other research papers underlying the
text discussion. 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.
A major change in this fifth edition is to orient the coverage of accounting standards
to those of the International Accounting Standards Board (IASB), in place of Canadian
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standards in the CICA Handbook. This is because of the planned adoption in 2011 of
IASB standards for public companies by the Canadian Accounting Standards Board. This
change does not affect the approach and structure of the book. While there are numerous
differences in detail, international and Canadian accounting standards are already similar
at a conceptual level, and are continuing to move closer together. Consequently, prior to
2011, Canadian readers can accept IASB standards as roughly equivalent to those in
Canada. Of course, this change to IASB standards should appeal to the numerous users of
this book in other countries that have adopted IASB standards.
As in previous editions, coverage of major U.S. accounting standards is included, par-
ticularly where these differ from, or are in advance of, international and Canadian stan-
dards. Other changes include expanded coverage of financial reporting issues arising from
global integration of capital markets, and improvements to the discussion and presenta-
tion of agency theory.
I have updated references and discussion of recent research articles, revised the expo-
sition as a result of comments received and experience in teaching from earlier editions,
and added new problem material. I have also expanded the number of optional sections
for those who do not wish to delve too deeply into certain topics.
This edition now accepts that securities markets are not fully efficient, although it
continues to argue that markets are close enough to full efficiency that the efficient mar-
ket model provides useful guidance to theory and practice. In part, this continuing accept-
ance of the efficient market model reflects my perception from the academic literature
that the efficiency model is recovering somewhat from the onslaught of behavioural
finance. More fundamentally, however, research suggests that departures from full effi-
ciency can be just as well explained by rational investor behaviour as by non-rational
behavioural characteristics. Consequently, this edition retains its acceptance of the
rational Bayesian decision theory model of the average investor.

SUPPLEMENTS
Instructor’s Resource CD-ROM (ISBN 978-0-13-604110-8)
This resource CD includes the following instructor supplements:
■ Instructor’s Manual The Instructor’s Manual includes suggested solutions to all the
end-of-chapter Questions and Problems. It also offers learning objectives for each
chapter and suggests teaching approaches that could be used. In addition, it comments
on other issues for consideration, suggests supplementary references, and contains
some additional problem material.
■ PowerPoint® Lecture Slides PowerPoint presentations offer a comprehensive selec-
tion of slides covering theories and examples presented in the text. They are designed
to organize the delivery of content to students and stimulate classroom discussion.

xii Preface
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Acknowledgments

I have received a lot of assistance in writing this book. First, I thank CGA Canada for
their encouragement and support over the past years. Much of the material in the ques-
tions and problems has been reprinted or adapted from the Accounting Theory I course and
examinations of the Certified General Accountants’ Association of Canada. These are
acknowledged where used.
I acknowledge 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. Financial support of the School of
Business of Queen’s University is also gratefully acknowledged.
I extend my thanks and appreciation to the following instructors who provided formal
reviews for this fifth edition:
• Granville Ansong (Saint Mary’s University)
• Sati P. Bandyopadhyay (University of Waterloo)
• Paul Berry (Mount Allison University)
• Kate Bewley (York University)
• Carla Carnaghan (University of Lethbridge)
• James C. Gaa (University of Alberta)
• Maureen P. Gowing (University of Windsor)
• Irene M. Gordon (Simon Fraser University)
• Mary Oxner (St. Francis Xavier University)
I also thank numerous colleagues and students for advice and feedback. These include
Sati Bandyopadhyay, Phelim Boyle, Dennis Chung, Len Eckel, Haim Falk, Steve Fortin,
Irene Gordon, Jennifer Kao, David Manry, Patricia O’Brien, Bill Richardson, Gordon
Richardson, Dean Smith, Dan Thornton, and Mike Welker. Special thanks to Alex
Milburn for invaluable assistance in understanding IASB standards, and to Dick
VanOfferen for helpful comments and support on all editions of this work.
I thank the large number of researchers whose work underlies this book. As previous-
ly mentioned, numerous research papers are described and referenced. However, there are
many other worthy papers that I have not referenced. This implies no disrespect or lack
of appreciation for the contributions of these authors to financial accounting theory.
Rather, it has been simply impossible to include them all, both for reasons of space and
the boundaries of my own knowledge.
I am 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 research assistance.
At Pearson Education Canada I would like to thank Samantha Scully, Gary Bennett,
Cas Shields, Megan Dunkley, Imee Salumbides, Melissa Hajek, Laurel Sparrow, Leanne
Rancourt, Deborah Starks, Hermia Chung, and Miguel Acevedo.
Finally, I thank my wife and family who, in many ways, have been involved in the
learning process leading to this book.
William Scott
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