CHAPTER 1

1.2 Historical perspective

Double entry system in 1494 by Luca Paciolo
Corporate Income tax in US introduced in 1909

A major lesson learned by accountants as a result of Great Depression was that values are fleeting. The
outcome was a strengthening of the historical cost basis of accounting.

Still historical cost is the primary basis of accounting however, if assets are impaired, there are written down to a
lower value.

Under IASB standards, capital assets can sometimes be written up over cost if their value has increased.

Generally speaking standard setters have moved steadily toward current value alternatives to historical cost
accounting.
There are two main current value alternatives:
Value in Use: such as discounted present value of future cash flow
Fair Value: also called Exit Price or Opportunity cost.

SEC usually chose to delegate most standard setting to the Profession.

Measurement of inflation is problematic, current values are very volatile so taking them into account would not
improve measurement of firm's performance. Nevertheless, standard setters mostly require some disclosure of
the effects of changing prices.

Theory of Rational Decision Making :

Prescribes how individuals may revise their beliefs upon receipt of new information.

Theory of Efficient Securities Markets : role of information in capital market

Possibility Theorem of Arrow : it is not possible to combine differing preferences of individual members of
society into a social preference ordering that satisfies reasonable condition. This implies that there is no such
thing as perfect or true accounting concepts since investors will prefer different accounting concepts that will
managers. So no set of concepts will be fully satisfactory to both parties.
These theories generated the concept of Decision Usefulness.

Theory of Economics of Imperfect Information : some individuals have an information advantage over others.
These led to the development of Theory of Agency.

Overtime the Handbook gained recognition as the authoritative statement of GAAP in Canada.

Stock market boom in the late 1990s and its collapse in the early 2000s (specially in the "hi-tech" industry
resulted in revaluation of numerous financial reporting irregularities including revenue recognition.

During the boom many firms specially newly established ones with little or no history of profits, attempted to
impress investors by reporting a rapidly growing stream of revenue which were premature and had to be
reversed.

Market Meltdown 207-2008 :

The rational reaction to growing suspicion about the value of a security was to lower the price offered or not to
buy at all leading to further decline in market value.
Liquidity Risk :
the risk of a continuing decline in demand due to skeptical investors' lack of buying which can result in market
value less than value in use.

Another major contributing factor to the market collapse (meltdowns )of 2007-2008 :
Counterparty Risk : CDS(Credit Default Swaps) issuers were not able to meet their obligations due to Shadow
Banking System.

The underlying causes are rooted in both Wealth Inequality & Global Imbalances in consumption, trade, and
foreign exchange market. However , the blame for the initial collapse is usually laid at the feet of :
• Lax mortgage lending practices and inadequate regulation
• Lack of transparency of the complex financial instruments created by the financial and investment
communities
• sponsors' failure to adequately control the risks of excessive leverage in the quest for leverage profits

Regulation to what extent?

• one response is to require financial institutions to hold increased capital reserve
• Another is to limit or modify the managerial compensation practices including large amount of stock
options , contributed to meltdowns by encouraging managers to indulge in excessive off balance sheet
leverage
• however we should remember that regulation is costly and subject to failure

4 points relevant to accounting stand out from the market collapse of 2007-2008:
1. Financial Reporting must be transparent so investors can properly value assets and liabilities and the firm
that posses them
2. Fair value accounting based on market value or estimate may understate value in use when market
collapse due to liquidity pricing resulted from severe decline in investor confidence.
3. Off - balance sheet activities should be fully reported, even if not consolidated since they can encourage
excessive risk taking by mgm
4. Substantial changes to existing standards, including increased disclosures of mgm compensation have
taken place.

Effective Contracting Approach:

The severe criticism of fair value accounting arising from the security market meltdowns have strength this
alternative. It argue that the contracts firms enter into create a primary source of demand for accounting
information. The role of accounting information is helping to maximize contract efficiency or more generally to aid
in effective corporate governance.

The role of financial reporting for debt and compensation contract is to generate TRUST. An efficient contract
generate this trust at lowest cost. Thus covenants in debt contracts increase lender trust in the security of their
loans. Basing managers compensation on net income increase investor trust.

Effective Contracting Approach leads to some major accounting differences:

1. An increased emphasis on RELIABILITY which benefit lenders and shareholders trust.

2. Role of CONSERVATISM in financial reporting (LC&NRW, IMPAIREMENT TESTS,...)
unrealized losses from decline in value are recognized when they take place, but gains from increase in
value are not recognized until they are realized.

How to restore and maintain public confidence in financial reporting?

Ø Through increased regulation including new accounting standards

Ø Ethical behavior of accountants and auditors is also required

Conforming to GAAP is not sufficient to prevent financial reporting failures. Accountants must behave with
integrity and independence in putting the public interest ahead of the employer's and client's interests
in case of conflict.
RULES-BASED VS PRINCIPLES-BASED
Rules-based standard attempt to lay down detailed rules for how to account but rules can be
circumvented by institutions.
Principle-based lay down general principles only and rely on auditor professional judgment.
 IASB standards are more Principle-based.
Even with a strong conceptual framework, standards will face pressures from managers and even
governments to bend financial reporting to their wishes. To resist such pressures accountants and
auditors will have to adopt the longer term view of their responsibilities (toward public).

COMPLEXITY of the environment of ACCOUNTING

It is complex because :
Ø the product of accounting is INFORMATION - a powerful & important commodity
Ø The absence of perfect or true accounting concepts & standards. As a result individuals will have different
reaction to the same information
Ø It does more than affect individual decisions. It also affects the working markets such as security
market and managerial labor market so it affect the efficiency and fairness of the economy

The CHALLENGE for financial accountants is to survive and prosper in a complex environment characterized by
conflicting preferences of different groups with interest in financial reporting.

INFORMATION ASYMETRY
happened when some parties to business transactions :
EITHER have an information advantage over others (ADVERSE SELECTION)
OR may take actions that are unobservable to others.(MORAL HAARD)

Both of them result from information asymmetry. The difference is that Adverse selection involves inside
information about matters affecting future firm performance while Moral Hazard involves manager effort.

Considering NET INCOME as a measure of managerial performance help to control moral hazard in two ways:
Ø can serve as motivator of manager performance
Ø inform the managerial labor market, so manager who shirks will suffer a decline in income, reputation
and personal market value in the long run.

The FUNDAMENTAL PROBLEM of financial accounting theory :

how to design and implement concepts and standards that best combine the investor-informing and manager
performance-evaluating roles for accounting information?

Ø some policies require tradeoffs between these roles

Ø other policies such as expanded disclosure may facilitate both roles
Ø OCI is another approach to reconciling the two roles

There is two view about fundamental problem:

1. One view argue that market force can sufficiently control the adverse selection and moral hazard
problem
2. The second view argue that information is such a complex and important commodity that market force
alone fail to adequately control the problem of adverse selection and moral hazard which leads directly
to the role of standard setting.

IDEAL CONDITION (FIRST BEST)

- Firms' future cash flows and their probabilities are known

-The economy has perfect and complete market
- Lack of information asymmetry and other barriers to fair and efficient working of market

[the process of standard setting pages 29-32]

 CHAPTER 2
Present Value Model provides the utmost in relevant information to F.S s users.

Relevant Information : information about the firm's future economic prospect ( its dividends, cash flows,
profitability)
Reliable Information : information that faithfully represents the firm's financial position and result of operation

State of Nature : uncertain future events that affect firm performance such as state of the economy

Under Ideal Conditions :

• market value of assets and liabilities can serve as indirect measure of present value.
• future cash flows are known with certainty.
• It is possible to prepare completely relevant and reliable F/Ss.
• firm's net income does not play any role in firm valuation because future cash flows are known. there is no
information in the current net income that helps investors predict future economic prospects of the firm.
When the condition are not ideal I/S assume a significant role
F/Ss based on Expected Present Value are also relevant and reliable. They are relevant because they are
based on expected future cash flows. They are reliable their values faithfully represent these expected future cash
flows.

Present Value Accounting

1- Embedded Value
2- Reserve Recognition Accounting (for oil & gas companies) : provisions such as
– only proved reserves are included
– Discounted at mandated rate of 10%
– Revenue recognized as reserves are proved
– Uses average oil & gas prices for the period Not when expected to be sold

are used to maintain the reliability however they reduce relevance since the extent to which the resulting present
value predicts future cash flows and their risk is reduced . Thus while RRA is more relevant than historical costs
of proved reserves it is by no means completely relevant.
Moreover, RRA is not a complete representation since it applies only to proved reserves so reliability is not
perfect. Also
– Estimates needed to apply RRA and Estimates are subject to error and bias this reduce the
reliability
 • Without ideal conditions , complete relevance and reliability are no longer attainable and one must be
traded off against the other. Greater relevance requires more estimates
• But, more estimates decrease reliability therefore Relevance and reliability must be traded off

Historical Cost VS Current Valuation

Historical cost accounting is relatively reliable since the cost of an asset or liability to a firm is usually a verifiable
number that is less subject to errors of estimation and bias than are present value calculations. However it may
be low in relevance. The relevance of current value accounting generally exceeds that of historical cost but the
need for estimates when condition are not ideal undermine its reliability.

Revenue Recognition :
under Historical Cost is as inventory sold
under Current Value is as change in current value occur. So it is earlier than under historical cost.

Recognition Lag : Extent to which the timing of revenue recognition lags behind changes in real economic value.
It is longer under Historical Cost
Matching of Costs and Revenues : There is little match under Current Value Accounting
The Non-Existence of True Net Income

• Why?
– Incomplete markets : Reasons for incompleteness
• thin markets
– As for oil and gas reserves
• information asymmetry
– Too much asymmetry, no market develops

– If market values are not available for all firm assets and liabilities due to incompleteness of
markets an income measured based on changes in market value is not possible
– If have to estimate present value, true net income does not exist

• The Implications for accountants

– Accountants not needed if true net income did exist
– Judgement required to estimate net income
– Judgement is essence of a profession
 CHAPTER 3
Accountant have adopted a decision usefulness approach to financial reporting as a reaction to the
impossibility of preparing theoretically correct F/Ss. However, this approach leads to two problems :
who are the users? and what information they need to make good decisions?

To answer these questions , accountants have turned to various theories in economics and finance. The
theory of Rational Decision Making help to understand how individuals may make rational decisions
under uncertainty.

The information system

The Rational, Risk-Averse Investor

Rational means in making decision, the chosen act is the one that yields the highest expected utility.
It is usually assumed that rational investors are Risk Averse.

The expected payoff of flipping a fair coin is zero, regardless of the amount at stake, since you have
50% chance of winning and a 50% chance of losing in all cases. Thus, your increasing nervousness as
stakes rises means another effect, beyond the expected value of gamble, is operating. This is Risk
Aversion.

Risk Averse individuals trade off Expected Return and Risk. They willing to bear more risk in exchange
for a higher expected value. Utility function of a risk-averse individual is CONCAVE

utility(x)

U(x)= √x , x≥0

payoff
If individual assumed to be risk neutral, They evaluate risky investments strictly in terms of expected
payoff and risk itself does not matter per se. Therefore utility is simply a linear function of the payoff.

Risk neutrality may be reasonable when the payoffs are small but risk aversion is most realistic
assumption in most cases.
Risk Aversion is important concept to accountants, because it means that investors need information
concerning The Risk as well as The Expected Value of future returns.

Management Discussion & Analysis is an explanation of the company performance, financial

condition, risk and future prospects. Its language should be understandable by the investors. Forward
Looking information is encouraged. Its objectives include :
• To supplement the financial statements/discuss information not fully reflected in the F/Ss
• Discussion of risks facing the firm
• Provide information to help investors determine if past performance is indicative of future
performance
The MD&A standard is consistent with theory of rational decision making. It emphasize full
disclosure and recognize that investors need forward looking information and information about risk.

Is MD&A decision useful? It is hard to evaluate since it consists mainly of words. It Also suffer from low
timeliness
Conceptual Framework
Major Professional Bodies such as IASB/FASB have adopted the decision usefulness approach
because according to them the objective of financial statements is to provide financial information that is
" useful to potential investors, lenders and other creditors".
 CHAPTER 4
Efficient Securities Market Theory alerts us to the Primary Reason for Existence of Accounting :
Information Asymmetry . Financial reporting protect investors with information disadvantage from
possible exploitation by the better informed. Accounting is a mechanism that enable communication of
useful information from inside the firm to outside.
To the extent that security markets are not fully efficient it increase the importance of financial reporting.

If information were free (like under ideal condition) all investors would use them and the process of
arbitrage ensure that the market value of the firm adjusted.

But it is not free under non-ideal conditions therefore :

• Investors must decide how much information to acquire to form their subjective estimates of firms'
future performance
• These estimates will need revision as new information comes along
So each investor face a cost-benefit tradeoff for information amount.

Informed Investors : Those who spend time and money to use information sources to guide their
investment decision. When a sufficient number of investors behave this way the market become
Efficient.

Efficient Security Market (semi-strong efficiency) : is one where prices of securities traded on that
market at all times fully reflect all information that is publicly known about those securities.

Strong Form Efficiency : Prices reflect all information not just that is publicly available.

Not every insider is "BAD". Some managers may seek ways to credibly communicate their inside
information to the market to strengthen their firms' share price and their reputations.
Managers may:
• Engaged in Voluntary Disclosure
• signal inside information by its choice of accounting policies. EX: Adoption of conservative
policies might be sign of high future cash flows and earning

Market Efficiency
• is a relative concept
 • implies that once new information become available to the public the market price will quickly
adjust to it
• Implies that investing is a " Fair Game"
• Implies that security market price should fluctuate randomly over time. (no serial correlation of
share returns.) because anything about firm value that can be EXPECTED will be fully reflected in
its security price by efficient market as soon as the expectation is formed
EX: seasonal nature of business, the retirement of its CEO, expected profit on a new contract

So the only reason for price to change again is if some relevant but UNEXPECTED information comes
along which by definition occur randomly. (Random Walk)

Market Efficiency does not guarantee that security prices fully reflect real firm value. It suggest that
prices are unbiased relative to publicly available information and will react quickly to new information.

The quantity and quality of publicly available information will be enhanced by Timely Reporting and Full
Disclosure.

what types of implication does the theory of efficient securities market hold for accounting?
According to William Beaver there are 4 major implications.
1) First, the selection of accounting policy does not affect security prices as long as the selected
policies:
A. are disclosed in financial statements along with sufficient information that enables readers to convert
across different policies.
B. Have no differential cash flow effects.
He believes accounting policy choices such as S.L vs declining balance for depreciation has only "
Paper Effect" .
Policy choice will not affect future cash flow& dividends, it only affect reported net income. Therefore, it
has no effect on the price of securities because price is determined based on future cash flow&
dividend.
2) Efficient security market leads to the need for full disclosure in financial statements. Management
should disclose all the relevant information on a timely basis. The more information the firm disclose
about itself, the greater confidence the investor have in the working of security market & less worry
about insiders .
However,
3) firm should not overly concerned about the naive investors( those who have less or no knowledge to
review financial statements) .This means there is no need for financial statement to be presented in a
simple manner that everyone can understand it. An efficient market implies that investors will be "price
protected" by market because informed investor will engage in busy/sell decision base on disclosed
information resulting in moving the market price toward its efficient level.
Also naive investors can hire experts to interpret information for them or can just follow informed
investors therefore any information advantage that informed investor have quickly shared between all
investors.
4) lastly, it is important to note that the accountants are not the only source of information for investors.
There are other sources such as : websites, medias disclosure by mgm, financial institutions. If financial
statement are not informative, the y become useless to investors. If accountants do not provide useful
cost effective information the role of the accounting function will decline over time as other sources take
over. Our survival is related to the recognizing the fact that the ultimate responsibility of our profession is
to society.

If prices fully reflect available information, there is no motivation for investors to acquire information.
Fully informative share prices would collapse as investors stopped gathering information. but once share
prices stopped reflecting all available information, investors would gather information and share price
would quickly become fully informative again. This process would continue over time.

We should be aware that there are other sources of demand and supply for securities than buy/sell
decisions of rational informed investors which called Noise Traders (those who sell / buy for variety of
UNPREDICTABLE reasons which are not based on a rational evaluation) therefore it is possible for the
security price to be higher because of Noise Traders and rational investor must find out which
explanation for the price is the correct one , noise trading OR real info.

Security prices are PARTIALLY INFORMATIVE in the presence of noise trading and rational expectation

The extent to which investor gather information depends on :

• how informative the price is
• the quality of F/S information
• the cost of analysis and interpretation

Security prices respond less to F/S information of large firms than small firms because they are more in
the news and their price are more informative
Critique of the CAPM (Capital Asset Pricing Model) . CAPM assumes :
• Rational expectation
• investor rationality
• that transaction cost of buying and selling securities are zero.
• no difference exists between rational investors

Information Asymmetry :

there are two types of information asymmetry .

Adverse selection & Moral hazard.
Adverse selection arise when one party knows something about the asset being traded that other party
does not know. Insider might have more information in compare to ordinary investors.
Moral hazard: arise because manger may shirk on effort and does not do his/her responsibilities
perfectly . This two types of information asymmetry increase the risk for investor therefore investors in
order to protect themselves bid down the price of securities and this increase firm's cost of capital.
A popular example of " Adverse Selection" is used car sales. The seller has an obvious information
advantage over the buyer by knowing the history of the cars how it has been driven and may try to take
advantage of this by bringing a lemon to market, hope to get more than it is worth. Buyer on the other
side, because of lack of information will lower the price they are willing to pay for any used cars
(pooling). In effect, the market of a used car reflect the average quality of used cars on market. As a
result, many good cars will have market value less than real value of their future benefits & vise versa
for bad cars. Knowing this, owners if good cars are less likely to bring them to market. In order to
prevent the collapse of market there is a variety of regulatory that market use to reduce the effect of
adverse selection. Safety certificates repair records, warranties, test drives .
Security markets are also subject to the lemons problem. Outside investors face estimation risk because
they do not know as much as insider about the firm's real performance however, unlike for used cars
investors may diversify some f the risk Firms that want to avoid this and prevent their cost of capital
from increase try to reduce inside information about themselves by disclosing related information as
much as possible.
In order to reduce potential affect of inside information many firms have "Blackout Policy" which restrict
firm insiders from trading company share during period when they are likely to possess inside
information .There is a study of 260 US firms which suggest that given the opportunity, insiders do
exploit their information advantage, however when general counsel approval was required for insider to
do the trade, some abnormal profits were eliminated.
To reduce the potential of inside information to concern investors firms might use Blackout Policies
which restrict insiders from buying or selling company shares during periods when they are likely to
possess inside information.

Fundamental Value of a Share

Is the value it would have in an efficient market if there is no inside information that is all existing
information about the share is publicly available.
This concept is theoretical idea. We would not expect that inside information can be completely
eliminated. It may not be cost effective for a firm to directly reveal strategic information about research in
process or plans for a takeover bid.

Government and accounting bodies effort to restore public confidence can be regarded as attempt to
reduce estimation risk arising from inside information by improving reporting informativeness therefore
moving share prices closer to fundamental value.

Several Possible reasons for Security Market Inefficiency (implied by inner circle):
• Biased Investors do not take all publicly available information into account
• Noise Trader who may drive market price away from the efficient market ideal.

These inefficiencies add an important role for financial reporting to reduce them by making the
mispricing area between the two inner circles as small as possible.
High quality reporting fulfill this role. It Can :
• Help behaviourically biased investors improve their decisions
 • Speed up the corrections to mispricing caused by noise trading
• Help rational investors learn over time or by releasing publicly available information reduce the
effects of higher order beliefs.

The market can provide incentives for firms to release inside information over and above that required
by regulation. These firms may enjoy higher share price and lower cost of capital because full disclosure
reduces investors' concerns about inside information.

Obviously regulation and market incentive are not mutually exclusive. Regulation is like a " stick" and
requires penalties to enforce it. The need for regulation will be reduced to the extent that "carrots"
operate to motivate full discloser
 CHAPTER 5

MARKET RESPONSE

- When security market price respond to accounting information we say that accounting information has
VALUE RELEVANCE. In this chapter F/S Information is limited to reported net income as its proxy.

- If market is going to react to earning information announcement it should do so in a narrow window of a

few days surrounding these dates.

- The Good or Bad news in reported net income is usually evaluated relative to what investors
EXPECTED. The proxy for the investors expected income are usually based on Previous Earning or
Analysts Earning Forecasts.

- There are many events taking place that affect a firm's share volume and price. So it is hard to find
market response to reported net income. Thus the impact of market-wide and firm-specific factors on
share returns should be separated.

Why the market might respond more strongly to the good/bad news in earnings for
some firms than for others?
1. Beta : The RISKIER the sequence of a firm's future expected return the LOWER its value will be
to a risk-averse investor, other things equal. For a diversified investor, the relevant risk measure
of a security is its BETA. High ß increases the portfolio risk, which will decrease the demand and
results in a lowered ERC
2. Capital Structure : High levered firms= lower ERC
3. Earning Quality :
4. Growth Opportunities : When there is more growth opportunities, ERC is higher.
5. The Similarity of Investors Expectations : More similar the investor’s earnings expectations
higher the ERC
6. The Informativeness of Price :

A Caveat About The Best Accounting Policy

Accountant can be guided by securities market reaction in determining usefulness of F/S Information.
We might tempt to conclude that the best accounting policy is the one that produce the greatest market
price response but we must be careful. Accountant may be better off to the extent that they provide
useful information to investors , but it does not mean that SOCIETY will necessarily be better off.
Because :
• The information has the characteristics of a Public Good (consumption by one person does not
destroy it for use by another) while Production of annual reports is costly. Also other costs include
the possible disclosure of valuable information to competitors. As a result investors may perceive
accounting information as useful and demand the extra amount of information even though from
society's stand point the cost of this information outweigh the benefit to investors.

• Information may be useful to potential investors and competitors but managers and current
shareholders may be harmed by supplying it. As a result the social value of such information
depends on both the benefits and costs of both sides.
Consequently, from a social perspective, we cannot rely on the extent of security market response to tell
us which accounting policies should be used or how much information to produce.

Fair Value accounting is Pro-cyclical , It increases the magnitude of booms and busts. in good times
it inflate earnings. firms are encouraged to expand and the bank are encouraged to lend to support this
expansion. However, when the boom collapses liquidity pricing can result. the banks stop lending and
the economy falls into recession.
 CHAPTER 6
The Measurement Approach to decision usefulness implies greater usage of current values in the F/S
proper. However accountants disagree about extent to which current value accounting increase
informativeness.

Why Average Investors Behavior May Not Correspond To The Rational Decision Theory?

1. Investors may have LIMITED ATTENTION due to have limited time or ability to process all
available information. Then they will rely on readily available information such as "bottom line"

2. Investors may be biased in their reaction to information such as being CONSERVATIVE in their
reaction to new evidence OR they retain excess weight on their prior beliefs.

3. Individual are often OVERCONFIDENT , they overestimate the precision of information they
collect themselves

4. Individuals may assign too much weight to evidence that is consistent with the individual's
impressions of the population from which the evidence is drawn (REPRESENTATIVENESS)
5. Some Individuals are SELF-ATTRIBUTION biased , they feel that good outcomes are due to their
abilities whereas bad outcomes are not their fault.
6. MOTIVATED REASONING is another factor. Individuals accept at face value information that is
consistent with their preferences (Good News) however Bad News are received with skepticism
and they attempt to discredit it

PROSPECT THEORY

Provides a behavioral-based alternative to rational decision theory. According to this theory an investor
considering a risky investment(a prospect) will separately evaluate prospective gains and losses in
contrast with decision theory where investors evaluate decisions in term of their effects on their total
wealth. This is an implication of NARROW FRAMING.

The investor's utility for gains is assumed to exhibit the Risk-Averse concave shape however, prospect
theory assume LOSS AVERSION whereby individuals dislike even very small losses.
The utility for losses is assumed to be convex so the investor exhibits Risk-Taking behavior. This
leads to a DISPOSITION EFFECT whereby the investor holds on to losers and sells winner, and may
even buy more of a loser security.
U(x)

Loss Gain

Stock Market Bubbles :

Share prices rise far above Fundamental Values, represent an extreme case of market volatility. Actually
the 2007-2008 market meltdown was a bubble. The development of a bubble does not necessarily
contradict market efficiency.

Efficient Security Market Anomalies

• Post - Announcement Drift

• Market Response to Accruals :

Net Income = Cash Flow from Operation +/- Net Accruals

Accrual are more subject to errors of estimation and possible manager bias than cash flows. This lower
reliability should reduce the association between current accruals and next period's Net Income.
Therefore it was presumed that the cash flow component of earnings is more persistent than the accrual
component but the research shows this does not happen.

Since low reliability accrual are more subject to manager manipulation the finding suggest that investors
do not fully take the possibility of earnings management into account when reacting to reported earnings
 CHAPTER 7

Both version of current value accounting offer increased RELEVANCE relative to historical cost
accounting however they both face problem of RELIABILITY.

under VALUE IN USE reliability issues arise both because future cash flows usually have to be
estimated and because management may strategically change intended use hence the future cash flows
of the assets and liabilities.

Reliability of FAIR VALUE is high when valuation is based on well-working market value however due to
market incompleteness such values may not exist then reliability issue also arise for fair value.

Partial List of Current Value -Based Measurements in GAAP :

• A/R & A/P
• Cash Flows fixed by contract
• The LC&NRV
• Revaluation Option for PPE
• Impairment Test for PPE
Therefore we can realize that a considerable amount of Measurement Approach is inherent in the
Mixed Measurement Model

Accounting for Financial Instrument is an important application of Fair Value accounting

Derivative Instruments are contracts the value of which depends on some underlying Price, Interest
Rate, Foreign Exchange Rate, or other variables. EX : Option, Future Contract, Forward Contract, Swap
Contract, Fixed Rate Loan Commitment, Interest Rate Cap or Floor,...

The main aspects of these derivatives is their LEVERAGE , a lot of protection can be acquired at a
relatively low cost. This low initial Investment characteristics is a reason why accountants have found
them difficult to deal with under historical cost accounting. Since there is a little or no cost to account for
, all or part of the contract is Off Balance Sheet. In this regard, the accounting for derivatives is moved
substantially toward a Measurement Approach under IFRS9 and they should be measured at fair value
for B/SH purposes.
Fair value accounting for financial instrument came under considerable pressure following the
2007-2008 market meltdowns due to concerns about huge write-offs of financial assets triggered
by falling market prices and lack of existence of prices due to inactive market in many cases.

The other factor that contributed to the 2007-2008 market meltdowns are:
DERECOGNITION & CONSOLIDATION
Off balance sheet financing , which concealed much of the risk borne by financial institutions, would not
be possible without asset derecognition and subsequent failure to consolidate the off balance sheet
entities that held many of the sponsors' derecognized asst. New rules attempt to control off balance
sheet financing.

Accounting for INTANGIBLES & GOODWILL

Application of the measurement approach to accounting for goodwill create severe Reliability Problems.
These problems is somehow lesser for purchase goodwill since at least an estimated cost figure is
available although the calculation of amortization was arbitrary due to the difficulty of establishing useful
life. Moreover management disliked being charged for goodwill amortization and took step to avoid it.
(by adopting Pooling of Interest & emphasize Pro-Forma Income.) Standard setters have moved toward
measurement approach to Purchase Goodwill by introducing impairment test.
For self-developed goodwill standard setters react by requiring immediate expensing of the cost which
create a mismatch between costs and revenues. A suggestion to improve the accounting for self-
developed goodwill is capitalization and amortization of successful research projects.
 CHAPTER 8
Efficient Contracting Theory studies the role of financial accounting information in moderating
Information Asymmetry between contracting parties thereby, contributing to efficient contracting and
stewardship and efficient corporate governance. In both case of moral hazard and adverse selection,
outside contracting parties look to accounting information to help protect themselves from exploitation.

Corporate Governance : Policies that align the firm's activities with the interests of its investors and
society. For good corporate governance contracts should be efficient (must attain an optimal tradeoff
between the benefits and costs of contracting.
Payoff Asymmetry : Stand to lose if the firm perform poorly but the gain is limited if the firm performs
well. (like for lenders,...). This asymmetry shifts lenders' Relevance-Reliability tradeoffs toward greater
concern for reliability relative to equity investors. Also it creates a demand for conditional conservatism
for impairment test. Lenders' demand for information about unrealized losses is greater than for
unrealized gain to be able to predict better financial distress.

CONTRACT RIGIDITY
Contract by their nature can be hard to change , they are RIGID.
Also many contract are long term. If long term contracts depends on accounting variables , any changes
in accounting standards can adversely affect covenant value increasing the likelihood of violation.
How To Solve The Problem?
1. possibility of RENEGOTIATION : such a process would be long and costly
2. Incorporate PROVISIONS : however it is impossible to anticipate all future events that can affect
covenant values particularly new accounting standards
3. To FREEZE the accounting policies used to calculate covenant values : This would incur the cost
and inconvenience of keeping track of the effects
Arguably a more efficient way to deal with changes in GAAP is to allow the manager some
FLEXIBILITY in accounting policy choice so he/she can adapt to unexpected circumstances.

This flexibility may open up the possibility of Opportunistic Behavior for rational manager. But if
manager has NO FLEXIBILITY a new accounting policy that reduce net income may result in the
manager changing OPERATING POLICIES such as cutting R&D or reduce maintenance.

Therefore firms face a tradeoff in the accounting policy flexibility granted to managers. Too little flexibility
leads to contract inefficiency while Too much flexibility opens up the possibility of manager opportunism.

When manager change operating policies OR accounting policies in response to change in

accounting standards This is called the standard change creates ECONOMIC CONSEQUENCE.
Under efficient security market theory accounting standard changes DO NOT have economic
consequences if they are fully disclosed AND do not have cash flow effects.
 CHAPTER 9
AGENCY THEORY:
Is a branch of Game theory that studies the design of contracts between principal and Agent that
motivate the agent to work in the best interests of the principal. An efficient contract does this at lowest
cost to the principal. There might be a conflict between the interest of two sides of contract.
In Game Theory and in Agency Theory one player will not choose an act desired by another player just
because that player says so. Rather each player chooses the act that maximizes her/his own Expected
Utility
RESERVATION UTILITY
If the manager is to be willing to work for the owner for the current period the compensation offered must
be sufficiently large that his/her expected utility is at least equal to its opportunity cost

Most people, even managers, would prefer to take it easy, all other things being equal. This tendency of
an agent to shirk is an example of Moral Hazard.

DESIGNING A CONTRACT TO CONTROL MORAL HAZARD:

1. Direct Monitoring
If the owner could costlessly observe the manager's chosen act, this would solve the problem and this
contract would be called FIRST-BEST . But is in unlikely that the owner could monitor the agent's effort
in a managerial situation. The nature of managerial effort is so complex that make it impossible for the
remote owner to verify. Thus we have a case of Information Asymmetry : Moral Hazard
2. Indirect Monitoring
3. Internalizing the Manager's Decision Problem
Owner rents firm to manager and no longer cares what action the manager takes
4. Give the Manager a Share of the Profits
Most efficient alternative if the first-best is not attainable. However the payoff is not fully
observable until next period yet the manager must be compensated at the end of this period. A
solution is to base compensation on a PERFORMANCE MEASURE like Net Income.
But Net Income is not FULLY Informative about Effort due to Recognition Lag , also Poor corporate
governance which allow random error or bias into net income. Also Current activities may generate
future liabilities. Therefore since accrual are subject to error and bias and fair values are volatile, net
income does not tell the full story about current manager performance and is NOISY.

Since the agent is assumed risk averse , imposing compensation risk reduces his/her expected utility of
compensation. This requires the principal to increase the share of net income so to maintain the agent's
reservation utility.
The SECOND-BEST contract is the contract that imposes the lowest amount of risk on the manager
while maintaining reservation utility and manager's incentive to work hard.

When only net income is the performance measure manager has a further information advantage over
the owner that could leads to the possibility of earning management.

Some degree of earning management cab be " Good".

PROTECTING LENDERS FROM MANAGER

Another moral hazard problem is that the manager may act opportunistically against the best interests of
lenders, thereby benefitting him/herself and/or the shareholders at lenders' expense through :
• paying excessive dividends
• undertaking additional borrowing
• undertaking excessively risky projects
Rational lender will anticipate this behavior and raise the interest rates demanding for loan. As a result
manager may accept a covenant and limit dividend or borrowing to pay less interest although debt
covenants do not completely eliminate the possibility of firm financial distress.

Another way to protect lenders interest is to require manager to hold company debt (in the form of
pensions and deferred compensation) to prevent adopting excessively risky projects by manager.
However this might end up with manager adopts only very safe projects .

These suggest that manager compensation should include both EQUITY and DEBT AWARDS .

The optimal proportion

The proportion of compensation based on equity will be high: when the firm has significant growth
opportunities.
The proportion of compensation based on debt will be high: If the firm faces substantial risk of
bankruptcy .
Subsequent to the 2007-2008 market meltdowns deferred compensation and callbacks of compensation
already paid.
Characteristics a performance measure should have :

SENSITIVITY : The rate at which the expected value of a performance measure increase as the
manager works harder or decrease as the manager shirks.
PRECISION : in predicting the payoff from current manager effort

There is a tradeoff between SENSIVITY & PRECISION

 CHAPTER 10
Many compensation plans are based on two performance measures : NET INCOME & SHARE PRICE

The role of net income in motivating manager performance is equally as important as its role in
informing investors.

Are INCENTIVE CONTRACTS necessary?

CONS (FAMA) PRO (AFG)

No. because the managerial labor market control
moral hazard. Manager in order to maintain a
reputation will work hard. This argument assumes the short run, by managing the release of
an efficient managerial labor market that
properly value the manager's reputation
No. For the lower-level managers any shirking
will be detected and reported by manager below
them who want to go ahead . A process of
"Internal Monitoring"
If the expected costs of lost reputation are strong
enough an incentive contract would not be
necessary.
Fama did not consider that the manager may be
able to disguise the effect of shirking, at least in
information. Manager may try to fool the market
by opportunistically managing earnings to cover
up the shirking. So the managerial market is
subject to ADVERSE SELECTION as well as
MORAL HAZARD.
Two-period contract is more efficient because it
impose less risk than a sequence of two single-
period contracts. Using a joint observable payoff
in each period, the owner could offer a more
efficient contract by exploiting the ability of each
manager to observe the other manager's effort.
This will reduce AGENCY COSTs of moral
hazard but does not eliminate them therefore, an
incentive contract for lower-level is still
necessary.
Wolfson's finding suggest that market forces can
REDUCE the manager's moral hazard problem
but they DO NOT ELIMINATE it.(Managerial
labor market is not completely effective in
controlling moral hazard.A manager's past
success does not fully convince investors that
he/she will always " work hard")
Conclusion : while internal and market forces may help control manager's tendencies to shirk they don't
eliminate them. It seems that effort incentives are desirable for efficient contracting.

RBC compensation plan imposes compensation risk on the manager in addition to the firm-specific risk
arising from bonus deferrals, requirement to hold company shares,... based on the AGENCY THEORY
that agents must bear risk if they are to work hard. However, RBC plan to limit compensation risk since
too much risk will require increased compensation for risk averse managers or generate opportunistic
manager behavior such as excessive avoidance of risky projects.

THE THEORY OF EXECUTIVE COMPENSATION

The efficiency of a compensation contract may be increased if it is based on TWO or MORE

performance measures. But what determine the relative weight of each measure (net income and
share price) in evaluating manager's overall performance?
BD demonstrated that the linear mix of performance measures depends on the product of the
SENSITIVITY & PERCISION of those measures.

SENSITIVITY : Rate at which the expected value of the measure responds to manager effort

PERCISION : Reciprocal of the variance of the noise in the measure

BD showed:
the lower the noise (the greater the precision) in net income OR
the greater its sensitivity to manager effort
The greater should be the proportion of net income to share price in determining the manager's overall
performance.

How accountant can increase the sensitivity of net income?

• Through REDUCING RECOGNITION LAG by moving to current value. Since more of the
future payoffs from manager effort show up in current net income. However, this is a double-
edged sword since it tends to reduce precision. Thus it is unclear it would result in a net gain
in importance for net income.
 • Through FULL DISCLOSURE, particularly of low-persistence items. It increases sensitivity by
enabling the compensation committee to better evaluate manager effort and ability and thus to
evaluate earnings persistence.
• GAAP can reduce the scope for opportunistic earning management which reduce the
manager's ability to disguise shirking and therefore increase sensitivity .

Why the PRECISION for share price is RELATIVELY LOW? Does share price can be replaced as a
performance measure?
Low precision of share price mostly derives from the effects of economy-wide factors. For example if
interest rates increase the expected effects on future firm performance will quickly show up in share
price. These effect however, may say relatively little about current manager effort.
BUT the SENSITIVITY of share price is sufficiently great that it will always reveal additional payoff
information beyond that contained in net income. So as long as it contains some additional effort
information ii is not replaceable.

Generally, firms with substantial investment opportunities will want to increase the proportion of share
price-based compensation(long run effort). Alternatively if firm has to cut costs the firm may wish to
increase the weight of net income in the manager's compensation(short run effort).

Datar,Klup and Lambert suggest that decision horizon must be traded off with the sensitivity and
precision of performance measure.

THE ROLE OF RISK IN EXECUTIVE COMPENSATION

In the presence of moral hazard, the manager must bear some compensation risk if effort is to be
motivated. The more risk manager bear the higher must be their expected compensation if reservation
utility is to be attained.
If not enough risk is imposed the firm suffers from low manager effort.
If too much risk is imposed the manager may underinvest in risky projects.

WAYS TO CONTROL COMPENSATION RISK

1. Relative Performance Evaluation (RPE) : Using the difference between the firm's net income
and/or share price performance AND The average performance of a peer group of similar firms.
Using this the systematic or common risk that the industry faces will be filtered out of the
incentive plan leaving a net performance that precisely reflect the manager's efforts.
 Under RPE it is possible for manager to do well even if the firm reports a loss or share price
down , providing the losses are lower than those of the average peer group firm. So manager
compensation negatively related to average economy or industry performance.

2. Through the BOGEY of the compensation plan :

That is incentive compensation does not start until some level of financial performance is
reached. This will limit the downside risk for managers so it seems reasonable for upside risk to
be limited too otherwise manager would have everything to gain and nothing(little) to lose
therefore many plans impose a CAP.
Conservative accounting also controls upside risk by delaying recognition of unrealized gains
and discouraging premature revenue recognition. It promote contract efficiency by constraining
the manager's ability to inflate current earning and hence compensation by recording unrealized
gain.
However basing compensation on conservative earning gives the manager little incentive to
invest in risky projects. This create a role for share-based compensation. since share price
will quickly reflect unrealized profit on long term projects manager can be encouraged to invest in
such projects. This on the other hand create greater incentive for manager to misstate the
financial statements in order to support stock price.
In sum we arrive to conclusion that a mix of performance measures is desirable.

3. Through the compensation committee of the board

Despite efforts to control compensation risk it is essential that some risk remains and manager
not be able to work out from under this risk.

Manager can shed compensation risk by selling shares and option acquired and investing in a
risk free asset but compensation plans usually constrain this possibility by restricting dispose of
these shares and options.

Manager can also shed risk by excessive hedging. firm may limit hedging behavior.

[422-432]
 CHAPTER 11

Managers may use earnings management to

• avoid reporting losses OR
• Meet analysts' forecasts

thereby hoping
• to avoid the reputation damage AND
• strong negative share price reaction that quickly follows a failure to meet investor
expectations
EARNING MANAGEMENT include both accounting policy choice AND real action.

Accounting policy choices :

• per se : SL vs Declining, Revenue Recognition Policies,...
• discretionary accrual : Provision for Credit Losses, Warranty Cots, Inventory Values,...

The possibility that earnings management can be good should not be used to rationalize
misleading or fraudulent reporting.

Patterns of EARNING MANAGEMENT:

1. Taking a bath : Can take place during periods of Organizational Stress OR restructuring.
If a firm has a loss manager may report a larger one. Consequently it will take a "big bath"
by writing off assets Providing for expected future cost and generally "clearing the decks".
Because of accrual reversal this enhance the probability of future profit.

2. Income Minimization: Similar to taking a bath but less extreme. Maybe chosen during periods
of high profitability OR when firms seek legislation to protect themselves from foreign
competition. It could include Rapid Write offs of capital assets and intangibles , the expensing of
advertising and R&D expenditures, Use of LIFO inventory ,...

3. Income Maximization : Manager may use this for bonus purpose OR when firms are close to
debt covenant violations
4. Income Smoothing : Managers may smooth reported earning over time :
• so as to receive relatively Constant Compensation.
 • To Reduce Volatility of reported net income so as to smooth covenant ratios over time
• To Reduce the likelihood of reporting low earnings
• For External Reporting Purposes. Smoothing can convey inside information to the market.
Over time the pattern chosen by a firm may vary due to Change in Contracts, Level of Profitability
and Political Visibility. Even at a given point in time the firm may face conflicting needs.

Evidence of Earning Management for BONUS PURPOSES

Healy predicted that managers would manage net income so as to maximize their bonuses under their
firms' compensation plans.

NET INCOME-BASED FINANCIAL TARGET ARE A MAJOR INPUT INTO SHORT-TERM INCENTIVE
AWARDS

BONUS SCHEMES: Bonus

(Piecewise Linear)

ReportedNetIncome
Bogey Cap
If Net Income is lower than Bogey:
Manager has incentive to lower the net income even further to take a bath. By doing such , the
probability of receiving a bonus the following years is increased since current write-off for example will
reduce future amortization charges

If Net Income is higher than the Cap:

There is motivation to adopt income minimization policies because bonus is permanently lost on
reported net income greater than Cap

If Net Income is between the Bogey and Cap:

The manager is motivated to adopt accounting policies to increase reported net income.
 How Manager manage Net Income?
Discretionary accruals are accruals over which manager have some control.

Amortization Expense : Annual amortization expenses is a NON-Discretionary accrual because it is

laid down by firms amortization policy and its estimates of assets' useful life.
However, in case , the firm change its policy by changing for example estimates of useful life
Amortization Expense would contain a discretionary component.

Increase in net A/R : This accrual is Discretionary, To the point that the manager has some flexibility
to control the amount such as through :
• less conservative estimate than previous years
• Include earlier revenue recognition
• A more generous credit policy
• Keeping the books open beyond the Y/E

If it is result of Simply an increase in volume of business it is NON-Discretionary .

Increase in Inventory :
Discretionary income-increasing accrual are available for inventory as well. such as Manufacturing in
excess of capacity to include fixed overhead costs in inventory rather than charging them to expense.

Increase in Inventory due to build-up in anticipation of a strike, or simply increased demand are NON-
Discretionary

Decrease in A/p & accrual liabilities : Discretionary accrual due to :

• being more optimistic about warranty claims on its product than past AND/OR
• Regarding some items
So Manager has considerable discretion to manage net income. But the reason of changes in
account balances is unknown to the investor and researcher and for many of these
Discretionary Accrual , it would be difficult for the firm's auditors to discover the earning
management or even if they found to object since all of these techniques except for holding the
book open are within the GAAP.
 OTHER MOTIVATION FOR EARNINGS MANAGEMENT
1. For Debt Covenant Purpose :
Debt Covenant can impose heavy costs such as :
• Direct : Higher interest rate, Fines and Penalties
• Indirect : Impairment of continuing business relationship, Reduced future ability to raise
financing,...
Therefore managers will EVEN try to avoid being close to violation because this will constraint
their freedom of action in operating the firm. So manager might use
• Greater use of income-increasing accounting change
• Tend to undertake early adoption of new accounting standards when it increased reported
net income and vice versa.
Most of the debt covenant violations are for private debt issues because public debt
contracts are much more difficult than private debt to renegotiate should the firm default.

2. Meet Investors' Earning Expectations

3. Stock Offering

Earning Management become part of firm's and managers overall strategy for survival.

[455-461,465-473]

chapter 2 : Q 7,8,9
chapter 3 : Q 5 & 7
chapter 4 : Q 1,3,4,5
chapter 5: Q 1,5,6,7
chapter 6 : Q 2,3 & 5
chapter 7: Q 1,3,7
chapter 8 : Q 1,2&4
chapter 9 : Q 1,2,4,5,6,8
chapter 10 : Q 2,4,5,8,12
chapter 11 : Q 2,4,11,14-a & b
chapter 12: Q 3,4,5
chapter 13 : Q 1,3,6,7