ACCOUNTING THEORY 1 - STUDY CHECKLIST
Lesson 1
 Ideal conditions; certainty and uncertainty (including differences & similarities), dividend
irrelevancy
 RRA - SFAS69; weaknesses of RRA (relevant but not as reliable)
 Historical Accounting problems (relatively reliable but lacks relevance) -> several ways to
account for same thing (ex. amortization of capital Assets; Full Cost & Successful Efforts)
 Relevance VS Reliability -> tradeoffs

Lesson 2
 Decision Usefulness Approach - theory of investor decision making in order to infer the
nature and types of information that investors need.
 PV Model (doesn’t work well in practice)
 Single Person Decision theory (concept of utility, investor maximizing his/her return; prior &
posterior probabilities; Bayes Theorem)
 Information System (conditional probabilities; main & off main diagonals; progression of
GN/BN -> future expected earnings -> future expected returns; positive relationship b/w F/S &
payoffs)
 Rational Risk Averse Investor (risk averse, chooses highest expected utility)
 Principle of Portfolio Diversification (trade-off b/w risk and expected return; firm specific &
market wide factors, beta risk)
 Optimal Investment decisions (including / ignoring transaction costs, beta risk)
 Portfolio Risk (covariance calc, portfolio expected value & variance)
 Decision Usefulness approach & standard setting bodies (SFAC1 & 2)
Lesson 3
 Efficient Securities Market (semi strong form, relative concept, fair game, random walk)
 Market Prices reflecting all available situation (Beaver study -consensus forecast)
 Beaver’s arguments - Implications for financial reporting (4 points)
 Informativeness of Price (noise traders)
 Capital Asset Pricing model (cost of capital, calculate abnormal return)
 Information asymmetry (adverse selection; timeliness of reporting; estimation risk)
 Social significance of properly working securities markets (penalties & incentives)
 Full disclosure -> e,g, MD&A; FOFI
Lesson 4
 Information Approach to Decision Usefulness – extent of security price change indicates
decision usefulness
 Security prices respond to net income (Beaver - dramatic increase in volume of share
trading)
 Factors which complicate finding the market response (3 points)
 Ball & Brown study (market responding to GN & BN in earnings)
 Earnings Response Co-Efficients (ERC)
 Beta
 Capital Structure
 Persistence ( look at components of F/S notes to identify which items are persistent
and which are non persistent)
 Earnings Quality
 Growth Opportunities
 Similarity of Investors’ Expectations
 Informativeness of price
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ACCOUNTING THEORY 1 - STUDY CHECKLIST
 Implications of ERC research – importance of disclosure
 Unusual, Non-recurring and Extraordinary Items (core earnings, operating earnings, IAS1,
unusual;/non-recurring/extraordinary charges -> “earnings in bank”, persistence concept)
 Best accounting policy? (public good VS private good, investor use of information)
 Information content of RRA - reasons for weak results for explanatory power of RRA
Lesson 5
 Measurement approach - current values incorporated into F/S proper
 Are Security Markets Efficient? (overconfidence; self attribution bias; share price
momentum)
 Prospect Theory (Kahneman and Tversky)
 Is Beta dead? (Fama & French)
 Stock Market Volatility
 Stock Market Bubbles
 Efficient Security Market Anomalies
 post announcement drift (Bernard & Thomas)
 market efficiency with respect to financial ratios (Ou & Penman)
 market response to accruals (Sloan)
 implications of securities market inefficiencies for financial reporting
 other reasons supporting a measurement approach
 Value relevance of financial statement info (Lev’s study on earnings quality)
 Auditor’s Legal Liability (supports use of valuations)
 Ohlson’s Clean Surplus Theory
 Measurement Oriented Standards – GAAP: lower of cost or market, ceiling tests for PPE,
OPEB’s; IAS 2, IAS 36, IFRS 6, IAS 19, SFAS 87
 Financial Instruments –
 IAS39; excess net income volatility, mismatch
 SFAS 115, 3 categories, gains trading, SFAS 157
 SFAS 130 other comprehensive income
 SFAS 107, SFAS 133, derivatives and risk
 Hedging - purpose of hedging and why a company would not hedge; fair value and cash flow
hedges, differences between SFAS 133 and IAS 39; supplemental disclosures of financial
instruments, IFRS 7
 Accounting for intangibles
 accounting for purchased goodwill
 self developed goodwill (Lev & Zarowin - R&D)
 clean surplus model revisited
 Beta Risk
 Stock Market Reaction to other risks (MD&A; risk related disclosures, SFAS 107, SFAS 133,
sensitivity analysis and value at risk)
Lesson 6
 Economic Consequences -changes in accounting policies & constituency reaction; reasons
why; standard setters’ actions as a result
 Employee Stock Options (APB25, SFAS 123, HB 3870, Black/Scholes model)
 Positive Accounting Theories
 Bonus Plan Hypothesis
 Debt/Equity Hypothesis
 Political Cost Hypothesis
 Efficient and Opportunistic versions of PAT
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ACCOUNTING THEORY 1 - STUDY CHECKLIST
Lesson 7
 Non co-operative games of mgr-investor conflict (Nash equilibriums, Danielson –> straight
forward maximization, constrained maximization)
 Co-operative Game Theory Models (binding agreements, moral hazard, reservation utility,
disutility of effort)
 Owner-Mgr employment contracts (first best; second best; rental; fixed & moving support)
 Bondholder-Mgr Lending contracts
 Holmström Agency Model
 Use of Net Income as a basis for contracting, auditing to add credibility
 Contracts (incomplete and rigid)
Lesson 8
 Are Incentive contracts necessary? (Fama, Arya, Fellingham & Glover, Wolfson)
 Managerial incentive plans
 Manager Compensation – Share price VS Net Income (pros & cons)
 Role of Risk in Manager Compensation (methods to reduce risk)
 Empirical Compensation Research
 Politics of Executive Compensation (Jensen & Murphy)
 Power Theory of Executive Compensation – compensation contracts are more consistent
with opportunistic version of PAT
 Patterns of Earnings Management
 Taking a bath
 Income Minimization
 Income maximization
 Income smoothing
 Earnings Management (Healy’s study)
 (1) Control various accruals (discretionary VS non discretionary -look at components of
F/S notes to identify which items are discretionary and which are non discretionary)
(2) Change accounting policies
Beneficial & adverse effects of earnings management
 Other Motivations for Earnings Management - contractual; meet investors’ expectations,
IPO’s, communicate information to shareholders
 Why does earnings management persist? – costly to find out inside info, use of
discretionary accruals to provide inside info
 Good Earnings Management (efficient contracting mgr behavior, blocked communication)
 Bad Earnings Management (opportunistic mgr behavior)
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ACCOUNTING THEORY 1 - STUDY CHECKLIST
Lesson 9
 Regulation of Economic Activity – central authority, standard setting, costs and benefits of
standard setting, proprietary information
 How to characterize information production
 Finer information
 Additional information
 Credibility
 CONTRACTUAL INCENTIVES (for regulation of info production)
 Manager incentive contract; Debt Covenants -> concept of internalization
 MARKET BASED (non contractual) INCENTIVES (for regulation of info production)
 Managerial Labour Market
 Takeover Market
 Efficient Securities Market (Capital Market)
 Securities Market Response to full disclosure – market liquidity, market depth, bid-ask
spread
 Other INFORMATION PRODUCTION INCENTIVES
* Disclosure Principle
* Signalling
* Private Information Search
 Externalities and Free Riding
 MARKET FAILURES
* Moral Hazard
* Adverse Selection
* Unanimity (lack of)
(Note: ensure you know what estimation risk is)
 Cost & benefits of regulation
 Decentralized regulation – management choice of reporting -> improved relevance, less
costly
Lesson 10
 Public Interest Theory; Interest Group Theory – legislature, regulatory bodies
 Standard Setting Process
 Ethical Perspective on Standard Setting – internal & external motivation, Bayles consumer
perspective -> client interests most important
 Conflict and Compromise – IAS 39, which applies to investments in debt and equity
securities, macro hedging. SFAS 130 Other Comprehensive Income (compromises!)
 Criteria for Standard Setting - decision usefulness; reduction of info asymmetry; economic
consequences; reasonable compromise
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