Module 1 summary
Outline of the course and update on recent developments
This module begins with an outline of the course as given in Chapter 1, with particular attention to the
structure of accounting standard setting bodies and the concept of due process. You should be aware of
the structure of standard setting, since standard setting comes up many times in the course.
The module also provides an outline of important events leading up to the market meltdowns beginning
in 2007, since these events have several important implications for accountants and are not discussed
specifically in Section 2.1 in the text.
Accounting under ideal conditions
This module defines the concepts of ideal conditions and illustrates preparation of financial statements
when ideal conditions hold. Balance sheet values are on the basis of expected present values of future
cash receipts from assets and liabilities. Net income is composed of accretion of discount on opening net
assets, plus or minus any deviation of actual cash flows for the period from expected cash flows. Reserve
recognition accounting (RRA) for oil and gas companies is used to illustrate the challenges of present
value accounting when ideal conditions do not hold. The concepts of relevance and reliability of financial
statement information are reviewed, and the reliability problems of RRA are explained.
Historical cost-based accounting is analyzed in terms of relevance and reliability, revenue recognition,
recognition lag and matching. It provides a tradeoff of these characteristics, between the extremes of
current value accounting and cash flow accounting. Despite the moves by accounting standard setters
toward increased use of current values, accounting for several important classes of assets and liabilities
remains based on historical costs.
Explain the concept of due process and understand how the structure of
accounting standard setting bodies attains due process.
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This module begins with an outline of the structure of the course (text, Chapter 1), with particular
attention to the concept of due process in standard setting. Due process is essential if reasonable
compromises between the interests of investors and managers in standard setting are to be
attained.
Review recent development relevant to financial accounting.
Implications for financial accounting of Enron and World.com scandals and the current market collapse:
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Off-balance sheet activities should be fully reported, since they can encourage excessive risk
taking by management.
Reporting must be transparent, so that investors can properly value assets and liabilities.
Fair value accounting may understate value-in-use when markets collapse, and therefore lead to
management objection.
Define the concept of ideal conditions and outline the necessary
assumptions that underlie the definition.
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Ideal
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Ideal
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conditions exist under conditions of certainty when
the future cash flows of the firm are publicly known with certainty
the single interest rate in the economy is given and publicly known
conditions are then extended to conditions of uncertainty in which
a complete and publicly known set of states of nature exists
the probabilities of states of nature are objective and publicly known
the single interest rate in the economy is given and publicly known state realization is
publicly observable
Explain and illustrate the concepts of states of nature and the probabilities
of states of nature (both objective and subjective).
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States of nature, also called states for short, are uncertain future events that may affect the
amount of the payoff. An example would be the state of the economy (good times or bad times).
Under ideal conditions, the probabilities of the states of nature are publicly known and objective.
In the real world, these probabilities would have to be assessed based on available information.
These are called subjective probabilities.
Explain and illustrate the concepts of expected value of an asset or
liability, abnormal earnings, and risk.
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The expected value of an asset or liability is calculated as the sum of the various possible cash
flows, based on the probabilities assigned to the various states of nature, discounted at the given
fixed interest rate for the economy.
Net income under ideal conditions consists of expected cash flows (accretion of discount) plus or
minus any abnormal earnings.
Abnormal earnings are defined as the difference between expected and actual cash flows.
Risk under ideal conditions is the knowledge that one of several different possible state realizations
will occur, but not knowing for sure which one it will be.
Use the present value model, under conditions of certainty, to prepare an
articulated set of financial statements for a simple firm.
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Using the definition of ideal conditions under certainty
o Financial statements are prepared on the basis of present value of future cash flow,
discounted at the given interest rate.
o Assets and liabilities are valued at their present values.
o Net income is equal to accretion of discount.
Use the present value model, under conditions of uncertainty, to prepare
an articulated set of financial statements for a simple firm.
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Using the definition of ideal conditions extended to conditions of uncertainty
o Financial statements are prepared on the basis of expected present value of future cash
flows, discounted at the given interest rate.
o Assets and liabilities are valued at their expected present values.
o Net income is equal to accretion of discount plus or minus the difference between expected
and actual cash flows.
Critically evaluate reserve recognition accounting (RRA) as an application
of the present value model.
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The Canadian Securities Administrators have issued NI 51-101, which requires present value-based
disclosures of reserves for Canadian oil and gas companies.
Most large Canadian oil and gas companies have received exemption from NI 51-101 providing
they disclose under the less detailed requirements of SFAS 69 of the Financial Accounting
Standards Board of the United States.
SFAS 69 requires affected firms to report supplementary information about the expected present
value, based on year-end prices, of their proven oil and gas reserves, and the factors that have
changed that expected present value during the year.
Present value of cash flows is discounted at a given interest rate of 10%.
Since ideal conditions do not hold in the real world, estimates are subject to wide errors, due to
revisions of amounts and timing of extraction of proven reserves and changes in prices. As a
result, RRA suffers from problems of reliability.
Possible manager bias also reduces reliability (for example, Royal Dutch/Shell).
RRA is often criticized by oil and gas company management, due to concerns about accuracy, and
about legal liability if reserves are overstated.
Explain why relevance and reliability of accounting information have to be
traded off.
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The problems faced by RRA give insight into the nature of relevance and reliability of accounting
information.
Relevant information is defined as information that enables investors to predict the firm’s future
cash flows.
Reliable information is information that faithfully represents without bias what it is intended to
represent.
RRA information represents high relevance, since present values of future receipts predict future
cash flow, by definition.
Unfortunately, much reliability is lost, since conditions are not ideal.
When ideal conditions do not hold, relevance and reliability must be traded off.
Evaluate historical cost-based accounting in terms of relevance and
reliability, revenue recognition, recognition lag, and matching.
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Historical cost accounting represents an intermediate tradeoff between relevance and reliability.
While historical-cost-based accounting information is not as relevant as present value-based
information, it is more reliable.
Historical cost accounting can also be evaluated in terms of revenue recognition, recognition lag,
and matching. As is the case for relevance and reliability, historical cost represents an intermediate
tradeoff between these characteristics of accounting information.
While ―true‖ net income does not exist in the non-ideal world in which accountants operate, theory
shows that current value accounting for specific assets and liabilities is desirable, provided that it
can be accomplished with reasonable reliability.
Current value accounting is now quite common in practice, although historical cost accounting for
major classes of assets and liabilities remains. Current practice can be described as a mixed
measurement model.
Module 2 summary
Decision usefulness approach to financial reporting
This module describes the theory of how risk-averse investors make rational investment decisions. It also
demonstrates that major professional accounting standard-setting bodies have adopted the theory as a
guide to the preparation of useful financial accounting information.
Define the concept of decision usefulness.
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The decision usefulness approach is an approach to the preparation of financial accounting
information that studies the theory of investor decision making in order to infer the nature and
types of information that investors need.
Outline the single-person decision theory.
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It suggests how a rational individual makes optimal decisions in the presence of uncertainty.
It requires the decision maker to identify a set of acts from which one must be chosen.
It requires the identification of a set of states of nature and the assessing of subjective prior
probabilities of these states.
The optimal decision is the one that maximizes the decision maker’s expected utility based on the
probabilities of the states of nature.
Explain prior probabilities of states of nature.
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Prior probabilities of states of nature are probabilities of the various states of nature that might
occur. These probabilities incorporate all that the decision maker knows, up to the point in time
just before the decision is to be taken.
Explain posterior probabilities of states of nature.
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Before making a decision, the individual may want to get more evidence.
An example of more evidence is the information contained in the most recent financial statements.
Posterior probabilities of states of nature are probabilities of the various states that might occur,
after using Bayes’ theorem to revise prior probabilities following the receipt of additional
information. These posterior probabilities then form the basis for the investor’s buy/sell investment
decision.
Define Bayes’ theorem.
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Bayes’ theorem is a formula that enables the decision maker to revise prior probabilities into
posterior probabilities.
where
P(H|GN) = the subjective posterior probability of the high state, given a good-news financial
statement
P(H) = the subjective prior probability of the high state
P(GN|H) = the objective probability that the financial statements show good news, given that the
firm is in the high state
P(GN|L) = the objective probability that the financial statements show good news, given that the
firm is in the low state
Define an information system.
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It is a way of conceptualizing the information content of financial statements.
It is represented by a table that gives, conditional on each state of nature, the objective probability
of each possible financial statement evidence item (for example, GN or BN). These probabilities
are inserted into Bayes’ theorem.
The higher the main diagonal probabilities of the information relative to the off-main diagonal
probabilities, the tighter is the link between the firm's current performance and its future
performance. That is, the more useful is the financial statement evidence.
Relevance and reliability are important properties of financial statements that increase the main
diagonal probabilities.
Since relevance and reliability must be traded off, the increase in main diagonal probabilities
resulting from greater financial statement relevance is offset by the decrease in these probabilities
from lower reliability. The net effect on decision usefulness depends on whether or not the
increase from greater relevance outweighs the decrease from lower reliability.
Define a rational investor in relation to risk.
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A rational investor is one who makes investment decisions in accordance with the single-person
decision theory model.
A risk-averse investor is one who derives less expected utility from an investment, given that the
investment return is constant but the risk is higher.
A risk-averse investor will want information on the riskiness of investments and their expected
returns.
Explain the principle of portfolio diversification.
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Increased expected utility of an investment decision for the risk-averse investor is possible by
choosing portfolio investments rather than a single investment.
Some of the risk cancels out when more than one investment is held. This is the firm-specific risk.
Maximum diversification is obtained when the investor holds some of all the investments in the
economy (the market portfolio).
Define beta.
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Beta measures the co-movement between the changes in the market prices of a security and the
changes in the market value of the market portfolio.
The risk of changes in the market value of the market portfolio is called economy-wide, or
systematic, risk.
Since economy-wide risk affects all securities in much the same way, it cannot be diversified away.
For well-diversified risk-averse investors, the only useful information about the riskiness of an
investment security is its beta.
Calculate expected return and variance of a portfolio, and its covariance
with other portfolios.
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Expected rate of return = the sum of rate of return × probability, for each payoff
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Variance = the sum of (rate of return per payoff – expected rate of return)2 × probability
Variance of a portfolio = weighted sum of the variances of individual securities
Covariance between two securities (A and B) in portfolio
The optimal investment decision
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When transactions costs are ignored, the optimal investment decision is to buy that combination of
the market portfolio and the risk-free asset that yields the best tradeoff between expected return
and risk.
The availability of stock market index funds and related securities enables the investor to closely
approach holding the market portfolio.
When transaction costs are not ignored, the optimal decision is to hold relatively few securities.
Then, the investor needs information about stocks’ expected returns and betas to trade off
expected return and risk.
Relate decision theory to the conceptual framework for financial reporting.
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The IASB and FASB have accepted the decision theory model as a guide to the preparation of
useful financial statement information.
The IASB/FASB Conceptual Framework, IAS 1, and IAS 8 contain evidence of the decision theory
model.
The pronouncements of these organizations recognize that financial statement information should
be useful for investors by:
o Helping them to assess the amounts, timing, and uncertainty of future cash flows
o Enhancing relevance and reliability of accounting information
Ethical issues related to the usefulness criterion
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CICA Handbook, section 1100
clarifies what is meant by Canadian GAAP
removes ability to depart from GAAP
purpose: to increase public confidence in GAAP and reduce misleading reporting
CICA Handbook, section 1400
o financial statements must conform to GAAP and section 1000 concepts
o full disclosure of significant transactions in an understandable manner
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Ethical issues related to the usefulness criterion
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The accountant/auditor is often caught between the demands of management and responsibility
for the interests of investors, including lenders.
If a management’s demands involve unethical behaviour, the accountant must take into account
the perspective of the deceived.
Module 3 summary
Efficient securities markets
This module reviews the theory of efficient securities markets and explains the capital asset pricing model
(CAPM). Implications of efficient securities market theory for accountants are described, including the
importance of full disclosure. The concept of information asymmetry and its implications for the proper
operation of capital markets are also described. Management Discussion and Analysis (MD&A) is used to
illustrate an accounting standard that promotes full disclosure.
Define an efficient securities market.
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An efficient securities market, in the semi-strong form, is a market where the prices of securities
fully reflect all public information at all times.
Security prices fully reflect all public information because rational investors immediately react to
new information, triggering buy/sell decisions that affect share price. While individual reactions to
new information may differ, on average their biases cancel out, leaving a share price that reflects
the average knowledge across all investors.
Explain the implications of securities market efficiency for financial
accounting and reporting.
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The financial accounting policies used by a firm will not affect its share price as long as
o the policies used are fully disclosed
o the market is sufficiently sophisticated that it can understand the implications of the policies
for future firm performance
Non-sophisticated investors are price-protected by the efficient market.
Accountants must compete with other information sources as suppliers of information.
Describe the extent to which securities market prices act as a source of
information to investors.
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If semi-strong efficiency is literally true, share prices are said to be fully informative with respect to
publicly available information — they fully reflect everything known about the firm. That is, prices
are the only source of information needed by the investor.
In this case, no investor would gather and process public information since all would be priceprotected.
But, if no investor gathers public information, how could share prices reflect publicly available
information? This is a logical inconsistency that threatens efficient markets theory.
To ―rescue‖ the theory, introduce the concept of noise traders (also called liquidity traders).
Noise traders are investors whose buy/sell decisions come at random. These random buy/sell
decisions affect share price (that is, through forces of demand and supply).
Then, share price no longer reflects everything known about the firm — it is always possible that
share price is above or below its ―fully reflects‖ value due to noise. In this case share prices are
only partly informative to investors.
When prices are only partly informative, it is worthwhile for investors to gather and process
information.
Some of the information gathered by investors is contained in financial statements prepared and
audited by accountants.
Explain the implications for securities pricing of the Sharpe-Lintner capital
asset pricing model (CAPM).
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CAPM specifies what the expected return of a share traded on an efficient securities market should
be (equivalently, the firm’s cost of capital).
The expected return on that share = a constant × the risk-free interest rate + another constant ×
the expected return on the market portfolio.
The constants depend only on the share’s beta and the return on the risk-free asset.
Firm-specific risk is diversified away by rational investors and therefore does not affect the share’s
price.
Holding beta risk, risk-free rate, and expected return on the market constant, expected return for
firm j does not change when new information about firm j comes along. Consequently, share price
changes in response to the new information to maintain expected return at the value it should be
as per CAPM.
The CAPM assumes beta is stationary, and that there is no information asymmetry. When these
are not so, estimation risk arises. This causes the firm’s actual cost of capital to be somewhat
greater than CAPM.
Explain the significance of information asymmetry.
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Information asymmetry is present when one or more market participants have more information
than others.
Then, there is the potential for the information advantage to be exploited.
Adverse selection is one form of information asymmetry.
Define the adverse selection problem as it applies to securities markets.
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Adverse selection is a situation in which insiders may earn excess profits at the expense of outside
investors by taking advantage of their inside information.
Insiders take advantage of their inside information by buying shares when they know the market
price is too low, or by selling shares when they know the price is too high.
Explain the significance of the adverse selection problem to financial
accounting theory.
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Adverse selection creates a problem for securities markets because inside information is a source
of estimation risk (that is, lemons problem).
Investors then demand higher return to compensate (that is, higher than the return given by the
CAPM), that is, they lower the price they pay for all shares or may withdraw from the market
completely.
Full disclosure has an important role to play in financial accounting theory by reducing the extent
of inside information and estimation risk.
Evaluate the social role of efficient securities markets in allocating capital
resources in the economy.
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Full disclosure reduces inside information and estimation risk.
Then, securities market efficiency ensures that share prices are as close as possible to their
fundamental value.
When share prices reflect fundamental value, firms with high quality projects are encouraged to
proceed since they receive a high price for their shares, and vice versa.
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This leads to proper allocation of scarce capital in the economy, thereby increasing social welfare.
Analyze the information content of management discussion and analysis
(MD&A).
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MD&A is a reporting product that has the potential to increase full disclosure, by helping investors
to interpret current firm performance and predict future performance.
MD&A should consist of more than a rehash of information already available from the financial
statements. To do this it should:
o Be written from management’s perspective
o Have a forward-looking orientation
o Discuss risks and uncertainties
By going beyond minimum disclosure requirements, management can:
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Meet a high ethical standard
Create a reputation for full disclosure, which
o Reduces estimation risk
o Raises share price and lowers cost of capital
Convey to investors that management has a confident view of its future
Module 4 summary
Information approach to decision usefulness
This module describes and evaluates the implications of empirical research in financial accounting. Some
of the problems of empirically finding a securities market response to financial accounting information are
outlined, and researchers’ procedures to overcome these problems are explained. Research that
documents a market response to the information content of reported net income has been particularly
successful, and is consistent with the predictions of decision theory and efficient securities market theory.
Implications for standard setters of findings about market response to net income are described. These
include expanded disclosures for smaller firms, full disclosure of liabilities, segment disclosures, and
greater detail in the income statement.
Explain why a securities market responds to information that investors find
useful, in light of the efficient securities market and decision usefulness
theories.
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The efficient securities market theory recognizes that the market will respond to information from
any source, including financial statements.
The decision usefulness approach recognizes that individual investors are responsible for predicting
future firm performance and concentrates on providing useful information for this purpose.
Outline some of the difficulties of conducting empirical research to
discover evidence of securities market reaction to accounting information.
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Since efficient markets react quickly, the researcher must find the date on which the market first
became aware of the information.
o For net income, the date the firm announces its earnings in the financial press is a
successful proxy.
o For other types of information, such as the financial statements themselves, the appropriate
date is much more difficult to determine.
It is also necessary to separate market-wide and firm-specific components of security returns so as
to adjust for the components that affect all shares’ returns.
o This is usually accomplished using the market model to predict expected share returns.
o The deviation of expected and actual share returns is taken as firm-specific return.
Explain Ball and Brown’s research techniques and findings.
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First, the assumption is that the market reacts to new information only if it differs from what was
expected, so an estimate of what the market expected is required.
For net income, successful expectation proxies include net income for the corresponding period in
the previous year and analysts’ forecasts.
If reported net income exceeds what is expected, BB expected to observe a positive firm-specific
return on the firm’s shares during a narrow window surrounding the date of the earnings
announcement, and vice versa. Their expectation was confirmed.
Define the concept of an earnings response coefficient (ERC) and identify
the factors that explain its magnitude.
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An earnings response coefficient measures the amount of abnormal share returns in response to
the amount of the unexpected component of reported net income. It identifies and explains why
share returns respond more strongly for some firms than for others.
ERCs have been found to be higher for
o less risky firms (in a beta sense)
o less levered firms
o firms with higher earnings persistence
o firms with higher earnings quality
o growth firms
o firms for which investors’ expectations of earnings are similar
Theory predicts that firms with less informative share price (such as smaller firms) should have
higher ERCs, but this has been difficult to document.
Apply the earnings response coefficient concept to accounting for unusual,
non-recurring, and extraordinary items.
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ERC research tells us that more disclosure in the income statement is desirable so that earnings
persistence can be evaluated.
Evaluation of earnings persistence is a particular problem when the firm has low persistence items
such as non-recurring or unusual items of gains or losses.
Unless these items are fully disclosed, investors may regard them as persistent when, in fact, they
are not.
To make matters worse, current low persistence items might increase future core earnings, and
these effects are not disclosed. This is a particular problem if the initial writeoffs are excessive.
This will decrease the usefulness of financial statements for investors.
Describe why an accounting policy that produces the greatest share price
reaction may not be best for society.
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Accounting information is a public good. This means that its use by one investor does not destroy
it for use by another.
Investors do not bear the full costs of the information that they use.
Therefore, supply and demand will not ensure that the ―right‖ amount of information is produced;
that is, the cost to firms and society of producing this information may not equal the benefits to
investors.
Nevertheless, the more useful investors find financial accounting information, the greater is the
securities market response to that information.
Thus, accountants can be guided by market response in choosing accounting policies and
designing better financial statements, even though standard setters cannot be guided by market
response in designing the ―best‖ accounting standards.
Evaluate the empirical evidence on securities market response to RRA.
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Securities market response to RRA is explored as an example of non-income financial statement
information.
If investors find RRA information useful, there should be a response to the share returns when this
information is released.
Results are mixed — it has been hard to find strong evidence of usefulness.
Possible reasons include low reliability or methodological problems in determining the date on
which the market first became aware of the information.
Module 5 summary
Measurement approach to decision usefulness
This module defines and illustrates the measurement approach on decision usefulness. Several reasons
for increased attention to fair values in financial statements, including theory and evidence that securities
markets may not be fully efficient, are suggested. Fair value accounting is illustrated with reference to
several Canadian and U.S. financial accounting standards. These include standards dealing with
accounting for financial instruments, such as derivative instruments, and in accounting for purchased
goodwill. Issues in the reporting of firm risk are also described and illustrated.
Explain the measurement approach to financial reporting.
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The measurement approach to financial reporting is an approach by which accountants undertake
the responsibility to incorporate current values into the financial statements proper, provided this
can be done with reasonable reliability.
This approach recognizes an increased obligation, beyond that of the information approach, to
assist investors in predicting future firm performance.
Explain why financial reporting is moving in a measurement direction.
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Historical cost based earnings have a low ability to explain abnormal securities returns (that is, low
value relevance).
Investors need more help in predicting future securities returns. This argument is supported by
theory and evidence that questions efficient securities markets.
Auditor liability.
The development of clean surplus theory provides a theoretical framework that supports the
measurement approach.
Understand theory and evidence suggesting that securities markets may
not be fully efficient.
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Efficient securities market theory has been questioned in recent years, for several reasons:
o increasing attention to alternative theories of investor behaviour, such as prospect theory
o evidence of excess stock market volatility and bubbles
o evidence of anomalies, that is, share price reactions to accounting information that do not
match those predicted by the efficient markets theory
Conclusions on securities market efficiency
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The text concludes that the theory and evidence questioning efficient securities market theory has
not progressed to the point where efficient market theory should be rejected.
Efficient securities market theory is still the most useful theory to assist accountants in supplying
useful information to investors.
However, theory and evidence questioning efficient securities market theory has progressed to the
point where it encourages a measurement approach.
Explain Ohlson’s clean surplus theory and its role in firm evaluation.
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Ohlson’s clean surplus theory shows how market value of a firm can be determined from balance
sheet and income statement information.
From the income statement, the theory takes actual earnings and calculates goodwill as the
difference between actual and expected earnings.
For the ―clean surplus,‖ net income must contain all gains and losses.
From the balance sheet, expected earnings are calculated as shareholders’ equity multiplied by the
firm’s cost of capital.
o Then, to determine the value of the firm, add the calculated goodwill to the book value.
o To calculate a share price, take the above value and divide by the number of shares
outstanding.
Although the model may not accurately predict actual share value, it is useful because empirical
studies suggest that the ratio of model value to actual value is a good predictor of future share
returns.
Outline measurement-oriented accounting standards.
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When future cash flows are fixed by contract, such as for accounts receivable and payable,
valuation is generally based on expected future cash flows. When the time period is short, such
cash flows may not be discounted.
Other examples involve a partial application of fair value, such as lower-of-cost-or-market rule.
Other measurement-oriented standards include
o ceiling tests for property, plant and equipment (partial application)
o pensions and other post-retirement benefits (present-value-based approaches)
Auditor legal liability encourages conservative accounting.
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Auditor legal liability appears to be increasing.
The auditor is more likely to be held liable for overstatements of assets and earnings than for
understatements.
This leads to conservative accounting, such as ceiling tests, since conservative accounting reduces
the likelihood of overstatements.
Evaluate the important concepts of financial instruments.
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There are two types of financial instruments:
o primary — including accounts and notes receivable, investments in debt and equity
securities
o derivative — contracts, the value of which depends on some underlying price, interest rate,
foreign exchange rate, or other variables; examples are options and swaps
Detail the important concepts of accounting for financial instruments.
Under IAS 39 and IFRS 9 (which has amended several provisions of IAS 39), financial instruments are
now either accounted for at amortized cost or fair value. The business model of the entity carrying the
financial instruments is an important determinant of the choice of accounting policy. Moreover, reclassification of financial instruments has been made more difficult than before.
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To help control the volatility of unrealized gains and losses, SFAS 130 created the concept of other
comprehensive income. Similar international standards are now in place. These are the important
aspects of other comprehensive income:
o Unrealized gains and losses from the fair-valuing of available-for-sale securities are included
in other comprehensive income.
o Other comprehensive income also includes unrealized gains and losses on fair-valuing of
derivatives designated as hedges of anticipated future transactions.
o Comprehensive income is the sum of net income and other comprehensive income.
o As items of other comprehensive income are realized, they are generally transferred to net
income.
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Accounting standards require extensive supplementary disclosures concerning financial
instruments, including disclosures of gains and losses, and disclosures of fair values if not already
fair valued in the financial statements proper.
Accounting for intangibles
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Goodwill is an important intangible asset for many firms.
There are two types of goodwill:
o Purchased
 This arises when one firm acquires another.
 Management disliked amortization of purchased goodwill. Standard setters
responded by eliminating amortization, but in its place imposed a ceiling test.
 Elimination of goodwill amortization in 2001 may have reduced management’s
emphasis on pro-forma income.
o Self-developed
 This often arises from successful R&D.
Self-developed goodwill usually not recorded on the firm’s books due to severe
reliability problems. This may explain the low relationship between net income and
share price.
Clean surplus theory may provide a way to value self-developed goodwill.
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Evaluate alternative approaches to reporting on risk.
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Two types of risk are identified:
o Price risk — risk arising from changes in interest rates, commodity prices, and foreign
exchange rates
o Credit risk — risk that other parties to a contract will not fulfil their obligations
Recently, firms have greatly expanded their reporting on firm risk, including in MD&A, despite the
implication of the theory of optimal investment decision that a stock’s beta is its only firm-specific
risk measure.
Reasons for control and reporting of firm-specific risk:
o Risk reporting reduces investors’ estimation risk. This risk is not included in the CAPM.
o Firms may wish to ensure availability of cash for future investment projects.
o Risk reporting helps to control, or at least to inform investors about, possible speculation by
management.
o Hedging to control risk may reduce losses and resulting lawsuits and legal liability.
IFRS 7 requires information about different types of risk, including credit risk, and in particular
quantitative risk disclosure, which is consistent with a measurement approach. Also, risk disclosure
is to be based on the risk information provided internally to management.
Risk disclosure requirements laid down by the SEC in the United States have moved risk reporting
in a measurement direction. These requirements include
o value at risk — the loss in earnings, cash flows, or fair values resulting from future price
changes that have a specified low probability of occurring
o sensitivity analysis — the impact on earnings, cash flows, or fair values of various price risk
Module 6 summary
Economic consequences
This module defines and illustrates the concept of economic consequences. According to this concept,
changes in accounting policies, including changes resulting from new accounting standards, matter to
firms and their managers, even if those accounting policy changes have no differential cash flow effects.
This seems inconsistent with the theory of efficient securities markets, which predicts that the market will
see through the financial statement impact of different accounting policies, with the result that firms’
share prices should be unaffected by accounting policy choice. In turn, this implies that accounting policy
choice should not matter to firms and their managers.
Examples of economic consequences are described. Based on these examples, it seems that accounting
policies do have economic consequences. Not only do accounting policy choices matter to managers, they
may also matter to investors, since accounting policies can affect manager actions, hence firm value.
Positive accounting theory asserts that management concern about accounting policies is driven by the
contracts that firms enter into, and, for very large firms, by political costs that result if these firms are
seen to be highly profitable.
Explain the concept of economic consequences.
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Economic consequences is a concept that asserts that, despite the implications of efficient
securities market theory, accounting policy choice can affect firm value.
If accounting policies affect firm contracts and political heat, they concern management.
Apply the concept of economic consequences to employee stock options
(ESOs).
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Many large firms issue stock options to executives, and often to other employees, as part of
compensation.
For many years, no expense needed to be recorded for ESOs providing that exercise price equalled
intrinsic value on the grant date.
Even if intrinsic value is zero, ESOs have a fair value on their grant date. This can be estimated by
o expected value of ESO on exercise date (under very simplifying assumptions)
o modifications of the Black/Scholes option pricing formula
A 1993 attempt by the FASB to require firms to record an expense for ESOs ran into extreme
opposition from management. It had to be withdrawn.
Recent financial reporting horror stories were often suspected to be driven by ESOs. This led to
renewed pressure to expense ESOs.
Despite concerns about the reliability of estimating ESO expense, expensing is now required in
Canada, the United States, and internationally.
Describe the concept of positive accounting theory and its predictions
about manager reaction to compensation contracts, debt covenants, and
political pressures.
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Positive accounting theory is concerned with predicting firms’ choices of accounting policies and
their response to new accounting standards.
Positive accounting theory is structured around three hypotheses:
o The bonus plan hypothesis predicts that managers who are compensated by means of a
bonus plan dependent on reported net income will be likely to maximize current reported
profits by choosing accounting policies that shift reported profits from future to current
periods.
o The debt covenant hypothesis predicts that the closer a firm is to violating debt covenants
based on accounting variables, the more likely is the firm manager to choose accounting
policies that shift reported profits from future to current periods.
o The political cost hypothesis predicts that the greater the political costs faced by a firm (for
example, very large firms are often felt to be more subject to political scrutiny than smaller
firms), the more likely is the firm manager to choose accounting policies that shift reported
profits from current to future periods.
Empirical research has produced a large body of evidence consistent with these predictions.
Compare the opportunistic and efficient contracting versions of positive
accounting theory.
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Positive accounting theory assumes that managers are rational, that is, they choose accounting
policies to maximize their own expected utility.
Thus, the accounting policies that managers choose are not necessarily the ones that are best for
the firm’s shareholders.
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Managers that choose accounting policies for their own benefit and at the expense of shareholders
and lenders are said to be behaving opportunistically (unethically).
By astute corporate governance, including clever contract design, firms can motivate managers to
perceive that choosing accounting policies in the best interests of shareholders is also in their own
best interest — this is called the efficient contracting form of positive accounting theory.
While examples of opportunistic behaviour persist, empirical research has produced considerable
evidence consistent with the efficient contracting form.
Understand how positive accounting theory contributes to economic
consequences.

Positive accounting theory shows how accounting policies can have economic consequences:
o Even without cash flow effects, accounting policies matter because they affect the
provisions of contracts based on financial statement variables and can affect the firm’s
political environment.
o Thus, accounting policies matter to managers — they have economic consequences.
Module 7 summary
An analysis of conflict
This module models the concept of conflict. Accountants are involved in conflict situations because they
are frequently caught between the conflicting interests of investors and managers. Conflict is modelled by
means of game theory and agency theory. These models provide insights into conflict resolutions, helping
you to understand why firm managers may adopt certain accounting and reporting policies, even if these
policies may bias net income and may not be the best for reporting to investors. The module also enables
you to complete the reconciliation of efficient securities market theory, which predicts that investors will
look through and adjust for different accounting policies, with economic consequences, which predicts
that accounting policies matter.
Explain the basic principles of non-cooperative game.
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A non-cooperative game is a game between rational players in which the players are not able to
enter into binding agreements as to which strategy or action to take.
Each player faces a thinking opponent. That is, the action chosen by each player depends on what
action that player thinks the other player will take.
Explain the Nash equilibrium of a non-cooperative game.

The Nash equilibrium is the strategy pair such that, given the strategy chosen by the other player,
no player wishes to depart from his or her chosen strategy. It is the predicted outcome of a noncooperative game, particularly when the game is played only once.
Explain the basic principles of the cooperative solution to a noncooperative game.
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The cooperative solution to a non-cooperative game is the strategy pair such that no player can be
made better off without making the other player worse off.
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The cooperative solution need not be a Nash equilibrium, and hence may not be played.
Since binding agreements are not possible, one or the other of the parties is unwilling to play the
cooperative strategy for fear that the other party will cheat. As a result, the outcome of the game
is driven to the Nash equilibrium.
This is unfortunate because then the parties attain lower payoffs from the game than the
maximum achievable under the cooperative solution.
If the game is repeated many times, the players may come to realize that it is to their mutual
advantage to play cooperatively.
Provide a game theoretic argument for constrained as opposed to
unconstrained maximization.
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Under unconstrained maximization, players play the Nash equilibrium.
Under constrained maximization, players are transparent in their intention to act in a trustworthy
manner. Consequently, players are willing to play the cooperative solution, even in a single play of
the game.
Firms are candidates for constrained maximization because their managers realize that to
maximize profits in the long run, the firm must act transparently and cooperatively.
Explain the basic principles of agency theory.
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Agency theory is a branch of game theory that studies the design of contracts to motivate an
agent to act in the best interests of a principal.
Conflict arises because the effort devoted by the manager to running the firm usually cannot be
observed by the principal (moral hazard problem). The principal wants to maximize his or her
utility, as does the manager.
When effort cannot be observed, the (effort averse) manager must, ideally, be motivated to work
hard by a contract that is based on firm payoff (that is, the cash flow resulting from the manager’s
effort in running the firm).
However, payoff is usually not observable until after the compensation contract has ended,
consequently a performance measure that predicts the payoff (for example, net income) is
needed.
When manager effort cannot be directly observed or inferred, the most efficient contract is the one
that gives the manager a share of the performance measure just enough that he or she is willing
to work for the firm, while providing an incentive to work hard.
If net income is an unbiased performance measure, greater precision (that is, less noise) in net
income enables an increase in contract efficiency.
However, net income may be biased by the manager. This is called earnings management.
In a single-period contract, the rational manager will manage net income upwards as much as
possible, thereby maximizing compensation.
It is possible to motivate the manager not to manage net income (revelation principle), but this
requires giving the manager the same compensation he or she would receive if net income were
unmanaged.
However, GAAP can limit (as opposed to eliminate) the ability of the manager to manage net
income, thereby increasing contract efficiency. This suggests that some earnings management can
be ―good.‖
Explain reservation utility.
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Reservation utility is the minimum utility that a manager will accept before deciding to go
elsewhere.
Essentially, reservation utility represents the utility to the manager of his or her ―market value.‖
Explain fixed and moving support.
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Fixed support is the situation where the set of performance measure realizations is fixed
regardless of the action choice. For example, net income can be any real number, regardless of
whether the manager shirks or works hard.
Moving support is where the set of performance measure realizations is different depending on the
action taken. When moving support holds, manager effort may be inferred and the first-best
contract can be attained.
Explain first-best versus second-best contracts.
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The first-best contract gives the owner the maximum attainable utility and gives the agent his or
her reservation utility. This contract can be attained if the manager’s effort can be directly
observed, or inferred.
Agency cost is the reduction in the principal’s utility if the first-best contract cannot be attained.
The second-best contract is the most efficient contract short of the first-best. The agency cost of
the second-best contract is the minimum attainable considering the unobservability of the
manager’s effort.
Analyze the important implications of agency theory for financial
accounting.
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Contracts of interest to accountants include compensation contracts between the firm and its top
management, and contracts between the firm and its debt-holders.
Frequently, these contracts depend on financial statement variables.
For example, compensation contracts may depend on reported net income, and debt covenants
may depend on liquidity or debt-to-equity ratios.
Study of such contracts gives accountants a better understanding of management’s interest in
accounting policy choice and why accounting policies can have economic consequences.
Understand the properties net income needs to compete as a performance
measure with share price.
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For compensation contracts, when more than one performance measure is available, both of which
contain incremental information about the manager’s effort in running the firm, both should be
used in the compensation contract (for example, net income and share price).
The relative proportions of each payoff measure in an efficient contract depend on the sensitivity
and precision of those measures.
Sensitivity is the rate at which the performance measure increases as manager effort increases.
Precision is the reciprocal of the variance of the performance measure (more precision = less
noise).
To maximize the relative proportion of net income in compensation contracts, accountants must
seek the most informative tradeoff between sensitivity and precision.
Explain how agency theory serves to reconcile efficient securities market
theory and economic consequences.
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Many important contracts depend on accounting variables.
Since contracts are rigid and incomplete, new accounting standards during the life of a contract
may negatively affect the level and volatility of manager compensation, and may lead to debt
covenant violation.
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Consequently, accounting policies have economic consequences.
Nothing in this argument conflicts with securities market efficiency.
Module 8 summary
Conflict between contracting parties
This module considers two applications of the agency theory. The first is executive compensation.
Reported net income has an important role to play as a performance measure in executive compensation
contracts. However, share price can be another performance measure. Most executive compensation
contracts for large, publicly-traded firms use both net income and share price as performance measures,
although in varying proportions. To the extent that net income is informative about manager effort, the
proportion of compensation based on net income will be maintained and enhanced, to accountants’
competitive advantage.
The role of monitoring manager performance and enabling efficient compensation contracts is as
important to society as the role of communicating useful information to investors.
The second application is earnings management. Given that reported net income influences
compensation, the probability of debt covenant violation, political visibility, and share price, positive
accounting theory predicts that managers and firms will be concerned about the accounting policies used
to calculate reported net income. Managers may use the flexibility of GAAP to manage earnings for a
variety of reasons. This management can be ―good,‖ as when it is used to reveal management’s inside
information about future earning power, or ―bad,‖ as when management behaves opportunistically to
maximize bonus or to attempt to deceive investors.
Explain why incentive contracts are necessary.
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Incentive contracts are necessary to align shareholders' and managers' interests in the presence of
moral hazard.
An executive compensation plan is an incentive contract between the firm and its manager that
attempts to align the interests of owners and managers.
This is done by basing the manager’s compensation on one or more performance measures, that
is, measures that predict the payoff from the manager’s effort in operating the firm.
Describe how an incentive plan can align the interests of the manager with
those of the shareholders.
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When compensation is based on performance measures, the manager is motivated to work hard.
This aligns manager and shareholder interests.
Compensation based on share price motivates a longer manager decision horizon than
compensation based on net income.
The relative proportions of these performance measures controls the length of the manager’s
decision horizon.
Comment on the theory and evidence pertaining to executive
compensation.
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Theory predicts that compensation committees will design compensation plans with an efficient
combination of sensitivity, precision, decision horizon, and risk.
Net income is low in sensitivity (less so under fair value accounting), but high in precision (less so
under fair value accounting).
Persistent earnings components are more sensitive than unusual, non-recurring, and extraordinary
items. These items are generally less informative about manager effort than core earnings, and
are also subject to manager manipulation.
Share price is high in sensitivity but low in precision.
Bushman and Indjejikian (1993), show that the relative proportions of net income-based and
share-based incentives can control the length of the manager’s decision horizon.
Lambert and Larcker (1987), found that the relative proportions of accounting-based and sharebased compensation vary as the theory predicts:
o For example, growth firms’ compensation plans are based more on share price, since net
income of growth firms is low in sensitivity.
Baber, Kang, and Kumar (1999) found that compensation committees value persistent earnings
more highly than transient, low-persistent items, when setting manager compensation.
Indjejikian and Nanda (2002), found that when firm risk was low, the firms in their sample tended
to award higher bonuses relative to salary.
Identify devices to control compensation risk.
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Since managers are assumed to be risk averse and cannot diversify their compensation risk,
incentive plans are designed to control risk while still maintaining effort motivation.
Devices to control compensation risk include
o compensation based on more than one performance measure
o a bogey in the compensation plan
o compensation committee
o relative performance evaluation
ESOs control downside risk but encourage upside risk-taking
Explain the political ramifications of executive compensation.
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Executive compensation attracts political controversy due to the large amounts of compensation
that are often involved.
Some argue that executives as a group are overpaid, pointing to low sensitivity of executive
compensation to firm performance, especially when performance is poor.
Others argue that executives are not overpaid, pointing out that the amount of compensation
received is very small relative to the shareholder values created. Also, managers cannot diversify
away their compensation risk.
Regulators have reacted to this controversy by requiring increased disclosure of executive
compensation, on the grounds that the managerial labour market and the shareholders of
individual firms can act if pay becomes excessive.
There is evidence that this regulation is having the desired effect (Lo (2003)).
Evaluate the power theory of executive compensation
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The power theory predicts that executives use their power in the organization to opportunistically
increase their compensation above competitive levels, thereby attaining more than reservation
utility.
To reduce outrage at this behaviour, managers use a variety of devices, such as hiring of outside
consultants and comparison with peer groups, to camouflage their high compensation.
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Regulators' mandating of increased disclosure of executive compensation helps to counteract
excessive compensation.
Identify patterns of earnings management.
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There are four main patterns of earnings management:
o taking a bath — If expected earnings are below the bogey, go all the way with writeoffs,
and so on.
o earnings minimization — This is earnings reduction that is not as severe as taking a bath. It
may occur if management expects earnings to exceed the bonus cap.
o earnings maximization — This occurs when the firm is between the bogey and the cap. It
may also be used to avoid violation of debt covenants.
o income smoothing — This is used to avoid excessive volatility of earnings.
Explain the various motivations for earnings management.
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Earnings management is a manager’s choice of accounting policies so as to achieve some specific
objective.
Earnings management can be studied by analyzing the accruals over which management has some
discretion, such as provisions for doubtful accounts.
There is empirical evidence that managers do engage in patterns of earnings management that
accomplish the following objectives.
Identify the objectives of earnings management.
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The objectives of earnings management are to
o maximize bonuses
o meet investors’ earnings expectations
o avoid the consequences of violation of debt covenants
o increase the proceeds of initial public offerings
o reduce political visibility
o influence government policy
o communicate blocked inside information to investors
Some of these objectives can be ―good‖ (that is, efficient). Others can be ―bad‖ (that is,
opportunistic).
Distinguish between earnings management that reveals inside information
to the market and earnings management that attempts to deceive the
market.
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Whether managers use earnings management opportunistically (bad earnings management) or
responsibly (good earnings management) is an important question for accountants, who are often
the ones advising management about accounting policies.
o Bad earnings management involves the manager selecting accounting policies to maximize
his or her own expected utility rather than the expected utilities of the owners. Policies to
maximize bonus are an example.
o Good earnings management is used to communicate blocked inside information about
future earnings prospects to investors, and to avoid the consequences of rigid and
incomplete contracts.
Explain the “iron law” of accruals.
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There is an ―iron law‖ of earnings management — accruals reversal.
If a manager uses discretionary accruals to increase reported earnings this year, the reversal of
those accruals in future years decreases future earnings by the same amount.
As a result, the manager must work ―harder‖ to find new income-increasing accruals in future
years if the pattern of income-increasing earnings management is to be maintained.
Conversely, if a manager records excessive income-decreasing discretionary accruals this year,
such as excessive provisions for re-organization or site restoration, this increases future reported
earnings. This is called putting earnings ―in the bank.‖
Furthermore, the banked earnings are typically buried in future core earnings, leading investors to
overestimate earnings persistence. This tempts management to ―overdose‖ on income-decreasing
discretionary accruals such as unusual, non-recurring, and extraordinary items.
Accountants could reveal banked earnings by separately reporting the effects of previous accruals
on current core earnings.
Evaluate whether or not managers accept securities market efficiency.
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Despite evidence to the contrary, many managers appear to believe that they can ―fool‖ the
market, implying that they do not accept market efficiency.
If the securities market is efficient, managers must hide opportunistic earnings management
behind poor disclosure to avoid detection.
Implication for accountants: Improve disclosure, regardless of whether managers do or do not
accept market efficiency.
Module 9 summary
Standard setting: Economic issues
This module considers whether market forces are sufficient to generate the ―right‖ amount of information
in society, or whether regulation by some central authority is needed. At present, there is a high, and
increasing, degree of regulation of firms’ financial reporting decisions, for example, in the form of GAAP.
However, past years have seen substantial deregulation of several industries. Will society benefit if the
information ―industry‖ is also deregulated? To address this question, you need to think of information as
a commodity, subject to market forces of supply and demand. This module outlines and evaluates these
forces as they apply to the information ―market.‖
Because information is a very complex commodity, we are unable to reach a conclusion as to the ―right‖
extent of regulation. Nevertheless, a study of forces that motivate managers to produce information even
in the absence of regulation makes accountants aware that indefinite expansion of rules and regulations
in financial reporting is not necessarily cost effective from a social perspective.
The accountant’s role increases in importance when regulation does not completely prescribe how to
report. Indeed, competent and ethical judgment about full and fair disclosure is then even more
necessary.
Distinguish between proprietary and non-proprietary information.
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Information can be categorized as proprietary or non-proprietary.
The release of proprietary information will directly affect the firm’s future cash flows — for
example, the release of valuable patent or process information.
The release of non-proprietary information, such as earnings, forecasts, and risks, does not
directly affect cash flows.
This distinction is important because regulation of firms’ information production applies primarily to
non-proprietary information.
It is difficult to require firms to release proprietary information.
Explain the concept of information as a commodity that has value and can
be produced by firms at a cost.
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Information can be produced in several ways:
o finer information — more detail
o additional information
o more credible information
While investors may benefit from an increased amount of information, there is a cost to the firm,
and therefore to society, to produce that information.
Outline private incentives for information production.
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Contractual incentives to produce information arise from the contracts firms enter into.
o Examples are managerial compensation contracts and debt contracts.
o These contracts usually depend on financial accounting variables.
o They are only effective when a few parties are involved.
Market-based incentives to produce information arise from securities markets and managerial
labour markets.
o They encourage managers to produce information so as to create and maintain reputation
for full disclosure.
o Such a reputation benefits the firm and manager through lower cost of capital and higher
reservation utility.
o Empirical evidence reveals that firms with good disclosure practices enjoy lower costs of
capital.
Other private incentives to produce information arise from the disclosure principle, signalling, and
private information search.
o The disclosure principle states that firms will release information because, otherwise, the
market will assume the worst and act as if the unrevealed information is the worst possible.
However, this principle does not always work because it requires assumptions that are often
not met in reality. Then, only partial information release is likely.
o Signals are actions taken by a high-type manager that would not be rational if that
manager was a low-type.
 Signals enable managers to credibly communicate information about their type,
which would not be credible if the manager simply announced the information.
 For a signal to be credible, it must be less costly for the high-type manager to give
the signal than for a low-type manager.
o A private information search encourages investors to produce information in the search
for mispriced securities.
 Even when securities markets are efficient, mispriced securities may exist because of
noise trading.
 However, such activities are inefficient from society’s standpoint because many
individuals expend resources to discover similar information.
Identify and explain sources of market failure in the private production of
information.
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Market failure is the failure of market forces to drive the ―socially correct‖ amount of production, in
this case, information production.
The socially correct amount of information is that level that equates the marginal social benefit of
information production with the marginal social cost of that production.
Market failure arises from externalities and free-riding, adverse selection, and moral hazard,
leading to lack of unanimity.
Describe externalities, free-riding, adverse selection, moral hazard, and
lack of unanimity.
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Externalities and free-riding arise because accounting information has characteristics of a public
good — firms cannot charge investors for the value of the information they produce.
Consequently, they produce less than they should, from a social perspective.
Free-riding is the benefit received by investors from the information that firms do produce, but for
which investors do not pay.
Adverse selection results in insider trading and failure, or delay, of managers to release all
information.
o As a result, investors do not perceive the securities market as a level playing field.
o They may withdraw from the market, in which case the market loses liquidity.
o This means that the securities market does not operate as well as it could to motivate firms
and investors to produce information.
Moral hazard tempts managers to shirk and disguise their shirking, at least in the short run, by
opportunistic earnings management.
o Such earnings management distorts the firm’s information production, leading to market
failure
Lack of unanimity arises when the amount of information investors desire is different from what
the manager wants to produce.
o This can happen even if the manager produces information to the point of maximizing the
firm’s share value, because in the presence of market failures, firms’ share prices are lower
than the prices they would be if there were no market failures.
Outline the complexity of measuring the costs and benefits of information
to society.
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The complexities of calculating the socially correct amount of information production mean that
the question of the extent of standard setting cannot be settled by means of economics alone.
Consequently, the setting of GAAP is as much a political process as it is an economic one.
Because information is such a complex commodity, even standard setters cannot calculate the
socially correct amount of information to require firms to produce.
Explain the regulatory implications of IFRS 8 on segment reporting.
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Regulation of a firm’s information production is viewed as a way to overcome the various market
failures in its production.
In accounting, much of this regulation is in the form of standards, collectively known as GAAP.
We do not know whether existing GAAP represent insufficient, exact, or too much information
production.
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However, because the setting of, and monitoring compliance with, GAAP is costly, a fact not
emphasized by standard setters, there is a danger that GAAP may go beyond the socially correct
amount.
IFRS 8, which requires firms to report segment information on the same basis as the firm
segments its business, was designed to minimize the cost to the firm of producing the information
while attempting to provide segment information that is of greatest use to investors.
Module 10 summary
Standard setting: Political issues
This module considers the political aspects of standard setting, describing how constituencies that are
affected by standard setting appeal to a political process to resolve the conflicts between them. As you
saw in Module 9, these conflicts cannot be solved strictly through economic analysis.
Compare the two theories of regulation — the public interest theory and
the interest group theory.
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The public interest theory of regulation assumes that regulators have the best interests of society
at heart and do their best to maximize benefit to society.
The interest group theory of regulation assumes that the various constituencies affected by
standard setting (the two main ones being investors and managers) lobby the legislature, and/or
regulatory bodies created by the legislature, for their preferred nature and extent of accounting
standards.
o The regulatory body (for example, AcSB, FASB) is supplied with power to set accounting
standards by the legislature.
o The regulatory body is assumed to maximize its own welfare while balancing the demands
of the various constituencies.
o The constituency that is most politically effective in its regulatory demands will receive most
of the benefits of regulation.
Outline the standard-setting processes in Canada.
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In Canada, accounting standards are set by the Accounting Standards Board (AcSB), as authorized
by the board of governors of the Canadian Institute of Chartered Accountants.
Standards relating to financial accounting and reporting are included in the IASB standards.
The Ontario Securities Commission (OSC) regulates all securities trading in Ontario. This includes
the Toronto Stock Exchange, the largest stock exchange in Canada.
o The OSC accepts accounting standards as laid down by the CICA Handbook, although it also
issues its own standards such as MD&A and Management Proxy Circulars, which do not
affect the financial statements directly. Note that those laid down by the CICA Handbook
now include a full set of IFRS in Part I.
o More recently, the Canadian Securities Administrators (CSA) was created to attempt to
harmonize securities regulation across Canada.
Outline the standard-setting processes in the United States.
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In the United States, financial accounting standards are set by the Financial Accounting Standards
Board (FASB).
The Securities and Exchange Commission (SEC) is a body established by the U.S. legislature to
regulate most securities trading in the United States. The SEC looks to the FASB to set financial
accounting standards.
As is also the case for the OSC and CSA, the SEC issues its own standards (for example, MD&A),
which do not affect the financial statements proper.
Outline the standard-setting processes internationally.
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The International Accounting Standards Board (IASB) publishes financial accounting standards and
promotes their world-wide acceptance.
The ultimate goal of international accounting standards setting is to develop a set of high-quality
accounting standards that all countries, including the United States, accept.
Comparability of the financial statements produced in different countries will lower firms’ and
investors’ costs, and promote share trading across countries, thereby facilitating international
capital flows. However, even high quality standards allow differences in accounting policy choice,
earnings management, and professional judgment. Investors should be aware that reporting
quality can differ across countries even though they use IASB standards.
Compare and contrast standard-setting processes in Canada, the United
States, and internationally.
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The structures of the AcSB, FASB, and IASB are characterized by representation of different
constituencies.
Unlike the AcSB, the structures of the FASB and IASB are foundation-based. A foundation-based
structure may give the standard-setting body greater independence from the management
constituency. However, recent standards in Canada, such as CSA MI 52-110, reduce these
concerns.
The processes of the AcSB and IASB require a super-majority to pass a new standard.
The deliberations leading up to a new standard feature due process, whereby all interested
constituencies have the opportunity of presenting their views.
The structure and process of the AcSB, FASB, and IASB are most consistent with the interest
group theory of regulation.
Scrutiny of the process of setting a new standard suggests that it is primarily one of conflict
resolution.
The final product is a standard that reflects a compromise between the wishes of the affected
constituencies.
Ethical issues related to standard-setting
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The accounting profession must develop strategies to be trustworthy, such as acting transparently.
Professionals must not impose their own values on the client. They have an obligation to act in the
client’s best interests.
Professionals must serve the public interest by acting with integrity. This includes conscientious
application of existing standards, rather than helping managers to circumvent the rules.
Implementation of rules-based accounting standards will particularly require accountants to be
trustworthy and serve the public interest when this conflicts with the client’s interest, as well as to
fully meet their own rules of professional conduct.
Evaluate the political aspects of some important standards.
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New accounting standards frequently run into opposition from managers, who fear the economic
consequences.
This requires compromise, since managers are an important constituency, whose interests must be
traded off with those of investors.
Examples of compromise:
o IAS 39, despite containing several provisions to meet manager concerns about fair value
volatility, encountered severe opposition by European banks, to the point where the IASB
had to introduce additional compromises.
o SFAS 130 created Other Comprehensive Income, to reduce management concerns about
earnings volatility. Subsequently, the IASB adopted a similar standard.
Assess the criteria for a successful standard.
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To be successful, an accounting standard must meet four criteria:
o It must convey useful information to investors.
o It must reduce information asymmetry, so as to improve the operation of capital and
managerial labour markets.
o The economic consequences must not be too great. It must not have too unfavourable an
effect on managerial compensation contracts, debt contracts, and firms’ political visibility.
o It must attain a consensus such that even a constituency that is not in favour of a standard
is willing to go along with it. Attainment of such a consensus requires due process by the
standard-setting body.