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Financial Accounting Theory To provide a framework within which contemporary financial accounting practice and issues, in a

market economy can be critically analysed and evaluated

Subject Aims 1. Understand the role of theory in explaining accounting behaviour

2. Appreciate the principal existing theories that explain the production and usage of

accounting reports

3. Understand and think critically about the accounting regulatory process

Theory: A coherent set of hypothetical conceptual and pragmatic principles forming the general

framework of reference for a field of inquiry

- A set of ideas used to explain/understand real world observations

Financial Accounting Theory: Used to explain, predict and prescribe accounting practice and

reactions to accounting regulations and practices. It explains when financial accounting information

will be decision-useful.

- It explain how, when and why information asymmetry is minimised in financial decision.

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Contents Subject Aims .................................................................................................................................... 1

FAT Week 1: Introduction and Overview ................................................................................................ 7

Two types of Information asymmetry ................................................................................................ 7

Efficient Contracts ............................................................................................................................... 7

Conservatism: ................................................................................................................................. 8

Why is conservatism important to efficient contracting ................................................................ 8

Wrap up .......................................................................................................................................... 8

FAT Week 2: The Benchmark Accounting System: Ideal Accounting ..................................................... 9

Learning Objectives ............................................................................................................................. 9

Ideal Conditions – valuation perspective ............................................................................................ 9

Certainty – There is no information asymmetry about the firm’s current or future prospects ..... 9

Present value model of Accounting (under certainty) ........................................................................ 9

Important points to note for ideal conditions of certainty ............................................................. 9

Relevance ............................................................................................................................................ 9

Reliability ............................................................................................................................................. 9

Financial statements under ideal conditions of certainty ................................................................ 10

Ideal conditions of uncertainty ......................................................................................................... 10

Assumptions .................................................................................................................................. 10

Financial statements under ideal conditions of uncertainty ............................................................ 10

Why are financial statements still 100% relevant and reliable .................................................... 10

Fair Value Accounting ....................................................................................................................... 11

Problems that prevent ideal conditions........................................................................................ 11

Estimating cost of capital (typical to have 3% standard error) ..................................................... 11

Timing of revenue recognition .......................................................................................................... 11

FV vs HC accounting .......................................................................................................................... 11

Big picture points (3) ..................................................................................................................... 11

True net income DOES NOT EXIST ................................................................................................ 11

Week 3: The meaning of ‘decision useful’ to the rational investor ...................................................... 12

Learning Objectives ........................................................................................................................... 12

Information perspective ............................................................................................................... 12

Single Person Decision Theory: Rational decision theory model – captures average investor

behaviour ...................................................................................................................................... 12

Attitude to risk .................................................................................................................................. 12

Risk Averse .................................................................................................................................... 12

Risk neutral ................................................................................................................................... 12

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Risk Seeking ................................................................................................................................... 12

Bayes’ rule: Tool to combine old information with new information .............................................. 13

𝐏𝐫𝑵𝒐𝒕 𝑨 × 𝐏𝐫 (𝑿|𝑵𝒐𝒕 𝑨) ............................................................................................................. 13

The Information System .................................................................................................................... 13

How are information system probabilities known by an investor? .............................................. 13

Determinants of earnings quality ................................................................................................. 13

IFA Week 4: Shareholder Decision Making in Capital Markets ................ Error! Bookmark not defined.

Learning Objectives .............................................................................. Error! Bookmark not defined.

Why is the efficiency of capital markets important ............................. Error! Bookmark not defined.

Reasons why efficient markets do not reflect true value ................ Error! Bookmark not defined.

What does an efficient market mean for the rational risk-averse investor? ..... Error! Bookmark not

defined.

Implications for Financial Reporting .................................................... Error! Bookmark not defined.

Is an inefficient market inherently a good or bad thing? ................ Error! Bookmark not defined.

Social implications of Adverse Selection .............................................. Error! Bookmark not defined.

Market Efficiency, Decision Useful Earnings and the Information Useful Perspective Error! Bookmark

not defined.

Learning Objectives .............................................................................. Error! Bookmark not defined.

Central Issues ................................................................................... Error! Bookmark not defined.

Event Study: Things you need to know ................................................ Error! Bookmark not defined.

Unexpected earnings (UEit) .............................................................. Error! Bookmark not defined.

Abnormal Returns ............................................................................ Error! Bookmark not defined.

First, need to find expected returns ................................................ Error! Bookmark not defined.

Ball & Brown (1968) ............................................................................. Error! Bookmark not defined.

Earnings Response Coefficients ........................................................... Error! Bookmark not defined.

Factors affecting ERC (which type of unexpected dollar does the market react most to) ..... Error!

Bookmark not defined.

Earnings Persistence ............................................................................ Error! Bookmark not defined.

ERC in Historical cost vs fair value accounting ................................. Error! Bookmark not defined.

ERC and earnings Quality ................................................................. Error! Bookmark not defined.

Implications of ERC Research ............................................................... Error! Bookmark not defined.

Week 5: Market anomalies and the trend to fair value........................... Error! Bookmark not defined.

Central issue ......................................................................................... Error! Bookmark not defined.

Why use the measurement perspective? ........................................ Error! Bookmark not defined.

Factors that cause market inefficiency ................................................ Error! Bookmark not defined.

Cognitive biases that impact rationality .......................................... Error! Bookmark not defined.

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Sloan Accruals anomaly ................................................................... Error! Bookmark not defined.

Week 7: Contracting Approach to decision usefulness ........................... Error! Bookmark not defined.

Focuses for part 2 of FAT ..................................................................... Error! Bookmark not defined.

If firm value is independent of accounting policy choice, why do managers care? ............... Error!

Bookmark not defined.

Nature of Agency problems ................................................................. Error! Bookmark not defined.

Calculating the utilities of the owner and manager ............................ Error! Bookmark not defined.

Factors we need ............................................................................... Error! Bookmark not defined.

Why does the agency problem arise? .................................................. Error! Bookmark not defined.

Manager’s information advantage ...................................................... Error! Bookmark not defined.

Net income as a noisy measure of performance ............................. Error! Bookmark not defined.

Positive Accounting Theory ................................................................. Error! Bookmark not defined.

Efficient contracts ................................................................................ Error! Bookmark not defined.

Measuring the manager’s effort .......................................................... Error! Bookmark not defined.

Long-term contracts and contract rigidity ........................................... Error! Bookmark not defined.

Efficient Contracting form ................................................................ Error! Bookmark not defined.

Opportunistic form .......................................................................... Error! Bookmark not defined.

The Three Hypotheses of Positive Accounting Theory ........................ Error! Bookmark not defined.

Week 8: Executive Compensation ........................................................... Error! Bookmark not defined.

Learning Objectives .............................................................................. Error! Bookmark not defined.

Types of compensation contracts ........................................................ Error! Bookmark not defined.

Fixed pay contract ............................................................................ Error! Bookmark not defined.

Performance-based contracts .............................................................. Error! Bookmark not defined.

How to measure the manager’s effort ............................................ Error! Bookmark not defined.

Attributes of good performance measures ......................................... Error! Bookmark not defined.

Accounting-based measures on informativeness ................................ Error! Bookmark not defined.

Short-term vs long-term measures .................................................. Error! Bookmark not defined.

Optimal mix of short-run and long-run performance measures ......... Error! Bookmark not defined.

Compensation risk ............................................................................... Error! Bookmark not defined.

Bogey and Cap.................................................................................. Error! Bookmark not defined.

Relative performance evaluation ..................................................... Error! Bookmark not defined.

Board & compensation committee .................................................. Error! Bookmark not defined.

Designing an Optimal compensation contract .................................... Error! Bookmark not defined.

The politics of Executive Compensation .............................................. Error! Bookmark not defined.

Are managers paid too much? ......................................................... Error! Bookmark not defined.

Week 9: Employee Stock Options ............................................................ Error! Bookmark not defined.

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Learning Objectives .............................................................................. Error! Bookmark not defined.

What are ESOs? .................................................................................... Error! Bookmark not defined.

Why use ESOs ....................................................................................... Error! Bookmark not defined.

Conceptual and Accounting Issues ...................................................... Error! Bookmark not defined.

Is ESO an expense ............................................................................ Error! Bookmark not defined.

Main Accounting Issues ................................................................... Error! Bookmark not defined.

Compensation Expense .................................................................... Error! Bookmark not defined.

Vesting Conditions (Allocating expense).......................................... Error! Bookmark not defined.

AASB 2: Equity-settled share-based payment transactions ............. Error! Bookmark not defined.

Calculating share options expense ...................................................... Error! Bookmark not defined.

What happens after the vesting date .............................................. Error! Bookmark not defined.

If options do not vest ....................................................................... Error! Bookmark not defined.

Accounting treatment of ESO .............................................................. Error! Bookmark not defined.

Why Regulate ESOs .............................................................................. Error! Bookmark not defined.

Economic Consequences of accounting for ESOs ................................ Error! Bookmark not defined.

Week 10: Earnings Management ............................................................. Error! Bookmark not defined.

What is Earnings Management? .......................................................... Error! Bookmark not defined.

How can earnings be manipulated .................................................. Error! Bookmark not defined.

Accounting adjustments (Accounting Earnings Management) ........... Error! Bookmark not defined.

Earnings Manipulation using incorrect classification .......................... Error! Bookmark not defined.

Real activities (Real Earnings Management) ........................................ Error! Bookmark not defined.

Income Smoothing ........................................................................... Error! Bookmark not defined.

Motives for Earnings Management ..................................................... Error! Bookmark not defined.

Contractual Motives ......................................................................... Error! Bookmark not defined.

Regulatory Motives .......................................................................... Error! Bookmark not defined.

Capital Market Motives.................................................................... Error! Bookmark not defined.

Other motivations ............................................................................ Error! Bookmark not defined.

How to detect Earnings Management ................................................. Error! Bookmark not defined.

Controlling Earnings Management ...................................................... Error! Bookmark not defined.

Consequences ...................................................................................... Error! Bookmark not defined.

Week 11: Standard Setting ...................................................................... Error! Bookmark not defined.

Learning Objectives .............................................................................. Error! Bookmark not defined.

Why is Regulation required.............................................................. Error! Bookmark not defined.

Incentives for producing information .................................................. Error! Bookmark not defined.

Contracting: provide information in order to raise capital .................. Error! Bookmark not defined.

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Coase Theorem (Conditions whereby externalities may be internalised) ...... Error! Bookmark not

defined.

Market-based incentives for information production (Disclosure principle & Signalling) ......... Error!

Bookmark not defined.

1. Disclosure Principle .................................................................. Error! Bookmark not defined.

2. Signalling .................................................................................. Error! Bookmark not defined.

Private information search .................................................................. Error! Bookmark not defined.

Consequences of increased information production .......................... Error! Bookmark not defined.

How much information is enough? .................................................. Error! Bookmark not defined.

Politics of Standard setting ...................................................................... Error! Bookmark not defined.

Key points ............................................................................................. Error! Bookmark not defined.

Public interest theory: Regulation is a response to public demand for information .............. Error!

Bookmark not defined.

Interest group theory: Each interest group has their own demand for information .............. Error!

Bookmark not defined.

Regulation Fair Disclosure: Selective disclosure to a select group of analysts and individuals

......................................................................................................... Error! Bookmark not defined.

Criteria for good accounting standards ............................................... Error! Bookmark not defined.

International Accounting ..................................................................... Error! Bookmark not defined.

Problems .......................................................................................... Error! Bookmark not defined.

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FAT Week 1: Introduction and Overview

3 key points that facilitated as a society to lower our risk, pool our capital and enhance the efficient

allocation of scarce resources

1. Share ownership

2. Professional management

3. Limited liability

Resulted in information asymmetry; substantial risk; management cannot be directly monitored.

Information asymmetry; production of accounting information to minimise the risk of misallocation

of resources.

Financial Accounting: An information reporting system designed to relieve information asymmetry in

economies

Its role is to explain when and how information asymmetry is minimised.

Information asymmetry: Two parties to a transaction; one party has an information advantage over

the other party.

Two types of Information asymmetry 1. Adverse selection: A type of information asymmetry where a party to a potential

transaction has an information advantage over other parties (PRE-CONTRACT)

- Selection problem in relation to a potential transaction; characteristics of a good/service is

not fully known

- Partially resolved through signalling using financial accounting

2. Moral hazard: A type of information asymmetry whereby a party to a transaction can

observe their actions in fulfilment of a transaction but the other cannot (POST-CONTRACT)

- All about incentive problems (behaviour problems)

These two types of information asymmetry give rise to two objectives of financial accounting

1. Valuation objective: Demand for information to precisely value a company’s shares. (buying

and selling) – Counters the adverse selection problem

2. Stewardship objective/ Moral Hazard/ Efficient Contracting view: Demand for information

to monitor and measure the performance of the corporate manager

The best measure of net income to control adverse selection is not the same as the best measure to

motivate manager performance.

- Historical Cost: Best method to measure manager performance

- Fair value: Best method to value a firm

Efficient Contracts For contracts to be efficient, parties need to trust each other

- Provide information that measures their performance in the fulfilment of their contract

- Need to be able to trust that financial accounting information – need for it to be RELIABLE

- Financial reporting should be conservative

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Conservatism: - An accounting policy that applies a higher verification standard for the recognition of gains

vs. losses

- To implement that principle: We only recognise gains when it’s a transaction with an

external party, yet we recognise losses as soon as we anticipate them

Why is conservatism important to efficient contracting - Can’t directly monitor a corporate manager

- Want an information system that reliably measures their performance

- Flexibility to take unrealised gains to P&L result in corporate manager taking these gains in

times where his/her performance is bad (Can’t trust this information)

- Conservatism makes for more precise measurement of a corporate manager’s performance

Wrap up 1. Role of financial accounting is to reduce or relieve information asymmetry via reducing

adverse selection and reducing moral hazard

2. Financial reporting needs to capture the substance of transactions

3. Standard setting is the mechanism used to regulate the provision of accounting information

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FAT Week 2: The Benchmark Accounting System: Ideal Accounting

Learning Objectives 1. To appreciate the concept of ideal conditions

2. Use PV model under ideal conditions to prepare an articulated set of financial statements for

a sample firm

3. To introduce the basic accounting concepts of relevance and reliability

4. To critically evaluate Reserve Recognition Accounting as an application of the PV model

5. To understand the practical non-existence of true net income

Ideal Conditions – valuation perspective - Future economic prospects are disclosed fully (dividends, cash flows, profits); RELEVANT

- Information is also precise and free from bias; RELIABLE

2 approaches; under certainty and uncertainty

Certainty – There is no information asymmetry about the firm’s current or future prospects 1. Future cash flows of the firm are known by everyone

2. The firms’ cost of capital are known by everyone

Present value basis of accounting

Income recognised as changes in PV occur (Income statement does not provide additional info)

Present value model of Accounting (under certainty) - BS will show the PV of total assets of the firm

PV can also be called value-in-use

FV can also be called exit price/ opportunity cost – what you can get in the market

Important points to note for ideal conditions of certainty 1. Book value = PV = market value = fair value

2. Fair value can be determined

- Directly (PV of future cash flows)

- Indirectly (Market value)

Relevance - Information about the firm’s economic prospects, I.e. future cash flows from which dividends

are paid, the PV of which is firm value

- Information has the quality of relevance when it influences the economic decisions of users

by helping them evaluate past, present, or future events or confirming, or correcting, their

past evaluations.

Reliability - Precise and unbiased

- Information has the quality of reliability when it is free from material error and bias and can

be depended upon by users to represent faithfully that which it either purports to represent

or could reasonably be expected to represent.

Information is 100% relevant and reliable in ideal conditions because of perfect certainty! If that

assumption is relaxed, we have ideal conditions in uncertainty.

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Financial statements under ideal conditions of certainty - Asset = NPV (future cash flows)

- Equity = depends on how the asset is financed

- expected income = PV of asset × interest rate

- Amortization expense = 𝑃𝑉𝑦𝑒𝑎𝑟 1 − 𝑃𝑉𝑦𝑒𝑎𝑟 2 → goes into the income statement\

- Dividend = whatever was declared, as a negative amount under Equity

In an ideal world, net income = expected income

Ideal conditions of uncertainty

Assumptions 1. Known set of states of nature (uncertain future events such as the state of the economy)

2. State probabilities are objective and publicly known

3. Realisation (cash flows) is publicly observable

4. Given interest rate

Having ideal conditions of uncertainty allows us to prepare financial reports that are both 100%

relevant and reliable

- Net income still provides no additional information.

Financial statements under ideal conditions of uncertainty - Asset = NPV (future cash flows)

- Equity = depends on how the asset is financed

- expected income = PV of asset × interest rate

- Abnormal earnings = Expected income – Actual income

- Net income = Accretion of discount – abnormal earnings

- Amortization expense = 𝑃𝑉𝑦𝑒𝑎𝑟 1 − 𝑃𝑉𝑦𝑒𝑎𝑟 2 → goes into the income statement\

- Dividend = whatever was declared, as a negative amount under Equity

In an ideal world, net income = expected income

Why are financial statements still 100% relevant and reliable

Relevant

BS is based on expected future cash flows (relevant for decision making)

Reliable

- Due to ideal conditions; we can obtain precise present values that are free from bias. They

faithfully represent the firm’s assets and liabilities!

Therefore, the market value of a firm is the expected PV of its future dividends, assuming that the

investor is risk-neutral.

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Fair Value Accounting Requirements:

1. Estimates of future cash flows

2. Expectations about possible variations in the amount and timing of cash flows; risk

3. Time value of money; risk free rate

4. The price for bearing uncertainty; risk premium

Problems that prevent ideal conditions 1. Subjective state probabilities: Actual state probabilities are not known

2. Incomplete markets: (MV may not exist for all A/L due to thin markets and/or IA

We need estimates for the requirements for FV accounting – results in unreliability

Estimating cost of capital (typical to have 3% standard error) - Which asset pricing model should be used

- Estimates of an asset’s risk loading

- Estimates of an asset’s factor risk premiums

Applying FV accounting in non-ideal conditions is thus prone to error and bias.

- BS will be unreliable

- These result in the need for ‘adjustments’ to PV estimates (Income statement).

- Adjustments in income statement adds noise to performance measurement

Timing of revenue recognition - Recognition lag: HC revenue recognition principle requires a firm to recognise revenues

when all or a substantial portion of the service has been performed and the cash receipt is

reasonably certain

- No recognition lag: FV recognises income as changes in the fair value of assets or liabilities

occur!

FV vs HC accounting - Matching principle: implies that Income statement is the primary source of information; BS

just residual

- FV implies that the BS is the primary source of information; no added info from IS

Big picture points (3) 1. FS taken as a whole clearly not PV accounting – hybrid or mixture; mixed model

2. Systematic guiding rule: As FV estimates become more reliable, more likely to mandate FV

accounting

- As the FV estimates become less reliable, more likely to mandate HC accounting

3. Substantial systematic biases (different classes use different accounting methods) in the way

Assets and Liabilities are recorded

True net income DOES NOT EXIST True net income: Change in wealth between t and t – 1

We don’t know the true wealth at any times because

1. Markets are incomplete

- Rely on PV estimates and in non-ideal conditions, they are subject to error

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Week 3: The meaning of ‘decision useful’ to the rational investor

Learning Objectives 1. Emphasise the decision usefulness objective of financial reporting

2. Operationalise this in a model of rational investment decision making

3. Introduce the concept of an information system

4. Appreciate the acceptance of the rational decision-making model by accounting regulators

Information perspective - Provide decision useful information in the income statement; investors make their own

decision to arrive at the value of the firm themselves

- Role of financial reporting is to supply information that is useful for investment decisions

- To prepare useful information, the accountant must know what the investor finds useful

Single Person Decision Theory: Rational decision theory model – captures average investor

behaviour - Formal model of rational decision making under uncertainty

- Information is evidence that has the potential to affect an individual’s decision

- Models how decision-makers update their subjective beliefs about future payoffs of their

decisions

Attitude to risk - No right or wrong, depends on people

- Need to understand average utility function

Risk Averse

𝑈𝑡𝑖𝑙𝑖𝑡𝑦𝑟𝑖𝑠𝑘−𝑎𝑣𝑒𝑟𝑠𝑒 = √payoff

- Markets assume investors are risk averse

- Due to marginal utility of wealth that underpins and explains risk aversion

Concave utility function for wealth

Risk aversion modelled by decision theorists through the device of a utility function

A decrease in wealth makes people more unhappy compared to an equivalent increase in wealth

Risk neutral 𝑈𝑡𝑖𝑙𝑖𝑡𝑦𝑟𝑖𝑠𝑘−𝑛𝑒𝑢𝑡𝑟𝑎𝑙 = payoff

Risk Seeking 𝑈𝑡𝑖𝑙𝑖𝑡𝑦𝑟𝑖𝑠𝑘−𝑠𝑒𝑒𝑘𝑖𝑛𝑔 = payoff 2

- These functions are just a proxy of measuring a utility function

- In real life, we can use surveys to calibrate actual risk function

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Bayes’ rule: Tool to combine old information with new information The formal model used to revise probabilities on the receipt of new information

Probability (good news given the firm is performing well) = P(GN | H)

Probability (good news given the firm is not performing well) = P(GN | B)

Issue is how much to alter priors when earnings news comes out

Pr(𝐴) × Pr (𝑋|𝐴)

Pr(𝐴) × Pr(𝑋|𝐴) + 𝐏𝐫(𝑵𝒐𝒕 𝑨) × 𝐏𝐫 (𝑿|𝑵𝒐𝒕 𝑨)

- Pr (A) is the prior probability of A

- Pr (A|X) is the conditional probability of A given X

- Pr (X|A) is the conditional probability of X given A

𝐏𝐫(𝑵𝒐𝒕 𝑨) × 𝐏𝐫 (𝑿|𝑵𝒐𝒕 𝑨) - The probability that the underlying reality is not A, but earnings report shows that it IS A

- Pr (A) and Pr (Not A) are both prior probabilities

Financial statements are a cost-effective source of information about future firm performance

The Information System The higher the main diagonal probabilities, the better the investor can predict the state of nature (i.e.

future firm performance)

- The main diagonal probabilities capture financial statement informativeness

- Highly informative financial statements also called

i. Transparent

ii. Precise

iii. High quality

How are information system probabilities known by an investor? - Reflect quality of GAAP

Prior probabilities are subjective. Investors get them based on all information available prior to

the investment decision

If prior probabilities are subjective, so are posterior probabilities

But, posterior probabilities are better predictors of future firm performance if financial statement

information is informative.

Determinants of earnings quality

Quality of accounting measurement principles (no single standard will perfectly measure true

income)

Quality of implementation (unintentional errors and intentional biases)

1. Governance and controls

2. Quality of auditor

3. Incentives to bias

Accruals – Increase relevance at the cost of decreasing reliability

- Timing issue → Revenue recognition principle: Recognise revenue as economic services are

performed

- Matching issues → Matching principle: Match revenues in 1 period with expenses