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Financial Accounting Theory Fifth Edition William R. Scott Purpose: To create an awareness and understanding of the financial reporting environment in a market economy Slide 2 Outlines Some Historical Perspective A Note on Ethical Behavior The Role of Accounting Research Organization of the Book Information Asymmetry Role of Financial Reporting Slide 3 South Sea Company The company, established in 1711 by the Lord Treasurer, Robert Harley Slave trading The share price from 128 in January 1720, to 175 in February, 330 in March and, following the scheme's acceptance, to 550 at the end of May. The Bubble Act,1720 Slide 4 Copyright 2009 by Pearson Education Canada 1 - 4 Famous First Bubbles? Slide 5 Copyright 2009 by Pearson Education Canada 1 - 5 South Sea Bubble Hogarthian image of the South Sea Bubble, by Edward Matthew Ward, Tate Gallery Slide 6 Copyright 2009 by Pearson Education Canada 1 - 6 Chapter 1 Introduction Slide 7 Copyright 2009 by Pearson Education Canada 1 - 7 1.2 Some Historical Perspective Paciolo, 1494 Paciolos work was translated into English, 1543 English Corporations Acts,1844 Compulsory audit, balance sheet Voluntary provision of information Reinstated after 1900s(compulsory audit) Slide 8 Copyright 2009 by Pearson Education Canada 1 - 8 Some Historical Perspective, Contd Developments in the United States Corporate income tax, 1909 provided a major impetus to income measurement, accepted amortization as a deduction from income SEC, 1934 Great Depression,1929 Securities Act of 1934 The search for accounting principles Sarbanes-Oxley,2002 Subprime Mortgage Crisis and Fair value measurement Slide 9 Copyright 2009 by Pearson Education Canada 1 - 9 Some Historical Perspective, Contd Great depression of 1930s reinforced historical cost accounting Alternatives to historical cost Cash basis accounting Current value accounting Value-in-use Fair value (exit price) Mixed measurement model Slide 10 Copyright 2009 by Pearson Education Canada 1 - 10 1.2 Financial Reporting Horror Stories Enron WorldCom Effects on financial reporting Sarbanes-Oxley Act More conservative accounting? Slide 11 Copyright 2009 by Pearson Education Canada 1 - 11 Hidden liabilities, the Case of Enron $124.8 $4.02 $115.2 $115.2: 4th quarter of 2000, $53 1 st quarter of 2001, $57.9 3 rd quarter of 2001, reverse $53+$57.9 = 110.9 as losses Slide 12 Copyright 2009 by Pearson Education Canada 1 - 12 ENRON CORP. Special Purpose Entities Associated with Enron On Enron Books Dr. Note Receivable$1.1 (billion) Cr. Capital Stock$1.1 Capital stock issued to Special Purpose Entity (SPE) (a limited partnership) SPE owned by Enron officers Slide 13 Copyright 2009 by Pearson Education Canada 1 - 13 Enron, Contd. GAAP requires amounts due from shareholders be deducted from shareholders equity Is a limited partnership, owned by Enron officers, a shareholder? Slide 14 Copyright 2009 by Pearson Education Canada 1 - 14 ENRON, Contd. Off-Balance Sheet Financing On SPE books: Cashxxx Debtxxx SPE borrows money, using Enron stock as security. Note payable to Enronxxx Cashxxx Cash is paid to Enron to reduce its note receivable from SPE Enron has the cash but debt does not appear on its books Slide 15 Copyright 2009 by Pearson Education Canada 1 - 15 ENRON, Contd. Enron Renders Services to the SPE A/C receivable $628 (millions) Net income $628 Services rendered to SPE 1997-2000 incl. If Ltd. partnership had been consolidated, revenue only recognized when earned outside the consolidated entity. Slide 16 Copyright 2009 by Pearson Education Canada 1 - 16 ENRON, Contd. Enron records its share of SPE profits Investment in SPExxx Net incomexxx SPE profits include increases in fair value of its holdings of Enron shares. Result: Enron includes increases in the market value of its shares in its net income. Slide 17 Copyright 2009 by Pearson Education Canada 1 - 17 ENRON, Contd. In 3rd quarter, 2001, Enron Recognized that the SPE should be Consolidated: Dr Shareholders equity$1.1 Cr Notes receivable$1.1 To deduct loan to SPE from shareholders equity Also, restate previous 4 years earnings to reduce by $628 millions Slide 18 Copyright 2009 by Pearson Education Canada 1 - 18 ENRON, Contd. Impacts of the Writeoffs No effect on operating cash flow Debt/equity ratio, debt covenants affected Loss of investor confidence Share price falls from $90 to 66 bankruptcy protection 2 Dec/01 SEC, Dept of Justice, Congressional Investigations Where were the auditors? The Board? Slide 19 Copyright 2009 by Pearson Education Canada 1 - 19 ENRON, Contd. Points to Think About Crucial role of investor confidence in financial information Role of auditor in adding credibility to financial information Off-balance sheet financing Earnings management Slide 20 Copyright 2009 by Pearson Education Canada 1 - 20 Fraud and Abuse WorldCom,2002 Overstated its earnings by about $11 billion Capitalization of network maintenance Reductions in the allowance for doubtful accounts Qwest,2002 Share price fell by 32% Separated long-term sales of equipment and services into two components Recognize revenue from the sale of fibre-optic cable despite an ability of the purchaser to exchange the cable at a later date Slide 21 Copyright 2009 by Pearson Education Canada 1 - 21 1.3 Ethical Behaviour by Accountants/Auditors Was accountant/auditor behaviour leading up to Enron & WorldCom reporting disasters ethical? Serve the client or serve society? Why would you behave ethically in similar circumstances? Ethical principles to do the right thing? Yours and the professions long run interests? Note each reason produces similar behaviour But mindset differs Slide 22 Copyright 2009 by Pearson Education Canada 1 - 22 1.5 The Role of Accounting Research To consider its effects on accounting practice To improve our understanding of the accounting environment Slide 23 Copyright 2009 by Pearson Education Canada 1 - 23 The Positive Accounting Theory Property rights, transition economy, role of government in economy Ownership and organization structures of SOE Stock market infrastructure, law, regulations, standards Accounting and auditing issues Slide 24 Copyright 2009 by Pearson Education Canada 1 - 24 Top-down approach Country Institutions The legal system (the court and the law) The government (regulations, public sector governance) The society (religion, ideology, custom, social norm) Markets Product, labor, manager, raw material, financial capital Firms Firm boundary (vertical integration, diversification) Ownership and control structures Governance structures and accounting Slide 25 Copyright 2009 by Pearson Education Canada 1 - 25 1.6 Role of Information in a Market Economy To improve operation of capital markets Adverse selection problem To improve operation of managerial labour markets Moral hazard problem Both roles crucial Results of Enron collapse show importance Recession in U.S. economy, 2001 Increased regulation (SOX) Slide 26 Copyright 2009 by Pearson Education Canada 1 - 26 1.6 Role of Financial Reporting in a Market Economy Control adverse selection Convert inside information into outside Supply useful information to investors Control moral hazard Control manager shirking Improve corporate governance Slide 27 Copyright 2009 by Pearson Education Canada 1 - 27 1.7 The Fundamental Problem Of Financial Accounting Theory The best measure of net income to control adverse selection not the same as the best measure to motivate manager performance Investors want information about future firm performance Current value accounting? Good corporate governance requires that managers work hard Do historical cost accounting, conservatism better reflect manager effort? Slide 28 Copyright 2009 by Pearson Education Canada 1 - 28 Financial Statement Presentation Slide 29 Copyright 2009 by Pearson Education Canada 1 - 29 1.8 Role of Standard Setting Is standard setting needed? Market forces motivate firms to produce information But market forces subject to failure Adverse selection Moral hazard Regulation steps in to try to correct market failures Regulation is costly Continued Slide 30 Copyright 2009 by Pearson Education Canada 1 - 30 1.8 Role of Standard Setting (continued) Standard setting mediates between conflicting interests of investors and managers Investors want lots of useful information Managers may object to releasing all the information that investors desire Slide 31 Copyright 2009 by Pearson Education Canada 1 - 31 1.9.5 Ways to Mediate Between Conflicting Interests Due process in standard setting Representation of diverse constituencies Super-majority voting Exposure drafts Slide 32 Copyright 2009 by Pearson Education Canada 1 - 32 1.9.5 Structure of Standard Setting Bodies IASB International standards FASB United States standards AcSB Canadian standards Securities commissions Role in enforcing firms to follow standards May set standards themselves Why do they delegate most standard setting? Slide 33 Copyright 2009 by Pearson Education Canada 1 - 33 FASB FASB Pronouncements and EITF Abstracts Statements of Financial Accounting Standards (168) Statements of Financial Accounting Concepts (7) FASB Interpretations (48) FASB Staff Positions FASB Technical Bulletins EITF Abstracts Slide 34 Copyright 2009 by Pearson Education Canada 1 - 34 GAAP CAP (Committee on Accounting Procedure) 1936-1959, ARBs (51) APB (Accounting Principles Board ) 1959-1973, APB Opinions (38) FASB (Financial Accounting Standards Board ) 1973-,Statements and Interpretations http://www.fasb.org/st/ Slide 35 Copyright 2009 by Pearson Education Canada 1 - 35 IFRS 2009 Slide 36 Copyright 2009 by Pearson Education Canada 1 - 36 Theories Relevant to Financial Accounting The rational investor A model of how an investor may use new information to revise beliefs about future firm performance Rationality holds on average, not necessarily for each individual Efficient securities markets Share prices fully reflect all publicly available information Efficiency is relative to a stock of information Role of financial reporting in improving/expanding the stock of information Continued Slide 37 Copyright 2009 by Pearson Education Canada 1 - 37 Theories Relevant to Financial Accounting (continued) Behavioural theories Investors do not use all the information in financial statements securities markets not fully efficient Agency theory Efficient contracts to motivate manager performance and achieve good corporate governance Slide 38 The End Thank you