Financial Accounting Theory
Fifth Edition
William R. Scott
Purpose: To create an awareness and
understanding of the financial
reporting environment in a market
economy
Outlines
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Some Historical Perspective
A Note on Ethical Behavior
The Role of Accounting Research
Organization of the Book
Information Asymmetry
Role of Financial Reporting
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
Famous First Bubbles?
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South Sea Bubble
Hogarthian image of the South Sea Bubble, by Edward Matthew
Ward, Tate Gallery
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Chapter 1 Introduction
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1.2 Some Historical Perspective
• Paciolo, 1494
• Paciolo’s work was translated into English, 1543
• English Corporations Acts,1844
– Compulsory audit, balance sheet
– Voluntary provision of information
– Reinstated after 1900s(compulsory audit)
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Some Historical Perspective , Cont’d
• 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
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Some Historical Perspective , Cont’d
• 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
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1.2 Financial Reporting Horror Stories
• Enron
• WorldCom
• Effects on financial reporting
– Sarbanes-Oxley Act
– More conservative accounting?
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Hidden liabilities, the Case of Enron
$124.8
$124.8
$4.02
$115.2
$124.8
$115.2
$124.8
$115.2: 4th quarter of 2000, $53
1st quarter of 2001, $57.9
3rd quarter of 2001, reverse
$53+$57.9 = 110.9 as losses
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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
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Enron, Cont’d.
• GAAP requires amounts due from shareholders be
deducted from shareholders’ equity
– Is a limited partnership, owned by Enron officers, a
shareholder?
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ENRON, Cont’d.
• Off-Balance Sheet Financing
– On SPE books:
• Cash
xxx
Debt
xxx
SPE borrows money, using Enron stock as security.
• Note payable to Enronxxx
Cash
xxx
Cash is paid to Enron to reduce its note receivable from SPE
– Enron has the cash but debt does not appear on its
books
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ENRON, Cont’d.
• 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.
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ENRON, Cont’d.
• Enron records its share of SPE profits
– Investment in SPE
xxx
Net income
xxx
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.
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ENRON, Cont’d.
• 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
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ENRON, Cont’d.
• Impacts of the Writeoffs
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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, Dep’t of Justice, Congressional Investigations
Where were the auditors? The Board?
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ENRON, Cont’d.
• 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
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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
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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 profession’s long run interests?
– Note each reason produces similar behaviour
• But mindset differs
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1.5 The Role of Accounting Research
• To consider its effects on accounting practice
• To improve our understanding of the accounting
environment
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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
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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
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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)
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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
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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?
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Financial Statement Presentation
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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
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» Continued
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
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1.9.5 Ways to Mediate Between
Conflicting Interests
• Due process in standard setting
– Representation of diverse constituencies
– Super-majority voting
– Exposure drafts
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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?
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FASB
• FASB Pronouncements and EITF Abstracts
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Statements of Financial Accounting Standards (168)
Statements of Financial Accounting Concepts (7)
FASB Interpretations (48)
FASB Staff Positions
FASB Technical Bulletins
EITF Abstracts
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GAAP
• CAP (Committee on Accounting Procedure)
– 1936-1959, ARB’s (51)
• APB (Accounting Principles Board )
– 1959-1973, APB Opinion’s (38)
• FASB (Financial Accounting Standards Board )
– 1973-,Statements and Interpretations
– http://www.fasb.org/st/
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IFRS（2009）
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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
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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
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The End
Thank you