22E00210 - Financial Accounting Theories

D.Sc.(Econ.), M.A.(Educ.) Hannu Ojala

Email: [email protected]
Professor of Practice, Aalto BIZ
Professor of Accounting (acting), University of Tampere
Adjunct Professor, International accounting and auditing, University of Eastern Finland
Aalto University / Chydenia (Runeberginkatu 22-24), room G3.18

22E00210 - Financial Accounting Theories (2019) 0-1

The objective of the course

• The objective of the course is to develop student’s
• ability to understand financial accounting theories. The
course is designed to
• foster a critical awareness of the financial accounting
environment, which is
• needed e.g. in preparing a research question in master
thesis and if one is to
• become a thoughtful professional.

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Feedback from the 2018 course

• Generally positive J
• Term papers & their presentation session were considered
very useful from the learning point of view
• Has helped to get a jump start to master thesis work (“I
developed the master thesis idea when we prepared the
term paper”)
• A summary of all to course topics at the beginning of the
course would have helped to decide the topic of the term
paper?

22E00210 - Financial Accounting Theories (2019) 0-3

Your expectations (course contents,

practicalities)?
• Text here

22E00210 - Financial Accounting Theories (2019) 0-4

 22E00210 - Financial Accounting Theories (2019) 0-5

Financial Accounting Theory

Seventh Edition
William R. Scott

Purpose: To create an awareness and

understanding of the financial reporting
environment in a market economy

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Today focus on pre-assignment

• Pre-assignment (deadline tomorrow on Tuesday at noon)

and term paper (deadline ) 40% weight in the course
grade
• What is a theory? How to find research articles? High
quality articles?
• We will skim through the course book topics

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Term paper

• We will discuss this tomorrow (on Friday).

• Today focus on pre-assignment

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 What is a theory?

• Here theory refers to discussion in high quality research

articles
• For high quality accounting & finance journals, see (all
journals listed here):
• http://www.mysmu.edu/faculty/rogerloh/links/journal_ranki
ngs.htm

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The right research approach

• Spot an interesting area (from prior literature) and try to

”deep dive” and find an answer to a ”sharp” research
question not thoroughly examined before rather than to
take a surface snorkling approach and looking a little bit to
every direction with a generic research question

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 Learning objectives of the pre-
assignment and the term paper
• The course book offers an array of alternatives from
where you can pick the theory framework that is of interest
to you
• By focusing on one the theoretical approaches and
gaining an understanding about it (including what are the
seminal studies of the respective research literature) will
help you greatly when you write the theoretical section of
your master thesis
• The (voluntary) hands-on empirical assignments with real
data during the course, will help you to plan the
methodology section and run empirical tests of your
master thesis

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Pre-assignment (deadline on
Friday, Jan 11th at noon)

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How do you find research articles?

https://scholar.google.fi/scholar?hl=fi&as_sdt=0%2C5&q=Daske+Hail+Leuz+Verdi+2008&oq=leuz
https://libguides.aalto.fi/c.php?g=410638&p=2797840

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A skim through the main areas of the course

content (this is to help you in the preparion of pre-
assignment)
• Investor informing role (chapters 2 - 7),
• Manager performance-evaluating role (chapters 8 - 11)
• Preparing reporting standards: economic and political
issues (chapters 12 - 13).

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Investor informing role (Ch 2-7)

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Manager performance-evaluating
role (ch 8 - 11)

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 Preparing reporting standards:
economic and political issues
(chapters 12 - 13)

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Investor informing role

• Accounting scandals: FV or Historical cost accounting,
additional regulation needed?
• Hick’s income and financial statements, ideal conditions of
accounting
• Indirect measurement of income, IASB
• Decision usefilness approach to financial reporting
• Efficient securities markets
• The value relevance of accounting information
• The measurement approach to decision usefulness

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Some Historical Perspective

• Early development
• Great depression of 1930s reinforced historical cost
accounting
• Alternatives to historical cost
– Current value accounting
• Value-in-use
• Fair value (also called exit price, opportunity cost)
– Mixed measurement model

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Financial Reporting Horror Stories

• Collapse of the stock market boom in early 2000s: many newly

established IT firms recognized revenues too early to impress
• Enron (-2001): SPEs not consolidated
• WorldCom (-2002): capitalization of network maintenance and other
costs
• Effects on financial reporting
– Sarbanes-Oxley Act (2002)
– More conservative accounting?
• Collapse of the stock market in 2008: use of financial instruments that
were not transparent in informing credit risks
• Better communication project of the IASB in 2015

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The Concept of Economic Income

Sir John Hicks (1939):

• “Income is the amount a person can consume during a
period and still be as well off at the end of the period as at
the beginning.”
• Income for a period
= cash flow realized ± change in value of assets during the
period
• Hicksian concept of economic income underlies
current value -based accounting under ideal conditions

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Example of Hick’s income in a two-

period model
• Cash flows a know with certainty
• We buy a machine that has a salvage value of 0 € after
two periods
• Machine will either run with high or low volume
according to the propabilities and gennerate the cash
flows presented in the next slided
• Interest rate is 5 % p.a.

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 Practicing in class how to apply Hick’s
income
• We will practice hands-on how to apply Hick’s income that
is the basis for fair value accounting

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Indirect measurement of income, IASB

• Financial accounting lacks of commonly agreed concept of
income. In economics, Hick’s has given an indication on how
much one can consume without impoverishing herself. From
this angle Hick’s defines the measurement of income as
follows: “a man’s income as the maximum value which he can
consume during a week, and still expect to be as well of at the
end of period as he was at the beginning” (Hicks, 1946, p. 172).

• Scott (2014, p. 73) argues that in the absence of commonly

accepted income measure in financial accounting “if we can’t
prepare theoretically correct financial statements, at least we
can try to make financial statements more useful.” The concept
of usefulness is at the hearth of financial accounting.
Empirically it is examined using value relevance tests.

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Decision usefilness approach to financial
reporting
• Single-Person Decision Theory
• The Rational, Risk-Averse Investor
• The Principle of Portfolio Diversification
• Increasing the Usefulness of Financial Reporting
• The Reaction of Professional Accounting Bodies to the
Decision Usefulness Approach

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Single-Person Decision
Theory

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Efficient securities markets

• The Meaning of Efficiency

• How Do Market Prices Fully Reflect All Available
Information?
• The Informativeness of Price
• A Capital Asset Pricing Model (CAPM)
• Fundamental Value
• The Social Significance of Securities Markets That Work
Well

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The Social Significance of Securities

Markets That Work Well

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The value relevance of accounting information
• Reasons for Market Response
• Finding the Market Response
• Separating Market-Wide and Firm-Specific Factors
• Comparing Returns and Income
• Ball and Brown (1968)
• Earnings Response Coefficients

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The Value Relevance Approach

• Assumes securities market efficiency
• Investors responsible for predicting future firm
performance
– Role of financial reporting to provide useful information for this
purpose
• Usefulness of financial statement information evaluated by
magnitude of security price response to that information
– Helps accountants to evaluate decision usefulness of different
accounting policies

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Ball and Brown (1968)

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 Apple shares close nearly 10% lower after
sales warning (Jan 3rd, 2019)

Profit warning:
Management knows
more than investors!

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https://www.bbc.com/news/business-46748972

How to measure market reaction?

• Abnormal returns
• Short window, e.g. three day window (one day before
announcement, announcement day, one day after)
• Remove overall market movement
• Does the remaining return differ from zero?
• What are the determinants that explain the market
reaction?
• Cf. Cox & Peterson 1994 / Journal of Finance for
methodology

Cox & Peterson

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1994
Measuring Investors’ Earnings Expectations

• Time series approach

• Depends on earnings persistence
– Earnings 100% persistent
• Unexpected earnings = change in earnings
– Earnings zero persistence
• Unexpected earnings = current year’s earnings
– Analysts’ forecasts approach
• Evidence suggests more accurate than time series
– Unexpected earnings = analyst forecast error
– Older forecasts tend to be less accurate
– Are analysts biased?

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The measurement approach to decision

usefulness
• Are Securities Markets Fully Efficient?
• Efficient Securities Market Anomalies
• The Value Relevance of Financial Statement Information
• Ohlson’s Clean Surplus Theory
• Auditors’ Legal Liability
• Asymmetry of Investor Losses

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What Is the Measurement Approach?

• Greater use of current values in the financial statements proper

• Recall two versions of current value
– Fair value: exit price
– Value-in-use: present value of future cash receipts or
payments
• Goal of measurement approach is to increase decision
usefulness by increasing financial statement relevance

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Why Are Accountants Moving Towards a

Measurement Approach? (Continued)
• Low R squared
• Empirical evidence that net income explains very little share price variation (i.e., low
“market share”). Lev (1989), Section 6.9

– Better measurement may increase accounting “market

share” in explaining share price changes

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Why Are Accountants Moving Towards a
Measurement Approach? (continued)
• Ohlson’s clean surplus theory
– A theoretical framework supportive of a measurement
approach
• Auditor Liability
– Better measurement may reduce auditor liability when firms
become financially distressed

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Are Securities Markets Fully Efficient?

• Behavioural finance
– Behavioural characteristics that question investor rationality
and market efficiency
• Limited attention
• Conservatism
• Overconfidence
• Representativeness
• Self-attribution bias
– Leading to share price momentum
• Motivated reasoning

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Prospect Theory
• An Alternative Theory of Decision Making
– Separate evaluation of gains and losses
• Narrow framing
– Weighting of probabilities
• Overconfidence: event probabilities underweighted
• Representativeness: event probabilities overweighted
– Prospect theory utility function
• See next slide
• Leads to a disposition effect
• Leads to earnings management to avoid reporting small
losses?

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Ohlson’s Clean Surplus Theory

• What is it?
– Expresses value of firm in terms of accounting variables
• Firm value = net assets ± present value of future abnormal
earnings (Goodwill)

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The value relevance of accounting information

https://en.wikipedia.org/wiki/Residual_income_valuation

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Role of Financial Reporting in a Market

Economy
• Control adverse selection
– Convert inside information into outside
– Supply useful information to investors
– Improve operation of capital market
• Control moral hazard
– Control manager shirking
– Improve corporate governance
– Improve operation of managerial labour market
• Both roles crucial
– Results of Enron collapse show importance
• Recession in U.S. economy, 2001
• Increased regulation (SOX)

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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”
• Historical cost accounting

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Manager performance-evaluating role

(chapters 8 - 11)
• The Efficient Contracting Approach to Decision
Usefulness
• An Analysis of Conflict
• Executive Compensation
• Earnings Management

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 The Efficient Contracting Approach to
Decision Usefulness
• Efficient contracting is an application of the game theory

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Game theory

(Selviytymis)strategiat!
Tehdäänkö yhteistyötä?

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 Game theory

John Nash, Nobel award-winner in 1994

In game theory, the Nash equilibrium is a solution concept of a non-
cooperative game involving two or more players, in which each
player is assumed to know the equilibrium strategies of the other
players, and no player has anything to gain by changing only their
own strategy

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What is Efficient Contracting Theory?

• Focus is on role of financial accounting information in
moderating information asymmetry between contracting parties
– Debt contracts and managerial compensation contracts
– Lenders’ interests and managers’ interests may conflict with
interests of shareholders
– An efficient contract generates trust between these
conflicting interests at lowest cost to firm.
– Contracts may be formal written documents or implicit
• Implicit contracts arise from continuing business
relationships
• Implicit contracts can be modeled as non-cooperative
games

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 An Analysis of Conflict

• Efficient contracting
• Contract rigidity
• Employee stock options
• Contract efficiency vs opportunism
• Implicit contracts
• Non-cooperative games

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https://www.youtube.com/watch?v=vI6Dk8sWHzU

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Agency Theory

• A principal wants to hire an agent for some specialized task

– Separation of ownership and control in most firms
– In our context, shareholder is principle, manager is agent
• Principal and agent are assumed rational. Agent is assumed
risk-averse. Principal may be risk-averse, but assume risk-
neutral for simplicity
• Principal wants agent to work hard
– But, agent is effort-averse

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Implications of Agency Theory for

Accounting
• Holmström’s agency model
– Basing manager’s compensation on 2 variables is better than on 1
variable, unless the 2 variables are perfectly correlated
– Holmström’s model implies that net income is in competition with
share price performance for “market share” in compensation
contracts

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Implications of Agency Theory for
Accounting (continued)
• Holmström’s agency model (continued)
– To maintain market share in compensation contracts, net
income must be informative about manager effort
– To be informative, net income must have
• Sensitivity
• Precision
– These two desirable qualities usually have to be traded off
• E.g., fair value accounting may be more sensitive than
historical cost, but less precise. Why?

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Executive compensation
• Are incentive contracts necessary
• Desirable properties of a performance measure
• Time horizon and congruence of performance
measures
• Risk in executive compensation
• Politics of executive compensation
• Power theory of executive compensation

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Are Incentive Contracts Necessary?
No: Fama (1980)
– Forces of reputation on managerial labour market enough to
motivate manager to work hard
– Assumes managerial labour market works well
Yes: Wolfson (1985)
– Forces of reputation help to motivate manager, but incentive
contract still needed
– Suggests that managerial labour markets do not work fully well

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The Theory of Executive Compensation

Desirable properties of a performance measure
– Sensitivity
– Precision
– Generally, these properties have to be traded off
Share price as a performance measure
– High in sensitivity, low in precision
Net income as a performance measure
– Low in sensitivity, high in precision

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How to increase sensitivity of net income

– Reduce recognition lag

• Net income “waits” until many aspects of manager effort are realized
– R&D, advertising, legal & environmental liabilities
– Capital investment programs
• Current value accounting reduces recognition lag
– But decreases precision

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How to increase sensitivity of net income

(continued)

– Full disclosure
• More difficult for manager to disguise shirking by earnings
management
• Enables compensation committee to better evaluate earnings
persistence

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 Is executive compensation too
high?
– If so, suggests inefficient contracting
• Jensen & Murphy (1990)
– According to authors, not too high, but managers do not bear enough
compensation risk--they need to hold more stock
– Does executive compensation ignore extraordinary losses?
• What about extraordinary gains?
– Gayle & Miller (2009)
• Suggests managers not overpaid
• Suggests increased manager compensation due to increased firm
size and increased compensation risk

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Power theory disputes efficient contracting

• Manager uses power in firm opportunistically, to earn

more than reservation utility
• Opportunism limited by “outrage”
• Devices to camouflage excessive compensation and
outrage
– Compensation consultants
– Peer groups
– Late timing of ESO awards

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 Earnings Management

• Patterns of earnings management

• Evidence of earnings management for bonus purposes
• Other motivations for earnings management
– Other contracting motivations
– To meet investors’ earnings expectations and maintain reputation
– Initial public offerings
• The good and bad sides of earnings management

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What Is Earnings Management?

• Earnings management is the choice by a manager of
accounting policies (accruals), or real actions, that affect
earnings so as to achieve some specific reported earnings
objective
– Real actions to manage earnings include, for example, cutting or
increasing R&D and advertising; manufacturing for stock
– Accrual-based earnings management includes, for example,
managing the allowance for bad debts, changing amortization
policy

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What Is Earnings Management? (continued)

• Here, we concentrate primarily on the role of accruals

in earnings management
– Note the “iron law” of accruals reversal: if accruals increase
earnings this period, their reversal lowers earnings in future
periods
• Two types of accruals
• Non-discretionary: management has little discretion to control
amounts
• Discretionary: management has discretion to control amounts
• To discover role of accruals in earnings management, accountant
needs to separate these two types
• Jones model usually used for this separation

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Patterns of Earnings Management

• Bath
• Income minimization
• Income maximization
• Income smooth

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Evidence of Earnings Management for
Bonus Purposes
• A contractual motivation
– Managing earnings to maximize cash bonus
• Evidence: [Healy (1985)]
– Confined to manager bonuses based on net income
– Recall concepts of bogey and cap
– Evidence of upward earnings management when net income between
bogey and cap
• Measuring discretionary accruals
– Healy used total accruals as proxy for discretionary
– Now usually measured based on Jones model

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Other Earnings Management Motivations

• Other contractual motivations
– To avoid violation of debt covenants
• Evidence: Dichev & Skinner (2002), text Section 8.5
– They report evidence of earnings management to maintain
debt covenant ratios well above contracted values
(covenant slack)
– To avoid political costs
• Evidence: Jones (1991), text Section 11.3
– designed the Jones model to separate discretionary and
non-discretionary accruals. Reports firms used income-
reducing discretionary accruals to bolster their case for
tariff protection

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Preparing reporting standards: economic
and political issues (chapters 12 - 13)
• Standard Setting: Economic Issues
• Standard Setting: Political Issues

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Standard Setting: Economic Issues

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Regulation
• Information as a Commodity
– Demand: information demanded by decision makers
– Supply: information supplied by firms, managers, analysts, media
• From society’s perspective, firms should produce
information until the marginal social benefit = marginal
social cost
– Called first-best information production
– But hard (impossible?) to operationalize

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Regulation (continued)

• A useful distinction
– Proprietary information
• Information that, if released, will directly reduce cash flows
– Non-proprietary information
• Information that, if released, will not directly reduce future cash flows

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 Ways to Characterize Information
Production
• Finer information
– Expanded note disclosure
– Additional line items
• Additional information
– Current value accounting?
– MD&A
• More credible information
– Audit increases financial statement credibility

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First-Best Information Production

• Social benefits of information
– Better investment decisions
• More efficient allocation of scarce capital
– Possible lower cost of capital for firms
– Lower estimation risk for investors
• Less adverse selection
– Securities markets work better
• Less moral hazard
– Managerial labour markets work better
– Reduction of monopoly power
• Easier for potential entrants to identify profitable industries
– Timely identification of failing firms
– Information externalities

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First-Best Information Production
(continued)

• Social costs of information production

– Direct costs of information production
– Possible release of proprietary information
– Possible increased contracting costs
• E.g., greater earnings volatility

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Market Failures in Information Production

• Externalities and free riding
– Information as a public good (Section 5.5)
• Adverse selection
– Insider trading
– Manager may delay in information release
• Moral hazard
– Opportunistic earnings management to disguise shirking
• Lack of unanimity
– Managers and investors may want different amounts of
information

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Contractual Incentives for Information
Production (continued)
• The Coase theorem
– Specifies conditions under which externalities (which
may otherwise require regulation to control) can be
internalized between the contracting parties, reducing
need for regulation
• E.g., farmers’ fences, firm’s release of information
– May break down
• Many contracting parties
– High bargaining costs
• Requires enforcement

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Standard Setting: Political Issues

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 Two Theories of Regulation

• Public interest theory

– Objective of regulator is to maximize social welfare
• Interest group theory
– Regulator takes own interests into account, while balancing
demands of investors and managers
– Implies conflict between constituencies
• Constituencies compete by lobbying the regulator to get
what they want, taking other constituencies lobbying into
account
• Benefits of regulation go to the most effective lobbying
constituency
• Standard setters’ emphasis on due process suggests that
interest group theory best applies

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Regulation FD (Fair disclosure)

• Prohibits selective release of information, to help the “little guys,”

reduce analyst information advantage, and improve fairness of
securities markets
• Concerns about Regulation FD
– Firms may release less information between earnings
announcements, to lower share price volatility
– Increased share price volatility at date of earnings announcement
• Did Regulation FD attain its goals?
– Mixed empirical evidence, but some evidence of lower analyst
information advantage
• SEC’s goal consistent with public interest theory, but the concerns
are consistent with interest group theory

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 Criteria for Standard Setting

• Decision usefulness
• Reduction of information asymmetry
• Economic consequences
– Standard setters should weigh costs as well as benefits
• Acceptable to constituencies
– “delicate balance” needed between demands of different
constituencies—due process

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Effects of customs and

institutions on financial reporting
– Code law countries
• Greater influence of families and banks in corporate governance than
in common law countries
• Lower moral hazard problem
• Shows up as less timely and less conservative reporting, even if
country has adopted IASB standards
– An implication is that investors should be aware of local practices
and customs when interpreting financial statements, even if
country uses IASB standards

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 Enforcement of accounting
standards
– Even high quality standards must be enforced
– Protection of small investors
• Moral hazard problem switches to one between an entrenched
controlling interest and small investors
– Role of auditor
• Auditor may be under great pressure from controlling interests
• Some evidence that auditors succumb to this pressure
– Guedhami & Pittman (2006)
– Francis & Wang (2008)

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Benefits to countries adopting

IASB standards
– Byard, Li & Yu (2011)
• Adoption of IASB by EU countries followed by improved analyst
forecast accuracy only when IASB and previous domestic GAAP
differed substantially, and strong law enforcement
– Landsman, Maydew & Thornock (2012)
• Increased information content of earnings following IASB adoption,
particularly if strong law enforcement
– Okan, Singer & Yu (2012)
• Increased usage of net income in manager compensation contracts
only when IASB and previous domestic GAAP differed significantly
– Daske, Hail, Leuz & Verdi (2013)
• Better working securities markets following IASB adoption for “serious”
country adopters but not for “label’ country adopters

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 IASB v. FASB standards

• Leuz (2003)
• Little difference in quality
• Barth, Landsman, Lang & Williams (2012)
• Some evidence that FASB standards are of higher quality

– Mixed evidence of which set of standards is of higher quality

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