Scott (2006) explained that his book 'Financial Accounting Theory' is about accounting and not how to account. He also argues that accounting students, having been exposed to the methodology and practice of accounting, need at least one course that critically examines the broader implication of financial accounting for the fair and efficient operation of our economy.
What is the objective of the book and why it designed a such way that every reader have to understand the current financial accounting and reporting and at the same time have to consider the diverse interest of the external users and management?
The Financial Accounting Theory book which was written by William R. Scott, in year 2006 is designed for upper level undergraduate accounting majors or postgraduate business students who already have a thorough grounding in accounting practice and basic economic and financial theory. This book is more understandable those level of students.
As explained given statement above, this book is about accounting but not how to account. That means this book is discussed about financial accounting theories, issues in this area but it is not discussed more about calculation.
According to Scott's ideas which were given in the Financial Accounting Theory book, the accounting system is meant to control two different types of information asymmetry: adverse selection and moral hazard. Controlling adverse selection requires a decision usefulness approach that emphasizes fair value accounting numbers that often fluctuate. Unfortunately, controlling moral hazard requires that income figures be highly interrelated with management effort, which argues for the use of "hard numbers." Understanding how the accounting system addresses these somewhat conflicting objectives is the goal of Scott's book.
The book contains four basic sections: accounting under ideal circumstances, the decision usefulness approach, moral hazard, accounting standard setters. Scott first outlined what accounting would look like under ideal circumstances (i.e., if neither adverse selection nor moral hazard problems existed). The author then introduced adverse selection and the means to address it, where he discussed the decision usefulness approach, efficient financial markets, and information and measurement perspectives on decision usefulness. The third section addressed moral hazard, the problem of management compensation, and the use of "hard numbers" as a solution. In this section of the book, Scott focused on economic consequences, the use of game theory to understand conflict, and issues such as management compensation and earnings management. The final section examined how accounting standard setters address these divergent objectives.
William Scott's broad coverage of financial accounting theory provides a very good overview of the major topics of financial accounting theory. More importantly, the book is broken up into separate parts that make it easy for readers to concentrate on areas of particular interest. The author is especially effective in explaining broad concepts such as information asymmetry or the social significance of accounting information.
While Financial Accounting Theory is well suited for an upper-level postgraduate students' seminar course, it is not without limitations. Furthermore, by its nature the book will not include the most current research on any particular topic. This book is best used in an upper-level undergraduate or postgraduate seminar course where the students anticipate a large amount of reading and discussion, and would not be particularly effective in a large class setting.
This book in financial accounting theory included in-depth treatment of contemporary issues and problems in the field. Topics covered the contributions of economics, finance, and other disciplines to accounting theory; the practical and theoretical problems of the present value model; foreign exchange accounting; hedging; the process and issues of standard setting; agency theory; and other topics related to specific industries or sectors of the economy.
Various theories that underlie financial accounting and reporting are described and explored in this subject. The relevance of these theories is explained and illustrated in order to better understand the practice of financial accounting and reporting. Initially, the concept of present value accounting under ideal conditions is examined and evaluated as a method of determining reliable fair values.
Then the theory of decision making under uncertain conditions is examined and related to stand-setting bodies' conceptual frameworks that are based on the concept of decision usefulness. Securities market efficiency is considered and related to capital asset pricing models. Information asymmetry that results from some parties having an information advantage over others is a recurring theme of the course. Both the insider vs. outsider dynamic of "adverse selection" and the unobservable management behavior dynamic of "moral hazard" are given close attention.
The fundamental problem of financial accounting theory is examined in an effort to reconcile the potentially conflicting roles of financial reporting in 1) informing investors with useful information that has a balance of relevance and reliability (controlling adverse selection) and in 2) motivating manager performance with information highly correlated with manager effort (controlling moral hazard).
The information perspective and measurement perspective on financial reporting are related to existing accounting standards. The concept of economic consequences is explained as well as its apparent inconsistency with decision usefulness and efficient securities market theory. To begin the reconciliation, positive accounting theory is introduced, then compared and related to management behavior.
An analysis of conflict includes a review of the implications of game theory and agency theory for financial accounting. An examination of conflicts between contracting parties includes both executive compensation contracts, debt contracts and resulting motivations for earnings management via accounting estimates and policy choices. Accounting standard setting processes are examined from the perspective of both economic issues and political issues.
Economic issues include information production and the manager/investor tradeoffs resulting from information asymmetry. Political issues include various theories of regulations and the trend towards convergence of differing accounting standards internationally.
Objectives of this book are followings:
Analyze the present value and future value concepts and explore their application to financial accounting and reporting.
Explain the concept of decision usefulness approach to financial reporting.
Critically evaluate the efficient securities market theory and its implications for financial reporting.
Understand management's interest in financial reporting, and concerns about disclosure, choice of accounting policy, and risk reporting.
Contrast the application of information perspective and measurement perspective on financial reporting.
Analyze the important implications of game theory and agency theory.
Identify conflicts of interest amongst stakeholders and apply models of conflict resolution.
Demonstrate knowledge of the complexity of measuring the costs and benefits of information.
Identify the elements of the standard-setting process and discuss the influence of political and economic consequences of regulation.
Describe ethical issues relating to the standard-setting process.
Above I explained about the whole Financial Accounting Theory book which is written by Scott. Now let me start to explain my ideas more briefly about this book from the first section which is accounting under ideal conditions.
Accounting under ideal conditions
It is understandable from the discussions and explanations of Financial Accounting Theory; this section defines the concepts of ideal conditions and illustrates preparation of financial reports when ideal conditions keep. Scott explained that balance sheet values are on the basis of expected current values of future monetary receipts from assets and liabilities. As discussed in the book net income is the change in the present value of the firm's net assets during the period. Reserve recognition accounting (RRA) for oil and gas companies, it is used to illustrate the challenges of present value accounting when ideal conditions do not hold. The concepts of relevance and reliability of information of financial statement were reviewed, and the reliability problems of RRA were explained. Historical-cost-based accounting from the point of its relevance and reliability, and was found to provide a different trade-off between relevance and reliability than RRA.
There are some ideal conditions exist under conditions of certainty.
the future cash flows of the firm are publicly known with confidence
the single interest rate in the economy is given and publicly known
Ideal 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
According to the author's idea, states of the nature also named the states for short, of uncertain future event which can mention quantity of payment. The economy state (good times or bad times) would be an example. Under ideal conditions, the probabilities of the states of nature are publicly known and objective. In our real world, these probabilities should be estimated based on the accessible information. These probabilities are called subjective probabilities.
There is a risk under ideal condition. 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. As explained in the book, unusual earnings were defined as the difference between the realized earnings and the expected earnings, based on the probabilities assigned to the various states of nature and the discount rate. 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.
Using given definition of ideal conditions under certainty, financial reports are prepared on the basis of present value of future cash flow, depreciated under the given interest rate. First of all, assets and liabilities are valued at their present values. Then net income is the change in present value of net assets during the period. Net income is also equal to the value of the opening net assets times the interest rate (accretion of discount).
At use of definition of ideal conditions, complete to conditions of uncertainty, financial reports are prepared on the basis of the expected current cost of the future streams of the cash depreciated under the given interest rate. Assets and liabilities are valued at their expected present values. Net income is the change in the expected present value of net assets during the period.
The problems faced by Reserve Recognition Accounting (RRA) gave insight into the nature of relevance and reliability of accounting information. Relevant information was defined as information that enables investors to predict the firm's future cash flows. Reliable information is information which is precise and free of management bias. 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.
After reading Accounting Financial Theory book, we can now see the reasons why accountants continue to use historical-cost-based accounting as the primary basis of financial statements for major classes of assets and liabilities. While historical-cost-based accounting information is not as relevant as present-value-based information, it is more reliable.
Many accountants feel that historical-cost-based financial accounting represents a better trade-off between relevance and reliability than present value accounting. While "true" net income does not exist in the non-ideal world in which accountants operate, theory shows that fair value accounting is desirable, provided that it can be accomplished with reasonable reliability.
The Decision Usefulness Approach to Financial Reporting
From the history of accounting, since the 1960s, the function of accounting has been increasingly regarded as "to provide quantitative information primarily financial in nature about economic entities that is intended to be useful in making economic decisions, in making resolved choices among alternative courses of action," and accounting was seen as a service activity.
At the simplified level, the decision-usefulness approach may be naturally appealing, but it could also be theoretically damaged and an example of circular reasoning: just because some people may take decisions based on the financial statements. Does this mean that decision-usefulness should be specified as the objective of financial statements? When someone takes a decision, this person should be looking to the future-yet the financial statements say very little about an organization's future. Someone should also consider the future economic climate, an organization's competitors, and expected technological developments; financial statements say very little about these things. Often short-term investors are more concerned about taking their decision in anticipation (buy long, sell short) of the publication of the financial statements rather than waiting for them to come out, reading them, and then taking a decision.
Discussions of the book showed that, an important component in the debate about the objective of financial statements has been the vagueness of the nature, scope and purpose of accounting "theory." One would have expected developments in financial reporting to have been built on theory and thus be conceptually robust. The focus on unspecified users taking unspecified decisions, at unspecified times, with unspecified results hardly seems an appropriate basis for the production of consistent and coherent financial reporting standards, and consequently there is a danger that the financial reporting standard-setters have been building on shifting sands rather than on firm foundations.
The Call for Real-Time Reporting
From the given existing importance on decision-usefulness, and the perceived limitations of financial statements in this respect, some analysts and other external parties have been calling for companies to make real-time accounting data available to them. The argument is that immediate access to, and a greater quantity of, data about a company should improve users' decision-making ability and thus improve market efficiency. However, if the companies should accept real-time reporting, would the results make sense?
There is a risk that there has been uncertainty over the "recording" aspect of accounting and the "reporting" aspect of the financial statements. "Raw" accounting data are simply a means of recording in order to keep track of the transactions undertaken by an organization-which is clearly very important for management to do. The periodic financial statements use these accounting data, and related assumptions and conventions, to distribute profit to the appropriate accounting period and to present the financial figures at a point in time. Given the scale of modern business, someone wonders what users would really make of all the data.
The ideas of the author showed us that the decision usefulness approach to financial reporting implies that accountants need to understand the decision problems of financial users. Single-person decision theory and its specialization to the portfolio investment decision provide an understanding of the needs of rational, risk-averse investors. This theory explained us that such kind of investors need information to help them assess securities' expected returns and riskiness of these returns. In the theory of investment, beta is an important risk measure, being the standardized covariance of a security's return with the return on the market portfolio. This covariance risk is the main component of the riskiness of a diversified portfolio, even if the portfolio contains only a relatively few securities.
As explained in the Accounting Financial Theory book, historical cost-based financial statements are an important and cost-effective source of information for investors, even though they don't report directly on future investment payoffs. They provide an information system that can help investors to predict future firm performance, which, in turn, predicts future investments returns. This predictive role is enhanced to the extent that financial statements are relevant and reliable.
The book mentioned us that major accounting standard-setting bodies such as the CICA and the FASB have adopted the decision usefulness approach. This is the evidenced by their conceptual framework, which show a clear recognition of the role of financial reporting in providing relevant and reliable information for investors.
Efficient Securities Markets
In an efficient securities market, prices completely reflect all accessible information, and the price changes on such market will behave randomly during long time. Efficiency is defined relative to a stock of information. If this stock of information is incomplete, tell because of inside, classified information, or it is wrong, security prices will be wrong. Thus efficiency of the market does not guarantee that the prices for safety completely reflect real steady firm value. It really assumes, however, that prices are unbiased relative to publicly available information and will quickly react to new or reconsidered information.
The quantity and quality of publicly accessible information will be increased by the fast and full reporting. However, individual investors may have various previous beliefs and can interpret the same information in another way. However, about conversation, we can think of these distinctions as about drawing up on the average so that the market price had a surpassing quality to quality of processing of the information of the people trading in the market. These arguments assume, however, that investors estimate the new information independently.
The preponderance of evidence is that securities markets are effective and tend to reflect the accessible information. Whether you believe that the markets are effective, it is very important for your decisions on corresponding investment strategy and tactics.
On one end of a spectrum if you believe that market prices completely reflect the accessible information then you are more probable to accept simply the current price as fair market value. Efficiency of the market means that even if you should participate in essential research, you only repeatedly would analyze the information which already influenced enough many other participants of the market who will be completely reflected in the current price.
If you do not believe that markets are generally efficient, you are much more possibly, participate in research in attempt to find passed or inadequate image the understood information. Your purpose would consist in using this underestimated information, to identify securities which properly are not estimated yet by the market. You would carry out trading strategy in hope that they will allow you to use for the benefit on that information and to earn exclusive profit.
The effective theory of the market gives rise to often repeated investment joke which enters into many various aromas. In general, two economists go down from street, and both see a dollar banknote at a rate of 100$ on the basis. One asks the other, "should I pick it up?" The other says, "Don't bother, the markets are efficient and therefore someone else already has." This joke shows some of misunderstanding which surround the efficient market theory.
The markets can be efficient if they tend to reflect completely the accessible information in the prices for securities on the average.
Through various securities and from time to time the price inefficiency can is unexpected arise here and there, and active participants of the market can and come nearer to get profit on this inefficiency. By picking up the occasional $100 dollar bill found on the ground, traders - or the economists in the joke - make the markets more efficient.
If securities markets are efficient, then, the positive and negative price inefficiency will tend to be small and to cancel each other. However, if profits net of analysis and trading costs on information-based trading strategies are significant and sustained for the long period it could be a sign that the market less than is completely efficient. However, it still could be only the result of good luck.
Note that efficient markets do not mean that the current price of a particular security is either "right" or "wrong."
As required, the markets, can seem, do the certain and regular errors of an estimation. The important thing about efficient market is that positive and negative pricing errors will tend to cancel out over the long run. These pricing errors - if indeed they are errors and not an exact reflection of current risk-adjusted knowledge - will also tend not to be systematically detectable by investors during long time.
Profits from inefficiencies would tend to increase to investors who can tell the difference and react promptly. Greater knowledge and quickness tend to be more the characteristics of professional instead of amateur investors. Professionals have more research resources and the ability to pay completely occupied attention to a choice of a portfolio and management. However and unfortunately for individual investors, the data specifies that it is actually impossible to find out professional managers with superior skills. Even more unfortunately, professional managers tend to charge more than they deliver in improved performance.
Certain individual investors may also have some skill in detecting price inefficiencies related to selected ordinary actions. Unfortunately, it seems that these more prescient investors can only track and hold a very small number of equities and they lose the "free lunch" benefits of portfolio diversification. Despite their activist investment efforts, on average their gross performance still tends to trail a passive multi-factor index investment strategy. When expenses and taxes consider, including alternative costs of their time, it is highly likely that their net returns are even more the lowest to a passive index strategy.
The Information Perspective on Decision Usefulness
The information perspective views financial reporting as a mean to convey useful information to investors. Investors must then decide whether to use this information in forming their own posterior probabilities of future profitability and share returns. The information perspective is consistent with the historical cost basis of accounting, but does not rely on it. It appears, on the basis of both theory and empirical evidence, that financial statements, traditionally containing a large historical cost-based component, provide useful information to investors. However, there is no particular reason why the information must be historical cost-based. RRA information is not historical cost-based, nor is much of the information in notes and MD&A.
The essence of the information approach is that, as mentioned above, investors are assumed to use accounting information and any other relevant information as well, in forming their own assessments of future performance -- the accountant does not do it for them. The particular form of disclosure does not matter, only the fact that the information is disclosed. Thus, the information perspective can be used to justify historical cost as the basis of the financial statements proper, while supplementing the statements with additional information. Efficient markets theory is then relied on to ensure that investors, on average, properly interpret this information.
Financial statement information has characteristics of a public good because its use by one person does not destroy it for use by another. Consequently, it is difficult or impossible for firms to charge investors for its value. Then, investors, who do not directly pay for it, may perceive it as free. As a result, there is no well-working market price to equate supply and demand of information, and some central authority may have to step in to require firms to issue more information than they would otherwise release.
Accountants can still be guided by the extent of security market reaction to accounting information. That is, if one accounting policy produces a higher market reaction (e.g., ERC) than another, this policy is found more useful by investors. Since accountants are in competition with other information sources about firms' performance and prospects, they are motivated to supply useful information so as to maximize their competitive position.
However, it does not follow that standard setters should be guided by security market response in setting accounting standards. For example, investors who perceive accounting information as free may demand more standards than are socially desirable given the costs of producing the information required by those standards. These costs include not only direct costs of preparing, monitoring, and enforcing the mandatory information, but possible costs of loss of competitive advantage if the mandatory information concerns business processes, risk control mechanisms, plans, and prospects.
As investors use this information, there may be a security market response, but this response is to a supply of information that is not socially optimal. If the supply of information is not socially optimal, security market response to this information is not socially optimal. Hence, the extent of security response to accounting information cannot be used to guide standard setters.
The Measurement Perspective on Decision Usefulness
As given ideas of the author in the Financial Accounting Theory book, this module defines and illustrates the measurement perspective on decision usefulness. Some reasons for increased attention to fair values in financial statements, including theory and evidence that securities offered that securities markets, probably, are not completely efficient. Fair value accounting is illustrated with reference to several Canadian and U.S. financial accounting standards. They include the standards dealing with drawing up of financial tools, such as derivative tools, and in drawing up of the purchased goodwill. Issues in the reporting of firm risk are also described and illustrated.
The measurement perspective on financial reporting is an approach by which accountants undertake the responsibility to incorporate fair values into the financial statements proper, provided this can be done with reasonable reliability. This approach recognizes an increased obligation to assist investors in predicting future firm performance.
Historical cost based earnings have a low ability to explain wrong securities returns (i.e., low value relevance). Investors required more help in predicting future securities returns. This argument is supported by theory and evidence that questions efficient securities markets. The development of clean surplus theory provides a theoretical framework that supports the measurement perspective.
Efficient securities market theory has been questioned in recent years, for several reasons:
increasing attention to alternative theories of investor behaviour, such as prospect theory;
evidence of excess stock market volatility and bubbles ;
evidence of anomalies, that is, share price reactions to accounting information that do not match those predicted by the efficient markets theory.
The author concludes in his book that the theory and evidence questioning efficient securities market theory has not yet 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 perspective.
Ohlson's clean superfluous displays of the theory as market cost of firm can be defined from the information of accounting balance and the report on profits and losses or income statement. From the income statement, the theory takes the actual income and calculates goodwill as distinction between the actual and expected income. 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. Then, to define the value of the firm, add the calculated goodwill to the book value. 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 share returns.
Economic consequences and Positive Accounting Theory
According to the Scott's ideas, Positive Accounting Theory (PAT) attempts to understand and predict firms' accounting policy choice is part of firm's overall need to minimize its cost of capital and other contracting costs. The accounting policies that do this are largely determined by the firm's organizational structure, which in turn is determined by its environment. Thus, accounting policy choice is part of the overall process of corporate governance.
Positive Accounting Theory does not imply that a firm's accounting policy choice should be uniquely specified. Rather, it is usually more efficient to have a set of accounting policies allowed by GAAP or it can be further restricted by contract. Allowing management some flexibility in accounting policy choice enables a flexible response to changes in the firm's environment and to unforeseen contract outcomes. However it is also opens the door to opportunistic management behavior in accounting policy choice.
From the perspective of PAT, it is not see why accounting policies can have economic consequences. From an efficiency perspective, the set of available policies affects the firm's flexibility. From an opportunistic perspective, the ability of management to select accounting policies for its own advantage is affected. Either way, changes in the set of available policies will matter to management.
While, as mentioned, managers' concerns about accounting policies and standards may be driven by opportunism or by efficient contracting, there is significant evidence in favor of the efficient contracting version of PAT. This suggests that firms are able to align managers' interests with those of shareholders. We now turn to consideration of how this alignment may be accomplished.
Conclusion
In conclusion, as I mentioned before, Financial Accounting Theory book is well suited for an upper-level seminar classes, it is not without limitations. Besides, by its nature the book will not include the most current research on any particular topic. This book is best used in an upper-level undergraduate or postgraduate seminar course where the students anticipate a large amount of reading and discussion, and would not be particularly effective in a large class setting.
The book included in-depth treatment of contemporary issues and problems in the field. Topics covered the contributions of economics, finance, and other disciplines to accounting theory; the practical and theoretical problems of the present value model; foreign exchange accounting; hedging; the process and issues of standard setting; agency theory; and other topics related to specific industries or sectors of the economy.
Various theories that underlie financial accounting and reporting are described and explored in this subject. The relevance of these theories is explained and illustrated in order to better understand the practice of financial accounting and reporting. Initially, the concept of present value accounting under ideal conditions is examined and evaluated as a method of determining reliable fair values.
