CH-5-8 Postulates, Principles, and Concepts – Accounting Theory: Conceptual Issues in a Political and Economic Environment : Book Guide

This Document Contains Chapters 5 to 8 Chapter 5: Postulates, Principles, and Concepts CHAPTER HIGHLIGHTS Chapter 5 starts with an analysis of ARS 1 (by Moonitz) and ARS 3 (by Sprouse and Moonitz), which were sponsored by the APB at its inception. While the shortcomings of these documents are discussed in depth, viewing them within the historical context presented in Chapters 5 and 6 is far more important. For example, ARS 1 and ARS 3 say little, if anything, about user objectives. However user objectives did not begin to make an impact upon accounting theory until much later in the 1960s. The numerous concepts that have arisen on an informal basis as a result of the needs of accounting are examined next. We have used a somewhat arbitrary, but hopefully useful, classification scheme. We presume that students are generally familiar with these concepts. Our main purpose is to assess how important we believe these concepts will be in the future, particularly in light of the development of a conceptual framework. The chapter closes with a review of the equity theories of accounting. These are essentially deductive and normative types of theories that attempt to explain the relationship between the enterprise and its owners. These theories today take a back seat to empirical research findings in accounting. Nevertheless, they are still useful in terms of assessing certain accounting models. QUESTIONS Q-1 Do you think the “broad principles” of ARS 3 are really principles as that term is used in science? A principle might be termed as an “enduring truth” in science. Unlike diamonds, however, they may not last forever. In ARS 3, “principles” are more like rules that are presumed to be useful, though other potential alternatives might be present depending upon factors such as costs and user needs. Such factors, however, were not considered in the early 1960s. Q-2 “Assuming all other things equal, it is possible that the lower-of-cost-or-market method can result in any given year in higher income than would be the case under the same inventory costing method without the use of lower-of-cost-or-market. If so, then lower-of-cost-or-market cannot be classified as a conservative method.” Do you agree with this statement? Discuss. The first statement is true because beginning inventory may be lower as a result of a lower-of- cost-or-market write-down. If the ending inventory write-down is less than the beginning inventory write-down, a higher income will occur under lower-of-cost-or-market than would be the case without it. However, we would still classify it as conservative. Cumulative income must be equal or lower using lower-of-cost-or-market and the balance sheet valuation of assets is equal or lower in any given year. Therefore, we believe it is conservative in terms of the definition given in the chapter. This Document Contains Chapters 5 to 8 Q-3 Why is it that postulates stemming from the economic and political climates as well as the customs and viewpoints of the business community would not serve as a good foundation for deducing a set of accounting principles? There is a strong probability (as evidenced by the A and B postulate groups) that these types of postulates will be so “bland” that they will simply be too insufficient to serve as meaningful bases for deducing meaningful principles (or conclusions). Q-4 Using different studies at different times it still appears to be the case that financial executives have a higher threshold for materiality than either Certified Public Accountants or financial analysts who, in turn, have a higher materiality threshold than users. Why do you think this ordering exists? Since financial executives are responsible for preparing financial statements, the higher mean for materiality judgments gives them a greater latitude for error by declaring an item as being non- material. Financial analysts as users and certified public accountants as auditors (who, at some point, might be subject to a lawsuit) would prefer lower materiality thresholds. Q-5 Do you think that the so-called equity theories of accounting are really theories in the scientific sense? If so, how would you classify them? Deductive logic appears to have been implicitly used in determining them. Real rigor was never used in setting down the premises and subsequently deducing the consequences. Hence, while they have been pragmatically useful, they probably stop short of being theories in the scientific sense. Rigorously derived conclusions using just deductive logic would qualify as theories in the scientific sense. Hence, we believe the problem is lack of rigor as opposed to type of methodology employed. Q-6 Why do you think the equity theories are less important today than they were, say, 50 years ago? Empirically testable hypotheses are much richer in terms of providing insights than the deductively derived equity theories. The equity theories provide interesting outlooks, but they are simply too narrow in scope to provide extensive insights into complicated problems. However, they do have their uses. Refer students to the discussion of stock options in Chapter 12. Q-7 Four postulates (going concern, time period, accounting entity, and monetary unit) were discussed as part of the basic concepts underlying historical costing. Can any of the principles discussed under the same general category be deduced or logically derived from these postulates? This question does present some interesting possibilities for discussion. We believe that these postulates are too broad and general to serve as a foundation for the development of accounting principles without the addition of some very specific objectives that pertain to defining users and their information needs. Q-8 How does agency theory (Chapters 2 and 4) differ from the equity theories discussed in this chapter? Agency theory is much richer in scope than the equity theories. Agency theory is concerned not only with owners but also with managers and other parties such as lenders. The firm itself is simply the connecting link among these parties. Agency theory is rich enough to allow empirical testing of the hypotheses, whereas the equity theories do not appear to allow such testing. One reason is that the firm itself is, behaviorally speaking, a purely passive entity. Hence, the equity theories appear to be deductive statements that cannot be further extended or tested. Q-9 Does the entity theory or the proprietary theory provide a better description of the relationship existing between the large modern corporation and its owners? The entity theory provides a better description of this relationship because stockholders are largely absentee owners in the large modern corporation. The firm is indeed separate from the owners. If this is the case, perhaps a discussion of how dividends differ from interest expense may be useful. How can exclusion of dividends on the income statement be justified assuming the entity theory; it cannot. Q-10 Why has the entity theory fragmented into two separate conceptions? There is a duality, as noted in the text, relative to the interpretation of the owners’ equity accounts. This ambiguity is most strongly highlighted in the difference between capital stock and retained earnings. The former was seen more strongly as pertaining to the owners, whereas the owners had a less solid claim on retained earnings. As a result, some anomalous situations can easily arise, such as stock dividends being interpreted as income to the owners because they result in a transfer from retained earnings to capital stock. The newer interpretation, which puts the entity in a stronger position, is much less ambiguous, because all of the owners’ equity accounts belong unequivocally to the firm. Q-11 Of the nine so-called principles shown in Exhibit 5-1, which do you think are the most important in terms of establishing a historical costing system? This is an open-ended question that should generate good discussion. In our opinion, realization and matching are the most important because they define the essence of the expense-revenue approach, as discussed in the Conceptual Framework Discussion Memorandum and SFAC No. 3. Sterling’s 1967 paper on conservatism makes a provocative case for conservatism. The remainder of the principles are far less important. Q-12 What is the difference between owners’ equity accounts representing shareholders’ claims as equity holders versus shareholders’ interests as owners? The conception of owners’ equity accounts representing shareholder claims is much weaker than owners’ equity accounts representing ownership interests. Shareholder claims probably go no further than the right to receive dividends once declared by the board of directors, the right to vote at annual meetings, and the right to buy shares when new issues are floated (and this is not even totally clear) as well as the right to sell shares.. Q-13 Postulates are supposed to be tight enough to prevent conflicting conclusions being deduced from them. Is this the case with ARS 1? Definitely not, because an exit value system—not to mention a general price-level adjustment— could just as easily have been deduced from ARS-1. Q-14 Is it fair to categorize ARS 1 and ARS 3 as failures? No, it is not fair. ARS 1 and ARS 3 should be seen in the historical context in which they arose. After years of putting out brushfires, it was suddenly decided to pursue a more conceptually rigorous approach. User objectives had not yet surfaced. The practicing arm of the profession was simply too provincial to accept anything but historical cost. So Moonitz and Sprouse were akin to an advance scouting party performing a historically necessary task. Q-15 How do the imperative postulates (group C) differ from the other two categories of postulates? They go beyond mere description, which appears in the A and B group, because they use terms such as “should,” which indicate value judgments. Q-16 Distinguish among the terms realized, realizable, and realization. Realized and realizable are terms referring to the assets that have been received or will be received as a result of the firm’s revenue recognition function. Realized means that either cash has been received or a legitimate claim (accounts receivable) is in place. Realizable refers to the ability to convert assets already held into known amounts of cash or claims to cash. Certain types of holding gains on assets are realizable in terms of replacement cost exceeding historical cost (see Chapter 13). Realization refers to the point when revenue is earned and either cash is received or claim to assets arises. Realization has been supplanted by recognition. The latter refers to the point when assets to be received as a result of performing the revenue function are realized or realizable, and the performance of the revenue function is substantially accomplished. Q-17 How does conventional retained earnings differ from entity equity under the Anthony conception of the entity theory? Entity equity would be less than retained earnings to the extent, if any, of unpaid dividends on both preferred and common stock. Q-18 What inconsistencies does Merino see in the proprietary theory at the turn of the twentieth century before the advent of entity theory? According to Merino, proprietary theorists wanted to focus upon absentee owners and the large profits that they presumably made. At the same time, however, proprietary theorists were also proponents of conservatism, which would tend to minimize the measurement (or calculation) of income. Q-19 Why is earnings-per-share calculation an example of the residual equity of a firm being broader than merely its current common shareholders? Earnings-per-share takes into account convertible bondholders on the basis that the bonds have been converted into common stock in fully diluted earnings-per-share and in primary earnings- per-share if the convertible bonds are a common stock equivalent. Q-20 Why is the residual equity theory more in line with recent research in finance than entity and proprietary theory? This is because preferred stock has been viewed as debt leaving the common stock as the sole residual equity component. Hence, common stock and residual equity are one and the same. While the modern view of the corporation holds to entity theory with debt and equity merely being different legal approaches to raising capital, but the finance view does maintain a sharp difference between debt and equity because of the absolute need to meet interest payments but not dividends. Q-21 Why do you think that security prices are impacted more by “bad news” than “good news”? Bad news has a tendency to jolt us more than the possibility that our fortunes will be increasing. Benjamin Franklin (1706-1790) summed it up as follows: nothing forces our concentration more than the fact that we may be hung for our actions. Q-22 Why do you think that operating ratios (return-on-assets) are more sensitive to the combined effect of immateriality items than would be the case with solvency ratios (debt-to-equity and current ratios)? It is quite likely that profitability ratios involve relatively smaller numbers – income numbers – than solvency ratios which are most likely dealing with relatively larger numbers. Q-23 At present time, the U.S. federal income tax code allows corporations to deduct interest expense but not cash dividends paid to stockholders. Does the tax code tie in with any of the equity theories? Yes. The tax code is definitely proprietarily oriented. Dividends are not tax deductible on the grounds that they are not expenses but are – instead – distributions of income whereas bond interest is tax deductible. Making both tax deductible would tie in with the more narrow view of the entity theory but – more importantly – lead to increased issuances of stock. Q-24 Why does it make sense to define materiality from the user’s perspective? It is the user who is making the decision; therefore, materiality from his/her perspective is what is important. The problem arises, however, as the user groups become more diverse. What may be material to one user may not be material for another. Q-25 What similarities are there between materiality and disclosure? Accounting information is considered material if its omission or misstatement affects decision- making process of any reasonable individual relying on the information. Materiality helps accountants determine when that information is material and should, therefore, be disclosed. The difficult aspect of both materiality and disclosure is determining how much is too much or too little. Neither has universally accepted criteria to apply; professional judgment is required. Q-26 Discuss how the concept of conservatism may be changing as viewed by Watts. Watts, Ross (2003a). “Conservatism in Accounting Part I: Explanations and Implications,” Accounting Horizons (Sept. 2003), pp. 207-221. FASB has been working to eliminate accounting conservatism to attain "neutrality of information.” So, the adage of anticipating no profit, but anticipating losses may be withering. Rather than being a strength of the accounting paradigm, it may be viewed as a weakness, distorting accounting information. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Assume the following for the year 2000 for the Staubus company: Revenues $1,000,000 Operating expenses Cost of goods sold $400,000 Depreciation 100,000 Salaries and wages 200,000 Bond interest (8% Debentures sold at maturity value of $1,000,000) 80,000 Dividends declared on 6% Preferred Stock (par value $500,000) 30,000 Dividends declared of $5 per share on Common Stock (20,000 shares outstanding a par value of $100 per share) 100,000 (a) Determine the income under each of the following equity theories: Proprietary theory Entity theory (orthodox view) Entity theory (unorthodox view) Residual equity (b) Would any of your answers change if the preferred stock is convertible at any time at the ratio of 2 preferred shares for 1 share of common stock? (a) Proprietary Orthodox Unorthodox Residual Entity Entity Equity Revenues $1,000,000 $1,000,000 $1,000,000 $1,000,000 Operating Expense 700,000 700,000 700,000 700,000 Operating Income 300,000 300,000 300,000 300,000 Other Revenues and Expenses Bond interest 80,000 -- 80,000 80,000 Preferred dividends -- 30,000 30,000 Common dividends -- 100,000 Net Income $220,000 $300,000 $ 90,000 $ 190,000 (b) Convertible preferred stock would be considered a common stock equivalent and should, therefore, be included in the calculation of common dividends. 2. Critique A Statement of Basic Accounting Postulates and Principles by a study group at the University of Illinois (it should be on reserve or otherwise made available to you). Your critique should cover, but not be restricted to, the following points: How do the definitions of postulates, concepts, and principles differ? Are the examples of postulates, principles, and concepts consistent with their definitions? Does this set of postulates, principles, and concepts provide a legislative body with a useful framework for deriving operating rules? The Illinois Study Group did a study entitled A Statement of Basic Accounting Postulates and Principles, which appeared in 1964, shortly after ARS 1 and ARS 3. Postulates were defined in the Statement in much the same way they were defined in ARS 1—as “underlying assumptions” that are viewed as being valid. Further discussion appears to make it clear that postulates are intended to be descriptive in nature. However, it also is made clear that other propositions will be deduced from them. Concepts, according to the Illinois Study Group, “are formed primarily through observation,” but they may also be derived deductively. Included among many of the concepts are basic elements of accounting, which were defined in SFAC No. 3. It appears that concepts generally arise outside of the theory process, though they would obviously be part of theoretical formulations. Principles were defined as “basic propositions which express significant relationships in accounting; they indicate in a broad sense those actions which will best accomplish the objectives of accounting.” It appears that they are largely, but not totally, deduced from the postulates. To some extent, the concepts play a mediating role in terms of determining the principles. It does not appear that all of the items in the Illinois Study Group effort are totally consistent. For example, a principle of the system is “recording,” which states that a complete record of all activities resulting in changes in assets and equities should be made. The statement is a tautology (though an imperative one). This could easily be restated (by eliminating the imperative) as a postulate. The measurement principle also contains strong elements of the monetary unit postulate as expressed in ARS 1: “enterprise data should be expressed in such monetary terms as will facilitate their use by the various interests in an enterprise.” The concepts consist of a number of definitions that have a hierarchical order, though none appears to be expressed. Income results from the way terms such as “assets,” “revenues,” “realization,” and “income” are defined and implemented. There are numerous other criticisms that could be made of this statement. We would conclude by saying that the resulting concepts and principles are too thin upon which to build a meaningful system of standards. It is, nevertheless, important to stress that this study was very much in the mainstream of activity when it appeared. It is relatively easy to find fault 40 years after the fact. The intellectual effort that went into this and similar projects should not be forgotten. 3. List and briefly discuss as many areas as you can in which an accepted method or technique is conservative, including why it is conservative. The examples that will be used here, in following the chapter definition, will be relative and will therefore compare alternatives. We will also cite other reasons that may underlie the situation. The classic example is lower-of-cost-or-market, which is conservatism in its purest form. This technique is still applicable to inventories, but since SFAS No. 115, it no longer applies to marketable equity securities. Research and development costs (SFAS No. 2) must be expensed. By requiring immediate write-off, however, verifiability may be improved since everyone now would be using one easily measurable method. Computer software development costs follow research and development. The presumed higher probability of recoverability of costs in software development clearly stamps this as being conservative. SFAS No. 19’s attempt to allow only successful efforts by oil and gas producers is conservative. As with research and development costs, however, verifiability would be improved by allowing only one method. Only loss contingencies (SFAS No. 5) are recognized (provided they are probable and can be reasonably estimated), whereas gain contingencies are not recognized. The dilutionary effect of stock options, even if they are not yet exercisable, are recognized in earnings-per-share calculations (APB Opinion No. 15). SFAS No. 87 requires the use of future salary projections for pension expense measurements, rather than current salaries. The presumed purpose is to help users predict future cash flows, though the linkage is rather tenuous. There may be a trade-off, since the pension obligation per se is not in the body of the balance sheet (which is definitely not conservative). Similar to SFAS No. 87 is SFAS No. 106, concerning other postretirement benefits, which requires the use (and estimation) of future medical costs. The FASB is on safer grounds here, because future medical costs are not executory relative to firm and employee, as are future pension costs. Unrealized future losses are more frequently recognized than unrealized future gains in APB Opinion No. 30, which discusses discontinued segments. Recognition of deferred tax assets were more restricted than recognition of deferred tax liabilities in SFAS No. 96, but they are now on an even footing in SFAS No. 109. Discontinued operations (APB Opinion No. 130) anticipate future losses but not future gains. Impaired asset writedowns (SFAS No. 121) are recorded but not asset writeups. 4. (Based on an article by nationally syndicated columnist Michael Kinsley). A few years ago both Halliburton Corporation, a large construction company, and its auditor, Arthur Andersen, were chided for allowing Halliburton to book a percentage of cost overruns that Halliburton attempted to collect from customers after projects were completed, but before both agreed settlements with customers and, of course, collection thereof. The practice of trying to collect cost overruns in the construction industry is not uncommon. Until 1998, cost overrun collections were not booked until received. Since that time, Halliburton “began guessing how much of a disputed surcharge would ultimately get paid and crediting itself in advance.” Required: Is there a case that can be made for allowing Halliburton to book these overruns? What arguments, if any, support Halliburton’s accounting methods? What situations should prevent Halliburton from booking these overruns prior to collection? a. The strongest case for allowing Halliburton’s approach is that (a) the work is completed and (b) it is an industry practice to attempt to collect cost overruns. It is also to Halliburton’s advantage that they are attempting to estimate portions that will be collectable assuming that the collectable portion is a legitimate estimate rather than an attempt to “pump up” current earnings. This practice may also provide a better matching since revenues would be recognized in the period when the project is completed rather than a later period. Notice the similarity of this situation to bad debts expense measurement. b. The principal problem would be an inability in each individual situation to accurately assess the amount of the collectable portion of the cost overrun. Bad debts, of course, are based on broad experiential factors. At its worst, this practice could devolve into an attempt to manage earnings (Chapter 12). CRITICAL THINKING AND ANALYSIS 1. How permanent do you think the postulates and principles underlying historical costing will be? Like everything else, some degree of change is bound to occur. The postulates may stay around but how much influence they will have is another matter. We have already mentioned that going concern leads to a logical dead end. Accounting entity will be important but the actual concept itself may change. For example, an increasing number of firms now have strategic alliances with each other without affecting ownership. We wonder if there will be some recognition of this on the balance sheet. While the monetary unit still appears to be stable, it is possible that current values will be enhanced on the balance sheet even though significant verifiability problems still exist with unique items of plant and equipment. Among the principles, conservatism may decline in importance. Disclosure and materiality will most likely gain in importance. How verifiability will change, particularly as current values grow in importance is hard to say. We believe uniformity or some variant of it will grow in importance. If all of these factors hold, comparability will also grow in importance. That leaves the two pillars of historical costing: recognition and matching. Traditional rules of recognition will probably expand. Recognizing unrealized gains and losses on trading securities provides an example. Matching will probably also be modified. Impaired asset write-downs, although an example of conservatism, provides a possible approach. This analysis is simply our view. Many other approaches and modifications are possible. This question might make an excellent term paper project for the course. 2. If you could relate materiality, disclosure, and conservatism to types of measurements (nominal, ordinal, interval, and ratio scale), how would you do so? Materiality would likely be a nominal measure. Is it material, yes or no? If an item is material, to what extent do you disclose (in financial statements only, notes only, both financial statements and notes). These would likely be interval metrics. Conservatism could be measured using a ratio measure, perhaps the ratio of number of material items disclosed to the number of questionable material items. Alternatively, use monetary amounts rather than number of items. From managerial accounting, you get what you measure. Discuss the behavioral aspects of reporting how conservative a set of financial statements might be using such ratios. 3. Zeff (2007) describes the SEC’s positions regarding historical costing in the 20th century, eventually questioning whether the United States has ever “had a private-sector process for establishing ‘generally accepted accounting principles’. To what extent do you agree/disagree with Zeff’s point? Zeff, Stephen A. (2007 Special Issue). “The SEC Rules Historical Cost Accounting: 1934 to the 1970s.” Accounting & Business Research, 49–62. This article is the basis for a class discussion after the students have answered the question outside class. Chapter 6: The Search for Objectives CHAPTER HIGHLIGHTS Chapter 6 continues the thrust of Chapter 5 by examining important documents and committee reports that have appeared since the publication of ARS 1 and ARS 3. As its title indicates, the chapter is concerned with the question of who financial reporting is prepared for and what information should accessible by them. ASOBAT was the first formal report to emphasize the importance of user needs to accounting standard setting, even though the actual development of the user needs themselves was quite limited. APB Statement 4 was the APB’s “last hurrah.” The document contained much of the “conventional wisdom” going back to the basic concepts underlying historical costing discussed in Chapter 5, as well as material coming from ASOBAT. In some ways it was more complete than ASOBAT, because it listed users of financial accounting information—classifying them into those with direct interests and those with indirect interests. In the wake of the demise of the APB, the AICPA commissioned the Wheat Committee and the Trueblood Committee reports. The former pertained to the organization of the APB’s successor and was briefly discussed in Chapter 3. The latter attempted to delineate the major overall objectives of accounting in terms of user needs. The objectives have been criticized as being non-operational. However, since they were intended to be at the apex of a metatheoretical structure, that criticism misses the point, in our opinion. SATTA, like its predecessor ASOBAT, was an attempt to assess the contemporary state of financial accounting theory. Unlike ASOBAT, which attempted to codify some elements of a metatheoretical structure, SATTA attempted to show why agreement in terms of selecting among competing accounting theories (valuation systems such as replacement cost or exit values) could not be achieved at that particular time. We believe that one of the crucial issues brought up in SATTA is the question of how diverse the information needs of the various user groups are. This is an empirical question that has not yet been resolved. In fact, little, if any, work has been done on this extremely important question. It is also interesting to note that SATTA took a very pessimistic view at almost the same time that the FASB launched the conceptual framework. The discussion of user objectives and user diversity, which was given in separate appendices in previous editions of this book, are now included in the body of the chapter. This information is important and supplements the discussion of the various committee reports and documents covered in the chapter. QUESTIONS Q-1 How do objectives differ from postulates? Objectives are goals to be strived for. As such, they must be normative in nature. They may also have different degrees of specificity. For example, an objective stating that information should be relevant to users is very broad and is not operational. Objectives standing below relevance would prescribe what information they need. Postulates are general statements that may be either normative or descriptive (or both). The more descriptive a set of postulates is, the more likely that it will be too broad to use as a basis for deductive reasoning—as in accounting. Where postulates are normative, they begin to take on the character of objectives (financial statements should be based upon a stable measuring unit, for example). Q-2 Do you think that the funds flow statement is more “factual” and less “interpretative” than the income statement and balance sheet? The funds flow statement is more factual than the other statements, but it is not wholly factual. Under funds provided from operations is income, excluding gains and losses, and also depreciation. However, income still includes elements such as cost of goods sold, which is interpretative because several ways of measuring this item can be used. The distinctions between factual versus interpretative concern the allocation problem. Q-3 Do you think that the standards mentioned in ASOBAT are really standards? Why or why not? If we reserve the term “standards” as rules or guidelines for practice, ASOBAT’s standards lie above standards in the sense that we presently use the term. They would lie below ASOBAT’s objectives. The FASB, in fact, used three of these standards in the conceptual framework but called them qualitative characteristics. The fourth standard, quantifiability, is a general term pertaining to measurement which apparently has been dropped because it is somewhat general and other standards (verifiability) certainly pertain to measurement. Q-4 Why is the problem of heterogeneous users so critical in the development of accounting theory? If different user groups have different accounting information needs, a very thorny problem exists. There is a cost associated with preparing and disseminating accounting information. On the other hand, users do not directly pay for the information they need. Hence, a market-oriented solution to the problem is not possible. Consequently, a rule-making body is faced with the problem of benefiting one group at the expense of another. The problems faced by accounting policy makers would be significantly easier to deal with if all groups needed much of the same information. Determining what that information is and how to present it would then be the rule- making organization’s principal tasks. More research is obviously needed on this issue. Q-5 APB Statement 4 defines assets in the following terms: “Assets are economic resources of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Assets also include certain deferred charges that are not resources but that are recognized and measured in conformity with generally accepted accounting principles.” Do you think this is a useful definition? Why or why not? This definition from APB Statement 4 is not very useful. The definition has a cart-before-the- horse problem because the definition should help in determining GAAP but it says that if GAAP calls it an asset then it is an asset. In addition it says that deferred charges are assets even if they are not resources (resources would be a substitute word for assets). Hence some “assets” are really not “assets.” Some examples would be unamortized organization costs and deferred tax debits (determined under APB Opinion No. 11 which is geared to a revenue-expense approach rather than an asset-liability approach). Q-6 How do the research orientations of accounting in Chapter 2 compare with SATTA’s organization of research? The orientations are different, but there is some overlap. Both list information economics as a separate category. In SATTA, the “classical” approaches were basically deductive and normative in nature with little, if any, emphasis upon user needs. Aside from information economics, current research was classified by whether it emphasized decision models or decision makers. The former case is normative and deductive in approach and is likewise the same category used in Chapter 1. The latter, which is empirical and attempts to be descriptive, is further broken down into individual users and aggregate market behavior. Many of the studies of individual users involve behavioral research, which was a separate category in Chapter 1. Similarly, aggregate market behavior largely corresponds with our category of capital market research. Agency theory had not yet burst onto the scene when SATTA was written. Q-7 The statement of Herbert Miller (footnote 33) is closest to which theoretical approach delineated in SATTA? Miller, Herbert E. (1974). “Discussion of Opportunities and Implications of the Report on Objectives of Financial Statements,” Studies on Financial Accounting Objectives, 1974 (Supplement to Journal of Accounting Research), pp. 18–20. Unquestionably, the Miller view is quite close to the decision model category of decision-usefulness discussed in SATTA. Q-8 How has the definition of accounting been modified in recent years? The decision-usefulness aspect of accounting was brought into the definition by ASOBAT, as opposed to previous definitions that emphasized the input side rather than the output side. The same definitional thrust was maintained in APB Statement 4. Q-9 What potential conflicts are present in terms of different user needs? The problem here is, in a very real sense, the opposite of the problem concerning the conflict among objectives. On one side are actual shareholders versus potential shareholders. The former would certainly desire “good news,” whereas “bad news” might benefit the latter to the extent of keeping the security price lower than it might otherwise be. This situation assumes some degree of market inefficiency. Labor unions might desire income to be as high as possible in order to support wage demands. On the other hand, suppliers might desire conservative information as a “margin of safety.” Management might desire a high income in order to look good or to maintain flexibility in terms of bond covenants. Management of firms that might be subject to antitrust pressure might, on the other hand, desire lower reported income to minimize governmental pressure. These are some of the possibilities. Many others probably exist. Nevertheless, we wonder if the problem is as serious as some seem to think it is. Certainly, empirical work is needed to attempt to shed more light on the problem. Q-10 Why has Ijiri advocated the need for a conceptual framework to implement accountability? We still need to know who the users of the accounting information would be: that is, how far the net should be cast in terms of covering user groups. Should we, for example provide information about environmental concerns and, if so, who should pay for the information? Similarly, the rights among various groups must be clearly staked out. For example, major credit providers might want very conservatively stated income statements to minimize dividend declarations and management bonuses. Thus, the rights of the various groups must be carefully established. While we agree that this is not easy, we do not think that the task is one of Everest-type proportions. Q-11 The Trueblood Committee Report advocated the use of financial forecasts. Why do you think that adoption of this suggestion has been very unenthusiastically received by preparers and auditors? Both preparers and auditors fear the risks involved, even though safe harbors have been provided. We suspect that management is also concerned with disclosing important information for potential use by its competitors. Q-12 Under an accountability orientation, Ijiri makes a strong case for the use of historical costing including the possibility of general price-level adjustments. Why do you think he has made this choice? To quote Ijiri himself from his “Theory of Accounting Measurement” (Studies in Accounting Research #10, American Accounting Association, 1975, p. 35): “. . . to protect both the accountor and the accountee from the abusive use of performance measures, the measurement used must be highly standardized and verifiable so that there is little room for dispute over a performance measure that is generated by an accounting system.” Thus, historical cost would fit the bill better than replacement cost or entry value systems. Ijiri would adjust historical costs by general price-level adjustment, which would still be highly verifiable. Q-13 Past viewpoints expressed that financial statement preparers are also the largest class of users of financial statements. Hence, the preparer has a “unique ability” to recognize user needs that the FASB does not really appreciate. Critique this viewpoint. They do indeed have a “unique ability” and they are important users. However, agency theory issues can easily get in the way relative to external statements: (1) an optimistic view if management wants to maximize bonuses or generally impress users or (2) a pessimistic view if the firm is very large and subject to governmental pressure. The enterprise could easily use one set of financial statements for published purposes and another for internal purposes. Q-14 Why would “fairness” in financial reporting be difficult to implement? We all have a tendency to think that what benefits us is “fair” and what does not benefit us is “unfair.” This is not, however, an insuperable problem, although it would certainly require care and caution on the part of a standard-setting agency. Q-15 What is the relationship between “stewardship” and “accountability”? Discuss. Accountability is related to but broader than stewardship. Both are concerned with good internal controls. Accountability is much more concerned with how well management has done. Thus, stewardship would be less interested in measures assessing management’s performance, such as earnings-per-share and return on investment, than would accountability. Q-16 Do you think that the income tax return mandated by the federal government is an example of user heterogeneity? Why or why not? Perhaps preparer heterogeneity would be a better term but the idea is definitely there. This is one reason why the federal income tax return is so complicated. One small example would be social security income which pertains to an older group of taxpayers. It is taxed at a lower rate than other forms of income. Another example involves home owning. Owners have interest and property tax deductions. Renters cannot deduct their rent payments. Q-17 If a division manager of a firm were fired due to poor operating results, would this be an example of stewardship? Stewardship refers to the providing of information to the organizations owners and creditors that show how the organizations’s resources were used during a financial reporting period. So, the provision of the information is the stewardship function, not the firing. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. A crucial question brought up in this chapter concerns the issue of whether the admittedly heterogeneous users of financial statements have highly diverse information needs in terms of their underlying objectives. State as carefully as you can (1) why the user groups have largely diverse information needs, and (2) why the user groups may have relatively similar information needs. Do you think user diversity or different user objectives presents the greater problem for accounting standard-setters? Different user groups do indeed have somewhat different user needs. Shareholders, for example, would want financial information which would tell something about the long-term growth and potential earnings increases – hopefully leading to security price increases – in the stock. Bondholders would be less interested in the overall growth of the stock but would be more interested in the overall safety and ability of the firm to pay interest and principal on the bonds. While these information needs are slightly different, they are not so different that a well developed set of financial statements should be able to cover both of these sets of needs. The same general statement applies to the other user groups mentioned in the chapter. Some problems apply more to different objectives more than to different user groups. For example, in Chapter 16 there is a conflict between cash flow predictions and accountability relative to measuring service costs of pensions. It is possible that shareholders might prefer the former measure and bondholders the latter but that is not entirely clear. Problems of this type may have to be dealt with on a case-by-case basis but this is not entirely clear. 2. Using the different valuation methods discussed in Appendix 1-A, what possible different user preferences do you see among the various user groups? Historical cost and possibly general price level adjustment might be the most understandable methods (which cuts across user groups). Management itself might prefer exit valuation since it shows liquidity available to management for assessing the possibility of liquidating assets for the purpose of getting into different assets or businesses. Entry value might be preferred by shareholders since it might be useful for predicting future cash flows because current value (replacement cost) of assets being used up helps to give more of an economic income perspective than historical costing. While there are some potential differences between user groups, the biggest preference or choice might be based upon the qualitative characteristics of the conceptual framework which appeared earlier in ASOBAT: relevance versus reliability (one aspect of which is verifiability). CRITICAL THINKING AND ANALYSIS 1. Do you see an evolutionary process involving the documents and reports presented in this chapter? Explain. There is a certain evolutionary pattern that is present. After the failure of ARS 1 and ARS 3, ASOBAT picked up the user orientation approach which was followed in APB Statement 4, the Trueblood Report, and eventually the FASB’s conceptual framework. Close up, several of ASOBAT’s standards for accounting information (relevance, verifiability, and freedom from bias) appear in the conceptual framework (freedom from bias is complementary to the conceptual framework’s qualitative characteristic of neutrality). APB Statement 4, as noted above, continued ABOBAT’s user orientation. It also picked up “basic features” of accounting which largely came from Moonitz’s ARS 1. The Trueblood Report kept the emphasis on users and objectives and was something of a “state of the art” position when it was drafted. The one exception to all this is SATTA. SATTA was imply a disagreement among academics on an appropriate value system. SATTA appeared at a time when the dominant research thrust in academe had swung from deductive to inductive. The irony of SATTA represented a breakdown of theoretical agreement among academics at a time when the FASB would commence with its conceptual framework project. 2. If different user groups do have different objectives, how might the situation be handled? This is a tough question. Can financial reporting be all things to all people? If it can, will the costs be acceptable to those bearing them? Perhaps technology can help. XBRL, for example, may provide greater transparency of financial data, allowing users to view the data from multiple perspectives and levels of detail. On the other hand, if financial reporting cannot be all things to all people, then the user group(s) should be clearly defined and financial reporting oriented towards meeting the needs of this more narrowly defined group. 3. Williams and Ravenscroft (2015) question decision usefulness as the basis for accounting standards. Take a position and argue its merits. Williams, Paul F. and Sue P. Ravenscroft (Summer 2015). “Rethinking Decision Usefulness,” Contemporary Accounting Research, 763-788. “We investigate whether decision usefulness currently articulates a sufficiently coherent basis for accounting as a social, regulatory practice. Relying on extensive evidence provided by disciplines that investigate human behavior we demonstrate that decision usefulness serves more as a legitimating myth rather than providing a coherent rationale for making public policy.” Williams and Ravenscroft provide a good chronological perspective of how decision usefulness became so dominate in our accounting discourse, especially by our standards setting bodies during the past 50 years. They propose that accountability (or stewardship) may better articulate accounting as a social, regulatory practice. This is a difficult assignment for students. Thinking through the subtle differences of the two views and the effect on standards that either might have requires some hard thinking. In small group and class discussions ask the question of how to make such a change in wording, if accountability were to replace decision usefulness. 4. What are the implications of Young (2006) on the standards promulgated by standards- setting bodies? Young, Joni J. (August 2006). “Making Up Users,” Accounting, Organizations and Society, 579– 600. Young provides a good chronological perspective of how we got to the importance of “users” and “decision usefulness” in our accounting standards. Our standards setting bodies chose to define users as investors and creditors, leaving out some of the other diverse bodies in the “users” definition. They also chose to not focus on what information users should want, but rather what rational economic decision-makers want. These restrictive views lead to narrow usefulness of financial reports; other information that the reports could provide are outside their purview. “This tight connection of accounting to an economic decision-maker qua investor/creditor severely limits the possible accountability relationships that might be enacted through and reported in accounting statements.” Class discussion might address the question “What additional statements (maybe financial, maybe not) would users other than the traditional investor and creditor find useful?” For example, would residents of Flint, Michigan in 2016 find the financial reports of local governments telling them everything they want to know about life in their community? Should accounting reports tell more than cash flows and profits? Must everything be boiled down to numbers? Chapter 7: The FASB’s Conceptual Framework CHAPTER HIGHLIGHTS While the FASB’s conceptual framework may not be all that we would like it to be, the fact is that it is “there” and has been used by the board members—though perhaps not as much as we would like. Despite its shortcomings, the FASB’s conceptual framework has served as a model for several other nations as well as the International Accounting Standards Committee. A minor, but important point is that the FASB’s framework is intended to be used when setting standards ; the IASB’s is used for setting standards and used by practice when the standards are unclear. Another important point, the conceptual framework is a non-authorative source of U.S. GAAP. It is not in the FASB Financial Accounting CodificationTM. The chapter contains a fairly extensive discussion of the parts of the conceptual framework, which are called Statements of Financial Accounting Concepts. These were preceded by a discussion memorandum. The discussion memorandum was a massive study of the possible valuation approaches that could be taken as well as orientations to the definitions of the main financial statement categories. SFAC No. 1 largely echoed the Trueblood Report in terms of setting out the objectives of accounting at the topmost level of the metatheoretical structure. It did, however, strongly take the position that a common core of user needs exists despite the heterogeneity of external user groups. SFAC No. 2, in effect, created a structure of the qualitative characteristics of financial accounting information. There are many difficult trade-offs that must eventually be made among the hierarchy of concepts if operating standards are to be implemented on a viable basis. SFAC No. 3 presented the definitions of ten “elements” of financial statements. These constitute a considerable advance over previous definitions, though several other important issues have not as yet been addressed. SFAC No. 4 was concerned with objectives of financial reporting by nonbusiness organizations, so it is beyond the scope of this text. Issues of recognition and measurement were to be dealt with in SFAC No. 5. The question of relevant attributes to be measured for elements such as assets, liabilities, and expenses was avoided by leaving it to future development and evolution. This largely made the question of recognition sterile if meaningful attributes were not being measured. In light of the dismal failure of SFAC No. 5, SFAC No. 6 turned out to be a slight refinement of the definitions of the elements that had previously been given in SFAC No. 3. It also extended the qualitative characteristics of SFAC No. 2 to nonbusiness organizations. After a period of fifteen years since SFAC No. 6 appeared, SFAC No. 7 came out in 2000. It is concerned with estimating fair value when this cannot be done at the point of recognition. A decade later, SFAC No. 8 replaced SFAC No. 1 and No. 2. The qualitative characteristics changed materiality from a pervasive constraint to one that is entity specific to relevance. Rather than focusing on relevance and reliability, the new hierarchy focuses on relevance and faithful representation. These changes resulted from the FASB-IASB convergence project on their respective conceptual frameworks. Two particularly interesting issues that are presented in the chapter are (1) the question of representational faithfulness versus economic consequences and (2) an examination of the type of instrument that the conceptual framework is. The first question lies at the heart of accounting: can we actually come up with representationally faithful numbers, or is accounting basically a log-rolling exercise where groups vie for the standards that they perceive will benefit them? The second question, concerning the type of document the conceptual framework is, leads to issues such as whether and how the framework could be changed or whether it is a completed document that is basically historical in nature. QUESTIONS Q-1 Of what importance in a conceptual framework or metatheory are definitions of such basic terms as assets, liabilities, revenues, and expenses? Definitions can be helpful in a theoretical structure after higher parts of a conceptual framework are formulated in order to help specify what qualifies (and does not qualify) as an asset, liability, revenue, expense, gain, and loss. The definitions, thus, help to make the actual rules formulated internally consistent by presenting verbal models for the components of financial statements. The definitions, of course, must be consistent with the desired objectives expressed in the metatheoretical structure. Q-2 What is the relationship between the economic consequences of accounting standards and the quality of neutrality presented in SFAC No. 8? Accounting information must have distributional effects: it favors some parties at the expense of others. That is the nature of economic consequences. Neutrality refers to a “let the chips fall where they may” attitude insofar as accounting standards are concerned. Nevertheless, this is supposed to be carried out in a context where the prime objective of financial statements is to provide useful information to external users such as investors and creditors. Q-3 Why must objectives be at the topmost level of a conceptual framework of accounting? A conceptual framework is basically a normative and deductive type of undertaking. The main thrust of the operating standards, while they may be affected by various types of constraints and trade-offs, should be geared to attempting to carry out the user objectives. Indeed, the constraints and trade-offs may well be influenced by the user objectives; the reverse, however, should not occur. Q-4 How does the freedom from bias mentioned in ASOBAT compare to the quality of neutrality mentioned in SFAC No. 8? The concepts are quite similar. Neutrality, however, refers to standard setters, whereas freedom from bias, as discussed in ASOBAT, refers to preparers of financial statements. Q-5 How does earnings as discussed in SFAC No. 5 differ from net income? Earnings excludes the effect on prior years of any changes in accounting principles. These appear with the extraordinary items under net income. Hence, earnings is more closely related to the current operating performance notion than is net income. Q-6 What is comprehensive income? Comprehensive income includes all changes in owners’ equity except for transactions with owners. Included would be cumulative changes in accounting principles, foreign currency translation adjustments, the effect of accounting errors, and benefits from realized tax loss carryforwards of acquired firms (the latter two items are now classified as prior period adjustments). Comprehensive income is thus the ultimate formulation of the all-inclusive income concept. See Chapter 11 for how this was worked out in SFAS No. 130. Q-7 Is neutrality consistent with the external user primary orientation of SFAC No. 1 and the pervasive constraint (benefits > costs) of SFAC No. 8? Rather than being inconsistent, the problem lies more in the nature of maintaining a delicate balancing act. User primacy and the benefits > cost constraint both involve economic consequences as well as providing information that is useful for decision making. Neutrality means attempting to provide the most meaningful information for external users given the pervasive constraint. Theoretically speaking, additional aspects of economic consequences should be ignored (in reality, of course, they are not). A simple example may help to demonstrate this point. Assume the FASB has decided that a current value system is beneficial for external users and that benefits > costs. Two choices are being examined: replacement cost and exit value (see Chapters 1 and 13). Security prices of some firms might benefit from replacement cost and others from exit values. For example, firms having highly specialized and immobile equipment would be subject to serious declines in market values if exit prices are chosen rather than replacement costs. In turn, securities prices of these firms could be adversely affected, so these firms would favor replacement costs. Firms not having this problem would appear relatively better under exit values. The FASB’s main task is with the comparative usefulness to external users and the cost of preparation, and not the distributive effects discussed above. Q-8 SFAC No. 6 is largely a repetition of SFAC No. 3. Discuss two possible reasons why this repetition occurred. One reason is that the failure of SFAC No. 5 created a desire to end on a happy note. One way to accomplish this was to repeat a prior success, which is exactly what occurred since the definitions of SFAC No. 3 were a marked improvement over those of APB Statement 4. The second view is that of Paul Miller (1990), who saw SFAC No. 6 as an attempt to reassert the primacy of SFAC Nos. 1-3, hence the maintenance of progress of those parts of the framework rather than giving in to the “counter-reformation” of SFAC No. 5. While these views are not dissimilar, the latter sees more of a progressive utopian spirit present at the FASB, while the former is more in the spirit of resignation. Q-9 Very carefully explain why conflicts can exist between prediction of cash flows and accountability. Can these conflicts be resolved? Pensions provide a classic example of this problem. In order to determine pension expense, future salaries must be estimated. While current management would estimate these, the future salaries themselves are entirely executory. These future salaries, which would be higher than present salaries, would be due to improvements in skills and promotions as well as inflation. However, current management does not receive these benefits even though it is “responsible” for them in the accountability sense. Hence, the use of accounting numbers for prediction of cash flow and accountability purposes leads to a conflict in this situation. Q-10 How does feedback value relate to predictive ability and accountability? Feedback relates to comparing actual results against expectations. Even if the numbers involved do not attempt to specifically predict future cash flows (see question 10 above), the numbers should be useful, in a general sense, for prediction. Thus, if a firm has a target market share of 20 percent and it attains 23 percent, current management may appear to be doing a good job and future prospects may thus look good. Feedback value, therefore, is primarily geared toward accountability, although it can have secondary implications for predictive purposes. Q-11 Is there a similarity between the codificational approach (Gaa) to standard setting and the jurisprudential approach? There is a similarity, but there are also differences. Both viewpoints are evolutionary but the codificational approach is grounded more in terms of developing a rational process for arriving at a conceptual framework and the resulting standards. This process will involve arriving at a consensus among the affected parties. The jurisprudential view would attempt to attain legitimacy through a stronger “logical” process than would codification: the use of cost-benefit analysis or, where possible, deductive and/or inductive analysis for determining accounting standards, thus giving them a quasi-legal status. Conceptual frameworks can be used with both approaches. Q-12 Verifiability is part of reliability in SFAC No. 2, but is now an enhancing qualitative characteristic in SFAC No. 8. What effect does this reclassification have on the importance of verifiability in the framework? Verifiability involves the statistical concept of the degree of consensus among measurers, whereas objectivity is concerned with the quality of evidence underlying accounting events. The new hierarchy has raised the importance of verifiability in it. Q-13 Conservatism is discussed in paragraphs 91–97 of SFAC No. 2. Why is its role in SFAC No. 2 rather ambiguous? Why is conservatism absent from SFAC No. 8? Conservatism is banished from the qualitative characteristics but appears outside of this framework as a “convention.” Conservatism can easily be in conflict with important characteristics such as representational faithfulness if, for example, cost is below market. If it has a role, it may be in the area of “quality of earnings”: for instance, recognizing a revenue or expense if the measurement technique indicates that there is at least a 90 percent probability that we are close to a mean, median, or modal value, but not if there is only a 50 percent probability. This issue has received little attention in accounting. BC3.27 Chapter 3 does not include prudence or conservatism as an aspect of faithful representation because including either would be inconsistent with neutrality. Some respondents to the Discussion Paper and Exposure Draft disagreed with that view. They said that the framework should include conservatism, prudence, or both. They said that bias should not always be assumed to be undesirable, especially in circumstances when bias, in their view, produces information that is more relevant to some users. From SFAC No. 8. Q-14 A study (discussed in the chapter) found a heavier emphasis placed on relevance rather than reliability in disclosure standards by the FASB. Why do you think this is the case? A heavier emphasis placed on relevance would most likely be the case because being outside the body of the financial statements would lead to “lowering the bar” on reliability (or faithful representation) which would increase the importance of relevance. Q-15 Samuelson would use a property rights definition of assets (discussed in the chapter). Do you think that SFAS No. 2 requiring immediate expensing of research and development costs is an example of Samuelson’s property rights approach? Discuss. While Samuelson’s view on assets is grounded in property rights, SFAS No. 2 is grounded in verifiability issues rather than property rights. Property rights would indeed attach to research and development though it may be hard to measure. Therefore, we do not believe that SFAS No. 2 would be an example of Samuelson’s approach. Q-16 Would changing the asset definition in the conceptual framework to one concerned with property rights have any other ramifications? Discuss. In our opinion, Samuelson’s definition may lead to an exit value orientation for assets because it is wealth oriented rather than being concerned with revenue generation. Q-17 Is capital maintenance oriented toward proprietary theory or entity theory? Capital maintenance is geared to both but it might be measured differently. Under proprietary theory, capital maintenance might be geared to a broader definition of wealth for the owners of the firm. Hence capital maintenance might be utilized using a general price level adjusted measurement of income. On the other hand, from the firm’s standpoint, if the firm is interested in replacing its presently owned assets with similar assets, replacement cost (entry value of assets) might be used for income measurement. Purchasing power gains or losses (Chapters 1 and 13) might likewise be measured in general purchasing power terms for proprietary theory purposes but might be measured in terms of the change in purchasing power of capital assets owned by the firm for entity theory purposes. These are by no means the only possibilities but the point should be made that capital maintenance applies to both entity and proprietary theory. It all depends on what you are trying to maintain in measuring income. Q-18 Do you see any inconsistency in SFAC No. 1, which sees financial statements as general purpose but geared primarily toward investors and creditors? Yes, there is an inconsistency. Using a broader user base might have led to primacy of accountability over cash flow prediction, for example. Q-19 Do you see any inconsistency between the present value of assets and liabilities in SFAC No. 7 since the latter is based on a firm-specific discount rate and the former does not use a firm-specific rate? Discuss. No, there is no inconsistency here. Assets have a value independent of the firm. Liability valuation cannot be divorced from the firm because the firm’s specific credit standing affects the value of the liability. Q-20 Stewardship is absent from SFAC No. 8; why? BC1.28 The Board decided not to use the term stewardship in this chapter because there would be difficulties in translating it into other languages. Instead, the Board described what stewardship encapsulates. Accordingly, the objective of financial reporting acknowledges that users make resource allocation decisions as well as decisions as to whether management has made efficient and effective use of the resources provided. From SFAC No. 8. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Discuss as many of the potential trade-offs among the qualities mentioned in SFAC No. 8 as you can and give either a general or a concrete example of each one. The first trade-off concerns the possibility of different information needs of different user groups. The benefits versus costs issue likewise involves a trade-off. There are several trade-off possibilities in the area of relevance versus faithful representation. Review the hierarchy and have students discuss each one in small groups. 2. Analyze three accounting standards promulgated by the FASB and show how economic consequences (rather than representational faithfulness) influenced the shaping of the standard (your professor may suggest particular standards for this case). SFAS No. 15, on troubled debt restructuring (now superseded by SFAS No. 114), is a classic example of economic consequences prevailing over representational faithfulness. In cases of restructuring, no loss is recognized as long as the undiscounted amount of the restructured debt exceeds the present value of the existing debt. The use of the undiscounted amount, particularly when being compared to a discounted amount, is virtually unprecedented in accounting (deferred tax assets and liabilities are also undiscounted, but the context is entirely different). The restructuring can thus be easily set up without the need to recognize a loss, which clearly appears to have happened. SFAS No. 13, on leases, while an improvement over APB Opinion Nos. 5 and 7, allows leases to be structured in a fashion in which bringing the debt on the balance sheet can be avoided. Obviously, title should not pass to the lessee, nor should bargain purchase options be present. That leaves the 75 percent test and the 90 percent test. The 75 percent test is the easier to get around. If an asset has a 20-year life, it should be leased for no more than 14 years, or estimated life should be “refigured” to come out a bit higher. In the case of the 90 percent rule, having an outside party guarantee the residual value gives the lessor and lessee the means to design the lease so that the present value of minimum lease payments, excluding the guaranteed residual, will be less than 90 percent of the fair market value of the property being leased. In SFAS No. 87, the projected benefit obligation approach is used for the purpose of determining service cost (and pension expense). However, for the purpose of determining the minimum liability, the board somewhat inexplicably reverts to the accumulated benefit obligation which, of course, would result in a lower minimum liability. Daley and Tranter (1990) have an excellent discussion of the economic consequences issue. They also illustrate economic consequence aspects of SFAS No. 12 on marketable securities. The single best example of the economic consequences issues arises in APB Opinion Nos. 2 and 4 on the investment tax credit (also discussed by Daley and Tranter). 3. One of the principal problems of SFAC No. 2 and 8 is whether representational faithfulness should predominate over economic consequences or the reverse relative to drafting accounting standards. State the case as carefully as you can for each of the two possibilities. This is an interesting and challenging writing assignment concerning the articles discussed in the chapter in the section on neutrality versus representational faithfulness. If the position is taken that representational faithfulness does not exist (Daley and Tranter), then economic consequences is preeminent and a standard-setting agency is simply mediating among competing groups in a political fashion. This position is, we believe, overstated. An interesting possibility might be to go with representational faithfulness where it can be measured with a high degree of verifiability. Where representational faithfulness cannot be instituted with a high degree of verifiability, then a system such as rigid uniformity (Chapter 9) might be instituted. A conceptual framework would still be necessary to identify users—investors and creditors versus an accountability orientation (Chapter 6), for example. This particular writing assignment underlies many of our problems in the standard-setting arena. 4. Part 1. Tucker Company has an asset in the form of a cash flow that it expects to collect in three years. However, the amount of the cash flow is not certain. These are the probabilities underlying the cash flow. Amount Probability $3,000 .30 $4,000 .30 $5,200 .40 The discount rate is 10%. Required: a. How should the asset be valued according to SFAC No. 7? b. What other valuation is possible? c. Which valuation do you prefer? Part 2. Donahoe Company has a liability of $10,000 which is due in three years. The discount rate applicable to the firm is 10%. Assume that the firm’s credit standing is adversely affected by an untoward economic event. As a result, the discount rate applicable to the firm goes up to 12%. Required: a. How does the value of the liability change? b. If the firm’s financial condition worsens, does it make sense for the value of the liabilities to decline? Explain. Part 1: a. $3,000 x.7513 x .3 = $ 676 4,000 x .7513 x .3 = 902 5,200 x .7513 x .4 = 1,563 $3,141 This is, perhaps, the best valuation: expected value. b. $5,200 x .7513 = $3,907 This is the modal value We prefer the expected value because it weights a wider number of possibilities so it seems more representative. Part 2: It goes from $7,513 ($10,000 x .7513) to $7118 ($10,000 x. .7118). Yes, because the worsening financial condition would lower the value of the liability to outsiders. 5. In examining recognition and measurement, Sterling believes that measurement should precede recognition whereas Archer believes that it is “logical” for recognition to precede measurement. What is your position? This is a “which came first,” the chicken or the egg, question. Do you recognize an economic activity and then measure it or do you measure an activity and then recognize it when measured results appear? We believe that ideally, the measurement processes would have been well thought out before the activity occurs, triggering the monetary recognition of the economic activity when some measured activity occurs. However, when creative people produce activities that have never been measured, does it make sense to not recognize the activity? By requiring that measurements be in place before recognition, innovative practices may be delayed or suppressed. You may want to discuss this in class. Does it matter? Should it matter? CRITICAL THINKING AND ANALYSIS 1. Murphy, et al (2013) argue “living law” applies to conceptual frameworks. How does this perspective affect current frameworks? Murphy, Tim, Vincent O’Connell, and Ciarán Ó hÓgartaigh (January 2013). “Discourses surrounding the evolution of the IASB/FASB Conceptual Framework: What they reveal about the ‘living law’ of accounting,” Accounting, Organizations, and Society, 72-91. The authors argue age-old stewardship (accountability) should not have been dropped from the IASB-FASB’s financial reporting objective of the joint project revising the respective Conceptual Frameworks. They also disagree with the limiting of users of financial reporting to only investors and creditors. They make these arguments by applying “living law” to accounting: “the moral or customary tradition of a particular community.” The authors argue that the focus on ‘‘decision-usefulness,’’ from an investor/creditor perspective, result in a usually artificial and inferior imitation of a “genuine story being told about an entity.” Assuming their views are correct, perhaps the Conceptual Framework might be tweaked to address their concerns. At a minimum, the morality of accounting’s obligations (even though they are not in the written law, Conceptual Framework) needs to be communicated to current and future accountants. 2. In SFAC No. 8, the objectives of financial reporting clearly take an entity perspective rather than a proprietary one. If the FASB had taken the proprietary perspective, what effect, if any, does it have on the resultant conceptual framework? We argue that the resultant framework would not differ significantly. Those qualitative characteristics of accounting should be universal. 3. Bradbury and Harrison (2015) study dissenting opinions in Financial Accounting Standards Board (FASB) standards. What changes, if any, do these opinions suggest need to be made in the conceptual framework? Bradbury, Michael E. and Julie A. Harrison (June 2015). “The FASB’s Dissenting Opinions,” Accounting Horizons, 363-375 This paper uses content analysis from qualitative research that is infrequently used by accounting researchers. By grouping specific text, themes can then be counted (building quantitative numbers that can then be summarized by frequency or percentages). Typically, this approach to research requires considerably more time/hours to complete than the statistical models based on samples. This research examined all dissenting opinions in Financial Accounting Standards over the period 1973 to 2009. They developed themes (note this is the qualitative part of the research) relating to conceptual, logic, scope, outcome, and due process arguments. Conceptual arguments were found to be the most frequent arguments used in dissenting opinions. This is an important point to make. The article does not lead to changes in the conceptual framework, but it does suggest that dissenting opinions should use more of the wording from the qualitative characteristics in their arguments. Many of the dissenting opinions used wording that was the in the spirit of a qualitative characteristic, but it was inferred, not stated. We suggest you have your students select a new Accounting Standard Update (ASU) and review the dissenting opinions. Leases would be an excellent place to start. Go to FASB’s website. Chapter 8: Usefulness of Accounting Information Chapter Highlights Chapter 8 is concerned with the usefulness of external accounting reports for decision making. The FASB emphasizes decision usefulness in both the conceptual framework project and in policy deliberations for specific standards. Therefore, it is possible to judge (to some extent) the benefits of external accounting reports by evaluating their usefulness to investors/creditors, the FASB’s primary user group. There are two distinct ways in which the research should be considered. First, it provides a basis for evaluating the present usefulness of accounting. Second, the research methods themselves represent techniques and approaches that may be applied in an ongoing way to assess the usefulness of future or alternative accounting policies. In other words, “economic consequences” of accounting regulation can be investigated through the research approaches discussed in the chapter. Clean surplus theory is a new valuation approach which may help researchers in assessing the relationship between firm valuation and accounting information. “Benefits” are the focus of the chapter. Questions of costs and the apportionment of costs are equally important. Some of the recent capital market research has focused on questions of how accounting policies affect owner wealth. These studies are often cast in terms of agency theory, and consider the “costs” of accounting policy changes in terms of their wealth impact on owners. However, the evidence on economic consequences is largely one-sided, focusing on benefits (e.g., information content) rather than costs. This point should be emphasized and related back to the question of determining optimal regulation (raised in Chapter 4). All of the research is empirical except information “economics,” which is included because decision theory illustrates how information has value in an uncertain decision setting. Capital market research dominates the empirical literature, which is reviewed. This is appropriate given its influence over the past 40 years. Other research is important, though it suffers from some methodological problems such as reliability (surveys) and lack of generality (experimental research). Another area of research mentioned in the text is the bond rating and bond risk premium literature (creditors). This research has considered the effects of accounting numbers and ratios on creditor lending decisions. It too supports the usefulness of accounting information for decision making. The role of the auditor in terms of providing assurance to users is also briefly discussed. One point that is becoming clear is limitations on the efficient markets hypothesis. This point arises in relation to post-earnings – announcement drift which has been determined from empirical research and the incomplete revelation hypothesis which is a deductive hypothesis. Combining these with empirical studies by Ou and Penman also showing that the market is not as efficient as we might believe and Lev’s study showing low correlation between earnings numbers and stock returns and the door is certainly open for putting time and effort into improving accounting standards. Questions Q-1 How is accounting data useful to investors? To creditors? The financial economics valuation models reviewed in the chapter suggest that accounting reports are useful in assessing a firm’s future cash flows. This is consistent with SFAC No. 1, which views the role of accounting reports as aiding in assessing the amounts, timing, and uncertainty of prospective cash flows. Beaver’s work, while similar in spirit, sees the linkage as less direct—current earnings predict future earnings, which in turn determine dividend-paying ability. The difference is that the former view sees a firm’s value as a function of future cash flows, and the latter sees it as a function of future expected dividends. Theory is less well developed with respect to the valuation of debt and the role of accounting information. The work reviewed in the chapter indicates that debt interest rates reflect a risk premium for the possibility of default. Therefore, the usefulness of accounting lies in aiding creditors to assess the likelihood of default. In very broad terms, this concern leads to an interest in future cash flows, viz., debt-servicing ability and the ability to repay or refund the principal amount of the debt. Hence, information to investors and creditors is complementary. Finally, both would be interested in accountability aspects of financial statements. Q-2 In what ways do you think information useful for investors (in assessing future cash flows) differs from that useful for creditors (in assessing default risk)? In general, investors and creditors are interested in the amounts, timing, and uncertainties of a firm's expected future cash flows. Cash payments to equity holders are theoretically unlimited, and the focus is typically on the upside potential of the expected future cash flows. In contrast, the cash payment for debt securities is fixed by contract. Hence, the usefulness of accounting information for creditors lies in its ability to predict the failure of a borrower to make timely payment of interest and principal. Furthermore, the likelihood of default affects the default risk premium, which in turn affects the rate the borrower is charged. Finally, we note that interest bearing debt securities trade infrequently. As a result, theories underlying the usefulness of accounting information to creditors are not as well developed as they are for equity securities. Q-3 Besides the primary investor-creditor group, what other user groups could claim to be stakeholders in the firm? How might their information needs be the same as the the primary investor-creditor group? How might their information needs differ? Any individual or entity whose income or payments are affected by a firm's financial wellbeing has stake in the firm. This would include taxing authorities, utility ratepayers, suppliers of materials and services, and even current or potential employees. To varying degrees, all of these stakeholders have an interest in forecasting the expected future cash flows, and in assessing the firm's financial wellbeing. Their respective information needs depend on the nature of the explicit or implicit contract. For example, income taxing authorities have a lot in common with shareholders; their receipts are more directly related to the firm's performance. In contrast, employees or utility rate payers, at least in the short-term, have contracts that provide for fixed receipts or rate payments. As such, the needs of these individuals might more closely be related to creditors. Q-4 Who are creditors? Creditors are mainly considered suppliers of materials, services, or capital. They need financial information about their customers to determine the terms of credit. Q-5 Why do we sometimes say that the dividend discount model is actually an earnings model? How does Lintner’s findings relate dividends and earnings? The dividend discount model is a mathematical model that expresses the value of a stock as the present value of the expected future dividends. Since dividends are considered to be paid from earnings, the dividend discount model can be rearranged to express the value of a stock in terms of the expected future earnings per share and the dividend payout ratio. Lintner interviewed a number of managers regarding how the managers make a decision regarding the payment of a cash dividend. Managers indicated that major changes in "permanent" earnings were the most important determinants of the companies' dividend decisions. Managers adjusted dividends to reflect expected changes in "permanent" earnings. Given the seriousness and forward-looking nature of the dividend policy decision, investors regard cash dividends as credible signals of future performance. A change in the cash dividend has information content. Q-6 What is residual income? Abnormal earnings? Economic profit? EVA? Residual income is a general term for income in excess of a charge for the capital employed to generate that income. The concept may be applied to the enterprise as a whole or to the firm’s common equity. When applied to the enterprise’s operating income and invested capital, residual income is often called economic profit or Economic Value Added (EVA®). When applied to the firm’s net income and common equity, residual income is often called residual income or abnormal earnings. Q-7 How does EVA differ from economic profit? Economic Value Added (EVA) is a proprietary form of economic profit developed by Stern Stewart & Co. EVA begins with residual income [economic profit] and makes a series of additional adjustments to GAAP accounting that are intended to produce a "better" estimate of economic profit. Q-8 What are some advantages and disadvantages of using residual income (including economic profit and EVA) for performance measurement? On the positive side, residual income can be used as a company and intra-company performance measurement tool. It recognizes that capital has a cost. Making capital an explicit part of the model raises the awareness of using excess capital to generate income; capital has a cost. In addition, residual income has been shown to have more explanatory power than reported earnings or cash flow from operations. It can also be used for valuation purposes. On the negative side, for any given year, the determination of the residual income itself is dependent on an accurate estimate of the cost of capital. And for valuation purposes, forecasts are crucial. All forms of residual income are consistent with discounted net cash flows for any book value and any method of depreciation. Lengthening the depreciable life for fixed assets decreases the per-period depreciation expense, increases NOPAT, and increases the residual income. In some cases, it may not be possible to determine whether the residual income calculated is actually due to management’s efforts or lack thereof. Residual income is an accounting measure and can be manipulated for any one period. Furthermore, if improperly applied, residual income could bias management against long-term investments. Unlike the stock price, which is forward looking, residual income focuses on historical performance. Finally, it is not clear that residual income leads to improved stock performance Q-9 Comment on the following statement. “The residual income model is no different from the dividend discount model. Therefore, it has no value to investors and analysts.” The residual income model is consistent with the dividend discount model. However, this does not mean that it has no value. As indicated above, it can be used as a performance measurement tool. Unlike net income, residual income recognizes that capital has a cost. Furthermore, residual income has been shown to have more explanatory power than reported earnings or cash flow from operations. Finally, Dechow, Hutton and Sloan have shown that the residual income model allows the user to incorporate non-accounting information into the model to improve its accuracy. Q-10 Comment on the following. “Maximizing residual income is the same as maximizing earnings. Managers should be rewarded for maximizing either one.” Managers can increase earnings by increasing the amount of capital employed. On average, investing in more assets translates to increased earnings. The problem is that there is no guarantee that the additional capital employed is earning its cost of capital. If not, deploying additional capital is destroying shareholder wealth, similar to investing another $1.00 to gain an additional $0.80 of intrinsic value. In contrast, residual income explicitly recognizes that capital has a cost. Managers can only increase value if they increase income above and beyond that which is required for the amount of capital employed. Managers should not be rewarded for maximizing earnings if the capital employed is not earning its cost of capital. Q-11 Why do managers of Berkshire Hathaway have an incentive to send cash to Omaha? Managers at Berkshire Hathaway are charged a high rate for the incremental capital that they employ. If they can generate income in excess of that capital charge, they create value and are rewarded. If not, they destroy value, and are penalized accordingly. Implicitly, this is an application of residual income model. If managers are not able to use the incremental capital to create value, they have a strong incentive to lower their invested capital and capital charge by sending the cash to Omaha (Warran Buffett). This lowers or eliminates any penalty. Cash that cannot be profitably invested is given to Warren Buffett who distributes it to the individuals who are best able to invest it. Q-12 Should firm’s capitalize research and development expenditures? Why or why not? Research and development expenditures are cash outflows. If they are expected to generate future income, one can make an argument that these expenditures are really investments, which should be capitalized. This is exactly what is done when firms use EVA. The problem is that there is less certainty about future income from R&D than there typically is with investments in other tangible assets. In the worst case, one can easily envision a case in which a firm capitalizes worthless R&D in order to lower operating expenses and increase reported income. Q-13 What is clean surplus accounting? What is its role in linking dividends and abnormal earnings? Clean surplus accounting is a term indicating that all profit and loss elements go through income. It relates the current book equity to previous book equity, earnings, and dividends. In the presence of clean surplus accounting, the residual income model is equivalent to the dividend discount model. Q-14 What is the efficient-markets hypothesis? In its simplest form, the efficient-markets hypothesis states that information is quickly “impounded” in security prices. Market efficiency refers to informational efficiency, not to social efficiency (in a Pareto sense). Q-15 Why does the concept of market efficiency (with respect to information) have no necessary relation to the quality of accounting information? Why is this distinction important with respect to accounting policy making? Market efficiency refers only to the speed with which new information is incorporated into security prices. It says nothing about the quality of the underlying information. Although, in the extreme case, if the “information” were purely noise, one would not expect to Q-16 Why is the efficient-market hypothesis being challenged? Numerous market anomalies have been reported. The Ou and Penman study, among others, raises the question of whether all publicly available information is really impounded in security prices. Also, post-earnings-announcement drift raises the question of why it takes up to 60 days for earnings announcements to be impounded in security prices. This may be due to transaction costs being too high for investors to take advantage of new information or possibly to underreaction to new information by security analysts. Q-17 What is meant by “information content” and how does capital market research determine the information content of accounting numbers? Information content is a term referring to abnormal security returns in response to the release of new, publicly available information. The research method is described in the chapter. There are two distinct problems with this research. The first relates to the implicit dual testing for both market efficiency (the efficient-market hypothesis) and information content (given an assumption of market efficiency). The second relates to the difficulties in applying asset pricing models, or even knowing if the asset model used is correct. Q-18 What is the advantage of being well diversified? Is there a downside? Why or why not? There are two types of risk. The risk associated with an individual firm or entity is called unsystematic (diversifiable, unique) risk. This risk can be eliminated with diversification. The remaining portfolio risk is called systematic (undiversifiable, market) risk. Systematic risk is also known as the relevant risk as this risk must be borne by the investor. Diversification does reduce the investor's risk. However the more securities or assets that are added to an investor's portfolio, the less the investor is able to meaningfully analyze each security. In the extreme case, a "fully diversified" investor may know or care very little about the securities he or she holds. Q-19 If investors are well diversified (e.g., own several hundred stocks), will they have a greater or lesser need for accounting information? What does this say about diversification? As indicated above, an investor who holds many securities does not have the time or resources to meaningfully analyze them. In this case, the investor is not able to effectively use the accounting information that is available. Hence, in effect, excessive diversification can lead an investor to be ignorant of his or her individual investments. Q-20 What are some limitations of capital market research? The study of price movements and the pricing mechanism in any market is an imposing task. Determining cause and effect between information and security prices is especially difficult because new information is continuously arriving. Since the set of information affecting security prices is large, it is difficult to isolate the effects of one piece of information. Furthermore, we are examining only a relatively small group of investors, those at the margin who influence stock prices. This difficulty means that the tests are going to be somewhat crude rather than precise. Failure to find evidence of information content should be interpreted cautiously, for the methodology may is not always capable of detecting information content. For this reason, the stronger evidence from efficient-markets research exists when there is information content rather than where there is none. Another weakness of capital market research is that it is a joint test of both market efficiency and the model used to estimate the abnormal returns. The absence of price responses is usually interpreted to mean that the information tested has no information content. This interpretation is correct only if the market is efficient and if the model used is correct. Finally market-based research considers only the aggregate effect of individual investor decision making. That is, the role of accounting information vis-à-vis an individual investor’s decision making is implicitly modeled as a black box; an “event,” occurs and the effect of this event is then inferred from whether or not there was an aggregate (market) reaction. Q-21 What is an event study? An event study is an empirical research method used in accounting and finance studies to detect the market’s reaction to some event that should have an impact on the stock price. Q-22 What are abnormal returns (AR) and cumulative abnormal returns (CARs)? What do they have to do with research in accounting? What do they have to do with accounting standards? An event study divides the period related to the event into three “windows:” an estimation window, the event window, and the post-event window. The “normal” relationship between a security’s returns and those of the market is estimated during the estimation window. This allows the researcher to estimate the parameters for the linear regression equation. After the parameters have been estimated, the regression equation is used to estimate the returns at the time of and subsequent to the event. The difference between the actual return and the return expected using the regression equation is called an abnormal return (AR). The sum of the ARs is known as the cumulative abnormal returns (CAR). In the absence of an event, the ARs should randomly fluctuate around zero and the CARs should show no upward or downward trend. If an unexpected event has occurred, the AR and the CAR should depart significantly from zero on the date of the event. However, if the market fully and immediately reflects the new information in the stock price, the subsequent ARs should again randomly fluctuate around zero, and the CARs should show no trend. Event studies are a tool to allow researchers to examine the relationship between the security prices and the information contained in the firm’s financial statements and associated documentation. This body of research is important to standard setters. The ability of markets to efficiently allocate resources (allocational efficiency) is crucially dependant on accounting information for analysis, valuation, and performance measurement. Investors need to know if the analysis of accounting data is a value-enhancing activity. Furthermore, standard setters need to know if the existing standards are fulfilling their intended purpose to improve the informational and allocational efficiency of markets. If not, it might be time for a new standard. Q-23 Explain Lee’s (2001) view of market efficiency. The null hypothesis for much of the capital markets research in accounting has been that the market fully and instantaneously adjusts to new information; the market price is equal to the security’s intrinsic value. This instantaneous response of the market is an extreme view. Lee offers an intriguing alternative in which the price convergence toward intrinsic value value is characterized as a process, which requires time and effort, and is only achieved at substantial cost to society. Q-24 Lee (2001) rejects the “naive view” of market efficiency. Explain. If Lee is correct, what are the implications for capital markets research in accounting? Lee suggests that we have been asking the wrong questions. Instead of focusing on or assuming that the market responds instantaneously to new information, he suggests that we consider fundamental value and market prices as two distinct measures. Furthermore, instead of assuming or testing market efficiency, researchers should be studying why, when, and how prices converge to intrinsic value, and how current market prices might be improved. Q-25 For event studies, the post event window is typically short (days or months). What are some issues associated with examining longer event windows (e.g., years)? For all practical purposes, event tests assume that aside from the event tested, all other things remain the same (ceteris paribus). However, the longer the post-event window, the lower the likelihood that ceteris paribus does not hold. If it does not, it becomes more difficult to draw meaningful conclusions from the data. Q-26 What do we mean when we say that capital market research involves a joint test of both market efficiency and the model used to estimate abnormal returns? In order to test the markets response to new information, the researcher must have a model of expected security returns. If the market does not appear to be efficient with respect to a piece of information, several possibilities may exist. The market might not be efficient with respect to the information analyzed. However, it is also possible that the model used to generate the expected returns might be flawed, providing for a flawed test. Unfortunately, it is impossible to separate the two. Q-27 Describe the general findings from capital market research concerning the information content of accounting numbers and the effects of alternative accounting policies. Accounting income numbers have evidenced information content in a wide variety of tests. It must be emphasized, though, that stock prices are probably affected as much or more by nonaccounting data. The research on alternative policies is ambiguous. Recent studies have used agency theory arguments to evaluate differences that, on the surface, appear to have noncash implications. However, indirect consequences on owner wealth are offered to explain the stock price responses. Q-28 Why is the choice between the FIFO-LIFO inventory methods an interesting issue in capital market research? The early capital market studies were motivated by tests of whether or not investors were “fooled” by bookkeeping differences that had no direct cash flow effects on firms. This is an important issue with respect to how sophisticated we assume users are—it will also affect the style and substance of accounting reports. For example, the FASB presumes that users are sophisticated. For the most part, the research rejects the naive investor hypothesis, though there are troubling anomalies such as the FIFO-LIFO research, which tends to support the notion that investors react naively to reported earnings without considering how those numbers have been constructed in terms of alternative (arbitrary) accounting policies. Q-29 As an investor, how would you react to a company changing is inventory accounting from FIFO to LIFO? Why? It would depend on the level of analysis. Change inventory accounting from FIFO to LIFO would ordinarily result in higher cost of goods sold and lower accounting income. However, because the same inventory accounting method must be used for both financial reporting and income tax purposes, taxable income will be lower as well. If the firm pays income taxes, the firm's income tax bill should decline, and after-tax cash flow should rise. This would be good for shareholders. Q-30 Over the years, the research findings regarding changing from FIFO to LIFO have varied? Why do you suppose this is the case? This issue, along with oil and gas accounting continues to produce some of the most anomalous results in capital market research. As with the oil and gas issue, the technical aspects of the research designs have varied across studies, as have the results. The research in this area highlights the problem of using capital market studies to study subtle issues of accounting policy choice (as opposed to more general questions such as the information content of reported earnings). Q-31 Why may accounting policies with no direct cash flow consequences indirectly affect investors or creditors? The argument derives from the agency or contracting theory. Existing contracts can be affectedby changes in accounting methods that affect accounting numbers used in the contracts. Typical uses of accounting numbers for contracting are in the areas dealing with restricting dividends, restricting new debt issues, and providing incentive compensation contracts with managers. Q-32 Why is it argued that capital market research cannot determine the optimality of accounting policies even for the limited investor-creditor group? Because of externalities associated with financial reporting (free-riders), a market mechanism does not operate to determine the optimal production of information. Q-33 How do market-level and individual decision-maker analyses complement one another in studying the usefulness of accounting information to investors and creditors? Market-level studies (i.e., capital market research) treat the individual decision maker as a “black box,” whereas the decision-maker studies focus explicitly on how decision makers respond to specific information cues in simulated laboratory decision making. Q-34 Lev talks about the low correlation between earnings and stock returns. Ou and Penman paper discuss the possibility of making abnormal returns based upon published financial data. Are these papers in conflict with each other or complementary to each other? The papers complement each other. Since Ou and Penman see a predictive role for accounting in a market that may not be efficient, then Lev’s call for improved accounting measures certainly makes sense. Furthermore, even if the market were highly efficient, Lev’s call for improved accounting standards can be interpreted as being concerned with the quality of the signal picked up by the market, which should result in the market providing a more meaningful equating of risk and return for individual securities. Wyatt (1983) essentially makes this point. Q-35 What is post-earnings announcement drift (PEAD)? If markets are efficient, security prices respond instantly and fully to new, relevant information. Post-earnings-announcement drift refers to situations in which it takes a much longer period of time for the market to adjust to unexpected earnings announcements. In some cases, it takes up to 60 days for the full effect of unexpected earnings announcements to be impounded in security prices. Q-36 Why does post-earnings-announcement drift challenge the efficient-markets hypothesis? Post-earnings-announcement drift is a contradiction of the efficient-markets hypothesis. The problem lies with the slow length of time it takes for new information to be impounded in security prices. Q-37 Why does post-earnings announcement drift appear to be more pronounced with smaller firms? What could be done from a company perspective to rectify this situation? What could be done from a standard setting perspective to mitigate the effects of PEAD? Post-earnings-announcement drift appears to be more pronounced for smaller firms. There is evidence that financial analysts underreact to very fundamental signals stemming from securities, which in turn, lead to forecast errors and incomplete security price adjustments. There is also evidence that shareholders do not distinguish well between cash flow portions of earnings and the accrual segment thereof. Another possibility is that in some cases, transaction costs are too high relative to the potential gain that can be earned from the mispricing of the securities. Finally, post-earnings-announcement drift appears to be inversely related to the number of experience analysts following the stock. With smaller firms, there are fewer analysts following the stock. Indeed, some small firms have no analysts following them. Smaller firms might be able to mitigate the problem by providing more disclosure and discussion of cash flows and other analyses normally provided by analysts. Accounting standards that improve the quality of financial reporting might eliminate some or all of the post-earnings-announcement drift, providing for better valuation of securities and ultimately, better allocation of resources in the economy. Q-38 What is the incomplete revelation hypothesis? The incomplete revelation hypothesis is a hypothesis that may help to show why markets are less efficient than we have previously believed. One reason is that it may be more difficult to determine the effect of some numbers, particularly if they are buried in footnotes. Hence, stock option disclosures in the footnotes (SFAS No. 123) may be more difficult to assess than if they were in the body of the income statement. Also, the presence of noise traders may impact upon market efficiency. These individuals have their own purposes which may not bear directly upon assessing risk and return. For example they may simply be rebalancing their portfolios, attempting to attain more liquidity or simply be acting upon whims or irrational tips. Q-39 Suppose an accounting event occurs and there is no market reaction. What should we conclude? It is sometimes hard to say. It could be that information was made available earlier via nonaccounting means. An example might be industry information revealed by a competitor. It is also possible that another piece of news has the exact opposite effect as the accounting event. For example, a firm may have a very positive earnings announcement on the same day that the Federal Reserve announces that it will increase interest rates. Q-40 Give some examples in which accounting information is not the most timely source of information affecting security prices. There are many examples. In this space we offer only a few. A competitor might announce that the industry is in a slump. This is apt to affect all firms in the industry. A supplier might announce that its employees are on strike. This could jeopardize future inputs to a firm. Commodity prices might increase or decrease for a variety of reasons, and have an immediate affect on transportation companies. Q-41 Instead of employing capital markets research techniques (e.g., event studies) why don’t we just ask investors how they would react to a hypothetical event? Why don’t we ask managers why they make specific accounting changes? This is an age-old question. Will the investors and managers provide a truthful answer? If they provide a truthful answer, will they provide an objective answer? Will their hypothetical answer be the same as their actual reaction? Finally, it is difficult to survey enough investors and managers in a timely fashion. In financial markets, we see the effects of decisions in real time. Q-42 Why is it important to improve the quality of accounting standards? Accounting information is useful in making valuation and compensation decisions. These decisions affect securities pricing and ultimately, the efficient allocation of capital in the economy (allocational efficiency). Directly or indirectly, everyone has a vested interest in the correct understanding of the financial wellbeing of firms. Since accounting standards have a substantial affect on the type and quality of accounting information provided, we would argue that accounting standards have an affect on the efficient allocation of capital in the economy. With better standards, we would expect improved allocational efficiency. Q-43 What do pensions have to do with a company’s operating performance? What do pensions have to do with the firm’s financing and investment decisions? Operating performance and the ability to generate cash eventually affects the firm's financing and investment decisions. Poor operating performance might lead to increased financing needs or to a reduction in investment expenditures. The converse is true for good operating performance. It is possible that poor operating performance and sub-optimal investment decisions leads to pension underfunding. On the other hand, it is also possible that poor management of the pension fund in the form of severe underfunding or poor investment decisions, eventually leads to poor operating performance and sub-optimal investment decisions. It appears that investors frequently do not fully recognize that the severe underfunding hasnegative valuation effects. Why this happens is yet to be resolved. Even when investors recognize the severe underfunding, it is possible that they may not adequately factor in the implications of that underfunding, such as difficulty in refinancing at favorable terms or or the inability to refinance at all. Q-44 There is evidence that investors do not fully recognize the valuation effects of severe pension underfunding. (See for example Franzoni, Francesco and José M. Marín (2006). Why do you suppose this is the case? What changes could be made to mitigate this problem? Franzoni and Marín present evidence that the market significantly overvalues firms with severely underfunded defined benefit pension plans. Furthermore, the effects of the overvaluation persists for a long time. Perhaps investors do not analyze the information contained in the footnotes as it relates to pension funding. It is also possible that even when they examine the footnotes, some investors might not understand the information provided. Finally, it is necessary for investors to recognize the implications from the information provided. For example, a pension liability is a debt—a promise to pay—similar to a bond. Firms that have severe underfunding might find it difficult to refinance existing debt at favorable terms. Worse yet, it is possible that such firms may not be able to refinance existing debt at all. These kinds of constraints may affect a firm's ability to undertake future investments and eventually have a negative affect on future operating performance. It is possible that improved disclosure or better accounting standards might help investors to understand the significance a firm's underfunded pension. Including both pension assets and pension liabilities on the balance sheet might also be useful. Q-45 Why are accounting ratios valuable for predicting bankruptcy? What cautions do we need in evaluating accounting ratios? Accounting-based ratios have been very useful in discriminating between firms that subsequently went bankrupt and those that did not. Prior to bankruptcy, companies that eventually go bankrupt tend to have financial ratios that differ from companies that do not go bankrupt. Predictability up to five years prior to bankruptcy has been demonstrated. Firms are complex enterprises, and it is not easy to reverse a positive or negative trend. Note, however, that we must be very careful in drawing conclusions. Companies with “poor” ratios will not necessarily go bankrupt in the future. However, unless a company's operating or financial performance changes, bankruptcy is more probable for companies with poor financial ratios. Q-46 Accounting earnings are useful in predicting one-year ahead cash flows. Is this sufficient? Why or why not? From a financial economic perspective, the value of a firm is equal to the present value all expected future cash flows. Clearly, the value of the firm depends on much more than the oneyear-ahead cash flow. Nevertheless, the one-year-ahead cash flow might be indicative of subsequent cash flows. Q-47 Why do high levels of accruals appear to be mispriced? Richardson, Sloan, Soliman, and Tuna find empirical evidence that suggests that accruals are related to earnings persistence. In addition, the less reliable the accruals, the lower the earnings persistence. Furthermore, they find that the market does not fully price the less reliable accruals. Future stock returns appear to be negatively related to accruals, and the negative relation is stronger for less reliable accruals. Liu and Qi provide evidence that the potential mispricing of accruals is substantial. Q-48 Evaluate Stewart’s (2009) discovery of a single overarching ratio, EVA Momentum, which is “superior to all other ratios.” Stewart III, G. Bennett (Spring 2009). “EVA Momentum: The One Ratio That Tells the Whole Story,” Journal of Applied Corporate Finance, 74–84. Stewart has done another outstanding job of marketing the next financial discovery; however, as was the case with EVA, we doubt the statement will weather academic empirical research studies. There is no panacea, no single metric to tell the whole story. However, the idea will likely enhance consulting revenues. Cases, Problems, and Writing Assignments 1. The usefulness of accounting data to investors and creditors for predictive purposes is necessarily forward looking. However, under generally accepted accounting principles, financial statements are constructed primarily as an historical record. Required: (a) What limitation does this impose on the usefulness of financial statements for predictive purposes, and how is this limitation evident from the research reviewed in the chapter? (b) Provide examples of important forward-looking events that either are not reported in financial statements or are not reported in a timely manner. (c) Why may the feedback value of audited financial statements make them very important to investors and creditors even though predictive value is not necessarily high? (a) The FASB conceives of accounting as an information system with the emphasis mainly on prospective cash flows. Since accounting systems are, by construction, historical records, they are necessarily backward looking. Therefore, feedback value is going to be better achieved than predictive value. Consistent with this is the low explanatory power of some capital market research. Unexpected earnings “explain” only about 5 percent or less of a firm’s abnormal stock return around the time of earning’s announcements. The capital market literature presumes that accounting functions as an information system, but it is more likely that its main role is for contracting and hence feedback purposes. (b) A good example is the mutually unperformed (executory) contract in which the firm and an outside party have an unperformed contract. By convention, such contracts do not meet the criteria for recognition. (c) If accounting is primarily a feedback system, it is nevertheless useful precisely for this reason. From a contracting perspective, accounting is important in bringing about control and accountability to investors and creditors, and it is for this reason that accounting numbers are used in writing contracts. For example, debt contracts with restrictive covenants, and employment contracts with managers, especially incentive compensation agreements, also feedback and accountability. They are also helpful to users in predicting cash flows. 2. A retail company begins operations late in 2000 by purchasing $600,000 of merchandise. There are no sales in 2000. During 2001 additional merchandise of $3,000,000 is purchased. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000. The management compensation agreement provides for incentive bonuses totaling 1 percent of after-tax income (before the bonuses). Taxes are 25 percent, and accounting and taxable income will be the same. The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending inventory would be $700,000 and $1,000,000, respectively, under LIFO and FIFO. a. How are accounting numbers used to monitor this agency contract between owner and managers? b. Evaluate management incentives to choose FIFO versus FIFO? c. Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth? d. Why is the management compensation agreement potentially counterproductive as an agency-monitoring mechanism? e. Devise an alternative bonus system to avoid the problem in the existing plan. (a) The bonus is part of the compensation agreement and is limited to financial performance. (b) See computations that follow. FIFO LIFO Sales $6,000,000 $6,000,000 Cost of Sales 2,600,000 2,900,000 Gross Margin 3,400,000 3,100,000 Operating Expenses 400,000 400,000 Operating income 3,000,000 2,700,000 Taxes on operating income (25%) 750,000 675,000 Basis for Bonus 2,250,000 2,025,000 Bonus (1%) $ 22,500 $ 20,250 In terms of the bonus alone, management would choose FIFO over LIFO. However, after-tax cash flows will be higher under LIFO. FIFO LIFO Gross Margin $3,400,000.00 $3,100,000.00 Operating Expenses 400,000.00 400,000.00 Bonus (1%) 22,500.00 20,250.00 Pre-tax Income 2,977,500.00 2,679,750.00 Taxes (25%) 744,375.00 669,937.50 Difference in taxes paid is $74,437.50 in favor of LIFO ($744,375 minus $669,937.50). (c) LIFO should increase firm value due to higher positive cash flows arising from lower taxes, compared with FIFO. (d) The agreement is a poor one because the bonus encourages a personal gain of $2,250 to the managers for choosing FIFO at a cost of $74,437.50 in higher taxes to the firm. This choice reduces shareholder wealth. (e) Some alternative arrangement might include non-allocation bases such as sales or cash flow operations, or net cash flows (see chapter 13), or nonaccounting-based incentives such as stock option plans. Another alternative might be a bonus plan based on LIFO, with management’s bonus percentage being slightly higher than it presently is to allow for the lower income under LIFO. Critical Thinking and Analysis 1. How do you think the efficient-markets hypothesis impacts the drafting of accounting standards? Bear in mind that many questions have been raised about the efficient- markets hypothesis itself. It’s nice that accounting information is presumably rapidly impounded into security prices but the FASB shouldn’t—and hasn’t—been seduced by the EMH. First of all, the quality of accounting information can be improved (see Lev, 1989 and Wyatt, 1983). Second, the FASB should not be indifferent between providing information within the body of the financial statements themselves and disclosure in footnotes and supplementary information. Third, the FASB should try and increase publicly available information and reduce inside information. In short, the EMH should not allow the FASB to slough anything off but should be a spur to improving financial information. 2. To what extent should the liquidity measures revisions be considered if LIFO were to be eliminated from U.S. GAAP? Provide examples of those likely measures that would be affected. . As an interesting side note, what does the 2016 United States Budget estimate the effect on revenues will be if LIFO accounting for inventory is repealed? This is a problem somewhat like the one faced when FASB first considered requiring all leases be placed on the balance sheet. In the case of leases, ratios were affected, severely in some cases. Inventory days supply on hand, current ratio, debt to asset ratios: they are all affected if a company values its inventory using LIFO, but then replaces the method with FIFO or weighted average valuation methods. Gross margins would likely increase on the income statement. Implementation costs to revise any agreements based on ratios might be costly to specific firms. The question relates to short-term implementation issues, a cost-benefit issue. To answer the estimated effect of repealing LIFO, go to https://www.whitehouse.gov/omb/budget/ and click on “The Budget”. Open the PDF for “Summary Tables” and FIND “Repeal LIFO method of accounting for inventories.” Note that the LIFO repeal is listed under “Other business revenue changes and loophole closers” and it estimates a 2017-2021 deficit reduction of >$38 billion. 2017-2026 the reduction is >$80 billion (actually $81,335 millions). Inclusion of such a repeal suggests political support from the Whitehouse for LIFO’s repeal and, therefore, potential convergence with IASB standards. 2. Trombetta, et al (2012) discusses how effects analyses might help determine the usefulness of accounting standards. Which research method do you argue provides the best analysis of a new standard? Trombetta, Marco, Alfred Wagenhofer, and Peter Wysocki (2012). “The Usefulness of Academic Research in Understanding the Effects of Accounting Standards,” Accounting in Europe, 127-146. Discussions should consider two macro approaches: • Theoretical approaches: economic, behavioral, historical research, and theorizing. • Empirical approaches: case studies and field studies, interviews and questionnaire surveys, archival, and experimental research. Students should consider who the target users are: investors and creditors. What is the standard’s purpose: decision usefulness. So, arguments should address how the chosen method(s) determine how the standard affects decision usefulness. There is not a single correct answer, but the question should force students to think. Solution Manual for Accounting Theory: Conceptual Issues in a Political and Economic Environment Harry I. Wolk, James L. Dodd, John J. Rozycki 9781483375021, 9781412991698