1 - 1,Copyright 2015 Pearson Canada Inc.,1 - 2,Financial Accounting TheorySeventh EditionWilliam R. Scott,Purpose: To create an awareness and understanding of the financial reporting environment in a market economy,1 - 3,Chapter 1Introduction,1.2 Some Historical Perspective,Early developmentGreat depression of 1930s reinforced historical cost accountingAlternatives to historical costCurrent value accountingValue-in-useFair value (also called exit price, opportunity cost)Mixed measurement model,1 - 4,1.2 Collapse of the Stock Market Boom of Late 1990s,EnronWorldComCollapse of public confidence in capital marketsEffects on financial reportingIncreased regulation and corporate governanceSarbanes-Oxley ActTighten rules re off-balance sheet entities,1 - 5,1.3 Market Meltdowns, 2007-2008,TerminologySecuritizationFinancial instrumentsAsset-backed securitiesCollateralized debt obligationsAsset-backed commercial paperCredit default swapsExpected loss notesLiquidity riskLiquidity pricingCounterparty risk Continued,1 - 6,Market Meltdowns, 2007-2008 (continued),Financial accounting issues leading up to the market meltdownsFair value accounting for financial instrumentsLiquidity pricingFair value less than value-in-useSevere criticism of fair value accountingHigh leverage of financial institutionsOff-balance sheet liabilitiesUse of expected loss notes to avoid consolidation of structured investment vehiclesWas disclosure of off-balance sheet liabilities adequate? Continued,1 - 7,Market Meltdowns, 2007-2008 (continued),Response of standard settersStopgap measures in response to government pressureFair value accounting guidance during liquidity pricingIncreased use of internal estimates (value-in-use)Increased use of cost-based valuationNew accounting standardsConsolidationDerecognitionIncreased disclosureResponse of standard setters considered in greater detail in Chapter 7 Continued,1 - 8,Market Meltdowns, 2007-2008 (continued),Response of other regulatorsIncreased disclosure of managerial compensationMove transactions to security exchanges and clearing houses from shadow banking systemIncreased capital reserves for financial institutions Continued,1 - 9,Market Meltdowns, 2007-2008 (continued),Implications for accountantsNeed for transparencyValue-in-use v. fair value accountingFull disclosure of off-balance sheet activitiesNew accounting standards to help prevent future abuses?,1 - 10,1.4 Efficient Contracting,A different view of the purpose of financial reporting than the current value orientation of standard settersBasic characteristics of efficient contracting viewEmphasis on contracts. A firm can be defined by the contracts it enters intoE.g., debt contracts, compensation contractsEmphasis on corporate governanceThose firm policies that align the firms activities with the interests of investors and society,1 - 11,Efficient Contracts,For good corporate governance, contracts should be efficientContracting parties must trust each otherE.g., a firm can generate lenders trust by incorporating a covenant into a borrowing contract. Covenants are a cost of contractingLenders reward firm with lower interest rate. This is a benefit of contractingAn efficient contract is the best tradeoff between contracting costs and benefits Continued,1 - 12,Efficient Contracts (continued),Efficient contracting emphasizes manager stewardshipCompensation contracts should motivate managers to work in the best interests of firm ownersAn efficient compensation contract does so at lowest compensation cost.,1 - 13,Accounting Policy Implications of Efficient Contracting,Financial reporting should be reliableReliable reporting generates investor trustFinancial reporting should be conservativeE.g., write assets down if current value less than book value. But, write assets up only if can be done reliably.Rationale: encourages stewardshipPrevents managers from increasing reputation and compensation by increasing reported profits through non-reliable asset writeupsThese policies often conflict with current value accountingCurrent value accounting sacrifices reliability for relevance,1 - 14,1.5 Ethical Behaviour by Accountants/Auditors,Was accountant/auditor behaviour leading up to Enron, WorldCom, and 2007-2008 market meltdowns episodes ethical?Serve the client (short run view) or serve society (long run view)?Why would you serve the client or serve society in similar circumstances?Ethical principles require you to do the right thingLong run interests of profession require you to do the right thingBut mindsets differ,1 - 15,1.6 Rules-Based v. Principles-Based Accounting Standards,Do rules-based accounting standards work?Enron, WorldComExpected loss notesWill more rules in new accounting standards work to prevent abuse?Principles-based standardsImportant role of Conceptual FrameworkRelies on ethical accounting/auditing profession,1 - 16,1.7 The Complexity of Information,Individual reactions to same information may differReporting to investors v. reporti。