Solution Manual for Financial Accounting Theory, 7th Edition

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SOLUTIONSMANUALforFinancial AccountingTheorySeventh EditionWilliam R. ScottUniversity of Waterloo

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ContentsChapter 1Introduction..................................................................................................1Chapter 2Accounting Under Ideal Conditions ..........................................................7Chapter 3The Decision Usefulness Approach to Financial Reporting......................68Chapter 4Efficient Securities Markets ......................................................................129Chapter 5The Value Relevance of Accounting Information.....................................153Chapter 6The Measurement Approach to Decision Usefulness................................194Chapter 7Measurement Applications ........................................................................237Chapter 8The Efficient Contracting Approach to Decision Usefulness....................285Chapter 9An Analysis of Conflict ...........................................................................321Chapter 10Executive Compensation .........................................................................371Chapter 11Earnings Management .............................................................................425Chapter 12Standard Setting: Economic Issues..........................................................487Chapter 13Standard Setting: Political Issues.............................................................527

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Scott, Financial Accounting Theory, 7th EditionChapter 11CHAPTER 1INTRODUCTION1.1The Objective of This Book1.2Some Historical Perspective1.3The 2007-2008 Market Meltdowns1.4Efficient Contracting1.5A Note on Ethical Behaviour1.6Rules-Based v. Principles-Based Accounting Standards1.7The Complexity of Information in Financial Accounting and Reporting1.8The Role of Accounting Research1.9The Importance of Information Asymmetry1.10The Fundamental Problem of Financial Accounting Theory1.11Regulation as a Reaction to the Fundamental Problem1.12The Organization of This Book1.12.1 Ideal Conditions1.12.2 Adverse Selection1.12.3 Moral Hazard1.12.4 Standard Setting1.12.5 The Process of Standard Setting1.13Relevance of Financial Accounting Theory to Accounting Practice

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Scott, Financial Accounting Theory, 7th EditionChapter 12LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES1.The Broad Outline of the BookI use Figure 1.1 as a template to describe the broad outline of the book. Sincethe students typically have not had a chance to read Chapter 1 in the first coursesession, I stick fairly closely to the chapter material.The major points I discuss are:•Accounting in an ideal setting. Here, present-value-basedaccounting is natural. I go over the ideal conditions needed for sucha basis of accounting to be feasible, but do not go into much detailbecause this topic is covered in greater depth in Chapter 2.•An introduction to the concept of information asymmetry andresulting problems of adverse selection and moral hazard. Theseproblems are basic to the book and I feel it is desirable for thestudents to have a “first go” at them at this point. I concentrate onthe intuition underlying the two problems. For example, adverseselection can be illustrated by asking who would be first in line topurchase life insurance if there was no medical examination, orwhat quality of used cars are likely to be brought to market. Formoral hazard I try to pin them down on how hard they would work inthis course if there were no exams.•The environment in which financial accounting and reportingoperates. My main goal at this point is that the students do not takethis environment for granted. I discuss the procedures of standardsetting briefly and point out that this is really a process ofregulation. In the past, there have been well-known cases ofderegulation, such as airlines, trucking, financial institutions, powergeneration. However, we are entering what is likely to be a periodof increasing regulation, at least for financial institutions. Instructors

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Scott, Financial Accounting Theory, 7th EditionChapter 13may wish to discuss briefly the pros and cons of markets v.regulation (since this book tends to be market-oriented) ofeconomic activity.2.The Concept of InformationBy now, I will have referred to the term “information” several times. I suggest thatit is easy to take this term for granted, and call for definitions. This usuallygenerates considerable hesitation by the students. The purpose at this point issimply to get them to realize that information is a complex commodity. Indeed, Imake an analogy between the financial accounting and reporting industry and astereotypical manufacturing industry such as agriculture or automobiles, and askwhat is the product of the accounting industry, why is it valuable, how is itquantified? I do not go deeply into the answers to questions like these, sincesome decision-theoretic machinery needs to be developed (Section 3.3) before aprecise definition of information can be given. Nevertheless, I try to end up withthe conclusions that information has something to do with improving the processof decision-making, and that it is crucial to the operation of securities markets.3.Relevance to Accounting PracticeMy undergraduate accounting theory classes usually consist of a majority ofstudents who are heading for a professional accounting designation. There areusually also some students heading for careers in management.Since students who are facing professional accounting exams can be quitefocused in their learning objectives, it is essential that the nature of the course inrelation to these objectives be discussed up front.I begin by pointing out that the book is intended to give the student anappreciation and understanding of the financial reporting environment, whichshould help with breadth questions on professional exams. I also argue thatone’s career continues well beyond attainment of a professional accountingdesignation, and that the nature of the textbook is longer-run and designed to

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Scott, Financial Accounting Theory, 7th EditionChapter 14foster a critical awareness of the financial accounting environment which isneeded if one is to become a thoughtful professional.Arguments such as these can only be pushed so far. Nevertheless, I think it isimportant to make them. I also point out that the text includes coverage of majoraccounting standards such as financial instruments, impairment, consolidations,de-recognition, and that they will have the opportunity to learn about thesestandards on the way through.I also refer the students to Section 1.13, and emphasize that the text recognizesan obligation to convince them that the material is relevant to their careers. To dothis, the text explains theoretical concepts in intuitive terms, and illustrates andmotivates the concepts based on a series of Theory in Practice vignettes, andproblem material based frequently on articles from the financial press andrelevant research findings.For the management students in the class, and for the professional accountingstudents who may some day be managers, I emphasize that the text does notignore them. Chapters 8 to 11 inclusive (the bottom branch of Figure 1.1) dealwith topics of interest to managers, including economic consequences, conflictresolution, executive compensation and earnings management. All of thesetopics demonstrate that management has a legitimate interest in financialreporting. I also argue that Chapters 2 to 7 inclusive (the top branch of Figure1.1) are relevant to managers since they give insights into how financialaccounting information is used by investors. Finally, since management is amajor constituency in standard-setting, a critical awareness of the need forstandard setting and the standard-setting process (Chapters 12 and 13) is usefulfor any manager.I have not had problems with student course evaluations as a result of using thematerial in this book. In fact, I have constantly been surprised at how far one canpush the students in a theoretical direction providing that I rely on the textbookmaterial to give the students an intuitive understanding, and concentrate in class

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Scott, Financial Accounting Theory, 7th EditionChapter 15on illustrating, motivating and discussing the application of the concepts. For this,I find that the financial media are helpful sources of current articles which I bringto class to serve as a basis for discussion. Numerous such articles form the basisof most “Theory in Practice” vignettes scattered throughout the text.4.The Structure of Standard-Setting BodiesThis edition continues to orient itself to International Accounting Standards Board(IASB) standards, although attention is also given to several U.S. standards.Instructors may wish to briefly discuss the structure of standard setting bodies atthis point.5.Social Issues Underlying RegulationInstructors who wish to dig more deeply into social issues underlying financialreporting and standard setting can usefully spend a class session on the 1982Merino and Neimark paper (in Section 1.2). This paper raises fundamental issuesabout the role of financial reporting in society which go well beyond the textbookcoverage of this paper, which confines itself largely to a brief description ofreporting problems leading up to the great stock market crash of 1929 and thecreation of the SEC. It provides food for thought both for those who do and donot favour the present financial reporting environment. For a contrasting viewfrom that of Merino and Neimark, Benston’s 1973 article is also worth assigning.This edition continues its discussion of the Enron and WorldCom financialreporting disasters, since these are still relevant to accounting theory andpractice. I continue to include (Section 1.3) a description of the 2007-2008market meltdowns surrounding financial assets and institutions, since theseevents are driving many new accounting standards and changes in executivecompensation discussed later in the text. In spite of the bewildering collection ofacronyms, instructors may wish to discuss these market meltdowns early in thecourse, since they pervade the book and continue to have major implications forfinancial accounting.

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Scott, Financial Accounting Theory, 7th EditionChapter 16Section 1.5 introduces the topic of ethics. With the extent of accountant andauditor involvement in numerous financial reporting disasters that have come tolight since 2000, such as Enron and WorldCom, and more recent criticisms of fairvalue accounting and off-balance sheet entities, the importance of ethicalbehaviour is very much apparent. Indeed, ethical behaviour underlies thedistinction between rules-based and principles-based accounting standards(Section 1.6). This distinction is important since the IASB constitution commitsthe IASB to principles-based standards.I emphasize, however, that ethics tends to produce similar behaviour as a longer-run maximization of one’s own interests (although the mind sets are different).Thus, a longer–run view of ethical behaviour quickly turns into questions of fulldisclosure, usefulness, reputation, and cooperative behaviour. The text tends toemphasize these latter components of professional responsibility. Someinstructors may wish to introduce and discuss ethical issues more broadly.6.Some influential accounting academics are critical of the moves bystandard setting bodies towards current value accounting. Chapter 8 is devotedto an alternative view, namely efficient contract theory (also called positiveaccounting theory). A brief introduction to this topic is given in Section 1.4.Instructors who wish to introduce this topic now may wish to discuss whyaccountants are generally regarded as conservative, whether financialaccounting can help to attain strong corporate governance, and whethermanagers like current value accounting.7.I have not prepared any questions and problems for this chapter. Onereason is that I usually like to let the first week of classes pass before givingformal assignments. More fundamentally, I use this first week to describe andmotivate the text material, as outlined above, and most of the material in Chapter1 is covered in greater detail later. However, extensive problem material isprovided for the remaining chapters of the book.

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Scott, Financial Accounting Theory, 7th EditionChapter 27CHAPTER 2ACCOUNTINGUNDERIDEALCONDITIONS2.1Overview2.2The Present Value Model Under Certainty2.2.1Summary2.3The Present Value Model Under Uncertainty2.3.1Summary2.4Examples of Present Value Accounting2.4.1Embedded Value2.4.2Reserve Recognition Accounting (RRA)2.4.3Critique of RRA2.4.4Summary of RRA2.5Historical Cost Accounting Revisited2.5.1Comparison of Different Measurement Bases2.5.2Conclusion2.6The Non-Existence of True Net Income2.7Conclusion to Accounting Under Ideal ConditionsLEARNINGOBJECTIVES ANDSUGGESTEDTEACHINGAPPROACHES1.To Appreciate the Concept of Ideal ConditionsThis concept is drawn on throughout the book. Roughly speaking, by ideal conditions Imean conditions where future firm cash flows and interest rates are known withcertainty or, if not known with certainty, where there is a complete and publicly known

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Scott, Financial Accounting Theory, 7th EditionChapter 28set of states of nature and associated objective probabilities which enables a completelyrelevant and reliable expected present value of the firm to be calculated.I assume risk-neutral investors in this Chapter, so that valuation of the firm is on thebasis of expected present value, that is, no adjustment for risk is needed. The conceptof a risk-averse investor is introduced in Section 3.4, and a capital asset pricing modelof the firm’s shares is described in Section 4.5.2.To Use the Present Value Model Under Ideal Conditions to Prepare anArticulated Set of Financial Statements for a Simple FirmThe text limits itself to financial statements for the first year of operations. The problemmaterial extends the accounting to a subsequent year (see problems 1, 2, 3, 5, 15, and19). In subsequent years, the firm earns interest on opening cash balance. This ispicked up by the accretion of discount calculation, since cash is included in opening netassets. Interest earned on cash balances leads naturally to the role of dividends inpresent-value accounting and the concept of dividend irrelevance.3.To Critically Evaluate Reserve Recognition Accounting (RRA) as anApplication of the Present Value ModelI usually allow some class time to criticize the assumptions of ideal conditions. Somestudents want to “blow off steam” because they perceive these assumptions as quitestrong. I find that RRA is an excellent vehicle both to motivate and critique presentvalue-based accounting. The fact that it is on line encourages students to take thepresent value model seriously, which I emphasize by basing class discussion on anexample of RRA disclosure for a Canadian oil and gas firm that also reports to the SEC.Such disclosures are usually in SEC Form 40-F, not in the annual report (which sayssomething about management’s view of RRA).I also emphasize the point that present value-based accounting products run intosevere implementation problems when the ideal conditions they need do not hold.

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Scott, Financial Accounting Theory, 7th EditionChapter 29I sometimes receive comments that the text over-emphasizes RRA. I find RRA sohelpful to illustrate numerous course concepts that I have resisted such comments.However, instructors may wish to emphasize that RRA, based on a United Statesaccounting standard, is relevant to Canadian oil and gas firms whose shares are tradedin the United States. In this regard, it is worth noting that Husky Energy Inc., used as thetext RRA illustration in Section 2.4.2, is a Canadian-based corporation.4.Historical Cost Accounting in the Mixed Measurement ModelInstructors may wish to discuss historical cost accounting in relation to current valueaccounting, since historical cost is still an important component of the mixedmeasurement model. Section 2.5 compares these measurement bases in terms ofrelevance and reliability, timing of revenue recognition, recognition lag, and matching.This is a good place to emphasize the trade-off between relevance and reliability, andhow different measurement bases imply different trade-offs.This is also a good place to discuss the relative importance of the balance sheet andincome statements under the two measurement bases. That is, historical costaccounting takes the view that the income statement is of greater importance because itgives the current installment of the firm’s earning power, and provides a place to start topredict future firm performance. Under current value accounting, the balance sheet is ofgreater performance, the argument being that current values of assets and liabilitiesprovides a better prediction of future firm performance.6.To Question the Existence of Net Income as a Well-Defined EconomicConstructI use the reliability problems of RRA to question the existence of “true” economicincome except under ideal conditions. With the text example, or some other example, ofRRA disclosure in front of us, I ask the students if they would be willing to pay the RRAvalue for the proved reserves of an oil and gas company. Discussion usually brings outa negative response, for reasons such as difficulties in assessing expected quantities

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Scott, Financial Accounting Theory, 7th EditionChapter 210and prices, disagreement with a 10% discount rate, possible inside information aboutcosts, additional reserves, etc.I then point out that there are numerous other assets and liabilities for which a quotedmarket price does not exist, and argue that information asymmetry is a major reasonwhy market prices may not exist. The market for used cars and problems surroundinginsurance markets in the presence of adverse selection and moral hazard provide otherexamples of “missing” markets.Having established that there are not quoted market prices available for “everything,” Ipoint out that it is then impossible to fully value a firm on this basis and, as a result, it isalso impossible to measure true economic income. I take a sort of perverse pleasure inasking those students who are heading for a professional accounting career if theyreally want to devote their lives to measuring something which does not exist. I amcareful to end on an upbeat note, however, by pointing out that lack of a true measureof income means that a large amount of judgement is required to come up with a usefulmeasure, and that judgement is the basis of a profession.I usually do not go further than the above intuitive argument that incomplete markets areat the heart of problems of income measurement. However, instructors who wish to diginto incompleteness more deeply and precisely can assign Beaver & Demski’s “TheNature of Income Measurement” (The Accounting Review, January, 1979).

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Scott, Financial Accounting Theory, 7th EditionChapter 211Suggested Solutions to Questions and Problems1.P.V. Ltd.Income Statement for Year 2Accretion of discount (10% × 286.36)$28.64P.V. Ltd.Balance SheetAs at Time 2Financial AssetShareholders’ EquityCash$315.00Opening balance$286.36Net income28.64Capital AssetPresent value0.00$315.00$315.00Note that cash includes interest at 10% on opening cash balance of $150.2.Suppose that P.V. Ltd. paid a dividend of $10 at the end of year 1 (any portion ofyear 1 net income would do). Then, its year 2 opening net assets are $276.36,and net income would be:P.V. Ltd.Income StatementFor Year 2Accretion of discount (10% × 276.36)$27.64

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Scott, Financial Accounting Theory, 7th EditionChapter 212P.V.’s balance sheet at time 2 would be:P.V. Ltd.Balance SheetAs at Time 2Financial AssetShareholders’ EquityCash: (140 + 14 + 150)$304.00Opening balance:$276.36(286.36 - 10.00 dividend)Capital Asset, atNet income27.64Present value0.00$304.00$304.00Thus, at time 2 the shareholders have:Cash from dividend$10.00Interest at 10% on cash dividend, for year 21.00Value of firm per balance sheet304.00$315.00This is the same value as that of the firm at time 2, assuming P.V. Ltd. paid nodividends (see Question 1). Consequently, the firm’s dividend policy does notmatter to the shareholders under ideal conditions. Note that a crucial requirementhere, following from ideal conditions, is that the investors and the firm both earninterest on financial assets, including reinvested dividends, at the same rate ofreturn.

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Scott, Financial Accounting Theory, 7th EditionChapter 213Note also that if the investor spends the dividend rather than investing it, thismust be because he/she values current consumption as preferable to investing.Thus, the investor is no worse off if the dividend is spent. Also, if the firm pays nodividend, and the investor wants to consume $10, he/she can borrow at 10%.This liability is offset by the additional $10 increase in firm value on the $10additional retained earnings. Again, the investor is no worse off.3.Expected net income is also called accretion of discount because the firm’sexpected future cash flows are one year closer at year end than at the beginning.Consequently, the opening firm value is rolled forward or “accreted” at thediscount rate used in the present value calculations.4.The procedure here is similar to that used in Question 2. Assume that the goodeconomy state is realized for year 1. Assume also that P.V. Ltd. pays a dividendof, say, $40 at time 1. If the good economy state is also realized in year 2, P.V.’syear 2 net income will then be:P.V. Ltd.Income StatementFor Year 2(good economy in year 2)Accretion of discount [(336.36 – 40) ×.10]29.64Abnormal earnings, as a result of good staterealization in year 2 (200 – 150)50.00Net income year 2$79.64PV’s balance sheet at the end of year 2 will then be:P.V. Ltd.

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