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Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

CHAPTER 1

INTRODUCTION

1.1 The Objective of This Book

1.2 Some Historical Perspective

1.3 The 2007–2008 Market Meltdowns

1.4 Efficient Contracting

1.5 A Note on Ethical Behaviour

1.6 Rules–Based v. Principles–Based Accounting Standards

1.7 The Complexity of Information in Financial Accounting and Reporting

1.8 The Role of Accounting Research

1.9 The Importance of Information Asymmetry

1.10 The Fundamental Problem of Financial Accounting Theory

1.11 Regulation as a Reaction to the Fundamental Problem

1.12 The Organization of This Book

1.12.1 Ideal Conditions

1.12.2 Adverse Selection

1.12.3 Moral Hazard

1.12.4 Standard Setting

1.12.5 The Process of Standard Setting

1.13 Relevance of Financial Accounting Theory to Accounting Practice

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

1. The Broad Outline of the Book

I use Figure 1.1 as a template to describe the broad outline of the book. Since

the students typically have not had a chance to read Chapter 1 in the first course

session, I stick fairly closely to the chapter material.

The major points I discuss are:

• Accounting in an ideal setting. Here, present–value–based

accounting is natural. I go over the ideal conditions needed for such

a basis of accounting to be feasible, but do not go into much detail

because this topic is covered in greater depth in Chapter 2.

• An introduction to the concept of information asymmetry and

resulting problems of adverse selection and moral hazard. These

problems are basic to the book and I feel it is desirable for the

students to have a “first go” at them at this point. I concentrate on

the intuition underlying the two problems. For example, adverse

selection can be illustrated by asking who would be first in line to

purchase life insurance if there was no medical examination, or

what quality of used cars are likely to be brought to market. For

moral hazard I try to pin them down on how hard they would work in

this course if there were no exams.

• The environment in which financial accounting and reporting

operates. My main goal at this point is that the students do not take

this environment for granted. I discuss the procedures of standard

setting briefly and point out that this is really a process of

regulation. In the past, there have been well–known cases of

deregulation, such as airlines, trucking, financial institutions, power

generation. However, we are entering what is likely to be a period

of increasing regulation, at least for financial institutions. Instructors

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

may wish to discuss briefly the pros and cons of markets v.

regulation (since this book tends to be market–oriented) of

economic activity.

2. The Concept of Information

By now, I will have referred to the term “information” several times. I suggest that

it is easy to take this term for granted, and call for definitions. This usually

generates considerable hesitation by the students. The purpose at this point is

simply to get them to realize that information is a complex commodity. Indeed, I

make an analogy between the financial accounting and reporting industry and a

stereotypical manufacturing industry such as agriculture or automobiles, and ask

what is the product of the accounting industry, why is it valuable, how is it

quantified? I do not go deeply into the answers to questions like these, since

some decision–theoretic machinery needs to be developed (Section 3.3) before a

precise definition of information can be given. Nevertheless, I try to end up with

the conclusions that information has something to do with improving the process

of decision–making, and that it is crucial to the operation of securities markets.

3. Relevance to Accounting Practice

My undergraduate accounting theory classes usually consist of a majority of

students who are heading for a professional accounting designation. There are

usually also some students heading for careers in management.

Since students who are facing professional accounting exams can be quite

focused in their learning objectives, it is essential that the nature of the course in

relation to these objectives be discussed up front.

I begin by pointing out that the book is intended to give the student an

appreciation and understanding of the financial reporting environment, which

should help with breadth questions on professional exams. I also argue that

one’s career continues well beyond attainment of a professional accounting

designation, and that the nature of the textbook is longer–run and designed to

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

foster a critical awareness of the financial accounting environment which is

needed if one is to become a thoughtful professional.

Arguments such as these can only be pushed so far. Nevertheless, I think it is

important to make them. I also point out that the text includes coverage of major

accounting standards such as financial instruments, impairment, consolidations,

de–recognition, and that they will have the opportunity to learn about these

standards on the way through.

I also refer the students to Section 1.13, and emphasize that the text recognizes

an obligation to convince them that the material is relevant to their careers. To do

this, the text explains theoretical concepts in intuitive terms, and illustrates and

motivates the concepts based on a series of Theory in Practice vignettes, and

problem material based frequently on articles from the financial press and

relevant research findings.

For the management students in the class, and for the professional accounting

students who may some day be managers, I emphasize that the text does not

ignore them. Chapters 8 to 11 inclusive (the bottom branch of Figure 1.1) deal

with topics of interest to managers, including economic consequences, conflict

resolution, executive compensation and earnings management. All of these

topics demonstrate that management has a legitimate interest in financial

reporting. I also argue that Chapters 2 to 7 inclusive (the top branch of Figure

1.1) are relevant to managers since they give insights into how financial

accounting information is used by investors. Finally, since management is a

major constituency in standard–setting, a critical awareness of the need for

standard setting and the standard–setting process (Chapters 12 and 13) is useful

for any manager.

I have not had problems with student course evaluations as a result of using the

material in this book. In fact, I have constantly been surprised at how far one can

push the students in a theoretical direction providing that I rely on the textbook

material to give the students an intuitive understanding, and concentrate in class

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

on 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 bring

to class to serve as a basis for discussion. Numerous such articles form the basis

of most “Theory in Practice” vignettes scattered throughout the text.

4. The Structure of Standard–Setting Bodies

This 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 at

this point.

5. Social Issues Underlying Regulation

Instructors who wish to dig more deeply into social issues underlying financial

reporting and standard setting can usefully spend a class session on the 1982

Merino and Neimark paper (in Section 1.2). This paper raises fundamental issues

about the role of financial reporting in society which go well beyond the textbook

coverage of this paper, which confines itself largely to a brief description of

reporting problems leading up to the great stock market crash of 1929 and the

creation of the SEC. It provides food for thought both for those who do and do

not favour the present financial reporting environment. For a contrasting view

from that of Merino and Neimark, Benston’s 1973 article is also worth assigning.

This edition continues its discussion of the Enron and WorldCom financial

reporting disasters, since these are still relevant to accounting theory and

practice. I continue to include (Section 1.3) a description of the 2007–2008

market meltdowns surrounding financial assets and institutions, since these

events are driving many new accounting standards and changes in executive

compensation discussed later in the text. In spite of the bewildering collection of

acronyms, instructors may wish to discuss these market meltdowns early in the

course, since they pervade the book and continue to have major implications for

financial accounting.

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 1

Section 1.5 introduces the topic of ethics. With the extent of accountant and

auditor involvement in numerous financial reporting disasters that have come to

light since 2000, such as Enron and WorldCom, and more recent criticisms of fair

value accounting and off–balance sheet entities, the importance of ethical

behaviour is very much apparent. Indeed, ethical behaviour underlies the

distinction between rules–based and principles–based accounting standards

(Section 1.6). This distinction is important since the IASB constitution commits

the 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 full

disclosure, usefulness, reputation, and cooperative behaviour. The text tends to

emphasize these latter components of professional responsibility. Some

instructors may wish to introduce and discuss ethical issues more broadly.

6. Some influential accounting academics are critical of the moves by

standard setting bodies towards current value accounting. Chapter 8 is devoted

to an alternative view, namely efficient contract theory (also called positive

accounting 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 why

accountants are generally regarded as conservative, whether financial

accounting can help to attain strong corporate governance, and whether

managers like current value accounting.

7. I have not prepared any questions and problems for this chapter. One

reason is that I usually like to let the first week of classes pass before giving

formal assignments. More fundamentally, I use this first week to describe and

motivate the text material, as outlined above, and most of the material in Chapter

1 is covered in greater detail later. However, extensive problem material is

provided for the remaining chapters of the book.