Financial Accounting Theory

Letter to the reader 11

Part I Accounting fundamentals, accounting theory and the information environment

1 Introduction  17

1.1 Perspectives on useful accounting—a utilitarian view 20

1.1.1 Economic (capital market) perspective 21

1.1.2 Social (stakeholder) perspective 24

1.1.3 Taxation perspective 24

1.2 Financial accounting in a capital market context 25

1.2.1 Determinants and consequences of high-quality accounting 26

1.2.2 Information uncertainty 30

1.3 Accounting, reporting and disclosures —Getting the 
 terminology in order 32

1.4 Financial accounting theory 34

1.5 Organization and contents of the book 35

Study questions 37

2 Theoretical underpinnings  39

2.1 Accounting theory: Definitions and concepts 42

2.2 The normative–positive divide 44

2.3 A summary of theories and hypotheses in the field of financial accounting 48

2.3.1 Efficient market hypothesis (EMH) 48

2.3.2 Theory of asymmetric information 51

2.3.3 The nature of the firm and agency theory 53

2.3.4 Positive accounting theory (PAT) 56

2.3.5 Institutional theory 58

2.3.6 Legitimacy theory 60

2.4 Accounting quality and accounting theory 62

2.5 Conclusions 63

Study questions 64

3 A capital market perspective and the roles of accounting  65

3.1 The efficient market hypothesis (EMH) 65

3.1.1 Strong form efficiency 68

3.1.2 Semi-strong form efficiency 68

3.1.3 Weak form efficiency 70

3.2 Alternative hypotheses 73

3.3 Information asymmetry and the roles of accounting 75

3.3.1 The valuation role of accounting: An ex ante perspective 76

3.3.2 The stewardship role of accounting: An ex post perspective 78

3.3.3 The trade-off between the valuation and the stewardship 
 roles of accounting 79

3.4 Conclusions 81

Study questions 81

Part II Accounting quality and regulation

4 Regulation of accounting  85

4.1 Economic rationales for and against regulation 86

4.1.1 Asymmetric information 86

4.1.2 Public goods and externalities 87

4.1.3 Market power 88

4.2 Determinants of accounting regulation and its outcomes 90

4.3 A brief history of Anglo-American accounting regulation 93

4.3.1 The UK 93

4.3.2 The US 96

4.4 Harmonization 101

4.4.1 Accounting regulation in Sweden 104

4.5 Principles-based and rules-based approaches to regulation 105

4.6 Conclusions 108

Study questions 109

5 Conceptual frameworks of accounting  111

5.1 Intended users and objectives of financial reporting 113

5.2 Qualitative characteristics 115

5.2.1 Relevance 118

5.2.2 Faithful representation 119

5.2.3 The trade-off between relevance and faithful representation 121

5.2.4 Comparability 122

5.2.5 Verifiability 124

5.2.6 Timeliness 124

5.2.7 Understandability 124

5.3 Principles excluded from the Conceptual Framework 125

5.3.1 Matching principle 125

5.3.2 Prudence 126

5.3.3 Substance over form 127

5.3.4 True and fair view 127

5.4 Conclusions 128

Study questions 129

Part III Accounting quality in capital markets research

6 Disclosures and disclosure quality  133

6.1 Consequenses of disclosures on capital markets 134

6.1.1 Effects on market liquidity, trading volume and analysts 134

6.1.2 Effects on firms’ cost of capital 136

6.1.3 Effects on corporate governance 142

6.2 Types of disclosures 143

6.2.1 Management’s discussion and analysis 144

6.2.2 The CEO’s letter to the shareholders 146

6.2.3 Environmental, Social, and Governance (ESG) disclosures 147

6.3 Determinants of disclosure 151

6.4 Disclosure quality in empirical research 154

6.4.1 Disclosure level 155

6.4.2 Complexity and readability 158

6.4.3 Tone (sentiment) 160

6.4.4 Specificity 161

6.5 Conclusions 162

Study questions 163

7 Earnings quality  165

7.1 Earnings properties 167

7.1.1 Earnings persistence 169

7.1.2 Earnings smoothness 171

7.1.3 Abnormal accruals 172

7.1.4 Earnings timeliness 177

7.1.5 Target beating 179

7.1.6 Which firms have higher earnings quality? 180

7.2 External indicators of earnings quality 181

7.2.1 Value relevance 181

7.2.2 Intermediaries’ evaluation of earnings 190

7.3 Conclusions 190

Study questions 191

Part IV Accounting quality, managerial incentives and 
 corporate governance

8 The incentive problem and the stewardship role of accounting  195

8.1 Active owners 197

8.2 The Board of Directors 199

8.3 Optimal contracts 201

8.3.1 Accounting-based performance measures in compensation contracts 202

8.3.2 Market-based performance measures in compensation contracts 203

8.4 Conclusions 206

Study questions 207

9 Managerial incentives, monitoring mechanisms and the 
 institutional environment  209

9.1 Incentives and accounting choices 210

9.1.1 Compensation contracts 212

9.1.2 Debt contracts 214

9.1.3 Political and regulatory forces 215

9.1.4 Market forces 216

9.1.5 Monitoring mechanisms, enforcement and the broader 
 institutional environment 217

9.2 Firm-specific monitoring mechanisms 219

9.2.1 Ownership structure 220

9.2.2 Board of directors 221

9.2.3 Auditors 222

9.3 The broader institutional environment 226

9.3.1 National and supranational enforcement 226

9.3.2 The legal environment 228

9.3.3 Some criticism of the evidence 230

9.4 Conclusions 232

Study questions 233

Part V Accounting quality and financial statement items

10 Structure of accounting issues  239

10.1 Definitions of financial statement elements 242

10.1.1 Assets and liabilities 243

10.1.2 Equity 244

10.1.3 Income and expenses 245

10.2 Four stylized accrual situations 246

10.3 Bases for measurement 250

10.3.1 The definition and measurement of fair value 253

10.4 The fair value debate 254

10.4.1 Theoretical (conceptual) views 254

10.4.2 Empirical (practical) views 257

10.5 Conclusions 261

Study questions 261

11 Assets  263

11.1 Property, plant and equipment 264

11.1.1 Definitions and summary of issues 265

11.1.2 Cost at acquisition 266

11.1.3 Measurement models 267

11.1.4 Depreciation method and useful life 268

11.2 Intangible assets 272

11.2.1 Definitions and summary of issues 272

11.2.2 Recognition on the balance sheet 273

11.2.3 Measurement models 276

11.2.4 Amortization method and useful life 277

11.3 Impairment of assets 278

11.3.1 Definitions and summary of issues 278

11.3.2 Impairment tests 279

11.3.3 Goodwill impairment 281

11.3.4 Impairment approaches under IFRS versus US GAAP 284

11.4 Inventories 288

11.5 Leases 289

11.5.1 Definitions and summary of issues 290

11.5.2 Classification into operating and finance leases 292

11.5.3 Assets defined as rights 297

11.6 Financial instruments 299

11.6.1 Definitions and summary of issues 301

11.6.2 Measurement 302

11.6.3 Impairment of financial assets 307

11.6.4 Hedge accounting 308

11.7 Conclusions 311

Study questions 311

12 Liabilities and equity  313

12.1 Financial liabilities 314

12.2 Provisions 316

12.2.1 Definitions and summary of issues 316

12.2.2 Recognition on the balance sheet 318

12.2.3 Measurement 320

12.2.4 Provisions and incentives 326

12.3 Employee benefits 328

12.3.1 Definitions and summary of issues 329

12.3.2 Recognition and measurement 330

12.3.3 Discount rate 332

12.3.4 Recognition versus disclosure: The case of actuarial gains and losses 334

12.4 Insurance contracts 336

12.5 Equity 339

12.5.1 Distinction between liabilities and equity 339

12.5.2 Classification and presentation of equity 340

12.6 Conclusions 341

Study questions 342

13 Profit and loss  343

13.1 Revenue recognition 344

13.1.1 Definitions and summary of issues 346

13.1.2 Choices, judgments and the five-step approach to revenue recognition 347

13.2 Share-based payment 349

13.2.1 Definitions and summary of issues 352

13.2.2 Recognition versus disclosure: The case of share-based 
 payment 353

13.2.3 Measurement 356

13.3 Other profit and loss items 359

13.3.1 Government grants 359

13.3.2 Foreign currency 360

13.3.3 Income taxes 363

13.4 Conclusions 364

Study questions 364

14 Group accounting  365

14.1 Consolidation 368

14.1.1 Scope of the entity 369

14.1.2 Control 371

14.1.3 Derecognition and structured entities 373

14.1.4 Associates and joint arrangements 374

14.2 Business combinations 377

14.2.1 Goodwill accounting 378

14.2.2 Restructuring provisions 382

14.2.3 Non-controlling interest 383

14.2.4 Stepwise acquisition and disposal 384

14.2.5 Common control transactions 386

14.3 Conclusions 386

Study questions 387

15 Presentation format and disclosure  389

15.1 Definitions and summary of issues 390

15.2 Financial statement format 392

15.2.1 Balance sheet and statement of changes in equity 392

15.2.2 Income statement 397

15.2.3 Statement of cash flows 400

15.3 Time series aspects 402

15.3.1 Changes in accounting policies and estimates 403

15.3.2 Information after the accounting period 404

15.3.3 Interim financial statements 405

15.3.4 Discontinued operations 406

15.4 Mandatory disclosure 407

15.4.1 The Disclosure Initiative 408

15.4.2 Specific disclosure requirements 411

15.4.3 Disclosure versus recognition 414

15.4.4 A note on research on mandatory disclosures 415

15.5 Conclusions 416

Study questions 416

16 Concluding remarks  419

16.1 Key findings and conclusions 421

16.2 Key articles 422

16.3 Research outlets and focus 428

16.3.1 Criticism of the current state of affairs 431

16.4 Future challenges and research 432

Bibliography 437

Index 461