INSTRUCTOR MANUAL For Accounting Theory, Conceptual Issues in a Political and Economic Environment 8 by StudyGuide

Chapter 1: An Introduction to Accounting Theory

Instructor’s Manual

CHAPTER HIGHLIGHTS The chapter is concerned with what accounting theory is and where it fits within the “structure” of financial accounting. The definition of accounting theory used in this chapter is broad and complements the objectives of the text. Theory itself helps to explain and predict phenomena that exist in a given field, and this likewise holds true in accounting. In accounting, theory can be developed in response to needs arising from practice, including concepts such as realization and matching. However, as an “infrastructure” has developed in financial accounting, theory is formulated in a more institutionalized way by means of the research process. Along with political factors and economic conditions, accounting theory contributes to the standard-setting process. The process of developing standards or making rules is itself largely a deductive process and is certainly concerned with accounting theory. The relationship of theory to measurement is very important. While some see measurement as closely related to but separate from theory (as we did in earlier editions), its importance relative to theory is so great that we now consider it to be part of theory. Measurement is the assignment of numbers to the attributes or properties of objects being measured. The different types of measurements and the quality or “goodness” of measurements are examined. The latter embodies (1) the usefulness of the measurement, illustrated here in a predictive context but showing up later in an assessment mode and (2) verifiability or objectivity, which is the degree of consensus among measurers in the statistical sense. The various valuation models are presented in Appendix 1-A. The models come under the scope of accounting theory. In addition, the different models are mentioned in several theory chapters before being discussed in depth in Chapter 14. Even if there is no desire to go further into inflation accounting in Chapter 14, it is important for students to gain a rudimentary grasp of the concepts involved, as illustrated in Appendix 1-A.

QUESTIONS Q-1

What does the term “social reality” mean and why are accounting and accounting theory important examples of it?

The term social reality pertains to the measurement of social phenomena and the use of these measurements. The measurements may be representationally faithful (low in bias) and have a high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may be the case. The important thing to grasp, however, is that important consequences stem from the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of income could cause management to be highly rated by shareholders and other interested parties, resulting in high management bonuses, or provide increased dividends to shareholders. All of this could occur even though income is a “construct”: not a “real” factor but a conceptual artifact. This example shows why accounting is an important area relative to social reality measurements and constructs. Hopefully, accounting theory can improve the fairness and usefulness of these measurements. Accounting Theory (8th edition)

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Why do the value choices (entry value, exit value, and historical cost) fall within the domain of accounting theory?

These are examples of different concepts involved with measuring income which have different underlying purposes. These different purposes—which affect social reality—are discussed in the appendix. Q-3

Of the three inputs to the accounting policy-making function, which do you think is the most important?

Of the three inputs (economic conditions, political factors, and accounting theory) to the policymaking function, economic conditions is clearly the most important input. Economic conditions can easily influence the accounting theory track as well as the policy-making function. Inflation, for example, in the USA during the 1970s and 80s triggered a significant amount of theoretical work. Theory responded to the actual economic environment. Another prominent example of the influence economic conditions has is the merger and acquisition wave of the 1960s, which lead to APB Opinion Nos. 16 and 17. Many other standards have also been triggered by economic conditions. Q-4

How can political factors be an input into accounting policy-making if the latter is concerned with governing and making the rules for financial accounting?

Those who are affected by the rules will usually try to influence what those rules will be. The investment tax credit provides an excellent example. When APB Opinion No. 2 did not allow flow through, lobbying led to APB Opinion No. 4, which did allow immediate recognition in income of investment tax credits. The stock option battles of the 1990’s (and continuing today) is another example of the political process and its effect on rule-making. From a predictive standpoint, we are concerned with how and why political factors play a role in the standardsetting process. Q-5

Is accounting theory, as the term is defined in this text, exclusively developed and refined through the research process?

Absolutely not. Many concepts such as conservatism and revenue recognition arose on a “common law” type of basis. They were responses to particular problems. Research has, of course, dealt with these issues. Any attempt to leave these concepts outside of the definition of accounting theory would make the subject matter of accounting theory artificial and incomplete.

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Chapter 1: An Introduction to Accounting Theory

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What type of measurement is the measurement of objectivity in Equation (1.1): nominal, ordinal, interval, or ratio scale?

It is ordinal, due to the squaring effect on each individual deviation from the mean. The zero point, however, is unique. Hence, there would be perfect consensus among measurers. It would mean that each individual measurement would be the same for all measurers. Q-7

The measurement process itself is quite ordinary and routine in virtually all situations. Comment on this statement.

This is not necessarily the case. Measurements can be extremely complex. For example, measuring the temperature of the earth’s atmosphere is extremely difficult. The increasing temperature has led both to the hypothesis of the greenhouse effect and to the theory that the warming global temperatures are simply a fluctuation, a naturally occurring variation. Measuring the success of a man’s life can be perplexing. How does accumulation of Bill Gates’ monetary wealth compare with the accomplishments of Ghandi, Nelson Mandela, or Wolfgang Amadeus Mozart? What does one actually measure to determine success? Measurements in accounting are significantly less complex, but should not be taken lightly. For example, determining the replacement cost or exit value of a firm’s machinery and equipment is not an easy task. Determining net income or earnings during a specified period of time may be more complicated that it appears to be on the surface. Q-8

Can assessment measures be used for predictive purposes?

Though an assessment measure concerns an attribute or characteristic of an object at the present time, it could be used as a surrogate for a prediction measure if none exists. For example, the best indicator of the current ratio of a firm in a year may be the current ratio today, if budgets have not been prepared. Q-9

A great deal of interest is generated each week during the college football and college basketball seasons by the ratings of the teams by the Associated Press and United Press International. Sports writers or coaches are polled on what they believe are the top 25 teams in the country. Weightings are assigned (25 points for each first place vote, 24 for each second place vote, . . . one for each 25th place vote) and the results are tabulated. The results appear as a weekly listing of the top 25 teams in the nation. Do you think that these polls illustrate the process of measurement? Discuss.

An argument can be made that a number is assigned to a team on the basis of a property that might be called the “goodness” or “strength” of a team. However, these measurements do not Accounting Theory (8th edition)

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Chapter 1: An Introduction to Accounting Theory

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have a great deal of precision. How good a team is relative to other teams is a property or quality that is extremely intangible compared to other measurements such as median weight of interior linemen, average speed of running backs per 100 meters, etc. Unquestionably, the measurements are indirect. The qualifications of the measurers are also open to question. Do sportswriters really “know” football? Constraints are also present because the voters may have seen very few teams and they may also have regional biases. The numbering scale used is basically ordinal because 1 is considered to be better than 2, which is better than 3. However, the “goodness” of the interval between rankings is not uniform. For example, a voter may feel it is a virtual “toss-up” between 1 and 2, both of which he considers to be vastly superior to 3. As a result, the aggregating process is open to serious question. It is also not clear whether the pollsters are making assessment or prediction measures. The measures would be prediction measures if the voter presumes that 1 would beat 2 if they played the following week. We suspect, however, that an assessment measure is being made. The property being assessed is the team’s record to date. Hence, a team with a 6-0-0 record is usually ranked higher than a team with a 5-0-1 record. Q-10

Accounting practitioners have criticized some proposed accounting standards on the grounds that they would be difficult to implement because of measurement problems. They therefore conclude that the underlying theory is inappropriate. Assuming that the critics are correct about the implementational difficulties, would you agree with their thinking? Discuss.

This question brings together the relationship among theory, policy, and practice. It also brings up Larson’s warning of the necessity to differentiate between theory and measurement even though we believe that Larson’s statement is too strong. Hence, even though the practitioners may be correct about the measurement process recommended by the proposed standard, it does not necessarily mean that the underlying theory is inappropriate. Some theories may indeed lead to dead ends in terms of implementation. More time may also need to be taken to make the measurements operational. Q-11

Some individuals believe that valuation methods proposed by a standard-setting body such as FASB should be based on those measurement procedures having the highest degree of objectivity as defined by Equation (1.1). Thus, some assets might be valued on the basis of replacement cost and others on net realizable value. Do you see any problems with this proposal? Discuss.

The problem here is basically the opposite of that presented in question 10. In this case, part of the measurement problem might be solved, but at the cost of sacrificing the theoretical base. Hence, the cart is put before the horse, conceptually speaking. However, there are other measurement problems presented by this proposal. It is questionable whether replacement cost dollars and net realizable value dollars can be meaningfully added together, even if computed for Accounting Theory (8th edition)

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Chapter 1: An Introduction to Accounting Theory

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the same point in time (this is the problem of additivity). Moreover, if firms were given latitude to employ valuation methods for their various balance sheet items that were more objective in their own particular cases, there could well be a major problem of lack of comparability in the resulting financial statements between and among firms. Q-12

What type of measurement scale (nominal, ordinal, interval, or ratio scale) is being used in the following situations? a. Musical scales b. Insurance risk classes for automobile insurance c. Numbering of pages in a book d. A grocery scale e. A grocery scale deliberately set 10 pounds too high f. Assignment of students to advisers, based on major

a. b.

Musical scales, Interval, there is no natural zero tonal point. Insurance risk classes for automobile insurance:Ordinal, Class 1 is “better” than Class 2 to the extent that people have had fewer accidents. However, within classes people do not have uniform accident records, and the “accident interval” between classes is not totally uniform. Numbering of pages in a book: Interval (possibly nominal). A grocery scale: Ratio. A grocery scale deliberately set 10 pounds too high: Interval — In effect, the “zero” point is set at 10 pounds, but interval differences remain constant.

c. d. e. f. Q-13

Assignment of students to advisers, based on major: Nominal If general price-level adjustment is concerned with the change over time of the purchasing power of the monetary unit, why is it not considered to be a current value approach?

Current value approaches (replacement cost and exit value) are concerned with questions such as what would it cost to replace an asset today with the same type of asset in the same condition or how much would an asset sell for if it were sold today. General price-level adjustment attempts to restate historical cost of assets in terms of the contemporary purchasing power of the money expended. Q-14

How do entry- and exit-value approaches differ?

As noted previously, entry value (replacement cost) concerns the cost of replacing an asset already owned in markets in which the asset is generally acquired by the firm. Exit value is the price the firm could get for the asset less costs of getting rid of the asset (e.g., removal costs, transportation).

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Chapter 1: An Introduction to Accounting Theory

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Exit value is generally lower than replacement cost because of restricted access to the market, disposal costs, and the possibility of “the perception of a lemon” on the part of prospective buyers. Q-15

Why is discounted cash flow extremely difficult to implement in the accounts?

The difficulty relates to measurement. Which discount rate should be used, how far in the future should one go, and how should one estimate cash flows? In addition, many assets contribute jointly to generating future cash flows. Problems of separating the cash flows for valuation purposes are virtually impossible to solve. Q-16

How do measurement and calculation in accounting differ from each other? Give three examples of each.

Measurement in accounting is concerned with determining real economic phenomena such as current values (entry and exit values) and discounted cash flows. Calculations are simply mechanistic assignments of the monetary unit to accounting categories. The word calculation is very similar to allocation as developed by Arthur Thomas (see Chapter 8). Calculations thus abound under historical costing. Some examples would be inventory amounts determined by LIFO, FIFO, or weighted average; depreciation calculations; and marketable securities carried at cost. Measurements would include inventories and marketable securities when carried at market; acquisition of inventories and fixed assets in general (but only at the acquisition point) as well as assets acquired in a purchase type business combination; and the carrying of accounts receivable (net) at net realizable value. Q-17

Are issues of costliness and timeliness as they pertain to accounting standards part of accounting theory?

Costliness and timeliness are part of accounting theory (refer to Statement of Financial Accounting Concepts No. 2 and No. 8 of the conceptual framework). Benefits of a standard should exceed their costs. Thus it could be too costly to improve the accuracy (representational faithfulness of a particular measurement of a desired characteristic of an asset). The same pertains to timeliness. A more accurate measurement requires more time, but the delay necessary to attain the increased accuracy makes the more accurate measurement less useful. Q-18

Do you think that changes brought about in accounting standards by failures of publicly traded companies such as Enron should be classified under political factors or economic decisions? Support your position.

We classify these as political factors. The inability to draft workable rules to bring special purpose entities (SPE) to the balance sheet is definitely political in nature.

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Chapter 1: An Introduction to Accounting Theory

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Political factors are an adverse influence on the accounting standard-setting function. Discuss this statement.

This is tough issue. Prior to the Enron, WorldCom, etc. scandals we would have said that to get firms to buy into the standard-setting process, those who must work to apply the standards should have input to the process. We still believe this, however, we now know that skeptical eyes and ears are important necessities when reviewing interested party inputs. Trust with a skeptical eye. Q-20

Did the 21st century begin on January 1, 2000?

By popular acclamation the 21st Century began on January 1, 2000. Since there was no year zero, each century ends with a year ending with an even hundred or a thousand. This question is a good example of a social reality—the effect of the odometer turning over—overcoming measurement theory. Q-21

Do you think that the color-coded terrorist threat system instituted by the Department of Homeland Security involves a measurement system? Explain.

Absolutely. Different colors refer to different degrees of danger. It would be an ordinal-type scale because the difference in degrees of danger between color codings is not uniform. For example, the highest point on the scale indicates that a terrorist attack is virtually imminent. This is a large step above the next level on the scale.

Q-22

Since the FASB makes the standards that are used by business and industry, they make accounting theory. Comment on this statement.

FASB uses accounting theory when developing accounting standards, but it does not make it. Does an aircraft manufacturer make aerodynamic theory when producing a new airplane or does it use specific theories to help design and produce a high quality product?

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Chapter 1: An Introduction to Accounting Theory

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Assume that three accountants have been selected to measure the income of a firm under two different income measurement systems. The results for the first income system (M1) were incomes of $3,000, $2,600, and $2,200. Under the second system (M2), results were $5,000, $4,000, and $3,000. Assume that users of accounting data believe that dividends of a year are equal to 75 percent of income determined by M1 for the previous year. Users also believe that dividends of a year are equal to 60 percent of income determined by M2 for the previous year. Actual dividends for the year following the income measurements were $3,000. Determine the objectivity and bias of each of the two measurement systems for the year under consideration. On the basis of your examination, which of the two systems would you prefer?

Designating the three accountants as A1 . . . A3 and using Equation (1.1) for measuring objectivity, we get: M1 (xi – x )2 A1 (3,000 – 2,600)2 = 160,000 A2 (2,600 – 2,600)2 = 0 A3 (2,200 – 2,600)2 = 160,000 $320,000 ÷ 3 = 106,667 M2 (xi – x )2 A1 (5,000 – 4,000)2 = 1,000,000 A2 (4,000 – 4,000)2 =

A3 (3,000 – 4,000)2 = 1,000,000 $2,000,000 ÷ 3 = 666,667

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To arrive at the bias present in the measures, solve for what income should be in the first period ( I *j1 ) in terms of user decision models from Equation (1.2): M1

Dj2 = f(.75 I*j1 )

Dj2 = f(.60 I *j1 )

$3,000 = .75 I *j1

$3,000 = .60 I *j1

$4,000 = I *j1

$5,000 = I *j1

Now solve for bias by using Equation (1.3): B = ( x – x*)2 i: M1 (2,600 – 4,000)2 = 1,960,000 M2 (4,000 – 5,000)2 = 1,000,000 Combining the two measures that are additive to arrive at an overall measure of reliability, we have: M1

R=V+B

$2,066,667 = $106,667 + $1,960,000; $1,666,667 = $666,667 + $1,000,000 M2 appears to have more reliability than M1. M2’s poorer objectivity is more than offset by its better predictive power in this example. These numbers give a quantitative grasp of objectivity and bias, but one cannot claim that M1 is approximately six times more objective than M2 or that M1 has twice as much bias as M2. Standard deviation might have been used for objectivity, in which case the objectivity ratio would come down to less than 3 to 1. Hence, the measures can give a comparative ordering for reliability—but that is all.

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Chapter 1: An Introduction to Accounting Theory 2.

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J & J Enterprises is formed on December 31, 2000. At that point it buys one asset costing $2,487. The asset has a three-year life with no salvage value and is expected to generate cash flows of $1,000 on December 31 in the years 2001, 2002, and 2003. Actual results are exactly the same as plan. Depreciation is the firm’s only expense. All income is to be distributed as dividends on the three dates mentioned. Other information: The price index stands at 100 on December 31, 2000. It goes up to 104 and 108 on January 1, 2002 and 2003, respectively. Net realizable value of the asset on December 31 in the years 2001, 2002, and 2003 is $1,500, $600, and 0, respectively. Replacement cost for a new asset of the same type is $2,700, $3,000, and $3,300 on the last day of the year in 2001, 2002, and 2003, respectively. Revenue is $1,000 per year and the internal rate of return is 10% and all cash flows are received (and distributed) on December 31. Required: Income statements for the years 2001, 2002, and 2003 under: Historical costing General price-level adjustment Exit valuation Replacement cost Discounted cash flows

2.1

Historical costing: Revenue Depreciation Net Income

2.2

2001

2002

2003

Total

$1,000 829 $ 171

$3,000 2,487 $513

2001

2002

2003

Total

$1,000 829 $ 171 — $ 171

$1,000 862a $ 138 33c

$1,000 895b $ 105 66d

$ 105

$3,000 2,586 $ 414 99 $ 315

General price level adjustment: Revenue Depreciation Operating Income Purchasing Power Loss Net Income

a $829 × 1.04 = 862 b $829 × 1.08 = 895 c $829 × [(1.04 – 1.00)/1.00] = $33 ($829 represents the firm’s cash holding on January 1, 2002) d $1,724 × [(1.08 – 1.04)/1.04] = $66

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Chapter 1: An Introduction to Accounting Theory 2.3

Exit valuation:e Revenue Depreciation Net Income

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2001

2002

2003

Total

$1,000 987 $ 13

$1,000 900 $ 100

$1,000 600 $ 400

$3,000 2,487 $513

2001

2002

2003

Total

$1,000 900 $ 100

$1,000 1,000 $ 0

$1,000 1,100 $100

$3,000 3,000 $0

Replacement cost:e Revenue Depreciation Net Income

e Purchasing power gains and losses might be computed but are omitted for simplicity here 2.5

Discounted cash flows:f Revenue Depreciation Net Income

2001

2002

2003

Total

$1,000 751 $ 249

$1,000 826 $ 174

$1,000 909 $91

$3,000 2,486 $514

f The problem was structured so that the asset has a 10% internal rate of return 3.

Objectivity (also called “verifiability”) and bias (usefulness) are two extremely important characteristics of accounting. Discuss each of the following situations in terms of how you believe they would impact upon objectivity and bias. The latest standard on troubled debt restructuring, SFAS No. 114, calls for newly restructured receivables to be discounted at the original or historical discount rate. Two board members disagreed with the majority position because they thought the discount rate should be the current discount rate, given the terms of the note and the borrower’s credit standing. SFAS No. 115 requires marketable equity securities to be carried at fair value (market value). Its predecessor, SFAS No. 12, required marketable equity securities to be carried at lower-of-cost-or-market. Assume that a new standard would allow only FIFO in inventory and cost of goods sold accounting with weighted average and LIFO being eliminated (you may ignore income tax effects).

This situation shows how even a minimum exposure to “accounting theory” can sharpen reasoning power. Other examples of the type illustrated here can be easily generated. The original historical rate would be more verifiable since it is precisely determinable, whereas the current rate would not be exact but should be restricted to a very narrow range. The current Accounting Theory (8th edition)

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discount rate should be more useful because its use would help to determine the current value of the restructured debt. On balance, we agree with the dissenters. Verifiability problems with the current discount rate should be quite small. While conservatism in accounting should not be totally thrown out, we believe that it is relied on too heavily. We believe that SFAS No. 115 has an absolute advantage in value terms over SFAS No. 12. Historical cost is not particularly useful for decision-making purposes. The consistent use of fair value is more useful, we believe, than lower-of-cost-or-market. If anything, verifiability should be better under SFAS No. 115 than SFAS No. 12, since one value is involved rather than two under lower-of-cost-or-market. The new standard would be more verifiable since only one calculation is allowed rather than two. Relative to usefulness, the usual argument might arise: LIFO is “better” in the income statement because costs used up are more current and thus give a better “matching,” but LIFO would be less useful on the balance sheet. Since neither of these calculations has an absolute advantage over the other, we would opt for the exclusive use of FIFO. In addition to being more verifiable, only one method would be less ambiguous for users. While the advantage is not absolute, we believe it is clearly in favor of FIFO only. 4.

Accounting theory has several different definitions and approaches. Using Hendriksen and van Breda (1992, Chapter 1) and Belkaoui (1993, Chapter 3), list and briefly discuss these definitions and approaches. From the perspective of a professional accountant, evaluate these approaches in terms of their usefulness.

Chapter 1 in Hendriksen and van Breda is devoted to accounting theory. Accounting theory is not defined until the conclusion of the chapter on page 21. Using Webster’s Dictionary as a background, accounting theory is defined as a “. . . coherent set of hypothetical, conceptual, and pragmatic principles forming a general frame of reference . . . ,” which is fairly close to the definition used here. The chapter talks about different “approaches” to theory, including tax, legal, ethical, economic, behavioral, and structural, hence, different frames of reference would evidently apply to each of these approaches. This entire framework is then related to philosophy of science issues such as the use of language involving pragmatics, semantics, and syntatics and theory as reasoning involving deductive and inductive approaches. Chapter 3 in Belkaoui is devoted to accounting theory, which is defined as “. . . a set of interrelated constructs (concepts), definitions, and propositions that present a systematic view of phenomena . . . with the purpose of explaining and predicting the phenomena.” His “approaches” then include pragmatic versus theoretical approaches with the latter mirroring the Hendriksen and van Breda approaches by covering deductive, inductive, ethical, sociological, economic, and eclectic approaches. We suspect that for both books, as well as this one, defining accounting theory has been a difficult task. The whole question of what do we know and how do we know it (and know that we know it) is an extremely interesting area. Epistemology is as important for accounting as for other disciplines.

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Chapter 1: An Introduction to Accounting Theory 5.

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What theoretical issues are involved in Statement of Financial Accounting Standards No. 2 which calls for expensing research and development costs?

SFAS No. 2, Accounting for Research and Development Costs, issued in 1974, establishes standards of financial accounting for research and development (R&D) costs. It requires that R&D costs be expensed when incurred. It also requires a company to disclose in its financial statements the amount of R&D that it charges to expense. Theoretical issues relate to: measurability (how to measure future benefits of R&D expenditures, especially given the associated uncertainties) and matching (recognizing costs as expenses on a cause and effect basis). 6.

Read “The Margins of Accounting” by Peter Miller in “The European Accounting Review (Volume 7, Number 4, 1998). What is Miller’s main point? Discuss the examples he uses to illustrate his main point including those pertaining to management accounting. What do you think the significance of his article is for understanding accounting?

This 17-page reading is available through the EBSCO library database. Miller argues that practices at the margins of accounting today may be at the core in the future and vice-versa. “accounting innovation is not the preserve of any single group.” His examples include cost accounting and nonfinancial measures. This article emphasizes how accounting has developed in relation to “localized concerns and issues,” much like medicine and law. It implies that accounting will change, evolve as time passes and environmental factors vary.

CRITICAL THINKING AND ANALYSIS 1.

Is accounting theory really necessary for the making of accounting rules? Discuss.

This question should hopefully shake students up. We doubt that a sophisticated answer that might arise when students have finished Chapter 4 suggesting that regulation, in some views, is unnecessary—will arise. Even prior to the appearance of any standard-setting agency, unifying themes such as realization and matching arose. In today's extremely complex environment, it is difficult to imagine financial accounting operating without a standard-setting body and that body operating without some type of conceptual (theoretical) guidelines since issues such as who the users are and what their information needs are, costs and benefits of different alternatives, verifiability issues, attaining comparability, and increasing information symmetry are all issues which must be considered by standard setters.

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Every fall U.S. News and World Report comes out with a much awaited ranking of American colleges and universities (you may have even used it yourself). While there has been much criticism of the methodology that the magazine employs as well as some “fudging” of the numbers by universities in their response to the questionnaire, this report represents what the chapter calls a “social reality.” What is meant by “social reality” and why does this college and university ranking provide a good analogy for accounting?

From Question 1: The term social reality pertains to the measurement of social phenomena and the use of these measurements. The measurements may be representationally faithful (low in bias) and have a high degree of objectivity (verifiability). Or the opposite for either or both of these qualities may be the case. The important thing to grasp, however, is that important consequences stem from the measurement, whether they are “good” or “bad.” For example, an excellent year in terms of income could cause management to be highly rated by shareholders and other interested parties, resulting in high management bonuses, or provide increased dividends to shareholders. All of this could occur even though income is a “construct”: not a “real” factor but a conceptual artifact. This is a particularly interesting application because the U.S. News & World Report survey is well known and widely used. It may well help many students in terms of narrowing down colleges and universities that they would be interested in by giving various “bottom line” summaries of the schools. Yet we might well ask how “good” and how meaningful these numbers are. Unquestionably, they influence actions. We know of college administrators who would “kill” to improve their ratings. 3.

Accounting rule making should only be concerned with information for investors and creditors. Discuss.

This is a good discussion question. You may want to also ask your students to determine who the two primary standards-setting bodies (FASB and IASB) identify as their primary customers of standards. Should the customers be all those using the information for making economic decisions or more limited to only one audience (e.g., investors, creditors, the entity alone)? Where do current and past employees fall in this investor-creditor classification? How about communities? Taxing authorities? Environmental regulatory agencies? This is a critical questions, “Who is the customer?”

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Chapter 2: Accounting Theory and Accounting Research

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CHAPTER HIGHLIGHTS The chapter provides the student an appreciation for the contribution of research to the general growth of our knowledge about accounting. It shows how accounting research affects the standard-setting process in financial accounting. The chapter focuses on the roles of deductive and inductive reasoning and how they relate to financial accounting. It is also important to stress that these methods are complementary and not an either/or orientation. It is important to stress that empirical research generally looks at fairly small, manageable types of questions. It thus can provide input to the standard-setting process. Making accounting rules, however, must still be seen as a normative function. The chapter also stresses that empirical research cannot be value-free. Values are embedded in the questions that are asked and the parameters that are used in attempting to measure phenomena. Given the rise of formal approaches to theory and a concern for the process of measurement discussed in Chapter 1, the question arises as to whether accounting is an art or a science. A science might be defined as a discipline or area where considerable measurement problems exist. In the physical and natural sciences, there should be a high degree of consensus among measurers. This will be less the case in the social sciences simply because of the variability of human behavior. Nevertheless, they should come under the domain of science. Accounting could certainly move closer to the science realm as a result of the rise of scientific method and the concern for measurement. The chapter also briefly discusses accounting research directions or trends. These are expanded throughout the text. The chapter closes with a look at the question, stemming from Kuhn, concerning whether a “scientific revolution” is occurring in accounting. At this time, the answer appears to be a fairly clear “maybe.” The included PowerPoint, revolutions and paradigms.ppt, references an article from The Wall Street Journal, suggesting the beginnings of a paradigm shift.

QUESTIONS Q-1

Do you think that the work of a policy-making organization such as the FASB or the SEC is normative (value-judgment oriented) or positive (oriented toward value-free rules)? Discuss.

It is unquestionably normative because judgments must be made in accordance with objectives or other criteria. While a standard-setting group may attempt to be neutral, it usually must decide among different positions, each of which will have its adherents. A standard-setting organization may use empirical research (which attempts to be descriptive or positive) as part of its input into the standard-setting process. Ijiri used the term “policy science” to describe financial accounting.

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An individual who was appraising accounting education had the following premises (assumptions): Accounting professors used to do more consulting with accounting practitioners than they do today. Accounting professors have become more interested in research that is abstract and not necessarily practical. He, therefore, concluded that accounting students are not as well prepared to enter the accounting profession as they used to be. Which type of reasoning was the individual using? What is your assessment of his conclusion?

The individual used deductive reasoning. The conclusion was not warranted from the premises because accounting professors generally teach “what is” as opposed to what research may say or imply. Q-3

In 1936 the United States was still suffering from the Great Depression. During the presidential election campaign, an extensive survey of voter attitudes was undertaken to find out whether the public preferred the incumbent, Franklin Delano Roosevelt, or the challenger, Alf Landon. The sample was gathered randomly from telephone book listings throughout the country. A preference was found for Alf Landon; however, Roosevelt won re-election by a huge landslide. What type of research was being conducted? Why do you think it failed to make an accurate prediction?

The method employed is inductive (empirical). The research failed because in 1936 a representative sample could not be gathered solely from people who had telephones because large segments of the population did not have telephones. The magazine (The Literary Digest) in fact failed as a result of its prediction that Landon would win; Franklin Delano Roosevelt won in a landslide. Q-4

In accounting, deductive approaches are generally normative. Why do you think this is the case?

As long as there is a value judgment or normative type of premise in the system, the results must be normative. If the premises (assumptions or postulates) are purely descriptive, it is highly likely that the conclusions derived from the system will be trivial. Therefore, the real issue is one of how acceptable any normative premises can be made.

Q-5

A frequent argument is that inductive reasoning is value-free because it simply investigates empirical evidence. Yet some charge that it is not value-free. What do you think is the basis for this charge?

As long as there are choices to be made, then research cannot be value-free. The choice of what one examines (question A versus question B) entails a value judgment. Parameters used in the research require value judgments. Furthermore, assumptions that may not even be stated are evidence that value judgments are being employed (the assumption that economic systems tend to move toward equilibrium is a value judgment, for example). Accounting Theory (8th edition)

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Several years ago an author stated that corporate income could be scientifically ascertained, but any type of adjustment for inflation would be pure folly because measurements would tend to become very subjective. Do you agree with the author’s appraisal? Comment in detail

The question pertains to an actual article that appeared in the early 1950s. The word “scientifically” was not defined in the article, so it is difficult to know what the author meant. The word was, however, undoubtedly being used to create an impression. The author appeared to be willing to sacrifice more economic reality (“faithful representation,” as it would now be called) because of a presumed lack of objectivity in measurement. The position was not unreasonable, but the real issues were hidden because of the way the author phrased his belief. Q-7

Of the four disciplines in the following list, which do you think qualify as sciences and which do not? State your reasons very carefully. Law Medicine Cosmetology Accountancy

Cosmetology (barbers and beauticians) is concerned with a relatively frivolous subject matter; hence, it should not qualify. While law uses a system of precedence and deductive reasoning, the judge (not to mention the jury) ultimately employs judgments in making decisions. The lawyers, of course, have vested interests. Measurement is not directly applied except in a crude ordinal fashion. As the chapter states, accounting is moving somewhat toward the realm of science. Policy-making in accounting may use the results of research, but it is not a scientific endeavor itself. Medicine might fall into the category of an “applied science,” because the results of scientific endeavor are used for particular purposes. There is a fair analogy between accounting and medicine, but accounting is certainly far cruder at this time. Q-8

Several occupations within two of the aforementioned disciplines are listed here. Which do you think come closest to being scientific? Accounting researcher Chief accountant for an industrial firm Medical researcher Doctor (general practitioner)

The accounting researcher and the medical researcher obviously come closest to being scientists, insofar as their work should be value-free (though this is not totally possible). They should be using formal research techniques to attempt to shed light on unanswered questions. Significant measurement problems are also present in work of this sort. Other researchers should arrive with similar results when they employ the same methods the original researchers used. However, replications should more easily come up in medical science than in accounting, because accounting is a social science where measurement pertains to human beings and their actions, choices, and values, and disagreement at basic research levels tends to be present. Accounting Theory (8th edition)

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The chief accountant and the general practitioner are using or applying the results of science as opposed to being scientists themselves. As a result, they fall more into the line of being professionals. Furthermore, the chief accountant undoubtedly is not neutral in his work: he is concerned with making his firm look as good as possible. The doctor should be concerned with maximizing the health of his patients as opposed to maximizing his or her own wealth. Q-9

What are some of the pitfalls of empirical research?

There are many pitfalls. Sample size relative to the universe being examined should be large enough to draw an inference with minimal chance of an incorrect conclusion. The parameters selected should be reasonable: for example what do we mean by “large firms” and “small firms.” Does the evidence that we examine really pertain to the hypothesis selected? Thus the presumed relationship between general price level adjusted income and reported historical cost income may or may not indicate something relative to a firm’s self perception of whether it may be subject to anti-trust action or other types of pressure if it is deemed to be large. We should also be careful of data manipulation possibilities: Watts and Zimmerman themselves determined the general price level adjusted incomes of the firms examined. It goes without saying that appropriate statistical tests and methods should be used. Q-10

If Watts and Zimmerman are correct that managers of very large firms oppose accounting standards that would raise their income and favor those that would lower it, what policy implications would this have for a standard-setting organization such as the FASB?

Managers of very large firms might fear possibilities such as antitrust action, excess-profits taxes, and adverse public opinion, which could unfavorably affect sales and profits. These same possibilities could affect FASB’s deliberations. Since one of the hallmarks of FASB deliberations is due process—listening to those who would be affected by accounting standards—it would be useful to understand firms’ motivations. If the FASB knows a lobbying firm’s intentions, it helps the FASB maintain its neutrality. Q-11

What is the major difference in orientation between positive accounting theory and more overtly normative theories, such as the valuation approaches discussed in Chapter 1?

The valuation approaches in Chapter 1 can each be viewed as a system. The choice of a valuation system (replacement cost over exit values, for example) is based on the value judgments (no pun intended) of advocates. Positive accounting theorists are making implicit value judgments in their examination and analysis of evidence. The questions and issues to be examined involve value judgments, as does the evidence examined (responses to FASB exposure drafts, income of firms, security prices, how FASB members vote, etc.), and parameters and statistical methods utilized (confidence intervals, regression analysis, ANOVA, and MANOVA).

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For a discipline to become a science, the results of experiments and research must be exact. Do you agree with this statement? Discuss.

Not necessarily. Science involves complicated questions of measurement. At other times, there may be disagreement relative to hypotheses. Nevertheless, science is an open process that uses agreed-upon methods of measurement, so that over the long run, agreement begins to appear in terms of measuring and interpreting phenomena. During the process of working out solutions to problems, strong disagreement does occur. On rare occasions, a scientific revolution may occur and questions are addressed in new and unique ways until general agreement once again occurs. Q-13

Why, in practical terms, is it impossible to separate deductive and inductive approaches to theoretical reasoning?

Inductive work usually contains basic assumptions that are accepted without any further questioning. Deductive work usually contains assumptions based upon real-world referents that have been subject to at least a crude form of induction. The methods are cooperative rather than exclusive relative to each other in their operations. Q-14

What is the relationship among scientific method, accounting research, and accounting policy making?

Accounting research is an important input to the accounting policy-making process. Most research today uses formal methods of deriving generalizations (deductive or inductive approaches). The scientific method is, therefore, a formalized means for carrying out research. Q-15

What are the two principal underlying assumptions of agency theory (positive accounting research)? Critique their role in constructing a theory of accounting.

The two principal assumptions are that individuals act in their own best interest and that the firm is the locus or nexus of many competing types of contractual relationships. The former is virtually true by definition while the latter (which is, of course, dependent upon the former) is an interesting assumption that is the cornerstone of the agency theory literature in accounting. There can be other views of the enterprise, such as Chambers’ coalition view. This points out, once again, that positive research simply cannot shake off its normative underpinnings. Q-16

The “uncertainty principle” of the famous physicist, Werner Heisenberg, states that physical phenomena cannot be precisely measured because the very act of measuring affects the phenomenon being measured. Which of the directions of accounting research discussed in the chapter does Heisenberg’s uncertainty principle relate to most closely?

The “uncertainty principle” clearly relates most closely to critical accounting. Critical accounting believes that by investigating a topic we literally help to shape the reality that we are investigating. It argues that there is an “observer effect.” Other research approaches see a “reality” that investigators do not directly affect. Accounting Theory (8th edition)

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Why do you think the term “deprival value” was used to name a specific type of replacement cost?

Deprival value tries literally to measure the cost to the firm of not having (being deprived of) the particular asset. Q-18

Of the following decision-model advocates discussed in the chapter (Chambers, Sterling, Solomons, Bell, and Ijiri), which one stands out as most unlike the others?

Ijiri stands out because he is an advocate of historical cost adjusted for the change in the general price level. He chooses this approach because the prime purpose of financial statements, as he argues, is accountability. The other individuals advocate various types of current value systems. Q-19

What is the difference between “accounting theory” and “accounting research?

Accounting research is an active process, the results of which can add to the “store” of accounting theory. This difference is very closely related to the economic concepts of “flows” (accounting research) and “stocks” (accounting theory). Q-20

Why does the decision-model orientation to research accord more closely with the standard-setting function than any of the other research directions?

The decision-model orientation attempts to prescribe valuation approaches on a "global" basis: exit value or entry value for example. If either of these approaches were instituted, the FASB would be involved with deriving rules for the selected valuation method. None of the other research approaches gets this close to the standard-setting process. Q-21

If there has been a paradigm shift (scientific revolution) in accounting research, but not in accounting practice, what may this signifiy?

It may indicate that accounting research and accounting practice are not in synchronization with each other. In the move toward empirical research in accounting (a paradigm shift in accounting research), one research problem which may have been overemphasized were studies of market efficiency. Practitioners (including financial analysts) were not carried away by this research (Chapter 8). In our opinion, practitioners were largely correct in this and other areas of research. However, research and practice may now be becoming more attuned to each other. For example, research on earnings management (chapter 12) may become very useful for standard-setters. Q-22

In accounting behavioral research, student subjects have been frequently used as proxies for real-world decision makers. Does this lead to any potential problems?

Using student subjects as proxies for real-world decision makers may lead to findings that may not generalize to the population. The students may have different values, analytical abilities, priorities, and life experiences that distinguish them from the real-world individuals making Accounting Theory (8th edition)

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decisions. This is always a consideration when designing research projects and is usually identified as a limitation at article-end. Q-23

Why do you think that ethnographic research (footnote 65) would be difficult to apply to organizations such as the SEC and FASB?

Ethnography is a social science research method. Data collection consists of interviews, observations, and document reviews over an extended period of time, usually years or perhaps decades. Its roots are in anthropology and the social sciences, so an ethnography of the FASB or SEC would be akin to living with the natives. The synthesis of data collected result in a descriptive narrative, a portrait of the subject. In most business programs the current tenure paradigm is not compatible with the time required to gather data for an ethnography. The time required to produce high quality case studies is likely to be as close to an ethnography that we can expect.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Agency theory takes the view that the corporation is the locus or nexus of many competing and conflicting interests. List as many of these conflicting groups as you can and discuss in detail the nature of their conflicts with other groups.

Among the conflicting groups would be management, auditors, shareholders, creditors, labor, and government. Management desires to maximize its own income through bonus arrangements (which may mean that cash flows are diverted from shareholders) and will probably desire lower reported income if it fears government antitrust action, excess-profits taxes, or simply adverse public opinion. Shareholders generally want high cash dividends and price appreciation on their shares (the latter is at least perceived to stem from higher reported income). Auditors want to maximize their income and minimize their risk. They prefer to avoid what might be perceived to be subjective judgments, hence, they have not favored rendering opinions on earnings forecasts, even if this might be very beneficial to users. They also prefer detailed standards in order to avoid pressure from management, which wants its own interpretation of standards. Creditors desire protection to maximize the probability of receiving interest and repayment of principal. Therefore, they desire protection from the possibility of shareholders “stripping” the firm through excessive dividends. This is often done by means of debt covenants in bond contracts, which may prevent payment of dividends if they are violated (maintenance of a maximum debt-to-equity ratio, for example). Management does not want bond covenants violated because of the potential adverse effect upon security prices. Labor wants to maximize its wage return relative to the previous three groups. Government would certainly like to maximize tax collections from the other groups without creating unrest, minimize labor-management turmoil, and minimize harmful business actions such as polluting the environment.

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Using the article by Colin Lyas (“Philosophers and Accountants”) in Philosophy (January 1984, pp. 99–110), discuss and compare Sterling’s scientific approach to standard setting with the judicial or jurisprudential approach of Stamp.

Lyas’s article is not particularly difficult to understand and dovetails neatly with the discussion in the chapter of the various directions in accounting research. Notice also that Lyas immediately refers to the public misperception of accounting as unambiguously objective and clear-cut in a similar fashion to the opening paragraph of Chapter 1 of this text. Lyas sees Sterling as being in the “objectivist” school, whereby values exist separate and apart from those who are measuring them. From this viewpoint, Sterling would be in the same boat as agency theorists, a prospect that would not particularly please him. Lyas also sees Sterling’s position in favor of exit values as a “judgment” rather than a scientific hypothesis. Perhaps the key point is why exit values take precedence over replacement cost or entry values and how would we decide on whether the numbers that we do generate have a high enough degree of verifiability, as discussed in Chapter 1. Perhaps Sterling’s answer to which system to choose lies in his article entitled “Relevant Financial Reporting in an Age of Price Changes,” Journal of Accountancy, February 1975, pp. 42-51. Lyas raises basic questions such as who should have access to what information, a relativist orientation which would, to this extent at least, put Stamp in the camp of the critical accountants. Therefore, given values that are tentative and questions of who should have access to what information, Lyas is much more comfortable with Stamp’s judgmental approach, which Lyas sees as being very compatible with a legalistic approach. It should also be mentioned that Stamp very definitely has a broad accountability approach to accounting information: many groups have a stake in accounting information, not just investors and creditors. Finally, the legalist approach of Stamp would not, in Lyas’s (and Stamp’s) view, lead to a total degree of arbitrariness in choice among accounting methods and other financial reporting.

CRITICAL THINKING AND ANALYSIS 1.

How can accounting move more toward becoming a science rather than an art? Discuss.

One method would be to eliminate arbitrary choices among accounting methods in generally similar event situations (LIFO versus FIFO although income taxes are a problem here, different depreciation methods, and moving towards principles based accounting standards such as requiring all long-term leases to be capitalized). Measuring real phenomena would help move accounting towards being a science. Even if current value systems might not be easily implemented, there are still factors where more realistic measures might be used. For example, with troubled debt restructuring, we still use the historical rate for discounting rather than the current rate. The latter should be able to be estimated with a fairly high degree of accuracy. Hence we gain usefulness with only a very small "giving up" of verifiability, a fairly clear-cut trade-off. To accomplish a movement toward measuring real phenomena, we may have to let go of conservatism.

Accounting Theory (8th edition)

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CHAPTER HIGHLIGHTS Accounting practice prior to 1930 was unregulated, and the procedures used by various enterprises generally were confidential. During the 1920s, the American public began to invest in corporate business far more extensively than in the past; however, it was not until the stock market crash of 1929 that investors began to question the accounting and reporting practices in use. A brief history of accounting in the United States prior to 1930 provides an overview and background. The New York Stock Exchange (NYSE) became very concerned because listed companies were using various undisclosed accounting procedures. A cooperative effort between the NYSE and the AICPA resulted in the first real effort to develop accounting principles. The organizations agreed that corporations should be allowed to follow any accounting procedures they deemed appropriate as long as those procedures were disclosed and were considered acceptable. Five broad accounting principles were then agreed upon by the AICPA and NYSE. The SEC came into existence in 1934 and was (is) empowered to prescribe accounting principles. It decided that self-regulation by the accounting profession was in the public’s best interest. That position has remained unchanged for about 80 years; however, on many occasions the U.S. profession has come close to losing its self-regulatory status. In recent years, accounting scandals have severely affected its independence; it is experiencing more governmental oversight, but less influence from organizations seeking preferential accounting standards. In 1933, the AICPA formed the Special Committee on Development of Accounting Principles, but this committee accomplished very little and was subsequently replaced by the Committee on Accounting Procedures (CAP) in 1936. The CAP did very little until 1938. At that time, the SEC issued an ultimatum that either the accounting profession must establish standards or the SEC itself would establish them. The CAP saw the need for a conceptual framework but felt that the time to develop one did not exist. Consequently, it embarked on a standard-setting mechanism that has been called the “brushfire” approach. Although the CAP was criticized, it did make significant contributions to accounting practice, and many of its pronouncements are still applicable. Perhaps its major contributions were that it established standard-setting in the private sector. The Accounting Principles Board (APB) was designed to overcome the major deficiency of the CAP. It was to operate on a dual approach: first by the establishment of a conceptual framework and then by the deductive development of accounting standards. Unfortunately, the attempt at a conceptual framework was a failure, and in a very short time the APB found itself in the same position as the CAP. In the APB’s relatively short life (1959-1973), it made two very significant steps forward. First, it issued APB Statement 4, which has served as groundwork for the Trueblood Committee report and the FASB’s conceptual framework project. Second, it greatly expanded the due process procedures for establishing accounting standards. The APB was the first to experiment with discussion memorandums, exposure drafts, and the general use Accounting Theory (8th edition)

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of its constituency. The APB’s ultimate failure, however, was due to its inability to develop a deductive approach and the lack of independence of its members. The Financial Accounting Standards Board (FASB), as an independent body from industry, was seen as a last chance to keep accounting standard setting out of the public sector. The initial charge to the FASB was to establish standards of financial accounting and reporting in the most efficient and complete manner possible. In that light, it decided that a conceptual framework in the long run is an absolute necessity. Consequently, much of the FASB’s resources were devoted to developing a conceptual framework, one that required multiple decades to develop. The FASB uses research in the development of accounting standards more than any of its predecessors. Although the FASB has been under constant attack, almost from its inception, it appears to have weathered the storm and will, most likely, remain in some form of existence for the immediate future. However, its role will likely differ. Sarbanes-Oxley of 2002 required that the SEC review principles-based accounting for application to U.S. issuing companies. Today, the FASB and IASB are pursuing convergence of their respective accounting standards (result of the Norwalk Agreement of 2002 and the subsequent conceptual framework project). Assuming that the convergence projects are successful, the need for redundant standards-setting bodies arises. This suggests that the most serious threat to the FASB may come from an external standardssetting body (IASB), not from the public sector. 100+ countries have adopted IASB standards to some extent; this makes it very difficult to argue that U.S. GAAP should be the world’s Lone Ranger of accounting. The challenge when IFRSs are adopted, not just converged with U.S. GAAP, will be to find new roles for the FASB. Structures are must easier to build than to dismantle. An additional threat, albeit small, comes from the AICPA. Since the PCAOB now has responsibility for major portions of what the AICPA did pre-SOX, the AICPA appears to be searching for its new role. For a while the AICPA adopted “baby GAAP” as its project to review separate standards for smaller companies, a project that should have been left to the official standards-setting body, the FASB. FASB appears to have picked up on the idea and a separate standards setting board is underway as of 2012. Note that a separate Microsoft PowerPoint file is available on Sarbanes-Oxley, one that you may want to review or lecture on at some point in the course. SOX provides for funding through accounting support fees for FASB, a point that makes its independence from industry and its funding significantly stronger than IASB’s. This will likely be something to be resolved before the U.S. will actually adopt IFRSs. Public accounting firms are emerging from the crisis created by joint and several liability. At the federal level since the Private Securities Litigation Reform Act of 1995, liability is largely restricted to proportionate liability which restricts damages to the defendant's proportionate share of the damages.

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QUESTIONS Q-1

How did the APB pave the way for the FASB?

The APB’s biggest contribution to the FASB was the due process procedures for the establishment of accounting standards. The APB initiated the use of discussion memorandums, public hearings, and exposure drafts, all of which have become standard procedures for the FASB.

Q-2

In what ways does the FASB differ most markedly from its two predecessors?

Perhaps the FASB’s biggest difference is its independence. The FASB, unlike its two predecessors, is independent from and not part of the AICPA. All board members must maintain complete independence. This not only applies to other employment arrangements, but also to investments. There must be no conflict, real or apparent, between the members’ private interest and the public interest. Financial independence from CPA firms and industry (attained from assessment of accounting support fees from companies issuing financial statements, SOX) reduces the appearance of undue influence from specific interests. Another important difference is the FASB’s commitment to research.

Q-3

What is the weakness of Grady’s approach in arriving at principles in ARS 7?

The primary weakness is that Grady codified existing pronouncements and then tried to derive the profession’s existing structure of principles. The study blended inductive and deductive approaches because it took the existing pronouncements and then attempted to deduce accounting principles from the body of accepted pronouncements.

Q-4

Do you think that the nonbinding status of the FASB’s statements of financial accounting concepts (like that of APB Statement 4) is a good idea or not?

The purpose of SFACs is not to establish accounting standards but to set forth the fundamentals on which financial accounting and reporting standards will be based. The FASB itself is likely Accounting Theory (8th edition)

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to be the major user of SFACs and thus the most direct beneficiary of the guidance provided by them. The problem with the nonbinding status of the SFACs, however, is that they can simply be ignored, as has occurred in a significant number of cases.

Q-5

Discuss the significance of the SEC’s ASR 150.

ASR 150 represented the first time that the SEC formally recognized that accounting standards set in the private sector had substantial authoritative support. It said that SFASs and Interpretations will be considered by the SEC as having substantial authoritative support, and practices contrary to such FASB promulgations will be considered to have no such support.

Q-6

What has been the SEC’s role in the evolution of the rule-making process? How has that role changed since the passage of SOX?

The SEC’s role in the evolution of the rule-making process has been as a behind-the-scenes observer. It has played a definite role in practically all standards, but has chosen to take a low profile in most situations. The SEC has chosen to pursue the low profile role because it has been assumed to be best for the profession as a whole. By staying out of the limelight, the SEC may also be maximizing its life span and survival. SOX has further strengthened the SEC’s authority. The PCAOB has responsibility for oversight of the audit and accounting functions (formerly AICPA’s responsibility), but the SEC has final approval on any policies, standards, etc. that it might propose. The FASB no longer receives its funding from corporate donations, increasing its independence from industry influence. Now, the SEC provides FASB’s funding by budget approval, so it is now more closely controlled by this regulatory body. Additionally, in 2007 the SEC and FAF agreed that the SEC would have input to board appointments. So, the FASB is now seen as a quasi-governmental body.

Q-7

What were the politics that led to the demise of both the CAP and the APB?

The “politics” that led to the demise of both the CAP and the APB was the SEC’s belief that both groups were unable to work effectively due to their lack of independence. The members of both groups were only part-time standard setters and full-time practicing accountants with various vested interests regarding certain accounting standards.

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“The FASB’s standard-setting procedure is a fairly narrow, cut-and-dried approach to developing accounting standards.” Evaluate this statement.

The FASB’s standard setting procedure/process is anything but “cut and dried.” While there is an overall sequence of steps involved, the consultations and politicking can be quite extensive. Refer to the Johnson and Swieringa article discussed in the chapter on SFAS No. 115 on marketable securities, certainly not one of the more complex and extensive standards. Two even better examples might be income tax allocation (SFAS No. 109) and stock options which resulted only in a disclosure standard. The work involved in both of these cases took years to play out with much vigorous discussion, debate, and politicking.

Q-9

Should constituents have input into the FASB decisions, or should the FASB neutrally and independently set standards?

Using constituents’ input and acting neutrally and independently are not mutually exclusive. Without question, the FASB should neutrally and independently set standards; however, it must consider its constituents’ input or its standards will not be accepted. One of the FASB’s biggest jobs is to obtain a consensus of the constituents on standards it promulgates. However, current conditions indicate a decline of influence by constituents, but it is still important to get their input.

Q-10

Explain how the role and form of research used by the APB and FASB differ.

The initial role of research used by the APB was to develop postulates and principles. That role, however, quickly changed to one of completely examining certain narrow subjects, goodwill, for example. The APB then used that research as a basis of its deliberations. The FASB uses research in the same manner, but has expanded the role extensively. It also uses research to determine the expected economic consequences of many proposed SFASs as well as the real economic consequences of its recently issued SFASs.

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What is the importance of the FAF and FASAC to the success of the FASB?

The FAF elects members to the Board of Trustees, whose responsibility is to select FASB members and perform the oversight role. The FASAC’s role is to advise the FASB on its operating and project plans, agenda and priorities, and appointment of task forces as well as on all major technical issues. FASAC’s influence will probably decline given the SEC’s increasing role. Note that now the SEC participates in board appoints; this is a significant change.

Q-12

The three attempts at standard setting in the private sector (CAP, APB, and FASB) have all dealt with the need for a theoretical foundation. Why were the CAP and the APB unsuccessful at this endeavor?

The CAP never really attempted to develop a theoretical foundation. Although it recognized the need for one, it did not believe that it could afford the time commitment. The APB attempted to develop a theoretical foundation by commissioning ARSs 1 and 3; but the accounting profession rejected both of those ARSs. APB Statement 4 was mildly successful in developing a theoretical foundation, but it neither had authoritative support nor went far enough. The short answer as to why the CAP and APB failed to develop a theoretical foundation is that they “put out fires,” focused their efforts on short-term successes versus the work required to assure long-term progress.

Q-13

Can any overall trend be detected in FASB pronouncements? Explain and cite examples to substantiate your opinion.

At one time there was an attempt to “clean up” the balance sheet by expensing items such as research and development costs (SFAS No. 2) and development stage enterprises (SFAS No. 7). There is, however, a movement toward current values with marketable securities (SFAS No. 115), derivatives (SFAS No. 133), and even impaired assets (SFAS No. 121 and 144) although this is a “lower-of” type of valuation. The FASB-IASB convergence project will likely result in increased fair value approaches, an asset-liability view. SOX actually required a review of principles-based accounting for U.S. standards, so this approach is likely in the future. The U.S. Congress now requires that the FASB and SEC report annually on progress towards adopting principles-based accounting and increased transparency in financial reporting.

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In terms of financial reporting in the future, do you expect greater refinement of measurements appearing in the body of the financial statements or increasing disclosure with less effort directed toward refinement of measurements?

In the foreseeable future, if the recent past is any indication, accounting standards probably will be directed more toward increasing disclosure with less effort on refinement of measurement. This is not necessarily acceptance by the FASB of the efficient-markets hypothesis, but rather the practicality of establishing accounting standards. It is easier to obtain a consensus on disclosure than on changing the measurement of items that appear on financial statements. Of course, stock options is an important counter-example, although disclosure is the final result!

Q-15

How has Sarbanes-Oxley of 2002 affected FASB’s jurisdiction and independence?

Sarbanes-Oxley places more emphasis on auditing because the Auditing Standards board of the AICPA will no longer be setting auditing standards. Pressure will also be placed on the public accounting firms and corporate officers to sign off on their financials. The beneficial changes affecting the FASB is that financing will come from assessments on public companies and accountants, but not contributions of companies politicking for their self-interest. However, the FASB is more of a quasi-governmental body. On balance, FASB should be more indpependent from industry influence, particularly as it works with the International Accounting Standards Board on “convergence.”

Q-16

In late 1990s, the “Wyden Amendment” was stricken from the Crime Bill passed by Congress. The amendment would have required reporting by auditors on internal controls. Letters sent by FEI members opposing the amendment were instrumental in its defeat. The AICPA supported the amendment. From an agency theory perspective, why do you think the AICPA supported the amendment and the FEI was against it? Explain

The AICPA supported the Wyden Amendment because its members would have generated more auditing fees from reporting on internal controls. The FEI was against it because the firms, represented by its members, would be paying the increased fees to the public accounting firms. The politics and positions were to be expected.

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“Since the FASB is independent from the AICPA, the latter is no longer concerned with standard setting and related issues.” Evaluate this statement.

This is not true; the AICPA is still interested in standard setting. Its members must understand the standards and audit their implementation by industry. Auditors are concerned with the implementation of the standards. AcSEC plays an important liaison role as well as issuing SOPs and Industry Accounting Guides. In addition, the AICPA works with the International Accounting Standards Board at the international level (Chapter 10). However, the AICPA, on balance, will be losing influence.

Q-18

What is the relationship between the National Commission on Fraudulent Financial Reporting and Private Securities Litigation Reform Act of 1995?

The activities of the National Commission on Fraudulent Financial Reporting were instrumental in helping to draft and pass the Private Securities Litigation and Reform Act of 1995.

Q-19

What is the difference between joint and severable liability and proportionate liability?

Joint and several liability can result in a guilty party being stuck with more than its proportionate share of the damages if other guilty parties do not have the financial means to pay their share of the damages. Proportionate liability restricts each defendant's damages to their proportionate share thereof.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

During its long tenure, the CAP produced a total of 51 ARBs. While the CAP was in existence, another committee, the Committee on Terminology of the American Institute of Accountants (the previous name of the AICPA), prepared certain definitions. Assess their definitions of assets and liabilities (see Chapter 11 for the definitions). Do you see any problems with one committee preparing rules and another making definitions? Read Chapter 15 of ARB 43 on unamortized discount, issue cost, and redemption premium on bonds refunded. Why do you think these issues concerned the committee? What were the two acceptable alternatives for dealing with the costs of any issue? Why would the definition of assets be helpful in analyzing a situation of this type? Are there any other situations that might be somewhat analogous to the bond redemption situation?

The definitions of assets and liabilities contained in the terminology bulletin are of little value to standard setters. They do not provide any discussion of the characteristics or attributes of assets and liabilities that would help standard setters determine what is an asset or liability. Basically, the definitions say that if an item doesn’t belong on the income statement, it must go on the balance sheet. The problem with one committee preparing rules and another preparing definitions is that the former must use those definitions; if its members do not agree on the definitions (because they did not write them), an impasse occurs and it becomes extremely difficult to issue sound rules.

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Read Chapter 15 of ARB 43 on unamortized discount, issue cost, and redemption premium on bonds refunded. Why do you think these issues concerned the committee? What were the two acceptable alternatives for dealing with the costs of any issue? Why would the definition of assets be helpful in analyzing a situation of this type? Are there any other situations that might be somewhat analogous to the bond redemption situation?

Make sure you check availability of ARB 43 to the students before assigning this case. Accounting for unamortized discount, issue cost, and redemption premium was an issue because the amounts involved very frequently are significant and the alternative accounting practices that existed affected financial statements significantly. The object was to eliminate alternatives in order to obtain uniformity. Unfortunately, the CAP was not successful because of a lack of good asset and liability definitions. Therefore, it was acceptable to write-off immediately all such costs, or to defer and amortize over a period shorter than the remaining life of the old issue. Under SFAS No. 4, all costs of early extinguishment of debt are considered to be extraordinary items (they may not, however, be infrequent). At least the FASB allows only one treatment in comparison to the two allowed by the CAP. Whether the redemption premium, which is a true opportunity cost, should be distinguished from the sunk costs—unamortized premium or discount and issuance costs—is an interesting question. Expense versus capitalization questions also involve the investment tax credit and research and development costs. A situation analogous to the opportunity cost nature of the redemption premium involves tearing down costs of old buildings located on land that has been acquired for development.

Read “FASB Response to SEC Study on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers” (Feb 2006, available on FASB’s website). Ask how would you frame the tenor of the FASB’s response. To what extent does it agree with the SEC’s study?

The FASB acknowledges that it was not asked to respond to the SEC’s report, a reminder that the SEC, not the FASB, has statutory authority to set accounting standards. This omission by the SEC to ask FASB for its feedback is a not so subtle indicator of who is in the driver’s seat. There is consensus that to improve accounting standards the emphasis must be on reducing complexity, improving transparency, and pursuing principles-based accounting standards.

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Chapter 3: Development of the Institutional Structure of Financial Accounting 4.

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Five so-called broad principles of accounting were prepared by the AICPA’s Special Committee on Cooperation with the Stock Exchange and approved by the NYSE’s Committee on Stock List in 1932. They were to be followed by all firms listed on the exchange. Subsequently, these principles (along with a sixth item) were codified as Chapter 1 of ARB 43 and two principles from ARS 7 are available in the text. Terms such as principles of accounting have been used frequently since 1932. Describe what you think the principles might be. Do any of the principles coming from ARB 43, Chapter 1, or ARS 7 qualify as principles as you have construed them? How similar are these two partial groups of principles?

Accounting principles are fairly broad in nature and few in number. In general, they specify how accountants should approach recognition and measurement of transactions and events that affect the financial position and results of operations of enterprises. Examples include the historical cost principle, the revenue recognition principle, the matching principle, and the full disclosure principle. The principles coming from ARB 43 and ARS 7 generally are more narrow than accounting principles as defined. The "principles" prepared by the AICPA's Special Committee on Cooperation with the Stock Exchange are quite specific and appear to be more in the nature of rules rather than principles. Notice, however, in principle (a) we do have the underpinning for part of the revenue recognition principle (as the word "principle" was defined in the chapter. These principles also have the flavor of being definitions: principle (b) defines the nature of capital surplus (paid-in-capital). The two principles from ARS 7 are also definitional in nature.

CRITICAL THINKING AND ANALYSIS 1.

Why have management consulting operations created problems for the public accounting industry? How has SOX affected these problems?

Consulting activities overshadowed auditing services in CPA firms during the 1990s. When consulting fees exceeded audit fees, the audit firm’s independence came into question. The audit firm’s independence became impaired, if not in fact, at a minimum in appearance. This breaching of the "Chinese Wall" did and can create some very difficult problems for auditors relative to the consulting services of their firms. SOX placed restrictions on the consulting-auditing services that a single audit firm can provide a client. Accounting Theory (8th edition)

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The FAF is considering the addition of “baby GAAP” for private companies. Take a position and argue why two GAAPs should or should not exist.

“Baby GAAP” is essentially a more simple GAAP for private companies. The argument for this second GAAP is that it is too costly for a private (and likely smaller company) to implement the GAAP standards for imposed on a publicly traded company. On the other hand, why should an economic activity be accounted for in multiple ways depending on the type ownership of the company. A transaction is a transaction is a transaction. Right? Also, two GAAPs means that auditors will need to develop expertise in two GAAPs, increasing the cost to audit. Perhaps FASB needs to consider the structure of standards to allow for ease of understanding and implementation.

The IASB and FASB are maintaining/developing two different XBRL taxonomies. What effect, if any, might this have on convergence of accounting standards?

The IASB’s XBRL taxonomy is not as advanced as the U.S. taxonomy. The same is true regarding the FASB Financial Statement CodificationTM. So, in the short-term it will likely not have a significant effect on convergence, but longer term, this will be a significant hurdle before U.S. adoption will occur.

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CHAPTER HIGHLIGHTS In recent years, the regulatory nature of accounting policy making has become a prominent topic in both academic and professional accounting literature. The purpose of this chapter is to expose students to the two extreme sets of arguments: those that favor free markets, and those that favor regulatory intervention. By looking at both sets of arguments, students should become more sensitive to the regulation issue, and realize that regulation creates both benefits and costs. These benefits and costs are hard to measure, and it is sometimes hard to identify on whom they fall. Most economists believe it is not possible to optimally allocate society’s resources under regulation (Arrow’s Impossibility Theorem). What one is left with, then, is the far less ambitious task of simply assuring that there is a net benefit from regulation (benefits exceed costs). If the text has a philosophical stance on regulation, it leans toward regulation but with the need to justify it more than has occurred in the past. This means carefully assessing the benefits and costs of accounting regulation. The second part of the chapter explains the political nature of regulatory decision making. Students should understand the “self-interest” principle in a regulatory environment. The selfinterest principle is applicable to (1) accounting regulators (FASB and the SEC) and (2) the constituency groups affected by accounting regulation. These latter groups include preparers, auditors, interpreters, and users of accounting reports. Traditional self-interest theories of regulation (capture theory and life-cycle theory) seem less applicable to accounting than to other areas. This is probably due to the public-good nature of accounting information compared to private property rights created by conventional regulation (e.g., transportation routes in the airline transportation industry). Finally, “economic consequences” has become a vogue term in accounting literature. Basically, it refers to the effect of accounting standards and reports upon the decision-making behavior of preparers and users. Economic consequences can be viewed as part of what is called the political economy of accounting. Simply put, the argument is that any choice of financial reporting systems, from laissez faire to complete regulation, makes some people better off and others worse off. It is thus difficult for standard setting to maintain neutrality. The FASB indeed has an extremely difficult task requiring exquisite balance: promulgating standards for the benefit of investors and creditors but within the context of benefits (to users) exceeding the costs of providing information. The codificational outlook discussed by Gaa provides a philosophical justification for standard setting by an organization such as the FASB. Finally, Sarbanes-Oxley of 2002 (SOX), by establishing the PCAOB and providing FASB funding from non-taxpayer accounting support fees, has reduced self-regulation by the accounting profession. This signals significant changes for several years to come.

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QUESTIONS Q-1

What are the arguments favoring regulation of financial reporting?

The arguments for regulation are in two groups: those relating to market failures and those relating to social goals. It can be argued that private incentives for financial reporting do not work because (1) firms are monopoly suppliers of information, (2) reporting sometimes fails to signal corporate fraud or bankruptcy, and (3) the public-good nature of accounting information leads to underproduction (underreporting) in a free market. In terms of social goals, the arguments are cast in terms of information symmetry and comparability.

Q-2

What are the arguments against regulation of financial reporting?

The arguments against regulation focus on the incentives to report voluntarily. Agency theory can be used to argue for reporting incentives between managers and owners. The competitive nature of capital markets and the concept of “corporate signaling” are used to argue for public reporting incentives. Finally, it is argued that nonpublic information could be privately purchased if demanded.

Q-3

Why is it difficult to evaluate the regulation question?

The free-market position cannot be easily researched (empirically) because the market is regulated. Benefits and costs of regulation are extremely difficult to identify and measure. As a result, the arguments, both for and against regulation, have been largely deductive in nature.

Q-4

Why does accounting information have some features of a public good? What are the implications for information production in both unregulated and regulated markets?

A public good is one that is characterized by non-rival consumption; that is, it can be consumed without reducing the opportunity for consumption by others. In one sense, an accounting report can be read without reducing the information available to subsequent readers. However, the usefulness of the information is highly related to time. Reading a 1980 report in 1984 may convey the same message in both years, but the opportunity to use the information passes quickly (if the efficient-markets hypothesis is correct). Finally, public goods are under produced in free Accounting Theory (8th edition)

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markets due to externalities and overproduced in regulated markets due to the free-rider problem. This is a paradox of regulation.

Q-5

Why can’t optimal regulation be determined? If optimal accounting regulation cannot be determined, how can a regulatory body such as the SEC or FASB make good decisions?

Arrow argues (in the Impossibility Theorem) that optimal regulation (resource allocation decisions) cannot be determined because individual preferences are not additive across individuals. Therefore, one cannot determine if regulation is economically desirable. So, the decision to regulate is achieved through imperfect preference revelation in the form of voting. Given a democratic mandate for regulation, a regulatory agency should at least try to achieve a net social benefit. Even here, determining costs and benefits is difficult due to measurement obstacles.

Q-6

A distinction was made in the chapter between two types of regulation: (a) the refinement and standardization of financial statements and (b) expanded disclosure. Why is the distinction important in evaluating the regulation question?

Refinement and standardization is probably more aesthetically pleasing because it is within the body of the statements themselves and should lead to increased comparability. The emphasis upon disclosure, particularly within the framework of a presumably efficient market with free riders using the information, can easily lead to steeply escalated production costs.

Q-7

Who pays for accounting regulation and who benefits?

These are important but unanswered questions, at least in terms of accounting research. From a self-interest viewpoint, auditors and financial intermediaries benefit from regulation because new work is created by new regulation. Users benefit to the extent that information is useful. Costs are incurred by producers of information (firms), but are probably passed to consumers. The costs of regulatory agencies are borne by society as a whole in the case of the SEC, and the private sector in the case of the FASB (primarily accounting firms and large corporations).

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Q-8

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Can accounting standards and policy making be neutral? In what sense is neutrality really important?

Neutrality is not possible in the sense that someone benefits from regulation, and someone pays the costs. Regulation creates wealth transfers. However, neutrality is at least conceptually possible in the sense of providing information that is useful for investors and creditors within a benefits exceeding costs (of production) framework. The FASB has an extremely difficult balancing act to maintain.

Q-9

Arrow (1963) warns that public participation and a consensual approach to social issues can lead to democratic paralysis; that is, to a failure to act due to an inability to agree on goals or objectives. How did such a situation lead to the demise of the APB (review Chapter 3)? Why is the FASB faring somewhat better?

The rejection of ARS 1 and ARS 3 by the accounting profession was a failure due to inability to agree on goals. While the APB did have some successes (pension and income tax allocation, for example), the APB floundered once again on the issue of business combinations and goodwill. The APB opened up the process of standard setting through public hearings and discussion memorandums. While these are important and necessary steps which were picked up by the FASB. The paradox is that these steps can lead to democratic paralysis: a general lengthening of the time that it takes to draft and complete standards. Of marginal benefit is the fact that the FASB has managed to get a conceptual framework in place, a process which was also accompanied by democratic paralysis (see Chapter 7).

Q-10

Horngren (1973) argues that accounting policies are a social decision and a matter of public interest. Evaluate this statement.

The decision to regulate is a social decision because it affects society’s allocation of resources. Therefore, accounting regulation falls in the domain of public policy. Laissez faire is also a “policy” decision inasmuch as it too affects society’s allocation of resources.

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Q-11

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Horngren (1973) believes that accounting standards must be marketed by regulatory bodies. By this he means that affected parties need to be sold on the benefits of standards. How is this concept consistent with the nature of regulation?

Regulatory theories suggest that regulators are motivated to make their constituents happy in order to enhance the position of the regulator. The essence of Horngren’s position is that the self-interest of accounting regulators is best served by making the constituency want the regulation. Horngren implies a normative aspect (it “should” be this way), which is harder to defend.

Q-12

It was suggested many years ago that a court should be created to resolve disputes in accounting. In what ways does the FASB function as an accounting court? In what ways is it different?

The due-process nature of regulatory decision making is adapted from the legal system. There is an obvious parallel between a judge and a regulator; both are presumed to be impartial arbiters. An important difference, though, is the absence of a body of law and precedents in accounting on which to base decisions. As a result, regulatory decision making is far more open-ended and the criteria more subjective.

Q-13

What benefit is the conceptual framework project to the FASB if (a) there is no way of determining optimal accounting regulation and (b) regulatory decision making is a political process?

Perhaps the best way of characterizing it is to liken it to the United States Constitution, as providing a frame of reference or departing point for analyzing policy issues. However, just as the Constitution has not prevented “bad” laws (e.g., the Jim Crow laws after the Civil War) or “bad” interpretations of the laws by courts, the FASB’s conceptual framework will not prevent bad accounting policy making, nor will it ensure that ephemeral and illusive quality of neutrality (see also question 14 below). The codificational justification by Gaa (1988) discussed in the chapter (and also in Chapter 6) is quite helpful in defending standard setting by organizations such as the FASB as well as both conceptual framework.

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What is the relationship between public goods and free riders?

Free riders are those individuals who capture the benefits of public goods without paying for those benefits. Public goods are goods that are not used up even though individuals have derived benefits from them.

Q-15

What is Pareto-optimality (sometimes called Pareto efficiency)? Why would adherence to it minimize accounting standard setting?

Pareto optimality refers to social situations where the benefit of one group or individual cannot be improved without hurting other groups or individuals. The problem with applying Pareto optimality to accounting standard setting is that each position of standards represents a unique Pareto optimal point. Any new standard or change in standards will adversely affect some individual or groups. This also includes preparers who must pay for the cost of preparing new standards or disclosures.

Q-16

How do agency theory and the codificational viewpoint differ in assumptions about the behavior of individuals?

Under the agency theory view, individuals act in their own best interest. The problem with this assumption is that it is tautological. The codificational view is more process-oriented than agency theory. While individuals do operate in their own best interest, the standard setting process is a rational process and individuals involved with the regulatory process will more or less try to carry out the assigned tasks of the organization (which may well be in their own best interest). This does not, of course, guarantee optimal standards, but an evolutionary and rational process.

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Q-17

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Why does codification presume a democratic setting?

Codification, which is essentially a rational process with a diffusion of power, can only occur in a democratic society. The process is also evolutionary in nature. Codification is inconceivable in societies that are other than democratic.

Q-18

The social goals underlying accounting regulation are information symmetry and comparability. Why are these goals complementary?

These are complementary because we not only want as much comparability between firms as possible, but we also want all users to have this information. It may well be impossible to maximize comparability without maximizing information symmetry.

Q-19

Is a regular quarterly announcement of earnings-per-share that is “good” be an example of signaling? What about early adoption of a new accounting standard that reduces income?

Regular reporting of information such as quarterly announcements of earnings-per-share would not be considered to be signalling. However, early adoption of a standard, particularly one that would lower income such as SFAS No. 106, would be an example of signaling. The firm, in effect, appears to be saying that it is in such good shape that it can afford to take an income "hit" early on.

Q-20

If accounting were not regulated, we would not be facing the difficult problems that have arisen as a result of Enron and other corporate auditing failures. Do you agree with this statement? Explain.

Absolutely not! Enron arose out of pure greed. Enron, WorldCom, and others arose because individuals tried to “game the system.” The problem would have been as bad – if not worse – if we had no regulation. This is evidenced by the overwhelming vote in favor of SOX passage in 2002. Despite SOX’s continued criticism, major components of this law are being emulated country-by-country.

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Chapter 4: The Economics of Financial Reporting Regulation Q-21

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Evaluate Ronen’s financial statement insurance proposal.

Ronen, Joshua (2002). “Policy Reforms in the Aftermath of Accounting Scandals,” Journal of Accounting and Public Policy 21, no. 3: 281–286. The key point about Ronen’s proposal is that the insurance company selects and pays the auditor. By putting the insurance company between the firm and the auditor, a dangerous moral hazard interface is eliminated.

Q-22

Under financial statement insurance why would the relation between the firm and its auditor and investors bear a slight resemblance to the relationship between Saddam Hussein and the weapons inspectors from the United Nations in 2002 and 2003?

The auditors’ role would be somewhat similar to the weapons inspectors and the firm would be similar to Iraq or, if you like, Saddam Hussein. The financial statement insurance proposal would certainly make the auditors stronger. The interesting question – which is now history – is whether Hans Blix led a strong or a weak inspection regime.

Q-23

What is due process in financial accounting standard-setting?

Due process refers to the bringing into the process all of those who are affected by it, standard setting in this case. Obviously this makes the standard-setting process longer and more complex.

Q-24

Why do companies, even those with “bad news,” have an incentive to disclose financial reporting information?

While “bad news” is no fun, it gets everything into the open. Not announcing would certainly add to the volatility of the security price. Of course one of the problems today is firms trying to get around uncertainly by “cooking the books.” The self preservation instincts of individuals may conflict with the firm’s incentives to disclose.

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Q-25

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Does the ability to swiftly-and at no cost-download music files convert this music from a private good to a public good?

Yes. Files can be shared at no cost resulting in an inability by the artist and the public to restrict use of the product to those who actually purchased it.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

What is the relationship among agency theory, economic consequences, and signaling? Explain in depth

There is a close connection between agency theory and economic consequences. An underlying assumption of agency theory is that the firm is a locus or nexus among competing groups: management tries to maximize its compensation at a cost to shareholders of money that might have gone into dividends, bondholders likewise want to get their interest and principal and not be jeopardized by excessive dividends to shareholders hence debt covenants protecting bondholders as part of the bond indenture, for example. Economic consequences, the idea that accounting standards can benefit some groups at the expense of others would be complementary to agency theory. Signaling appears to be directed primarily toward one group: shareholders and prospective shareholders so it would neither be in agreement or disagreement with agency theory and economic consequences. However, it is seen as complementary to agency theory in terms of being an instrument making accounting regulation unnecessary. Agency theory gives rise to the idea that management can maximize its welfare by keeping relations with shareholders and others on a good basis by means of techniques such as having audits comply with generally accepted accounting principles. In a complementary fashion signaling would help to make regulation unnecessary because it would lead to voluntarily sharing information with shareholders—even if the news is bad—in light of competitive capital markets.

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Benston (1982, p. 102), in an analysis of corporate social accounting and reporting (CSAR), says: “The social responsibility of accountants can be expressed by their forebearing from social responsibility accounting.” However, in a critique of Benston’s analysis, Schreuder and Ramanathan (1984, p. 414) state: The comments . . . do not purport to convey the message that there is no value at all in analyzing the potential of CSAR from a shareholder perspective and proceeding from the (implicit) assumption of perfect and complete markets. We do, however, wish to point out that this may not be the most appropriate perspective as (1) CSAR is addressed toward a more inclusive group of stakeholders and (2) one of its main objectives is to include in the accounting system those aspects of corporate behavior that are decidedly not handled well by the market. Therefore, the perspective implied in Benston’s analysis is of very limited value at best. Required: CSAR assumes there is a legitimate interest or “stake” in the corporation beyond the stockholders’ interests, and that these other stakeholders’ interests are not well served by traditional financial statements. Therefore, it follows that within a broad political economy of accounting, CSAR is an important policy-making issue. Critically evaluate this proposition and indicate your agreement or disagreement and the underlying reasons for your position.

This case is intended to raise serious questions about the “primacy” of the FASB’s primary user group of investors/creditors. Lip service is paid to the existence of other stakeholders, but with a wave of the magic wand their interests are reduced to and equated with investors/creditors. A wider accountability beyond investors and creditors is a distinct possibility and is examined in later chapters. One difference between the United States and other Western countries is the issue of the broadness of the stakeholder group. We contend that the focus could be broadened somewhat from investors and creditors without making the problems of the FASB any worse than they are. Of course, the conceptual framework would need to be broadened from the perspective of investors and creditors to a wider primary user group. The FASB and IASB’s current convergence project (initiated in 2004) on the conceptual framework will likely move toward a more inclusive user group definition.

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Discuss the economic consequences issues that are present in each of the following transaction situations. SFAS No. 13 allows lease contracts to be set up so that the transaction can usually be set up as an operating lease rather than a capital lease. When SFAS No. 19 was passed, medium-sized petroleum exploration firms campaigned hard to set it aside. SFAS No. 19 would have allowed successful efforts only, whereas the lobbying firms wanted an unrestricted choice between full costing and successful efforts. A securities industry group objected to part of APB Opinion No. 10, which would have required that all convertible debt be broken down into debt and equity portions at the time of issue. The debt portion (bonds payable plus premium or minus discount) would be booked at the effective rate without the conversion privilege with the equity portion credited to paid-in capital. The industry group was pleased by APB Opinion No. 14, which did not break out the equity portion of convertible debt except if detachable stock warrants were issued. Why was the securities industry group (which represented investment bankers who floated large loans for industry) unhappy with Opinion No. 10 and pleased with Opinion No. 14? SFAS No. 87 does not show the full pension obligation or liability in the balance sheet (although a “minimum” liability may be present). SFAS No. 96 made it much more difficult to recognize deferred tax assets as opposed to deferred tax liability (a more even-handed treatment was used in recognizing deferred tax assets and liabilities in SFAS No. 109, which superceded SFAS No. 96). The FASB tried to include the cost of stock options as an expense but they were prevented from doing so by vociferous opposition from the business community, although it now is going to happen under SFAS No. 123R.

This allows for a “better” measurement of debt-equity ratios from the perspective of shareholders—less of a problem of violating debt covenants—hence making it easier to pay dividends. Shareholders thus benefit from the ability to more easily receive dividends, which can work to the detriment of the firm’s bondholders. SFAS No. 19 would have lowered the income of firms using full costing. These were generally medium-sized firms. The claim was that the lower income under successful efforts would raise the cost of borrowing to firms that were using full costing. Of course, efficient-market advocates would say that the market should be able to see behind the income difference between the two methods, but the lower debt-equity ratio that would result under successful efforts could indeed more easily threaten violation of debt covenants. This could affect potential dividend payments and could, therefore, raise the cost of capital (see Chapter 8). Of course, this latter effect could also lower the cost of debt capital, since it would be better protected, but that also depends upon players in the market understanding this issue. Use of one method—successful efforts—rather than two methods might also benefit users of financial statements, who would not have the

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problem of reconciling incomes for different firms using different methods. Use of one method would also improve verifiability. Zeff (1978) discusses this situation. It appears that the crux of the problem under the break-out of debt and equity is that by assigning some of the credit to equity, the resulting lower carrying value of debt would raise the effective rate of interest (as opposed to no break-out of equity) and also lower the level of income by either reducing the premium or increasing the discount (as opposed to no break-out of equity). The securities industry group may therefore have thought that convertible debt raised through their auspices had a higher cost than, in their opinion, it really had. Assume that a ten-year $1,000,000 convertible debt issue is sold at par. Coupon rate is 10%, and $100,000 is assigned to equity (which would now create a $100,000 discount). Straight-line amortization is used. Entries for the first year would be: Cash

1,000,000

Discount on bonds

100,000

Bonds payable

1,000,000

Paid-in capital

100,000

Interest expense

110,000

Cash

100,000

Discount on bonds

10,000

No break-out of equity would leave the interest expense at $100,000. The discount would also lower the carrying cost of the debt which would also raise the effective interest rate. SFAS No. 87 results, in most cases, in keeping debt off the balance sheet which benefits debtequity ratios which are often used as debt covenants in bond indentures. Hence it favors stockholders over bondholders. SFAS No. 96 would have had a detrimental effect on debt-equity ratios and would likewise have resulted in lower income when deferred tax assets were not recognized. Hence it would have been beneficial for bondholders over stockholders. The lower income which would have resulted in some cases (where deferred tax assets would not have been recognized) might have resulted in lower security prices. This is a now classic example of trying to keep a cost off of the income statement in order to make income higher and cost of capital lower. It also presumably enables start-up companies to avoid spending much larger outlays for managerial compensation. See Chapter 11 for more on stock options. Accounting Theory (8th edition)

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Although a recent study by Barton and Waymire indicates that there are incentives for higher quality financial information under unregulated financial reporting, why is this finding not an effective one in support of unregulated financial reporting?

References: Barton, Jan and G. Waymire (2004). “Investor Protection Under Unregulated Financial Reporting,” Journal of Accounting and Economics (December 2004), pp. 65-116. Leftwich, Richard, (2004). “Discussion of: ‘Investor Protection Under Unregulated Financial Reporting’ (by Jan Barton and Gregory Waymire).” Journal of Accounting and Economics (December 2004), pp. 117-128. Barton and Waymire conclude that firms with higher quality financial reporting experienced substantially lower price declines when stock prices dropped in October 1929. With each accounting scandal prompting increased regulation over the last 70+ years, the markets have responded favorably and flourished. It is difficult to convincingly show that the markets would have been even better without the increased regulation.

Etzioni (2009) argues that the 2008 financial crisis points towards widespread regulatory capture resulting in special interests benefiting from the capture. Rather than pursue more or less regulation, Etzioni argues for capture-proof regulations. Evaluate Etzioni’s proposals.

Etzioni, Amitai (July 2009). “The Capture Theory of Regulations–Revisited,” Society, 319–323. Etzioni suggests that what is needed is a way to make regulations stronger, more capture-proof. “This requires, first of all, greatly restricting the role of private money in public life, mainly through reforming campaign-finance laws. Unless this change is adopted, regulations will continue to be captured on a large scale and will continue to serve special interests rather thanthe public at large.” The student response should include the feasibility of keeping private money out of the democratic process.

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CRITICAL THINKING AND ANALYSIS 1.

Evaluate the costs and benefits of the accounting standard-setting process (versus an unregulated environment).

This question spans the entire chapter. Repeating the arguments from the beginning of the chapter should not be sufficient but it is most likely necessary. Balancing the pros and cons is probably important. The social goals of improving comparability and increasing information symmetry are, we believe, extremely important goals which can only be brought about through regulation. Nevertheless, the bottom line will undoubtedly result in a costs versus benefits analysis. Despite the many problems such as democratic paralysis, inability to attain social optimums, making some people and groups worse off, as well as the politics resulting from the standard setting process, we believe that the benefits of standard setting are greater than the costs. There's no question that it is a close call.

How might the “capture” of auditors by auditees be mitigated?

Capture theory argues that the group being regulated eventually comes to use the regulatory process to promote its own self interest. One approach to responding to the question would address the long-term relationship between the audit firm (auditor) and its client (auditee). Perhaps the relationship with an individual regulatory body (audit firm in this case) could be periodically changed to restart the clock, so to speak. For example, Brazil requires that public companies periodically rotate audit firms, not just audit partners. This limits the ability of time to affect the audit-client relationship, keeping it professional rather than too friendly. What would be the effect of mandated audit firm rotations every 5-10 years in the USA? The idea of the cost-benefit should arise. Sarbanes-Oxley of 2002 (SOX) requires audit partner rotations every five years, not audit firm rotations; will this mitigate the capture? Another approach would be to view the question from a financial influence perspective. SOX took the approach that restricting consulting activities by the audit firm issuing the audit opinion would mitigate the capture of auditors by auditees. This removes the non-audit related fees from the process of issuing an audit opinion. This move towards greater independence of the auditor (real and perceived) could also be achieved by assigning the audit responsibilities to the public sector. Also, consider that if a single client represents a significant percentage of the audit firm’s revenues, the potential loss of a client due to an unfavorable audit opinion

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A good class discussion might result if you approach the question from increasing the integrity of individual accountants. If we in the accounting profession are persons of unquestionable integrity, would we ever be “captured” by an auditee? Is this a realistic approach? If so, ask how the educational system might be used to produce accounting professionals with more integrity.

Ball (2009) evokes the question of responsibility for the rash of accounting scandals in the 2000s. What actions do you propose to address the problem, if you agree that one exists?

Ball, Ray (May 2009). “Market and Political/Regulatory Perspectives on the Recent Accounting Standards,” Journal of Accounting Research, 277–323. This is a thought provoking question. Ball views responsibility for recent accounting scandals from multiple perspectives, arguing for and against specific views. This should be a good classroom discussion after students have thoroughly read the article.

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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-ofcost-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 Accounting Theory (8th edition)

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equal or lower in any given year. Therefore, we believe it is conservative in terms of the definition given in the chapter. 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 nonmaterial. 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.

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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.

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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

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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 earningsper-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.

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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 decisionmaking 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.

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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) Dividends declared of $5 per share on Common Stock (20,000 shares outstanding a par value of $100 per share) (a)

30,000

100,000

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?

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(a)

Proprietary Revenues $1,000,000 Operating Expense 700,000 Operating Income 300,000 Other Revenues and Expenses Bond interest 80,000 Preferred dividends Common dividends Net Income $220,000

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Orthodox Entity $1,000,000 700,000 300,000

Unorthodox Entity $1,000,000 700,000 300,000

Residual Equity $1,000,000 700,000 300,000

---$300,000

80,000 30,000 100,000 $ 90,000

80,000 30,000 $ 190,000

(b)

Convertible preferred stock would be considered a common stock equivalent and should, therefore, be included in the calculation of common dividends.

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 Accounting Theory (8th edition)

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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). Accounting Theory (8th edition)

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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?

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. 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).

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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.

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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.

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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 Accounting Theory (8th edition)

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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 rulemaking 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-thehorse 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 Accounting Theory (8th edition)

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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.

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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.

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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

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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.

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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.

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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 Accounting Theory (8th edition)

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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. You should review the project’s status on the FASB and IASB web sites for possible in-class discussions.

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.

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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 Accounting Theory (8th edition)

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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.

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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 Accounting Theory (8th edition)

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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.

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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 Accounting Theory (8th edition)

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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 4,000 x .7513 x .3 5,200 x .7513 x .4

$ 676 902 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.

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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.

Evaluate the benefits versus costs of an accounting conceptual framework.

While it is true that some individuals have seen a conceptual framework as a cosmetic instrument to help the standard setter (Dopuch and Sunder and Hines, for example), we see it as providing important guidance for standard setters in terms of grounding standards in desired objectives and also for maintaining definitional consistency from standard to standard. We also see the conceptual framework as a potentially useful tool for accountants using professional judgment to account for an economic activity not yet addressed by a specific standard. Of course, Daley and Tranter are correct to the extent that the politics of standard setting cannot be eliminated but at least a conceptual framework can be a buffer against political interference in the standard-setting process. It is also interesting that Anglo-American countries as well as the International Accounting Standards Board have adopted conceptual frameworks. Note that the FASB and IASB have determined that to converge their accounting standards, a common conceptual framework is a necessity. 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.

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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 25 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.

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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 Accounting Theory (8th edition)

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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 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.

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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.

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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 the 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 (Warren 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).

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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.

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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. It considers stock price changes before and after some event that occurs, attempting to determine information content.

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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 Accounting Theory (8th edition)

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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.

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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 affected by 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.

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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.

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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.

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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 lead to poor operating performance and sub-optimal investment decisions. It appears that investors frequently do not fully recognize that the severe underfunding has negative 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

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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.

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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.

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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. Sales Cost of Sales Gross Margin Operating Expenses Operating income Taxes on operating income (25%) Basis for Bonus Bonus (1%)

FIFO $6,000,000 2,600,000 3,400,000 400,000 3,000,000 750,000 2,250,000 $ 22,500

LIFO $6,000,000 2,900,000 3,100,000 400,000 2,700,000 675,000 2,025,000 $ 20,250

In terms of the bonus alone, management would choose FIFO over LIFO. However, after-tax cash flows will be higher under LIFO.

Gross Margin Operating Expenses Bonus (1%) Pre-tax Income Taxes (25%)

FIFO $3,400,000.00 400,000.00 22,500.00 2,977,500.00 744,375.00

LIFO $3,100,000.00 400,000.00 20,250.00 2,679,750.00 669,937.50

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.

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(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.

This is a problem somewhat like the one faced when FASB proposed making all leases be placed on the balance sheet. In the case of leases, ratios were affected, severely in some cases, and companies voiced very strong opposition. The opposition was strong enough that FASB reversed its position. 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.

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Chapter 9: Uniformity and Disclosure: Some Policy-Making Directions

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CHAPTER HIGHLIGHTS It is extremely important in this chapter to make sure that definitions of concepts are well understood. The first important distinction is between simple and complex events. How relevant circumstances can affect complex events is the next link. Examples of the two types of relevant circumstances (present magnitudes and future contingencies) should help to reinforce the concept. With these various definitions and distinctions in mind, the two types of uniformity can then be examined. The point should be stressed that finite uniformity is not “better” than rigid uniformity. Which one would be preferable is very definitely a cost versus benefits question. Part of the cost of implementing finite uniformity would be a more extensive standard-setting apparatus than would be the case with rigid uniformity. Hence, finite versus rigid uniformity is very much a cost-benefits-oriented question. Finite and rigid uniformity, as total systems, represent ideal types. Nevertheless, a better understanding of current standards can be acquired if they are analyzed from the standpoint of finite and rigid uniformity. A third orientation, flexibility, is also present where several methods are allowed and no relevant circumstances are present. Since disclosure is becoming more important in light of increasing transaction (event) complexity as well as the impact of the efficient-markets hypothesis, and also has implications relative to the uniformity issue, it is examined in the last part of the chapter. The most important aspect of disclosure is the shift from protective to informative disclosure, which appears to be taking place at the SEC. While not much is said about the extensive growth of disclosure, it is certainly worthy of class discussion. The chapter contains an extensive discussion of disclosure and also lists and discusses different methods of disclosure. The difference between selective and differential disclosure is discussed as well as arguments in favor of more or less disclosure. Forms and methods of disclosure include management’s discussion and analyses, signalling and management earnings forecasts, segmental disclosures (the Jenkins Committee Report and SFAS No. 131), and quarterly information.

QUESTIONS Q-1

Is Cadenhead’s conception of circumstantial variables as the only permissible departure from prescribed accounting methods closer to finite or rigid uniformity?

Cadenhead’s conception of circumstantial variables is more narrow in scope than the concept of relevant circumstances discussed in the chapter. Departures from the rigidly prescribed accounting methods are intended to be very infrequent. Therefore, though his approach falls between finite and rigid uniformity, his intention is to be closer to rigid uniformity.

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Do you think management policies should be acceptable as potential relevant circumstances? Why or why not?

Obviously, either side of the issue can be taken. Our position would be only insofar as management policies involve a choice among relevant circumstances. For example, a managerial choice between a lease for 60 percent of the economic life of an asset versus a 90 percent lease involves a choice among relevant circumstances, at least in terms of the way SFAS No. 13 defines the problem. The situation becomes more difficult where future contingencies are involved, because either managerial judgment or managerial policy implications are involved. It is highly questionable whether management can be expected to be unbiased in these situations. The long-run reward for “good” financial reporting by management can hardly be expected to govern in these situations. Q-3

How do present magnitudes differ from future contingencies?

The time dimension is the difference, of course. Under present magnitudes, the relevant circumstances are present in the nature of the transaction, which is accepted as a surrogate or indicator of different cash flows. In the case of future contingencies, the nature of the event leading to cash flow differential itself must be relied upon. Future contingencies may thus be less verifiable than present magnitudes. Q-4

Are simple transactions really examples of rigid uniformity? Why or why not?

Since no relevant circumstance differentials are present in simple event situations, their treatment should be the same as rigid uniformity. The significance of rigid uniformity is its usage in complex event situations. Q-5

Finite and rigid uniformity would result in different information being received by users of financial statements. What difference would this make in terms of resource allocation when viewed from a macroeconomic standpoint?

It would be hoped that the additional information provided by finite uniformity, which would affect security prices, would result in a more accurate portrayal of the risk-return configuration of securities. As a result, it would be hoped that resources would be allocated more efficiently. Of course, the cost involved to attain the more efficient allocation of resources concerns the cost of producing the presumed better quality of information. Hence, we have an extremely difficult information economics problem. Q-6

Why does segment disclosure in SFAS No. 131 represent a potential improvement over segment disclosure in SFAS No. 14?

SFAS No. 131 is supposed to result in segment reporting along the lines that enterprise management itself uses rather than the more arbitrary and flexible approach of SFAS No. 14.

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How do protective and informative disclosures differ?

Protective disclosure assures that unsophisticated investors are not treated unfairly. Informative disclosure provides the full range of information useful for investment analysis purposes. The primary difference is the financial sophistication of the user groups. Q-8

Under previous disclosure requirements of the SEC, dividends paid during the past two years to shareholders must be stated in the annual report. This requirement has been broadened: • There must be disclosure of any restrictions on the firm’s present or future dividend-paying ability. • If the firm has not paid dividends in the past despite the availability of cash, and the corporate intention is to continue to forgo paying dividends in the foreseeable future, disclosure of this policy is encouraged. • If dividends have been paid in the past, the firm is encouraged to disclose whether this condition is expected to continue in the future. Do you think that this broadening of disclosure of dividend policy is primarily protective or informative? Discuss.

There is, of course, some overlap between protective and informative disclosure. The broadening of disclosure of dividend-paying policy appears to be more protective since the information is particularly important to those who might be relying on the hope of immediate dividend payments. There are informative aspects of this information. Why is the firm following its particular dividend policy? For example, is its financial situation endangered, or is it expanding using internally generated funds? A retained earnings restriction might also convey the latter information. Q-9

ASR 242 of the SEC states that relative to payments made to foreign governmental and political officials, “. . . registrants have a continuing obligation to disclose all material information and all information necessary to prevent other disclosures made from being misleading with respect to such transactions.” This ASR appeared shortly after the passage of the Foreign Corrupt Practices Act. Do you think this type of disclosure is primarily protective or informative in nature?

Businesses subject to the Foreign Corrupt Practices Act must provide systems of internal control in terms of maintaining accountability for assets and ensuring that transactions are in accordance with management’s authorization; access to assets is permitted only to those having proper authority. Obviously, information of the type required by the Act is concerned with protective elements, since it pertains to appropriate internal controls relative to foreign business. At the same time, information of this type can provide much insight into a company’s mode of operation. Hence, the main thrust of the disclosure is protective, but it can also be highly informative if a breakdown in the firm’s internal controls occurs and is disclosed.

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If uniformity means eliminating alternative accounting treatments, then surely comparability of financial statements of different enterprises would be improved. Do you agree with this statement? Comment.

The sense of uniformity in the statement is rigid uniformity. Where methods are restricted, the results are not necessarily more comparable because of possibilities of different circumstances being present despite the same method being used. Of course, rigid uniformity could result in better comparability when compared with a situation of flexibility. Q-11

Is the choice of LIFO a relevant circumstance compared to FIFO?

On their own the choice would not be a relevant circumstance. The choice would not affect actual inventory flows. The switch would really be nothing more than a choice among allocations. However, the choice involves a change in cash flows relative to income tax payments. Hence it would be a relevant circumstance although we do not like to see relevant circumstances arising from tax considerations. Q-12

Do you agree that it is not necessary to provide information for undiversified investors? Discuss.

It is not clear what information would be specifically applicable to undiversified stock owners that would not be useful to diversified shareholders as well. Q-13

SFAC No. 6 defines circumstances as follows: Circumstances are a condition or set of conditions that develop from an event or series of events, which may occur almost imperceptibly and may converge in random or unexpected ways to create situations that might otherwise not have occurred and might not have been anticipated. To see the circumstance may be fairly easy, but to discern specifically when the event or events that caused it occurred may be difficult or impossible. For example, a debtor’s going bankrupt or a thief’s stealing gasoline may be an event, but a creditor’s facing the situation that its debtor is bankrupt or a warehouse’s facing the fact that its tank is empty may be a circumstance. How does this definition of circumstances relate to the definition of relevant circumstances presented in the chapter?

Circumstances, as defined in SFAC No. 6, may or may not entail relevant circumstances as the term is defined in the chapter. The situations described in SFAC No. 6 all entail changes in cash flows hence they are relevant circumstances that require event recognition. What they do not entail, however, is a choice among alternative accounting methods involving choices of how to recognize the event.

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SFAS No. 13 in effect regards a lease period of 75 percent or more as a relevant circumstance in distinguishing between capital and operating leases. What economic factors (cash flow differentials) lie behind this policy choice?

At least as the FASB sees it, where the asset is leased for more than 75 percent of its economic life, the lessee is closer to an owner in terms of risk considerations. This would probably mean a lower cost per unit of usage of the leased asset’s services, but less flexibility if the asset becomes partially obsolescent. As noted in the text, the 75 percent benchmark may be very arbitrary in nature. Q-15

An argument against additional disclosure is that financial analysts aggressively seek this information, which is then sold to their customers, resulting in an adequate market solution to the problem of providing timely and relevant information on securities. Do you agree?

Certainly, as Brownlee and Young have argued, while accounting information is a public good, those who acquire it from financial analysts do have the time utility benefit of acquiring it first. This is at least a partial market solution to the problem. The issue raised by Lev, however, is a powerful one. Those who do not have information or do not have it on a timely basis will tend to take defensive actions, even extreme ones such as getting out of the market. As a result, those having the benefit of information might be operating in a “thin” market and would not tend to receive the benefits of their information advantage. Hence, even these individuals would benefit from additional disclosure. Q-16

What are the possible benefits of a disclosure process that is integrated with major policies in marketing, production, and finance? Do you think only “good news” items should be disclosed?

Lev sees an integrated disclosure policy leading to a reduction of uncertainty over the long run, which should, therefore, lead to higher security prices. Of course, the release of “bad news” (as opposed to not releasing it) can lead to lower security prices in the short run. The general perception of being an “information discloser” should, over the long run, lead to greater confidence in the firm and its management. Q-17

Do you think that disclosures of smaller firms have more information content than disclosures for larger firms?

Yes. The reason is that there is significantly less publicly available information about smaller firms than larger firms. Q-18

What is meant by the term “degrees of representational faithfulness?”

The term degrees of representational faithfulness refers to a relative rather than an absolute view of representational faithfulness. Sterling (1985) is an exemplar of the absolute approach: it either is or is not representationally faithful, although even he admits to measurement Accounting Theory (8th edition)

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difficulties. However, in the absolute mode, there could be no trade-off between relevance and reliability. Representational faithfulness, in effect, covers both categories. Finite uniformity represents the relative approach. Some measurements are better than others in terms of representational faithfulness, and a choice among methods involves trade-offs between relevance and reliability. A “successful efforts” approach to research and development costs would be more representationally faithful than SFAS No. 2, but it could add significantly to verifiability problems. (We personally would favor this treatment, but that is not the issue.) Q-19

Firm A and B are exactly the same size as are Firm C and Firm D. Firm A acquires for cash 100 percent of the common stock of Firm C. Firm B acquires 100 percent of Firm D by exchanging one share of its own stock for each share of common stock of Firm D. Are there differences in relevant circumstances between these two transactions? Explain.

This is a somewhat loaded question which is asking whether purchase and “pooling” are really different transactions requiring different accounting approaches. By way of analogy, assume a fixed asset were being acquired by means of (1) cash or (2) some amount of the acquiring firm’s common stock given in exchange for the asset. In both cases we would value the asset acquired in terms of the value of the consideration given up but there would be no different form of accounting for the acquired asset. We might want to use a different method of depreciation based on how we were going to use the asset but how the asset was acquired would be irrelevant. In other words consideration given up to acquire an asset or assets might affect the determination of the value of the asset but would not lead to a different method of valuation (purchase price versus historical cost). Relevant circumstances pertain to how an asset is controlled or used up but not to how much was given to acquire it. Q-20

How do Lev’s views on disclosure differ from the views of Brownlee and Young?

Lev is in favor of publicly disseminating as much corporate information as possible to eliminate insider information. He feels that this will prevent markets from getting “thin.” Brownlee and Young favor disseminating information through financial analysts who will aggressively seek this information and sell it to clients. However, this is a form of selective disclosure and not all “players” will have this information. Hence Brownlee and Young would put information on a “supply and demand” basis. Market value of securities, however, would not be based on information symmetry. Q-21

Distinguish between the discrete and integral views of quarterly information disclosure.

The discrete view sees each quarterly period as standing on its own whereas the integral view sees the quarter as part of a larger whole: the fiscal year. Q-22

What evidence supports the statement that SFAS No. 131 is an improvement over SFAS No. 14?

There has been a reduction in the number of firms claiming they only operate in one segment. In addition, the average number of segments reported has increased per firm. Also, the number of Accounting Theory (8th edition)

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items reported per segment has increased. Firms have also changed the definition of their schedules to presumably show them in accordance with management’s own internal analysis but this could be an attempt to hide relevant information. All in all, SFAS No. 131 does appear to have brought improvements to segment reporting.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Refer to either a current intermediate accounting text or a guide to current “generally accepted accounting principles.” Give at least one example for each of the four cells of Exhibit 9-1 (your instructor may desire to modify this problem).

Cell IA (relevant circumstances and finite uniformity) • SFAS No. 13 uses the 75 percent rule relative to the proportion of the estimated economic life that the asset is leased for (costs should be lower the longer the lease period extends, but we would still prefer to use rigid uniformity and capitalize all long-term leases). • SFAS No. 19 (superseded by SFAS No. 25) requires successful efforts because write-off of drilling costs occurs for dry holes and capitalization occurs for productive holes. Cell IB (relevant circumstances and rigid uniformity) • SFAS No. 86 requires the expensing of software development costs until the point where “technological feasibility” is attained, even though these costs have a higher probability of generating future cash flows than research and development costs. Cell IIA (no relevant circumstances with finite uniformity: this is really flexibility) • FIFO, LIFO, and weighted average inventory methods holding aside tax issues. • APB Opinion No. 10 for installment accounts where either accrual or cash method can be used. • Straight-line or effective interest method can be used for amortization of bond premium or discount. Cell IIB (no relevant circumstances with rigid uniformity) • APB Opinion No. 21 for notes without a specified interest rate must be discounted. • SFAS No. 4 on refunding of long-term debt requires that gains and losses must be treated as extraordinary gains or losses. 2.

Compare and contrast the Hutton (2004) and Lev (1992) disclosure strategies.

Lev, Baruch (Summer 1992). “Information Disclosure Strategy.” California Management Review, Summer 1992, pp. 9-32. Hutton, Amy (Fall 2004). “Beyond Financial Reporting: An Integrated Approach to Corporate Disclsoure.” Journal of Applied Corporate Finance, pp. 8-16. Lev proposes a voluntary disclosure strategy versus Hutton’s mandated data and disclosure.

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Give as many examples as you can of flexibility under current generally accepted accounting principles.

As noted in the text, the investment tax credit (aside from any carryforward aspects), inventories, and treasury stock involve no differences in relevant circumstances; hence, they are classic examples of flexibility. Depreciation is a special case because different usage patterns might involve relevant cash flow differentials, but these have not been used by standard setters. A free choice exists among selection of methods, such as straight-line, sum-of-the-years’-digits, and fixed percentage of declining balance. Marketable debt securities prior to SFAS No. 115 provide an interesting de facto case of flexibility. SFAS No. 12 states that marketable equity securities are to be carried at lower-ofcost-or-market, while marketable debt securities are not mentioned in the standard. While some authors believe implied preference exists in SFAS No. 12 for carrying all temporary investments at lower-of-cost-or-market, treatment of marketable debt securities by either cost or lower-ofcost-or-market was acceptable. Since no relevant circumstantial differences are present, the result is one of flexibility. SFAS No. 19 attempted to eliminate full costing in the oil and gas industry in favor of only one method, successful efforts. Accounting Series Release 253 of the SEC permitted either method, and SFAS No. 25 then rescinded SFAS No. 19, leaving an unfettered choice between full costing and successful efforts. For further coverage, see Chapter 15. It is very unclear that legitimate relevant circumstances exist in terms of differentiating between purchases and poolings. Consequently, the situation was to be one of flexibility. Pooling is now gone. Another example involves bonds payable. Premium or discount can be amortized on either a straight-line basis or the effective interest basis. Finally, revenue on installment sales is supposed to be recognized in the period of sale, but if the uncollectability factor is too difficult to estimate, gross profit can be recognized in accordance with the collection of installment receivables. Theoretically, this falls under the category of Cadenhead’s circumstantial variables, but in practice it may break down into flexibility.

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SFAS No. 115 defines held-to-maturity securities as debt securities that the firm “has the positive intent and ability to hold those securities to maturity.” Trading securities “are bought and held principally for the purpose of selling them in the near term....” Available-for-sale securities are simply everything else. SFAS No. 115 requires held-to-maturity securities to be valued at amortized cost with the other two carried at fair value. Unrealized gains and losses on trading securities are recognized in net income but for trading securities unrealized gains and losses are recognized as other comprehensive income and as a separate part of owners’ equity. Two members of the FASB voted against the standard. They wanted the three types of securities to be carried at market value and unrealized gains and losses of the three “types” to go through income. Required: Evaluate the Board’s attempt to use a finite uniformity approach to the investments covered in the standard. How did the dissenters to SFAS No. 115 want to deal with the problem?

This is what we would call phony finite uniformity. The finite uniformity being employed is based on managerial intent which is not a good way to go. Why an intent – which may or may not materialize – should result in bond investments to be carried at cost if this is an intent to hold them to maturity is not clear. It would avoid “Messy” unrealized gains or losses but why this would be a benefit is not clear. The difference between trading securities and available-for-sale securities is so tenuous that the different treatment for unrealized gains and losses is in our opinion, totally unjustified. The two dissenters desire to use market value for all three “types” of investments and similar treatment of unrealized gains and losses – in other words rigid uniformity makes perfectly good sense to us.

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Cadenhead presented an approach to uniformity referred to as circumstantial variables. Circumstantial variables are environmental conditions (conditions beyond the control of the individual firm that are applicable to the particular industry that the firm is in). Circumstantial variables lead to problems relative to either (1) costliness of the prescribed method in the particular event situation or (2) a low degree of verifiability because estimates vary widely relative to the prescribed method. For example, Cadenhead notes that the existence of a ready market with regularly quoted prices would facilitate inventory valuation if realizable value were not used relative to inventories, but the absence of such a market would allow a firm to use another type of inventory/cost of goods sold measurement. In the four situations discussed here, classify each situation according to whether it involves finite uniformity, rigid uniformity, flexibility, or circumstantial variables. Research and development costs: SFAS No. 2 requires that all research and development costs (some of which will have future cash flow benefits and others will not) be written off to expense as incurred. Are there any other accounting principles that are present here? Discuss. Unusual right of return by customers: SFAS No. 48 covers those industries (of which there are not many) where buyers have an unusual right of return due to industry practices that cannot be avoided by the individual firm. The “unusual right of return” arises where buyers have an unusually long time period during which purchase returns can be made. From the seller’s standpoint, revenue is recognized at time of sale, provided that the future returns can be reasonably estimated (there are five other conditions that must also be met but they are of no concern here). If sales returns cannot be reasonably estimated, then sales revenues are not recognized until returns can be reasonably estimated or (more likely) the return privilege has substantially expired. Hence, it is not cash flow differences that are at issue but rather the ability to estimate the expected returns that is the key point. Investment tax credit (assume no investment tax credit carryforward problem): All of the cash benefits in the form of lower taxes are received in the year of asset acquisition. The enterprise may recognize benefit (in the form of lower tax expense) in the year of acquisition or the benefits may be spread over the life of the asset in the form of lower annual depreciation. Oil and gas accounting: SFAS No. 19 tried to allow only “successful efforts.” In successful efforts, the costs of dry holes must be written off once it is known that the holes are dry. If (and only if) a well were successful, drilling costs would be capitalized and amortized over future years. a. This would be an example of rigid uniformity because capitalization is not attained even if future cash flows materialize. Immediate expensing must occur regardless of future cash flow prospects. This would also be an example of conservatism and also results in a higher degree of verifiability. b. This is a case of a circumstantial variable. One industry where this situation arises is book publishing. It is customary in the industry to allow a very long

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period for returns, so it is beyond the control of any single firm within the industry to break with this practice. The inability to reasonably estimate future returns is the second aspect of circumstantial variables, the feasibility (low degree of verifiability) of making the required measurement. c. This would be a situation of flexibility because one situation exists relative to receipt of cash flows, but one of two methods can be used as the firm desires. d. This is finite uniformity because successful efforts requires writing off the costs of drilling if no oil or gas is there, but it would require capitalization if gas or oil is present. Hence, future cash flows dictate the accounting treatment. Students frequently answer this as rigid uniformity because they see one method and two cash flow possibilities. Of course, the method has a built in “branching”: expense if no future cash flows, but capitalize if future cash flows are present. Successful efforts is more conservative than full costing, which is more liberal relative to capitalization of lease costs. Colleges and universities frequently get graduating seniors to donate money to them. A very common practice is to divide this money up over a number of years. Thus a $30 donation might be divided up over a five year period (based on a Wall Street Journal article of March 2, 2007; the $30 contribution and the $6 division over five years was actually cited in the article). Required: Is this an allocation? Discuss. Why do you think that colleges and universities follow this practice? What entry did the college make for the five year division? Do you have any other comments you would like to make about this practice? Golden, Daniel (2007). “To Boost Donor Numbers, Colleges Adopt New Tricks,” The Wall Street Journal, March 2, 2007: page A1. a. An allocation is a "slicing up" or dividing of costs or revenues arising in one period which are applicable to many periods. The key question to ask relates to the donor’s intentions when the gift was made. If the donor clearly indicates that this is a multi-year gift, an allocation would likely make sense to match the gift with the periods in which the intentions cover. However, the tenor of the article indicates this is not the case. If so, we would classify this practice as manipulation, not allocation. b. From managerial accounting, “What you measure is what you get.” Program rankings may include alumni-giving rates to the university. It is likely more easy to manipulate the metric than to actually increase the percentage of alumni giving. The manipulated metric may result in an improved ranking, increased prestige, and higher demand for the university or college’s programs. For those institutions “playing by the rules” and producing “true” alumni-giving rates, they are actually penalized for their honesty. c. The college likely accounted for the donation by debiting cash and crediting a “future years contribution” account. Each year during the 5-year period, the

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accountant adjusts the future years contribution account, assigning a portion to the current year alumni-giving. d. This should foster some good in-class discussion. Some organizations require annual fees to be an alumni member; however, they may also offer a one time fee for a lifetime membership (e.g., Fulbright Alumni Association). What should the accounting be in this instance? If colleges clearly communicate that this is a “lifetime” request for donations from alumni and that no future requests will ever be made, how should the contribution be booked? Assume that an individual names the college as beneficiary to a life insurance policy that he/she pays the annual premium. How should it be accounted for each year? What if it is a single premium policy, the donor is 30 years old, and no additional policy premiums are made? Should the annual alumni-giving percentage include this life insurance donor only one year or for all future years until his/her death?

CRITICAL THINKING AND ANALYSIS 1.

What is the relationship between uniformity (both finite and rigid) and disclosure?

Uniformity, in terms of employing finite where it is feasible and cost effective, and using rigid where it is not both require extensive disclosures to further bring about comparability. Finite uniformity may require more extensive disclosure than rigid as a means of explaining and justifying the event alternatives that have been taken. There is much disclosure that simply cannot be squeezed into the body of the financials segmental disclosure (SFAS No. 131), pension and OPRB information (SFAS Nos. 87 and 106), and disclosure of proven reserves in petroleum exploration (SFAS No. 69 and Chapter 15) are some examples worth noting.

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CHAPTER HIGHLIGHTS Chapter 10 examines the standard-setting process in other English-speaking countries, and the attempt to achieve international harmonization, convergence, or equivalence (whatever the term du jour is) of accounting standards. There are subtle differences between the terms, but in practice they are increasingly used as having similar meanings. The Anglo-Saxon (also called the Anglo-American) and the continental approaches to accounting reflect some marked cultural differences within Western civilization. The AngloSaxon approach is grounded in strong equity capital markets and a strong accounting profession with accounting rule making usually centered in a quasi-private organization. For continental countries debt financing through major banks has been far more important than the use of equity capital though this is beginning to undergo change. In addition, the accounting profession has not been especially strong in continental countries and accounting rules have been determined by law. The formation of the European Union (EU) brought changes to this picture, first by the issuance of several directives that attempted to bring about harmonization of accounting to EU members. However, in 2005 all countries within the EU began using International Accounting Standards Board (IASB) standards for consolidated financial statements. EU standards are also allowed for financial reporting on the New York Stock Exchange without the need for reconciling to United States GAAP. The latter has come about as a result of an attempt to bring about “convergence,” a moving together between IASB standards and U.S. GAAP. This EU adoption gave legitimacy to the IASB as a global standards setter; it is now on equal ground with the FASB. For years, the U.S. was relatively passive about international standards with little need to go beyond U.S. GAAP. Without a doubt, U.S. GAAP provided the most developed and most broad set of standards in the world for the last century. However, the corporate accounting and auditing scandals left everyone reeling in the early 2000s. Hence, following directives from the SEC and Congress, the FASB’s newfound interest in convergence with IFRS blossomed. The IASB-FASB convergence projects started with the Norwalk Agreement of 2002 and are reaffirmed in the annual Memorandum of Understanding. The projects are both short-term and long-term in nature. The short-term projects are intended to remove numerous individual differences in standards between IFRS and US GAAP. The long-term projects include those areas where accounting guidance will be improved (e.g., share-based payments, revenue recognition). In 2004 the two bodies added a conceptual framework project to their joint work. They have completed work on the objectives and qualitative characteristic (item 1) and are pursuing convergence on (2) elements, recognition and de-recognition, and (3) measurements. Projects not yet started include: (4) reporting entity, (5) presentation and disclosure, (6) purpose and status, (7) applicability to not-for-profits, and (8) finalization of the complete framework.

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We recommend that you review the IASB’s most current work plan online before starting this chapter. The changes are occurring significantly faster than any textbook can keep up with given its publication cycle. Note: There is a short project at the end of this file that you may want to use in your course. We have found that it is best assigned to small student groups, 2-3 members per group. Once the papers are submitted, group presentations to the class complete the projects.

QUESTIONS Q-1

What does harmonization of accounting standards mean?

Harmonization concerns the degree of similarity or uniformity among the various sets of national accounting standards and methods of financial reporting. Q-2

What is convergence and how does it differ from harmonization?

Convergence arose as a result of an effort to eliminate major differences between IASB standards and U.S. GAAP. The reasons for the convergence projects vary, but a generally accepted one is an effort to improve financial reporting efficiency. Convergence of the two standards would allow for American security registrations and for published financial statement purposes without reconciliation between the two. The term “equivalence” has also been used when referencing convergence projects. Convergence projects are underway between the IASB, the USA, and Japan. However, as of 2011, the Japanese convergence project is moving significantly slower than the one with the USA. The Norwalk Agreement of 2002 and the separate conceptual framework project of 2004 are moving forward, showing good progress towards convergence. U.S. laws now require annual reporting by the SEC, FASB, and PCAOB on improving financial reporting (e.g., principles-based accounting, transparency, understandable standards), so continued progress towards convergence of IASB and U.S. GAAP is probable, albeit slower than what we would like to see. The IASB usually takes about five years to publish a new standard, so this is definitely a long-term project. Harmonization is more passive and involves a general movement among “first world” countries. One aspect of harmonization, material harmonization, refers to making the accounting practices of different enterprises similar. Note that recent articles in the popular press tend to use the terms harmonization, convergence, and equivalence as meaning the same thing. The key thing to look for in the U.S. once convergence is attained will be “adoption.” Q-3

The EU opted to use exclusively IASB standards for consolidated financial statements beginning in 2005. What drove this decision?

While the Fourth and Seventh Directives improved harmonization, the pace was not fast enough, particularly since many firms needed access to major capital equity sources. As a result, the IASB’s body of accounting standards allowed for a significantly faster harmonization of financial Accounting Theory (8th edition)

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reporting within the EU nations. In 2005, 7,000 listed EU companies began reporting using IFRSs, creating a significant workload for the IASB. Q-4

Compare the true and fair view of the United Kingdom, the “present fairly” outlook of the United States, and the legalistic view of the Continental model.

The “true and fair” view is grounded in “economic reality” and refers to using judgment in order to make financial statements more useful for decision-making purposes. This may well mean going around existing standards. The “present fairly” outlook has been seen as somewhat similar to the true and fair view, but generally means that financial statements are presented in accordance with GAAP. Superficially, then, the present fairly outlook seems to correspond with the legalistic view of the continental model, except that United States GAAP is much more useroriented than the continental model, which is geared more toward protecting creditors and determining income tax liabilities. Q-5

What are the different conceptions of the true and fair view?

The true and fair view, which is an abstract concept to begin with, appears to be subject to individual interpretation within each of the EU nations according to their own needs. Note that this term has drawn particularly strong responses from the UK accounting profession. The IASB-FASB convergence project on a conceptual framework evoked strong words regarding what the UK views on this term really mean. Note that translation of the words “true and fair” to a non-English language is problematic, especially when the culture lacks a strong economic language. Q-6

Why has no Continental model country developed a conceptual framework?

The primary purposes of the continental model—at least prior to the EU directives, which are geared to the true and fair view though done within the cultural restraints of each member country—have been to protect creditors and to determine tax liability. These relatively narrow objectives do not really need a broad theoretical document such as a conceptual framework for developing accounting standards. Even more to the point, continental model countries do not have standard-setting organizations such as the FASB. Conceptual frameworks would hardly be used where company law alone is the primary instrument for making accounting rules. Q-7

What is the relationship between the IFAC and IASB?

IFAC (International Federation of Accountants) and IASB (International Accounting Standards Board) are complementary and work in different spheres, but they cooperate with each other. IASB’s primary function is the harmonization of accounting standards, which they attempt to achieve by issuing international accounting standards. IFAC issues guidelines in areas such as auditing standards, education, and ethics. A good class discussion question might address why these two organizations should or should not consider merging at some point in the future. Q-8

What are the main distinctions between the Anglo-Saxon and the continental models?

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Anglo-Saxon countries are more user-oriented and less oriented toward the primary purposes of protecting creditors and determining income tax liability. Anglo-Saxon countries have stronger accounting professions than do the continental countries. They are also more likely to have standard-setting agencies and conceptual frameworks, though these are much more recent developments. Q-9

How does the role of government differ in the United Kingdom and the United States relative to financial reporting?

Standard setting in the United States is accomplished through private sector bodies; today the FASB is that body. The SEC has statutory authority to set accounting standards, but has relegated that to the FASB. It is important that the FASB receives its funding from the SEC approval of its budget. The FASB’s funding comes from accounting support fees, not taxpayer monies. However, the collected fees are funneled through the SEC for its approval of the FASB’s annual budget. There is no United Kingdom equivalent of the SEC. The main standard-setting thrust in the United Kingdom has come through the company laws in the past. In addition, there have been some government-sponsored committees that have made recommendations in the United Kingdom in areas such as inflation accounting, but these committees have included members from the profession. The United Kingdom has been moving closer to the American model of standard setting since 1970. Q-10

What are the possible implications if accountants outsource the balance sheet to external appraisers (applying fair value accounting) for period-end financial statement reporting?

This is a thought question. Might the internal accounting function be relegated to simply bookkeeping with periodic receiving of finished parts from external vendors for assembly into a finished financial report. Discuss whether accounting as a manufacturing entity, producing financial reports, might benefit or be adversely affected by this type outsourcing. Might we learn from the automotive industry? Might the audit be shifted from individual companies to the suppliers (appraisers) supplying the fair values for balance sheet preparation. This would be a paradigm shift that the accounting profession would resist and likely not see coming (consistent with Kuhn’s view of paradigm changes). Q-11

For years the FASB had little interest in pursuing international harmonization projects. What prompted its seemingly new interest in 2002 to work with the IASB in such a cooperative manner?

Remarks by Paul A. Volcker before the Accounting Regulatory Committee of the European Commission, Brussels, 25 Feb 2005. Paul Volcker, former Chair of the International Accounting Standards Committee Foundation (IASCF) says that international standards were fine for years, “so long as they were made in the good old U.S. of A” It was the series of accounting and auditing frauds that created the more receptive attitude towards international standards. The U.S. model of financial reporting was obviously not Accounting Theory (8th edition)

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working. Add some very specific changes in the law (SOX of 2002) requiring the SEC to act and the idea of working with the IASB became significantly more attractive than in the past. Q-12

Evaluate the IASB’s approach to convergence.

The IASB sees development of a single set of high quality, global accounting standards to help users make economic decisions as its objective. It assumes that if attained: (1) financial reporting costs will be reduced, (2) comparability will be enhanced, (3) investment risk will be reduced and, therefore, lower the cost of capital, (4) international capital flows will be improved, and (5) financial returns will improve. Approximately 50% of the world’s market capitalization is in the U.S. and there are only two major standard-setting bodies, IFRSs and U.S. GAAP. So, the IASB’s plan to converge with U.S. GAAP, its only viable competitor, makes sense to us. IFRSs (as of 2007) are used in over 100 countries for listed companies and over 60 countries for unlisted companies. By converging with U.S. GAAP, it enhances its credibility with the remainder of the non-IFRS world. It also improves the possibility that the U.S. will eventually adopt IFRSs. The challenge/risk with convergence is that differing standards will be negotiated to reduce variances. The result could affect the high quality objective. Special interests could overrule the need for transparent reporting. Finally, once convergence is stated as being achieved, consistency of implementation (especially when translating the English standard) is a concern that will need to be addressed. Otherwise, you may think you have comparability when none exists. Q-13

As Schipper seets it, why do the rules based and principles based approaches to standard setting tend to converge?

Schipper, Katherine (2005). “The Introduction of International Accounting Standards in Europe: Implications for International Convergence, “European Accounting Review” (May, 2005), pp. 101-126. Schipper believes that a principles-based approach needs extensive implementational guidance to make it work well. This will result in an erosion of the differences between rules-based and principles-based approaches. Without the implementational guidance, preparers and auditors will revert to other sources for guidance (e.g., local jurisdiction-specific GAAP, EITF pronouncements), reducing comparability. So, as convergence progresses between U.S. GAAP and IFRS, expect IFRS to look more like rules-based standards. Q-14

How will the role of national standard-setting bodies be affected by adoption of IASB standards?

This is a thought provoking question, one with no single correct response. One extreme would be to assume that adoption of IASB standards would negate the need for any local (country) standard-setting body. Politically, this is not likely. New Zealand is a good example of what has occurred when this change took place. We suggest that if (probably when) the U.S. adopts IASB Accounting Theory (8th edition)

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standards, the FASB will remain as a standards-setting body, but with a revised role. That role may be one of advisory to the IASB or it may morph to a standards setter for private companies. For decades the U.S. has led the world with its accounting standards. This leadership culture will resist relinquishing that role. However, if another round of accounting scandals emerges, we believe IASB adoption is likely. Q-15

How do de facto harmonization and de jure harmonization differ from each other?

De facto harmonization (also called material harmonization) refers to harmonization of the financial reporting practices. De jure harmonization (also called formal harmonization) refers to of harmonization of the accounting rules or regulations of different countries or groups. So, the difference relates to the rules themselves versus how they are implemented. Harmonization is, therefore, a moving target and measurement of the degree of harmonization is problematic. Q-16

What are the advantages of convergence-harmonization of accounting standards?

Financial reporting costs will be reduced. Comparability of financial reports will be enhanced. Investment risk will be reduced and, therefore, lower the cost of capital. International capital flows will be improved. Financial returns will increase. Note that the idea of convergence is not 100% accepted by all as the way to go; ask your students to search for the positions of the larger CPA firms. Q-17

Is the revenue-expense orientation consistent with fair value measurement?

Benston, George, M. Bromwich, and A. Wagenhofer (2006). “Principles-Versus Rules-Based Accounting Standards: The FASB’s Standard Setting Strategy,” Abacus (Vol. 42, No. 2), pp. 165-188. BB&W suggest that the principles-based approach would work better in tandem with the revenue-expense orientation rather than the asset-liability of SFAC No. 6. Their reason for this view is that with fair value accounting increasingly coming on board, accounting standard setters would have an extremely complex mechanism with many rules and guidelines (this point is true relative to SFAS No. 157). They see the revenue-expense model as being able to produce more reliable and auditable numbers. However, there is an inconsistency between the revenue-expense approach and fair value measurement because fair value is primarily geared to the primacy of the balance sheet. BB&W would provide under either principles-based or rules-based standards, a true-and-fair override which would give accountants more professional responsibility and provide more transparent numbers.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

What are the main distinctions between the Anglo-Saxon and the Continental models relative to accounting and financial reporting? Within the Anglo-Saxon group, how does the United States differ from other members of the group? What developments are leading to erosion of differences between at least some members of the Anglo-Saxon and Continental groups?

The Anglo-American model is more strongly oriented toward providing financial information for users (mainly investors and creditors), whereas the continental group is more oriented toward protecting creditors and providing tax information. The accounting profession is much stronger in Anglo-American countries as opposed to continental countries, whereas governmental influence is stronger in the latter. Within the Anglo-American group, the United States’ approach of a private-public partnership regarding standard setting is unique. However, most countries in this group now have standardsetting organizations that diminish, to some extent, the dominance of company laws in the standard-setting arena. Also like the United States, the United Kingdom, Canada, and Australia have now developed conceptual frameworks, although these newer conceptual frameworks have a slightly broader purpose—accountability—as opposed to primarily being geared to user (investor and creditor) needs. Organizations similar to the Emerging Issues Task Force are arising in Anglo-American countries. The great leveler between the Anglo-American and continental groups is that the European Union consists of countries in both groups. Hence, differences within the EU were slowly beginning to crumble in light of the Fourth and Seventh Directives, which favor the true and fair view. Nations, however, could implement these directives within their own cultural orientation, at least to a limited extent. The requirement that all EU countries must use IASB standards for consolidated financial statements will – in a short time – tear down the wall between the two groups. 2.

According to Alexander and Archer (2000), Anglo-Saxon (or Anglo-American) accounting is a “myth.” Discuss their reasons for this. Do you agree with them?

Alexander, David, and S. Archer (2000). “On the Myth of ‘Anglo-Saxon’ Financial Accounting,” The International Journal of Accounting (Vol. 35, No. 4), pp. 539–557. Alexander and Archer analyze "true and fair view" and "fair presentation in accordance with GAAP" showing that a difference exists between the UK and US approaches. The differences between UK and US financial reporting are taking on an increased significance that is evident in recent articles resulting from the IASB-FASB convergence projects. Increased SEC oversight of the FASB suggests that the FASB as an Anglo-Saxon model member is changing, making the term one for historical reference only.

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CRITICAL THINKING AND ANALYSIS 1.

Why do we need international accounting standards? Why not simply let each country develop and use its own standards and let it go at that?

With increasing registration of foreign securities listings on domestic stock exchanges, securities exchanges very likely want as much harmonization as possible whether it comes through IASB standards or standards of the various nations. Securities exchanges such as the New York Stock Exchange would also want harmonized standards which might be termed as “high quality” standards. From the standpoint of regional associations such as the European Union (and possibly NAFTA, somewhere down the line) this may prove to be a boon because it is going to be very difficult to attain harmonization within their grouping where national legislatures within continental model countries retain so much power. A supranational organization such as IASB may be quite helpful in terms of bringing about harmonization. Note, however, that the IASB has no authority to force adoption of its standards. The role of standard-setting agencies in Anglo-Saxon model countries, such as the FASB, is most ambiguous. With the IASB playing a dominating role in harmonization, country-specific standard-setters appear to be relinquishing power to the IASB. However, the politics behind the scenes is an unknown at this point, a very intriguing topic. Another possibility involves a possible two tiered approach with national standards by the FASB and other standard-setters exceeding minimum level standards of the IASB is another possibility. How much freedom domestic firms would have to choose IASB standards over their own national standards becomes an interesting question. 2.

The IASB and FASB are pursuing a single, converged conceptual framework. The United States has a good start with SFAC No. 8. What additional changes should FASB make to further improve its conceptual framework?

This is an appropriate in-class, small group discussion assignment. Have the students review the respective conceptual frameworks before class. The qualitative characteristics are converged, so what needs to be done next? There is not a correct answer, but the process highlights the difficulty in developing a single framework. Emphasize that the FASB framework is for standard-setters; the IASB’s is for standard-setters and practice. When faced with an unclear accounting problem, IFRSs practice first looks for comparable existing standards and then relies on the conceptual framework for guidance. FASB’s framework has no such authoritative nature.

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In 2003, South Africa was the first country to adopt IFRS with fair value accounting. The country does not allow for differential accounting treatment depending on the size of enterprise. What type of response do you expect from this implementation?

Many of the country’s small farmers were outstanding vintners, but not accountants. Principlesbased IFRS was overly complex with relatively few guidelines for implementation. Language and culture were obstacles that produced stress from the accounting, not from the production of their grapes.

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Note: A small project, one not listed in the text book, for the semester that you may want to consider follows: Objective of the project Obtain an understanding of U.S. GAAP, IFRS, and GAAP as practiced by a third accounting body (e.g., Canada, China, India, Mexico, Russia, Taiwan, Vietnam). This triangular review of these systems should identify the commonalities and analyze the differences between the three accounting systems. Small Group Collaboration This assignment will completed by student teams of 2-3 students per team, a size of three members being ideal. FASB and IASB GAAPs will be relatively easy to identify and analyze. The third country’s GAAP may be difficult to locate and translate, so invest some time reviewing individual country GAAPs before locking in your selection. Outline of the Paper Introduction: Tell me what you are going to tell me. Specific country • Description of country (e.g., demographics, language, economics). • Description of its accounting standards setting body, equivalent of the FASB and IASB. Include its history, board composition, processes, structure, whatever is necessary to understand its processes used to create GAAP. Make sure you research your country on the Internet to determine if the standards-related information is in a language you can understand. Do this before telling your teacher which country you want to study. • Country’s accounting standards, define its GAAP. Couch the description in the context of the type model it tends to follow (e.g., Continental, Anglo-Saxon). This could become lengthy, so talk with your teacher, if it appears to be overwhelming. Comparisons • Prepare a table that compares the three GAAPs. To facilitate comparability within the class, format your table as follows: o Column 1, IASB standard o Column 2, FASB standard o Column 3, your specific country’s GAAP o Column 4, your qualitative assessment of the variance between the three GAAPs. 0. insignificant or no differences between the bodies 1. minor differences between the bodies 2. significant difference between two of the bodies 3. significant difference between all three bodies Note that IASB has some 41 standards (some may have been superceded); this is too many to address in your research. Instead, focus on 10-12 at most. • Analysis o Analyze those standards you have assigned a number three (3) in column 4 above, a maximum of five (5) standards. If you have less than five number 3s, add number 2s to your potential analysis list until you have a minimum of seven (7) standards to analyze. o In your analysis, determine the theoretical basis (the rationale) for each of the respective GAAPs. • Convergence Accounting Theory (8th edition)

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o Present your proposal to harmonize/attain convergence of each standard (again, focus on the five standards you identified as having the most significant differences). o Describe the largest obstacles to attaining convergence of each standard, immediately following your proposal for each one. o Which, if any, of your country’s GAAPs are possible solutions for IASB and FASB differences? Summary • What are your conclusions from your study? • Tell me what you told me. Style Requirements Submit your assignment electronically to Professor Dodd before the beginning of the class on 17 August. • Microsoft Word document • 12-point font • Use the header and footer in this document • Single-spaced body of the text • Double-spaced between paragraphs • Beginning of paragraphs is not indented • Bibliography (references) is last page of your paper • Parenthetically cite your references (e.g., Dodd and Chen, 1996)

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Example of the Comparisons section of your country-specific project India This is just a very brief comment to introduce you to the example country that follows. The Institute of Chartered Accountants of India (ICAI) is the governing professional body representing the accountancy profession at national and international levels. The Accounting Standards Board of the ICAI issues statements of Accounting Standards (AS) prescribing methods of accounting approved for application to financial statements. In addition to the AS, the ICAI issues generally accepted accounting principles (GAAP), and guidance notes that must be followed. Comparisons Prepare a table similar to the following one. Note that I added endnotes to clarify why I classified the variance as a “1, minor differences in the bodies” in this single example. The instructions do not require that you footnote/explain every number in your Variance column, but you may find it helpful as you analyze each standard. I used IAS 7, Cash Flow Statements, as an example of how to approach the assignment. IFRSi IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 3 Consolidated Financial Statements superceded by IAS 27 and 28 IAS 4 Depreciation Accounting replaced by IAS 16, 22, and 38 IAS 5 Information to Be Disclosed in Financial Statements IAS 6 Accounting Responses to Changing Prices Superseded by IAS 15, which was withdrawn December 2003 IAS 7 Cash Flow Statements

FASB

Indiaii

Varianceiii

SFAS 95 Statement of Cash Flows

AS 3, revised 1997 Cash Flow Statements

1iv

etc. through IAS 41 IFRS 1 through 8 Note that the instructions require that you start with the IASB standards. This will be the limiting factor in your analyses (41 IASs + 8 IFRSs). Note that some of the IFRSs have been withdrawn and will require no comparisons or analysis; some may have no comparables at FASB or within your country. Once you have completed the table, go to the next step and analyze those with variances rated as threes, significant difference between all three bodies, but limit your Accounting Theory (8th edition)

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analysis to only five standards. This will meet the requirements for this part of the assignment. However, if you actually get interested in this assignment, you may want to go beyond this step and identify differences that this methodology misses. Remember that the objective of the assignment is to obtain an understanding of the similarities and differences between the accounting standards of IASB, FASB, and a set of country-specific standards. It requires detailed work that can become frustrating. So, remember that patience is definitely a virtue.

i The term 'IFRSs'. The term International Financial Reporting Standards (IFRSs) has both a narrow and a broad meaning. Narrowly, IFRSs refers to the new numbered series of pronouncements that the IASB is issuing, as distinct from the International Accounting Standards (IASs) series issued by its predecessor. More broadly, IFRSs refers to the entire body of IASB pronouncements, including standards and interpretations approved by the IASB and IASs and SIC interpretations approved by the predecessor International Accounting Standards Committee. Reference: Deloitte URL: http://www.iasplus.com/standard/standard.htm ii It may be helpful to add an appendix (for reference only) with the more detailed explanations of each standard India uses. ICAI URL: http://www.icai.org/icairoot/resources/as_index.jsp iii Qualitative assessment of the variance between the three GAAPs 0. insignificant or no differences between the bodies 1. minor differences between the bodies 2. significant difference between two of the bodies 3. significant difference between all three bodies iv India requires that cash flows arising from interest paid and interest and dividends received in the case of a financial enterprise be classified as cash flows arising from operating activities. In the case of other enterprises, cash flows arising from interest paid are classified as financing activities. IASB allows for interest classification as an operating or financing activity. FASB requires that it be within the operating activities section.

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Chapter 11: The Balance Sheet

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CHAPTER HIGHLIGHTS This chapter starts by examining the philosophical relationship between the balance sheet and income statement. Two separate issues emerge: articulation between the two and which one is to dominate, assuming articulation (asset-liability or revenue-expense approach). These choices are pure cases but they do illustrate the broad theoretical choices that exist. The changes in element definitions (assets, liabilities, and owners’ equity) are detailed from the Accounting Terminology Bulletins, to APB Statement No. 4, to SFAC Nos. 3 and 6. The important point is that there is a marked reorientation to the asset-liability perspective in APB Statement No. 4 and the conceptual framework project, away from the revenue-expense perspective of the Accounting Terminology Bulletins. The chapter moves to an overview of recognition and measurement practices with respect to major types of assets and liabilities, as well as components of owners’ equity. The general rule of recognition is that assets and liabilities are recorded on the basis of events in which resources (assets) are acquired or obligations (liabilities) incurred. Assets and liabilities are generally measured at the exchange prices established in the transactions. However, subsequent values of accounts become much more varied, especially for assets. Receivables approximate net realizable value because of the allowance for uncollectible accounts. Depreciable (or amortizable) assets, inventories, and investments subject to equity accounting (APB Opinion No. 18) are all examples of arbitrary accounting book values in which the assets represent unique accounting attributes rather than any market referent (either entry or exit prices). From a pure measurement theory point of view, these varied and diverse accounting calculations/measurements are not additive. This does not mean that the balance sheet is uninformative, but it does legitimately raise the issue of whether or not ratio analysis on the components of the balance sheet is meaningful. The chapter contains extensive discussions on investments in marketable securities (SFAS No. 115), impaired assets (SFAS No. 121), and financial instruments with emphasis on derivatives. The chapter concludes with a discussion of classification within the balance sheet. The convention is based on liquidity, but, as pointed out in the text, liquidity is perhaps better captured in the cash flow statement, which is discussed in Chapter 13. Alternative classification schemas are suggested relating to how the assets are utilized, or to the nature of the liability (contractual, constructive, equitable, contingent, and deferred charges). Finally, one could group assets and liabilities by the basis of measurement or accounting calculation in order to achieve a more systematic basis of classification.

QUESTIONS Q-1

What are the characteristics of assets, liabilities, and owners’ equity, and how have they evolved over time?

Assets have evolved from narrow definitions based on legal property to a broader concept based on economic resources. Liabilities have evolved in a similar manner. Owners’ equity is usually

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treated as a residual (the net of assets minus liabilities), subject to legal capital requirements to comply with state laws of incorporation. This is a proprietary approach. Q-2

Why is it difficult to define the basic accounting elements?

In order to unambiguously define elements, the definitions would need to be very narrow, probably based on legal concepts. This produces a very narrow balance sheet. Broader definitions, while potentially more relevant, are also ambiguous. There seems to be a tradeoff between reliability and relevance, even at the basic definitional level. Q-3

Why are asset and liability definitions important to the theoretical structure of accounting? Why are definitions important to policy setting bodies? At the most basic level, element definitions represent the accounting classification system. They determine (partially at least) what is to be recognized and how it is to be classified. Given the inexact nature of accounting as a science, the definitions by themselves are insufficient. Accounting relies heavily on a pragmatic, secondary series of rules to complete the recognition process. Q-4

Numerous attributes are measured in the balance sheet. What are the different attributes? Why is this practice criticized?

Some attributes would be replacement cost provided it is lower than historical cost (inventories) replacement cost (fair value) for trading and available-for-sale securities; net realizable value in the case of accounts and notes receivable, though this is undoubtedly above the amount at which they could be sold or factored; and unamortized historical cost in the case of depreciable and amortizable assets, though this term, in turn, might be subject to several interpretations based on the method of amortization used. Cash is multi-dimensional in nature. Liabilities are generally valued at net realizable value (the amount at which they can be disposed). Bonds payable are an exception. Unamortized cost applies if straight-line amortization of premium or discount is used. If “scientific amortization” is used, it is valued at present value using a historical cost rate, however. Owners’ equity is a residual, but elements here are often affected by statute. Valuation is, hence, very much of a “mixed bag.” Additivity (the ability to add like numbers/quantities), as well as relevance, is certainly open to question. This question should generate considerable class discussion and may also be quite eye-opening. Q-5

What do aggregated balance sheet totals represent? These balance sheet data are used for ratio analysis. How useful do you think ratio analysis is?

The answer to this question is really an extension of question four above. The question of the lack of additivity and relevance is obviously at issue here which can severely impact ratio analysis. Good financial analysis recognizes this potential problem and invests in adjustments to evaluate a firm’s economic value.

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Multiple approaches have been advocated concerning the definition of accounting elements and the relationship between the balance sheet and income statement. What are these approaches and how do they differ?

The basic distinction is between two approaches: articulated and not articulated. Within the articulated approach, the question is which statement is to be primary, and which is to be derivative (the asset-liability and revenue-expense approaches, respectively). Q-7

What is the meaning of “owners’ equity” in the balance sheet? Why are certain unrealized gains or losses included in owners’ equity?

Traditionally, owners’ equity is seen as the residual of net assets after fulfilling obligations to creditors. A proprietary approach has been taken in its presentation. Inclusion of unrealized gains/losses relates directly to articulation between the balance sheet and income statement. These items represent postponed income statement items, and produce a kind of non-articulation. The items are restricted to gains/losses on foreign operation translation (SFAS No. 52) as well as available-for-sale securities (SFAS No. 115). Q-8

What are deferred charges and deferred credits, how do they come about, and do they conform to asset and liability definitions?

Deferred charges/credits are debits/credits that are postponed in the income statement through balance sheet recognition. These debits/credits are clearly neither assets nor liabilities (except in limited instances), yet have been forced into these balance sheet categories by default. Of course, they come about because of a revenue-expense orientation, that is, primacy of income statement recognition rules. Q-9

Why have mutually unperformed executory contracts traditionally been excluded from financial statements? Can this practice be justified in terms of asset and liability definitions? How relevant is this approach for professional sports franchises?

Mutually unperformed executor contracts traditionally been excluded from financial statements since there is an implied offset of the unrecorded asset and liability. Another way to explain it is that neither party is obligated because both have unfulfilled (and offsetting) future obligations. There is a contractual benefit and promise, even though unexecuted. Recognition has been prohibited on the more practical grounds of uncertainty or measurement problems. For an operation such as a sports franchise, virtually all economic “assets” and “liabilities” are related to employment contracts (which are mutually unperformed). In terms of relevance, a case can be

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made for recognizing these contracts. Another issue is whether executory items should be used in the determination of current expense numbers as in the case of pensions. Q-10

What is the purpose of balance sheet classification? How useful is the information produced from a classified balance sheet? What are some alternative classification systems that could be used?

Classification could proceed along several lines: by attribute being measured, by liquidity, by way in which realization will occur. In effect, all of these represent partial disaggregation of totals. In terms of pure measurement theory, total aggregation is dubious because of the individual accounts not being additive. However, movement towards fair value accounting will reduce this problem. Q-11

As a potential investor, what do you feel would be the most useful attribute of measurement for each of the following: inventories held for sale, inventories held for production, and long term debt? Would your answer differ if you were a potential lender? What if you were a manager of a company? What measurement problems are illustrated by this question?

At issue here is the possibility that alternative measurements are useful to different types of users. This ties in to the user heterogeneity problem. Inventories held for sale might be most relevantly reported at exit prices for investors and creditors, and both exit price and replacement cost for managers. Inventories held for production might be reported at replacement cost for investors and managers, and exit price for creditors. Long-term debt might be reported at book value for creditors, and present value for investors and managers. Multi-attribute reporting is one possible means of improving the information content of the balance sheet, but at a cost of adding complexity to the reporting process. Q-12

Why is it difficult to determine the historical acquisition cost of self constructed assets? Do definitions of accounting elements and general principles of recognition and measurement resolve the controversy over full absorption costing and variable costing of manufactured inventory?

The issue is what is appropriately charged to asset cost, particularly in the absence of an arm’s length transaction. Even more ambiguous is the allocation of overhead costs to self-constructed assets. Element definitions do not help in resolving this measurement problem.

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The limitation of the accounting classification system depicted in Exhibit 11-1 was referred to throughout the chapter. What is meant by this? Give some examples. Why is the accounting classification system the foundation of the accounting discipline?

With broad, ambiguous element definitions, there is the potential for dissimilarity among the elements. This was emphasized in the text for both assets and liabilities. Disaggregation is one way of dealing with this problem. It is an important issue because classification is the foundation for any science. Q-14

Is the “available for sale” category for debt and equity securities used in SFAS No. 115 a homogeneous category?

Distinctions between available-for-sale securities and the other two categories are fairly loose. As noted in the text, transfers between available-for-sale and trading securities should be relatively easy. Available-for-sale categories are not very clearly defined: they are simply everything not in the other two categories. Furthermore, selection among categories is based upon management intent, which leaves the door open for potential management/manipulation. Q-15

Based on your reading of this chapter, plus your general knowledge of accounting standards, identify five examples of measurement flexibility in the statement of financial position.

Some examples are depreciation, inventory, treasury stock, conversion of convertible debt, full cost/successful efforts for oil and gas companies, and stock dividends between 20 and 25 percent. An interesting question to pose is whether rigid uniformity would affect manager-owner wealth, and what the net social benefit or cost would be. It could be argued that there would be a net benefit at the social level, due to simplification and lower accounting costs, while at the individual level, the redistributive (wealth) effects would net to zero. Q-16

SFAS No. 133 (213 pages), 149 (78 pages), and 155 (27 pages) define standards for derivatives in 318 pages. How would a principles-based approach to setting standards affect their length…or would it have any effect?

Rules-based standards are necessarily lengthy. Introduction of a rule makes implementation of the standard easier in practice, but makes the standards read more like legal briefs than guidance expressing the spirit of the standards. The trade-off is that professional judgment must be relied upon more when using principles-based accounting to set the standards.

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Discuss the bright line that does or does not distinguish debt and equity classifications.

The distinction (bright line) between debt and equity is very fuzzy. Convertible bonds have aspects of both debt and equity and are included in earnings-per-share calculations. Redeemable preferred stock has attempted to enter into this hazy area, even though it appears to actually be debt. Q-18

Why is there an implicit recognition of fair value in the 1984 Revised Model Business Corporation Act?

The 1984 Revised Model Business Corporation Act allows dividends to be paid as long as insolvency is avoided, one of the criteria of which is that fair value of liabilities exceeds fair value of assets. Hence, as in the case of Holiday Inn, which declared a dividend exceeding owners’ equity, implicit recognition of fair values occurs. Q-19

How does the asset impairment measurement approach of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, compare to deprival value?

Deprival value is a more broad-gauged measure because it aims to determine value in use. By taking the higher of present value of future cash flows and net realizable value and comparing the “winner” with replacement cost and taking the lower of the two, a value in use measurement results which is not grounded in conservationism. Impairment is basically a “lower of” conservative type of calculation and nothing more. Also, future cash flows are not discounted. Q-20

Why are interest rate swaps a zero sum game?

What one party gains, the other party loses netting out to a zero effect; this is referred to as a zero sum game. There is no incremental value created by the interest rate swap, merely a transfer of wealth between parties. Q-21

What is a securitization and why do firms use this technique?

Assets such as mortgages receivable are “packaged” and sold to a transferee. The transferee finances the sale by issuing securities to another party. Assuming the transferor has relinquished all rights to the assets given up, the transferor has received funds without creating any debt which would occur if the transferor borrowed money using the assets as collateral.

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Of the various reasons that a firm might deal in its treasury stock, are there any that you might think are questionable? Discuss.

Of the various reasons for dealing in treasury stock, supporting the market price of the firm’s stock is questionable because it raises the issue of whether stock price is being artificially increased. EPS management to meet analysts’ forecasts is suspect; is it symptomatic of more extensive accounting management/manipulation within the firm? Q-23

Are disclosures of hedging effectiveness effective?

In interest rate swaps, the criteria for effectiveness appear to be too broad to zero in on effectiveness (the notional amount of the swap is equal to the asset or liability being hedged and the fair value of the swap is zero at its inception). Forward hedge contracts appear to provide better measures of effectiveness. Q-24

Why are convertible bonds and convertible preferred stock not examples of embedded derivatives?

Convertible bonds and convertible preferred stock are not embedded derivatives because their values are tied to closely to that of main or host contract itself, that is the common stock to which these instruments are connected via the specific conversion ratios involved. Q-25

How does the term “embedded derivatives” compare with the term “embedded journalists” (from the Iraqi War)?

Embedded derivatives are “embedded” in a “host” contract in a roughly similar way that journalists were “embedded” with military units. However, the secondary contract applying to the embedded derivative has no analogue relative to embedded journalists. This is a thought question, one with no clear correct response. However, the trend towards relevance over reliability suggests increasing reliance on professional judgment. Fair value accounting complements this trend very well. The challenge will be to determine processes to value intangibles with increased reliability. Q-26

Traditional measures of net assets do not capture the value of human capital in an organization. Which trends, if any, suggest that intellectual capital may eventually be a candidate for inclusion as an intangible on the balance sheet?

This is a thought question, one with no clear correct response. However, the trend towards relevance over reliability (term under old qualitative characteristics) suggests increasing reliance on professional judgment. Fair value accounting complements this trend very well. The

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challenge will be to determine processes to value intangibles with increased faithful representation. The Nordic countries appear to be leading the way towards workable models.

CASES, PROBLEMS, and WRITING ASSIGNMENTS 1.

Review a recent annual report and consider the following: Identify all attributes of measurement explicitly identified in the balance sheet and accompanying notes. Notice which items are not specified. Group the accounting elements by attribute. How thorough is the explanation of measurement in the balance sheet? Identify any unusual assets or liabilities. How useful is the current noncurrent distinction for assessing liquidity? Based on your review, what level of user sophistication do you think is necessary to understand how the balance sheet numbers have been derived? How useful do you think the balance sheet is? What are its limitations and how might it be improved, especially from a communication viewpoint?

This is an open-ended case designed to make students think about conceptual foundations of accounting measurement, as embodied in the output (balance sheet). Among the things to highlight are (1) the lack of detail concerning measurement and (2) the high level of aggregation. Ask students to discuss any unusual items they find. In terms of communication, it should be obvious that one needs to be an accountant to have even a basic knowledge of how an individual company accounts for itself. A useful discussion question to pose is the “reliability of efficient market research” in light of the sophistication required to understand financial reports. Intuitively, one is inclined to suspect that it might be possible to “fool” the market, particularly given investor preoccupation with bottom line information. Also, managers still seem to behave as if they believe this too.

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Assume that an asset is being examined and it is determined that its cash flows would be $10,000 per year for four years (assume that all cash flows are received at the end of the year). The carrying value of the asset is $35,000 and its replacement cost is $30,000. The firm’s cost of capital is 10 percent. Required: (a)What would be the amount, if any, that should be written off because the asset is impaired under SFAS No. 121? (b)Why is your answer in part (a) anomalous and how does SFAS No. 121 justify it? (c)Would your answer to part (a) be different if the cash flows were $8,000 rather than $10,000? Explain. (d)Is there anything unusual about your answer to part (c) since accounting rules are frequently concerned with conservatism? (a) None, because the undiscounted cash flows exceed the carrying value of the asset. (b) The cash flows are undiscounted (reminiscent of troubled debt restructuring in SFAS No. 12) as well as carrying value also exceeding replacement cost (fair value). The standard takes the view that “cost recoverability” is the issue of real concern to management. This still flies in the face of the pervasiveness of present valuation. (c) Yes. The undiscounted cash flows total $32,000, which is less than the carrying value of the asset, so write-down occurs. The write-down will be $5,000 (down to the replacement cost of the asset). (d) The answer is anomalous for several reasons. First, replacement cost may well exceed the discounted value of the cash flows. Second, cash flows enter into the calculation of whether or not to write the asset down, but they are not part of the write-down measurement itself.

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3. Assets A, B, and C comprise an asset group. Asset B is considered to be the principal asset in this group. Asset B has a three-year estimated life and A and C have remaining lives of four years. Data on the expected undiscounted cash flows of the three assets, their book values (carrying values), and their fair values less costs to dispose are shown below: Undiscounted cash flows by year 1 2 3 4

$18,000 15,000 12,000 10,000

$80,000 70,000 65,000

$12,000 10,000 9,000 6,000

Book value $60,000 $220,000 $20,000 Fair value less $65,000 $18,000 $25,000 Disposal costs Required: (a) Determine the amount of impairment according to SFAS Nos. 121 and 144. (b) By how much should each of the assets be written down? (c) What theoretical problems do you see with the application of SFAS Nos. 121 and 144 to asset impairments?

(a) and (b) Since Asset B is the principal asset in this group, it’s 3 year life governs. The 3 year undiscounted cash flow total $291,000 which is less than the book value of the three assets. Therefore, there is a $30,000 write-down (book value of $300,000 less fair value of $270,000). The impairment would be split on the basis of the proportionate book values: B would be 220/300 X $30,000- = $22,000, A would be 60/300 X $30,000 = $6,000 and C would be 20/300 X $30,000 = $2,000. (c) There are numerous theoretical problems. Cash flows are undiscounted in both standards. As in this problem, SFAS No. 144 may ignore cash flows of the secondary assets which occur after the end of the life of the principal asset in the group. The standards are “lower of” types of standards hence by definition they are conservative and only involve write downs.

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4. Assume an interest rate swap with a notional value of $1,000,000. Firm A receives fixed and pays variable. The fixed rate on December 31, 2000, is eight percent. The swap has two years to run with variable interest rates of 7.8 percent and 7.6 percent expected on December 31, 2001, and 2002, respectively (annual settlements are assumed for simplicity). Firm A’s discount rate is eight percent. Required: (a)Determine the fair value of the derivative and state whether it would be an asset or a liability. (b)Assume that the swap occurred prior to December 31, 2000, and the interest rate swap contract had a debit balance of $1,000. Under this circumstance make the entry for the fair value as of December 31, 2000. (a) At this point in time (Dec. 31, 2000), we would set up the following simplified table where the holder is receiving fixed and paying variable.

December 31, 2001 December 31, 2002

“Received” by Firm A $8,000 8,000

“Paid” by Firm A $7,800 7,600

Net Received $ 400 200 $ 600

We discount these receivables at 8%, the fixed rate in effect on December 31, 2000: December 31, 2001 December 31, 2002

$400 × .92593 = $200 × .85734 =

370 171 541

The variable rates in effect might also be used as the discount factor since the amount received is the difference between a fixed and a variable amount. Since the amount is to be received it would be set up as an asset. (b) Since $541 is the new debit balance which was $1,000 before we would debit Bonds Payable contra account for $459 ($1,000 – $541) and credit Interest Rate Swap contract for $459. The debit to Bonds Payable contra represents a decrease in valuation. Unrealized Holding Gain or Loss would be debited and credited for the $541 and represents unrealized holding gains and losses on the interest rate swap contract and the bonds payable which offset each other (we assume that the previous $1,000 unrealized holding gain and loss have been closed to comprehensive income).

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Shown below are paragraphs 8–10 of ARB 43, Chapter 7 on stock dividends. Para. 8. The question as to whether or not stock dividends are income has been extensively debated; the arguments pro and con are well known. The situation cannot be better summarized, however, than in the words approved by Mr. Justice Pitney in Eisner v. Macomber, 252 U.S. 189, wherein it was held that stock dividends are not income under the Sixteenth Amendment, as follows: “A stock dividend really takes nothing from the property of the corporation and adds nothing to the interests of the stockholders. Its property is not diminished and their interests are not increased . . . the proportional interest of each shareholder remains the same. The only change is in the evidence which represents that interest, the new shares and the original shares together representing the same proportional interests that the original shares represented before the issue of the new ones.” Para. 9. Since the shareholder’s interest in the corporation remains unchanged by the stock dividend or split up except as to the number of share units constituting such interest, the cost of the shares previously held should be allocated equitably to the total shares held after receipt of the stock dividend or split up. When any shares are later disposed of, a gain or loss should be determined on the basis of the adjusted cost per share. Para. 10. As has been previously stated, a stock dividend does not, in fact, give rise to any change whatsoever in either the corporation’s assets or its respective shareholders’ proportionate interests therein. However, it cannot fail to be recognized that, merely as a consequence of the expressed purpose of the transaction and its characterization as a dividend in related notices to shareholders and the public at large, many recipients of stock dividends look upon them as distributions of corporate earnings and usually in an amount equivalent to the fair value of the additional shares received. Furthermore, it is to be presumed that such views of recipients are materially strengthened in those instances, which are by far the most numerous, where the issuances are so small in comparison with the shares previously outstanding that they do not have any apparent effect upon the share market price and, consequently, the market value of the shares previously held remains substantially unchanged. The committee therefore believes that where these circumstances exist the corporation should in the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed to him will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions.1 Required: (a)From a logical standpoint, evaluate the CAP’s argument involving situations where market value of common stock should be capitalized in certain stock dividend situations. (b)Do you see a possible “hidden agenda” here involving certain economic consequences that the CAP was trying to bring about relative to stock dividends?

(a)

Reprinted by permission.

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The CAP’s argument is quite convoluted. They appear to be saying that they (the CAP) understand that stock dividends are really not dividends but since recipients think that they are dividends, small stock dividends should be treated as if they really are dividends. If this isn’t bad enough, how would people really know that they are being treated as if they were really dividends. Short of reaching a point of ludicrousness, it would be difficult for a footnote to really convey this information. (b) There is clearly a hidden agenda here. At the time of passage virtually all dividends had to be paid out of earned surplus (retained earnings). Because shareholders do not know as much about the firm as management does, whether the stock dividend was really a “good news” signal may have been open to question. Therefore the CAP may have been trying to prevent small stock dividends by forcing a capitalization of earned surplus at market value if it exceeded par value. This might have put a strain on the source of future cash dividends. Whether this rule had any effect upon the declaration of any small stock dividend declarations is, in our opinion, highly doubtful.

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6. Leeson Company entered into an interest rate swap with Morley Corporation on January 1, 2003. The notional amount of the swap is $20,000,000. Leeson will pay Morley a fixed annual rate of 8 percent. Morley will pay Leeson LIBOR plus 1 percent. Settlement is to be made every six months and the contract lasts for three years. The annual variable rates based on LIBOR plus 1 percent are: July 1, 2003 8.26% January 1, 2004 8.32% July 1, 2004 8.18% January 1, 2005 7.92% July 1, 2005 7.90% January 1, 2006 8.06% Required: (a)Set up a schedule showing the net receipts or payments for Leeson. (b)Why would Leeson enter into a strategy of this type? (c)Has Leeson benefited from this transaction? (d)What dangers are present? (a)

Date 01-Jul-03 01-Jan-04 01-Jul-04 01-Jan-05 01-Jul-05 01-Jan-06

Fixed Rate 8% 8% 8% 8% 8% 8%

LIBOR Percent 8.26% 8.32% 8.18% 7.92% 7.90% 8.06%

Leeson's “Receipt” “Payment” Net Receipt from to Morley or (Payment) Morley $826,000 $800,000 26,000 832,000 800,000 32,000 818,000 800,000 18,000 792,000 800,000 (8,000) 790,000 800,000 (10,000) 806,000 800,000 6,000

(b) By paying fixed interest and receiving variable rate interest, Leeson may well be hedging against rises in variable rate types of debt that they owe other parties. (c) Leeson has benefited in this transaction as a result of the rise in variable rates, which may well be offsetting variable rate borrowing from creditors. Thus, it appears that Leeson has hedged against a rise in variable interest rates. The danger is slipping from hedging into gambling. Thus, if Leeson puts an inordinate amount of money into swaps of this sort with the expectation that the variable interest rate will go up, and it goes down instead, the company could easily take a big loss.

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7. On January 1, 2000, $1,000,000 of 10 percent debenture bonds were acquired by Means Corporation at $927,908, which would yield a 12 percent rate of return. The bonds mature on December 31, 2004. Interest is paid annually on December 31. Means Corporation classifies these securities as available for sale securities. Shown below are the effective interest rate and market value of the securities at various dates. Date Effective Interest Market Value December 31, 2000 11% $968,975 December 31, 2001 9% $1,025,310 December 31, 2002 12% $966,195 December 31, 2003 9% $1,009,173 Required: (a)Using the method suggested by Kathryn Means (i.e., use the current interest rate for the recognition of income and determination of fair value with the holding gain component going to owners’ equity), determine the income and unrealized holding gain components for the years 2000 through 2004 (assume that the interest rate change occurs on each December 31). (b)Make the entries that result from assuming that these debenture bonds were Means Corporation’s only available for sale securities. (a)

Year

Beginning of Year

Effective Interest

Stated Interest

12%

$111,349

$100,000

$11,349

939,257

Yield a

Amortization

Carrying Value

968,975

29,718

975,562

1,025,310

49,748

($7,722)

1,017,588

966,195

(51,393)

100,000

$15,943

982,138

1,009,173

27,035

100,000

($9,174)

1,000,000

2000

927,908

2001

968,975

11%

$106,587

100,000

$6,587

2002

1,025,310

$92,278

100,000

2003

966,195

12%

$115,943

2004

1,009,173

$90,826

($1,000,000 × .56743) + ($100,000 × 3.60478) $927,908 + $11,349 (net investment at beginning of year plus or minus amortization) c($1,000,000 × .65873) + ($100,000 × 3.10245) d ($1,000,000 × .77218) + ($100,000 × 2.5313) e ($1,000,000 × .79719) + ($100,000 × 1.69005) f($1,100,000 × .91743) (b) a

DEBIT

CREDIT

2000 Cash

100,000

Available-for-Sale Securities

11,349 Interest Income

Available-for-Sale Securities

111,349 29,718

Owners’ Equity—Unrealized Holding Gain/Loss

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Unrealized Gain (Loss)

Market Value

29,718

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2001 Cash

100,000

Available-for-Sale Securities

6,587 Interest Income

Available-for-Sale Securities

106,587 49,748

Owners’ Equity—Unrealized Holding Gain/Loss

49,748

2002 Cash

100,000 Available-for-Sale Securities

7,722

Interest Income

92,278

Owners’ Equity— Unrealized Holding Gain/Loss

51,393 Available-for-Sale Securities

51,393

2003 Cash

100,000

Available-for-Sale Securities

15,943 Interest Income

Available-for-Sale Securities

115,943 27,035

Owners’ Equity—Unrealized Holding Gain/Loss

27,035

2004 Cash

100,000 Available-for-Sale Securities

9,174

Interest Income

90,826

Owners’ Equity— Unrealized Holding Gain/Loss

55,108 Realized Holding Gains Available for Sale Securities

55,108

The last entry in 2004 takes the sum of the unrealized holding gains/losses on available-for-sale securities and runs it through income. Holding these available-for-sale bonds to maturity would probably not occur frequently, but it illustrates Means’ approach adequately. Notice that the sum of the interest income and the holding gains equals $572,091, which is also equal to the cash dividends of $500,000 and the discount of $72,092 ($1,000,000 – $927,098). Available-for-sale securities are, of course, an example of non-articulation.

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CRITICAL THINKING AND ANALYSIS 1.

It might be said that we are slowly moving toward an asset-liability approach in the balance sheet. Which event situations support this statement?

Several indicators suggest a movement towards the asset-liability approach in U.S. standards including: • Income tax allocation has moved from revenue-expense in APB Opinion No. 11 to assetliability in SFAS No. 109. • Pensions went from revenue-expense in APB Opinion No. 8 to asset-liability in SFAS No. 87. • Other postretirement benefits in SFAS No. 106 is largely asset-liability in orientation. • Finally, the FASB Response to the SEC Study on the Adoption of a Principles-Based Accounting System (July 2004) states that the FASB agrees with the SEC that the assetliability view is most appropriate to setting financial accounting reporting standards. In a previous report the SEC had encouraged the FASB to maintain the asset-liability view in its movement towards objectives-oriented (the FASB interprets the terms “principles based” and “objectives-oriented” to be synonymous) standards setting. 2.

In July 2003, the SEC submitted to Congress its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. A year later, FASB issued its reply, FASB Response to the SEC Study on the Adoption of a Principles-Based Accounting System (July 2004). The SEC recommended that FASB when setting standards “avoid the use of percentage tests (‘bright-lines’) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.” Identify where bright lines currently exist in the statement of financial position, areas in which we might expect revisions in the future. What is the argument for use of bright-line tests?

These two reports from the SEC and FASB are very interesting. You may want to have your students read both (the FASB one at a minimum) as part of this assignment. They clearly show expectations of institutional roles and show future directions for accounting standards. Movement from “bright-lines” and towards intent within standards again shows a leaning towards relevance rather than reliability. They also emphasize the spirit of accounting for a transaction rather than the ease of implementation by meeting a rule. The argument for brightlines is primarily that it increases comparability, but the SEC study argues that this is only a false sense of comparability. Examples of bright lines include: common stock dividends, leases as capital versus operating expenditures, consolidation of SPEs, regular consolidations, and the corridor used for smoothing gains or losses on defined benefit pension plans.

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The comingling of legal and contingent liabilities exists under current GAAP accounting. Discuss potential problems this creates and propose alternatives to address them.

Legal liabilities are “certain” claims on the assets of the firm. Contingent liabilities may or may not be claims on the assets of the firm. Determining the amount of assets owed to outsiders becomes problematic when they are co-mingled. Financial ratios are then suspect.

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Chapter 12: Income Statement

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CHAPTER HIGHLIGHTS Chapter 12 is intended to be a comprehensive overview of the income statement. However, the focus is not on detailed issues; rather, fundamental questions of element definitions, recognition, and measurement are examined. The amount of time spent on Chapter 12 will depend on the background of the class and the instructor’s interests. At one level, considerable time could be spent reviewing each area covered, in effect recasting intermediate accounting topics in a more conceptual approach. Alternatively, the chapter could be examined more for broad generalities. For 50 years the primary theoretical thrust to the measurement and recognition of income has been a revenue-expense approach rather than an asset-liability approach. More recently, however, the FASB appears to be changing that emphasis. Definitions of comprehensive income, revenues, and expenses contained in SFAC No. 6 clearly reflect that change. It probably will be several more years, however, before that change in emphasis will have an impact upon the income statement, because the statement is a product of 50 years of accounting standards based on the revenue-expense approach. Accounting theory regarding the recognition of revenue provides accounting practice some practical guidance in that it states that revenue should be recognized when the earning process is complete. Unfortunately, the completion of the earnings process frequently does not coincide with the time that objective measurements of the amount of revenue can be made. As a result, we find that revenue is recognized on the income statement at different times in different industries, even though the underlying circumstances surrounding the event giving rise to the revenue are identical or at least similar. The chapter points out several examples, such as revenue recognition when right of return exists and transfers of receivables with recourse, where inconsistencies exist today and why they were allowed to evolve. Future events is a very difficult area to maneuver through, and we are just starting to think about it systematically. Future events are, of course, related to future contingencies under finite uniformity. But we would still be facing the future events problem in rigid uniformity cases. If, for example, rigid uniformity were going to be used on an industry basis for depreciation accounting, issues of years-of-life and salvage values, both future events, would have to be faced. In general, accounting theory regarding expense recognition, i.e., matching, provides no practical guidance as to the timing or amount of expense to be recognized on the income statement. Basically, expenses should be recognized when the benefits from those expenses are received; however, it is difficult, if not impossible, to objectively determine how and when benefits are received. As a result, most expenses are recognized in accordance with a systematic and rational method of allocation. Accounting standards regarding the format of today’s income statement are reviewed in the chapter. Specific standards of the display of elements in the operating section do not exist; however, they do exist for the nonoperating section. Those standards or rules tend to be very strict and result in rigid uniformity as opposed to finite uniformity being the order of the day. Accounting Theory (8th edition)

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For events classified as extraordinary and prior period (displayed in the retained earnings statement), there has been a definite shift in recent years away from finite uniformity to rigid uniformity, because of management abuses in order to accomplish income smoothing. In the specialized areas discussed stock options are of particular interest. We believe that they are not an expense under the entity theory approach but they are under the proprietary approach. Earnings management continues to be problematic, it just will not go away despite increased laws and media attention. The chapter concludes with some new proposals on income. Of particular interest here is pro forma earnings, an attempt to release income members to financial analysts on a current operating type basis.

QUESTIONS Q-1

Describe how definitions of income, revenues, and expenses have changed in statements issued by successive standard-setting bodies.

The definitions of income, expenses, and revenues have changed over time. The changes have been from a clearly income statement orientation, i.e., the revenue-expense approach, to a balance sheet orientation, i.e., the asset-liability approach. Q-2

Four points in the revenue cycle, from production through to cash collection, are possible events for revenue recognition. What relevant circumstances would justify finite uniformity rather than rigid uniformity for revenue recognition, and which approach is used in practice?

While most businesses recognize revenue at the point of sale, there is limited finite uniformity for certain special industries. The relevant circumstance, of course, is when revenue is judged to be “earned.” So, by custom, methods have evolved that depart from a sale basis of recognition. Among the two major exceptions are during production for long-term construction contracts and cash collection for installment sales (though this is now strongly discouraged, except for tax purposes). In the case of long-term construction contracts, the relevant circumstance is that the time of a contract is so long that meaningful financial statements could not be produced on an annual basis. Hence the “relevant circumstance” is not a cash flow differential but the time factor. Installment sales on a cash basis might be a stretch but the idea is that cash collections might be either very uncertain or difficult to estimate. Q-3

What is the matching concept and why is there an implied hierarchy for expense recognition?

Matching is part of the revenue-expense orientation and has as its goal the assignment of costs incurred in the earning of income. The hierarchy recognizes that all costs cannot be directly matched to recognized income, and so allows for a more indirect approach based on a “rational Accounting Theory (8th edition)

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and systematic” allocation over time. Finally, certain costs are so general with respect to revenue generation that they are simply treated as period costs, in effect, independent of any association with revenue. Q-4

Why is there no matching problem for periodic costs, and what are some examples?

Period costs are not matched to revenues. Examples include insurance, interest, and certain overheads not allocable to production. Q-5

What types of costs present matching problems, how are they dealt with, and what are some examples of such costs?

The main problems arise with indirect matching through arbitrary allocation procedures such as depreciation methods and inventory costing methods. These techniques are simply conventions for allocating costs against revenues over time and bear no necessary relation to the income earning process. Q-6

There has been a trend toward rigid uniformity in the format of the income statement. Explain how and why this has occurred.

The trend toward rigid uniformity in the income statement format has occurred primarily in the nonoperating sections. The reason is that with finite uniformity, many financial statement preparers tended to report transactions in a manner that was in their own best interest. The FASB has tended toward rigid uniformity to eliminate those opportunities. Q-7

Why might the distinction between revenues and gains, and between expenses and losses, be important to report yet unimportant as to how they are reported?

The issue here concerns disclosure. That is, it may be informative to distinguish between revenues and gains, or expenses and losses, but it may not matter how they are reported, i.e., through disclosure or by being formally reported in the face of the statement. This does ignore that accounting numbers are explicitly used for contract monitoring, and so managers may prefer flexibility (as existed under the current operating performance approach) as opposed to the comprehensive income approach. Q-8

Research, while inconclusive, has shown that earnings are manipulated downward prior to a management buyout. What is the logic of this and why do management buyouts present a difficult agency theory problem?

The downward manipulation of earnings would be intended to lower the price that managers would have to pay shareholders for their stock. The conflict of interest arises due to managers both representing shareholders in their management functions and at the same representing their own interests when buying the firm from the shareholders.

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Why is comprehensive income an application of proprietary theory?

Comprehensive income tries to show all changes in owners’ equity (except for transactions with shareholders themselves) as elements of income or comprehensive income. Q-10

If a separate statement of comprehensive income is presented, do all elements of comprehensive income appear in this statement?

Some elements of comprehensive income are staying in their regular place on the income statement. These include discontinued operations, extraordinary items, and gains and losses arising from changes in accounting principle. In addition, prior period adjustments will still go to retained earnings. Q-11

When dealing with earnings per share, why is less really more with SFAS No. 128?

Primary earnings per share, with its common stock equivalent category, was extremely confusing. Hence its elimination makes earnings per share clearer and more understandable. Q-12

Describe the incentives that might motivate income smoothing, and the ways it could be done.

The incentives could be to reduce variance in annual earnings numbers, thus reducing risk perception in the marketplace and leading to higher security prices. This is the traditional view of smoothing incentives. More recent research has advanced the argument concerning manager’s inclination to play with accounting policies in response to contracts that use accounting numbers but do not specify in detail the accounting policies to be followed. Smoothing can be achieved by the timing of transactions between periods, by the discretionary choice of accounting policies where such choices exist (e.g., depreciation, inventory, etc.), and by net accruals. Q-13

Why is income smoothing difficult to research, and what are the research findings to date?

Smoothing is difficult to “observe” because, if really successful, there is no ready way to determine what unsmoothed earnings would look like. The research in this area suggests that smoothing may be occurring through accruals, policy choices, or classification (prior to APB Opinion No. 30), but the evidence should be viewed with some skepticism given the difficulties raised above. Q-14

Why may interindustry income uniformity be more difficult to achieve than intraindustry uniformity, and what are the implications of this in terms of a conceptual framework project, specific accounting standards, and comparability of accounting income numbers?

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There is a greater tendency (we believe) to see uniformity in accounting procedures within industry groups. Other things being equal, this should lead to greater uniformity within industries (including income recognition and measurement) than between industries, where greater diversity exists. Lower comparability would exist on an interindustry basis, the usefulness of a conceptual framework could be undermined, and individual standards might be interpreted differently. Q-15

What is the relationship between earnings management and income smoothing?

Earnings management is the more general term, with income smoothing being a subset of the former. Earnings management is any type of “purposeful intervention” in the determination and measurement of income used for external purposes. Hence, the whole agency theory area involves earnings management. Income smoothing, as its name implies, tries to even out income with the intention of showing less risk because of less volatility for a given amount of income over the long term. Q-16

Is earnings per share an example of finite or rigid uniformity?

The very specific and complex rules underlying EPS indicate an attempt to bring about rigid uniformity. This attempt appears to be successful, now that primary earnings per share has been eliminated. Q-17

Why is the handling of troubled debt restructuring under SFAS No. 114 illogical?

The original discount rate is still used, even though it is out of date and no longer applicable. The original rate is probably still used because of its verifiability. Q-18

Why are future events so important to the issue of revenue and expense measurement?

The reason is that future events are so pervasive relative to the attempt to measure current transactions. Q-19

Which factor discussed under future events is the most important and why?

The most important factor is the probabilistic nature of future events: the probability of an event occurring or not. Choices relative to future events can also be more than “yes” or “no” situations, as in determining depreciable lives, for example. Q-20

From the standpoint of management, are there any differences between attempting to control bad debt expense percentages and research and development expenses?

Bad debt expense is a discretionary accrual. The percentage might be changed without a real change in management policy or cost. In the case of research and development costs, a nondiscretionary accrual, any changes in expense would be accompanied by changes in real expenditures which, in turn, could effect revenues.

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Why do you think earnings is managed when it appears that actual income might be less than management’s voluntary forecasts of earnings?

A very crucial test for management is whether actual earnings has exceeded forecast. The results here, including estimates of quarterly earnings and their comparison with actual results, can have an important effect upon security prices. Notice also that this comparison falls under the feedback aspect of relevance of SFAC No. 2. Q-22

Evaluate the attempt by the FASB to separate stock options from stock appreciation rights that are payable in cash?

This could solve the measurement problem for stock options. The credit side difference-liability versus owners’ equity – is not a germane distinction in our view. Q-23

Should incentive and nonqualified stock options be treated the same on the financials?

We do not believe that the relation between market value and strike price at the date of grant is a critical difference. We also do not think that different tax treatment should govern even though it could be considered to be a relevant circumstance. Q-24

In what two different senses is the term pro forma used?

These numbers are presented to financial analysts and are intended to provide a better view of “sustainable earnings” by leaving out one-time non-representative events. Hence pro forma earnings are a descendant of the current operating approach to income. The problem is that management has tried to stack the deck by leaving out some negative items which should be in pro forma earnings. The SEC is trying to straighten out this problem. Q-25

In SFAS No. 154, changes in accounting principle result in a restatement, whereas under APB Opinion No. 20, a change in accounting principle is handled in a pro forma manner. How does a restatement differ from a pro forma presentation?

Restatements change what was reported (actual); pro formas are “what if” presentations. Q-26

What is classification shifting?

Classification shifting is the placement of data in an inappropriate area of the income statement. Bottom line net income will not be affected; however, movement of dollars from COGS to S&A can artificially increase the firm’s gross margin. Alternatively, costs could be moved below the operating income line to increase its appearance of ongoing profitability. You can also find classification shifting on the Balance Sheet to avoid violating loan covenants. On the Statement of Cash Flows dollars may be shifted between Operating and Investing activities to manage how the company’s cash flows appear users of the financials.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Revenue recognition, when the right of return exists, was standardized in 1981 by SFAS No. 48. Prior to this, SOP 75-1 provided guidance but was not mandatory (which is why the FASB has brought various SOPs into the accounting standards themselves). As a result, three methods were widely used to account for this type of transaction: (1) no sale recognized until the product was unconditionally accepted, (2) sale recognized along with an allowance for estimated returns, and (3) sale recognized with no allowance for estimated returns. SFAS No. 48 mandated revenue recognition for such sales subject to six conditions: (1) price is substantially fixed or determinable at sale date; (2) buyer has paid or is obligated to pay the seller, and payment is not contingent on resale of the product; (3) buyer’s obligation would not be changed in the event of theft or physical damage to the product; (4) buyer acquiring the product for resale has economic substance apart from the seller; (5) seller has no significant obligations to bring about resale by the buyer; and (6) future returns can be reasonably estimated. Required: a. Discuss the underlying conceptual issues concerning revenue recognition when the right of return exists. Can any (or all) of the pre-SFAS No. 48 methods be justified? b. Indicate the rationale for each of the SFAS No. 48 tests before a revenue is recognized. c. Is SFAS No. 48 an example of finite uniformity or of circumstantial variables as developed by Cadenhead (see Chapter 9)? d. Discuss the role of future events in SFAS No. 48. (a) Revenue recognition when the right of return exists raises interesting issues concerning whether or not revenue is “earned” at the conventional point of sale. Methods 1 and 2 would be plausible under certain circumstances, but Method 3 would be inconsistent (unless returns were simply not material). What SFAS No. 48 did was to create clear rules in an unregulated area where diversity existed, but presumably was unjustified. (b) Test 1 deals with measurement preconditions for recognition. Test 2 establishes whether or not the earnings process is really complete. Test 3 is evidence that the risk of ownership has passed to the buyer. Test 4 establishes that the transaction is at arm’s length. Test 5 again refers to whether or not the earnings process is complete. Finally, Test 6 is concerned with verifiability. (c) We believe this is a case of circumstantial variables rather than finite uniformity with [6]; the key issue is that future returns are reasonably estimable. The unusual right of return situation is an industry-specific custom that is beyond the control of the firm; hence, it is an environmental condition. A classic example exists in the case of book publishing, where retailers have the right to return books to the publisher long after the “sale” has been made. It would be virtually impossible for an individual book publisher to buck this industry-wide trend. This problem, in turn, leads to verifiability problems in terms of measuring sales. Hence, this is an excellent example of a circumstantial variable. (d) The key future event involves estimating future returns.

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Accounting for the transfer of receivables with recourse has been problematic. At issue is whether such a transaction is, in substance, a sale, in which case a gain/loss would be recognized, or a financing transaction, in which case any gain/loss should be amortized over the original life of the receivable. (The receivable could be long-term; for example, a sale of an interest-bearing note.) SOP 74-6 concluded that most transfers with recourse are financing transactions based on the argument that a transfer of risk (i.e., no recourse) must exist for a sale to have occurred. In 1983, the FASB reached a different conclusion in SFAS No. 77. A sale is now recognized if (1) the seller surrenders control of future economic benefits embodied in the receivable and (2) the seller’s obligation under the recourse provisions can be reasonably estimated. If these conditions are not met, the proceeds from a transfer are reported on the balance sheet as a liability. Required: a. What is the critical issue in interpreting the nature of this transaction? How does interpretation of the critical issue lead to the two different viewpoints? b. Explain why the SOP 74-6 view represents a revenue-expense orientation, while the SFAS No. 77 represents an asset-liability orientation. (a) The key issue is whether the existence of recourse is a relevant circumstance to distinguish the transaction from a normal factoring of receivables in which there is no recourse to the seller in the event that there is default on the receivables. SOP 74-6 takes a very narrow interpretation and holds that recourse defeats the sale. By contrast, SFAS No. 77 takes a broad view that a sale of receivables has occurred, even though there is recourse, if the two tests are satisfied. The tests concern the transfer of economic benefits (note that tie-in to SFAC definitions of elements) and the ability to measure (estimate) the seller’s obligations under recourse. (b) SOP 74-6 is a revenue-expense orientation, because the focus is on whether or not the conditions of a sale (of receivables) have been met. SFAS No. 77 adopts an assetliability view, because the concern is on whether or not the transfer of an asset (the receivables) has occurred.

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In its 1994 monograph on future events, the FASB discussed several orientations that might be related to asset valuation. As an example of its thinking, assume that we are assessing future sales of a product for the purpose of determining the value of the asset which is used to manufacture the product. The product is expected to sell for $25 per unit. Probability and unit sales are shown here. Probability Estimated Sales .45 0 .10 5,000 .30 6,000 .15 8,000 Required: Part 1: Determine (a) the modal (most likely individual unit sales), (b) the cumulative probability (summed probability of sales being either positive or negative), and (c) the weighted probability number (expected value of probability times estimated sales times sales price). Part 2: How might these approaches be utilized to value the asset which is used to manufacture the product?

Part 1 (a) The most likely event is estimated sales of 0 at 45 percent. (b) The cumulative probability approach would take into account the fact that there is a cumulative probability of 55 percent that sales will be positive; hence, some positive value should be assigned to the asset (see part (c)). However, under the cumulative probability approach, if the positive probabilities summed to less than 50 percent, a positive asset value would not be recognized, making the outlook in this situation similar to the modal amount. (c) The “weighted probability” approach is the familiar weighted average approach using sales dollars. Estimated Selling Probability × Sales × Price = Valuation .45 0 $25 = 0 .10 5,000 25 = $12,500 .30 6,000 25 = 45,000 .15 8,000 25 = 30,000 $87,500 Part 2 The approach discussed in the FASB (1994) monograph would appear to be much more useful for management accounting purposes for capital budgeting. The weighted probability approach might be used, but the issue of verifiability relative to estimating sales probabilities should be very carefully weighed before using the method. In addition, if applicable, the $87,500 should be present valued. As mentioned in the report (p. 10), the modal approach probably underlies SFAS No. 2 on research and development: the single most likely outcome of any research and development project is zero from a modal perspective or a cumulative probability perspective (zero payoff probability is above 50 percent). Accounting Theory (8th edition)

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In 1983, a number of computer software companies reported use of an accounting procedure that was investigated by the SEC. The accounting policy is to capitalize the cost of developing computer software and amortize it over the life of the software (usually three to five years). This procedure is used by large and small companies, but the impact is more pronounced on smaller, new companies, in which a greater portion of their activity is devoted to software development. An official of Comserv, a small company that specializes in software, said that small companies would be in deep trouble because of SFAS No. 86. He said smaller companies would be under strong pressure to keep costs down if development costs had to be expensed. He also said, relative to the immediate write-off of these costs that smaller companies would not be able to put as much cash into their own growth and development because of SFAS No. 86. The SEC’s concern was whether this accounting policy was consistent with SFAS No. 2 concerning the expensing of research and development costs as incurred. In 1985, SFAS No. 86 treated software-related research and development costs the same as in SFAS No. 2. Required: a. Evaluate the software capitalization argument with reference to SFAS No. 2. b. Why is the choice of accounting policies (expensing vs. capitalization) more likely to affect smaller companies? c. Comment on the claim that small companies “wouldn’t be able to invest as much cash in their own growth if they couldn’t use [capitalization].” Is this a real economic consequence? d. If you were a FASB member, how would you have voted on this issue? (a) Students should review SFAS No. 2 to establish the relationship between the issue in the cases and the general policy on R&D accounting. It boils down to whether these types of costs are R&D, at least in terms of consistent policy. It is by no means selfevident. These costs could be considered analogous to tool and die costs (which are capitalized), or to both R&D as defined in SFAS No. 2. This dilemma highlights the difficulty in achieving unambiguous accounting policies. (b) Small companies, particularly new ones, are likely to show a wider variation between the two methods, compared with larger, older, and more diversified companies. (c) This is the type of non sequitur that one often finds concerning the economic consequences of accounting policies. Other things being equal, cash flows will be the same regardless of how the costs are allocated to the income statement. The statement implies that companies would have disincentives to invest in software if accounted for like R&D, because of the negative short-term EPS impact. This viewpoint clearly assumes a naive market. (d) In order to be consistent with SFAS No. 2, we would proscribe capitalization. However, a strong case can be made that an economic asset exists, and a higher probability of realization of future cash flows is quite justified.

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Discuss the role of future events in the following revenue and expense recognition situations. a. Modification of terms under troubled debt restructuring in SFAS No. 114. b. Pension accounting relative to measuring current expense in SFAS No. 87. c. Other postretirement benefits under SFAS No. 106. d. Full costing and successful efforts in oil and gas accounting as well as the SEC’s reserve recognition accounting proposal. (a) The main future event problem concerns to what extent the cash flows from the modification will be paid. The historical interest rate is used rather than determining the current rate (see question 18) applicable to the transaction. (b) Future events dominate the pension and other postretirement benefits situations. In the case of pensions, numerous future circumstances must be considered, such as turnover, mortality, the expected long-term rate of return on plan assets, and expected future salaries. Expected future salaries are wholly executory in nature, and were introduced in SFAS No. 87 for the purpose of helping users to predict future cash flows as opposed to using current salaries, which would provide more of an accountability orientation (see Chapters 8 and 16). Paragraph 169 of the standard also mentions “. . . unwritten but substantive commitment to increase regularly the benefits paid to retirees to reflect inflation . . . ,” which goes beyond the present written plan (though this would appear to be encompassed by estimating future salaries). (c) Similar to pension benefits, other postretirement benefits encompass numerous future events. As with pensions, mortality and turnover must be considered. The service cost component is based upon the amount and timing of future benefits (taking into account mortality and turnover) to be paid to covered employees computed on the basis of expected future costs for these services. Since the future benefits are based upon expected future services to be provided, the verifiability problem is far more difficult to cope with than in the pension situation. Moreover, some future events that would help to contain other postretirement benefit costs, such as plan amendments, employee contributions, and Medicare changes, were not to be considered. Hence, we have a standard steeped in both predicting future cash flows and the use of conservatism (resulting in higher expense calculations), a major inconsistency. (d) Full costing, by capitalizing all drilling, largely avoids major pitfalls of future events except for the number of years selected for the write-off, which is not an excessively difficult problem. In the case of successful events, the decision as to whether to capitalize or expense will be delayed until it is clear that either a productive oil well or a dry hole has resulted, so the major future events problem is avoided. Reserve recognition accounting had to be given up due to problems of future events. These included estimating quantities of discovered petroleum and changes therein, future selling prices, future production, and estimating the timing of future sales. The future event difficulties should have been immediately obvious to the SEC.

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Shown below is the bottom part of the income statement of Waste Management, Inc., for the year ending December 31, 1998. Also shown below is a note from its financial statements showing the elements of its comprehensive income items, which were shown as part of the statement of changes in equity. Required: a. Recast the income statement for December 31, 1998, so that it includes comprehensive income. b. Even though not allowed by the FASB, compute the EPS for comprehensive income. c. Do you think that elements specific to comprehensive income should be shown only in the statement of changes in equity? d. Do you think there are circumstances in which Waste Management might desire to show comprehensive income elements within the income statement itself? (a) Net Income (per income statement) (770,702) Other Comprehensive Income (net of tax) Foreign currency translation adjustment (77,842) (137,611) Minimum pension liability adjustment (59,769) Comprehensive Income $(908,313) (b) Earnings per share on net income is $(1.32) per share hence the average number of shares outstanding is 583,865,150 (–$770,702,000 ÷ –$1.32). Hence overall earnings per share including comprehensive income would be –$1.556 per share (–$908,313 ÷ 583,865). (c) No, there is too much flexibility that is present with it. We would like to see it shown as part of the income statement itself. Users should still understand the importance of net income before comprehensive income. Comprehensive income elements do not get shunted aside under this approach. (d) They probably would like to show it within income if the elements were positive in total. To be fair to the company they do show a footnote in which comprehensive income elements are added in to net income before comprehensive income (as shown in (a) above).

Utilizing the stock options proposal made in this chapter, show entity and proprietary income in the following situation for the Ethan Neil Corporation: Income before taxes $4,810,000 Interest expense 182,000 Stock options expense (incentive) 240,000 Income tax rate 40% Entity Income Less: Interest expense Tax savings Stock options expense Proprietary Income

$4,919,2001 $182,000 72,000 $109,200 240,000

349,200 $4,570,000

Add back interest expense net of tax savings.

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CRITICAL THINKING AND ANALYSIS 1.

The question of the usefulness of cost allocations was discussed in Chapter 8, Chapter 9, and this chapter (discretionary accruals and management compensation plans). What, if anything, would you do about (fixed) cost allocations? Don’t forget to consider political costs.

This ties together the whole question of fixed costs. We are presently in a situation of flexibility. Rigid uniformity, possibly by industry, could increase comparability but corporate managements would say that their ability to tell their “story” was being impeded. Efficient contracting employing finite uniformity would be the ideal. Developing and implementing standards for this would not be easy and would bring up reliability considerations. Opposition by management relative to earnings management and interference with management compensation plans would surely arise but would not be couched in terms of these issues. Also worth mentioning here is the Lev and Zarowin plan for partial capitalization of research and development costs discussed in Chapter 10. All of these approaches would hopefully cut down on manipulation of discretionary accruals. This question would make an excellent term paper project, particularly for graduate students.

Moehrle et al. (2010) respond to the FASB regarding possible financial statement presentation changes. Evaluate their response.

Moehrle, Stephen, Thomas Stober, Karim Jamal, Robert Bloomfield, Theodore E. Christensen, Robert H. Colson, James Ohlson, Stephen Penman, Shyam Sunder, and Ross L. Watts (2010). “Response to the Financial Accounting Standards Board’s and the International Accounting Standard Board’s Joint Discussion Paper Entitled ‘Preliminary Views on Financial Statement Presentation,’”Accounting Horizons, 149–158. This paper sets forth the American Accounting Association Financial Accounting Standards Committee _hereafter, the committee_ summary comments as well as responses to several of the FASB’s and IASB’s _hereafter, jointly mentioned, the Boards_ specific objectives and principlesrelated questions. Overall, the committee believes that the model has several appealing features, but also has several potential problems. Many of the problems discussed related to potential learning impediments for users to adapt to the new presentation format. Taken from abstract.

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CHAPTER HIGHLIGHTS Even though SFAS No. 95 replaced the statement of change in financial position with the cash flow statement, Chapter 13 begins with a discussion of funds flow reporting and the statement of change in financial position. There are two reasons for retaining this historical literature in the text. First, the rationale for funds reporting is very similar to that for cash flow reporting—a concern that accrual accounting masks the firm’s operating flows. Therefore, funds reporting was viewed as a supplement to accrual-based statements, and the reporting of more basic funds flow data thus reverses—at least to some extent—the effects of arbitrary allocations and other conventions of historical costing. Second, the cash flow statement can be viewed as a statement of change in financial position, with “funds” defined as cash. While there are some differences in format, the point remains that SFAS No. 95 can be characterized as amending APB Opinion No. 19 by requiring rigid uniformity in the definition of funds as cash plus cash equivalents. The statement of change in financial position (SCFP) is another way of classifying and reporting the firm’s transactions that already appear in the income statement and balance sheet, but with the emphasis on undoing at least some of the effects of accrual accounting in order to get at a more basic measure of flows. The research that has been done supports the notion that a cash definition of “funds” results in the newest information—over and above the accrual data in the balance sheet and income statement. In addition, using a cash definition of funds can also be viewed as being in line with the objective of “predicting, comparing, and evaluating cash flows.” Finally, it should be emphasized that the FASB’s rigid uniformity here is well placed and that, for measuring liquidity, a cash definition of funds is the most representationally faithful. While the SCFP used a very general sources and uses framework, focusing mechanically on the narrow accounting debit-credit relation, the SCF classifies cash receipts and payments into more meaningful categories relating to operating, financing, and investing activities. Cash is defined as literal cash on hand or on demand deposits, plus cash equivalents. There have been questions raised, however, relative to the classification of interest and dividends under SFAS No. 95. In fact, three of the seven members of the FASB dissented from the statement, arguing that interest and dividends received arise from investing activities rather than from operating activities, and that interest paid is an element of financing activities rather than an operating cost. SFAS 95 states that operating cash flows may be presented using either the direct or the indirect method. The direct method reports literal cash flows related to income statement classifications (revenues, cost of sales, etc.). By contrast, the indirect or reconciliation method starts with accrual income and adjusts it for the associated noncash items. If the direct method is used, a separate schedule shall reconcile net operating cash flow with net income. Thus, the indirect or reconciliation method must be used either alone or as a supplement to the direct method. The great bulk of American firms use the indirect method. Nonarticulation is a problem that occurs when the cash flows arising from the changes in the working capital accounts of consolidated enterprises are not equal to the working capital adjustments listed in the operations section of the SCF. This problem arises when the indirect Accounting Theory (8th edition)

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method of reporting is used and non-cash flow elements affect the balances of working capital accounts. The chapter discusses a variety of causes of nonarticulation. The three-part structure of the SCF—operating, financing, investing, is generally in accordance with the finance literature. However, SCF classifies interest and dividend receipts as operating inflows, and interest payments as operating outflows. While this classification might be appropriate for the banking industry, it does not appear to be appropriate for the vast majority of firms. Despite classification and nonarticulation problems, the SCF has been shown to be a very useful statement. The SCF is less manipulable than income, but it is not exempt from the problem. We provide several examples in which operating cash outflows have been misclassified as investing cash flows. To maximize its value to investors and creditors, SCF must be viewed in its entirety. Free cash flow is a recent and increasingly popular cash flow metric. It focuses on the ongoing operations of the firm, including its investing activities. Unlike cash flow from operating activities, free cash flow treats interest expense as a financing item. Finally, we review the cash and funds flow research. While research shows the SCF to be a very useful statement, it is not beyond improvement. In the text, we discuss potential improvements relating to working capital adjustments, the classification of specific cash flows among the SCF's three sections, and the option to use either the direct or indirect method.

QUESTIONS Q-1

How did the all-inclusive or all-resources approach to the SCFP with funds defined as working capital differ from the older funds flow statement?

The all-resources approach to the SCFP was a broader statement than the older funds flow statement. The older funds flow statement just showed funds flow changes. The all-resources approach also included investing and financing transactions that did not involve the funds accounts. Q-2

SFAS No. 95 allows a choice between the direct and the indirect method for calculating the operations section of the SCF. Do you think this is a case of flexibility? Explain.

We do not consider this to be a case of flexibility because direct and indirect methods are different ways of arriving at the one correct number (cash flow from operations) rather than a case of different methods resulting in different net income numbers, the usual result of flexibility. Q-3

What is the “fineness” issue raised by Nurnberg and Largay relative to accounting for hedging transactions in SFAS No. 104?

“Fineness” relates to a comparative situation where one method provides more information— hence it would be the “finer” method than a second method of presentation. Hence, SFAS No. Accounting Theory (8th edition)

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104 allows a flexible presentation approach where the hedge may be shown on the balance sheet with the particular account which it is hedging. Q-4

Does the “fineness” issue arise relative to the handling of capitalized interest costs (SFAS No. 34) relative to the treatment of this item in SFAS No. 95? Explain.

Presumably it does. SFAS No. 34 presumably results in a fuller presentation of the costs of self constructed fixed assets built for internal use. Of course this will conflict with the treatment of interest costs in the statement of cash flows. Q-5

What advantages do you see for classifying interest expense as an investing cash flow rather than an operating cash flow? What is the advantage of classifying it as an operating cash flow? What is the advantage of classifying it as a financing cash flow?

It is more consistent to classify the interest cost, along with changes in principal, as an investing activity. This would be consistent with the finance function itself and would be an entity theory orientation since interest would no longer be an operating element. Classifying it as we presently do would make the cash flow statement consistent with the income statement. The present approach would be a proprietary theory orientation since interest is considered to be an expense rather than a distribution to a particular set of capital providers. Q-6

Explain how cash flow data complement the income statement and balance sheet.

This occurs in two ways. First, it represents a reclassification of the firm’s transactions in a manner that differs from the balance sheet and income statement. Second, it disaggregates the accrual effects by quite literally removing them, thus leaving the realized cash flows. Q-7

What is the “quality of income” concept, and how does cash flow reporting relate to it?

This refers to the concern about the impact of accruals on accounting income and how accruals can, in the extreme, create quite a divergence between cash flows and accrual income. Q-8

What attribute is being measured in the SCF and how well is representational faithfulness achieved? Compare this to when funds are defined as working capital.

Since it “undoes” the effect of accrual accounting, cash flow reporting quite literally removes the allocations and other arbitrary procedures followed in conventional accounting practices. Q-9

Why is the three-way classification system in the SCF more informative than the twoway source/use classification?

In an abstract sense, what is being measured is an indicator of the firm’s operating liquidity, as well as net investment and net financing. Cash most robustly represents liquidity, whereas the more vague “funds” in APB Opinion No. 19 was less representationally faithful.

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How does the source/use classification reflect the structure of double-entry accounting?

The two-way source/use structure evolved out of the double-entry structure of accounting. The three-way system in SFAS No. 95 reclassifies the same data to focus separately on operating flows, net financing flows, and net investment flows. Q-11

What is the purpose of reporting noncash items in the SCF?

Sources correspond to “credits” such as income, new capital, and new debt. Uses correspond to “debits” such as losses, investments, interest payments, and dividends. Q-12

Why is the SCF called a derivative statement?

This is the all-inclusive perspective, and represents the view that all transactions should be reported in the statement, even if there is no effect on funds (i.e., cash). Q-13

What do research findings indicate concerning the relevance of cash and funds flow data?

It is derivative in the sense that it is based on the same set of transactions as are reported in the balance sheet and income statement. However, it reports new information in the form of disaggregating the accrual data into accruals and cash flows. Q-14

What does it mean to classify a cash flow according to the basic nature or function of the event as opposed to the ultimate purpose of the transaction? Which method do you prefer?

Accounting is a historical record of the firm’s transactions. As such, liquidity and financial flexibility cannot be measured in a representationally faithful fashion. Q-15

Reexamine Exhibit 13.11. Explain the purpose of each performance measure. As a manager, which performance measure would you want to use. Which measure would you want used to evaluate you? Why? How would your decision change if your firm was experiencing a boom? A recession? How would your decision change if your firm's plant and equipment needed to be replaced? What if plant and equipment were new?

While the research is limited, there is evidence that cash flow data are informative, over and above accrual accounting data. One should also add that research has shown that accrual data are informative, over and above cash flow data. Neither of these results is surprising since, it can be argued, each represents different attributes of measurement. Q-16

Should a CEO be evaluated based on one year's cash flows? Why or why not? (Your answer might be affected by your definition of cash flow.)

Probably not. The value of the firm is equal to the present value of the expected future cash flows. A given year's free cash flow can be increased by deferring investment, probably to the Accounting Theory (8th edition)

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detriment of future free cash flows and firm value. Even cash flow from operating activities can be increased in a given year by deferring maintenance or research and development expenses. Again, this would probably be to the detriment of future free cash flows and the value of the firm. It is important to examine cash flows over longer periods of time. It is equally important to examine the composition of the cash flows. Q-17

The value of the firm is equal to the discounted value of the firm's free cash flows. Is it possible to forecast distant free cash flows? If not, what is the alternative?

Accurate forecasting of future free cash flows is not easy. It involves a great degree of uncertainty. Unfortunately, there is no easy, simple, or more accurate alternative. Using simple relative valuation alternatives such as price-to-cash flow or price-to-earnings ratios largely ignores the forecasting problem and bases valuation on only one cash flow or earnings number. (Sometimes the cash flows or earnings used are historical numbers; sometimes they are forecasted one year ahead.) Moreover, both of these ratios have market price in the numerator. One may question whether using a measure that contains the current market price is a reliable way to estimate the underlying intrinsic value. Q-18

Comment on the following statement: Cash flow from operating activities is the most important section of the SCF. Hence, analysis should be focused on this section.

Cash flow from operating activities is an important section of the SCF, but not the most important one. The SCF should be viewed as a whole, not with a single-minded emphasis on a single area. The WorldCom Inc. example in the text provides support for carefully examining all three parts of the SCF. Q-19

Does the statement of cash flows obviate the possible need for exit price financial statements?

The SCF provides useful information about an entity’s activities in generating cash through operations. It helps to assess factors such as the entity’s liquidity, financial flexibility, profitability, and risk. Moreover, cash flow data provide feedback on actual cash flows, as well as provide help in predicting future cash flows. There is little ambiguity about cash. The exit-price accounting systems are intended to measure flexibility of the firm in terms of the amount of cash that could be realized from non-forced liquidation of assets. However, compared to the data provided in the SCF, exit-price measurement is a crude indicator of liquidity and flexibility. While exit price data might provide an estimate of the cash conversion value of a firm’s resources, it is the speed of conversion that ultimately determines both liquidity and flexibility. Unfortunately, the usefulness of exit-price accounting is for assessing a firm’s flexibility is questionable, especially if the firm intends to keep and utilize the great bulk of fixed assets future operating purposes. Finally, we note that in the analysis of SFAS No. 157 on fair value (Chapter 14), a slightly different twist is put on the exit value approach which stresses estimating cash flows. This is a future events orientation, which stresses the prediction of cash flows, as opposed to an actual Accounting Theory (8th edition)

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accounting of past cash transactions. In contrast, the SCF is an analysis of past cash flows, which stresses accountability and past performance. Hence, SFAS No. 157 does not supplant the SCF. Q-20

What are the benefits of evaluating a CEO based on the sum of earnings and cash flow divided by two? What is the downside to this metric? Make sure you clearly identify which cash flow and earnings you use in your calculation.

In the 1970s Teledyne used a similar formula to measure entity performance (based on one author’s experience as an employee in budgeting). The averaging of net cash increase (decrease) between the parent-subsidiary and after-tax income made it very difficult for management to smooth any financial returns using accruals or classification shifting. The downside was that managers still tried to manage/smooth the metric to their self-interest.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Presented in the exhibit for Case 1 (see text) is a graph of accounting income, cash flows from operations, and working capital flows from operations for W. T. Grant Company, a retailer that filed for bankruptcy in 1976. As late as 1973, the company’s stock was selling for 20 times earnings. What does the chart indicate concerning the usefulness of income, cash, and funds flows? What could explain the significant differences between working capital flows and cash flows?

This graph provides a classic illustration of how accrual income and working capital funds flow can mask underlying cash flow trends. It is only in 1974 that accrual income and working capital flows declined, while the cash flow decline started in 1969. Inventory buildups (unsold) and liberalized credit policies resulting in accounts receivable increases are two situations that would be concealed by accrual income and working capital flows. One should not infer from this graph that accrual income is useless. The point is that cash flows from operations provide a more useful supplemental disclosure than working capital flows.

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This case is adapted from Appendix B of the exposure draft leading up to the FASB’s standard on cash flow reporting. Prepare in good form an SCF. Use the direct format. (Please see the text for background material. Due to its length, we have not repeated it here.)

Illustration 1. Cash flow from operating activities is reported directly. Noncash transactions are reported in a separate schedule. Cash flows from operating activities: Cash received from customers Dividends received Cash provided by operating activities Cash paid to suppliers and employees Interest and taxes paid Cash disbursed for operating activities Net cash flow from operating activities Cash flows from investing activities: Purchases of property, plant, equipment Proceeds from disposals of property, plant, equipment Acquisition of Company ABC Purchases of investment securities Proceeds from sales of investment securities Loans made Collections on loans Net cash used by investing activities Cash flows from financing activities: Net increase in customer deposits Proceeds of short-term debt Payments to settle short-term debt Proceeds of long-term debt Payments on capital lease obligations Proceeds from issuing common stock Dividends paid Net cash provided by financing activities Effect of exchange rate changes on cash Net increase (decrease) in cash Schedule of noncash investing and financing activities Capital lease obligations incurred for use of equipment Acquisition of Company ABC $(100) Property, plant, and equipment acquired 3,000 Long-term debt assumed (2,000) Common stock issued to settle long-term debt

Accounting Theory (8th edition)

$10,000 700 10,700 6,000 1,750 7,750 $2,950 (4,000) 2,500 (900) (4,700) 5,000 (7,500) 5,800 ($3,800) $1,100 75 (300) 1,250 (125) 500 (450) $2,050 100 $1,300

$750

$900 $250

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Illustration 2. Cash flow from operating activities is presented indirectly and reported in a separate schedule. Noncash transactions are reported in a separate schedule. Net cash flow from operating activities $ 2,950 Schedule reconciling earnings to net cash flow from operating activities: Net income Noncash expenses, revenues, losses, and gains included in income: Depreciation and amortization Deferred taxes Net increase in receivables, inventory, and payables Increase in interest earned but not received Increase in interest accrued but not paid Gain on sale of property Net cash flow from operating activities Schedule of noncash investing and financing activities: Capital lease obligations incurred for use of equipment Acquisition of Company ABC: Working capital other than cash acquired Property, plant, and equipment acquired Long-term debt assumed Cash paid to acquire Company ABC Common stock issued to settle long-term debt

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$ 3,000 1,500 150 (850) (350) 100 (600) $ 2,950

$ 750

( 100) 3,000 ( 2,000) $ 900 $ 250

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Due to the length of this case, we have not repeated the background material. Please see the text for details. For N-M Company: a. Do a conventional SCF in accord with SFAS No. 95. (Use the indirect method.) b. Do a second SCF in accordance with the modifications suggested in the section of the chapter entitled “Classification Problems of SFAS No. 95.” c. Discuss the underlying reason for the two approaches.

a. Cash flows from operating activities (indirect method) Net income as reported $ 17,358 Depreciation 15,000 Lease interest expense 3,170 Amortization of bond discount 100 Decrease in accounts receivable 6,000 Gain on sale of fixed asset $ (2,200) Decrease in accounts payable (3,000) Net cash flows from operating activities Investing activities Lease payments Sale of fixed asset1 Financing activities Dividend payments Increase in cash Beginning balance of cash Ending balance of cash

$ (10,000) 14,200

(7,800)

$ 36,428

4,200

(7,800) $ 32,828 47,000 $ 79,828

1Fixed asset decrease of $20,000 and gain of $2,200 gives total credits of $22,200. Accumulated depreciation debit is $8,000, based on a beginning accumulated depreciation of $72,000, depreciation of $7,075, and ending accumulated depreciation balance of $71,075.

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b. Cash flows from operating activities (indirect method modified) Net income before taxes $ 28,930 Add back other revenues and expenses as reported 4,070 Net income before taxes exclusive of other revenues and expenses 33,000 Less: Income taxes at 40% (13,200) Modified net income after taxes 19,800 Depreciation 15,000 Decrease in accounts receivable 6,000 21,000 Decrease in accounts payable (3,000) Net cash flows from operating activities $ 37,800 Investing activities Lease payment Sale of fixed asset less tax on gain ($14,200 – $880) Interest revenue net of tax Financing activities Dividends Interest expense net of tax2

Increase in cash Beginning balance of cash Ending balance of cash

$ (6,830) 13,320 600 7,090 $ (7,800) (4,262) (12,062) $ 32,828 47,000 $ 79,828

Interest expense is $7,270 with tax savings at 40% of $2,908. Noncash flow portions of tax $100 includes bond discount amortization resulting in $7,170 minus $2,908.

c. The SFAS No. 95 approach hews to the current format of the income statement, making it easier to compare cash flows from operating activities to the income statement. The second statement provides a better functional orientation to operating, investing, and financing activities, but at the cost of a closer alignment with the income statement.

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Ventius Company issued $10,000 of four-year bonds on December 31, 2000. The coupon rate on the bonds is 7½%. The bonds were sold for $9,400. a. Show four possible ways that the interest, principal, and discount can be distributed (allocated) between operating and financing cash flows for the years 2000–2004. b. Discuss these four approaches and state your preferences.

a. OF=Operating Flow; FF= Financing Flow

2000 2001 2002 2003 2004 2004

Method 1 OF FF $ 9,400 $ (750) $ (750) (750) (750) (750) (10,000)

Method 3 OF FF $ (600) $ 10,000 (750) (750) (750) (750) (10,000)

Method 2 OF FF $ 9,400 (750) (750) (750) (600)

(9,400)

Method 4 OF FF $ 9,400 $ (600) (150) (600) (150) (600) (150) (600) (150) (10,000)

b. We believe Method 1 is the clearest and simplest method to follow. Method 3 may have a slight advantage over Method 1 because it breaks the original proceeds into a financing portion equal to the maturity value and sets up the discount or premiums as an operating flow. Method 2 is similar to three except it breaks out the premium or discount in the last year as an operating flow. We prefer the up-front treatment of premium or discount of method 3. Method 4 seems the most illogical. By assigning the premium or discount to each of the four years as an investing flow, it uses an accrual accounting concept. This amount comes out of the cash interest in the operating flow column. Consequently, operating flow and investing flow are both wrong although the total outflow for the two columns combined equals the correct outflow for the operating flow column alone.

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Please see the text for the balance sheets and income statements for both P Company and S Company. Due to the length of this case, we have not repeated them here. a. Show separate SCFs for P and S for the year 2006 (for S it will be from July 1, 2006 to December 31, 2006) using the indirect method. b. Show a consolidated SCF for 2006 (from January 1, 2006 to December 31, 2006). Hint: Your cash flow will not show the correct cash increase for 2006. c. Where does the discrepancy in b. lie and what is it an example of? How might the situation be remedied? d. In b., show how you think the SCF would be done in actual practice.

5. (a) Separate cash flow statements (S will be from July 1, 2000) for 2000 using the indirect method: P S Operations Income as reported $78 $21 Add: Changes in depreciation 20 10 Working capital changes Inventories 23 (13) Accounts receivable (18) 6 (5) Accounts payable 17 Total $120 $19 Investment Acquisition of S Financing Dividends Change in cash flows

(80) (15) $25

$19

5 (b) Consolidated cash flow statements for P and S for 2000 using the indirect method: P Operations Income as reported $ 78 Add: Changes in depreciation 20 Working capital changes Inventories 23 Accounts receivable (18) Accounts payable 17 Total Operating Activities $ 120 Investment Acquisition of S (80) Financing Dividends (15) Change in cash flows $ 25

Accounting Theory (8th edition)

Consolidated

$ 21 10

$ 99 30

(48) (24) 40 $ (1)

(25) (42) 57 $ 119

—

(80)

$ (1)

(15) $ 24

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5 (c) Notice that the total consolidated increase in cash flows for P and S is $44 made up of P’s increase of $25 (ending balance of cash $225 less beginning balance of $200) and S’s increase of $19 (ending balance of $39 minus beginning balance of $20 on July 1 of 2000 when S was acquired). This ties in with the separate totals of P and S in part (a) but does not articulate with the consolidated cash flow of $24 in part (b) because the July 1 balances of S are omitted in the consolidated statement of cash flows. The difference is the omission in (b) of the beginning balances of S’s working capital accounts. These would be accounts receivable, $30; inventory, $35; and accounts payable, ($45). These net out to the $20 difference in total cash flows between (a) and (b). 6.

Select a publicly traded company (your instructor may do this for you). Over a 10-year period trace the following elements: a. Net income with depreciation and amortization added back to make it more b. comparable to cash flows. c. Cash flows from operations (from the SCF). d. Cash flows from investing activities. e. Cash flows from financing activities. Required: Assess how closely the company adheres to the Ingram-Lee model in absolute and relative terms: If income increases, does cash flow increase at a lesser rate? Does investing have net outflows and financing have net cash inflows?

This should be a fascinating problem. If different companies are assigned to different individuals or teams, and if the results are tabulated, we anticipate that the Ingram and Lee hypothesis will hold. 7.

WorldCom, Inc. improperly capitalized $3.8 billion dollars of expense from January 1, 2001 through the first quarter of 2002 ($3.04 billion occurred in 2001). Selected balances from its balance sheets are given in the text. a. What effect did WorldCom’s misclassification have on cash flows (a) in total and (b) by classification? b. Why is it difficult to accept the effects on cash flow from operations of the working capital items listed above? c. WorldCom’s long-term debt went up by approximately $13 billion during 2001. Is it possible that some of WorldCom’s current liabilities were reclassified as long-term during 2001?

Bear in mind that we are dealing with fraudulent financial statements and answers are extremely difficult to obtain. 7 (a) Because of the fraudulent overstatement of income for 2001, WorldCom's cash flows would be overstated by $3.04 billion during 2001, less any extra depreciation taken on the $3.04 billion. All of this would appear in the first section of the SCF, cash flow from operations. 7 (b) Assuming that there are no noncash flow elements affecting working capital there are huge unaccounted for differences between the balance sheet changes and the amounts reported in the Accounting Theory (8th edition)

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SCF. In the analysis below, an increase to income in the first part of the SCF (cash flow from operations) means either a decrease in current assets or an increase in current liabilities. The converse applies to decreases. (In the table below, D = decrease, I = increase, numbers are in millions, BS = Balance Sheet, SCF = Statement of Cash Flows) Effect of BS Change on Cash Other current assets $ 223 D Accounts receivable (net) 1,507 I Accounts payable and other liabilities 1,607 D

Reported On SCF $164 D 281 D 1,154 D

Effect on Reported Cash $ 59 I 1,226 D 453 D

The $1,154 decrease to income from the current liabilities indicates that these balances are decreasing but not as much as on the balance sheet. This analysis indicates that they have covered the “shortfall” of cash by $1.62 billion. If we assume a five-year writeoff of the improperly capitalized $3.04 billion, they would still need to cover approximately $1 billion in other parts of the SCF. Oh, what a tangled web we weave when first we practice to deceive! 7 (c) Yes. Reclassifying current liabilities as long-term might provide a good way to cover the cash flow shortage because declines in current liabilities would indicate an outflow of cash. Whether any of the $453 million dollar “excess” outflow from current liabilities went that route cannot be discerned from these numbers, but it is certainly possible.

CRITICAL THINKING AND ANALYSIS 1.

Do you think that the indirect method of reporting cash flows from operations should be eliminated, allowing only the direct method in the SCFs? Discuss.

The present system should probably be eliminated. There really is no choice, since if the direct method is presented, the indirect also must be shown as a supplementary schedule hence the cost of preparing information is lower if one simply presents the indirect method. This one explanation as to why the indirect method is used much more frequently than the direct method. The two methods present slightly different information. The indirect method can be more easily generated by the user than the direct method, but the presence of non-cash flow transactions affecting working capital accounts (nonarticulation) can be a problem. We believe both methods provide useful information with the indirect method presenting a reconciliation through the income statement, while the direct method—as the title indicates—presents a direct cash flow approach to operations, one that is easier to understand. We propose requiring both methods to be presented since the information is complementary or we just require the direct method. In any case, the present situation is unsatisfactory. 2.

What is cash flow? In your answer, be sure to reference the use to which it is put.

The term "cash flow" is a term that is frequently used indiscriminately and ambiguously. To be Accounting Theory (8th edition)

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clear and unambiguous, users need to be more precise in the use of their terms. The choice of “definition” depends on time, resources, and its intended use. One simple definition of cash flow that is frequently used in the financial press and in analysts' reports is net income plus depreciation. This definition recognizes that depreciation is a noncash expense. We do not find this definition very useful as it ignores the cash effects of various accruals and investing outflows. Cash flow from operating activities is well defined by SFAS 95. It reflects the cash effects of various accruals such as accounts receivable and accounts payable, and is often used as a check on the “quality” of net income. However, cash flow from operating activities mixes financing activities with operating activities by treating interest expense as an operating expense. Moreover, it does not reflect the cash outflows from investing activities. This can be problematic especially if a firm engages in improperly classifying certain operating expenses as investing cash flows. (See the discussion of WorldCom in the text.) One remedy is to examine all parts of the statement of cash flows, and subtract from cash flow from operating activities, cash flows from investing activities. For focusing on operations or for determining the intrinsic value of a firm, one can use free cash flows. In principle, the definition of the free cash flows is the same as that used for capital budgeting purposes. Free cash flows treat interest expense as a financing expense, and are consistent with the notion of an ongoing firm. Note that in the term “free cash flow,” the word “free” refers to an absence of a superior claim. Paying out free cash flow will not affect the firm’s ability to generate more free cash flows in the future. Free cash flows are defined as NOPLAT – investment in operating invested capital. NOPLAT is net operating profit less adjusted taxes, or taxes paid on operating income. 3.

Why is the use of free cash flows increasing?

The use of free cash flows is probably growing as a reaction to numerous accounting problems and cases of earnings management over the past 5 – 10 years. It provides investors with a measure of a firm’s operating performance. Free cash flow is much harder to manipulate than is net income. 4.

Broome (2004) recommends that the FASB should provide more guidance on classification of cash flows for the three sections. What guidance would you suggest?

Broome, O. Whitfield (March/April 2004). “Statement of Cash Flows: Time for Change!” Financial Analysts Journal, 16–22. There are many possible answers for this question. In fact, this type of question would make for good classroom discussion or an extended essay. Below, we provide a few suggestions.

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Chapter 13: Statement of Cash Flows

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In its present form, the adjustments required by the indirect method are sometimes hard for the user to understand. Moreover, more often than not, the working capital adjustments in the operating section of the SCF do not match the changes in their respective balance sheet accounts. It would be helpful if firms provided a schedule reconciling the working capital adjustments in the operating section with the balance sheet changes. Disclosing the effects of reclassifications would be particularly interesting. Firms that are involved in mid-year acquisitions should provide a schedule that reconciles the working capital adjustments in the operating section of the SCF with the respective balance sheet changes. The schedule should allow the user to understand adjustments related to the parent company, adjustments related solely to the acquisition, and adjustments related to the subsidiary as a standalone entity. It might also be helpful to provide details when a subsidiary is acquired via an exchange of stock. While this is technically a noncash transaction, it might be helpful to provide a supplementary schedule indicating the investing activity that would have been recorded had the subsidiary been acquired for cash. Doing so more clearly reveals the true cost of the acquisition. Finally, we note that the possibility of reclassifying interest and dividend receipts as investing activities and interest payments as financing activities in line with finance theory should be carefully considered even though all three are presently classified as operating flows. This is in line with the proprietary theory approach (Chapter 5). 5.

Monsen (2001) proposes using cameral accounting to reduce the difficulties in preparing the Statement of Cash Flows using the direct method. Evaluate Monsen’s proposal from an implementation perspective.

Monsen, Norvald (2001). “Cameral Accounting and Cash Flow Reporting: Some Implications for Use of the Direct or Indirect Method,” European Accounting Review, 705—724. Most accountants have not studied cameral accounting, essentially single entry accounting used in government. This is a thought provoking challenge to double-entry accounting that should foster a lively classroom discussion. 6.

Ohlson and Aier (2009) propose a framework of Modified Cash Accounting (MCA) rather than the current SCF. Evaluate their proposal.

Ohlson, James A. and Jagadison K. Aier (Winter 2009). “On the Analysis of Firms’ Cash Flows,” Contemporary Accounting Research, 1091–1114. This is another thinking type read for classroom discussion.

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Chapter 14: Accounting for Inflation and Changing Prices

Instructor Manual

CHAPTER HIGHLIGHTS Chapter 14 begins with a brief history of inflation accounting in the United States prior to SFAS No. 33. The history provides a foundation of how we got to where we are today in U.S. GAAP. The sections on purchasing power gains and losses and holding gains and losses form the building blocks of the income measurement systems section. It is also important to compare purchasing power gains and losses and holding gains and losses with each other. A discussion of the principal requirements of SFAS No. 33 covers why this standard failed. The resolution of inflation accounting in SFAS Nos. 82 and 89 follows. A significant portion of the chapter is devoted to SFAS No. 157, Fair Value Measurements, and its extension in SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115. The shift towards current value (now called fair value) is clear, one that will bring about significant changes in all aspects of accounting in the coming years. The accountant’s role appears to be changing from one of an objective reviewer to one of a subjective valuation expert. Alternatively, in the future, the accountant may be more like a bookkeeper or compiler, obtaining fair values from an outside vendor and inserting them into the balance sheet. This outside vendor will likely be in a growth industry, valuation.

QUESTIONS Q-1

How would you explain a purchasing power loss to someone who says you have not really lost either money or real assets?

During periods of inflation, a “purchasing power loss” occurs on holding monetary assets due to the decline in purchasing power of the dollar. Assume a company owes you $100 that you carry as an Accounts Receivable. Assume a 20% inflation rate. If the company finally pays you the $100 one year later using these cheaper dollars, you are receiving less than you would have received a year earlier due to the devaluation of each dollar by 20%. Purchasing power gains or losses are shown in the price-level adjusted income statement. Reference the uncle who stashes all his savings under his mattress, not trusting banks or the stock market. He places $25,000 under the mattress in 1955 planning to pay cash for a new home after he marries later that year. $25,000 is sufficient to purchase a very nice home in suburban Chicago in 1955. At the last moment the planned marriage is cancelled. He decides to leave the cash where it is until he finds a new bride. In 2008 he finally marries and removes the cash to buy his bride a new home. Describe the home that his $25,000 stash will purchase in 2008.

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Chapter 14: Accounting for Inflation and Changing Prices

Q-2

Instructor Manual

What is the relationship between fair value and deprival value.

Deprival value is the opportunity cost to the enterprise of being deprived of the asset. It is the lower of two calculations: (A) net realizable value (essentially exit value) or the present value of future cash flows and (B) replacement cost. Fair value will be the higher of the two. Q-3

In addition to inflation subsiding, what other reasons underlie why SFAS No. 33 would most likely have failed?

SFAS No. 33 failed for several reasons. In addition to inflation subsiding, measurement problems were present, as were questions of understandability and usefulness for predictive purposes. Q-4

How did the SEC undercut the FASB’s general price level approach?

The FASB deferred action on its exposure draft because the Securities and Exchange Commission (SEC) issued Accounting Series Release (ASR) 190, which reversed the SEC’s long- standing position of forbidding the presentation of information other than historical cost. ASR 190 resulted in the FASB immediately reconsidering its position (general price-level restatement at that time) and led to the dual approach adopted in SFAS No. 33. Q-5

Do you think there is any reason to distinguish between in-use and in-exchange categories in SFAS No. 157?

This is an interesting question for discussion. Some may argue that since multiple categories are identifiable and multiple potential values exist, management intent should dictate which one to use. The real question is whether management intent is an unnecessary complication. Q-6

Are observable inputs always specific prices?

No, observable inputs also include non-monetary data such as interest rates and yield curves. Q-7

Relative to the firm, does the nonperformance factor work against it or for it?

Nonperformance risk pertains to the possibility of the firm itself not being able to pay its debts as they mature. In terms of the firm valuation process, this would result in raising the discount rate and lowering the carrying value of the debt which would result in a gain to the enterprise. Q-8

SFAS No. 157 is exit-value oriented; hence no entry value numbers can be used. Is this statement correct?

Entry value refers to replacement cost in markets in which the asset, liability, or expense is ordinarily acquired by the enterprise. Exit value refers to the net realizable value or disposal value of the firm’s assets and liabilities in what has been termed a system of “orderly liquidation.” SFAS No. 157 is an exit value system. At the measurement date, a hypothetical transaction focuses on the price that would be received to sell the asset or to transfer the liability. Accounting Theory (8th edition)

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However, if unobservable inputs make it unreasonable to determine exit price, entry value numbers may be a viable alternative. Q-9

Is it correct that transaction costs play no role in determining highest and best use for an asset in SFAS No. 157? Explain.

A fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement (Paragraph 10 of SFAS No. 157). Frequently the initial cost or transaction price will be equal to the exit value at the initial recognition. This will be true of financial instruments but not for fixed and other operating assets (paragraph 17). So, the standard is somewhat murky. Q-10

Costs of identical assets are always a Level 1 measurement under SFAS No. 157. Is this statement correct? Explain.

Level 1 assets involve quoted prices in active markets for identical assets and liabilities. If identical assets Level 2 assets may include identical assets in markets that are not overly active. So, yes, the statement is not correct. Q-11

In-use and in-exchange categories play no role relative to liability measurement in SFAS No. 157. Is this statement correct? Explain.

This statement is correct. The lowest price governs without any of the complexities that may surround different asset markets. Q-12

What is the additivity problem?

The additivity problem results from the values assigned to accounts on the balance sheet at different times. A dollar today is not the same as a dollar 30 years ago. So, when you simply sum a list of assets on a balance sheet, you may be adding apples and oranges. Financial analysts are aware of the problem and invest in adjusting the accounts to a common price-level. Q-13

Why do we get a poor measure of capital maintenance under historical costing?

Capital maintenance represents the amount that can be distributed to shareholders as dividends without breaching capital. Under periods of inflation historical cost income overstates the firm’s dividend possibilities due to understating expenses such as depreciation and cost of goods sold. SFAS No.157, therefore, is lacking in the way it allows historical costs for inventories. Q-14

What is a “market specific” versus an “entity specific” measurement and does this distinction hold?

“Market specific” means that the price was determined by buyers and sellers in the market place (think of a supply curve and a demand curve determining price). “Entity specific” means that it is entity determined. SFAS No. 157 gives the example of a firm owning a large block of stock Accounting Theory (8th edition)

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which would affect the market price if placed for sale on the market. By sticking with the current market price (which would really be a market specific price) the standard views this as entity specific. This distinction does not logically hold. Q-15

Why, under deprival value, do we compare exit-value and present-value numbers taking the higher of the two?

The rationale for comparing exit-value and present-value numbers and taking the higher of the two is to determine “fair value.” Q-16

Should capital stock be valued at fair value?

A thought question, one that would best be discussed in class. If capital stock were to be valued at fair value (current market prices), this would take the entire balance sheet toward fair value and make financial analysis easier. Q-17

FASB Accounting Standards Update 2011-04 replaces the word “should” with the word “shall.” What, if any, is the significance of this change?

“Should” can mean “ought.” “Shall” means “definitely will.” There is less flexibility attached to “shall.”

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

A firm has a net monetary liability balance of $10,000 on January 1, 2001. During the first third of the year, the balance decreased to $7,500. During the second third of the year, the balance increased to $12,500. During the last third of the year, the balance increased to $20,000. The general price index was 100 during the first third of the year, 110 during the second third, and 106 during the last third. Compute the purchasing power gain or loss for the year.

Period First 1/3 Second 1/3 Last 1/3 For the Year

Net Monetary Liability Balance $7,500 $12,500 $20,000

Change

$5,000 $7,500

Price Level Adjustment 106/100 106/110 106/106

In Terms of End of Year Purchasing Power $7,950 $4,818 $7,500

Purchasing Power Gain (Loss) $450 $(182) $0 $268

There would be a $268 purchasing power gain because actual net monetary liabilities are $268 less than the restated net monetary liabilities.

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Chapter 14: Accounting for Inflation and Changing Prices 2.

Instructor Manual

A plot of land costing $200,000 was acquired on January 1, 2001. The price level was 120 on that date. One-quarter of the land was sold on December 31, 2001, for $60,000 when the general price level was 180. Compute the following holding gains: a. Realized real holding gain. b. Unrealized real holding gain. c. Realized monetary holding gain. d. Unrealized monetary holding gain.

The presumption is that the entire plot of land would be valued at $240,000 on December 31, 2001. The holding gains would be computed as follows: Total monetary holding gain: ($200,000 × [180/120]) – $200,000 = $100,000 Therefore, the total real holding loss would be $60,000. [$200,000 + $100,000 (MHG) – $60,000 (RHL) = $240,000]. The realized portion of each of the above would be one-quarter, and the other three-quarters would be unrealized. Hence, the answers would be: a. ($15,000) b. ($45,000) c. $25,000 d. $75,000

CRITICAL THINKING AND ANALYSIS 1.

How does the traditional concept of exit value differ from that presented in the current FASB Accounting Standards CodificationTM?

Most conceptions of net realizable value or exit value take into account transaction costs. Fair value as defined in the FASB Accounting Standards CodificationTM does not. 2.

How does FASB Accounting Standard Update (2011-04) address any concerns that Schmidt (2009) expressed some two years before its publication?

Schmidt, Martin (2009). “Fair Value: Your Value or Mine? An Observation on the Ambiguity of the Fair Value Notion Illustrated by the Credit Crunch,” Accounting in Europe, 271–282. This is a good class discussion. Have the students read ASU 2011-04 and Schmidt article to determine if his research was considered before issuing the Accounting Standards Update.

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Chapter 15: Income Taxes and Financial Accounting

Instructor Manual

CHAPTER HIGHLIGHTS Students should come away from this chapter with an appreciation of the complexities bearing upon financial accounting stemming from the federal government’s role in the taxation process and fiscal policy. It should also be clear that income tax allocation presents extremely difficult problems of allocation. A viable means of viewing the income tax allocation problem is by means of comparing and contrasting the numerous positions on the question. Exhibit 14-6 can be used as a frame of reference for evaluating the various positions. The question of the deferred credit position of APB Opinion No. 11 and the definition of liabilities in SFAC No. 6 could be a fruitful approach. A full view of the complexities of income tax allocation can be gleaned from the discussion using the example of accelerated tax depreciation versus straight-line for financial reporting. The heart of the chapter will probably be on how SFAS No. 109 works and its changes from its predecessor, SFAS No. 96. The change relative to the recognition of tax-loss carryforwards is also discussed. The discounting of deferred tax liabilities is also discussed and illustrated. The investment tax credit is largely of historical interest at the present time. Some comparisons can be made between investment tax credit and income tax allocation approaches. For example, the net-of-tax approach to income tax allocation and the reduction of asset cost approach for the investment tax credit have the similarity of reducing the cost of the asset. The investment tax credit was previously repealed two times, but it always seems to come back because it is a good macroeconomic tool for stimulating economic investment.

QUESTIONS Q-1

As a type of allocation, why is income tax allocation unique?

As Thomas has said, “. . . tax allocation may be perceived as an attempt to make allocation consistent, and its allocation problems are the consequences of other arbitrary allocations.” In other words, using different depreciation methods (an allocation) for tax and financial reporting purposes in turn leads to income tax allocation. The question is, “Is all the added complexity worth it? Does it really make a significant difference when valuing a firm?” Q-2

Relative to depreciation, why is comprehensive allocation an example of rigid uniformity and partial allocation an example of finite uniformity?

Comprehensive allocation is rigid because it unconditionally requires allocation as long as a timing difference exists. Partial allocation is finite because it requires allocation only if there is a perceived real payback (as measured by several of the deferred tax liability accounts) of accelerated tax benefits.

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Chapter 15: Income Taxes and Financial Accounting Q-3

Instructor Manual

Although net-of-tax depreciation gives the same bottom-line result as comprehensive allocation, are there any financial ratios that would be affected by the choice between these methods?

Debt-to-equity ratio would be more favorable under net-of-tax because the “debt” would be classified as additional accumulated depreciation. In addition, net-of-tax would result in a higher return on investment because classification as additional accumulated depreciation would result in a lower asset base than would arise under conventional income tax allocation. Q-4

How do the deferral and liability methods of implementing comprehensive allocation differ?

The two methods, deferral and liability, differ in two respects. The first is the designation of the account. It is referred to as a “deferred credit” under the deferral approach and a liability under the liability approach. However, this distinction has been blurred due to the fact that the definition of a liability from APB Statement No. 4 includes “certain deferred credits that are not obligations but that are recognized and measured in conformity with generally accepted accounting principles.” The second distinction refers to the fact that the balance of the account is adjusted if there is a change in the income tax rate under the liability approach, but no adjustment occurs under the deferred. Q-5

What is the rollover defense of the liability interpretation of deferred taxes, and how has it been attacked?

The “rollover” defense views each asset separately. The benefits that are received in the early years of the fixed asset’s existence resulting from excess tax depreciation relative to book depreciation are “paid back” in later years when the relationship between book and tax depreciation reverses. Sometimes the rollover view uses the analogy of accounts payable. Anti-rollover proponents knock this last argument down by saying the analogy between accounts payable and income taxes is not valid, because each individual account payable must be paid off with funds as it comes due. This is not true of income taxes. Consistent with this thinking, anti-rollover proponents tend to look at the behavior of the deferred tax account from a macro viewpoint. At most, they would tend to see a liability when the balance of the deferred tax account decreases (this is the partial allocation position). Q-6

What is the justification for discounting deferred tax liabilities under either comprehensive or partial allocation?

Other long-term liabilities that bear interest, such as leases and bonds payable, are carried at their present values. While there is no explicit interest on funds financed by deferred taxes, the opportunity cost concept is applicable: if funds had to be borrowed from the next-best source, they would have a cost. Measuring this cost and keeping it separate from pure income tax expense would, thus, be appropriate. Opportunity costs are, of course, utilized in accounting. Donated land, for example, would be booked at fair market value.

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Chapter 15: Income Taxes and Financial Accounting

Q-7

Instructor Manual

What is the interpretation of income tax expenses under partial allocation?

Income tax expenses equal an amount paid for income taxes attributable to operations of the current year. In addition, the expense will also include an amount attributable to the current year, which will not be paid until a later year (this amount equals the excess of tax depreciation over book depreciation, which is not “shielded” by additional acquisitions of fixed assets). Similarly, tax expenses would be reduced by reversals of taxes previously booked as liabilities under partial allocation. Obviously there are verifiability and agency theory issues here, but that is not the main consideration. Q-8

What is permanent deferral?

“Permanent deferral” refers to a situation in which the excess of tax depreciation (MACRS) over book depreciation on newer assets exceeds the reversal (book depreciation exceeding tax depreciation) on older assets. The result is an increase in the credit balance of the deferred tax account. When this situation continues indefinitely, permanent deferral results. The specter of permanent deferral, which empirical research has shown, raises the issue of whether a liability exists. Q-9

How did SFAS No. 96 differ from APB Opinion No. 11?

SFAS No. 96 tried to go from the revenue-expense approach of APB Opinion No. 11, which used deferred debit and credit accounts. SFAS No. 96 required deferred asset and liability accounts. In line with the asset-liability approach, it also required the use of future enacted tax rates and required adjustment of deferred asset and liability accounts if tax rates changed. APB Opinion No. 11 used current rates only and no change in deferred debit and credit accounts if tax rates changed. Q-10

How does SFAS No. 109 differ from SFAS No. 96?

The differences between SFAS Nos. 109 and 96 are less extreme than those between APB Opinion No. 11 and SFAS No. 96, but they are nevertheless important. First, SFAS No. 109 is much more liberal in recognizing deferred tax assets than its predecessor. SFAS No. 109 simply requires reasonable certainty of realization of deferred tax assets, whereas its predecessor required much more specificity (carryback against taxable income or offsetting net deferred tax liabilities via carryback or carryforward). In addition, tax loss carryforwards are recognized as deferred tax assets under SFAS No. 109, but not by SFAS No. 96. Finally, classification of current versus noncurrent deferred assets and liabilities differs. SFAS No. 96 based the distinction on when the item reverses. Reversal within a year or the operating period, if longer, would be current under SFAS No. 96, but in SFAS No. 109 the current/noncurrent distinction is based on the item that gives rise to the deferred asset or liability. Thus, deferrals arising from tax and book depreciation differences would be noncurrent, whereas differences between accrual methods of bad debt and actual write-offs of uncollectibles would be current.

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Chapter 15: Income Taxes and Financial Accounting

Q-11

Instructor Manual

Refer to Exhibit 15.8. Under SFAS No. 96, there was a “conservative” recognition of deferred tax assets. As a result, the $135 deferred tax asset in 1997 needs to be “carried back” to 1994. Why is this result not conservative?

The carryback from 1997 to 1993 or 1994 would not be conservative because the deferred tax asset debit would be higher as a result of a 46% tax rate rather than the 34% in 1997. Q-12

If discounting were used in the area of deferred tax assets and liabilities (as this chapter advocates), would there be any particular difficulty relative to tax-loss carryforwards?

The problem would be how to deal with the timing (present valuing) of when tax-loss carryforwards should be recognized in the future. This is a very difficult future events situation. Yes, a study taking into account the current year’s tax payments plus net increases deferred taxes— whether current or non-current—was better able to predict tax payments for the succeeding year than a model just using the preceding year’s tax payments. Q-13

Do you think that income tax allocation can improve the prediction of future tax payments in the short-run?

Yes, in the short run, income tax allocations can improve the prediction of future tax payments in the short run. Research shows that models using only preceding year tax payments were not as good as those considering deferred taxes. Q-14

Do deferred tax liabilities arising from using tax depreciation for tax purposes and straight-line depreciation for financial reporting lead to true future cash flows?

Deferred tax liabilities arising from using tax depreciation for tax purposes and straight-line depreciation tend to grow over time. So, the temporary difference apparently becomes a permanent one for companies growing. This suggests a cash flow benefit to the firm. Q-15

What are the weaknesses of partial allocation?

Partial allocation records in the books only those deferred credits that can be reasonably expected to reverse in the future. Verifiability and agency theory should be considered with partial allocations. Might management use partial allocation to lower current year income based on a future contingency? The issue of future events is problematic. Also, since the potential liability is beyond one year, should a discounted amount be calculated? Q-16

How are valuation allowances used in income tax allocation?

The deferred tax asset measures potential benefits to be received in future years. Since future income may not be large enough to actually receive a benefit from the deferred tax asset, SFAS No. 109 requires that a valuation allowance be used to reduce the deferred tax asset to a level that will likely be realized.

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Chapter 15: Income Taxes and Financial Accounting Q-17

Instructor Manual

Should tax-loss carryforwards be booked? Explain.

Characteristics of an asset include: probable future benefit that it contributes to future net cash flows, the firm receives the benefit and has control over its access, and the event must have already occurred. The first two characteristics are met, but the third one is not met. These are gain contingencies. So, the portion that can be applied to prior years is an asset, but not the portion applicable to future years.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Refer to Exhibit 15-8. Assume that in 1996 accounting income is $2,000. There is one new temporary difference: installment sale income of $350 is recognized in 1996 but will not be taxed until 1997 when the cash is collected. Required: Prepare the tax entries for 1996 in accordance with SFAS No. 109. 1996

Accounting Income Temporary Differences Depreciation Bad Debts Warranty Expense Installment Sale Deferred Compensation

1997

1998

1999

…. 2003 .

2000

Taxable Income for 1996 x enacted tax rate = Tax liability for 1996 and deferred tax assets or liabilities beyond 1996

(120) (100)R (125)R 50R 0

(60)O

100R

130R

(75)R 350R 0

(30)

1705 34% 580

215 34% 73

100 34% 34

130 34% 44

(30) 34% (10)

O=Originating, R=Reversing The journal entry would be: Income Tax Expense ($2,000 × .34) Current Deferred Tax Liability Noncurrent Deferred Tax Asset Current Deferred Tax Asset Income Taxes Payable ($1,705 × .34)

680 17 41 76 580

The three deferred tax accounts are adjusted to their correct end-of-year balances. The current deferred tax liability should have a balance of $119 ($350 × .34). Noncurrent deferred tax assets should have a balance of $31 ($90 × .34, which includes the originating depreciation difference of $60 in 2002 and $30 of reversing deferred compensation in 2003). Current deferred tax asset should have a balance of $26 ($75 × .34). The amounts in the entry represent the difference between the

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ending balances in 1997 and the ending balances in 1996 shown in the text. The two current and the two noncurrent accounts could also be combined. 2.

Nowell Company is experimenting with comprehensive-liability income tax allocation called for in SFAS No. 109 but, in addition, they are employing discounting. No temporary differences exist up to 2000. Shown here is a schedule of tax depreciation, book depreciation, and income before depreciation.

Year 2005 2006 2007 2008

Book Depreciation A1 A2 A1 A2 $50,000 $35,000 40,000 $60,000 35,000 $50,000 30,000 50,000 35,000 50,000 20,000 40,000 35,000 50,000

Tax Depreciation

Income Before Depreciation $300,000 400,000 420,000 440,000

The tax rate is 45 percent. The discount rate is 8 percent. Required: Prepare income tax entries for2005, 2006, 2007, and 2008discounting deferred tax liabilities at 8 percent. Why would using discounting be a stronger asset-liability orientation than not discounting deferred tax liabilities? 2000 Income Tax Expense Noncurrent Deferred Tax Liability Income Taxes Payable ($250,000 × .45)

Debit 118,001

Credit 5,501 112,500

2002: 5,000 x .45 x .85734 = 2003: 10,000 x .45 x .79383 =

1,929 3,572 5,501 2000’s excess of tax depreciation over book depreciation reverses in 2002 and 2003.

2001 Income Tax Expense Imputed Interest ($5,501 × .08) 440 Noncurrent Deferred Tax Liability Income Taxes Payable ($300,000 × .45)

Debit 140,787 440

2002: 5,000 × .45 × .85734 = 2003:10,000 × .45 × .85734 =

1,929 3,858 5,787

Credit

6,227 135,000

Asset A1 has an excess of tax over book depreciation reverses in 2003 and Asset A2 has an excess of tax over book which also reverses in 2003. Interest of $440 is also added in.

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Chapter 15: Income Taxes and Financial Accounting

2002 Income Tax Expense Imputed Interest ($11,728 × .08) Noncurrent Deferred Tax Liability Income Taxes Payable ($340,000 × .45)

Debit 150,750 938

Instructor Manual

Credit

1,312 153,000

($5,000 × .45) – $938 = $1,312 2003 Income Tax Expense Imputed Interest ($10,417 × .08) Noncurrent Deferred Tax Liability Income Taxes Payable ($380,000 × .45)

Debit 159,750 833

Credit

10,417 171,000

($25,00 × .45) – $833 = $10,417 Notice that Noncurrent Deferred Tax Liability balances to zero (with a $1 rounding error). If deferred tax accounts are really assets or liabilities because they represent potential future cash flows, then in line with APB Opinion No. 21 and many other areas involving future cash flows (pensions and leases, for example), they should be discounted to their present value.

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Chapter 15: Income Taxes and Financial Accounting 3.

Instructor Manual

Accounting income for the Kolbow Company for 2005 (its first year of operations) was $1,700,000. Differences between book and income were as follows: Municipal bond interest (permanent) $ 75,000 Excess of tax over book depreciation 240,000 Excess of installment sales over collections 30,000 Compensatory stock option expense 37,000 Scheduled temporary differences over the next several years are:

Depreciation Excess of installment collections over sales Compensatory stock option expense

2006 2007 2008 2009 ($160,000) $100,000 $140,000 $160,000 20,000 10,000 ($37,000)

Parentheses above indicate a deduction in the previous schedule. Enacted tax rates are as follows: 2005 40% 2006 40% 2007 35% 2008 30% 2009 30% Required: (a)Determine the taxable income for2005. (b)Prepare a schedule and do the tax entries for 2005. (c)Taxable income in 2006 is $1,400,000. One new temporary difference has arisen. Baddebt expense of $22,000 occurred during 2001, but the actual write-off (which is when the tax deduction is taken) is not expected to occur until 2002. Prepare a schedule and do the tax entries for2006. (a) Accounting income Add: Compensatory stock options expense not allowed for taxes

$1,700,000 37,000 $1,737,000

Less: Permanent difference (municipal bond interest) Excess of tax over book depreciation Excess of installment sales over collections Taxable Income

Accounting Theory (8th edition)

75,000 240,000 30,000

(345,000) $1,392,000

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(b) 2000 1,700,000

2001

2002

2003

2004

1,392,000 40%

(140,000) 40%

110,000 35%

140,000 30%

123,000 30%

556,800

(56,000)

38,500

42,000

36,900

Accounting Income Temporary Differences Excess of tax over book depreciation (240,000)O (160,000)O 100,000R 140,000R 160,000R Installment Sales (30,000) 20,000R 10,000R Compensorary Stock 37,000 (37,000)R Subtotals (taxable income for 2000) x Enacted tax rate = Tax liability for 2000 and deferred tax assets or liabilities beyond 2000

2000 Income Tax Expense 618,200 Noncurrent Deferred Tax Asset 75,100 Noncurrent Deferred Tax Liability Current Deferred Tax Liability Income Taxes Payable

125,000 11,500 556,800

Noncurrent deferred tax asset ($160,000 × .4) + ($37,000 × .3) = $75,100 Noncurrent deferred tax liability ($100,000 × .35) + ($140,000 × .3) + ($160,000 × .3) = $125,000 Current deferred tax liability ($20,000 × .4) + ($10,000 × .35) = $11,500 (c)

Accounting Income Temporary Differences Excess of tax over book Installment Sale Compensatory stock options Bad debt expense Taxable Income x enacted tax rate = Tax liability for 2001 and deferred tax assets or liabilities beyond 2001

Accounting Theory (8th edition)

2001 1,518,000

2002

2003

2004

(160,000)

100,000

140,000

160,000

20,000R

10,000R

(37,000)R 22,000

(22,000)

1,400,000 40%

88,000 35%

140,000 30%

123,000 30%

560,000

30,800

42,000

36,900

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Income Tax Expense ($2,000 × .34) 608,300 Current Deferred Tax Asset ($22,000 × .35) 7,700 Current Deferred Tax Liability 8,000 Noncurrent Deferred Tax Asset Income Taxes Payable

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64,000 560,000

Current deferred tax liability Ending balance ($10,000 × .35) Beginning balance Adjustment

3,500 11,500 8,000

debit

Noncurrent deferred tax asset Ending balance ($37,000 × .3) Beginning balance Adjustment

11,100 75,100 64,000

credit

There is no change in the noncurrent deferred tax liability. 4.

Gillette Company, maker of shaving products and many other personal products, showed a net income of $1.428 billion in 1998 and $1.427 billion in 1997 on page one of its 1998 annual report. A note to the 1998 income said that the 1998 income of $1.428 billion was to be reduced $347 million due to reorganization and realignment expenses. Consistent with this, the net income in the consolidated statement of income for 1998 was $1.081 billion. In addition, following information appeared in the footnotes for the 1998 corporate annual report (figures are in millions). See text for remainder of the problem. Required: a. Why do you think Gillette initially showed its income for 1998 to be $1.428 billion? Discuss. b. Is the expensing of the reorganization and realignment costs of $347 million after taxes for 1998 correct? Explain. c. What is the valuation allowance? d. Why do you think Gillette maintains this account? e. Do you think that earnings management is being used by Gillette?

a. The initial impression that the reader gets is that income is $1,428 billion which is virtually the same as in 1997 ($1,427 billion). Notice that this makes their income look like pro-forma income by leaving the “one time” item out. b. Restructuring charges (which include asset impairments of $153 million before taxes) are considered to be ordinary charges and Gillette shows them in this fashion in their consolidated

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statement of income. However, the table in the footnote on page 32 does give the impression that these charges contain future benefits. c. The valuation allowance appears to be specifically related to operating loss and credit carryforwards which would have an extremely long carryforward period. During both 1997 and 1998, the valuation allowance is over 90% of the carryforward, an extremely high percentage. d. The results in part (c) do raise the issue that the valuation allowance might be used in the future to manage income by reversing out the allowance and lowering tax expense thus increasing income. e. During this short two year period, earnings management appears to be more implicit than explicit. While the actual income included the effect of the restructuring costs, the highlights omitted them. The valuation allowance might be explicitly used after 1998. 5.

Worldcom in 2001 and 2002 capitalized basic switching costs from expenses to capital assets to the tune of $3.8 billion dollars with approximately $3.04 billion occurring in 2001. The corporate tax rate is 35 percent. For 2001, Worldcom’s income before taxes was $2.432 billion and its income tax expense was $0.943 billion for 2001. Assume that Worldcom, on its tax return, expenses the entire $3.04 billion. Required: Would Worldcom’s actions have led to a situation of income tax allocation? Explain. Do you think, based on the numbers shown above, that Worldcom allocated the income taxes stemming from the incorrect capitalization of the switching expenses?

a. Assuming that Worldcom expensed the $3.04 billion there would be a situation of income tax allocation because $3 billion of phony capitalized expenditures arose with the entire $3 billion taken for expense purposes. We suspect that this is exactly what happened because we would not expect Worldcom to forego $3 billion of tax deductions despite the false capitalization. b. The $2.432 of accounting income does not include the expense writeoff of $3.04 billion which was capitalized. Assuming a five year MACRS writeoff, the net reduction from reported income to taxable income would result in the latter being zero ($3.04 –1/5 of $3.04 billion equals exactly $2.432 billion). Hence with taxable income being zero we would expect a zero tax expense. But the $.943 billion of tax expense therefore indicated that they did allocate. The $.943 billion is slightly in excess of the 35% tax rate when related to the $2.432 reported accounting income (actually 38.77%). This strongly indicates that (a) they deducted the $3.04 billion on the tax return and (b) they did allocate. The allocation entry debits tax expense and credits deferred tax liability.

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Nortel Networks, the Canadian telecommunications equipment manufacturer has recently suffered large losses, creating very large tax loss carryforwards. The company also has a very sizable valuation allowance which it deducts from the tax loss carryforwards on the balance sheet. During the last quarter of 2005, it reduced the valuation allowance by $111 million. In the first quarter of 2006, however, it added back $90 million to the valuation allowance. Required: What do you think may have been the underlying reason for Nortel's behavior relative to the manipulation of the valuation allowance?

First, you must buy into the idea that a manipulation of the valuation allowance has occurred. Management may have conducted an objective review of the deferred tax assets and genuinely determined that Nortel’s profitability outlook deems an adjustment to the valuation allowance. Since many corporations do their strategic planning along with high-level financial plans during Q1 of each year, this new information may have resulted in this revision. However, a skeptical individual would likely respond that management used the valuation allowance to “window dress” its year-end financial reports. Why? Perhaps it was done to meet profit plan targets, achieve specific ratios for compensation. Given that it was adjusted at year end and then apparently reversed the next quarter, it is suspicious. Note you can access the Nortel annual reports at http://www.nortel.com.

CRITICAL THINKING AND ANALYSIS 1.

What are the strengths and weaknesses of (1) no allocation, (2) comprehensive allocation with an income statement orientation, (3) comprehensive allocation with a balance sheet orientation, and (4) partial allocation. Which would you choose?

No allocation is tempting. It is a cash flow number and avoids the complexities of the allocation process and might also be justified on the grounds of permanent deferral in many cases. (2) Comprehensive allocation with an income statement orientation emphasizes the revenue-expense approach but that day appears to be over. (3) Comprehensive allocation with a balance sheet orientation attempts to resurrect the balance sheet which we consider to be an important strength. (4) Partial allocation brings about a stronger definition of liabilities and assets. The future events problem coupled with potential agency theory implications is too strong a deterrent, we believe. Our preference lies with (3) provided it were coupled with discounting using a FIFO orientation which would be highly feasible. 2.

Is the deferred tax “liability” really a liability?

If it is a liability, it would embody a present obligation to the government in the future. If it is a liability, the firm has little or no discretion to avoid the future sacrifice. If it is a liability, it was created by past events that created the temporary differences. So, it appears that a deferred tax liability is really a liability, at least according to SFAS No. 109.

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Chludek (2011) finds that deferred tax components have little relevance when valuing a firm. If so, why make the accounting differences so potentially complicated to report?

Chludek, Astrid K. (2011). “Perceived versus Actual Cash Flow Implications of Deferred Taxes: An Analysis of Value Relevance and Reversal under IRFS,” Journal of International Accounting,” 1–25. That’s a very good question. Why not just ignore book income tax calculations and record current tax obligations? Perhaps Thoreau had it right, “Simplify. Simplify.”

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CHAPTER HIGHLIGHTS Chapter 16 is intended to give the student a comprehensive overview of legal, funding, and accounting aspects of corporate-sponsored pension plans. The lengthy background material at the beginning of the chapter is necessary in order to understand the accounting implications of defined contribution and defined benefit plans. A weakness of most accounting discussion on pensions is the avoidance of technical issues. As a result, the accounting theory and policy issues are not clearly delineated. For example, it is not possible to discuss accounting issues independent of legal and funding aspects. Because of this, it is highly recommended that students read Appendix 15-A on actuarial funding. The chapter also introduces post-retirement benefits other than pensions arising from SFAS No. 106. The fundamental theory and policy issue is whether a pension plan gives rise to an accounting liability for the sponsoring corporation. Past and present accounting standards have said no, and the emphasis has been defining annual pension expense. An arbitrary and flexible policy existed in which accrued pension expense had to be based on one of five actuarial methods prior to SFAS No. 87. The situation was analogous to arbitrary depreciation methods. SFAS No. 87 allows only one actuarial method for calculating pension expense, a rigid uniformity approach. SFAS No. 87 also came down in favor of liability recognition. This position is little more than a belated acknowledgment that ERISA created a legally unavoidable obligation for pension plan sponsors. At this point, the policy issue turns to measuring the liability. Two theories from the labor economics literature, implicit and explicit contract views, are useful in relating what the FASB attempted in Preliminary Views (the implicit contract view, i.e., using projected future salaries to value the pension benefit in real terms) versus the compromise position in SFAS No. 87 (the explicit contract view, i.e., using current salary levels to value projected benefits). FAS No. 87 is definitely a compromise made in the interest of getting pensions onto the balance sheet, where they do belong. While accrued pension expense is linked to the increase in actuarial valuation of benefits over the period using future salary projections, the standard only requires a liability to be recognized if the value of benefits measured using current salary projections exceeds the pension fund. Naturally, actuarial values are lower when current salaries are used. The other dubious character of the standard, and an issue not fully brought out in the text, concerns the creation of an intangible pension asset on the balance sheet if a pension liability is recognized. Surely this is either a charge to income, or a prior period adjustment. By debiting this “odd” intangible pension asset, a smoothing effect occurs viz. the income statement recognition of unfunded pension liabilities. The economic consequences literature is reviewed in the pension area. One set of studies focuses on whether stocks are priced “as if” pensions are a liability (pre-SFAS No. 87 studies). Generally, the evidence, not surprisingly, is that they are treated as if they are liabilities. There is some limited research that suggests a firm’s bond ratings also reflect pensions as debt equivalents. However, as in other areas, there could still be economic consequences arising from Accounting Theory (8th edition)

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balance sheet recognition, and this is likely to explain why a record number of firms lobbied against the proposal. Appendix 16-A gives a concise example of service cost determination under both projected and accrued benefit cost approaches, and also illustrates two funding approaches. SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R), brought the over (under) funded status of a defined benefit pension plan from the footnotes to the balance sheet. It also requires an employer to measure the funded status of a plan as its year-end balance sheet date. The IASB-FASB work plan is addressing pension accounting, but their review is not scheduled for completion until 2014.

QUESTIONS Q-1

What do the following actuarial terms mean: accumulated benefits, actuarial liability, vested benefits, service cost, and unfunded accumulated benefits? How are they measured? How are projected benefit obligations, accumulated benefit obligations, and vested benefit obligations defined in SFAS No. 87, and how are they actuarially calculated?

Accumulated benefits and actuarial liability are the same terms, and are calculated by any of several primary actuarial methods for accrued benefits earned to date. Vested benefits are those no longer contingent upon continued employment (i.e., they are legally binding), and unfunded benefits are simply those benefits not funded by a pension fund. Finally, service cost is the increase in accumulated benefits for a year. SFAS No. 87 refers to projected benefit obligations (measured using future salary levels), accumulated benefit obligations (measured using the accrued benefit method without future salary projections), and vested benefit obligations (a subset of accumulated benefit obligations). Q-2

Why is there a pension accounting problem with defined benefit pension plans, but not with defined contribution plans?

With defined contribution plans, there is no promise to pay based on future salaries. The employee receives only his or her benefits that have been earned up to retirement without any guaranteed amount. Q-3

Explain how previous pension accounting standards were based on a revenue-expense approach to the financial statements.

APB Opinion No. 8 focuses almost exclusively on the problem of determining annual pension expense. The rationale of APB Opinion No. 8 is that the results achieve rational and systematic Accounting Theory (8th edition)

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matching of labor-related pension costs to the revenues generated by labor. No major consideration is given to balance sheet issues. Q-4

Why did APB Opinion No. 8 only minimally improve uniformity between companies?

APB Opinion No. 8 closed the “GAAP” between discretionary and nondiscretionary funders (companies). It forced an accrual of pension expense, regardless of actual cash funding. However, flexibility in the choice of actuarial method still results in diversity and poor comparability. Q-5

Is the treatment of unrecognized prior service cost and actuarial gains/ losses in SFAS No. 87 an example of the asset-liability or revenue-expense orientation?

Both would be examples of an expense-revenue orientation because both use an accrual/matching orientation rather than bringing the liability from prior service costs onto the books. Likewise, neither recognizes the asset/liability effect of actuarial gains and losses via the extremely modified corridor amortization approach. Q-6

How has ERISA affected pension accounting?

ERISA (Employee Retirement Income Security Act) has created a legal obligation for the sponsor to fund vested benefits (guaranteed by the PBGC), as well as to meet annual funding requirements. Prior to ERISA, both of these obligations were “avoidable” by the sponsor— legally, at least. So, a strong case exists that these are also accounting liabilities. Q-7

Given the evidence from the research in the stock market, does it matter whether pension information is disclosed in the formal financial statements or as supplemental disclosure?

Looking solely at direct cash consequence, it would not appear to make any difference. However, there could be indirect consequences, which are discussed in the next question. Of course more empirical research, generally speaking, is coming to the conclusion that recognition is preferable to disclosure. Q-8

What economic consequences of SFAS No. 87 were suggested in the chapter?

Recognition of a liability would affect debt-equity ratios, which are specified in restrictive debt covenants. There could be an indirect consequence, then, on dividend payments or a company’s borrowing capacity. These are, of course, agency theory arguments. Q-9

Research has shown that discount rates used by firms are generally above rates suggested by the FASB. Will this make the interest cost portion of pension expense higher or lower than if discount rates were lower? Why do you think firms favor using a higher rate?

The higher interest rate, in and of itself, would lead to a higher interest expense but it also leads to a lower present value of the pension obligation which would lower the interest expense. The

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lower present value of the pension obligation reduces the probability of recording a minimum pension liability. Q-10

Is SFAS No. 87’s argument favoring recognition of a pension liability for accumulated benefits consistent with the conceptual framework project?

The analysis in the chapter concluded that unfunded accumulated benefits are an unambiguous legal liability in terms of SFAC No. 6 definitions. Q-11

If actuarial gains and losses and prior service costs, in line with SFAS No. 158, are to be recognized in the period when incurred, is there a double counting effect when these elements are recognized as part of net pension expense?

No, there is not a double-counting. Pension expense affecting the income statement are offset by adjustments to comprehensive income. Q-12

How does the “give-and-take” differ between the FASB and its constituents in the drafting of SFAS No. 87 on pensions versus in SFAS No. 106?

The battle over SFAS No. 87 was quite stormy. The initial proposal was not put out as an exposure draft but as “Preliminary Views.” The exposure draft was also not well received but many compromises were made in arriving at the final standard. While SFAS No. 106 was also greeted with almost 500 letters, its path to final acceptance was much smoother with OPEB accounting seen as being related to and consistent with pension accounting. Relatively few changes were made in going from the exposure draft to the final standard, unlike the pension situation. Q-13

Voluntary pension plan terminations have been increasing [see Stone (1987)] in which surplus plan assets are recaptured by sponsoring companies after deferred annuities (of equivalent value to accrued benefits) are purchased for plan participants. Why do you think this practice has been criticized by some employee groups, and how might SFAS No. 87 affect voluntary terminations?

A very serious issue is at stake—who owns pension fund assets. While there are court challenges in process, to date the answer has been that they belong to the sponsoring company as long as they “pay off” existing plan members by buying them insured annuities equal in value to their accumulated benefits. Employee groups have challenged the claim that excess pension funds belong to sponsors rather than to employees. SFAS No. 87 could, possibly, lead to an increase in plan terminations for those plans with excess pension fund assets. The reason is to avoid the possibility of future period recognition of a pension liability, as might occur if pension fund assets drop in value (as indeed occurred in the crash of 1987).

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What issues of qualitative characteristics of accounting information (SFAC No. 2) are important relative to accrual accounting for OPEBs?

Costs of measurement may be quite high, which relates to the benefits > costs pervasive constraint. Under reliability there are very serious questions relative to the verifiability of OPEB measurements. Q-15

What types of economic consequences may arise from accrual accounting for OPEBs in SFAS No. 106?

Bond covenants could be affected as a result of higher debt-equity ratios. Management compensation could be affected as a result of booking OPEB expenses. The question is also raised relative to curtailing or at least cutting back on OPEB benefits as a result of booking expenses and liabilities. Finally, the issue of competitive disadvantage of American firms in international capital markets has been raised as a result of lowering income and raising liabilities. Q-16

According to The Wall Street Journal article on February 1, 1996 (“Intrinsic Value” by Roger Lowenstein, p. C1), pension fund assets in the United States grew dramatically— by approximately 29 percent—during 1995, an excellent year in the stock market. However, underfunding of pension plans increased by a very sizable amount. Why do you think that this occurred?

The problem is that pension liabilities can increase even faster if the discount declines as in 1995, for example. That year the discount rate decreased from 9% to 7% and pension obligations grew by 40% whereas pension assets grew by only 29%. The effect in the year 2000 and beyond will be interesting to see with interest rates rising and earnings rates on pension assets being somewhat sluggish.

Q-17

While ERISA has been helpful, how well are employees protected in situations where overfunded pension plans exist?

Loopholes still exist. As with the Dillard’s case mentioned in the chapter, if 25% of surplus pension assets are put into a replacement plan, the excise tax on fund assets is only 20% and the remainder of pension assets can be diverted to other uses. Q-18

What is the danger, particularly to older employees of restructuring pension plans into “cash benefit plans?”

A movement to “cash benefit plans” may well work to the detriment of older employees in favor of younger employees. Of course the shoe could be on the other foot when the younger employees reach retirement. Hence cash benefit plans could prove to be a shell game.

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What differences exist, relative to the use of future costs and future salaries, in the case of OPEBs (SFAS No. 106) and pensions (SFAS No. 87)?

The minimum liability determines any underfunding by using the accrued benefit obligation, whereas the transition gain or loss determines underfunding (or possibly overfunding) using the projected benefit obligation. Both amounts are then combined with the balance of the prepaid/accrued pension cost account. The purpose of the transition gain or loss account is to bring about the switch from the accumulated benefit obligation (current salaries) to a projected benefit orientation (future salaries). Hence, under transition gain or losses the differentials do go through income, whereas minimum liability amounts are oriented only to the balance sheet (the Wolk-Rozycki article in the chapter references illustrates both minimum liabilities and transition gain or losses). Q-20

Is it inconsistent to use future salaries for service cost calculations and current salaries for minimum liability calculation purposes?

It is somewhat unsettling but not necessarily inconsistent. The purpose of using future salaries in service cost calculations is to help predict future cash flows. Future salaries would be preferable for this purpose over present salaries though problems of reliability and executory contractual issues have been brought up in the text. It would appear that present salaries would be more representationally faithful for determining minimum liabilities than estimated future salaries.

CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Refer to Appendix 16-A. Assume that the firm is using projected accrued benefit cost funding. Suppose that a plan amendment was introduced during 2002 granting one year of prior service (for the year 2000) to each employee. Required: Determine the contribution to the pension fund for 2002 and 2003.

First find the increase in final benefits as a result of the plan amendment. This can be done by modifying equation 16.1 and using the additional number of years covered, which is one: Additional benefit equals expected final salary times expected number of employees who will be with the firm times the proportion of salary to be received times one year: $25,000 = $50,000 × 5 employees × .10 × 1 year The $25,000 is then added to the expected annual benefits during retirement of $75,000 in 2004 and 2005, as shown in Exhibit 16-4. The new total of $100,000 annual benefits is then discounted back to its present value on December 31, 2003 at the expected earnings rate of 12%: $100,000 × 1.69005 = $169,005

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Since only 2002 and 2003 are affected, the $33,682 already paid in on December 31, 2001 (Exhibit 16-4, Panel A) is compounded forward for two years at 12%, which equals $42,251 ($33,682 × 1.2544). The $42,251 is then subtracted from $169,005, which leaves $126,754 to be covered. The $126,754 is divided by two years (the number of remaining years), giving equal undiscounted amounts of $63,377. The $63,377 due on December 31, 1992 is discounted for one year at 12% (.8929), resulting in a payment of $56,589. Hence, the amending of the plan by including one additional year of coverage results in the following changes:

New payment Old payment (from Exhibit 16-4, Panel A) Differential

31 Dec 02 $56,589 37,724 $18,865

31 Dec 03 $63,377 42,251 $21,126

Smurfit-Stone Container Corporation’s 2004 annual report shows the following information pertaining to its minimum pension liability (this is before SFAS No. 158; 000’s omitted): Accumulated benefits obligation $3,336 Fair value of plan assets 2,466 Underfunded status 870 Unrecognized actuarial loss 762 Unrecognized prior service cost 79 Net unrecognized costs 841 Net minimum liability $ 29 Required: How do you think Smurfit-Stone would justify their calculation of the minimum liability and do you agree with them?

You can access a PDF copy of Smurfit-Stone Container Corporation’s 2004 annual report at http://phx.corporate-ir.net/phoenix.zhtml?c=75794&p=irol-reportsannual, but will need to access its 10K report on the SEC’s EDGAR database at http://www.sec.gov . The company’s assumptions related to the discount rates indicates that a reduction was necessary, given the current and projected environment. However, a concurrent review of its rate of compensation assumptions indicates an upward adjustment is necessary. These offsetting assumptions are suspect since they suggest smoothing by management. 3.

Using SFAS No. 87 and SFAS No. 106 for additional background, list and briefly discuss as many similarities and differences as you can between pension accounting and OPEB accounting.

Appendix B of SFAS No. 106 provides a good comparison between SFAS Nos. 87 and 106. We start with similarities.

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Similarities Both appear to be liabilities according to SFAC No. 6 and both are so interpreted. Both use the benefits/years of service approach and both are based on projected numbers: projected salaries in the case of pensions, and projected health care costs in the case of OPEB. Service cost, interest cost on the projected benefit obligation, and actual return on plan assets are largely similar. Prior service costs, including their measurement and amortization, are largely similar, including negative plan amendments. Gain and loss treatments are largely similar. Plan assets for both must be segregated and restricted for the sole purpose of providing defined benefits. Differences The attribution period for pensions covers years of service ending with retirement, but under OPEB it goes only to the date of full eligibility (which frequently may be the retirement date). There is no minimum liability under OPEB. Normal pension cost is based on an asset-liability orientation, but normal OPEB costs are basically revenue-expense (for example, see the equalized annual service cost in Exhibit 16-2). Future salaries used in pension service cost are wholly executory, but future health care costs are only partially executory and are not under management accountability. There is one major difference between the future cost orientations of SFAS Nos. 87 and 106. The future salaries in SFAS No. 87 are wholly executory on the part of both the firm and the employees. Future salary increases pertain to factors such as advancement and promotion as well as increasing skills. These services have not as yet been provided by employees and, of course, the firm has not started paying for them; hence, the future salary increases are mutually unperformed and executory (raises due to inflation only would automatically discount back to current salary levels). In contrast to future salaries, future health care costs of postretirement benefits do not have this same doubly unperformed aspect. Health care costs provided after retirement are executory relative to the firm, but not to its employees. At the present time, employees do not have to do anything more relative to the amount of health care services received to date.

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CRITICAL THINKING AND ANALYSIS

To qualify as a liability, a past transaction must exist. Is this the case with pensions and OPEBs? How does the use of financial statements for predicting future cash flows as opposed to evaluating management performance enter the picture?

First of all it would have put the debt in the balance sheet where, we believe it belongs. Secondly, the orientation of this number would move away from prediction of cash flows to assessment of management performance (accountability). Thirdly, the executory nature of these numbers would be eliminated. Fourthly, verifiability should be improved. We would favor the proposal. 2.

Biggs (2010) presents a bleak picture for future generations attempting to meet the obligations related to public pension plans (e.g., State of New York; Jefferson County, Alabama). How does his logic hold up when reviewing U. S. public corporations?

Biggs, Andrew G. (March 22, 2010). “Public Pension Deficits Are Worse Than You Think: How can fund managers assume an 8% rate of return?,” The Wall Street Journal: WSJ.com, accessed March 23, 2010, http://online.wsj.com. Biggs estimates that public pensions are underfunded by $3 trillion. Ouch! And that’s OK per the accounting our public organizations are using? 3.

How might standard setters address the concerns that Gordon and Gallery (2012) highlight related to pension accounting comparability?

Gordon, Isabel and Natalie Gallery (2012). “Assessing Financial Reporting Comparability Across Institutional Settings: The Case of Pension Accounting,” The British Accounting Review 44: 11–20.

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CHAPTER HIGHLIGHTS Lease capitalization is one of the most interesting policy areas in accounting. This is because of the gradual evolution of policy over a long period of time (nearly 40 years). Such a long evolution permits a ready analysis of the theoretical rationale behind the successive accounting standards. The overriding issue presented in the chapter is the search for finite uniformity. In the case of leases, this means classification into capital and operating leases. Capital leases are likened to purchases. By simple analogy, operating leases are made to resemble rentals. This simple twoway dichotomy illustrates the limitation of the accounting model. Leases are obviously neither purchases (sales) nor simple rentals in the strict legal sense. Yet the accounting choice is limited to these two analogies. Given the large number of successive lease accounting standards, the chapter presents a historical development of the arguments pertaining to lease capitalization. This review also illustrates the importance of definitions of accounting elements. The trend toward increased capitalization is closely related to the broadening of asset and liability definitions over the same time period. What emerges from the review is that finite uniformity is difficult to define and implement where there is a continuum of possibilities. The rules of capitalization emerge as an arbitrary point in the continuum; for example, the 75 percent rule in SFAS No. 13. Another important point is the incentive to circumvent lease capitalization, and the ability to do so by defeating the various (arbitrary) capitalization tests. This latter point illustrates a practical weakness in the policy of finite uniformity, and has led many critics to advocate an “all or none” attitude toward lease capitalization (rigid uniformity). The final point to be highlighted concerns the incentives to circumvent capitalization, and the economic consequences of mandatory lease capitalization. Survey evidence indicates a management preference for noncapitalization in order to achieve “off-balance-sheet” financing. There is some evidence that the market was “fooled” by hidden lease contracts: a study of APB Opinion No. 31 by Ro (1978) found evidence that its adoption had “information content” and that security price responses were negative. This could be explained in terms of the revelation of hidden debt. Another study (Pfeiffer, 1980) also found a negative price response to securities during the FASB’s public hearings in late 1974. It was argued that debt covenants would have affected stockholders wealth due to dividend and other restrictions relating to debt levels. In spite of the apparent market effects earlier, there was no evidence that the actual implementation of SFAS No. 13 affected security prices (Abdel-Khalik, 1981). This body of contradictory research can be reconciled. The studies by Ro and Pfeiffer, in effect, support the belief by management that “off-balance-sheet” financing can deceive the market regarding a company’s real debt level. The lack of information content in SFAS No. 13 may be explained by two factors. First, any adverse market reaction would probably have already occurred by the time of its adoption. Second, the long phase-in period may have mitigated any Accounting Theory (8th edition)

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serious consequences in terms of debt covenants and debt-equity ratios. In short, there was ample time to restructure leases to avoid capitalization. Finally, the continued behavior by management to defeat the SFAS No. 13 tests are quite interesting and warrant an explanation. Agency theory arguments concerning debt covenants are one possibility. All in all, there is little doubt that lease capitalization has information content. The evidence is ambiguous on the point of whether it matters how the disclosure is made (footnotes or in the body of the statements). The IASB and FASB added leasing to its agenda in 2006. They have been spinning their wheels, driving in circles, back to where they started several years ago multiple times. Placement of all leases on the balance sheet is the appropriate way to proceed, but industry push-back is strongly opposed. All leases on the balance sheet shows the fragility of many organizations that they prefer not be so apparent. We suggest you review the IASB and FASB web sites for a status of the Boards’ work.

QUESTIONS Q-1

What is the argument for finite uniformity in accounting for leases? Why is finite uniformity difficult to achieve? Explain what the relevant circumstances are in accounting for different types of leases.

The argument reduces to this: some leases are, by analogy, the equivalent of purchases (or sales to a lessor), while others are the equivalent of simple rentals. Finite uniformity is difficult because leases do not naturally fall into these two categories. The criteria (relevant circumstances) have changed over the years, and are discussed at length in the chapter for each standard. In broad terms, they have always been based on the “in-substance-purchase” argument. However, the specific tests have changed often. Q-2

Why is the aspect of conveyance of leases emphasized in capital leases and the contractual element emphasized in operating leases?

In law, leases have both elements. Obviously, the conveyancing aspect (purchase/sale) dominates in capitalization, and the contractual element (rental) dominates in noncapitalization.

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What are the similarities and differences between leases and other means of property acquisition? How can these similarities and differences be reported in the financial statements?

Some leases are very similar to conditional sales agreements (title passes at end of payments). Title passes immediately under other types of sales, regardless of financing aspects. Remedies are unique for lessors: they must either sell or lease the asset again, then sue for any residual losses. In other words, the lessor must first mitigate the loss, and the loss is not defined as the unpaid future lease payments. This requirement does not exist for conditional sales. This emphasizes the unique nature of leases, and reinforces the weak nature of the “sale analogy” argument used to justify capitalization. Q-4

Is the executory nature of lease contracts important in assessing lease accounting? How have leases been interpreted? Why might noncancellability override the executory nature?

The answer depends on how you regard the executory contract argument. If the executor argument is accepted, then leases should not be capitalized (to be consistent). If the executor argument is rejected, then there can be no objection to capitalization on these grounds. This issue illustrates the rather shaky nature of theory. The executory nature of leases certainly distinguishes them from sales-type agreements, as discussed in the previous question. So, even without the executory contract issue, lease capitalization is something unique in accounting. Q-5

Review the evolution of capitalization criteria in lease accounting standards. Why did APB Opinion No. 5 have little impact? What impact has SFAS No. 13 had? Has there been an underlying theme in the development of lease accounting?

The broad criterion has always been the “in-substance-purchase” argument. Each standard has developed specific (and different) tests. ARB 38 took a legal approach and restricted capitalization to leases that were de facto conditional sales (installment sales). APB Opinion No. 5 embraced the “material equity” concept and focused on the existence of either a renewal option covering useful life or a bargain purchases option. Five narrower tests were suggested, but ignored due to the wording of the standard. Finally, SFAS No. 13 adopted the concept of a “material transfer of risks and benefit,” and uses any of four specific tests. APB Opinion No. 5 had less impact than expected due to poor wording. SFAS No. 13 has increased capitalization substantially. Q-6

Does it matter if capital leases are reported in a footnote or in the body of the balance sheet? What research evidence exists to help evaluate this question?

A simple answer would be no. Disclosure is disclosure; form is unimportant. However, this approach ignores the cost of information processing to the user (in making necessary transformations, say, to a debt-equivalent in the balance sheet). There are also the agency theory

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arguments. Capitalization will quite clearly affect debt ratios established in restrictive debt covenants. Therefore, there could be wealth effects on stockholders. The study by Pfeiffer (1980) is consistent with this argument. Q-7

Does symmetry exist between lessors and lessees under SFAS No. 13? Should symmetry be a goal of lease accounting?

There are two causes of asymmetry. First, traditional sales-type tests apply to lessors. These tests concern the uncertainty of cash collection. Second, the interest rate used for present value calculation could differ. The sales test is legitimate and consistent with the body of practice. For example, installment sales may be accounted for as a normal purchase by the buyer. The second cause creates a unique asymmetry. One cause of difference in interest rates is the inclusion of tax benefits for the lessor. In effect, asset cost was reduced by investment tax credits. This was not done with lessee computations because it was not applicable to them. So, the asymmetry created by the sales tests is logical. However, the computational asymmetry is hard to defend in terms of general practice. Q-8

How is representational faithfulness achieved in the capitalization requirements of SFAS No. 13?

In the sense that the measurement may not be representationally faithful (see the previous question), the rules themselves are fairly objective. Key terms (for example, lease life) are open to a wide range of estimates, much in the same way that depreciable lives and estimates of salvage value are subjective in depreciation calculations. In the end, much noncash flow accounting is quite subjective. Q-9

Is there a measurement reliability (verifiability) problem with lease capitalization?

Lease capitalization is an interesting example of finite uniformity. The costs are expensed as selling expenses if a sales-type lease, but implicitly amortized against future interest revenue if a financing lease. It is a logical extension of the matching concept, but it implies a precision in lease capitalization that does not exist. Q-10

Evaluate the manner in which initial direct lease costs are accounted for under SFAS No. 13.

In going from true “off-balance-sheet” financing, as was the case prior to APB Opinion No. 31, to supplemental disclosure of noncapitalized leases, new information was clearly disclosed, and was potentially negative to stockholders because of larger-than-expected debt claims on the firm. Of course, by disclosing such leases, one appeal of leasing was abolished. Here is where neutrality comes into play. What if accounting policy lowers the incidence of leasing? Is this fair? The SEC argued that if the sole incentive for leasing rested with “off-balance-sheet” financing, then no social good was being achieved. It is useful to point out that leasing continues

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to be popular for a wide variety of operating, financing, tax, and accounting reasons, and that accounting policy did not kill leasing. Q-11

Why was there reason to expect some negative economic consequences arising from lease capitalization? What is the role of neutrality in such a situation? What is the response based on research findings to date?

The Ro (1978) and Pfeiffer (1980) studies, plus surveys of analysts, support the notion that lease capitalization is useful. Costs exist because of the compliance cost (i.e., accounting costs). Q-12

Does the reporting of capital leases appear to have value to users of financial statements? Why are there costs of reporting capital leases?

Because of the potential material effect on the balance sheet, the four-year transitional period permitted companies to restructure their leases, or capital structure generally. This political consideration lessened the unpopularity of SFAS No. 13 among companies. Policy making in the lease area has been quite political; for example, the SEC pushed policy-making bodies for increased capitalization during the 1970s. Q-13

What considerations may have motivated the FASB to grant a four-year transitional period in capitalizing pre-1977 leases meeting the capitalization tests of SFAS No. 13? What other political behavior is evident in the evolution of lease accounting?

Should valuable lease options of lessees be capitalized?

Since valuable lease options are valuable, yes, they should be capitalized. Two leases that are exactly the same except for a bargain purchase or lease renewal option should not be capitalized for the same amount. Q-15

Why is the G4+1 like the Big Ten (a.k.a. Western Athletic Conference)?

The G4+1 has six members and the Big Ten football conference in the USA has eleven members. At least in the case of the Big Ten this situation shows the importance of branding.

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Why is the IASB standard (IAS 7) substantially shorter than the FASB’s standard (SFAS No. 13)?

IAS 17 is more principles-based, lacking the “bright lines” found in SFAS No. 13. IAS 17 requires more judgment on the part of the accountant, but fewer words in the standard itself. Q-17

Current discussions by the Boards leave room open for two Accounting for Leases Standards; one for lessee and another one for lessor. Should two Accounting for Leases Standards be issued? Support your response?

The ideal would be for one standard with lessor and lessee making mirror journal entries to record the lease. However, the likelihood that one size fits all is of low probability. Organizational size and industry may differ significantly between lessor and lessee.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Human Genome Sciences, Inc., a biopharmaceutical company, discovers, develops, and markets new gene and protein-based drugs. Its 1998 annual report showed property, plant, and equipment net of accumulated depreciation of $20,965,000 with total net assets of $244,247,000. A note on operating leases revealed the following: Operating Leases The Company leases office and laboratory premises and equipment pursuant to operating leases expiring at various dates through 2017. The leases contain various renewal options. Minimum annual rentals are as follows: Years Ending December 31, 1999 $5,990,790 2000 6,074,955 2001 6,197,186 2002 6,278,051 2003 5,353,707 Thereafter (2004–2017) 35,001,144 $64,895,833 Required: a. Assume that the company’s cost of capital is 10 percent and that operating lease payments between 2004 and 2017 are equal amounts per year. By how much would Human Genome Sciences’ property, plant, and equipment and its total net assets increase by on December 31, 1998 if these leases were capitalized? b. Assume that the company’s net income for 1998 was $20 million. What was its return on assets (ROA) (a) before and (b) after capitalizing the operating leases? Use straight-line depreciation over 14 years for the capitalized leases. Operating lease expense for 1998 is $5,900,000.

(a) First determine the present value of the future lease payments using 8% discount rate. We use the present value of $1 for the first five years and then an annuity for the remaining nine years: Year 1 2 3 4 5 6-14

Amount $5,990,790 $6,074,955 $6,197,186 $6,278,051 $5,353,707 $3,889,016

Total Accounting Theory (8th edition)

PV Factor 0.92593 0.85734 0.79383 0.73503 0.68058 4.25152

PV Amount $5,547,052 $5,208,302 $4,919,512 $4,614,556 $3,643,626 $16,534,229 $40,467,277 Page 7 of 17

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(b) Interest Expense would be 8% × $40,467,277 Depreciation on a straight-line basis for the newly capitalized leases would be: $40,467,277 ÷ 14 Total Expenses

$3,237,832 $2,890,520 $6,128,352

(c) Return on Assets (ROA): Before Capitalization $20,000,000/$244,247,000 =8.188% After Capitalization $19,771,648/$284,714,247 = 6.944% The $20,000,000 of income was reduced by the excess of total expenses after capitalization ($6,128,352) over the operating lease expense during 1998 ($5,900,000). The result of the capitalization is a significant reduction in return on assets.

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Wright Company leases an asset for five years on December 31, 2000. Annual lease cost of $10,000 is payable on each December 31 beginning with the year 2001. In addition to the annual lease cost, the lease contract calls for a guaranteed residual value of $3,000. The asset has an economic life of seven years. Wright’s incremental borrowing rate is 8 percent. The asset has an acquisition cost of $45,000. There are no purchase options. Required: a. As things now stand, is this a capital lease or an operating lease? Show figures. b. What can Wright do to convert this lease to an operating lease? Explain and show figures. c. Will lessee and lessor’s accounting for this lease be symmetrical (capital lease for both lessor and lessee or operating lease for both lessor and lessee)? Explain. d. Do you think that Wright’s action in (b) represents a loophole to avoid capitalization or is it a useful part of the present leasing rules? Explain.

(a) As it stands now, this is a capital lease. The lease period is less than 75% (five years out of a total economic life of seven years), but the present value of the five year’s worth of lease payments plus the guaranteed residual value exceeds 90% of the fair market value of the property:

$10,000 x 3.99271 $3,000 x 0.68058

= $39,927 = $2,042 $41,969

and $41,969/$45,000 = 93.26% (b) Wright can get an outside party to insure that if the fair market value of the property is less than the guaranteed residual value, the outside party will pay the shortfall. If this is done, the guaranteed residual value is left out of the 90% calculation resulting in $39,927/$45,000 = 88.7%. Interesting, since this is under 90%, it is an operating lease. Yes, there is a lack of symmetry because the residual value, whether guaranteed or unguaranteed, is included in the lessor’s 90% calculation. Therefore, it is an operating lease for the lessee and a capital lease for the lessor. We believe it is clearly a loophole. This is an example of possible financial engineering and bright-lines. The lessee’s ability to use an outside third party opens the door to lease term manipulations to ensure operating lease treatment by the lessee.

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Assume the following facts concerning a sales-type lease: • The lease term is three years and qualifies as a capital lease for both lessor and lessee. The asset reverts to the lessor at the end of the lease term. Assume straight-line depreciation by the lessee. • Payments are $50,000 at the beginning of each year, plus a guaranteed residual value of $10,000 at the end of the lease term. The lessor estimates a total residual value of $15,000. Lease payments include $4,000 for executory costs under a maintenance agreement. • Initial direct costs associated with the lease are $2,700. • Cash sales price of the asset is $137,102.50. Lessor’s manufacturing cost is $100,000. • The lessee does not know the lessor’s implicit rate, but its own incremental borrowing rate is 11 percent. Required: a. Prepare the accounting entries for both lessor and lessee for the three years. What happens in Year 3 if residual value is only $8,000? b. Assume the same facts as before except that the asset is first sold to a finance company, which then leases the asset to the lessee. Prepare the required entries in all three years for lessor and lessee. c. Evaluate the differences between requirements (a) and (b) as well as the differences between lessor and lessee.

This is a comprehensive numerical exercise. Depending on the nature of the course, instructors may wish to exclude it. Part (a) Lessor: Year 1 Cost of goods sold 100,000.00 Lease payments receivable 153,000.00 Sales Inventory (asset) Unearned interest Selling costs 2,700.00 Cash Cash 50,000.00 Lease payments receivable Executory costs Unearned interest 9,110.25 Interest revenue 9,110.25

137,102.50 100,000.00 15,897.50 2,700.00 46,000.00 4,000.00

Year 2 Cash

50,000.00 Lease payments receivable Executory costs Unearned interest 5,421.28 Interest revenue

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Year 3 Cash

50,000.00 Lease payments receivable Executory costs Unearned interest 1,365.97 Interest revenue Asset 15,000.00 Lease payments receivable

46,000.00 4,000.00 1,365.97 15,000.00

Calculation of interest rate: $137,102.50 = 46,000(1+i)0 + 46,000(1+i)1 + 46,000(1+i)2 + 15,000(1+i)3 i = .10 Net Lease Receivable Gross Lease – Unearned Interest = Net × .10 = Interest Revenue Year 1 (153,000 – 46,000) – 15,897.50 = $91,102.50 × .10 = $9,110.25 Year 2 (107,000 – 46,000) – 6,787.25 = $54,212.75 × .10 = $5,421.28 Year 3 (61,000 – 46,000) – 1,365.97 = $13,634.03 × .10 = $1,365.97* *Rounding error Part (a) Lessee: Year 1 Leased asset 132,088.00 Leased obligations Executory costs 4,000.00 Lease obligations 46,000.00 Cash Depreciation expense 40,696.00 Accumulated depreciation Year 2 Executory costs Lease obligations Interest expense Cash Depreciation expense Accumulated depreciation

132,088.00

50,000.00 40,696.00

4,000.00 36,530.32 9,469.68 50,000.00 40,696.00 40,696.00

Year 3 Executory costs 4,000.00 Lease obligations 40,548.64 Interest expense 5,451.36 Cash 50,000.00 Interest expense 991.00 Lease obligations 991.00 Lease obligations 10,000.00 Leased asset 10,000.00 Depreciation expense 40,696.00 Accumulated depreciation 40,696.00 Present Value = 46,000(1.11)0 + 46,000(1.11)1 + 46,000(1.11)2 + 10,000(1.11)3 = $132,088

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Lease Obligation Outstanding Year 1 132,088 – 46,000 = 86,088 × .11 = $9,469.68 Interest Expense Year 2 86,088 – 36,530.22 = 49,557.78 × .11 = 5,451.36 Interest Expense Year 3 49,557.78 – 40,548.64 = 9,009.14 × .11 = 991.00 Interest Expense Note that interest in Year 3 applies only to the present value of the $10,000 residual value, and that the residual value is written up to the final balance of $10,000 by the Year 3 interest expense. Note also that depreciation is [(132,088 – 10,000)/3] = 40,696. If Year 3 residual value unexpectedly turns out to be only $8,000, the following adjustments would be made, in addition to the above entries: Lessor Cash Loss

2,000 5,000 Asset

Lessee Loss Cash

7,000 2,000 2,000

Part (b) Lessor: Year 1 Asset

137,102.50 Cash 137,102.50 Lease payments receivable 153,000.00 Taxes Payable 13,710.25 Asset 137,102.50 Unearned interest 29,607.75 Unearned interest 2,700.00 Cash (initial direct costs) 2,700.00 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 15,177.48 Interest revenue 15,177.48 Year 2 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 11,730.27 Interest revenue 11,730.27 Year 3 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 2,393.66 Interest revenue 2,393.66 Asset 15,000.00 Lease payments receivable 15,000.00 The interest rate that amortizes the adjusted balance of unearned interest (29,607.75 – 2,700.00 = 26,907.75) is arrived at by trial and error: i = 18.95%.

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Net Lease Receivable Gross Lease Unearned Interest = Net × .1895 = Interest Revenue Year 1 (153,000 – 46,000) – 26,907.75 = 80,092.25 × .1895 = $15,177.48 Year 2 (107,000 – 46,000) – 11,730.27 = 49,269.73 × .1895 = $9,336.61 Year 3 (61,000 – 46,000) – 2,393.66 = 12,606.34 × .1895 = $2,393.66* *Rounding error Part (b) Lessee:

Entries the same as for part (a) Part (c) It makes no difference whether a lease is a sales-type or financing type, from a lessee’s viewpoint. In part (a), asymmetry between lessor and lessee exists in terms of the interest rate and the treatment of residual value ($10,000 by the lessee and $15,000 by the lessor). Further asymmetry occurs in part (b) due to the treatment of initial direct costs by the lessor. These calculations should make the rules of SFAS No. 13 seem somewhat arbitrary, particularly in terms of representational faithfulness. 4.

One of the four capitalization tests of SFAS No. 13 is that the lease term is 75 percent or more of the asset’s remaining economic life. Lease term is defined as follows in SFAS No. 13 (as amended by SFAS No. 98, para. 22a): The fixed noncancellable term of the lease plus (i) all periods, if any, covered by bargain renewal options, (ii) all periods, if any, for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured, (iii) all periods, if any, covered by ordinary renewal options during which a guarantee by the lessee of the lessor’s debt related to the leased property is expected to be in effect, (iv) all periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable, and (v) all periods, if any, representing renewals or extensions of the lease at the lessor’s option; however, in no case shall the lease term extend beyond the date a bargain purchase option becomes exercisable. A lease which is cancellable (i) only upon the occurrence of some remote contingency, (ii) only with the permission of the lessor, (iii) only if the lessee enters into a new lease with the same lessor, or (iv) only upon payment by the lessee of a penalty in an amount such that continuation of the lease appears, at inception, reasonably assured shall be considered “noncancellable” for purposes of this definition. Required: How can this test be circumvented through either the structuring of the lease contract or interpretation of the test? What are other ways in which lease capitalization could be avoided through the structuring of lease terms or interpretation of the tests? What problem does this exercise illustrate?

In interpreting “lease term,” judgment is required concerning whether a bargain purchase option or renewal option exists. This determination will affect the derivation of lease term for applying Accounting Theory (8th edition)

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the 75 percent test. Of course, the test could also be manipulated through the estimated economic life. In short, even the 75 percent rule is far from being an objective test. Another way mentioned in the chapter is the use of third-party guarantors for residual value to the lessor. This will result in a lower present value of minimum lease payments for the lessee, and defeat the present value test. So, if a company wishes to avoid lease capitalization, it can do so and still stay within the bounds of SFAS No. 13. For this reason, some critics believe finite uniformity in lease accounting invites such behavior, and is consequently a failure. 5.

This problem shows the importance of considering the importance of converting operating leases to capital leases for the purpose of financial statement analysis. It is based upon the techniques developed and illustrated in Imhoff, Lipe, and Wright (1991 and 1997) though it is much simplified from their presentation. See the text for details related to McAdoo Restaurants. Required: a. Convert the operating lease to a capital lease which is 1 year old (Hint: Use the present value of a 10-year ordinary annuity). Assume that straight-line depreciation is used for both book and tax purposes. There would be a zero salvage value. b. Determine the net income after taxes if the leases are treated as capital leases. c. Determine the return on assets under the (a) operating lease assumption and (b) capital lease assumption. d. Determine the debt-equity ratio under the (a) operating lease assumption and (b) capital lease assumption. e. Do you think it is useful to convert operating leases to capital leases for financial statement analysis purposes? Discuss.

(a) We determine the capitalized amount of the lease as both an asset and liability by adding to the Jan. 1, 2001 balance sheet the following amount: $3,000 × 6.14457 = $18,434 (b) and (c) For the year 2001 we would deduct the $3,000 in capital lease payments and add depreciation of $1,843 and interest of $1,843 for total additional expenses of $686 ($3,686 – $3,000). However, this reduces taxes by $240 ($686 × .35). Hence through capitalization, income is reduced by $446 ($3,000 – $3,686 + $240). ROA is now shown: Without Capitalization: ROA = $6,500/$80,000 = 8.125% With Capitalization: ROA = $6,046/$98,434= 6.142% (We used beginning-of-year assets.) (d) In computing the debt-equity ratio on December 31, 2001, we deduct the principal reduction of $1,157 ($3,000 payment minus interest at 10% of $1,843 equals principal reduction of $1,157). We assume that there is no change in liabilities, other than the leases during the year and that there were no transactions with owners.

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Without Capitalization: Debt-Equity Ratio = $45,000/$86,500 = 52.02% With Capitalization: Debt-Equity Ratio = $62,277 b/$102,645c = 60.67% b$45,000 + ($18,434 – $1,157) = $62,277 c$80,000 + ($18,434 – $1,843) + $6,054 = $102,645

(e) Yes, we do think it is useful. Many lease contracts are constructed to avoid capitalization. This is really a facet of earnings management. We believe a much better appraisal of managerial effectiveness (accountability) can be accomplished by capitalizing operating leases. 6.

SFAS No. 98, which contained some amendments to SFAS No. 13, passed by a 4 to 3 vote. The following dissent to the opinion was made: Please refer to the text for the details of this lengthy question. Required: Using the perspective on uniformity developed in Chapter 9, analyze the rigid versus finite uniformity approach to the distinction between the two positions.

This is a complex area and, among other pronouncements, SFAS No. 98 modifies parts of SFAS No. 13 and SFAS No. 66 and is itself rather complex. Hence, much can be done with this case, including the assignment of term papers evaluating different treatments of sales of real estate and the handling of sale-leaseback transactions. Limiting the scope of this case to issues of comparability and uniformity is still quite revealing. SFAS No. 98 does, at least in part, reasonably employ finite uniformity. Those “sale-leaseback” transactions that do not qualify for sale-leaseback treatment do involve differential cash flow alternatives from ordinary sale-leasebacks. Some of these factors mentioned in paragraphs 11 and 12 of SFAS No. 98 are: a. The seller-lessee has an obligation or option to reacquire the property or the buyerlessor can force repurchase by the lessee. b. The buyer-lessor’s investment or return thereon is guaranteed by the seller-lessee. c. The seller-lessee provides guarantees to reimburse the buyer-lessor for declines in market value of the property beyond usual wear-and-tear considerations. In these and other cases, the FASB requires methods such as the “deposit” method, in which the property stays on the seller-lessee’s books and depreciation by the seller-lessee continues (see paragraph 65 of SFAS No. 66). Given the finite uniformity treatment, for which a case can certainly be made that comparability is improved, the three dissenters to SFAS No. 98 are, in our opinion, absolutely correct. According to paragraph 7 of SFAC No. 98, to qualify for sale-leaseback accounting treatment under SFAS No. 13, the transaction must involve a “normal leaseback.” The latter cannot Accounting Theory (8th edition)

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involve subleasing of the property unless the subleasing is minor. The question of subleasing involves a different transaction: the usage that the seller-lessee intends for the property. The factors mentioned above from paragraphs 11 and 12 concern cash flow aspects of the sale and leaseback itself. Other examples used throughout this text involving finite uniformity similarly concentrate on analyzing the particular event under discussion, and not a totally separate event that is not an integral part of the transaction at hand.

CRITICAL THINKING AND ANALYSIS 1.

”All leases beyond a year be capitalized!” Evaluate this position.

The short answer is “Yes, all leases should be capitalized.” It does not make sense that an arbritrary bright-line should require 100% or zero percent to be capitalized. Proportionally capitalization of all leases is a more reasonable route to take. From a legal standpoint we believe that the reality of the situation is that the lessor, by providing the property to the lessee, does not result in a mutually unperformed contract. The fact that the lessor, in case of the lessee’s default, must mitigate the loss is not especially relevant. As long as the lessee has a material equity in the property where rental payments exceed economic value of the property or bargain purchase options or bargain lease renewal options are present, then capitalization is definitely merited. The same end result occurs where benefits and risks incident to property ownership are largely transferred to the lessee. We believe all of these arguments generally lead to the same result: capitalization of the lease. Only if one adopts the narrow legal argument that the lease is mutually unperformed could one avoid capitalization. This is much too narrow a base for accounting to be operating from. 2.

Bauman and Francis (2011) propose several improvements to lease accounting standards. Evaluate their proposals and add ones that they may have missed.

Bauman, Mark P. and Richard N. Francis (June 2011). “Issues in Lessor Accounting: The Forgotten Half of Lease Accounting,” Accounting Horizons, 247–266. This should be a good class discussion paper. From its abstract about the FASB and IASB 2010 exposure draft on leases, “Disclosure quality, residual values, and the balance sheet impact of the proposal are examined, and numerous suggestions are offered to enhance the usefulness of lessor financial statement disclosures for decision makers.”

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Zechman (2010) studies firms using synthetic leases. How might her findings influence the setting of lease accounting standards?

Zechman, Sarah L. C. (June 2010). “The Relationship Between Voluntary Disclosure and Financial Reporting: Evidence From Synthetic Leases,” Journal of Accounting Research, 725–765. Synthetic leases are leases that are kept off the balance sheet and recorded as an expense only. They allow a company to control assets without showing them on the balance sheet. Zechman finds that cash constrained companies are more likely to finance purchases using synthetic leases. Knowing this, standards should be less flexible when set.

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CHAPTER HIGHLIGHTS This chapter focuses on the general question of how to account for equity investments. Framed in this way, one can see how there is an extensive structure of finite uniformity and how this structure ties together the separate topics of equity versus fair value method for nonconsolidated equity investments, plus consolidation ). The overriding relevant circumstance has to do with “effective control” by the investor over the investee company. Exhibit 18-1 sets out the finite uniformity framework for equity investments. Of course the elimination of pooling and the elimination of goodwill but subject to impairment are the big issues in intercorporate equity investments. The question might be raised as to the “symmetry” of the fair value to equity method to consolidation . This may be a rather creaky finite uniformity approach. Hence, proportionate consolidation might provide a worthwhile rigid uniformity alternative. SFAS No. 94 has brought rigid uniformity to consolidation policy by requiring that all majorityowned equity investments be consolidated. ARB 51 allowed exemptions for heterogeneous subsidiaries and for foreign subsidiaries. A criticism of SFAS No. 94 is that it blindly presumes that consolidated accounting “fictions” are informative. In fact, it’s easy to think of situations in which they aren’t—for example, when there are no cross-guarantees of debt between a parent and subsidiary. Therefore, it is regrettable that the FASB did not wait until it thought through the reporting entity project before issuing SFAS No. 94. Foreign currency translation is traced from SFAS No. 8 to SFAS No. 52, showing how the conflicts between accounting exposure and economic exposure were reduced.

QUESTIONS Q-1

Are there relevant circumstance differences between purchase and pooling of interests? Explain

No, we do not believe so. Suffice it to say that relevant circumstances do not deal with how assets are acquired; they deal with potential uses thereafter. Q-2

The logic of pooling rests heavily on the assumption that no substantive economic transaction occurs between the combinor and stockholders of the combinee. Evaluate this assumption.

We suggest this is a weak argument. Clearly a transaction between the combinor and stockholders of the combinee has occurred.

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Why may companies not be indifferent to purchase and pooling accounting, and what do we know about this issue from research studies?

Pooling produces a better income statement because combinee assets aren’t written up and goodwill is not recognized. ROI is also higher due to a lower asset base in the combined balance sheet. The limited research has not shown that the use of pooling versus purchase accounting produces any gains viz. security prices. Q-4

Why would proportionate consolidation result in rigid uniformity for intercorporate equity investment accounting?

Consolidation would occur throughout the spectrum of percentage of common stock owned on a proportionate basis without introducing any arbitrary percentage breaks. Q-5

Compare proportionate consolidation with capitalizing of all leases extending beyond a year, another example of rigid uniformity.

The comparison is quite close between proportionate consolidation and capitalization of all leases beyond a year. One way to institute proportionate consolidation would be for all equity investments above 10 percent to avoid the “nuisance” problem of consolidating many very small and temporary equity investments. Q-6

The equity method reports neither the investor’s cost nor the market value of the investment. Do you believe the equity method provides useful information? Why or why not?

The equity method is a kind of perverse extension of the accrual concept to equity investments. But it is a completely fictitious attribute, and it is probably not more informative than the cost basis of accounting. Q-7

Compare the present system involving consolidation, equity method, and fair value accounting for intercorporate equity investments with finite uniformity as it exists in lease accounting.

Leasing has a dichotomy: capital lease or operating lease. Inter-corporate equity investments have a trichotomy. The alternatives of capitalization versus expensing have stronger economic consequence results in leasing (keep debt off the balance sheet) than in inter-corporate equity investments, For both leases and inter-corporate equity investments, the distinctions are on a continuum involving percentages, so the breaks between categories are not very clear-cut in either case.

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Instructor Manual

What is meant by the term one-line consolidation? What differences occur in financial statements when a one-line consolidation rather than full consolidation is used?

The equity method essentially picks up the proportionate change in investee book value and records this in the investment account and the income statement—hence, its name as a one-line consolidation. There is no persuasive rationale for the method. APB Opinion No. 18 tries to tell a tale about “influence” that is substantial but less in degree than “control.” The tale is, in our view, a tall tale. The best method would be to carry at market value where the security is traded, and to approximate fair value for unlisted investments. Q-9

What are some reasons why consolidated reports are thought to be relevant?

By custom, we have grown to uncritically accept the accounting fiction of consolidation as truly representing the “firm” (an interesting question of faithful representation). Accounting is a powerful language of reduction, and we believe this is the best way to make sense of complex, related entities, such as those that exist in consolidations. Q-10

Discuss the limitations of consolidated financial statements and why dual reporting (consolidated and separate entity statements) as well as other forms of disaggregated reporting, such as SFAS No. 131, make sense.

Consolidations tell one story—indeed, a fictitious story at that. There are other possible accounting stories that can also be told, including parent-only statements and disaggregated data (e.g., the segmental disclosures of SFAS No. 131 ). In simple terms, detail is lost in consolidated reports. In some cases, such a loss might not matter—in other cases, it could easily distort the picture. Q-11

Why does the FASB’s reporting entity project logically precede any conclusion regarding consolidated financial reporting? “…an entity for financial reporting purposes should not be limited to legal entities, such as companies, trusts, and partnerships. Rather, an entity should be defined more broadly to include other types of organizational structures, including a natural person, a sole proprietorship, and, in some circumstances, a branch or segment of a legal entity.” “Some Board members reached the conclusion that a parent-only entity could be a reporting entity but view the parent-only financial statements and the consolidated financial statements as different forms of presentation for the same entity.” (from April 5, 2006 FASB Board Meeting minutes).

The FASB appears to agree that the notion of the consolidated entity is a useful fiction for the purpose of financial reporting. This conclusion should become the basis for a consolidation standard.

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Instructor Manual

Describe the implicit assumption made in SFAS No. 94 about the reporting entity.

SFAS No. 94 presumes that the fiction of a consolidated entity is appropriate for financial reporting purposes. Q-13

What is push-down accounting? What problems would arise in connection with the implementation?

Push down accounting refers to attempts to require firms that have been acquired in purchases to keep their accounts on the basis of the combinor’s purchase price rather than their own (combinee’s) historical costs. There would be a lack of comparability between those combinee entities carried on a fair value basis and other separate entities that are not combinee firms. Push down accounting also raises significant questions about debt covenants involving ratios such as debt-equity ratios. Debt holders would not be happy to have equity measured in fair value terms. Q-14

How are minority interests handled in consolidations?

Note that the term, minority interests, is an older one that is now called “noncontrolling interests.” Flexibility of presentation exists relative to minority interests. It has appeared as a liability, between liabilities and stockholders’ equity, and within the stockholders’ equity section. Q-15

What is an equity carve-out?

Equity carve-outs arise when a parent dilutes its interest in a subsidiary by setting a portion of its interest thereof to another entity or even has an initial public offering of the subsidiary (keeping at least a 50% ownership share). Q-16 • • • •

Q-17

Distinguish among sell-offs, spin-offs, split-offs, and split-ups. Sell-offs occur when a subsidiary’s stock is sold for cash, other assets, or in settlement of a debt. Spin-offs arise when the subsidiaries shares are distributed to the parent’s shareholders as a dividend. Split-offs arise when the subsidiaries shares are distributed to the parent’s shareholders in exchange for the parent’s stock. A split-up occurs when the shares of two or more subsidiaries are distributed to the parent’s shareholders in exchange for all of the parent’s shares. The parent is then liquidated. The split-up is similar to the split-off with the difference that the parent is liquidated under the split-up. Why does the elimination of poolings (SFAS No. 141) and the indefinite life of goodwill subject to impairment (SFAS No. 142) represent a possible “quid pro quo?”

The “bad news” of pooling elimination was offset by the “good news” of not having to amortize goodwill at least as long as it is not impaired. Accounting Theory (8th edition)

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Instructor Manual

Why does the elimination of poolings improve representational faithfulness and comparability

We do not believe that pooling was representationally faithful because a transaction occurred but the combinee’s assets are treated as if there was no transaction. Q-19

What are the main issues surrounding the special purpose entity and its successor, the variable interest entity.

Despite up to a 97% investment, the sponsoring firm can keep the SPE’s debts off the sponsors books. In the case of Enron, considerable questions arose relative to the activities being carried on under the banner of the SPE. For example, poor performing asset’s on Enron’s books were sold to one of its SPEs. A huge amount of Enron derivative transactions were transferred to an SPE’s books. These problems more than offset the legitimate use of SPEs in financing activities. Q-20

What are the differences between a foreign currency orientation and a U.S. dollar orientation regarding the translation of foreign currency operations?

A U.S. dollar orientation attempts to make the foreign currency operations appear as if they occurred in U.S. dollars. A foreign currency orientation recognizes that the foreign operations occurred in a foreign currency and that those operations may not affect U.S. dollars; therefore, accounting should be consistent with the foreign currency economic impact of the operations. Q-21

How do accounting exposure and economic exposure differ?

Accounting exposure is the exposure to exchange gains and losses resulting from translating foreign-currency-denominated financial statements into U.S. dollars. Basically, it is the result of translating various items at different exchange rates and usually does not affect cash flows. For example, if a building was purchased by long-term debt and the building was translated at historical exchange rates while the debt was translated at current exchange rates, accounting exposure would equal the amount of the difference. If both were translated at current exchange rates, there would not be an accounting exposure. Economic exposure is the exposure to cash flow changes resulting from dealings in foreign-currency-denominated transactions and commitments, e.g., the necessity to use more U.S. dollars to settle a foreign-currencydenominated debt. Q-22

Why would balance sheets prepared under SFAS No. 8 lack additivity?

Items carried on balance sheets at current price, such as monetary items and inventories and investments at market (when lower than cost), were translated at current exchange prices. Conversely, items carried at historical costs, such as fixed assets, were translated at the historical exchange rate (rates existing when the item was acquired). This would, of course, also impact the income statement.

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Instructor Manual

Why does SFAS No. 52 provide an example of finite uniformity in terms of the use of remeasurement?

If a subsidiary is really an extension of the parent, with frequent remissions of cash to the parent, the U.S. dollar is the functional currency. If a subsidiary is self-contained, however, its own (or another nation’s) currency would be the functional currency. Hence, the question of whether a subsidiary is merely an extension of the parent versus being self-contained has cash flow implications and is, thus, a relevant circumstance. Q-24

What is the disappearing asset problem?

The disappearing asset problem occurs whenever the current exchange rate is used for translation purposes and the functional currency is experiencing rapid inflation much in excess of that experienced in the reporting currency. The result is that the exchange rate deteriorates to such a point that the historical cost of fixed assets (as measured by the functional currency) is so small that it becomes misleading when translated into the reporting currency. SFAS No. 52 states that in highly inflationary economies, defined as those with a cumulative inflation rate of approximately 100 percent over three years, the U.S. dollar should be used as if it were the functional currency. Translations, therefore, are similar to the SFAS No. 8 approach, and fixed assets are translated at the historical rate. Q-25

What does the term functional currency mean?

The term, functional currency, refers to what might be called the main or primary national economic environment in which a subsidiary operates regarding events leading to cash inflows and outflows. Q-26

What prompted FASB Accounting Standards Update 2009-09?

This ASU makes a correction to the codification and includes SEC observer comments to the standards.

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CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1.

Examine the 2001 and 2002 annual reports for a corporation having a financial subsidiary. (Your instructor may suggest a corporation on the EDGAR Website. http://www.sec.gov/edgarhp.htm). Determine the effect of SFAS No. 94 on operating ratios, profitability ratios, liquidity ratios, and leverage ratios.

We recommend that you assign different companies on an individual or small team basis; the range of results should be quite interesting. 2.

The following items pertain to a parent company and its 60 percent-owned subsidiary at year end. There are no cross-guarantees of debt between the parent and subsidiary. Parent Subsidiary Current assets $ 500,000 $1,000,000 Noncurrent assets(excluding subsidiary investment) 5,000,000 2,000,000 Current liabilities 750,000 250,000 Noncurrent liabilities 2,000,000 750,000 Revenues 1,700,000 1,500,000 Expenses 1,600,000 900,000 Dividends 100,000 600,000 Required: Explain and illustrate how consolidated reporting using the previous data can be misleading.

Consolidation is misleading for several reasons: (a) The current debt-paying ability of the parent does not appear good, while that of the subsidiary appears excellent; consolidated, it appears mixed, thus not truly reflecting either enterprise’s position. (b) The parent’s income, return on sales, and return on assets appear low, while the subsidiary’s appear high; consolidated, they appear mixed, thus not truly reflecting either enterprise’s position. (c) The dividends of the subsidiary are substantial, while those of the parent are minimal; consolidation again produces a misleading picture.

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Instructor Manual

Acquirer Company bought Servile Company for $5,000,000 on January 2, 2004. The fair market value of the individual net assets was $3,500,000. In succeeding years, the fair market value of Servile’s costs and goodwill were as follows:

Year 2005 2006 2007

Fair Market Cost of Servile’s Value of Net Assets and Servile Goodwill $7,100,000 $7,000,000 7,300,000 6,700,000 8,000,000 9,300,000

Required: a. What amount of goodwill should be recognized as a result of the acquisition of Servile in 2004? b. Determine the amounts of the goodwill write-offs (if any) in 2005, 2006, and 2007. a. Goodwill would be $1,500,000. b. 2005: Writeoff of $100,000. 2006: No change. 2007: Writeoff of $1,300,000. 4.

Why do the six criteria or guidelines for determining the functional currency in SFAS No. 52 provide a good example of finite uniformity?

The six indicators are clearly grounded in distinctions involving cash flow differentials. The first one, labeled cash flow indicators, concerns whether funds are rapidly transmitted to the parent or stay with the subsidiary. Obviously, given fluctuations among currencies, the rapidity with which funds are transmitted to the parent affects both the amount and timing of cash flows. Whether sales prices are primarily affected, local competition in the subsidiary’s currency are determined by worldwide competition affecting the amounts of cash flows. The same is true for sales market indicators and expense indicators. The latter is concerned with amounts of cash flows in terms of whether prices are determined in the local currency of the subsidiary or whether expenses depend on the situation in the parent company’s country. Financing indicators are concerned with whether financing is done primarily in the subsidiary’s currency or the parent’s currency. Given exchange rate differentials, the amount of cash flows is impacted by these financing considerations. The last indicator, inter-company transactions and arrangements indicators, appears to be a “safety blanket” covering the previous five indicators in terms of whether the subsidiary is largely independent and does most of its business in its own country, or whether there is a high volume of transactions between parent and subsidiary.

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CRITICAL THINKING AND ANALYSIS 1.

If you had to choose among the current method of consolidation for combinees where the combinor owns at least 50 percent, the new entity approach, or proportionate consolidation, which would you choose? Explain.

We would remain with the current approach; the subsidiary forms part of the combined entity despite the presence of minority ownership. The new entity approach would be very appealing but runs into verifiability issues relative to valuing all parts of the consolidated entity. It also has comparability problems because some enterprises may not have acquired subsidiaries recently so their valuation would not be comparable to firms that just acquired subsidiaries. Proportionate consolidation is also appealing but the consolidated entity would be very artificial comprising fractional estimates of subsidiaries. The elimination of the minority interest is a beneficial aspect of this approach.

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