Solution Manual For Financial Accounting Theory 7th
i i i i i i
Edition by William R. Scott, Patricia O'Brien Chapters
i i i i i i i i
1 - 13, Complete
i i i
, Contents
Chapteri1 Introduction.................................................................................................. 1
Chapteri2 AccountingiUnderiIdealiConditions ........................................................... 7
Chapteri3 TheiDecisioniUsefulnessiApproachitoiFinancialiReporting ........................ 68
Chapteri4 EfficientiSecuritiesiMarkets .......................................................................129
Chapteri5 TheiValueiRelevanceiofiAccountingiInformation .......................................153
Chapteri6 TheiMeasurementiApproachitoiDecisioniUsefulness..................................194
Chapteri7 MeasurementiApplications ........................................................................237
Chapteri8 TheiEfficientiContractingiApproachitoiDecisioniUsefulness ...................... 285
Chapteri9 AniAnalysisiofiConflict ........................................................................... 321
Chapteri10iiExecutiveiCompensation .......................................................................... 371
Chapteri11iiEarningsiManagement .............................................................................. 425
Chapteri12iiStandardiSetting:iEconomiciIssues ........................................................... 487
Chapteri13iiStandardiSetting:iPoliticaliIssues .............................................................. 527
Pearson Canada Inc.
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
CHAPTERi1iI
NTRODUCTION
1.1 TheiObjectiveiofiThisiBook
1.2 SomeiHistoricaliPerspective
1.3 Thei2007-2008iMarketiMeltdowns
1.4 EfficientiContracting
1.5 AiNoteioniEthicaliBehaviour
1.6 Rules-Basediv.iPrinciples-BasediAccountingiStandards
1.7 TheiComplexityiofiInformationiiniFinancialiAccountingiandiReporting
1.8 TheiRoleiofiAccountingiResearch
1.9 TheiImportanceiofiInformationiAsymmetry
1.10 TheiFundamentaliProblemiofiFinancialiAccountingiTheory
1.11 RegulationiasiaiReactionitoitheiFundamentaliProblem
1.12 TheiOrganizationiofiThisiBook
1.12.1 IdealiConditions
1.12.2 AdverseiSelection
1.12.3 MoraliHazard
1.12.4 StandardiSetting
1.12.5 TheiProcessiofiStandardiSetting
1.13 RelevanceiofiFinancialiAccountingiTheoryitoiAccountingiPractice
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
LEARNINGiOBJECTIVESiANDiSUGGESTEDiTEACHINGiAPPROACHES
1. TheiBroadiOutlineiofitheiBook
IiuseiFigurei1.1iasiaitemplateitoidescribeitheibroadioutlineiofitheibook.iSinceitheistu
dentsitypicallyihaveinotihadiaichanceitoireadiChapteri1iinitheifirsticourseisession,iIist
ickifairlyicloselyitoitheichapterimaterial.
TheimajoripointsiIidiscussiare:
• Accountingiinianiidealisetting.iHere,ipresent-value-
basediaccountingiisinatural.iIigoioveritheiidealiconditionsineedediforis
uchiaibasisiofiaccountingitoibeifeasible,ibutidoinotigoiintoimuchidetailib
ecauseithisitopiciisicoverediinigreateridepthiiniChapteri2.
• Aniintroductionitoitheiconceptiofiinformationiasymmetryiandiresultingi
problemsiofiadverseiselectioniandimoralihazard.iTheseiproblemsiarei
basicitoitheibookiandiIifeeliitiisidesirableiforitheistudentsitoihaveiai“firsti
go”iatithemiatithisipoint.iIiconcentrateionitheiintuitioniunderlyingitheitw
oiproblems.iForiexample,iadverseiselectionicanibeiillustratedibyiaskin
giwhoiwouldibeifirstiinilineitoipurchaseilifeiinsuranceiifithereiwasinoime
dicaliexamination,ioriwhatiqualityiofiusedicarsiareilikelyitoibeibroughtit
oimarket.iForimoralihazardiIitryitoipinithemidownionihowiharditheyiwoul
diworkiinithisicourseiifithereiwereinoiexams.
• Theienvironmentiiniwhichifinancialiaccountingiandireportingioperates
.iMyimainigoaliatithisipointiisithatitheistudentsidoinotitakeithisienvironm
entiforigranted.iIidiscussitheiproceduresiofistandardisettingibrieflyiand
i pointioutithatithisiisireallyiaiprocessiofiregulation.iInitheipast,ithereihav
eibeeniwell-
knownicasesiofideregulation,isuchiasiairlines,itrucking,ifinancialiinstit
utions,ipowerigeneration.iHowever,iweiareienteringiwhatiisilikelyitoibei
aiperiodiofiincreasingiregulation,iatileastiforifinancialiinstitutions.iInstr
uctors
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
mayiwishitoidiscussibrieflyitheiprosiandiconsiofimarketsiv.ireg
ulationi(sinceithisibookitendsitoibeimarket-
oriented)iofieconomiciactivity.
2. TheiConceptiofiInformation
Byinow,iIiwillihaveireferreditoitheitermi“information”iseveralitimes.iIisuggestithatiitiisie
asyitoitakeithisitermiforigranted,iandicalliforidefinitions.iThisiusuallyigeneratesiconsi
derableihesitationibyitheistudents.iTheipurposeiatithisipointiisisimplyitoigetithemitoire
alizeithatiinformationiisiaicomplexicommodity.iIndeed,iIimakeianianalogyibetweenith
eifinancialiaccountingiandireportingiindustryiandiaistereotypicalimanufacturingiindu
stryisuchiasiagricultureioriautomobiles,iandiaskiwhatiisitheiproductiofitheiaccountingi
industry,iwhyiisiitivaluable,ihowiisiitiquantified?iIidoinotigoideeplyiintoitheianswersitoi
questionsilikeithese,isinceisomeidecision-
theoreticimachineryineedsitoibeidevelopedi(Sectioni3.3)ibeforeiaipreciseidefinitionio
fiinformationicanibeigiven.iNevertheless,iIitryitoiendiupiwithitheiconclusionsithatiinfor
mationihasisomethingitoidoiwithiimprovingitheiprocessiofidecision-
making,iandithatiitiisicrucialitoitheioperationiofisecuritiesimarkets.
3. RelevanceitoiAccountingiPractice
Myiundergraduateiaccountingitheoryiclassesiusuallyiconsistiofiaimajorityiofistude
ntsiwhoiareiheadingiforiaiprofessionaliaccountingidesignation.iThereiareiusuallyial
soisomeistudentsiheadingiforicareersiinimanagement.
Sinceistudentsiwhoiareifacingiprofessionaliaccountingiexamsicanibeiquiteifocusedi
initheirilearningiobjectives,iitiisiessentialithatitheinatureiofitheicourseiinirelationitoithe
seiobjectivesibeidiscussediupifront.
Iibeginibyipointingioutithatitheibookiisiintendeditoigiveitheistudentianiappreciationian
diunderstandingiofitheifinancialireportingienvironment,iwhichishouldihelpiwithibread
thiquestionsioniprofessionaliexams.iIialsoiargueithatione’sicareericontinuesiwellibey
ondiattainmentiofiaiprofessionaliaccountingidesignation,iandithatitheinatureiofitheite
xtbookiisilonger-runiandidesignedito
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
fosteriaicriticaliawarenessiofitheifinancialiaccountingienvironmentiwhichiisine
edediifioneiisitoibecomeiaithoughtfuliprofessional.
Argumentsisuchiasitheseicanionlyibeipushedisoifar.iNevertheless,iIithinkiitiisiimport
antitoimakeithem.iIialsoipointioutithatitheitextiincludesicoverageiofimajoriaccounting
i standardsisuchiasifinancialiinstruments,iimpairment,iconsolidations,ide-
recognition,iandithatitheyiwillihaveitheiopportunityitoilearniaboutitheseistandardsio
nitheiwayithrough.
IialsoireferitheistudentsitoiSectioni1.13,iandiemphasizeithatitheitextirecognizesianiob
ligationitoiconvinceithemithatitheimaterialiisirelevantitoitheiricareers.iToidoithis,itheite
xtiexplainsitheoreticaliconceptsiiniintuitiveiterms,iandiillustratesiandimotivatesitheico
nceptsibasedioniaiseriesiofiTheoryiiniPracticeivignettes,iandiproblemimaterialibased
i frequentlyioniarticlesifromitheifinancialipressiandirelevantiresearchifindings.
Foritheimanagementistudentsiinitheiclass,iandiforitheiprofessionaliaccountingistude
ntsiwhoimayisomeidayibeimanagers,iIiemphasizeithatitheitextidoesinotiignoreithem.i
Chaptersi8itoi11iinclusivei(theibottomibranchiofiFigurei1.1)idealiwithitopicsiofiinteres
titoimanagers,iincludingieconomiciconsequences,iconflictiresolution,iexecutiveico
mpensationiandiearningsimanagement.iAlliofitheseitopicsidemonstrateithatimanag
ementihasiailegitimateiinterestiinifinancialireporting.iIialsoiargueithatiChaptersi2itoi7i
inclusivei(theitopibranchiofiFigurei1.1)iareirelevantitoimanagersisinceitheyigiveiinsig
htsiintoihowifinancialiaccountingiinformationiisiusedibyiinvestors.iFinally,isinceiman
agementiisiaimajoriconstituencyiinistandard-
setting,iaicriticaliawarenessiofitheineediforistandardisettingianditheistandard-
settingiprocessi(Chaptersi12iandi13)iisiusefuliforianyimanager.
Iihaveinotihadiproblemsiwithistudenticourseievaluationsiasiairesultiofiusingitheimate
rialiinithisibook.iInifact,iIihaveiconstantlyibeenisurprisediatihowifarioneicanipushitheis
tudentsiiniaitheoreticalidirectioniprovidingithatiIirelyionitheitextbookimaterialitoigiveit
heistudentsianiintuitiveiunderstanding,iandiconcentrateiiniclass
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
oniillustrating,imotivatingiandidiscussingitheiapplicationiofitheiconcepts.iForithis,iIifin
dithatitheifinancialimediaiareihelpfulisourcesioficurrentiarticlesiwhichiIibringitoiclassit
oiserveiasiaibasisiforidiscussion.iNumerousisuchiarticlesiformitheibasisiofi mosti“The
oryiiniPractice”ivignettesiscatteredithroughoutitheitext.
4. TheiStructureiofiStandard-SettingiBodies
ThisieditionicontinuesitoiorientiitselfitoiInternationaliAccountingiStandardsiBoardi(IA
SB)istandards,ialthoughiattentioniisialsoigivenitoiseveraliU.S.istandards.
Instructorsimayiwishitoibrieflyidiscussitheistructureiofistandardisettingibodiesiatithisi
point.
5. SocialiIssuesiUnderlyingiRegulation
Instructorsiwhoiwishitoidigimoreideeplyiintoisocialiissuesiunderlyingifinancialireporti
ngiandistandardisettingicaniusefullyispendiaiclassisessionionithei1982iMerinoiandiN
eimarkipaperi(iniSectioni1.2).iThisipaperiraisesifundamentaliissuesiaboutitheiroleiofif
inancialireportingiinisocietyiwhichigoiwellibeyonditheitextbookicoverageiofithisipaper
,iwhichiconfinesiitselfilargelyitoiaibriefidescriptioniofireportingiproblemsileadingiupitoi
theigreatistockimarketicrashiofi1929ianditheicreationiofi theiSEC.iItiprovidesifoodiforit
houghtibothiforithoseiwhoidoiandidoinotifavouritheipresentifinancialireportingienviro
nment.iForiaicontrastingiviewifromithatiofiMerinoiandiNeimark,iBenston’si1973iarticl
eiisialsoiworthiassigning.
ThisieditionicontinuesiitsidiscussioniofitheiEnroniandiWorldComifinancialireportingi
disasters,isinceitheseiareistillirelevantitoiaccountingitheoryiandipractice.iIicontinueit
oiincludei(Sectioni1.3)iaidescriptioniofithei2007-
2008imarketimeltdownsisurroundingifinancialiassetsiandiinstitutions,isinceitheseie
ventsiareidrivingimanyinewiaccountingistandardsiandichangesiiniexecutiveicompe
nsationidiscussedilateriinitheitext.iInispiteiofitheibewilderingicollectioniofiacronyms,ii
nstructorsimayiwishitoidiscussitheseimarketimeltdownsiearlyiinitheicourse,isinceith
eyipervadeitheibookiandicontinueitoihaveimajoriimplicationsiforifinancialiaccountin
g.
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
Sectioni1.5iintroducesitheitopiciofiethics.iWithitheiextentiofiaccountantiandiauditoriin
volvementiininumerousifinancialireportingidisastersithatihaveicomeitoilightisincei20
00,isuchiasiEnroniandiWorldCom,iandimoreirecenticriticismsiofifairivalueiaccountingi
andioff-
balanceisheetientities,itheiimportanceiofiethicalibehaviouriisiveryimuchiapparent.iIn
deed,iethicalibehaviouriunderliesitheidistinctionibetweenirules-
basediandiprinciples-
basediaccountingistandardsi(Sectioni1.6).iThisidistinctioniisiimportantisinceitheiIAS
BiconstitutionicommitsitheiIASBitoiprinciples-basedistandards.
Iiemphasize,ihowever,ithatiethicsitendsitoiproduceisimilaribehaviouriasiailonger-
runimaximizationiofione’siowniinterestsi(althoughitheimindisetsiareidifferent).
i
Thus,iailonger–
runiviewiofiethicalibehaviouriquicklyiturnsiintoiquestionsiofifullidisclosure,iusefulne
ss,ireputation,iandicooperativeibehaviour.iTheitextitendsitoiemphasizeitheseilatteri
componentsiofiprofessionaliresponsibility.iSomeiinstructorsimayiwishitoiintroducei
andidiscussiethicaliissuesimoreibroadly.
6. Someiinfluentialiaccountingiacademicsiareicriticaliofitheimovesibyistandar
disettingibodiesitowardsicurrentivalueiaccounting.iChapteri8iisidevoteditoianialtern
ativeiview,inamelyiefficienticontractitheoryi(alsoicalledipositiveiaccountingitheory)
.iAibriefiintroductionitoithisitopiciisigiveniiniSectioni1.4.iInstructorsiwhoiwishitoiintro
duceithisitopicinowimayiwishitoidiscussiwhyiaccountantsiareigenerallyiregardedia
siconservative,iwhetherifinancialiaccountingicanihelpitoiattainistrongicorporateigo
vernance,iandiwhetherimanagersilikeicurrentivalueiaccounting.
7. Iihaveinotipreparedianyiquestionsiandiproblemsiforithisichapter.iOneireasonii
sithatiIiusuallyilikeitoiletitheifirstiweekioficlassesipassibeforeigivingiformaliassignmen
ts.iMoreifundamentally,iIiuseithisifirstiweekitoidescribeiandimotivateitheitextimaterial
,iasioutlinediabove,iandimostiofitheimaterialiiniChapteri1iisicoverediinigreateridetailil
ater.iHowever,iextensiveiproblemimaterialiisiprovidediforitheiremainingichaptersiofit
heibook.
, Scott, Financial Accounting Theor Instructor’s Solutions Manual Chapter 2
CHAPTERi2
ACCOUNTINGiUNDERiIDEALiCONDITIONS
2.1 Overview
2.2 TheiPresentiValueiModeliUnderiCertainty
2.2.1 Summary
2.3 TheiPresentiValueiModeliUnderiUncertainty
2.3.1 Summary
2.4 ExamplesiofiPresentiValueiAccounting
2.4.1 EmbeddediValue
2.4.2 ReserveiRecognitioniAccountingi(RRA)
2.4.3 CritiqueiofiRRA
2.4.4 SummaryiofiRRA
2.5 HistoricaliCostiAccountingiRevisited
2.5.1 ComparisoniofiDifferentiMeasurementiBases
2.5.2 Conclusion
2.6 TheiNon-ExistenceiofiTrueiNetiIncome
2.7 ConclusionitoiAccountingiUnderiIdealiConditions
LEARNINGiOBJECTIVESiANDiSUGGESTEDiTEACHINGiAPPROACHES
1. ToiAppreciateitheiConceptiofiIdealiConditions
Thisiconceptiisidrawnionithroughoutitheibook.iRoughlyispeaking,ibyiidealiconditionsiIimea
niconditionsiwhereifutureifirmicashiflowsiandiinterestiratesiareiknowniwithicertaintyior,iifin
otiknowniwithicertainty,iwhereithereiisiaicompleteiandipubliclyiknown
7
Copyright © Pearson Canada Inc.
, Scott, Financial Accounting Theor Instructor’s Solutions Manual Chapter 2
setiofistatesiofinatureiandiassociatediobjectiveiprobabilitiesiwhichienablesiaicompletelyirele
vantiandireliableiexpectedipresentivalueiofitheifirmitoibeicalculated.
Iiassumeirisk-
neutraliinvestorsiinithisiChapter,isoithativaluationiofitheifirmiisionitheibasisiofiexpectedipre
sentivalue,ithatiis,inoiadjustmentifoririskiisineeded.iTheiconceptiofiairisk-
averseiinvestoriisiintroducediiniSectioni3.4,iandiaicapitaliassetipricingimodeliofitheifirm’sis
haresiisidescribediiniSectioni4.5.
2. ToiUseitheiPresentiValueiModeliUnderiIdealiConditionsitoiPrepareianiAr
ticulatediSetiofiFinancialiStatementsiforiaiSimpleiFirm
Theitextilimitsiitselfitoifinancialistatementsiforitheifirstiyeariofioperations.iTheiproblemimate
rialiextendsitheiaccountingitoiaisubsequentiyeari(seeiproblemsi1,i2,i3,i5,i15,iandi19).iInisub
sequentiyears,itheifirmiearnsiinterestioniopeningicashibalance.iThisiisipickediupibyitheiacc
retioniofidiscounticalculation,isinceicashiisiincludediiniopeninginetiassets.iInterestiearnedio
nicashibalancesileadsinaturallyitoitheiroleiofidividendsiinipresent-
valueiaccountingianditheiconceptiofidividendiirrelevance.
3. ToiCriticallyiEvaluateiReserveiRecognitioniAccountingi(RRA)iasianiA
pplicationiofitheiPresentiValueiModel
Iiusuallyiallowisomeiclassitimeitoicriticizeitheiassumptionsiofiidealiconditions.iSomeistuden
tsiwantitoi“blowioffisteam”ibecauseitheyiperceiveitheseiassumptionsiasiquiteistrong.iIifindit
hatiRRAiisianiexcellentivehicleibothitoimotivateiandicritiqueipresentivalue-
basediaccounting.iTheifactithatiitiisionilineiencouragesistudentsitoitakeitheipresentivalueim
odeliseriously,iwhichiIiemphasizeibyibasingiclassidiscussionionianiexampleiofiRRAidisclos
ureiforiaiCanadianioiliandigasifirmithatialsoireportsitoitheiSEC.iSuchidisclosuresiareiusuallyi
iniSECiFormi40-
F,inotiinitheiannualireporti(whichisaysisomethingiaboutimanagement’siviewiofiRRA).
Iialsoiemphasizeitheipointithatipresentivalue-
basediaccountingiproductsiruniintoisevereiimplementationiproblemsiwhenitheiidealicond
8
Copyright © Pearson Canada Inc.
i i i i i i
Edition by William R. Scott, Patricia O'Brien Chapters
i i i i i i i i
1 - 13, Complete
i i i
, Contents
Chapteri1 Introduction.................................................................................................. 1
Chapteri2 AccountingiUnderiIdealiConditions ........................................................... 7
Chapteri3 TheiDecisioniUsefulnessiApproachitoiFinancialiReporting ........................ 68
Chapteri4 EfficientiSecuritiesiMarkets .......................................................................129
Chapteri5 TheiValueiRelevanceiofiAccountingiInformation .......................................153
Chapteri6 TheiMeasurementiApproachitoiDecisioniUsefulness..................................194
Chapteri7 MeasurementiApplications ........................................................................237
Chapteri8 TheiEfficientiContractingiApproachitoiDecisioniUsefulness ...................... 285
Chapteri9 AniAnalysisiofiConflict ........................................................................... 321
Chapteri10iiExecutiveiCompensation .......................................................................... 371
Chapteri11iiEarningsiManagement .............................................................................. 425
Chapteri12iiStandardiSetting:iEconomiciIssues ........................................................... 487
Chapteri13iiStandardiSetting:iPoliticaliIssues .............................................................. 527
Pearson Canada Inc.
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
CHAPTERi1iI
NTRODUCTION
1.1 TheiObjectiveiofiThisiBook
1.2 SomeiHistoricaliPerspective
1.3 Thei2007-2008iMarketiMeltdowns
1.4 EfficientiContracting
1.5 AiNoteioniEthicaliBehaviour
1.6 Rules-Basediv.iPrinciples-BasediAccountingiStandards
1.7 TheiComplexityiofiInformationiiniFinancialiAccountingiandiReporting
1.8 TheiRoleiofiAccountingiResearch
1.9 TheiImportanceiofiInformationiAsymmetry
1.10 TheiFundamentaliProblemiofiFinancialiAccountingiTheory
1.11 RegulationiasiaiReactionitoitheiFundamentaliProblem
1.12 TheiOrganizationiofiThisiBook
1.12.1 IdealiConditions
1.12.2 AdverseiSelection
1.12.3 MoraliHazard
1.12.4 StandardiSetting
1.12.5 TheiProcessiofiStandardiSetting
1.13 RelevanceiofiFinancialiAccountingiTheoryitoiAccountingiPractice
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
LEARNINGiOBJECTIVESiANDiSUGGESTEDiTEACHINGiAPPROACHES
1. TheiBroadiOutlineiofitheiBook
IiuseiFigurei1.1iasiaitemplateitoidescribeitheibroadioutlineiofitheibook.iSinceitheistu
dentsitypicallyihaveinotihadiaichanceitoireadiChapteri1iinitheifirsticourseisession,iIist
ickifairlyicloselyitoitheichapterimaterial.
TheimajoripointsiIidiscussiare:
• Accountingiinianiidealisetting.iHere,ipresent-value-
basediaccountingiisinatural.iIigoioveritheiidealiconditionsineedediforis
uchiaibasisiofiaccountingitoibeifeasible,ibutidoinotigoiintoimuchidetailib
ecauseithisitopiciisicoverediinigreateridepthiiniChapteri2.
• Aniintroductionitoitheiconceptiofiinformationiasymmetryiandiresultingi
problemsiofiadverseiselectioniandimoralihazard.iTheseiproblemsiarei
basicitoitheibookiandiIifeeliitiisidesirableiforitheistudentsitoihaveiai“firsti
go”iatithemiatithisipoint.iIiconcentrateionitheiintuitioniunderlyingitheitw
oiproblems.iForiexample,iadverseiselectionicanibeiillustratedibyiaskin
giwhoiwouldibeifirstiinilineitoipurchaseilifeiinsuranceiifithereiwasinoime
dicaliexamination,ioriwhatiqualityiofiusedicarsiareilikelyitoibeibroughtit
oimarket.iForimoralihazardiIitryitoipinithemidownionihowiharditheyiwoul
diworkiinithisicourseiifithereiwereinoiexams.
• Theienvironmentiiniwhichifinancialiaccountingiandireportingioperates
.iMyimainigoaliatithisipointiisithatitheistudentsidoinotitakeithisienvironm
entiforigranted.iIidiscussitheiproceduresiofistandardisettingibrieflyiand
i pointioutithatithisiisireallyiaiprocessiofiregulation.iInitheipast,ithereihav
eibeeniwell-
knownicasesiofideregulation,isuchiasiairlines,itrucking,ifinancialiinstit
utions,ipowerigeneration.iHowever,iweiareienteringiwhatiisilikelyitoibei
aiperiodiofiincreasingiregulation,iatileastiforifinancialiinstitutions.iInstr
uctors
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
mayiwishitoidiscussibrieflyitheiprosiandiconsiofimarketsiv.ireg
ulationi(sinceithisibookitendsitoibeimarket-
oriented)iofieconomiciactivity.
2. TheiConceptiofiInformation
Byinow,iIiwillihaveireferreditoitheitermi“information”iseveralitimes.iIisuggestithatiitiisie
asyitoitakeithisitermiforigranted,iandicalliforidefinitions.iThisiusuallyigeneratesiconsi
derableihesitationibyitheistudents.iTheipurposeiatithisipointiisisimplyitoigetithemitoire
alizeithatiinformationiisiaicomplexicommodity.iIndeed,iIimakeianianalogyibetweenith
eifinancialiaccountingiandireportingiindustryiandiaistereotypicalimanufacturingiindu
stryisuchiasiagricultureioriautomobiles,iandiaskiwhatiisitheiproductiofitheiaccountingi
industry,iwhyiisiitivaluable,ihowiisiitiquantified?iIidoinotigoideeplyiintoitheianswersitoi
questionsilikeithese,isinceisomeidecision-
theoreticimachineryineedsitoibeidevelopedi(Sectioni3.3)ibeforeiaipreciseidefinitionio
fiinformationicanibeigiven.iNevertheless,iIitryitoiendiupiwithitheiconclusionsithatiinfor
mationihasisomethingitoidoiwithiimprovingitheiprocessiofidecision-
making,iandithatiitiisicrucialitoitheioperationiofisecuritiesimarkets.
3. RelevanceitoiAccountingiPractice
Myiundergraduateiaccountingitheoryiclassesiusuallyiconsistiofiaimajorityiofistude
ntsiwhoiareiheadingiforiaiprofessionaliaccountingidesignation.iThereiareiusuallyial
soisomeistudentsiheadingiforicareersiinimanagement.
Sinceistudentsiwhoiareifacingiprofessionaliaccountingiexamsicanibeiquiteifocusedi
initheirilearningiobjectives,iitiisiessentialithatitheinatureiofitheicourseiinirelationitoithe
seiobjectivesibeidiscussediupifront.
Iibeginibyipointingioutithatitheibookiisiintendeditoigiveitheistudentianiappreciationian
diunderstandingiofitheifinancialireportingienvironment,iwhichishouldihelpiwithibread
thiquestionsioniprofessionaliexams.iIialsoiargueithatione’sicareericontinuesiwellibey
ondiattainmentiofiaiprofessionaliaccountingidesignation,iandithatitheinatureiofitheite
xtbookiisilonger-runiandidesignedito
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
fosteriaicriticaliawarenessiofitheifinancialiaccountingienvironmentiwhichiisine
edediifioneiisitoibecomeiaithoughtfuliprofessional.
Argumentsisuchiasitheseicanionlyibeipushedisoifar.iNevertheless,iIithinkiitiisiimport
antitoimakeithem.iIialsoipointioutithatitheitextiincludesicoverageiofimajoriaccounting
i standardsisuchiasifinancialiinstruments,iimpairment,iconsolidations,ide-
recognition,iandithatitheyiwillihaveitheiopportunityitoilearniaboutitheseistandardsio
nitheiwayithrough.
IialsoireferitheistudentsitoiSectioni1.13,iandiemphasizeithatitheitextirecognizesianiob
ligationitoiconvinceithemithatitheimaterialiisirelevantitoitheiricareers.iToidoithis,itheite
xtiexplainsitheoreticaliconceptsiiniintuitiveiterms,iandiillustratesiandimotivatesitheico
nceptsibasedioniaiseriesiofiTheoryiiniPracticeivignettes,iandiproblemimaterialibased
i frequentlyioniarticlesifromitheifinancialipressiandirelevantiresearchifindings.
Foritheimanagementistudentsiinitheiclass,iandiforitheiprofessionaliaccountingistude
ntsiwhoimayisomeidayibeimanagers,iIiemphasizeithatitheitextidoesinotiignoreithem.i
Chaptersi8itoi11iinclusivei(theibottomibranchiofiFigurei1.1)idealiwithitopicsiofiinteres
titoimanagers,iincludingieconomiciconsequences,iconflictiresolution,iexecutiveico
mpensationiandiearningsimanagement.iAlliofitheseitopicsidemonstrateithatimanag
ementihasiailegitimateiinterestiinifinancialireporting.iIialsoiargueithatiChaptersi2itoi7i
inclusivei(theitopibranchiofiFigurei1.1)iareirelevantitoimanagersisinceitheyigiveiinsig
htsiintoihowifinancialiaccountingiinformationiisiusedibyiinvestors.iFinally,isinceiman
agementiisiaimajoriconstituencyiinistandard-
setting,iaicriticaliawarenessiofitheineediforistandardisettingianditheistandard-
settingiprocessi(Chaptersi12iandi13)iisiusefuliforianyimanager.
Iihaveinotihadiproblemsiwithistudenticourseievaluationsiasiairesultiofiusingitheimate
rialiinithisibook.iInifact,iIihaveiconstantlyibeenisurprisediatihowifarioneicanipushitheis
tudentsiiniaitheoreticalidirectioniprovidingithatiIirelyionitheitextbookimaterialitoigiveit
heistudentsianiintuitiveiunderstanding,iandiconcentrateiiniclass
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
oniillustrating,imotivatingiandidiscussingitheiapplicationiofitheiconcepts.iForithis,iIifin
dithatitheifinancialimediaiareihelpfulisourcesioficurrentiarticlesiwhichiIibringitoiclassit
oiserveiasiaibasisiforidiscussion.iNumerousisuchiarticlesiformitheibasisiofi mosti“The
oryiiniPractice”ivignettesiscatteredithroughoutitheitext.
4. TheiStructureiofiStandard-SettingiBodies
ThisieditionicontinuesitoiorientiitselfitoiInternationaliAccountingiStandardsiBoardi(IA
SB)istandards,ialthoughiattentioniisialsoigivenitoiseveraliU.S.istandards.
Instructorsimayiwishitoibrieflyidiscussitheistructureiofistandardisettingibodiesiatithisi
point.
5. SocialiIssuesiUnderlyingiRegulation
Instructorsiwhoiwishitoidigimoreideeplyiintoisocialiissuesiunderlyingifinancialireporti
ngiandistandardisettingicaniusefullyispendiaiclassisessionionithei1982iMerinoiandiN
eimarkipaperi(iniSectioni1.2).iThisipaperiraisesifundamentaliissuesiaboutitheiroleiofif
inancialireportingiinisocietyiwhichigoiwellibeyonditheitextbookicoverageiofithisipaper
,iwhichiconfinesiitselfilargelyitoiaibriefidescriptioniofireportingiproblemsileadingiupitoi
theigreatistockimarketicrashiofi1929ianditheicreationiofi theiSEC.iItiprovidesifoodiforit
houghtibothiforithoseiwhoidoiandidoinotifavouritheipresentifinancialireportingienviro
nment.iForiaicontrastingiviewifromithatiofiMerinoiandiNeimark,iBenston’si1973iarticl
eiisialsoiworthiassigning.
ThisieditionicontinuesiitsidiscussioniofitheiEnroniandiWorldComifinancialireportingi
disasters,isinceitheseiareistillirelevantitoiaccountingitheoryiandipractice.iIicontinueit
oiincludei(Sectioni1.3)iaidescriptioniofithei2007-
2008imarketimeltdownsisurroundingifinancialiassetsiandiinstitutions,isinceitheseie
ventsiareidrivingimanyinewiaccountingistandardsiandichangesiiniexecutiveicompe
nsationidiscussedilateriinitheitext.iInispiteiofitheibewilderingicollectioniofiacronyms,ii
nstructorsimayiwishitoidiscussitheseimarketimeltdownsiearlyiinitheicourse,isinceith
eyipervadeitheibookiandicontinueitoihaveimajoriimplicationsiforifinancialiaccountin
g.
,Scott, Financial Accounting Theory Instructor’s Solutions Manual Chapter 1
Sectioni1.5iintroducesitheitopiciofiethics.iWithitheiextentiofiaccountantiandiauditoriin
volvementiininumerousifinancialireportingidisastersithatihaveicomeitoilightisincei20
00,isuchiasiEnroniandiWorldCom,iandimoreirecenticriticismsiofifairivalueiaccountingi
andioff-
balanceisheetientities,itheiimportanceiofiethicalibehaviouriisiveryimuchiapparent.iIn
deed,iethicalibehaviouriunderliesitheidistinctionibetweenirules-
basediandiprinciples-
basediaccountingistandardsi(Sectioni1.6).iThisidistinctioniisiimportantisinceitheiIAS
BiconstitutionicommitsitheiIASBitoiprinciples-basedistandards.
Iiemphasize,ihowever,ithatiethicsitendsitoiproduceisimilaribehaviouriasiailonger-
runimaximizationiofione’siowniinterestsi(althoughitheimindisetsiareidifferent).
i
Thus,iailonger–
runiviewiofiethicalibehaviouriquicklyiturnsiintoiquestionsiofifullidisclosure,iusefulne
ss,ireputation,iandicooperativeibehaviour.iTheitextitendsitoiemphasizeitheseilatteri
componentsiofiprofessionaliresponsibility.iSomeiinstructorsimayiwishitoiintroducei
andidiscussiethicaliissuesimoreibroadly.
6. Someiinfluentialiaccountingiacademicsiareicriticaliofitheimovesibyistandar
disettingibodiesitowardsicurrentivalueiaccounting.iChapteri8iisidevoteditoianialtern
ativeiview,inamelyiefficienticontractitheoryi(alsoicalledipositiveiaccountingitheory)
.iAibriefiintroductionitoithisitopiciisigiveniiniSectioni1.4.iInstructorsiwhoiwishitoiintro
duceithisitopicinowimayiwishitoidiscussiwhyiaccountantsiareigenerallyiregardedia
siconservative,iwhetherifinancialiaccountingicanihelpitoiattainistrongicorporateigo
vernance,iandiwhetherimanagersilikeicurrentivalueiaccounting.
7. Iihaveinotipreparedianyiquestionsiandiproblemsiforithisichapter.iOneireasonii
sithatiIiusuallyilikeitoiletitheifirstiweekioficlassesipassibeforeigivingiformaliassignmen
ts.iMoreifundamentally,iIiuseithisifirstiweekitoidescribeiandimotivateitheitextimaterial
,iasioutlinediabove,iandimostiofitheimaterialiiniChapteri1iisicoverediinigreateridetailil
ater.iHowever,iextensiveiproblemimaterialiisiprovidediforitheiremainingichaptersiofit
heibook.
, Scott, Financial Accounting Theor Instructor’s Solutions Manual Chapter 2
CHAPTERi2
ACCOUNTINGiUNDERiIDEALiCONDITIONS
2.1 Overview
2.2 TheiPresentiValueiModeliUnderiCertainty
2.2.1 Summary
2.3 TheiPresentiValueiModeliUnderiUncertainty
2.3.1 Summary
2.4 ExamplesiofiPresentiValueiAccounting
2.4.1 EmbeddediValue
2.4.2 ReserveiRecognitioniAccountingi(RRA)
2.4.3 CritiqueiofiRRA
2.4.4 SummaryiofiRRA
2.5 HistoricaliCostiAccountingiRevisited
2.5.1 ComparisoniofiDifferentiMeasurementiBases
2.5.2 Conclusion
2.6 TheiNon-ExistenceiofiTrueiNetiIncome
2.7 ConclusionitoiAccountingiUnderiIdealiConditions
LEARNINGiOBJECTIVESiANDiSUGGESTEDiTEACHINGiAPPROACHES
1. ToiAppreciateitheiConceptiofiIdealiConditions
Thisiconceptiisidrawnionithroughoutitheibook.iRoughlyispeaking,ibyiidealiconditionsiIimea
niconditionsiwhereifutureifirmicashiflowsiandiinterestiratesiareiknowniwithicertaintyior,iifin
otiknowniwithicertainty,iwhereithereiisiaicompleteiandipubliclyiknown
7
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, Scott, Financial Accounting Theor Instructor’s Solutions Manual Chapter 2
setiofistatesiofinatureiandiassociatediobjectiveiprobabilitiesiwhichienablesiaicompletelyirele
vantiandireliableiexpectedipresentivalueiofitheifirmitoibeicalculated.
Iiassumeirisk-
neutraliinvestorsiinithisiChapter,isoithativaluationiofitheifirmiisionitheibasisiofiexpectedipre
sentivalue,ithatiis,inoiadjustmentifoririskiisineeded.iTheiconceptiofiairisk-
averseiinvestoriisiintroducediiniSectioni3.4,iandiaicapitaliassetipricingimodeliofitheifirm’sis
haresiisidescribediiniSectioni4.5.
2. ToiUseitheiPresentiValueiModeliUnderiIdealiConditionsitoiPrepareianiAr
ticulatediSetiofiFinancialiStatementsiforiaiSimpleiFirm
Theitextilimitsiitselfitoifinancialistatementsiforitheifirstiyeariofioperations.iTheiproblemimate
rialiextendsitheiaccountingitoiaisubsequentiyeari(seeiproblemsi1,i2,i3,i5,i15,iandi19).iInisub
sequentiyears,itheifirmiearnsiinterestioniopeningicashibalance.iThisiisipickediupibyitheiacc
retioniofidiscounticalculation,isinceicashiisiincludediiniopeninginetiassets.iInterestiearnedio
nicashibalancesileadsinaturallyitoitheiroleiofidividendsiinipresent-
valueiaccountingianditheiconceptiofidividendiirrelevance.
3. ToiCriticallyiEvaluateiReserveiRecognitioniAccountingi(RRA)iasianiA
pplicationiofitheiPresentiValueiModel
Iiusuallyiallowisomeiclassitimeitoicriticizeitheiassumptionsiofiidealiconditions.iSomeistuden
tsiwantitoi“blowioffisteam”ibecauseitheyiperceiveitheseiassumptionsiasiquiteistrong.iIifindit
hatiRRAiisianiexcellentivehicleibothitoimotivateiandicritiqueipresentivalue-
basediaccounting.iTheifactithatiitiisionilineiencouragesistudentsitoitakeitheipresentivalueim
odeliseriously,iwhichiIiemphasizeibyibasingiclassidiscussionionianiexampleiofiRRAidisclos
ureiforiaiCanadianioiliandigasifirmithatialsoireportsitoitheiSEC.iSuchidisclosuresiareiusuallyi
iniSECiFormi40-
F,inotiinitheiannualireporti(whichisaysisomethingiaboutimanagement’siviewiofiRRA).
Iialsoiemphasizeitheipointithatipresentivalue-
basediaccountingiproductsiruniintoisevereiimplementationiproblemsiwhenitheiidealicond
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