Financial Accounting Theory

Citation

Scott, W. R., & O'Brien, P. C. (2019). Financial Accounting Theory (8th ed.). Pearson Canada.

Chapter Summary

The publisher describes the book as presenting financial accounting as a means of resolving problems of asymmetric information and facilitating contracting. It draws on decision theory and information economics to argue that accounting serves important purposes in society, enhancing trust and meeting information needs. Despite the theoretical orientation, it covers the institutional structure of financial accounting and standard setting, with critical evaluation of specific standards and regulations. The thirteen entries in the table of contents fall into four groups.

Introduction and Accounting Under Ideal Conditions

The book opens with an Introduction and a chapter titled Accounting Under Ideal Conditions. The second takes ideal conditions as a benchmark case; the later chapters on information, contracting and regulation then deal with what accounting does when those conditions do not hold.

The Decision Usefulness Approach

Four chapters develop the idea that financial reporting should be useful to investors making decisions: The Decision Usefulness Approach to Financial Reporting; Efficient Securities Markets; The Value Relevance of Accounting Information; and The Valuation Approach to Decision Usefulness. The sequence moves from the approach itself to the market that prices information, to the empirical question of whether accounting numbers are value relevant, and to valuation models that link accounting to value.

Valuation Applications and the Efficient Contracting Approach

Valuation Applications continues the valuation theme. The next chapters turn to the other main perspective on usefulness: The Efficient Contracting Approach to Decision Usefulness, An Analysis of Conflict, and Executive Compensation. Here accounting is treated as an input to contracts among managers, shareholders and lenders, with conflict of interest and executive pay as the main settings.

Earnings Management and Standard Setting

Earnings Management follows, covering managers' choices in reporting. The final two chapters, Standard Setting Economic Issues and Standard Setting Political Issues, treat the economics of regulating accounting and the political processes by which standards are accepted. The publisher adds that the book gives considerable coverage and critical evaluation of fair value accounting, financial instruments, reserve recognition accounting, management discussion and analysis, employee stock options, impairment tests, hedge accounting, derecognition, consolidation and comprehensive income, and describes the structure of standard-setting bodies.

Key Concepts

Foundations

• Asymmetric information: the situation in which one party knows more than another, which the book treats as a core problem accounting helps to resolve.
• Accounting under ideal conditions: the benchmark case that frames the rest of the book.

Decision usefulness

• Decision usefulness: the idea that reporting should help investors make decisions.
• Efficient securities markets: the market assumption behind much of this research.
• Value relevance: whether accounting information is reflected in security prices.
• Valuation approach: using valuation models to link accounting numbers to firm value.

Contracting, management and standards

• Efficient contracting: accounting numbers as inputs to contracts, with conflict among parties.
• Executive compensation and earnings management: how incentives shape reporting choices.
• Standard setting: the economic and political issues in making accounting rules.

Critical Analysis

Strengths

• A clear theoretical thread. The table of contents moves from a benchmark case through two perspectives on usefulness (decision usefulness and efficient contracting) to management behavior and regulation, so the book explains why reporting has its form rather than listing rules.
• Connects theory to standards. The publisher stresses that the book does not ignore institutional structure and critically evaluates named standards, including fair value accounting, hedge accounting and impairment tests.
• Covers the regulatory process. Two chapters on the economic and the political side of standard setting treat regulation as a subject in its own right.
• Draws on neighboring disciplines. Decision theory and information economics, which the publisher names as the book's sources, give the reader tools beyond accounting rules.

Limitations

• Not a technical accounting text. The table of contents has no chapters on preparing statements or on individual accounting topics, so it has to be read alongside a technical text.
• Research-oriented. Chapters on efficient securities markets, value relevance and the valuation approach address empirical questions about markets and information, which will be heavy going without some finance background.
• Standards change. The named standards in the publisher's description (fair value, financial instruments, hedge accounting, consolidation) are areas in which the rules continue to be revised, so details need checking against current requirements.
• Jurisdiction. This edition is published by Pearson Canada; readers elsewhere should check which standards (IFRS or a local framework) apply to the specific rules discussed.

Where It Fits in the Course

This is the theory text at the top of the financial accounting list. The others teach the practice of financial reporting: Principles of Accounting, Volume 1: Financial Accounting (OpenStax) follows transactions through the accounting cycle to the statements; Financial Accounting: An Introduction (Weetman) builds on the accounting equation and the IASB Conceptual Framework under IFRS; Financial Accounting for Decision Makers teaches how to read and analyze statements; and Intermediate Accounting (Kieso) is a detailed treatment of recognition, measurement and disclosure under US GAAP. Financial Accounting is a general undergraduate introduction.

Scott and O'Brien asks a different question, why reporting looks as it does and what it does for markets and contracts. Read it after an intermediate course, with Kieso or another technical text as the companion for any standard it discusses.

How to Use This Book

Intermediate financial accounting, introductory finance and microeconomics are the expected background.

• Core: the first chapters through the decision usefulness approach, and the efficient contracting chapters, for the book's two main perspectives.
• Selective: Valuation Applications and the efficient markets and value relevance chapters if your interest is capital markets research; Executive Compensation and Earnings Management if your interest is management incentives.
• Standard setting: the final two chapters for regulation, with the standards listed above as case material.

Read alongside the actual standards (IFRS or the local equivalent) so the discussion of fair value, impairment or hedge accounting can be checked against the rules.