Readers Of Financial Statements Research Articles

Accounting for In-Process Research and Development Costs

This paper examines accounting for research and development costs and specifically the treatment of those costs acquired in business combinations that are accounted for as in-process research and development (IPR&D). Both the SEC and the FASB expressed concerns over an increase in IPR&D costs immediately charged against earnings in purchase-type business combinations in the past decade. The AICPA formed an Emerging Issues Task Force to address these concerns and compiled a set of best practices with respect to recording and reporting IPR&D costs. With recent changes in accounting for business combinations and the treatment of goodwill created in acquisitions, readers of financial statements should be aware of the potential impact of IPR&D costs on reported earnings in the year of combination as well as in subsequent years. Examples of the reporting of IPR&D costs are drawn from recent business combinations in the biotechnology and pharmaceuticals industries.

Employee Stock Option Fair‐Value Estimates: Do Managerial Discretion and Incentives Explain Accuracy?*

AbstractWe examine the determinants of managers' use of discretion over employee stock option (ESO) valuation‐model inputs that determine ESO fair values. We also explore the consequences of such discretion. Firms exercise considerable discretion over all model inputs, and this discretion results in material differences in ESO fair‐value estimates. Contrary to conventional wisdom, we find that a large proportion of firms exercise value‐increasing discretion. Importantly, we find that using discretion improves predictive accuracy for about half of our sample firms. Moreover, we find that both opportunistic and informational managerial incentives together explain the accuracy of firms' ESO fair‐value estimates. Partitioning on the direction of discretion improves our understanding of managerial incentives. Our analysis confirms that financial statement readers can use mandated contextual disclosures to construct powerful ex ante predictions of ex post accuracy.

Employee Stock Option Fair-value Estimates: Do Managerial Discretion and Incentives Explain Accuracy?

We examine the determinants of managers' use of discretion over employee stock option (ESO) valuation-model inputs that determine ESO fair values. We also explore the consequences of such discretion. Firms exercise considerable discretion over all model inputs and this discretion results in material differences in ESO fair-value estimates. Contrary to conventional wisdom, we find that a large proportion of firms exercise value-increasing discretion. Importantly, we find that the use of discretion improves predictive accuracy for about half of our sample firms. Moreover, we find that both opportunistic and informational managerial incentives together explain the accuracy firms' ESO fair value estimates. Partitioning on direction of discretion improves our understanding of managerial incentives. Our analysis identifies that financial statement readers can use mandated contextual disclosures to construct powerful ex ante predictions of ex post accuracy.

The Association Between Stock/Compensation Mix and Earnings Usefulness

Management incentives have been suggested as a factor affecting the usefulness of reported earnings for readers of financial statements. Prior research has demonstrated that the quality of earnings has been associated with levels of managerial ownership (Warfield, Wild and Wild (1995)), audit quality using Australian data (Gul, Lynn, and Tsui (2002), and compensation mix in 0%-5% manager owned firms (Behn, Nagy, and Riley (2000). We extend this line of research by theoretically demonstrating and empirically examining whether companies, with any level of stock ownership, can use higher levels of stock remuneration relative to annual salary and bonus compensation to enhance the informativeness of accounting information. We proxy for earnings informativeness by using the earnings-returns relationship and three different earnings management techniques: discretionary accruals, R&D investments and advertising expenditures. By using a more precise and theoretically derived stock compensation ratio on a sample of all publicly traded firms and using different measures of earnings management techniques, we provide additional, more robust, empirical evidence that the stock compensation ratio (SCR), not just ownership levels, can improve the informativeness of earnings. Our findings suggest that higher levels of the SCR are associated with improvements in the usefulness of earnings and with reductions in the magnitude of discretionary accrual adjustments, advertising expenditures, and to a lesser extent, research and development investments. This study contributes to the extant managerial compensation and earnings quality literature by enhancing our understanding of the financial disclosure environment by providing empirical evidence for specific factors that improve the usefulness of earnings disclosures.

Comprehensive income: What do the numbers disclose?

This year's annual reports are the first to inform investors and analysts about comprehensive income. What format have companies used? Have the numbers proven important to users of financial statements, as the Financial Accounting Standards Board (FASB) contends? In fact, what do they disclose? The author reviews the rules for disclosure, examines actual company disclosures, and discusses the implications—for chief financial officers (CFOS) and financial statement readers. © 1999 John Wiley & Sons, Inc.

The Accounting Education Change Commission and Accounting Principles Courses: A Survey of Accounting Programs

Abstract Accounting education has been criticized for focusing too narrowly on techniques for preparing financial information, with little attention paid to how that information is used by readers of financial statements. The Accounting Education Change Commission (AECC) has issued wide-ranging recommendations for restructuring the first accounting principles course. This study surveyed accounting programs to determine the extent to which the AECC recommendations have been adopted. The results indicate that many schools have modified the content of, and the instructional methods employed in, their accounting principles courses.

Professional judgment and accounting standards

This essay explores relationships between accounting standards and people's inferences and judgments. Acknowledging that Demski's impossibility theorem implies that the standards will be “social-preference incomplete”, the paper shows that they are also “decision-procedure incomplete” on three levels. These levels correspond to three kinds of professional judgment: semantic, pragmatic and institutional. The investigation facilitates understanding of (1) how accountants exercise judgment and deduction in applying incomplete standards; (2) how financial statement readers use the incomplete standards to draw deductive inferences from financial reports which are based on accountants' judgments; (3) the special kinds of judgment required of standard setters; and (4) the meaning and extent of professional liability, given the relationships identified between accounting standards, inferences and judgments.

Accounting for equity investments of life insurance companies*

Abstract. This paper deals with the accounting for equity investments by a life insurance company. Various procedures for recognizing unrealized changes in market values of securities in its investment portfolio are analyzed. These range from direct recognition of market values to the method currently employed by Canadian life insurance companies which involves extensive smoothing. Summary statistics are suggested that describe the properties of the resulting accounting numbers obtained from various smoothing procedures. These summary statistics are viewed as compact, cost effective ways of summarizing the effects of the procedures for financial statement readers. The second part of the paper describes how a particular user group can obtain a ranking among various accounting alternatives. The Analytic Hierarchy Process (Saaty 1980) is proposed for combining the judgments of different individuals into a group preference. The feasibility of the method is illustrated using a small pilot study to rank various proposals concerning the accounting treatment of life insurance companies' equity investments.

Inflation Accounting: The SEC Proposal for Replacement Cost Disclosures

On August 21, 1975, the Securities and Exchange Commission (SEC) entered the inflation accounting arena with a proposal that might be called revolutionary.' This article examines the implications of that proposal for the analysis of financial statements. The SEC proposes requiring disclosure affecting both the balance sheet and the income statement. For the balance sheet, the disclosures would provide the current replacement cost of both inventory and those plant assets used in operations at the balance sheet date(s). For income statements the required disclosures would tell the replacement cost of goods sold computed at the times of sale and depreciation charges for the year based on the average replacement costs of plant during the year. The SEC does not propose requiring supplementary financial statements based on the new disclosures, only the disclosures themselves. As is often the case, the SEC requires supplemental disclosure of financial information without requiring that income or financial position be measured in a way different from that currently considered generally acceptable by the accounting profession. That is, the SEC is often content to have financial statement readers informed of important information without requiring that alternative financial position and income amounts be shown.2 In the case of the new proposed replacement cost disclosures, the SEC may have refrained from specifying that supplementary financial statements be issued because there is still considerable argument among theorists about how income should be measured in replacement cost terms. There are at least three measures of income that emerge from the use of replacement cost information. Later in this article we discuss each of these concepts of income and how the analyst might view them.

Discussion of an Empirical Investigation of the Concept of Materiality in Accounting

Professor Frishkoff's paper reports on empirical study designed, in his words, determine the pattern of materiality decisions. This the author has done in a thorough and scholarly fashion. The paper does not, however, represent an empirical investigation of the concept of The conceptual basis of materiality is only briefly touched upon in the author's discussion of his choice of methods of research. Frishkoff has not really shown why we must resolve the awesome problem of identifying the level of sophistication of the typical investor before we can successfully set out to study the problem of materiality. It is certainly not self-evident that the professional accountant's determination of what is material and what is not depends significantly on the level of sophistication of the readers of financial statements. In fact, if materiality is the significant accounting concept Frishkoff deems it to be, it should then not be assumed to vary quantitatively and qualitatively from one user group to the other. Once a decision on the relative materiality of item is reached on the basis of certain facts and circumstances, this judgment should not be subj ect to change depending on who is to use the financial statements. In the study of materiality, the focus should be on the objectives of financial statements and the uses to which they are put rather than on the intellectual capabilities and the sophistication of the elusive average reader. I fully subscribe to the proposition that essential prerequisite to the improvement of accounting is research into both what practice is and what it ought to be. However, in determining what practice is, the broad

The Flow of Funds Statement. An Effective Tool

How many dollars were poured into new investments this year? What additions to buildings and equipment were made during the year? Were premium and investment revenues sufficient to cover benefit payments, operating expenses, and taxes? Did new issues of capital stock occur this year? Are stockholders receiving larger or smaller amounts of cash dividends? The above questions relate to transactions occurring within the typical life insurance company today, which are of considerable interest to financial statement readers within and outside the industry. Unfortunately, the answers to many of these questions are difficult to find in the current versions of financial reports prepared by life insurance companies. Three primary statements appear * Dale Armstrong, Ph.D., C.P.A., is Associate Professor of Accounting at Oklahoma State University. This article represents an expanded development of concepts described in the author's doctoral dissertation prepared at the University of Texas under the supervision of Professors C. Aubrey Smith and John S. Bickley. A condensed version of the dissertation, entitled An Examination of External Financial Reporting Practices and Underlying Accounting Principles Applicable to Life Insurance Companies, was published in 1968 by the College of Business, Oklahoma State University, as Research Study No. 5. The Research Foundation, Oklahoma State University, provided funds to finance the additional research undertaken in the preparation of this article. in the annual statement that is submitted to state insurance departments-Assets; Liabilities, Surplus and Other Funds; Summary of Operations; and Surplus Account. Condensed replicas of these financial reports are distributed to stockholders, policyholders, and other interested parties. The result to date-mass confusion. Even the financial analysts express deep concern over hoiw they can interpret the financial operations of these organizations in a manner that will convey some useful meaning to their respective readers.

The Visibility of the Auditor's Disclosure of Deviance from APB Opinion: An Empirical Test

The purpose of this study is to provide one piece of empirical evi,dence impinging upon the broad question of what constitutes adequate disclosure in published financial statements. More specifically, it examines the relative visibility of a few selected ways of disclosing a deviance from Accounting Principles Board Opinions. The purpose and scope of the study was prompted by three things. First, the governing Council of the AICPA has directed its members to see to it that departures from APB Opinions (and predecessor Accounting Research Bulletins) are disclosed in either the auditor's report or in a footnote to the financial statements for fiscal periods beginning after December 31, 1965. Prior to this either-or decision, a special committee had recommended to the Council that disclosure be made in the auditor's report. There was sufficient opposition to the recommendation and/or preference for footnote disclosure that both methods of disclosure were accepted. Of relevance to choice between the two methods of disclosure is the question of whether they are equally visible to readers of financial statements. If they are equally visible, the visibility question can be ignored and choice can be made on other grounds. If they are not equally visible, choice must surely consider this factor among others. Second, some research efforts in the area of psychology indicate that forewarning may have a significant effect. For example, forewarning in-