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Financial reporting: An accounting revolution
Journal of Accounting and Economics 3 (1981) 243-252, North-Holland Publishing Company
BOOK REVIEW
William Beaver, Financial reporting: An accounting revolution (Prentice-Hall, Englewood Cliffs, N.J., 1981). This book is an excellent summary of academic research during the past fifteen years on the role of financial reporting in a market economy. At first glance, one could be properly skeptical of the claim that this research constitutes a 'revolution'. But reading through the book one is reminded that "our views of the role of financial reporting as well as the role of research to help determine 'optimal' accounting standards and financial disclosures have changed dramatically since 1970. Beaver develops the current perspective of financial reports as an information system in a multi-person environment with diverse constituencies producing, receiving, and processing financial information. With the multi-person environment, the selection of a financial reporting system for a firm is viewed as a problem of social choice since the selection has diverse economic consequences on the different constituencies for financial reporting information. Beaver shows that the social choice perspective arises once one acknowledges that firms exist in an uncertain environment with incomplete and imperfect markets for their assets and liabilities. Thus, the revolution in accounting thought is the shift in emphasis from searching for THE correct and proper method for accounting for various events to recognizing that ultimately any choice of accounting method or valuation technique is actually a problem of social choice under uncertainty. Unfortunately, this new perspective provides very little guidance to standard setters about how to set standards or even how to measure the consequences of alternative accounting and disclosure procedures on the differing constituencies. Therefore, the research concludes that optimal financial standards cannot be determined rather than developing constructive approaches for aiding the FASB or the SEC in choosing among accounting and disclosure alternatives. Chapter 1 briefly traces the development of the theory of financial reporting and serves as a summary for the entire book. The initial stewardship function is reviewed with its emphasis on historic cost, the matching concept, and the importance of the income statement. This is followed by a discussion of the formal information perspective of financial reporting that developed in the late 1960's. In this context the question is 0165-4101/81/0000--O000/$02.75 © 1981 North-Holland
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raised whether the historic cost accrual accounting model is a better predictor of future cash flows and future dividend paying ability than simply reporting current cash flows. (At present this is an open question and not one that seems even to be actively researched.) Beaver indicates how the existence of financial intermediaries (e.g., mutual funds, pension funds) and information intermediaries (e.g., brokerage research departments, research advisory services) plays a vital role in processing the output of a firm's financial reporting system. These sophisticated financial and information intermediarties are probably the main consumers of the FASB and SEC initiatives and therefore provide some justification for the increasing amount of 'soft' data and footnote disclosure being mandated. The audience for the financial reporting system is no longer the naive 'average' investor but the research departments of financial and information intermediaries, staffed with highly trained finance and accounting specialists. Chapter 2 develops the role of the financial reporting system within the information economics, decision theory paradigm. It starts with single-person decision-making under uncertainty and is generalized to a much more complicated multi-person exchange model. Beaver reviews the economic literature on the optimality of information disclosure with both homogeneous and heterogeneous beliefs among investors. The conclusions from these models are that the economic consequences of financial information affect: (i) (ii) (iii) (iv)
the the the the
distribution of wealth among investors, distribution of risk among investors and managers, rate of capital formation and the allocation of capital among firms, resources devoted to information production and analysis.
Because of these diverse effects, among many individuals in the economy with different preferences, prior beliefs, expertise, and wealth positions, it will be impossible to select the 'best' accounting method; except in the unlikely circumstance that there is unanimity among all the constituencies. Therefore, any selection of a particular financial reporting system is a social choice requiring a trade-off of welfare among the many constituencies of financial reports. Having provided the conceptual basis for the social choice view of financial information in Chapter 2, Beaver proceeds in Chapters 3 and 4 to demonstrate why unanimity is unlikely to arise in the selection of an income measurement approach. Chapter 3 develops the earnings concept under certainty and shows that the key concept is obtaining the value of the firm by computing the present value of future cash flows. Because of the certainty assumption, everyone agrees on the market value of all the firm's assets and claims and, while an accounting earnings model can easily be derived from the valuation process, there is no particular role for the financial accounting
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or accrual process in this deterministic setting. Therefore uncertainty seems necessary for there to be a role for financial accounting and accrual processes. Chapter 4 develops the earnings model under uncertainty using a simple two-period, two-state (per period) model. Even this simple setting is sufficient to demonstrate the complexities of income measurement under uncertainty. This chapter does a n excellent job in sorting out many income concepts in the context of a relatively simple model. For example, it introduces the distinction between ex ante permaiaent earnings (based on expected cash flows) and ex post distributable earnings based on actual cash flows and end of period market prices. Beaver shows how historic cost accounting can be viewed as a mixture of ex post. earnings (actual cash flows) and ex ante earnings (depreciation based on historic cost). In the general case of uncertainty, where ithere are not unique market prices for the firm's assets and claims, then there is not a unique income concept since the appropriate valuation concept is unclear. Again we cannot derive the value of an accrual accounting model in this context. But Beaver does present at least a plausible role for accrual accounting as perhaps a cost-effective way of conveying forecasts or expectations. With the aid of a simple example on the collection of accounts receivable, he shows that an accrual concept is a compromise between one extreme of reporting just the actual cash flows received and the other extreme of disclosing the entire probability distribution for the collection of future cash. The main message for me of Chapter 4 is a clear demonstration of the breakdown of the income concept under conditions of uncertainty with incomplete and imperfect markets for the firm's assets. In retrospect, the various income and valuation concepts developed during the past century (the Paton-Littleton matching concept, replacement cost, exit values, discounted cash flows) have been formulated in simple deterministic settings. They were illustrated using simple examples drawn from retailing or manufacturing (or, in one case, a taxicab company) in which uncertainty in the market price of assets was never considered explicitly. It is therefore not surprising that none of these concepts has proven completely satisfactory to describe the operations of today's heterogeneous, multi-national corporations with their complex contracting arrangements (pensions, leases, raw material contracts, etc.) and diverse assets and capital structure. Certainly it seems futile to argue, based on simple deterministic models, for which method best summarizes, in a single income number, the millions of transactions and changes in market value of the assets and liabilities of a modern corporation. Chapter 5 summarizes empirical research on the link between financial information, primarily the annual earnings number, and security prices. Many studies are cited to demonstrate that, despite the doubts introduced in Chapters 2-4 about the role of the historic-cost accounting model, there is JAE- C
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still ample evidence of a strong observed relationship between security prices (which represent, in some sense, the value of the firm) and the historic-cost earnings number. Therefore, earnings numbers do appear to be correlated with the value of the firm but are only one of many sources of information used by security market participants in pricing the firm's shares. Chapter 6 is an extensive discussion of market efficiency, the theory, the evidence, and the implications. Market efficiency is the link between security prices and information. The chapter provides a fine survey of this important topic and is beneficial in describing counter-evidence to market efficiency in addition to the more widely known supporting evidence. Beaver's rationalizations of the counter-evidence to market efficiency, including the market responses to Briloff's articles or the consistently higher returns for stocks with low price-earnings ratios, are somewhat strained but at least the reader is afforded a glimpse that not all empirical studies are obviously consistent with market efficiency. An excellent section summarizes the implications and non-implications of market efficiency; correcting some incorrect observations occasionally made by poorly informed commentators. Chapter 6 also includes a summary of the emerging literature on developing a theory of market efficiency; the process by which information is impounded into prices by informed and uninformed market participants. Beaver argues that markets can be efficient even without experts if the idiosyncratic behavior of 'less-than-fully-informed' individuals is uncorrelated across all investors. In this way, a consensus across all individuals (e.g., the market) may be a superior forecast than that of any single market participant. While this argument is sufficient, were it to be true, it is not clear that it is relevant for many accounting informational issues. For example, when examining the market response to accounting changes - - such as from FIFO to LIFO, from accelerated to straight-line depreciation, from purchase to pooling-of-interests the naive investor hypothesis focuses on a systematic misperception, that the investor just responds to reported earnings-per-share and not on the underlying cash flows. Therefore, inefficient investors will tend to have correlated, not uncorrelated, behavior so that if their naive behavior is not to influence the market price, they must be dominated by expert investors. Chapter 6 concludes with a discussion of the implications of market efficiency for the many constituencies of financial reporting-investors, policy makers, management, auditors and information intermediaries. The section on management's role is too sketchy. Beaver claims that management has incentives to provide information to outsiders so that it can raise new capital. Given the limited use of new equity financing by firms; this hardly seems like a compelling incentive. Also it ignores the potential for legal liability if management provides a 'soft' non-mandated forecast that is subsequently not achieved.
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Management is presumed to desire, along with shareholders, actions that will maximize share prices. This correspondence is achieved through stock ownership, stock options or other forms of compensation related to the price of a company's shares. This argument ignores the principal-agent problem in which management can, because of limited or costly observability by outside investors, take actions that benefit themselves at the cost of the outside shareholders. Some obser ers believe that the financial reporting system is a mechanism to reduce such divergence of interests between management and external investors. Also, a principal reason why management prefers high share prices derives not from stock options or stock ownership. Should the price of a company's shares drop too low, the firm may become the subject of a takeover bid resulting in demotions or loss of jobs for the senior management of the firm. Therefore the interplay between information, market efficiency, and management behavior is much more complex than Beaver develops in this section. The relationship of market efficiency to auditors is also much too sketchy. The implications of an efficient market, dominated by investors with highly diversified portfolios, for the legal liability of auditors deserves more attention. Also, if prices reflect all publicly available information, should not auditors be tracking unusual price movements in their clients' stocks, attempting to identify the information driving these movements, and then assessing the audit and disclosure implications of this information? In summary, Chapter 6 is an ambitious survey of the theory, evidence, and implications of market efficiency. There are many excellent sections and summaries but the topic is so broad that the chapter suffers from attempting to cover too much in too few pages. Its deficiencies relate to omissions not to commissions. What is there is quite good but highly condensed and occasionally incomplete. Chapter 7, the final chapter, surveys the evidence both supporting and opposing the regulation of the financial reporting system. The arguments for regulation - - concern with fraud, under-investment in the production of a public good - - are presented. These are countered with the arguments against regulation the cost of regulation and mandatory disclosure especially when the magnitude of the externality in a non-regulated environment is unknown, the divergence of interests between lawyers in the SEC and the owners of publicly traded firms, and the existence of many private sector alternatives to periodic financial statements for information disclosure. A few theoretical papers are cited in which incentives can be shown to exist for investors and management to obtain and disclose private information about the firm. My evaluation of the conclusions from these papers is quite ambivalent. Researchers have been able to construct highly simplified and abstract models, bearing only a faint resemblance to actual information disclosure and trading in markets, which suggest that regulation
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may or may not be desirable. At this stage, it is hard to imagine, nor does Beaver mean to imply, that based on this research, the SEC and the FASB should withdraw from the standard setting and disclosure business. This chapter succeeds in opening up some relevant issues on the regulation of the financial reporting system but provides few definitive conclusions. The main conclusion is the principal message of the book; that financial reporting regulation is a social choice because of the diverse effects or consequences on the constituencies of financial reports. Therefore, some regulatory group may be required to balance off these diverse and occasionally conflicting interests and make the tough political choices. This chapter-by-chapter review should indicate the diversity and ambition of the material contained in the book. There are some surprising omissions from the scope of coverage. The viewpoint, throughout the book is the role of financial reporting as an information system in the multi-person setting of modern capital markets. This was clearly a viewpoint that emerged in the 1960's and remained influential through the 1970's. But recently, we have become aware that financial reports are more than an information source for investors. Financial reports can be a central feature of contractual relationships. For example, the compensation of senior management is frequently a direct function of the numbers produced by the financial reporting system. It is hard to understand the vitriolic comments by management to the earnings fluctuations induced by FAS 8 solely in terms of the information content of these disclosures. It is only when one recognizes how the bonus pool of senior managers varies with earnings fluctuations that one can start to understand the attitude of these managers to accounting-induced income variations. In addition to the effects on management compensation, financial accounting numbers are also part of lending agreements between the firm and its creditors. Bond covenants make extensive use of financial numbers produced under GAAP. Thus, changes in accounting procedures could affect the independence of the firm from its creditors. Also earnings numbers have become part of the political and regulatory discussions on the role of corporations in the U.S. economy. Governmental initiatives on price controls, taxes ('windfall' and otherwise), anti-trust, and divestiture can be based on the income and other numbers produced by the financial reporting system. Corporate profitability is also relevant during deliberations with organized labor. In the limit, the prices and real profitability of governmentally regulated firms are determined based on the numbers produced b y these firms' financial reports. Thus, the financial reporting system is more than an information system to diverse investors. It also provides a basis for real resource transfers: between owners and managers, between the firm and its creditors, between corporations and the public sector, between corporations and its labor force, and between the
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corporation and its customers. These real resource transfers, to and from the corporation, limit the ability of the financial reporting system to serve Primarily as an information system to a diverse ownership group. These other uses and constituencies are certainly consistent with the multiperson, diverse consequence setting developed by Beaver. But an explicit discussion of these issues is unfortunately missing from the book despite the emergence of an extensive literature during the past five years. Readers of this journal will certainly have no trouble identifying the relevant articles in this area that are not incorporated in Beaver's analysis but which should have been part of any comprehensive discussion of the demand for and supply of financialreporting information. A principal conclusion from this monograph - - the indeterminacy of income measurement under conditions of uncertainty with incomplete and imperfect markets - - is very valuable in limiting the claims of many accounting 'theorists' to having the true measure for income measurement and asset valuation. As previously mentioned, we can now see that these 'theoretical' claims arose from analysis of extremely simple deterministic models in which market prices were always assumed known and observable. Thus, Beaver's analysis is helpful in showing that generalizing from simple deterministic settings to the problem of income measurement in a highly complex and uncertain world can be misleading, to say the least. It would seem that a similar message should also be heeded by researchers attempting to generalize from abstract, highly simplified representations of information production and market trading under uncertainty. We are just at the birth of this literature so that it could be just as misleading to draw conclusions about the role of regulation, corporate reporting and stock market trading from models with only two investors in a two-period world with two states-of-the-world each period. This literature certainly gives us some insights but we should be very cautious before jumping to policy conclusions and testifying in fr6nt of the SEC or the FASB on the role of disclosure based on these early models. For example, as Beaver points out, Hirschleifer's surprising result on the limited 'social value' of information was subsequently shown to hold only for the highly restrictive assumptions made in Hirschleifer's models. It could not be generalized to more realistic settings. In particular, none of the recent research summarized in Beaver's monograph gives us any insight as to why an accrual accounting system is extensively used in our modern market economy. The 'information' in the models of this research is highly stylized and bears essentially no relation to contemporary financial reporting debates on the timing of income recognition, alternative asset and liability measurement procedures, and the measurement or disclosure relating to leases, pensions, R&D, foreign operations, depreciation, inventory, etc. Thus, while we may have had a revolution in financial reporting thought, the outcome is closer to anarchy
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than to an alternative framework for financial reporting. We now think we understand the problem but our understanding is such that we can offer no solutions. Beaver tries to point us in some useful directions when he speculates that the role of accrual accounting may be to distinguish changes in permanent earnings from transitory earnings changes, and that accrual accounting may be a cost-effective mechanism for capturing some of management's expectation about the future. This speculation would have been strengthened had Beaver discussed just such a result obtained by Kanodia in a 1980 Econometrica paper. But such hopes are still a long way from enabling this 'revolution' in financial reporting to provide guidance to either regulating agencies or even management and investors on the selection of measurement procedures and costly disclosures. We are left more with an impossibility result than with a constructive approach to financial reporting in a complex industrial society. Yet decisions have to be continually taken by managers, auditors, and regulators on measurement and disclosure issues and contemporary research has seemingly removed academics from participating in these deliberations. Somehow, it was more fun when we thought we knew the answers rather than our current state when all we know are the problems. Mention should be made of the style and classroom relevance of this book. The book is designed to be used in a financial reporting elective as an alternative to the traditional intermediate financial course that provides in depth coverage of topics such as pensions, leases, foreign currency accounting, deferred taxes, etc. Whether a theory or concepts based course, using Beaver's book, is a sensible substitute for a procedures-oriented topics course is a question of the taste and philosophy of the instructor. My personal preference would be to view the concepts course as a useful supplement to the topics course but not as a substitute for it. I have two reasons for this recommendation. First, even if students are not going to become public accountants, they could benefit from a greater knowledge of the problems of income measurement, and asset and liability valuation that arise in the specific circumstances of each of the topics discussed in an intermediate level financial reporting course. Such a course should not be exclusively devoted to coverage of the currently operative APB/FASB/SEC pronouncements on each subject. Rather it should raise the particular issues that arise with each topic, discuss alternative suggestions for dealing with these issues, and last (and perhaps least) describe existing practice. In this way, the students will become more familiar and knowledgeable about the complexity of financial reporting issues that must be resolved, in some manner, in order for the firm to prepare periodic financial statements. My second reason for preferring a topics-oriented financial reporting course to precede a concepts-oriented one is that the topics provide the background and motivation for Beaver's concepts-oriented course. Students,
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without an exposure to the complexities of contemporary financial reporting issues, m a y not appreciate the difficult choice problems that are at the heart of Beaver's monograph. A good topics-oriented course should therefore be useful preparation for the concepts-oriented course that Beaver proposes. The concepts-oriented course certainly does have a valuable role in explicating a conceptual framework, within which choices among financial reporting alternatives must be made. Beaver claims to have used the book already in a second year MBA financial accounting elective at Stanford. Frankly, I am impressed by this claim. The book assumes an extensive knowledge of multi-person decision making under uncertainty. The book uses many undefined terms which would be familiar to researchers who have read widely or written in the field. To the outsider, however, phrases such as 'firm-related outcomes', 'statelabeled time-dated consequence vector', 'state-contingent claims to consumption', and 'costless information systems can be ranked according to a fineness criterion', could appear to be academic jargon. If your students are comfortable with a definition of the moral hazard problem as 'the agent I-using] the position of superior information to maximize the agent's selfinterest at the expense of the principal' and will not get glassy-eyed over 'perfect and complete markets permit a costless, riskless arbitraging of intertemporal claims and hence require the pricing of the claims to behave such that a present value formulation is attainable', then this book can be used in your classes. Personally, I would have preferred these abstract concepts to be better motivated and better illustrated with actual examples from financial reporting issues. As researchers, we have evolved a language that facilitates and shortens communication among us. But when introducing these abstract concepts to our students, particularly professional students in undergraduate, MBA, and executive programs, we should try to explain and motivate our technical shorthand with many examples and, if possible, to use the concepts themselves without referring to them by their technical names. I view this book not as a text but as a vehicle for Bill Beaver to communicate to professional colleagues his views on efficient market research and income measurement under uncertainty. He has done an admirable job of organizing an extensive literature on these subjects wrapped around a few relatively simple examples. The references to the literature are sufficient for researchers who are familiar with the primary sources (or can read the ones they have missed) to understand the contribution of these papers to Beaver's framework and conclusions. But readers who have not read the basic papers referenced in the chapters (i.e., almost all non-Ph.D, students) will encounter some difficulties. The one-sentence to one paragraph summaries of these studies are too brief to get much understanding of the important concepts introduced in each study. I enjoyed reading the book. I am sure many others
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of Beaver's academic colleagues will be similarly grateful to him for having organized this material. But I am less confident that my students will be equally as appreciative. To summarize, this is an important book that provides an excellent summary and organization of recent research on income measurement, market efficiency, and the multiple constituencies of the financial reporting system. With the exception of Chapters 3 and 4, which build conclusions from specifiC models, the book is more a survey of the literature thian a comprehensive, self-contained development o f the financial reporting 'revolution'. The book should make this literature more accessible to many academics and a f e w practitioners and certainly should indicate why "many researchers will be reluctant to give normative recommendations to standard setting bodies on 'optimal' accounting standards and disclosure requirements. Robert S. KAPLAN
Carnegie-Mellon University
BOOK REVIEW
William Beaver, Financial reporting: An accounting revolution (Prentice-Hall, Englewood Cliffs, N.J., 1981). This book is an excellent summary of academic research during the past fifteen years on the role of financial reporting in a market economy. At first glance, one could be properly skeptical of the claim that this research constitutes a 'revolution'. But reading through the book one is reminded that "our views of the role of financial reporting as well as the role of research to help determine 'optimal' accounting standards and financial disclosures have changed dramatically since 1970. Beaver develops the current perspective of financial reports as an information system in a multi-person environment with diverse constituencies producing, receiving, and processing financial information. With the multi-person environment, the selection of a financial reporting system for a firm is viewed as a problem of social choice since the selection has diverse economic consequences on the different constituencies for financial reporting information. Beaver shows that the social choice perspective arises once one acknowledges that firms exist in an uncertain environment with incomplete and imperfect markets for their assets and liabilities. Thus, the revolution in accounting thought is the shift in emphasis from searching for THE correct and proper method for accounting for various events to recognizing that ultimately any choice of accounting method or valuation technique is actually a problem of social choice under uncertainty. Unfortunately, this new perspective provides very little guidance to standard setters about how to set standards or even how to measure the consequences of alternative accounting and disclosure procedures on the differing constituencies. Therefore, the research concludes that optimal financial standards cannot be determined rather than developing constructive approaches for aiding the FASB or the SEC in choosing among accounting and disclosure alternatives. Chapter 1 briefly traces the development of the theory of financial reporting and serves as a summary for the entire book. The initial stewardship function is reviewed with its emphasis on historic cost, the matching concept, and the importance of the income statement. This is followed by a discussion of the formal information perspective of financial reporting that developed in the late 1960's. In this context the question is 0165-4101/81/0000--O000/$02.75 © 1981 North-Holland
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raised whether the historic cost accrual accounting model is a better predictor of future cash flows and future dividend paying ability than simply reporting current cash flows. (At present this is an open question and not one that seems even to be actively researched.) Beaver indicates how the existence of financial intermediaries (e.g., mutual funds, pension funds) and information intermediaries (e.g., brokerage research departments, research advisory services) plays a vital role in processing the output of a firm's financial reporting system. These sophisticated financial and information intermediarties are probably the main consumers of the FASB and SEC initiatives and therefore provide some justification for the increasing amount of 'soft' data and footnote disclosure being mandated. The audience for the financial reporting system is no longer the naive 'average' investor but the research departments of financial and information intermediaries, staffed with highly trained finance and accounting specialists. Chapter 2 develops the role of the financial reporting system within the information economics, decision theory paradigm. It starts with single-person decision-making under uncertainty and is generalized to a much more complicated multi-person exchange model. Beaver reviews the economic literature on the optimality of information disclosure with both homogeneous and heterogeneous beliefs among investors. The conclusions from these models are that the economic consequences of financial information affect: (i) (ii) (iii) (iv)
the the the the
distribution of wealth among investors, distribution of risk among investors and managers, rate of capital formation and the allocation of capital among firms, resources devoted to information production and analysis.
Because of these diverse effects, among many individuals in the economy with different preferences, prior beliefs, expertise, and wealth positions, it will be impossible to select the 'best' accounting method; except in the unlikely circumstance that there is unanimity among all the constituencies. Therefore, any selection of a particular financial reporting system is a social choice requiring a trade-off of welfare among the many constituencies of financial reports. Having provided the conceptual basis for the social choice view of financial information in Chapter 2, Beaver proceeds in Chapters 3 and 4 to demonstrate why unanimity is unlikely to arise in the selection of an income measurement approach. Chapter 3 develops the earnings concept under certainty and shows that the key concept is obtaining the value of the firm by computing the present value of future cash flows. Because of the certainty assumption, everyone agrees on the market value of all the firm's assets and claims and, while an accounting earnings model can easily be derived from the valuation process, there is no particular role for the financial accounting
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or accrual process in this deterministic setting. Therefore uncertainty seems necessary for there to be a role for financial accounting and accrual processes. Chapter 4 develops the earnings model under uncertainty using a simple two-period, two-state (per period) model. Even this simple setting is sufficient to demonstrate the complexities of income measurement under uncertainty. This chapter does a n excellent job in sorting out many income concepts in the context of a relatively simple model. For example, it introduces the distinction between ex ante permaiaent earnings (based on expected cash flows) and ex post distributable earnings based on actual cash flows and end of period market prices. Beaver shows how historic cost accounting can be viewed as a mixture of ex post. earnings (actual cash flows) and ex ante earnings (depreciation based on historic cost). In the general case of uncertainty, where ithere are not unique market prices for the firm's assets and claims, then there is not a unique income concept since the appropriate valuation concept is unclear. Again we cannot derive the value of an accrual accounting model in this context. But Beaver does present at least a plausible role for accrual accounting as perhaps a cost-effective way of conveying forecasts or expectations. With the aid of a simple example on the collection of accounts receivable, he shows that an accrual concept is a compromise between one extreme of reporting just the actual cash flows received and the other extreme of disclosing the entire probability distribution for the collection of future cash. The main message for me of Chapter 4 is a clear demonstration of the breakdown of the income concept under conditions of uncertainty with incomplete and imperfect markets for the firm's assets. In retrospect, the various income and valuation concepts developed during the past century (the Paton-Littleton matching concept, replacement cost, exit values, discounted cash flows) have been formulated in simple deterministic settings. They were illustrated using simple examples drawn from retailing or manufacturing (or, in one case, a taxicab company) in which uncertainty in the market price of assets was never considered explicitly. It is therefore not surprising that none of these concepts has proven completely satisfactory to describe the operations of today's heterogeneous, multi-national corporations with their complex contracting arrangements (pensions, leases, raw material contracts, etc.) and diverse assets and capital structure. Certainly it seems futile to argue, based on simple deterministic models, for which method best summarizes, in a single income number, the millions of transactions and changes in market value of the assets and liabilities of a modern corporation. Chapter 5 summarizes empirical research on the link between financial information, primarily the annual earnings number, and security prices. Many studies are cited to demonstrate that, despite the doubts introduced in Chapters 2-4 about the role of the historic-cost accounting model, there is JAE- C
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still ample evidence of a strong observed relationship between security prices (which represent, in some sense, the value of the firm) and the historic-cost earnings number. Therefore, earnings numbers do appear to be correlated with the value of the firm but are only one of many sources of information used by security market participants in pricing the firm's shares. Chapter 6 is an extensive discussion of market efficiency, the theory, the evidence, and the implications. Market efficiency is the link between security prices and information. The chapter provides a fine survey of this important topic and is beneficial in describing counter-evidence to market efficiency in addition to the more widely known supporting evidence. Beaver's rationalizations of the counter-evidence to market efficiency, including the market responses to Briloff's articles or the consistently higher returns for stocks with low price-earnings ratios, are somewhat strained but at least the reader is afforded a glimpse that not all empirical studies are obviously consistent with market efficiency. An excellent section summarizes the implications and non-implications of market efficiency; correcting some incorrect observations occasionally made by poorly informed commentators. Chapter 6 also includes a summary of the emerging literature on developing a theory of market efficiency; the process by which information is impounded into prices by informed and uninformed market participants. Beaver argues that markets can be efficient even without experts if the idiosyncratic behavior of 'less-than-fully-informed' individuals is uncorrelated across all investors. In this way, a consensus across all individuals (e.g., the market) may be a superior forecast than that of any single market participant. While this argument is sufficient, were it to be true, it is not clear that it is relevant for many accounting informational issues. For example, when examining the market response to accounting changes - - such as from FIFO to LIFO, from accelerated to straight-line depreciation, from purchase to pooling-of-interests the naive investor hypothesis focuses on a systematic misperception, that the investor just responds to reported earnings-per-share and not on the underlying cash flows. Therefore, inefficient investors will tend to have correlated, not uncorrelated, behavior so that if their naive behavior is not to influence the market price, they must be dominated by expert investors. Chapter 6 concludes with a discussion of the implications of market efficiency for the many constituencies of financial reporting-investors, policy makers, management, auditors and information intermediaries. The section on management's role is too sketchy. Beaver claims that management has incentives to provide information to outsiders so that it can raise new capital. Given the limited use of new equity financing by firms; this hardly seems like a compelling incentive. Also it ignores the potential for legal liability if management provides a 'soft' non-mandated forecast that is subsequently not achieved.
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Management is presumed to desire, along with shareholders, actions that will maximize share prices. This correspondence is achieved through stock ownership, stock options or other forms of compensation related to the price of a company's shares. This argument ignores the principal-agent problem in which management can, because of limited or costly observability by outside investors, take actions that benefit themselves at the cost of the outside shareholders. Some obser ers believe that the financial reporting system is a mechanism to reduce such divergence of interests between management and external investors. Also, a principal reason why management prefers high share prices derives not from stock options or stock ownership. Should the price of a company's shares drop too low, the firm may become the subject of a takeover bid resulting in demotions or loss of jobs for the senior management of the firm. Therefore the interplay between information, market efficiency, and management behavior is much more complex than Beaver develops in this section. The relationship of market efficiency to auditors is also much too sketchy. The implications of an efficient market, dominated by investors with highly diversified portfolios, for the legal liability of auditors deserves more attention. Also, if prices reflect all publicly available information, should not auditors be tracking unusual price movements in their clients' stocks, attempting to identify the information driving these movements, and then assessing the audit and disclosure implications of this information? In summary, Chapter 6 is an ambitious survey of the theory, evidence, and implications of market efficiency. There are many excellent sections and summaries but the topic is so broad that the chapter suffers from attempting to cover too much in too few pages. Its deficiencies relate to omissions not to commissions. What is there is quite good but highly condensed and occasionally incomplete. Chapter 7, the final chapter, surveys the evidence both supporting and opposing the regulation of the financial reporting system. The arguments for regulation - - concern with fraud, under-investment in the production of a public good - - are presented. These are countered with the arguments against regulation the cost of regulation and mandatory disclosure especially when the magnitude of the externality in a non-regulated environment is unknown, the divergence of interests between lawyers in the SEC and the owners of publicly traded firms, and the existence of many private sector alternatives to periodic financial statements for information disclosure. A few theoretical papers are cited in which incentives can be shown to exist for investors and management to obtain and disclose private information about the firm. My evaluation of the conclusions from these papers is quite ambivalent. Researchers have been able to construct highly simplified and abstract models, bearing only a faint resemblance to actual information disclosure and trading in markets, which suggest that regulation
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may or may not be desirable. At this stage, it is hard to imagine, nor does Beaver mean to imply, that based on this research, the SEC and the FASB should withdraw from the standard setting and disclosure business. This chapter succeeds in opening up some relevant issues on the regulation of the financial reporting system but provides few definitive conclusions. The main conclusion is the principal message of the book; that financial reporting regulation is a social choice because of the diverse effects or consequences on the constituencies of financial reports. Therefore, some regulatory group may be required to balance off these diverse and occasionally conflicting interests and make the tough political choices. This chapter-by-chapter review should indicate the diversity and ambition of the material contained in the book. There are some surprising omissions from the scope of coverage. The viewpoint, throughout the book is the role of financial reporting as an information system in the multi-person setting of modern capital markets. This was clearly a viewpoint that emerged in the 1960's and remained influential through the 1970's. But recently, we have become aware that financial reports are more than an information source for investors. Financial reports can be a central feature of contractual relationships. For example, the compensation of senior management is frequently a direct function of the numbers produced by the financial reporting system. It is hard to understand the vitriolic comments by management to the earnings fluctuations induced by FAS 8 solely in terms of the information content of these disclosures. It is only when one recognizes how the bonus pool of senior managers varies with earnings fluctuations that one can start to understand the attitude of these managers to accounting-induced income variations. In addition to the effects on management compensation, financial accounting numbers are also part of lending agreements between the firm and its creditors. Bond covenants make extensive use of financial numbers produced under GAAP. Thus, changes in accounting procedures could affect the independence of the firm from its creditors. Also earnings numbers have become part of the political and regulatory discussions on the role of corporations in the U.S. economy. Governmental initiatives on price controls, taxes ('windfall' and otherwise), anti-trust, and divestiture can be based on the income and other numbers produced by the financial reporting system. Corporate profitability is also relevant during deliberations with organized labor. In the limit, the prices and real profitability of governmentally regulated firms are determined based on the numbers produced b y these firms' financial reports. Thus, the financial reporting system is more than an information system to diverse investors. It also provides a basis for real resource transfers: between owners and managers, between the firm and its creditors, between corporations and the public sector, between corporations and its labor force, and between the
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corporation and its customers. These real resource transfers, to and from the corporation, limit the ability of the financial reporting system to serve Primarily as an information system to a diverse ownership group. These other uses and constituencies are certainly consistent with the multiperson, diverse consequence setting developed by Beaver. But an explicit discussion of these issues is unfortunately missing from the book despite the emergence of an extensive literature during the past five years. Readers of this journal will certainly have no trouble identifying the relevant articles in this area that are not incorporated in Beaver's analysis but which should have been part of any comprehensive discussion of the demand for and supply of financialreporting information. A principal conclusion from this monograph - - the indeterminacy of income measurement under conditions of uncertainty with incomplete and imperfect markets - - is very valuable in limiting the claims of many accounting 'theorists' to having the true measure for income measurement and asset valuation. As previously mentioned, we can now see that these 'theoretical' claims arose from analysis of extremely simple deterministic models in which market prices were always assumed known and observable. Thus, Beaver's analysis is helpful in showing that generalizing from simple deterministic settings to the problem of income measurement in a highly complex and uncertain world can be misleading, to say the least. It would seem that a similar message should also be heeded by researchers attempting to generalize from abstract, highly simplified representations of information production and market trading under uncertainty. We are just at the birth of this literature so that it could be just as misleading to draw conclusions about the role of regulation, corporate reporting and stock market trading from models with only two investors in a two-period world with two states-of-the-world each period. This literature certainly gives us some insights but we should be very cautious before jumping to policy conclusions and testifying in fr6nt of the SEC or the FASB on the role of disclosure based on these early models. For example, as Beaver points out, Hirschleifer's surprising result on the limited 'social value' of information was subsequently shown to hold only for the highly restrictive assumptions made in Hirschleifer's models. It could not be generalized to more realistic settings. In particular, none of the recent research summarized in Beaver's monograph gives us any insight as to why an accrual accounting system is extensively used in our modern market economy. The 'information' in the models of this research is highly stylized and bears essentially no relation to contemporary financial reporting debates on the timing of income recognition, alternative asset and liability measurement procedures, and the measurement or disclosure relating to leases, pensions, R&D, foreign operations, depreciation, inventory, etc. Thus, while we may have had a revolution in financial reporting thought, the outcome is closer to anarchy
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than to an alternative framework for financial reporting. We now think we understand the problem but our understanding is such that we can offer no solutions. Beaver tries to point us in some useful directions when he speculates that the role of accrual accounting may be to distinguish changes in permanent earnings from transitory earnings changes, and that accrual accounting may be a cost-effective mechanism for capturing some of management's expectation about the future. This speculation would have been strengthened had Beaver discussed just such a result obtained by Kanodia in a 1980 Econometrica paper. But such hopes are still a long way from enabling this 'revolution' in financial reporting to provide guidance to either regulating agencies or even management and investors on the selection of measurement procedures and costly disclosures. We are left more with an impossibility result than with a constructive approach to financial reporting in a complex industrial society. Yet decisions have to be continually taken by managers, auditors, and regulators on measurement and disclosure issues and contemporary research has seemingly removed academics from participating in these deliberations. Somehow, it was more fun when we thought we knew the answers rather than our current state when all we know are the problems. Mention should be made of the style and classroom relevance of this book. The book is designed to be used in a financial reporting elective as an alternative to the traditional intermediate financial course that provides in depth coverage of topics such as pensions, leases, foreign currency accounting, deferred taxes, etc. Whether a theory or concepts based course, using Beaver's book, is a sensible substitute for a procedures-oriented topics course is a question of the taste and philosophy of the instructor. My personal preference would be to view the concepts course as a useful supplement to the topics course but not as a substitute for it. I have two reasons for this recommendation. First, even if students are not going to become public accountants, they could benefit from a greater knowledge of the problems of income measurement, and asset and liability valuation that arise in the specific circumstances of each of the topics discussed in an intermediate level financial reporting course. Such a course should not be exclusively devoted to coverage of the currently operative APB/FASB/SEC pronouncements on each subject. Rather it should raise the particular issues that arise with each topic, discuss alternative suggestions for dealing with these issues, and last (and perhaps least) describe existing practice. In this way, the students will become more familiar and knowledgeable about the complexity of financial reporting issues that must be resolved, in some manner, in order for the firm to prepare periodic financial statements. My second reason for preferring a topics-oriented financial reporting course to precede a concepts-oriented one is that the topics provide the background and motivation for Beaver's concepts-oriented course. Students,
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without an exposure to the complexities of contemporary financial reporting issues, m a y not appreciate the difficult choice problems that are at the heart of Beaver's monograph. A good topics-oriented course should therefore be useful preparation for the concepts-oriented course that Beaver proposes. The concepts-oriented course certainly does have a valuable role in explicating a conceptual framework, within which choices among financial reporting alternatives must be made. Beaver claims to have used the book already in a second year MBA financial accounting elective at Stanford. Frankly, I am impressed by this claim. The book assumes an extensive knowledge of multi-person decision making under uncertainty. The book uses many undefined terms which would be familiar to researchers who have read widely or written in the field. To the outsider, however, phrases such as 'firm-related outcomes', 'statelabeled time-dated consequence vector', 'state-contingent claims to consumption', and 'costless information systems can be ranked according to a fineness criterion', could appear to be academic jargon. If your students are comfortable with a definition of the moral hazard problem as 'the agent I-using] the position of superior information to maximize the agent's selfinterest at the expense of the principal' and will not get glassy-eyed over 'perfect and complete markets permit a costless, riskless arbitraging of intertemporal claims and hence require the pricing of the claims to behave such that a present value formulation is attainable', then this book can be used in your classes. Personally, I would have preferred these abstract concepts to be better motivated and better illustrated with actual examples from financial reporting issues. As researchers, we have evolved a language that facilitates and shortens communication among us. But when introducing these abstract concepts to our students, particularly professional students in undergraduate, MBA, and executive programs, we should try to explain and motivate our technical shorthand with many examples and, if possible, to use the concepts themselves without referring to them by their technical names. I view this book not as a text but as a vehicle for Bill Beaver to communicate to professional colleagues his views on efficient market research and income measurement under uncertainty. He has done an admirable job of organizing an extensive literature on these subjects wrapped around a few relatively simple examples. The references to the literature are sufficient for researchers who are familiar with the primary sources (or can read the ones they have missed) to understand the contribution of these papers to Beaver's framework and conclusions. But readers who have not read the basic papers referenced in the chapters (i.e., almost all non-Ph.D, students) will encounter some difficulties. The one-sentence to one paragraph summaries of these studies are too brief to get much understanding of the important concepts introduced in each study. I enjoyed reading the book. I am sure many others
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of Beaver's academic colleagues will be similarly grateful to him for having organized this material. But I am less confident that my students will be equally as appreciative. To summarize, this is an important book that provides an excellent summary and organization of recent research on income measurement, market efficiency, and the multiple constituencies of the financial reporting system. With the exception of Chapters 3 and 4, which build conclusions from specifiC models, the book is more a survey of the literature thian a comprehensive, self-contained development o f the financial reporting 'revolution'. The book should make this literature more accessible to many academics and a f e w practitioners and certainly should indicate why "many researchers will be reluctant to give normative recommendations to standard setting bodies on 'optimal' accounting standards and disclosure requirements. Robert S. KAPLAN
Carnegie-Mellon University