Accnt Theory

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Many people say that they do not need theories; that by definition theories are not practical or useful in t

real world. However, theories are necessary for us to try to understand the world we live in.

Rule focussed○

With little use for theory○

Accounting viewed as a practical discipline•

Understand the world we live in○

Provide a basis for decision making○

However, theory is necessary to•

Concepts of Materiality○

Relevance

Faithful Representation

Recognition Criteria○

The Conceptual Framework○

Measurement Bases○

All accounting is premised on theories•

Accounting Theory

A belief or principle that guides actions or behaviour•

An idea or set of ideas that is intended to explain something•

The set of principles on which a subject is based or of ideas that are suggested to explain a fact or event•

THEORY

A description, explanation or a prediction [of accounting practice] based on observations and/or logicalreasoning

•

Accounting Theory

Logical reasoning in the form of a set of broad principles that (1) provide a general framework of reference

which accounting practice can be evaluated and (2) guide the development of new practice and procedure

•

To provide an explanation of what is happening•

To help us predict what will happen•

Even partial or inaccurate theories can be of (limited) use•

Why Is Theory Needed

Theories drive many real world situations•

Tax○

Interest Rates○

Global Warming○

Education○

Construction○

Theory informs decisions about•

Almost every aspect of our lives•

The Affect Of Theories

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Some of these theories explain•

Some of these theories predict•

Some of these theories conflict•

Different Theories

Capital Market Theory

Describe and explain current practice○

Agency Theory

Predict practice○

Provide principles for decision making○

The conceptual framework

Identify problems and deficiencies and offer solutions○

Some accounting theories•

Different Accounting Theories

positive theories1.

normative theories.2.

Types Of Theories

Positive theories are about the world as it is.•

Describe what is happening○

Explain what is happening○

Make predictions about what will happen○

They•

Based around Hypotheses•

Also called empirical theories•

Positive Theories

What should happen○

What ought to be○

Make suggestions about•

Observations or facts are considered in development of normative theories•

Normative Theories

E.g. how should accounting items be measured○

There are often competing theories about an issue or observation•

Which theory is correct?•

Simple: Intuitive or anecdotal approaches○

Systematic Approaches○

Scientific Approaches○

A range of approached are taken•

Evaluating And Testing Theories

Be logical in its construction○

Be clearly articulated○

Be testable○

Be consistent with observation○

A good theory should•

A theory can never be proved true•

A single observation can prove a theory false•

Acceptance of Theories

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Research is the ‘diligent and systematic enquiry or investigation into a subject in order to discover facts or

principles’.

•

Research is often repeated and adjusted, so that knowledge is expanding.•

Most research studies will not provide definitive answers•

Instead each study should contribute to our understanding of the issue.•

Understanding The Role Of Research

Research is used at all stages of the theory process•

Exploratory○

Experimental○

Observational○

Theoretical○

Quantitative○

Qualitative○

Research can be•

Relationship Between Theory and Research

Research of or about accounting considers the role of accounting itself•

What is the role of accounting?○

Is accounting information useful in investment decisions?○

Should accountability or decision usefulness be the key goal of accounting?○

What impact does culture have on accounting?○

What role has accounting played in the rise of capitalism or environmental degradation?○

It considers questions such as:•

Research Of or About Accounting

Research in accounting focuses at the more micro level on issues within accounting•

What measurements are being used?○

What measures should be used?○

What impact do changes in specific accounting policies have on share prices?○

It considers questions such as:•

Research In Accounting

Capital Markets Research•

Accounting Policy Choice Research•

Accounting Information Processing Research•

Critical Accounting Research•

International Accounting Research•

Research Areas In Accounting

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It is a normative theory-

It prescribes the basic principles that are to be followed in preparing financial statements-

It is a coherent system of concepts, which are guidelines to the accounting standards used for financial repo-

A Conceptual framework is a group of ideas or principles used to plan or decide something.

designed to provide guidance and apply to a wide range of decisions-

Conceptual Framework•

Specific requirements for a particular area-

May go beyond the framework-

Are mandatory-

Sometimes conflict with the framework-

Accounting standards•

Conceptual Framework vs Accounting Standard

CONCEPTUAL FRAMEWORK

1920s and 1930s attempts to draft statements of principles to guide accounting.•

1970s development of more comprehensive and formal conceptual frameworks•

1989 the existing Framework for the Preparation and Presentation of Financial Statements issued by the IAS•

2010 the Conceptual Framework for Financial Reporting issued by the IASB•

History And Evolution Of The Conceptual Framework

What is the purpose of financial statements?-

Who are they prepared for?-

What are the assumptions to be made when preparing financial statements?-

What type of information should be included?-

What are the elements that make up financial statements?-

When should the elements of financial statements be included?-

The Conceptual Framework can be seen as providing answers to questions such as:•

The Structure And Components Of The Conceptual Framework

In 2004, the IASB and FASB began undertaking a project to develop a common framework.•

objectives and qualitative characteristics.a.

elements and recognitionb.

measurementc.

reporting entityd.presentation and disclosuree.

purpose and statusf.

application to not-for-profit entitiesg.

remaining issuesh.

The project is being conducted in eight phases•

Current Developments

These are financial reports intended to meet the needs of users who are not in a position to require an

to prepare reports tailored to their particular information needs.

-

The Conceptual Framework states that it is concerned with general purpose financial reports.•

Not special purpose financial reports•

Purpose, Objective And Underlying Assumption

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A reporting entity is a circumscribed area of economic activities whose financial information has the

potential to be useful to existing and potential equity investors, lenders, and other creditors who cann

directly obtain the information they need in making decisions about providing resources to the entity

assessing whether the management and the governing board of that entity have made efficient and ef

use of the resources provided.

Proposed definition of a reporting entity•

Focus on economic events and transactions, not legal form•

Designed for ‘for-profit’ entities•

This is a matter for individual countries to decide at law-Does not actually set out which entities must prepare General Purpose Financial Reports•

The objective of general purpose financial reporting is to provide financial information about the reporting

that is useful to existing and potential investors, lenders and other creditors in making decisions about provi

resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and

providing or settling loans and other forms of credit

The Objective of Financial Reporting

Help predict the future-

Provide feedback on previous decisions-

Accountability and stewardship-

Financial statements should provide information that is useful to users in making decisions.•

Existing and potential investors-

Lenders-

Other creditors.-

The Conceptual Framework identifies the following users•

Very limited list when compare with previous framework•

The financial statements are normally prepared on the assumption that an entity is a going concern and will

continue in operation for the foreseeable future

Underlying Assumption

Affects recognition and measurement•

Fundamental-

Enhancing-

There is a hierarchy of qualitative characteristics:•

Information must have both of the two fundamental characteristics-

The enhancing characteristics are not essential-

But can improve the usefulness of the information-

To be useful for decision making•

Qualitative Characteristics

Aims to ensure that only useful information is included-

An important part of this concept is materiality -

Relevance1.

What is shown corresponds to the actual events and transactions that are being represented-

Complete Depictioni.

Neutralityii.

Freedom for Erroriii.

Three key elements-

Faithful Representation2.

Fundamental Qualitative Characteristics

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Achieved with consistent measurement and presentation of items over time and between entities-

Comparability3.

Information can be supported or confirmed so that users are confident in relying on it-

Verifiability4.

Users need information on a timely basis-

Timeliness5.

have reasonable knowledge of business and economic activities, and-

will conduct a diligent review and analysis of the information-

Financial reports are prepared for users who-

Understandability6.

Ideally information will have all characteristics•

Timeliness versus faithful representation-

Relevance versus verifiability-

Relevance versus understandability-

In reality there are often trade-offs•

Cost versus benefit-

Cost Constraint on Financial Information•

Determining the Relative Importance of Qualitative Characteristics

A resource controlled by the entity as a result of past events and from which future economic benefits

expected to flow to the entity.

Assets

A present obligation of the entity arising from past events, the settlement of which is expected to resu

an outflow from the entity of resources embodying economic benefits.

Liabilities

The residual interest in the assets of the entity after deducting all its liabilities.

Equity

Increases in economic benefits during the accounting period in the form of inflows or enhancements o

assets or decreases of liabilities that result in increases in equity, other than those relating to contribu

from equity participants.

Income

Decreases in economic benefits during the accounting period in the form of outflows or depletions of

or incurrences of liabilities that result in decreases in equity, other than those relating to distributions

equity participants.

Expenses

The Elements of Financial Statements

Recognition is the process of incorporating an item in the balance sheet or income statement . . . It involves

depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sh

income statement totals.

•

Probability1.Measurability2.

Two tests for recognition•

Recognition Criteria

(a) it is probable that any future economic benefit associated with the item will flow to or from t

entity

an element should be recognized if -

Probability criteria is met if ‘the event if more likely than not to occur’.-

Probability

an element should be recognized if -

Reliable Measurement

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(b) the item has a cost or value that can be measured with reliability.

Estimation is acceptable-

Either a cost or a value-

Improve the practice of accounting and to provide a basis for answers to specific accounting questions

problems.

-

By providing a basis and guidance for those who set the specific accounting rules.-

By helping individuals involved in preparing or auditing or using financial statements.-

It is stated that the Conceptual Framework does this in two ways:-

Technical Benefits

Prevent political interference in setting accounting standards.-

Accounting information has significant real-world affects-

Political Benefits

Protect the professional status of accounting and accountants.-

Professional Benefits

The Benefits Of A Conceptual Framework

The principles are too vague-

Too much room for alternative interpretations.-

It is ambiguous1.

The Conceptual Framework simply describes current accounting practise.-

Should be prescriptive (normative) and try to improve practice.-

It is descriptive not prescriptive2.

The concept of faithful representation is inappropriate3.

Financial statements . . . Are representationally faithful to the extent that they provide an objective pi

of an entity’s resources and obligations

Realist view:4.

Although the underlying events and transactions do exist the accounting measures that are reported a

created by accountants and do not exist independently of them.

Materialist view:5.

Problems & Criticisms Of The Conceptual Framework

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Rules-based standards are sets of detailed rules that must be followed when preparing financial statements.

Rules-based Versus Principles-based Standards

The focus is on the economic substance of a transaction, engaging the professional judgement and expert

those preparing financial statements.

-

Principles-based standards are based on a conceptual framework that provides a broad basis for accountants to

Rules-based standards can be very complex.○

Organisations can structure transactions to circumvent unfavourable reporting.○

Standards are likely to be incomplete or even obsolete by the time they are issued.○

Manipulated compliance with rules makes auditing more difficult.○

Disadvantages of Rules-Based Standards

Principles-based standards are simpler.○

They supply broad guidelines that can be applied to many situations.○

They improve the representational faithfulness of financial statements.○

They allow accountants to use their professional judgement.○

Evidence suggests that managers are less likely to attempt earnings management.○

Advantages of Principles-Based Standards

Managers may select treatments that do not reflect the underlying economic substance.○

The judgement and choice involved in many of the decisions mean that comparability among financial

statements may be reduced.

○

Disadvantages of Principles-Based Standards

Accounting information is a ‘public good’•

Therefore some argue it is likely to be under produced without regulation•

Others suggest supply would exist without regulation•There are competing theories regarding the need for and intention of regulation•

Theories Of Regulation

“Regulation is the policing, according to a rule, of a subject’s choice of activity, by an entity not directly party to

involved in the activity.”

Intention to intervene○

Restriction on choice to achieve certain goals○

Exercise of control by a party independent of those directly involved in the activity.○

Elements of regulation

Companies face a competitive capital market populated by sophisticated investors.

Above-average entities motivated to show that they are better than non-reporting entities.

Non-reporting entities are perceived as of even poorer quality than before.

Creates a virtuous cycle where regulation is not necessary

Suggests reporting entities can increase their value through financial reporting.○

Signalling Theory

Argues signalling theory relies on the function of a perfect, free-market economy.○

Economic markets are generally not perfect.

Regulation is virtually costless.

Public interest theory assumes:○

Public Interest Theory

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Concludes that regulation is supplied in response to the demands of the public for the correction of these

inefficient or inequitable market practices.

○

People are rational utility maximisers.

The coercive power of government can be used to give valuable benefits to particular groups.

Regulation can be viewed as a product that is governed by the laws of supply and demand.

Capture theory holds that regulation is supplied in response to the demands of self-interested groups tryi

maximise the incomes or interests of their members.

○

Capture Theory

Regulations tend to arise from crises.

Resulting rules do not necessarily deal with the issues that caused the crisis.

Rather they gain media exposure so that politicians are more likely to gain re-election.

Bushfire theory highlights the political and public nature of regulatory influences by attempting to take int

account the reactions of users, and society in general, to ‘failures’ of regulatory processes.

○

‘Bushfire’ Theory

Lobbying is viewed as a mechanism through which regulators are informed about policy issues.

the political ideologies of the regulators, and□

the impact of special interest lobby groups.□

Predicts that the effectiveness of regulation will depend on

Ideology theory of regulation relies on market failure but introduces the role of lobbying in influencing the

actions of regulators.

○

Ideology Theory of Regulation

Increased efficiency in allocating capital.○

Cheaper production.○

Check on perquisites.○

Public confidence.○

Standardisation.○

Public good.○

Advantages of Regulation

Difficult to achieve efficiency and equity.○

Determining the optimal quantity of information is problematic.○

Regulation is difficult to reverse.○

Communication is restricted.○

Reporting entities are different.○

There is lobbying.○

Monopolisation of accounting standards.○

Disadvantages of Regulation

There are few accounting studies which apply regulatory theories to standards setting.•

The majority of such studies support a version of regulatory capture.•

‘the shift of accounting regulation to the private IASB has been caused by the sheer dominance of a highly

organized financial sector . . . [whose] actors are the best connected and most represented in the standar

setting network’

Theory And Accounting Regulation Research

There is a mix of private and public participation in the standard setting process.•

Internal stakeholders may like flexibility○

External stakeholders may like comparability○

Parties that have an interest in accounting standards often have conflicting interests. E.g.•

Political Nature Of Setting Accounting Standards

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Auditors like objective (auditable) reporting○

Those affected by accounting standards have an incentive to lobby standard setters to achieve a favourab

outcome.

○

Whether they should lobby.

Which method of lobbying they should use.

When they should lobby.

What arguments they should use to support their position.

Those affected must decide:○

Lobbying

Highly motivated and resourced

Industry and Management○

Disparate interests, few resources

Casual non-professional users○

Secretive and non-responsive

Full-time professional users○

Accused of self-interest

Auditors○

Strangely quietAcademics○

Lobby Groups

G100○

Large accounting firms○

Professional accounting bodies○

ASX○

Major banks○

Lobby Groups in Australia

International Accounting Standards Board○

European Union○Asian-Oceanian Standard-Setters Group○

G20○

International Organisation of Securities Commissions○

FASB○

International Lobby Groups

One of the functions of the AASB is to participate in and contribute to the development of a single set of

worldwide accounting standards.

○

International comparabilityi.

Reduced cost of capitalii.

Reduced conflicting reporting requirementsiii.

Three main benefits have been identified○

Harmonisation

Various methods of implementation leads to inconsistencies○

Listed entities underestimated the complexities, effects and cost of IFRSs○

Compromise leads to diversity○

Problems with Harmonisation

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MEASUREMENT is the process of determining the monetary amounts at which the elements of the financia

statements are to be recognized and carried in the balance sheet and income statement.

Conceptual framework definition:•

May involve calculation, estimation, and/or apportionment.•

Impacts quality and therefore usefulness•

Makes financial statements decision useful - gives meaning to the items included1.

Allows users of accounting information to:

Assess an entity’s financial performance and position2.

Compare the entity’s performance and position over time.3.

Compare entities4.

Benefits of Measurement•

Measurement In Accounting

Little or no agreement on what measures should be used.1.

The inherent flexibility and the nature of a mixed measurement approach reduces comparability.2. Measurement can be quite subjective.3.

With flexibility comes opportunistic accounting choices.4.

The current approach results in the additivity problem.5.

Limitations of Measurement•

The Conceptual Framework does not provide guidance as to which measurement bases should be used○

In reality a range of bases are used○

Historic cost remains dominant○

Steady shift towards fair value○

Measurement Approaches And Accounting Standards•

Assets are recorded at the amount of cash or cash equivalents paid or the fair value of consideration givenacquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in

exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash

cash equivalents expected to be paid to satisfy the liability in the normal course of business.

○

Historical Cost

Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an

equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash

equivalents that would be required to settle the obligation currently.

○

Current Cost Replacement Cost

Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the

in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts oor cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

○

Fair Value Realizable or Settlement Value

Assets are carried at the present discounted value of the future net cash inflows that the item is expected

generate in the normal course of business. Liabilities are carried at the present discounted value of the fut

cash out flows that are expected to be required to settle liabilities in the normal course of business.

○

Present Value

Essentially the loss that would be suffered if an entity was deprived of the asset.○

Determination of the deprival value of an asset may incorporate:○

Deprival Value

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present value if the item was held for use-

net realizable value if the item was held for sale-

replacement cost associated with replacing the item or the services that were received from the item-

different measurement bases are employed to different degrees and in varying combinations during the

preparation of the financial statements.

○

IASBs use a mixed measurement model•

This leaves a large amount of flexibility and choice within particular standards•

Measurement and International Accounting Standards

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Future Directions on Measurement

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Measurement is an important part of the IASB Conceptual Framework Project•

Actual or estimated current prices○

Actual past entry prices with adjustment○

Prescribed computations or calculations based on discounted or undiscounted estimates of future cash flo○

Approaches tentatively considered:•

What will provide the most decision useful information-

Potential users of the financial statements○

Is it possible to calculate-

Cost versus benefit-

Practical considerations○

Short-term versus long-term-

Impact on incentives-

Reputational impact-

Managements motivations and objectives○

Significant influences include:•

Relevance○

Faithful Representation○

Understandability○Comparability○

Verifiability○

Measurement choices impact include:•

Decision criteria and influences on choice of measurement approach

Relevance Faithful Representation Understandability Comparability

Historic Cost Low:

especially as time passes

High:

measures an objective

transaction

High:

concept well known

& understood

Medium:

purchasing power o

money changes

Current Cost High:

indicative of future

potential

High:

determined by

reference to actual cost

Low:

can be subjective,

depends

Medium:

can be subjective,

depends

Present Value High:

indicative of future

potential

Low:

can be very subjective

Medium:

assumptions used

can be complex

Medium:

involves many differ

assumptions

Deprival Value Low:

not related to business

care

Low:

can be very subjective

Low:

assumptions used

can be complex

Low:

Involves many differ

assumptions

PRO Fair Value Focuses on future

potential

Determined using

objective market prices

Simply

representation of

current market value

Focus on market va

not individual entity

CON Fair Value Hypothetical and not

relevant to specific entity

If no objective market

prices then highlysubjective

Often based on

complex assumptionsand calculation

Different models lea

to very different res

There appears to have been a distinct move from historical cost to fair value accounting.•

Market Approach○

Cost Approach○

Income Approach○

Valuation Methods•

Users have different and sometimes conflicting needs when it comes to accounting information.•

Stakeholders And The Political Nature Of Accounting Measurement

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What do users really need to know?○

How do users influence the measurement approach?○

The impact and relevance of measurement to investors and other users of the financial statements is obvious.•

Concerned with the risk inherent in, and the return provided by, their investments.•

Assists them in deciding whether to buy, hold, or sell their shares.○

Enables them to assess the entity’s ability to pay dividends.○

They want accounting information that:•

Fair Value?○

Therefore need forward looking information•

Existing and Potential Investors

Interested in information that enables them to determine whether amounts owing to them will be paid when du•

Liabilities it has compared to its assets.○

Particularly interested in the entity’s net position•

Fair value would seem to be the most useful approach, assuming that items can be reliably measured.•

Creditors/Lenders

Different interest groups may favour different accounting measurement approaches.•

May have made economic crisis worse-

May not be reliable-

May have hidden problems-

May be difficult to regulate-

Fair value has been particular focus during the GFC.•

The Political Nature of Accounting Measurement

Tension between flexibility and potential to mislead-

Inappropriate choices of method.•

Tradition has led to difference-

Variability in practice•

Subjectivity involved•

Short/long term impact on profit-Impact of measurement on organisation•

Why Measurement Is A Controversial Accounting Issue

What needs to be measured and accounted for?-

How can the discretion and subjectivity associated with the estimation of values be managed?-

What are the consequences associated with accounting for social and environmental aspects of the entity?-

Green assets and other sustainability issues•

Complexity and variation exists in terms of how intangible assets are measured on recognition-

Intangible Assets•

Water accounting standards are being developed in several countries, with no single body taking responsib

for international standards

-

Wide range of stakeholders-

How should value be determined-

Water quality and recognition-

Measurement and Valuation-

Water is a limited natural resource which needs to be managed, measured and reported.-

Water Assets•

Current Measurement Challenges

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Theories guide many activities•

Decisions of financial report prepares○

Actions of financial report users○

Influences of organisational environment○

Potentially better measurement and reporting○

Accounting theories help us understand•

Accounting is a human activity•

What Value Does Theory Offer?

Recommend what should happen-

Prescribe action to achieve specific objectives-

E.g. The Conceptual Framework-

Normative Theories

Describes, explains or predicts activities-

Help us understand what happens in the world-

E.g. Agency theory-

Positive Theories

Types Of Theories

Used to explain and predict accounting practice.•

suppliers of equity capital (owners),-

managerial labour (management)-

debt capital (lenders or debt holders)-

It examines a range of relationships between the entity and•

based on the ‘rational economic person’ assumption•

Positive Accounting Theory

Suggests that the organisation is characterised as a legal ‘nexus of contracts’.-

With contracting parties having rights and responsibilities under these contracts.-

managerial contracts, and

debt contracts,

Positive accounting theory focuses on-

These are agency contracts used to manage relationships where there is a separation between manage

and capital providers.

-

Contracting Theory

Used to understand relationships whereby a principal employs the services of, and delegates the decis

making authority to, an agent. Fiduciary relationship, trust and confidence.

-

Creates a moral hazard.-

Monitoring costs, as how principal measure and observe the behaviour of the agenti.

Bonding costs, as cost of monitoring would eventually be charged against the agent in the disgu

low remuneration.

ii.

Residual loss, at the end, it is hard or too costly to determine whether the agent will push for th

interest of the principal

iii.

Leads to 3 ‘costs’-

Agency Theory

Agency theory identifies a number of problems that can exist between managers and owners.-

Contracts and accounting information can be used to ‘bond’ the interests of owners and managers.-

Owner –Manager Agency Relationships

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Horizon problem, where stockholders may have different interest from the managementi.

Risk aversion as management might prefer conservative operation to minimize losses while

stockholders might want aggressive operation to have a better return for their investment

ii.

Dividend retention, management may wish for less percentage of income to be declared as divid

while stockholders wishes for the opposite.

iii.

Addresses 3 specific problems-

Excessive dividend payments may result to default payment of debts

Underinvestment

Asset substitution, commitment of asset as collateral may hinder operation and growth

Claim dilution

When a lender agrees to provide funds to an entity there is the risk that the lending party may not repthose funds.

-

To avoid higher interest costs managers have incentives to show they are acting in a way that is not

detrimental to lenders.

-

Manager –Lender Agency Relationships

Accounting information forms one of the major components of both manager remuneration and lendi

contracts.

-

To write the terms of managerial contracts.i.

To determine performance against the terms of the contracts and consequently the amount of b

and other pay components managers will receive.

ii.

For managers accounting information plays two roles in the contracting process:-

Lenders look to regular financial updates to ensure companies are maintaining the terms of their coven-

Role of Accounting Information in Reducing Agency Problems

Results from managers having more information about the current and future prospects of the entity t

outsiders.

-

Managers can choose when and how to disseminate this information.-

Under positive accounting theory there are incentives to disclose most news, good or bad, to the mark-

Information Asymmetry

Comes from management literature.-

It considers how rules, norms and routines become established as authoritative guidelines, and consid

how these elements are created, adopted and adapted over time.

-

Practices within organisations can be predicted from perceptions of legitimate behaviour derived from

cultural values, industry tradition, entity value etc

-

Institutional Theory

Comparison of Agency and Institutional Theories

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Relates to the explicit and implicit expectations society has about how businesses should act to e

they survive into the future.

Organisations need to show they are operating in accordance with the expectations in the social

contract.

Based on the idea of a social contract-

The values and norm evident in the social contract have changed over time.

In the past legitimacy was considered only in terms of economic performance.

Now businesses are now expected to consider a range of issues, including the environmental an

consequences of their activities.

Organisational legitimacy-

Seek to educate and inform society about actual changes in the organisation’s performanc

activities

1)

Seek to change the perceptions of society, but not actually change behaviour2)

Seek to manipulate perception by deflecting attention from the issue of concern to other rissues

3)

Seek to change expectations of its performance.4)

Lindblom identifies four ways an organisation can obtain or maintain legitimacy:

An entity might provide information to offset negative news which may be publicly availab□

An organisation may draw attention to strengths.□

Disclosure of information about an organisation’s effect on, or relationship with society can be u

each of the strategies.

Public reporting through the annual report or the entity website can be a powerful tool in showi

organisation is meeting the expectations of society.

Accounting Disclosures and Legitimation-

Legitimacy Theory

Considers the relationships that exist between the organisation and its various stakeholders.-

Stakeholders are ‘any group or individual who can affect or is affected by the achievements of an

organisation’s objectives’-

a normative theory, known as the ‘ethical branch’,

an empirical theory of management, which is a positive theory

There are two versions of stakeholder theory-

Argues that organisations should treat all their stakeholders fairly.

An organisation should be managed for the benefit of all its’ stakeholders.

Stakeholders are identified, and should be considered in organisational decisions because of the

interest in the activities of the organisation.

Normative Branch of Stakeholder Theory

Seeks to explain how stakeholders influence organisational actions.

The extent to which an organisation will consider its stakeholders is related to the power or influ

of those stakeholders.

A stakeholders’ power is related to the degree of control they have over resources required by t

organisation.

Managerial Branch of Stakeholder Theory

Stakeholder Theory

One important way of meeting stakeholders’ needs and expectations is providing information ab

organisational activities and performance.

Role of Accounting Information in Stakeholder Theory

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Stakeholder theory has been used to examine disclosure of voluntary information to stakeholde

most commonly relating to social and environmental performance.

Proposes that organisations are all affected by a range of factors that differ across organisations.○

External environment.

Organisational size.

Business strategy.

Organisations need to adapt their structure to take into account a range of factors such as○

They conclude that

There is no universally appropriate accounting system that can be applied to all organisations.

Features of appropriate accounting systems are contingent upon the specific circumstances the

organisation faces.

Contingency frameworks have been used to evaluate management accounting information and interna

control systems.

○

Contingency Theory

Accountants use judgement to make a range of accounting decisions on a daily basis.•

Whether to expense or capitalise costs.-

What accounting estimates to use.-

What, where and how to disclose information.-

Examples include:•

Theories offer some assistance in explaining managers’ and accountants’ decisions.•

Using Theories To Understand Accounting Decisions

Managers on compensation contracts which have bonuses tied to a current measure of entity perform-

Entities with lending agreements with a leverage covenant,-

Agency theory would hold that•

would prefer to capitalise costs.•

Institutional theory would explain the influence of external norms on managerial compensation policy.•

Expensing and Capitalising Costs

Managers and accountants, acting in self interest, are likely to ensure their own bonuses are maximise

the entity is not at risk of breaching debt contracts.

-

Agency contracts can explain managerial decisions in this regard.•

Legitimacy and stakeholder theory suggest there are times entities, for political reasons, will actively reduce

reported profits.

•

Accounting Estimates

Disclosure policy relates to additional disclosure within the annual report or media releases.•

Stakeholder theory would explain these disclosures in terms of providing relevant information to maintain

relationships with powerful stakeholders.

•

Legitimacy theory sees voluntary disclosure as a way of maintaining or regaining legitimacy by demonstratin

the entity is meeting societal expectations.

•

Disclosure Policy

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‘a circumscribed area of economic activities whose financial information has the potential to be useful to existi

potential equity investors, lenders, and other creditors who cannot directly obtain the information they need in

making decision about providing resources to the entity and in assessing whether management and the governi

board of that entity have made efficient and effective use of the resources provided’.

Identification Of The Reporting Entity

International accounting standards require financial reports to be presented at least annually.•

In many countries, listed companies are required to produce interim financial accounts.•

Real-time reporting opens up the possibility of non-standardised reporting periods.•

When Information Is Reported

It allows investors to compare and evaluate managements of different reporting entities.1.

The requirement for dividends makes it necessary to close the books and calculate profits to declare a dividend.2.

Various company acts require entities to produce annual financial statements.3.

Accounts also are a control mechanism and this requires standardisation of the reporting period.4.

Arguments for Standardisation of Reporting Periods

Any standardised period cuts across many uncompleted transactions and therefore requires arbitrary apportion1.

Better to focus on natural earnings cycle of business.2.

Reduce short term earnings management.3.

Arguments for a More Flexible Approach to Reporting Periods

Not mandated by IASB•

Required by Australian law for some entities•

Condensed balance sheet○

Condensed income statement○

Condensed statement of changes in equity○

Condensed statement of cash flows○

Selected explanatory notes○

Comparative information○

Covered by AASB134 and must include:•

Interim Reporting

Use of management’s discretion to make accounting choices or to design transactions to affect the possibilities

wealth transfer between the company and society (political costs), funds providers (cost of capital) or managers

(compensation plans).

•

Ongoing and serious concern•

Earnings Management•

Fraud•

Why does management manipulate the accounts?•to influence wealth transfers among the various stakeholders. Including•

Management, controlling shareholders, other shareholders and potential shareholders.•

Why are accounts open to manipulation?•

Information asymmetry•

Bottom-line profit is the most widely used indicator of performance.○

Usually based on the timing differences that arise between accrual and cash accounting.

Can be earnings managed.○

Often managed to meet analysts’ forecasts.’○

Earnings Management

Alleged Manipulation Of Reported Earnings

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‘Good’ versus ‘bad’ earnings management.○

Called ‘taking a bath’.□

Above-normal profits are artificially reduced by certain provisions.

These provisions are called upon inflate below- normal profits.

Management artificially manipulates earnings to produce a steadily growing profit stream.○

Allows managers to increase remuneration.○

Also can be politically beneficial.○

Income Smoothing

The company has not operated for a full year.

There is a significant accounting policy change.

Exclude one-time or unusual items.

Pro forma results are primarily used to show ‘as though’ results. Often used when○

Firms are more likely to use them when their share price and earnings decline in order to meet analy

expectations and to downplay bad earnings news.

Critics claim they are incomplete, inaccurate and misleading.○

Pro Forma Reports: Massaging Earnings

Accounting regulations may result in inaccurate reporting.○

Voluntary disclosure can be used to fill the void between what can be reported within accounting rules and

drivers of value generation within firms.

○

Exclusion Of Activities From The Financial Reporting Process

‘As much of two-thirds or three-fourths of the real value of the company is based on intangibles, and

investors are not getting the information they need to make decisions’.

Traditional accounting systems are not able to provide good information about corporate intangible assets○

This is seen to be the reason the book value of corporations has been shrinking in relation to market value○

AASB138/IAS38 specifically prohibits the recognition of brands, mastheads, publishing titles, customer lists

expenditure on research, training, advertising and start-up activities.

○

Once recognised revaluations are restricted to those intangibles for which there is an active market.○

Intangibles

Capital created by employees or purchased, such as patents, computer and administrative systems,

concepts, models research and development.

relationships with customers and suppliers that consist of brand names, trademarks and the like

capital embedded in employees, such as through education, training, values and experience.

Refers to○

Only intellectual capital that has been purchased will be recognised in the financial statements○

Knowledge organisations’ assets are their employees because of the increasing tendency for technology to

embodied in intellectual property and labour.

○

The rate of return to intellectual capital investment can be determined only through an analysis involving o

expenditure data.

○

Intellectual Capital

The annual report contains both mandated financial statements and voluntary disclosure.○

Information outside the financial statements is not audited.○

The annual report can be used as a marketing tool as well as a conveyor of a particular organisational imag

its readers.

○

Narrative voluntary disclosures in annual reports used to report activities excluded by accounting standar

from the financial statements.

○

Impression management used to improve corporate image.○

Can be biased, even misleading.○

Voluntary Disclosures

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Using websites, message boards and blogs.○

Both financial and non-financial information is disclosed on reporting entities’ websites.○

Only some, or none, of this may be audited.○

Boundaries of reports should be clear.

Content of should be the same as the paper-based reports.

Reports should be complete, clearly dated and timely.

Information should be user friendly and downloadable.

Information should be secured to ensure reliability.

The IASB has developed a code of conduct for Internet reporting.○

Extensible Business Reporting Language (XBRL)○

It standardises presentation.

It makes possible continuous disclosure by reporting entities.

It offers cost savings.

It improves efficiency, accuracy and reliability.

XBRL is a language for electronic communication of financial data.○

Electronic Reporting

Mandated accounting information is constrained.•

Definition of users is limited.•

Organisations require and desire broad support.• They have multiple responsibilities.•

Variety of information is necessary to satisfy and inform range of stakeholders.•

Why Entities Voluntarily Disclose

To comply with legal requirements1.

Because of economic rationality arguments2.

Because of accountability to stakeholders3.

Because of borrowing requirements4.

To comply with community expectations5.

To ward off threats to organisational legitimacy6.

To manage powerful stakeholders7.

To forestall regulations8.To comply with industry requirements9.

To win reporting awards10.

Management Motivation to Disclose

Views corporations, through their management, as reacting to the concerns of external parties.○

Accountability involves monitoring, evaluation, and control of organisational agents○

Accountability focuses upon the relationship between the corporation and users of its annual reports.○

Accountability Theory•

The annual report is a tool with which management signals its reactions to the concerns of particular

stakeholders.

○

Successful legitimation depends on reporting entities convincing society that a congruency of actions and v

exists.

○

Legitimacy Theory•

Management stakeholders about entity activities through means such as the annual report○

Stakeholder theory•

Research into Annual Reports

Accnt Theory

Documents

Transcript of Accnt Theory