Welcome to ACC3116: Financial Accounting TheoryWelcome to ACC3116: Financial Accounting Theory

Unit Leader - Julie CotterUnit Leader - Julie Cotter

Room - L106Room - L106

Phone - 4631 2916Phone - 4631 2916

Email - cotter@usq.edu.auEmail - cotter@usq.edu.au

Home page - www.usq.edu.au/users/cotterHome page - www.usq.edu.au/users/cotter

TutorialsTutorials

Tutorial times are:Tutorial times are: TuesdayTuesday 11 – 111 – 1 K303K303 WednesdayWednesday 2 – 4 2 – 4 K308K308

Consultation times are:Consultation times are: MondayMonday 1 – 31 – 3 WednesdayWednesday 1 – 2 & 4 - 51 – 2 & 4 - 5 FridayFriday 3 – 5 3 – 5

AssessmentAssessment

Assignment 1Assignment 1 10%10% Due 20 AugustDue 20 August Assignment 2 10%Assignment 2 10% Due 20 SeptemberDue 20 September Exam 80%Exam 80%

Restricted - Translation dictionary onlyRestricted - Translation dictionary only

Module 1Module 1

Introduction to Financial Introduction to Financial Reporting DecisionsReporting Decisions

Lecture Overview

DefinitionDefinition of financial reporting (1. of financial reporting (1.11))Financial reporting decisions (1.Financial reporting decisions (1.22))The fundamental problem of The fundamental problem of financial financial

reportingreporting (1. (1.3 & 1.43 & 1.4))Overview remainder of unitOverview remainder of unit

Definition of Financial ReportingDefinition of Financial Reporting

Forms of AccountingForms of Accounting

In your degree you have studied In your degree you have studied bookkeepingbookkeeping management accountingmanagement accounting financial reporting (fin acct, comp acct, law of financial reporting (fin acct, comp acct, law of

assoc)assoc) Accounting adapts to the size and form of Accounting adapts to the size and form of

organisationorganisation

SummaryForms of Accounting

SummaryForms of Accounting

Form of AccForm of Accounounttinging is a function of is a function of separation of ownership and control (linked to size)separation of ownership and control (linked to size) diffusion of ownershipdiffusion of ownership

Small business (centralised), owner-managers = Small business (centralised), owner-managers = bookkeepingbookkeeping

Decentralised firm with tight ownership = mgmt acct Decentralised firm with tight ownership = mgmt acct + bookkeeping+ bookkeeping

Decentralised firm with diffuse ownership = financial Decentralised firm with diffuse ownership = financial reporting + mgmt acct + bookkeepingreporting + mgmt acct + bookkeeping

Scope of Financial ReportingScope of Financial Reporting

Financial reporting covers more than just Financial reporting covers more than just financial/company accounting (preparation of 3 financial/company accounting (preparation of 3 financial statements). Although this is an financial statements). Although this is an important part of it.important part of it.

Financial reporting also includes disclosures that Financial reporting also includes disclosures that are not contained in the financial statements are not contained in the financial statements

Examples of disclosuresExamples of disclosures Environmental disclosures, notes to the accounts Environmental disclosures, notes to the accounts

regarding the valuation of assets, press releasesregarding the valuation of assets, press releases

Financial Reporting =

Financial Accounting +

Disclosures

Financial Reporting =

Financial Accounting +

Disclosures

Financial AccountingFinancial Accounting

Profit = Cash from Operations (CFO) + accrualsProfit = Cash from Operations (CFO) + accruals Accountants and managers apply the accrual system to Accountants and managers apply the accrual system to

convert cash flows into profits/losses (earnings)convert cash flows into profits/losses (earnings) Examples of accrualsExamples of accruals

recognition of sales prior to receipt of cashrecognition of sales prior to receipt of cash depreciation and amortisation of non-current assetsdepreciation and amortisation of non-current assets

Reported profit depends on financial accounting decisionsReported profit depends on financial accounting decisions There is less discretion to manage CFO than accruals There is less discretion to manage CFO than accruals

(earnings management)(earnings management)

Financial Reporting DecisionsFinancial Reporting Decisions

Financial Reporting DecisionsFinancial Reporting Decisions

Financial reporting decisions relate to Financial reporting decisions relate to application of the accruals system (financial application of the accruals system (financial accounting) as well as disclosure related accounting) as well as disclosure related choiceschoices

Five types of financial reporting decisionsFive types of financial reporting decisions Expensing versus Capitalisation of CostsExpensing versus Capitalisation of Costs Accounting MethodsAccounting Methods Accounting EstimatesAccounting Estimates Disclosure versus RecognitionDisclosure versus Recognition Disclosure PolicyDisclosure Policy

Expensing versus CapitalisationExpensing versus Capitalisation

The treatment of an outlay as an expense or as an The treatment of an outlay as an expense or as an asset affects profit, equity, and assetsasset affects profit, equity, and assets

eg. a large repair / overhaul of a motor vehicleeg. a large repair / overhaul of a motor vehicle Dr Expense - it goes to net income, or Dr Expense - it goes to net income, or Dr Asset - it goes to net income over many years Dr Asset - it goes to net income over many years

as depreciationas depreciation Long term total profit over time is unaffected but the Long term total profit over time is unaffected but the

timing of profit recognition is affected, which affects timing of profit recognition is affected, which affects ability to pay dividends, impression of mgmt ability to pay dividends, impression of mgmt performance and other decisions made by stakeholdersperformance and other decisions made by stakeholders

Accounting Methods / PrinciplesAccounting Methods / Principles

There are many accounting standards There are many accounting standards which must be adhered to, however choices which must be adhered to, however choices are often allowedare often allowed

Eg. Depreciation involves acct policy Eg. Depreciation involves acct policy choicechoice straight line, reducing balance, units of straight line, reducing balance, units of

productionproduction

Accounting EstimatesAccounting Estimates

There are many acct estimatesThere are many acct estimates Bad debts, provisions for warranties, recoverable Bad debts, provisions for warranties, recoverable

amount test for AASB 1010, depreciationamount test for AASB 1010, depreciation Eg. Depreciation involvesEg. Depreciation involves

estimate of useful life, estimate of residual valueestimate of useful life, estimate of residual value Abuse of estimates can be controlled by auditors, Abuse of estimates can be controlled by auditors,

regulatory authoritiesregulatory authorities eg. Reserve bank has published concerns over current eg. Reserve bank has published concerns over current

levels of banks’ bad debt allowances levels of banks’ bad debt allowances not as visible as changes to accounting methodsnot as visible as changes to accounting methods

Disclosure versus RecognitionDisclosure versus Recognition

Recognition involves booking an item to the Recognition involves booking an item to the accounts, whereas disclosure does not affect the accounts, whereas disclosure does not affect the accountsaccounts

Example: an asset revaluationExample: an asset revaluation The firm can have land and buildings valued by an The firm can have land and buildings valued by an

independent valuerindependent valuer Its choices areIts choices are

Record a full or partial revaluation in the accountsRecord a full or partial revaluation in the accountsDisclose the asset values in the notesDisclose the asset values in the notesDo not disclose the information at allDo not disclose the information at all

Disclosure PolicyDisclosure Policy

Disclosure can includeDisclosure can include Good news - new investment projects, discoveriesGood news - new investment projects, discoveries Bad news - lossesBad news - losses

They can be madeThey can be made in the notes to the financial statementsin the notes to the financial statements in the ‘front end’ of the annual reportin the ‘front end’ of the annual report via press release or letters to shareholdersvia press release or letters to shareholders made to financial analysts in various forumsmade to financial analysts in various forums

Certain disclosures are required (eg. ASX), Others are Certain disclosures are required (eg. ASX), Others are voluntaryvoluntary

SummaryFinancial Reporting Decisions

SummaryFinancial Reporting Decisions

Financial reporting involves decision making Financial reporting involves decision making about application of the accruals process and about application of the accruals process and disclosuresdisclosures

Financial reporting decisions impact the Financial reporting decisions impact the information provided to users of financial reports - information provided to users of financial reports - this may impact on users decisionsthis may impact on users decisions

Important to understand determinants of financial Important to understand determinants of financial reporting decisions and expected impacts on reporting decisions and expected impacts on decisions of stakeholdersdecisions of stakeholders

The Fundamental Problem of Financial Reporting

The Fundamental Problem of Financial Reporting

Information AsymmetryInformation Asymmetry

Occurs when some parties to a business Occurs when some parties to a business transaction have an information advantagetransaction have an information advantage

Adverse selectionAdverse selectionone party has knowledge not possessed by the one party has knowledge not possessed by the

otherother Moral hazardMoral hazard

arises when some parties cannot observe all the arises when some parties cannot observe all the actions of the other parties to the transactionactions of the other parties to the transaction

Adverse SelectionAdverse Selection

Key Issue: managers have considerable Key Issue: managers have considerable inside informationinside information about past performance of the firm & its about past performance of the firm & its

future prospectsfuture prospects Solution : financial accounting and Solution : financial accounting and

reporting to make inside information reporting to make inside information available to stakeholdersavailable to stakeholders

Moral HazardMoral Hazard

Key Issue: motivating manager effortKey Issue: motivating manager effort difficult for owners to observe mgmt behaviourdifficult for owners to observe mgmt behaviour manager can shirk on effort or over consume manager can shirk on effort or over consume

perks of the jobperks of the job Solution: net income can be determined and Solution: net income can be determined and

utilised as an indicator of management utilised as an indicator of management performanceperformance

Summary:Information AsymmetrySummary:Information Asymmetry

Adverse selectionAdverse selection(Financial reporting to convert(Financial reporting to convert inside info to outside info.)inside info to outside info.)

Moral hazardMoral hazard(Accounting to monitor the(Accounting to monitor thebehaviour of managers)behaviour of managers)

What is the Fundamental Problem of Financial Accounting?What is the Fundamental Problem of Financial Accounting?

There are conflicting roles for accounting There are conflicting roles for accounting information to solve the problems of adverse information to solve the problems of adverse selection and moral hazardselection and moral hazard

ie. the best measure of net income to inform ie. the best measure of net income to inform investors (to control adverse selection) need not investors (to control adverse selection) need not be the same as the best measure to motivate be the same as the best measure to motivate managers (to control the problem of moral managers (to control the problem of moral hazard) hazard)

The Fundamental Problem of Financial Accounting TheoryThe Fundamental Problem of Financial Accounting Theory

Provision of relevantProvision of relevantinfo. to aid investorinfo. to aid investorDecision makingDecision making

Provision of reliableProvision of reliableinfo. to controlinfo. to controlmanagement behaviourmanagement behaviour

The Fundamental Problem of Financial Accounting TheoryThe Fundamental Problem of Financial Accounting Theory

How to reconcile the different roles for How to reconcile the different roles for accounting informationaccounting information

impacts onimpacts on asset valuationasset valuation income measurementincome measurement disclosure decisionsdisclosure decisions

What is the Solution?What is the Solution?

How do we reconcile these different roles for How do we reconcile these different roles for accounting informationaccounting information

solution 1: rely on market forcessolution 1: rely on market forces supply (managers) and demand (stakeholders)supply (managers) and demand (stakeholders) can market forces control the adverse selection and moral can market forces control the adverse selection and moral

hazard problems so thathazard problems so that investors are protected andinvestors are protected and markets work fairly and efficientlymarkets work fairly and efficiently

Solution 2: RegulationSolution 2: Regulation to protect investors - reliance on market forces has been to protect investors - reliance on market forces has been

rejected by our society (and in US, UK...)rejected by our society (and in US, UK...)

Historical Cost vs Present ValuesHistorical Cost vs Present Values

Present valuesPresent values involve estimation and involve estimation and compromisecompromise these estimates make the information subject to these estimates make the information subject to

wide degree of error and therefore unreliablewide degree of error and therefore unreliable Historical cost is also a compromise Historical cost is also a compromise

between relevance and reliabilitybetween relevance and reliability HC asset values lack relevance, but make up for HC asset values lack relevance, but make up for

it through increased reliabilityit through increased reliability

Historical Cost RevisitedHistorical Cost Revisited

HC model is not completely reliableHC model is not completely reliable IIt involves matching revenue and expense t involves matching revenue and expense

to determine a net income figure to determine a net income figure Accruals are subject to estimation problemsAccruals are subject to estimation problems

(earnings management)(earnings management)

Improving on Historical CostImproving on Historical Cost

Likely that HC will be with us for the Likely that HC will be with us for the foreseeable futureforeseeable future

use of PVuse of PVss is not is not always always practicalpractical we can observewe can observe

greater use of market values in some areasgreater use of market values in some areas greater amounts of disclosures in annul reportsgreater amounts of disclosures in annul reports

Overview of Remainder of UnitOverview of Remainder of Unit

Framework of the unitFramework of the unit

Some areas of financial reporting are regulatedSome areas of financial reporting are regulatedMod 2: current reg. environment / theories of Mod 2: current reg. environment / theories of

regulationregulation Much of financial reporting is unregulated, so we look Much of financial reporting is unregulated, so we look

at making financial reporting decisionsat making financial reporting decisionsMod 3: contracting determinants of financial Mod 3: contracting determinants of financial

reportingreportingMod 4: social determinants of financial Mod 4: social determinants of financial

reportingreportingMod 5: critique of theoriesMod 5: critique of theories

Framework of the unit (cont.)Framework of the unit (cont.)

We also look at the impact of financial reporting We also look at the impact of financial reporting decisionsdecisions

Mod 6: impacts on share priceMod 6: impacts on share priceMod 7: impacts on individual financial Mod 7: impacts on individual financial

statement usersstatement users We finish by looking at two financial reporting issuesWe finish by looking at two financial reporting issues

Mod 8: Asset measurementMod 8: Asset measurementMod 9: Environmental Performance ReportingMod 9: Environmental Performance Reporting

Purpose of the UnitPurpose of the Unit

ACC3116 is about theories which relate to ACC3116 is about theories which relate to financial accounting practicefinancial accounting practice

accountants do bookkeepingaccountants do bookkeeping apply technical skills (apply acct standards)apply technical skills (apply acct standards) exercise judgement / make decisionsexercise judgement / make decisions

Theoretical frameworks help us to make decisionsTheoretical frameworks help us to make decisions The unit is designed to The unit is designed to

Enhance your decision making skillsEnhance your decision making skills Improve your written communication skills and your Improve your written communication skills and your

critical thinking skillscritical thinking skills

For TutorialsFor Tutorials

Required reading Required reading Selected readingSelected readings s 1.11.1, 1.3, 1.4 & 1.5, 1.3, 1.4 & 1.5

(pages indicated in your study book)(pages indicated in your study book) Self assessment questionsSelf assessment questions

Questions 1 – Questions 1 – 6 6 from module 1from module 1 Answers in tutorialsAnswers in tutorials

Important - YOU ARE REQUIRED Important - YOU ARE REQUIRED TO READ FOR THIS SUBJECT!TO READ FOR THIS SUBJECT!