Chapters refer to the prescribed text: Rankin, M, Stanton, P, McGowan, S, Ferlauto, K & Tilling, M 2012, Contemporary issues in
accounting, John Wiley & Sons Australia.
2014
Advanced Accounting
Notes Unit 200267
University of Western Sydney
1
Advanced Accounting
Topic: Introduction to advanced accounting
Chapter 1
What is theory?
Theory helps explain a phenomena, a situation etc. It helps explain an opinion.
Positive theory - Describes - Explains - Predicts - Uses deductive reasoning
Normative theory - Suggests - Recommends - Uses inductive reasoning (this is the
type of reasoning accountants tend to use)
Why do we use theories in accounting?
In accounting we use theories for the following reasons:
1) To explain what is happening in the accounting practice
2) To describe what is happening in the accounting practice
3) To predict what may happen in the accounting practice
4) Recommend or suggest what should happen in the accounting practice
Positive theory explained
Positive research seeks to predict and explain particular phenomena. The associated
theories of positive research are positive accounting theories (PAT). Positive theories are
developed through some form of deductive logical reasoning. Thus, the explanation and
prediction of particular phenomena is assessed based on observation – that is observing
how the theory’s predictions correspond with the observed facts.
Normative theory explained
Normative theories prescribe particular actions. It is based on what the researcher believes
should occur in particular circumstances. As it is not based on observation it cannot be
evaluated on whether they reflect actual accounting practice. They may rather suggest
radical changes in the way things are done.
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Topic: The Conceptual Framework
Chapter 2
What is the Conceptual Framework (CF)?
The CF is a set of guidelines we use as accountants to prepare financial reports. The CF is a
normative theory, which is used to apply theory to practice. It consists of a coherent system
of concepts, which are guidelines to the accounting standards used for financial reporting.
Under paragraph 12 of the CF, talks about “helping users make useful decisions”, this is
known as the decision usefulness theory, which explains how it helps stakeholders make
decisions about organisations.
The CF as normative theory
The CF is a normative theory in that it seeks to guide individuals in selecting the most
appropriate accounting policies for given sets of circumstances. The CF is seen as a
normative theory in that it provides guidance on how assets, liabilities, expenses, income
and equity should be defined recognised and measured.
Difference between CF and Accounting Standards
Conceptual Framework - Designed to provide guidance and
apply to a wide range of decisions - Concerned with General Purpose
Financial Statements (GPFSs)
Accounting Standards - Specific requirements for a particular
area - May go beyond the CF - Are mandatory - Sometimes conflict with the
framework
Note: The CF is used as guidance for setting Accounting standards.
Structure and components of the CF
What is the purpose of financial statements? -Concerned with GPFS - prepare financial information useful to existing and potential investors, lenders and other creditors in making decisions. - FSs should provide information that:
Help predict the future
Provide feedback on previous decisions
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Accountability and stewardship
Who are they prepared for? - Existing and potential investors - Lenders - Other creditors
What assumptions are to be made when preparing financial statements?
- Normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future
What type of information should be included?
Fundamental qualitative characteristics: - Relevance - Faithful representation
Enhancing qualitative characteristics:
- Comparability - Verifiability - Timeliness - Understandability
What are the elements that make up financial statements?
- Assets - Liabilities - Equity - Income - Expenses
When should the elements of financial statements be included?
The elements should be included if they meet the two criteria below:
- Probability; and - Measurability
Pros and Cons of the CF
Benefits Problems and Criticisms
- Technical benefits:
Basis for setting accounting rules
Helps individuals prepare, audit or use FSs
- Political benefits:
Prevents political interference in setting accounting standards
- Professional benefits:
Protects the professional status of accounting and accountants
- Its ambiguous, principles can be too vague therefore leaving room for alternative interpretations
- Its descriptive not prescriptive - The concept of faithful
representation is inappropriate
Realist view: FSs are representationally faithful as long as they provide and objective picture of an entity’s resources
Social constructionist view: although the world is as it is, we as accountants information and therefore create reality.
True and fair view in accounting
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P 1.1: AASB 101 paragraph 15; tells us that FSs shall present fairly the financial
position performance and cash flow of the entity.
The Australian Corporations Law s297, 295 paragraph 3 part c; talks about faithful
representation
The CF: Qualitative Characteristics; faithful representation
What is the decision usefulness theory and why is it such an important theory?
The CF defines the objective of decision usefulness theory that financial information about
the reporting entity is useful to existing and potential investors, lenders and other creditors
in making decisions about providing resources to the entity.
This is an important theory in that it helps provide information useful to users in making
decisions. The decision usefulness theory helps us to predict what may happen in the future
although financial statements do not necessarily provide information in relation to the
future; they help users make predictions upon these. This theory also helps provide
feedback on previous decisions. Information in financial statements can help decide
whether past decisions were correct and the information used to make those decisions
where appropriate. Thus this helps users to assess whether better decisions can be made in
the future.
Topic: Measurement issues and the theory of decision usefulness
Chapter 4
Supporting evidence: Whittington Article
Why do we measure things?
To provide information for users to make decisions.
What theories link to measurement?
- Decision usefulness theory
- CF as a normative theory
What is measurement issues facing accountants?
There are a number of measurement challenges that accountants face especially when
accounting for social and environmental aspects of accounting. The three key issues
surrounding measurement in a social and environmental perspective:
- What needs to be measured and accounted for?
- How can 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.
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One of the most significant challenges is coping with measurement in the context of
accounting for green assets and other environmental and sustainability issues. Challenges lie
in the measurement issues and controversy surrounding how intangible assets are
accounted for. Challenge is how to measure and account for water as a limited natural
resource with a view to sustainability.
How can theories help us resolve these dilemmas?
Should our CF and standards allow choices of measurement methods?
How does this choice of measurement methods connect to ideas of decision usefulness?
The measurement methods used to produce accounting information impact on the quality
and thus usefulness of accounting information The decision usefulness theory is of
significance as financial statements produced containing good quality information will
enable users to make appropriate decisions in order to fulfil the decision useful objective.
However, poor quality information could potentially mislead users and lead them to make
inappropriate decisions. This in effect will give the impression that management has not
performed to the best of their abilities and have not managed the resources of the entity
effectively and efficiently. Therefore, it is crucial to provide information using measurement
methods that is both beneficial to users and accurately depicts the performance of
management.
How do we measure patents (i.e. intangible assets)?
Cost approach is the best valuation technique for patents. Intangible assets use estimation
valuations to measure them.
Topic: Measurement: The Fair Value debate
Chapter 10
Supporting evidence: L & L article 2009
Fair value vs historical cost
Main two types of measurement:
Fair value Historical cost
Advantage - Relevant (as it based on present
value)
Advantage - Comparable - Reliable (since asset price cannot be
changed)
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Disadvantage - Problems with reliability: as the
market changes - Involves subjectivity in tier 2 and 3 - Tier 1 does not always work because
of inefficient markets
Disadvantage - Problems with relevance
3 tiers of Fair value
Tier 1 Active market: use active market price
Tier 2 Adjust: if no active market then look at a similar assets to set price
Tier 3 Estimate: use calculator to put a value to that asset e.g. intangibles, biological assets etc.
Why is the fair value debate so important?
The fair value debate has become important as a result of the GFC. Standard setting has
moved increasingly towards the use of fair value. Current accounting standards allow a
range of measures – mixed measurement system and this is likely to change. It is important
to be aware of the strengths and weaknesses of fair value accounting (FVA) as the increased
adoption of FVA is likely to affect the future careers of accountants.
Arguments for and against fair value
FOR AGAINST
- Faithful representation – quoted market price set by forces outside the entity for tier 1
- Relevant – useful, how much we pay or receive for an item now is relevant to decision to buy or sell…timely
- Understandable – easy concept to grasp, amount to be received if item was sold. What the item is worth from a market perspective. However, not so easy for tier 2 and 3
- Comparable between entities, determined at the same point in time
- Ignores the going concern assumption – measures values as though the entity was intending to sell off all assets and liquidate
- value depends on circumstances e.g. current market conditions
- specialised assets – not bought and sold on an active market, unique with no value other to entities
- measured at current date – influenced by short term
- subjective – for items with no active market, we form an estimate of fair value
- market prices – represent expectations, expectations based on predictions, predictions may not be correct = volatility in market prices caused by market corrections
Fair value valuation techniques
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Market approach: based on the ability to identify a market for an identical or comparable
asset or liability.
Income approach: based on converting future cash flows or income and expense into a
single present value.
Cost approach: based on an estimate of the cost of replacing the ‘service capacity’ of the
asset under consideration. Known as the current replacement cost in accounting theory.
What is information asymmetry?
This is where managers possess more information about current and future prospects of an
entity than people external to the entity for example investors. Therefore, since managers
can choose when and how to communicate this information, this creates volatility in the
market.
PAT theory suggests that managers who have possession of this information, are given the
incentive to disclose this information in the form of good or bad news to the market, which
further supports the volatility of the market and impacts upon the decisions of external
stakeholders to entity in that it directly affects market speculations.
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Topic: Positive Accounting theory, Signalling theory and Earnings Management
Chapters: 5,6 and 8
Supporting evidence: Gaffikin 2007
Positive Accounting Theory (PAT)
- Based on the works of Watts and Zimmerman. It seeks to explain and predict why
managers choose certain accounting methods over others. (Rankin 2012, pg. 134). PAT is
derived from the agency theory and contracting theory.
Central to PAT is the acceptance of the rational economic person assumption, which
assumes that an accountant is primarily motivated by self-interest, which is premised on the
fact that the accountant is rewarded in terms of accounting based bonuses.
PAT has three hypotheses developed under the Agency theory:
Hypotheses Description
Bonus plan Aims to look better in front of investors. Manager in a firm with a bonus plan tied to report net income at higher levels therefore, this is achieved by choosing accounting methods that bring earnings forward (i.e. earlier recognition of gains)
Debt covenant Firms with a higher debt equity ratio (i.e. firm more reliant on debt), the manager is likely to choose accounting methods that increase net income where the firm is less likely to breach debt covenants.
Political cost Larger firms are associated with more political scrutiny, therefore; too much net income results in more government interference and regulation. So management adopts accounting policies that reduce reported net income.
Perspectives of PAT
Efficiency perspective Opportunistic perspective
Choosing accounting methods that best reflect underlying economic use.
Every manager is for himself or herself and acts in self interest and opportunistic behaviour.
Contracting theory: theory that organisations are characterised as a ‘legal nexus of
contracts’, with contracting parties having rights and responsibilities under these contracts
(Rankin 2012, pg. 135). Contracting is designed to reduce monitoring and bonding costs and
to reduce the resulting residual loss.
Agency theory: theory concerning the relationship between a principal and an agent of the
principal. Agency theory concentrates on two agency relationships: the relationships
between owners as principals and managers as their agents; and the contractual
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relationship between lenders as principals and managers acting on behalf of owners as
agents (Rankin 2012, pg. 135).
PAT criticisms normative theories
Since normative theory is not based on observation (under PAT observation based research
is deemed to be scientific research which is considered akin to ‘good’ research) but rather
on personal opinion about what should happen. In contrast, PAT theorists argue that they
do not impose their view on others; they merely provide information about the expected
implications or particular actions and let individuals decide for themselves as to what they
should do.
Normative theory criticisms of PAT
As PAT does not provide prescriptions, this decision could alienate accountants from their
counterparts in the profession, as a lack of prescription implies a conservative bias.
Normative theory also argues that PAT is value free, as it stresses that all human action is
driven by self-interest. This assumption is regarded as far too negative and simplistic
perspective of human actions, as researchers preferences and expected payoffs affect the
choice of topics, methods and choices of individuals. In this sense all research including
positive research is value laden.
Criticisms of PAT
- Only describes what is already happening. Doesn't suggest ways to improve
accounting practice to help in the real world.
- Cannot say that all individuals act in self-interest when there are various codes of
ethic and conduct accountants must follow and adhere to as members of
professional accounting bodies.
- Firms make more than one accounting policy choice throughout the financial year,
therefore it’s not possible to a research only one policy choice as different policy
choices offset each other creating a portfolio effect.
- By focusing on one goal or accounting policy choice at a time, you miss out on
interactions between goals and trade offs
Signalling theory
Signalling theory suggests that reporting entities can increase their value through financial
reporting. So when organisations disclose information about themselves to the public
because they want to tell something important. This theory provides that manager’s choices
reveal private information, making private information public. To be a signal there must be a
choice as choices signal credible information about expectations and the entity. The
diversity of reporting practices facilitates this role of reporting as a signal. Earnings
management (EM) can acts a vehicle for the release of inside information and act as a signal.
This characteristic of signalling theory gives entities the motivation to show that they are
better than non-reporting entities through the disclosure of financial statements. Thus, this
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theory is a self-regulating system, in which every entity has a reason to issue financial
statements to lower its cost of capital.
Earnings Management
Earnings management (EM) is the use of accounting discretion through choice of accounting
policy, with a specific objective regarding the level of reported earnings (i.e. to achieve a
desired level of earnings in a particular reporting period). EM takes advantage of timing
differences and brings revenue into year where it is needed and postpones expenses to
subsequent years.
EM comes with information asymmetry. It is an accounting tool. Within the law EM is
referred to as income smoothing and creative accounting. Outside the law it can constitute
fraud.
EM is linked to the decision usefulness theory in light of the opportunistic and efficiency
perspectives of EM. See supporting evidence from Signalling theory paper.
Good and Bad Earnings management
Good EM Bad EM
- Provides choice of accounting policy - Actions affect earnings - Communicates inside information
which acts as a vehicle to signal the market
- Smooths earnings- ensure future stability of the firm/political outcomes
- Efficient contracting- level of manager effort is depicted
- Credibility – market knows managers would be foolish to report higher earnings that cannot be sustained
- Confuses or does not disclose - Less decision useful info, earnings
power overstated - Encourages shirking and increases
asymmetry - Affects actions in real world and long
term objective - Opportunistic manager behaviour - Debt covenant constraints - Maximisation proceeds on share
issue - Motivations to manage earnings
Fraud and EM
- EM could lead managers to provide incorrect information on financial statements. Could
lead to the intentional misstatement or omission for example WorldCom – capitalisation vs
expenditure and Enron – inadequate disclosure obligations. There could also be intent to
deceive or mislead which as a result could lead to illegal actions to manipulate financial
statements to cover up illegal acts – embezzlement.
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Topic: Accounting regulation and standard setting
Chapter 3
What is regulation?
Regulation is the policing, according to a rule, of a subject’s choice of activity, by an entity
not directly party to or involved in the activity (Rankin 2012, pg. 70).
Elements of regulation:
- Intention to intervene
- Restriction on choice to achieve certain goals
- Exercise of control by a party independent of those directly involved in the activity.
The elements of regulation explain the objective of regulation and why regulation is needed.
Why is there a need for regulation?
The above elements of regulation are the prime reasons why regulation is needed.
Some form of regulation is necessary, as markets do not always operate effectively and in
the interests of society. Thus it can be said that the need for regulation arises from the
ideology of efficient markets and the need to maintain a competitive market environment in
order to avoid bureaucratic control in the form of monopolies (Gaffikin 2005, p4-5).
The need for regulation also arises due to information asymmetry, in that accounting
standards are created to address the problem of information inadequacies, which relates to
decision usefulness theory (Gaffikin 2005, pg 5).
Regulation is also necessary in the rationalisation and coordination of economic activity, so
as to organise behaviour or industries in an efficient manner. This also creates information
useful to users when making decisions.
Theories that support why regulation is needed
With regulation comes decision usefulness. Therefore, if we had no regulation then
accounting information wouldn't be useful.
Public interest theory: accounting information is seen as a public good, in which it assumes
that economic markets are not perfect and regulation is costless (Lecture 6, slide 11).
Under this theory, regulation is seen as achieving publicly desired goals and is provided in
response to the demand from the public to correct inefficient and inequitable markets,
which if left to the market alone would not be achieved (Gaffikin 2005, pg. 8).
As there is a mix of public and private participation in the standard setting process, parties
that have an interest in accounting standards often have conflicting interests, for example
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external stakeholders may prefer flexibility whereas external shareholders may prefer
comparability. On the other hand auditor may prefer objective reporting.
Private interest group theory: regulation is a product of lobbying. There is the assumption
that there are powerful groups in the accounting profession which influence how
accounting information is produced. Therefore we need regulation to minimise the risk of
such professional bodies from abusing their power while lobbying.
Under this theory, powerful groups affected by accounting standards have an incentive to
lobby standard setters to achieve favourable outcomes in their interests.
Many different lobby groups include:
- Industry and management; who are highly motivated and resourced
- Casual non-professional users: those who have disparate interests and few resources
- Full time professional users: secretive and non responsive
- Auditors: accused of self interest
- Academics:
Examples of lobby groups in Australia:
- G100
- Large accounting firms (ego Big Four)
- Professional accounting bodies (egg CPA, ICA)
- ASX
- Major banks (e.g. Westpac)
Capture theory: based on the assumption that powerful groups capture how regulation
works and use it for their self-interest. This theory assumes that self-interested groups aim
to maximise the incomes or interests of their members. This assumption is supported by the
idea that coercive government power can be used to give valuable benefits to particular
groups and that regulation can be viewed as a product that is governed by the laws of
supple and demand (Lecture 6, slide 12)
Bushfire theory: when there is a crisis in the market, standard setters step in to create new
standards or change standards to control the situation.
This theory highlights the political and public nature of regulatory influences by attempting
to take into account the reactions of users and society, to failures of regulatory processes
(Lecture 6, slide 13).
Refer to the GFC.
Theory that supports why there is no need for regulation
Signalling theory: suggests that reporting entities can increase their wealth through
financial reporting, which is affected by the information asymmetry of managers. Therefore,
firms face a competitive capital market populated by sophisticated investors. Above-average
13
entities are motivated to show that they are better performers than non-reporting entities.
Therefore, non-reporting entities are perceived as poorer quality then before (Lecture 6,
slide 10). This ultimately creates a virtues cycle where regulation is not necessary, as non-
reporting entities will produce information available to investors in order to stay
competitive. Therefore under the signalling regulation is not needed, as information supple
would still exist without regulation.
Advantages of regulation
- increased efficiency in allocating capital
- Cheaper production
- Check on prerequisites
- Public confidence
- Standardisation
- Public Good
Disadvantages 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
Rule based standards vs Principle based standards
Rule based standards: sets of detailed rules that must be followed when preparing financial
statements.
Disadvantages of rule based
- Can be very complex and stringent
- 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
Principle based standards: based on the CF that provides a broad basis for accountants to
follow. The focus is essentially on the economic substance of transaction, engaging the
professional judgment and expertise of those preparing financial statements.
Advantages of principle based
- They are simpler
- They supple broad guidelines that can be applied to many situations
14
- They improve faithful representation of financial statements
- They allow accountants to use professional judgment
- Evidence suggests that managers are less likely to attempt earnings management
Disadvantages of principle based
- Managers may select treatments that do not reflect the underlying economic
substance
- The judgment and choice involved in many of the decisions mean that comparability
among financial statements may be reduced.
Topic: Systems oriented theories:
Political economy
Legitimacy
Stakeholder
Institutional Chapter 5
Systems oriented theories help understand the behaviour and reporting of management,
specifically when it comes to sustainability reporting.
Political economic theory: accepts that society, politics, and economics are inseparable so that issues, such as economic issues, cannot be considered in isolation from social and environmental issues (Deegan & Blomquist 2006, p.8)
The perspective embraced is that society, politics and economies are inseparable, and
economic issues cannot meaningly be investigated in the absence of considerations about
the political, social and institutional framework in which the economic activity takes place.
Gurthrie and Parket (1990) states that corporate reports cannot be considered as neutral,
unbiased documents …., but rather are ‘a product of interchange between the corporation
and its environment and attempt to mediate and accommodate a variety of sectional
interests.’
Two Broad streams which Gray, Owen and Adams have labelled are:
Classical political economy Bourgeois political economy
– Karl Mars explicitly places “sectional (class) interests, structural conflict, inequity, and the role of the State at the heart of the analysis. Classical political economy tends to perceive accounting reports and disclosure as a means of maintaining the favoured positon of those who control scarce
– Gray, Kouhy and Lavers largely ignores these elements and, as a result, is content to perceive the world as essentially pluralistic. Bourgeois political economy does not explicitly consider structural conflicts and class struggles but rather ‘tends to be concerned with interaction between groups in an essentially pluralistic world.
15
resources (captial), and as a means of undermining the position of those without scarce capital. “It focuses on the structural conflicts within society”.
Stakeholder theory and legitimacy theory are grounded in the ‘bourgeois branch’ of political economy theory (Gray, Owen and Adams. 1996).
Legitimacy theory
Is based on the idea of social contract and links to the idea of influencing the perceptions of
stakeholders (Rankin 2012, p.124). Legitimacy Theory relies upon the notion that there is a
‘social contract’ between the organization in question and the society in which in operates.
The ‘Social contract’ is the concept used to represent the multitude of implicit and explicit
expectation that society has about how the organisation should conduct its operations.
A corporate entity wants to be seen as a legitimate corporate citizen; however this is not
always the case as legitimacy would be threatened.
Legitimacy Theory asserts that organizations continually seek to ensure that they operate
within the bounds and norms of their respective societies, that is, they attempt to ensure
that their activities are perceived by outside parties as being “legitimate”.
These bounds and norms are not considered to be fixed, but rather, change over time,
thereby requiring the organization to be responsive to the environment in which they
operate.
It is assumed that society allows the organisations to continue operations to the extent that
it generally meets their expectation. Legitimacy Theory emphasises that the organization
must appear to consider the rights of the public at large, not merely those of its investors.
Failure to comply with societal expectations may lead to sanctions being imposed by
society. For example, in the forms of legal restrictions imposed on its operation, and
reduced demand for its products.
Lindblom 1994 identifies four courses of action that an organisation can take to obtain or
maintain legitimacy as follows:
1. Seek to educate and inform its ‘relevant publics’ about changes in the organisations performance and activities;
2. Seek to change the perception of the “relevant publics”; 3. Seek to manipulate perception by deflecting attention from the issue of concern to
other related issues through an appeal to emotive symbols or; 4. Seek to change external expectation of its performance.
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Stakeholder theory
There are two branches of stakeholder theory, namely:
- Ethical (moral) or normative branch and; - Positive (managerial) branch.
Managerial perspective (positive theory) Ethical perspective (normative theory)
- Meet the information needs of powerful groups e.g. government, banks, professional bodies and employees etc.
The managerial branch of stakeholder theory perspectives attempt to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders. According to Gray, Owen and Adam, this perspective tends to be more ‘organization centred’. Within the stakeholder theory, the organisation is also considered to be part of the wider social system, but this perspective theory specifically considers the different stakeholder groups within society and how they should best be managed if the organisation is to survive. Freeman (1984) discusses the dynamics of stakeholder influence on corporate decisions. A major role of corporate management is to assess the importance of meeting shareholder demands in order to achieve the strategic objectives of the firm. According to Evan and Freeman (1988), the very purpose of the firm is, in our view, to serve as a vehicle for coordinating stakeholders. It is through the firm that each stakeholder group makes itself better off through voluntary exchanges. Within the managerial perspective of Stakeholder Theory, information is a major element that can be employed by the organization to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval. This is consistent with the
- Meet the information needs of a wide range of groups despite power e.g. local community, minority groups, customers, environmental groups and individual activists etc.
The moral (and normative) perspective of Stakeholder Theory argues that all stakeholders have the right to be treated fairly by an organization, and that issues of stakeholder power are not directly relevant. Clarkson (1995) sought to divide stakeholders into primary and secondary stakeholders. A primary stakeholder was defined as ‘one without whose continuing participation the corporation cannot survive as a going concern’. Secondary stakeholders were defined as ‘ those who influence or affect, or are influenced or affected by, the corporation, but they are not engaged in transactions with the corporation and are not essential for its survival. In considering the notion of rights to information, we can briefly consider Gray, Owen and Adam’s perspective of accountability as used within their accountability model. Gray, Owen and Adam defined accountability as: The duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible. It would involve two responsibilities or duties: 1 The responsibility to undertake certain
actions; and
17
strategies suggested by Lindblom (1994).
2 The responsibility to provide an account of those actions.
-
Institutional Theory
It considers how rules, norms and routines become established as authoritative
guidelines, and considers 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. (Lecture 7, slide 4).
Institutional theory attends to the deeper and more resilient aspects of social
structure. It considers the processes by which structures, including schemas; rules,
norms, and routines, become established as authoritative guidelines for social
behaviour. It inquires into how these elements are created, diffused, adopted, and
adapted over space and time; and how they fall into decline and disuse (Scott 2004,
p.2).
This theory focuses on the environmental factors experienced by an organization
such as “external or societal norms, rules, and requirements that organizations must
conform to, in order to receive legitimacy and support”. The institutional theory
depends, heavily, on the social constructs to help define the structure and processes
of an organization.
Topic: Reporting issues:
Intangible assets
Heritage assets
Capitalisation
Chapter 14
Background Accounting standards limit the reporting of many items that might otherwise be considered assets or liabilities. This can create a significant difference between a company’s book and market value. There is ongoing tension between the reporting of relevant and reliable information. Some people have suggested that the general problem of incomplete information shows that more information is better even if it is uncertain where relevance is key. However, accounting regulators are increasingly moving to prevent entities measuring and reporting internally generated intangible assets in which faithful representation is a key consideration. (Lecture 8, slide 4).
Accounting for intangible assets
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Accounting Standard AASB 138 Intangible Assets (that incorporates IAS 38 Intangible Assets) sets out the accounting requirements for intangible assets, including internally generated intangible assets. It requires that all research costs be expensed, while development costs are capitalised if they meet certain specified criteria. Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance are not recognised. This contrasts with accounting for intangible assets that are acquired in a business combination Topic: Critical perspectives/accounting in society. Reading: Reading 8 Deegan (2009).
Tutorial topic: What is critical theory? What are the wider implications of our choices as accountants and regulators of accounting on society as a whole? Are the philosophical underpinnings of accounting and accountants important? Key theories: Everything we’ve studied this semester plus critical theory.
“…in communicating reality, accountants simultaneously construct it”.
“Accounting is a social practice within political struggles and not merely a market practice
guided by equilibrium and an efficient market” (Ruth Hines, 1988)
What is critical theory?
Critical theory was first defined by Max Horkheimer as a social theory oriented toward
critiquing and changing society as a whole.
Critical theory acknowledges the role of power and political connection with accounting.
Gaffikin states that political systems in countries such as Australia are premised on a
capitalist order, in which accountants have been providing information to facilitate optimal
economic decision making in serving the interests of the providers of capital. Critical
theories challenge the assumptions inherent in capitalism since accounting's subservient
relationship to capitalism poses problems for accounting from a critical perspective.
Cooper and Hopper [1990] articulate that "critical accounting is critical of conventional
accounting theory and practice and, through critical social science theory, it seeks to explain
how the current state of accounting has come about". Critical accounting researchers that
an understanding of the significance of accounting and its development requires an
examination of its social context and development of theory needs to be considered open
and refutable (Gaffikin & Lodh 1991).
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Reading Article Summaries
Stakeholder Influence on Corporate Reporting: An Exploration of the
Interaction Between the World Wide Fund for Nature and the Australian Minerals Industry
by Craig Deegan and Christopher Blomquist
Introduction Two theoretical perspectives that have been used to explain corporate social and environmental reporting practice are stakeholder theory and legitimacy theory. Both stakeholder theory and legitimacy theory are derived from the broader political economy theory (Gray, Owen and Adams, 1996, p.48). Political economy theory, legitimacy theory and stakeholder theory may essentially be seen as broadly similar, as they are concerned with, the power of society to pressurise organisations into disclosure and the desire and ability of the organisation to use information (and particularly social and environmental accountability) to legitimate, to deflect criticism, and to control the debate being held in the wider community (Gray, Owen and Adams 1996, p.48). Legitimacy theory Legitimacy theory posits that organisations continually seek to ensure that they operate within the bounds and norms of their respective societies, that is, that they attempt to ensure that their activities are perceived by outside parties as being ‘legitimate’. Legitimacy theory relies upon the notion that there is a ‘social contract’ between the organisations in question, and the society in which it operates (Deegan & Blomquist 2006, p.9). The ‘social contract’ concept is used to represent the multitude of implicit and explicit expectations that society has about how the organisation should conduct its operations (Donaldson, 1982). This perspective assumes that society allows the organisation to continue operations to the extent that it generally meets their expectations. Legitimacy theory emphasises that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Failure to comply with societal expectations (that is, failure to comply with the terms of the ‘social contract’) are theoretically linked to sanctions being imposed by society, for example, in the form of legal restrictions imposed on its operations, limitations on resources (for example, financial capital and labour) being provided, and reduced demand for its products (Deegan & Blomquist 2006, p.9). Given the potential costs (sanctions) associated with conducting operations that are deemed to be outside the terms of the “social contract”, Dowling and Pfeffer (1975) state that organisations will take various actions to ensure their operations are perceived to be legitimate. One central action is public disclosure of information (referred to as the process of ‘communication’). As community expectations change, organisations must adapt and change, and importantly, such changes must be communicated.
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Stakeholder theory Within the managerial branch of stakeholder theory the organisation is considered to be part of the wider social system (as in legitimacy theory), but this perspective of stakeholder theory specifically considers the different stakeholder groups within society and how they should best be managed if the organisation is to survive (hence we call it a managerial perspective of stakeholder theory) (Deegan & Blomquist 2006, p.12). Like legitimacy theory, it is considered that the expectations of the various stakeholder groups will impact the operating and disclosure policies of the organisation. The organisation will not respond to all stakeholders equally (from a practical perspective, they probably cannot), but rather, will respond to those that are deemed to be ‘powerful’ where the most powerful stakeholders will be attended to first. (Deegan & Blomquist 2006, p.12) A stakeholder’s power to influence corporate management is viewed as a function of the stakeholder’s degree of control over resources required by the organisation (Ullmann, 1985). The more critical the stakeholder resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands will be addressed. A successful organisation is considered to be one that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups (Deegan & Blomquist 2006, p.12).
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Gaffikin Article 2007
Gaffikin, M, 2007, ‘Accounting research and theory: the age of neo-empiricism’, The
Australasian Accounting Business & Finance Journal, February 2007, vol. 1, no. 1, pp. 1-19.
Rational choice theory is fundamental to PAT, in that that is material self-interest is the basis
of all economic activity, which is also termed opportunistic behaviour. Thus self-interest is
suggested to be the reason for the choice of accounting methods, techniques and policy
decisions.
In PAT the firm is described in terms of a collection of contracts, which is explained by
contracting theory. This is where contracts are necessary in order to get self-interested
individuals to agree to cooperate within a firm, and get individual parties to act to maximise
the wealth of shareholders. Thus, PAT holds that firms will seek to minimise the contracting
costs and this will affect the policies adopted, including the accounting policies
There are three hypotheses around which PAT's predictions are organised, viz, the bonus
plan hypothesis, the debt covenant hypothesis and the political cost hypothesis.
Bonus plan hypothesis (page 9)
The bonus plan hypothesis suggests that managers of firms will be more likely to choose accounting procedures that shift reported earnings from future periods to the current period. To understand the need for this hypothesis it is necessary to note that one of the theories underlying positive accounting research is agency theory.
Agency Theory (page 9)
Agency theory extends traditional information economics by recognising that several forces
are at play in organisations that affect how it operates. For example, the notion of
information asymmetry is a problem that impacts on resource allocation issues. There is
information asymmetry when managers have greater information than investors. Agency
theorists believe there has to be incentives for managers to make additional voluntary
disclosures.
According to PAT both parties will act in their own self-interest which will not necessarily
coincide. The classic example of this sort of agency relationship is that between the
shareholders and the managers of a company. Shareholders will be interested in maximising
their wealth; the manager will want to maximise his or her rewards from managing the firm.
Debt covenant (page 10)
The debt covenant hypothesis in PAT is that, other things being equal, the closer a firm is to violating an accounting-based debt covenant, the more likely the owner-manager is to
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select accounting procedures that shift reported income from a future period to the present period. Any increase in current reported income would reduce the likelihood of a technical covenant default. Remember, however, that PAT assumes opportunistic behaviour, so covenants will usually include the basis on which such measures are made because often there are slight variations in how certain accounting measures are derived.
A complicating factor in the debt covenant hypothesis relates to who the managers are. If there is a separation of ownership and management then there is an extra agency relationship to be considered. Consequently, in research to test the hypothesis the case of the owner-manager has often been assumed so as to make it easier to understand why opportunistic behaviour occurs.
Political cost hypothesis (page 10-11)
The third PAT hypothesis is the political cost hypothesis. This suggest that, other things being equal, the greater the political costs faced by a firm, the more likely the mangers will choose accounting procedures that defer reported income from current to future periods. This hypothesis introduces the idea of political implications into accounting policy choice.
This hypothesis of PAT draws attention to the fact that not all policy decisions (including accounting) adopted by a firm will be based on purely economic considerations. When banks announce record profits there will be public pressure on the government to examine their customer charges. Petrol prices are very susceptible to public attention and in 2004 and 2005 the companies that were the leading profit companies (in countries around the world) were oil companies. It lead in some countries to special taxes being imposed on petroleum companies who then (in countries where it was legal, such as the USA) switched to LIFO inventory valuations, which would lead in turn to lower recorded profits and, therefore, lower taxes. Many firms because of their sheer size attract political attention from a variety of "public watchdogs".
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Laux & Leuz 2009
Laux, C & Leuz, C 2009, 'The crisis of fair-value accounting: making sense of the recent
debate', Accounting, Organisations & Society, vol. 34, no. 6-7, pp. 826-834.
Purpose:
- Discusses the potential impact FVA had on the GFC. - Four important issues are highlighted in the article: 1) Controversy about the use of FVA is a result of confusion about what is new and
different about FVA. 2) Concerns about FVA affecting the GFC. And the problems that apply to FVA as set
out by accounting standards 3) Historical cost accounting (HCA) is unlikely to be the remedy. 4) Implementation issues with FVA in practice
Issue 1: FVA what is it and what are the key arguments (pg 827)
- Fair value is defined under IFRS as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties, in an arm’s length transaction.
- Arguments for FVA: FV for assets or liabilities reflect current market conditions and provide timely information, which increases transparency and encourages prompt corrective actions (Laux & Leuz 2009, pg 827).
- Arguments against FVA: Controversy is in relation to whether FVA is helpful in providing transparency and whether it leads to undesirable actions especially on part of banks and firms. There is a claim that FV is not relevant and potentially misleading for assets that are held for long periods and that prices could be distorted by market inefficiencies, irrationality of investors and that FVs based on models (ie level 3 of the FV hierarchy are not reliable).
Issue 2: FVA and its affect on the GFC (pg 829)
- The primary concern about FVA in the business cycle is procyclical, in that it worsens
swings in the market, and may cause a downturn in financial markets.
- FVA can provoke contagion in financial markets, especially in its pure form by marking to
market prices under any circumstances.
- According to Laux and Leuz (2009) the fair value debate should not be polarised. They
suggest that FVA is neither responsible for the financial crisis nor entirely innocent.
Furthermore, arguments against fair value do not automatically translate into arguments for
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historical cost accounting. The L&L article further suggests that the polarisation in the
debate is founded primarily on different views about the goals of accounting.
Issue 3: Using HCA as a remedy for FVA (page 828)
- Historical costs do not reflect the current fundamental value of an asset. - HCA could come at the price of delaying and increasing underlying problems such as
excessive sublime lending by banks. - Not only should the costs of FVA be considered but the costs of alternatives and the
incentives available to use HCA over FVA during normal or boom times.
Issue 4: Implementation issues with FVA in practice (pg 830 – 831)
- There is a trade-off between relevance and reliability, therefore it is difficult to set FVA standards that provide flexibility to managers when needed and constrain their behaviour when it is not needed.
- Restrictive standards or even some contagion effects are the price for timely write-offs when assets are impaired. Again, this is a trade-off that is important to recognize and difficult to escape in practice242424.
- Implementation problems arise from litigation risk. As deviations from market prices under existing FVA standards require substantial judgment by the financial report preparers however, managers and directors face severe litigation risks. In this environment financial report preparer are likely to weigh the personal costs and risks associated with deviations from market prices differently than investors.
Conclusion (pg 833)
- FVA introduces volatility in the financial statement in ‘‘normal times” (when prompt action is not needed).
- - Second, full FVA can give rise to contagion effects in times of crisis, which need to be addressed – be it in the accounting system or with prudential regulation.
Analysis suggests that implementation problems and, in particular, litigation risks could have
played a role for the performance of FVA standards and banks’ reporting practices in the
crisis.
Finally, it is important to recognize that accounting rules and changes in them are shaped by
political processes (like any other regulation). The role of the political forces further
complicates the analysis. For instance, it is possible that changing the accounting rules in a
crisis as a result of political pressures leads to worse outcomes than sticking to a particular
regime (e.g., Brunnermeier et al., 2009). In this regard, the intense lobbying and political
interference with the standard setting process during the current crisis provide a fertile
ground for further study.
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Whittington Article 2010
Whittington, G 2010, 'Measurement in financial reporting', ABACUS, vol. 46, no. 1, pp.
104-110.
Purpose:
- Identify the single measurement basis that best conforms to relevance and faithful representation.
- Discuss arguments for and against a single measurement basis. - Problems with a single measurement basis due to market imperfection. - Discuss arguments for and against a mixed measurement approach.
Single measurement basis
For (page 105)
- Use of a single method approach would promote consistency and avoid mismatches within accounts.
- This approach will also promote comparability across entities. However comparability will only be useful of the accounting information being compared is relevant to the user.
- When considering fair value as single measurement basis, standard setters have claimed that the fair value method does have relevance properties in that it measures the market’s expectations of future cash flows. And in doing this objectivity was achieved in the sense that the fair value measurement basis reflects the market’s view rather than the entity specific views of managers.
Against (page 105-106)
- In reality the market is imperfect that is markets are not complete and in perfectly competitive equilibrium, therefore, a single measurement method will not always be relevant and reliable.
- Information asymmetry is a barrier to market perfection, as information is not available making it costly and prices cannot perfectly reflect the information available.
- In a setting of market imperfection, accounts provide useful information for decision-making; this means that it is more useful to adopt the objective of identifying the information that is most likely to serve the needs of users when making decisions. This will help provide information to users in their decision making process.
- Ideally in reality a single measurement would be difficult because there are different assets requiring different measurement approaches, which creates an imperfect market in reality. Thus if a single measurement method was used then users cannot make useful decisions.
Mixed Measurement approach (page 107 -108)
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- Mixed measurement approach allows decision usefulness, as different assets will be treated in a different way, therefore different measures for different purposes are appropriate in accounting.
- The objective of a mixed measurement approach allows different measurement methods to be utilised in different circumstances. Thus this method assumes that a pure measure, which uses only one approach, could be associated for example with a particular asset item. However, it recognises that different assets items could be measures by using different methods which best represent the economical properties of the asset item. Therefore the use of a mixed measurement approach provides information that is most relevant to users in assessing the current economic and financial performance and position of the entity they are making decisions about.
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Essay Questions and Answers
Topics:
- Earnings Managements: good or bad?
- Approaches to accounting measurement good or bad?
- For and against regulation
- How does the role of accounting reduce agency problems?
- Systems Oriented theories: What are the implications of using theory to analyse social and environmental disclosures?
Earnings Management
Question 1: Is earnings management good or bad? Discuss. Justify your response through
making connections to relevant theory.
Question 2: What do we mean by the term good EM? Good EM can add value to accounting
information produced. Discuss.
Introduction
Earnings management (EM) is the use of accounting discretion through choice of accounting
policy, with a specific objective regarding the level of reported earnings (i.e. to achieve a
desired level of earnings in a particular reporting period). EM takes advantage of timing
differences and brings revenue into year where it is needed and postpones expenses to
subsequent years. EM comes with information asymmetry. It is an accounting tool. Within
the law EM is referred to as income smoothing and creative accounting. Outside the law it
can constitute fraud.
This definition indicates that EM gives rise to two perspectives, i.e. whether it is good or
bad. The first perspective is that EM can attempt to potentially manipulate the financial
statements through the process of accounting policies manipulation to report earnings in a
more favourable way. The second perspective is that EM attempts to control earnings by
changing actual transaction details or the timing of transactions related to earnings
achieved in a particular period.
1) Good EM
- Theory behind good EM
- Signalling theory (Scott 2009): The main theory in support of the good side of EM is
signalling theory in that EM can act in a way that helps communicate information to
external users. Under the signalling theory managers are able to communicate the
financial health of the organisation, this process of communication involves earnings
management to be used to inform outsiders of the inside information management
by exercising their expertise and professional judgement, EM acts ‘as a vehicle for
inside information’ (Scott 2009) which acts a signal. Signalling theory suggests that
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reporting entities can increase their value through financial reporting. So when
organisations disclose information about themselves to the public because they
want to tell something important. This theory provides that manager’s choices reveal
private information, making private information public. To be a signal there must be
a choice as choices signal credible information about expectations and the entity.
The diversity of reporting practices facilitates this role of reporting as a signal.
Earnings management (EM) can acts a vehicle for the release of inside information
and act as a signal. This characteristic of signalling theory gives entities the
motivation to show that they are better than non-reporting entities through the
disclosure of financial statements. Thus, this theory is a self-regulating system, in
which every entity has a reason to issue financial statements to lower its cost of
capital.
- Efficiency perspective: under the efficiency perspective of signalling theory managers
have the freedom and influence to use accounting policies that help estimate certain
items, which may increase the quality of accounting information, and thus be
efficient. Therefore the efficiency perspective can help maximise the value of the
firm whilst at the same time helps users of financial information to make appropriate
and informed decisions.
- Income smoothing: In the context of an efficient market income smoothing has the
potential to improve earnings informativeness, if managers communicate their
assessment of future earnings. A s fluctuations of reported earnings reduce
investors’ confidence in the expected future cash flows of a firm, this can be a
motivating factor for managers to smooth earnings (Tucker & Zarowin 2005, pg 6).
Even in the absence of an incentive, managers may communicate future earnings
under the efficient contracting theory and thus smooth income, which could make a
firm’s earnings more informative about future earnings and cash flows (Tucker &
Zarowin 2005, pg 6). This in return could improve the decision usefulness of
information provided by the firm to external parties.
- Efficient contracting: under efficient contracting EM is considered good in the sense
that contracts are used to bond the agent to the principal, and financial statement
information is often used to monitor the agent’s compliance with these contracts. As
a result agents have incentives to present the financial statements in a way that
ensures the best outcome under the contracts. Therefore, since contracts need to be
considered when making financial reporting decisions, managers will have an
incentive to use EM in way that doesn’t compromise the ability of individuals both
within and outside the organization to make useful decisions and as long as the
option of flexibility on contracts excludes a manager’s self-interested opportunistic
motivations.
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2) Bad EM
- PAT: 3 hypothesis
The main theory underlying the disadvantageous side of EM is based on the works of
Watts and Zimmerman’s positive accounting theory (PAT). PAT seeks to explain and
predict why managers choose certain accounting methods over others. (Rankin 2012,
pg. 134) which is derived from the agency theory and contracting theory. Central to PAT
is the acceptance of the rational economic person assumption, which assumes that an
accountant is primarily motivated by self-interest, which is premised on the fact that the
accountant is rewarded in terms of accounting based bonuses. PAT has three
hypotheses developed under the Agency theory, under which EM can be used adversely.
Under the bonus plan hypothesis, EM can be used in an attempt to look better in front of
investors. Manager’s in a firm with a bonus plan tied their income may report net income at
higher levels, this is achieved by choosing accounting methods that bring earnings forward
(i.e. earlier recognition of gains). Under the debt covenant hypothesis occurs where a firm
has a higher debt equity ratio, in which the manager is likely to choose accounting methods
that increase net income where the firm is less likely to breach debt covenants. The final
hypothesis is political cost, where larger firms use EM as they are associated with more
political scrutiny, therefore; too much net income results in more government interference
and regulation. So management adopts accounting policies that reduce reported net
income.
- Big bath accounting concept can be used as form of bad EM where: A big bath may be
taken, “during the periods of organizational stress or reorganization” or when “a firm
must report a loss” (Scott 2009). As management may adopt accounting policy choices
to reflect the financial performance of the firm to make it look better than what is
actually is. The likelihood of a big bath being taken when a management change occurs
is also high as a firm may seek to use a change of management as an opportunity to
remove factors that may put pressure on future business performance.
- Examples of bad EM- fraud
EM can be bad in the sense that it can reduce the reliability of financial statements if
reported earnings are changed for unclear reasons and without sound justification by
management. EM could lead managers to provide incorrect information on financial
statements. Could lead to the intentional misstatement or omission for example WorldCom
– capitalisation vs expenditure and Enron – inadequate disclosure obligations. There could
also be intent to deceive or mislead which as a result could lead to illegal actions to
manipulate financial statements to cover up illegal acts – embezzlement.
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Conclusion
In essence, EM has both a good side and bad side to it, which ultimately depends on how
management uses accounting policy choices and creative accounting in exercising
professional judgement. EM is primarily good when it is used to truly reflect the economic
position and performance in a way, which conforms to the Conceptual framework’s
enhancing qualitative characteristics of relevance and faithful representation. If EM is used
appropriately without any bad intentions then it can help add value to financial information
about an entity.
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Approaches to Accounting Measurement: Good or Bad?
Question: Is having choice in approaches to accounting measurement good or bad? Discuss.
Provide an example and make connections to relevant theory to justify your response.
Introduction
- CF provides measurement choices - State that there are both good and bad assumptions about accounting measurement
choices
Body
Arguments that support accounting choices are good
- Flexibility: flexibility in choosing accounting measurement approaches for a firm can allow items to be faithfully represented. If items are faithfully represented then they are more decision useful (AASB 101, paragraph 15). Faithful representation in this context requires that transactions and events should be accounted for in a way that represents the true economic substance of the financial information rather than legal form.
- For example intangible assets cannot be measured using fair value in that no functioning market for these types of assets exist (Hitz, 2007, pg 337). Thus, intangible assets will best be measured using estimation valuations. For example the cost approach will be the best valuation technique for patents as no active market exists for this asset, which illustrates the need to have accounting policy choices to make the most appropriate measurement choices.
- Generally accepted accounting principles (GAAP) require that judgment be exercised in
preparing financial statements by financial report preparers. This exercise of professional
judgment provides information to outsiders when information asymmetries are present.
Thus, the use of professional judgment requires managers to be disinterested and objective
in choosing accounting measurement methods (Fields, Lys & Vincent 2001, pg 259). This in
turn suggests that accounting choice is beneficial when making decisions about which
measurement type will assist investors in making appropriate decision about the firm.
- Another benefit of accounting choice is that it is driven by driven by information
asymmetries, which attempts to influence asset prices. The primary focus in this here is to
overcome problems that arise when markets do not perfectly aggregate individually held
information by investors (Fields, Lys & Vincent 2001, pg 262). Therefore, accounting choice
may provide a mechanism by which better-informed managers can communicate
information to less well informed outside parties about the timing, and the risk associated
with future cash flows.
Arguments that support accounting choices are bad
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- Despite the benefits of having choices in accounting measurement methods,
unconstrained accounting choice is likely to impose costs on financial statement users as
financial report preparers are likely to have incentives to convey self-serving information
(Fields, Lys & Vincent 2001, pg 259).
- There is no doubt that the availability of accounting measurement choices reduces the
comparability of financial reports between entities. This is important in that comparability
of financial reports is an enhancing qualitative characteristic under the CF. Therefore, if this
characteristic cannot be achieved by firms when preparing financial reports then this could
potentially compromise the decision usefulness of information in financial reports. As users
of these financial reports will not be able to make informed decisions about a firm, which
can ultimately undermine the objective of the purpose of financial statements of being
decision usefulness.
Choices can also lead to creative accounting utilised by managers. Managers may use
measurement techniques that overstate earnings, which in turn affect the faithful
representation of information and its decision usefulness.
PAT
- Under PAT, it is suggested that managers exploit their accounting discretion to take
advantage of the incentives provided by bonus plans. Based on the bonus plan hypothesis
there is an assumption that manager’s will aim to look better in front of investors, by
choosing accounting methods that bring earnings forward (Gaffikin 2007, pg 9).
- Another assumption of manager’s motivations for accounting choice is that of influencing
third parties. In situations where third parties use financial information, firms may have an
incentive to manage those numbers due to potential affects of their disclosure policies on
third parties (Fields, Lys & Vincent 2001, pg 281). The common hypothesis referred to here
is the political costs under PAT. This suggests that the greater the political costs faced by a
firm, the more likely it is that managers will choose accounting methods that will defer
reported income to future periods (Gaffikin 2007, pg 10-11) primarily for taxation purposes.
Thus, this hypothesis introduces the idea of political implications of third parties and that
not all choices are based purely on economic considerations when making choices about
measurement methods.
This hypothesis has the potential to affect the decision usefulness of accounting information
and impact upon the decisions of those who use the financial information disclosed by
firms.
Conclusion
Since accounting is used for many purposes, in most situations multiple accounting choices
can be chosen solely or jointly to accomplish one or more goals. Therefore, it would be
inappropriate to analyse an accounting goal in isolation of another, as one goal would have
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a comprehensive theory of accounting choice behind it. Depending on the objectives and
motivations of management, choices in accounting measurement methods can be good or
bad. Nevertheless, since the CF provides measurement choices, it can be concluded that
having a choice in approaches to accounting measurement is good, in that different firms
will need to apply different accounting policies in order to best reflect the financial
performance and measurement of the entity, as well as attain the goals of the firm.
Arguments For and Against Regulation
Arguments for regulation
Public interest theory
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Under the public interest theory one argument supporting regulation is that it is in the public
interest. Without regulation, there is the possibility of failure in the free market system the firm is a
monopoly supplier of information about itself. This situation creates the opportunity for restricted
production of information and monopolistic pricing if the market is unregulated. Therefore,
mandatory disclosure would result in more information and a lower cost to society. Better
regulation is necessary to raise the quality of financial reporting in order to protect the public from
fraud and failures.
Relating further to public interest theory is that accounting information is a public good, and public
goods will be under-produced in a free market. Under-production of public goods occurs because
producers are not able to impose production costs on all users of the good, and are not motivated to
meet real demand. Intervention in the form of regulation can increase production as mandatory
requirements of producing accounting information will ensure that the real demand for such
information is adequately met.
Regulation will also reduce information asymmetry. Since free markets are contrary to society’s
goals they may not communicate enough information to the market in the absence of regulation,
resulting in insiders i.e. managers having information that is not available to shareholders. Thus,
regulation of disclosure requirements will help markets become efficient in that accounting
information would be available to outsiders, i.e. external parties to the firm. This in turn will help
external parties make well-informed decision, which would otherwise not be available in
unregulated markets.
Arguments against regulation
The arguments supporting unregulated markets for accounting information are based on agency
theory, signalling theory, and private contracting opportunities.
Agency theory predicts a conflict of interest between owners and managers, where owners are
interested in maximising return on investment and security prices, while managers desire to
maximise their total remuneration. Due to this potential conflict, owners incur costs in monitoring
agency contracts, which in effect reduce managers’ remuneration package. Therefore, financial
reporting is deemed to be a way of mitigating this conflict, and allowing owners to monitor
employment contracts with their managers. Minimising agency costs is an economic incentive for
managers to report accounting results reliably to owners. Good reporting will enhance the
reputation of a manager, and should result in higher remuneration amounts as agency monitoring
costs are minimised if owners perceive that accounting reports are reliable. Thus this help depicts
that accounting information will still be produced in an unregulated market.
Signalling theory explains why firms have an incentive to report voluntarily to the capital market in
the absence of regulation: voluntary disclosure is necessary in order for firms to compete
successfully in the market to maximise its earnings. Since insiders know more about a firm and its
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future prospects than outsiders; investors will protect themselves by offering a lower price for the
firm’s stock price. However, the value of a firm can be increased if the firm voluntarily signals
private information about itself that is credible and reduces outsider uncertainty (Scott 2009).
Based on the assumptions of contracting theory another argument against regulation is the
presumption that anyone who genuinely desired information about a firm would be able to obtain it
by privately contracting for information with the firm itself. The parties to these contracts can
include shareholders, managers, lenders, employees, suppliers and customers (Rankin 2012, pg135).
If information were desired beyond that which is publicly available and free of charge, private
individuals would be able to buy the desired information where market forces should result in the
optimal allocation of resources to the production of information.
Since the goal of the standard setting process should be to provide the best standards from the
societal point of view, it is not possible to derive regulatory policies that will knowingly maximise the
welfare of society. In the absence of a free market pricing system, it is difficult aggregate social
preferences. However, if there is a free market pricing system, aggregate social preferences are
revealed through supply-demand, and resources will be allocated according to market prices.
Therefore, there is no comparable rule in a regulated market, so it is difficult to know if accounting
regulation is producing the optimal quantity and quality of financial information for the benefit of
society.
Role of Accounting and Agency Question: How does the role of accounting reduce agency problems?
Accounting information plays an important role in reducing agency costs, by monitoring and binding
the mechanisms to control the efforts of self-interested agents (Deegan 2006).
The role of accounting plays a central role in both determining the extent of the agency conflicts, and in designing the mechanisms that resolve such conflicts. Specifically, a wide range of agency conflicts are either created or exacerbated by the fact that certain contracting parties possess superior firm-specific information at various times before or during the contracting relationship. Further, even when all contracting parties are equally informed, uncertainty about future events creates demand among contracting parties for information about current and future business conditions. In this paper, we discuss literature related to how financial reporting helps to satisfy capital providers’ contracting demand for information about firm performance and managers’ actions, and thereby mitigates agency conflicts. Debt covenants
Even in the absence of information asymmetry, information uncertainty poses problems in debt
contracting. That is, even when managers and lenders enter into contacts with the same
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information, the incomplete nature of debt contracts creates a demand for mechanisms that
allocate decision rights in the future conditional on the realization of certain events (both foreseen
and unforeseen).
The general conclusion in this literature is that financial reporting is useful because more efficient contracts can be established when contracting parties are able to commit to a more transparent information environment. Another key theme of our review is the notion that a firm’s contractual arrangements and its corporate information environment evolve together over time to resolve agency conflicts. That is, certain contractual arrangements work more efficiently with certain information environments in general and financial reporting choices in particular. As a result, one does not expect to observe firms converging to a single dominant type of corporate governance structure, compensation contract, debt contract, or financial reporting system This survey highlights the important role that the corporate information environment plays in contracts that serve to mitigate governance- and debt-related agency conflicts. With respect to governance, we emphasize research on the role of financial reporting in reducing information asymmetries that exist between managers and both outside directors and shareholders. This asymmetry stems in large part from the fact that managers typically have better firm-specific information than outside directors and shareholders, but cannot always be trusted to report information that is detrimental to their personal interests (e.g., information indicating poor performance, extraction of private benefits, etc.). Boards, which are largely comprised of outside directors and shareholders, therefore, are typically assumed to be at an informational disadvantage when monitoring managers. Indeed, in the absence of information asymmetries, it becomes relatively easy for boards to resolve many (or most) agency conflicts with managers, particularly since boards retain considerable discretion in their monitoring of managers and can therefore take immediate action upon receiving new information. Thus, one potential role for the financial reporting system is to provide outside directors and/or shareholders with relevant and reliable information that aids in the effective monitoring of management and/or directors. Further, to the extent that financial reporting serves as a mechanism to reduce information asymmetries, one expects to observe cross-sectional variation in other governance mechanisms that covaries with financial reporting characteristics.
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Systems Oriented Theories
Question: What are the implications of using theory to analyse social and environmental disclosures? Discuss this question using legitimacy and stakeholder theory in light of real life examples.
Which of the following theories provide insight as to why social and environmental issues and impacts such as carbon emissions and management of water are so important from a reporting perspective?
Explain the connections to relevant theory/theories to justify your response
- Stakeholder theory - Legitimacy theory - Institutional theory - Accountability theory
Introduction
In recent years stakeholders have been increasingly expecting more than just the disclosure
of financial information in relation to the financial position and performance of the entity. A
wide range of stakeholders also requires information about the environmental and social
performance and impacts of an entity. Therefore, reporting entities have increasingly used
their annual reports to voluntarily report information relating to their social actions and in
particular concerning the natural environment (Gray et al 1995). There has been a move by
entities towards a triple bottom line reporting model, which is also known as sustainable
reporting where in addition to economic performance, social and environmental issues of
the entity’s performance are given (Deegan 2002). Thus, there are a number of theories
which have been postulated as to why entity’s disclose such information which are based on
systems oriented theories which focus on the role of information and disclosure in the
relationships with stakeholders and in which the entity is assumed to be influenced by the
society in which it operates and to have an influence on it. The three key theories are
stakeholder theory, legitimacy theory and institutional theory.
Body
Stakeholder - ethical
Stakeholder theory has both an ethical (normative) branch, as well as a managerial
(positive) branch (Deegan, 2000). The ethical branch aims to meet the information needs of
a wide range of groups despite power e.g. local community, minority groups, customers,
environmental groups and individual activists etc. Under this normative perspective,
Stakeholder theory argues that all stakeholders have the right to be treated fairly by an
organization, and that issues of stakeholder power are not directly relevant. All
shareholders have a right to be provided with information because it prescribes how
stakeholders should be treated; it is a normative approach and is based on various ethical
perspectives. Managerial branch seeks to explain and predict how an organization will react
to demands of various stakeholders. Relative power and importance can change across
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time, associated with control of resources. The firm will take actions to manage its
relationships with stakeholders (Jarrett,1971).
The BP oil spill in the Gulf of Mexico under the stakeholder theory is used to evaluate the
performance of BP. It prescribes how stakeholders should be treated based on various
ethical perspectives, following the oil spill accident. BP has contacted government officials,
NGOs and investors and has listened to them expressed their concerns with BP in 2010. This
provides an example as to how the actions of stakeholder and BP under the ethical branch
of stakeholder theory aims to meet organization’s long term sustainable development of BP
in a way that will benefit various other stakeholders and not solely aim to save the public
image of BP, but also for the continuing development of their financial sustainability.
Stakeholder- managerial
The managerial branch of stakeholder theory attempt to explain when corporate
management will be likely to attend to the expectations of particular (powerful)
stakeholders. The main objective of this branch is to meet the information needs of
powerful groups e.g. government, banks, professional bodies and employees etc. Within the
managerial branch of stakeholder theory the organisation is considered to be part of the
wider social system, but this branch of stakeholder theory specifically considers the
different stakeholder groups within society and how they should best be managed if the
entity is to survive (Deegan & Blomquist 2006).
This branch considers that the expectations of the various stakeholder groups will impact
the operating and disclosure policies of an entity. The entity will not respond to all
stakeholders equally but rather, will respond to those that are deemed to be ‘powerful’
where the most powerful stakeholders will be attended to first. (Deegan & Blomquist
2006). Within the managerial perspective information is a major element that can be
employed by the organization to manage or manipulate the stakeholder in order to gain
their support and approval, or to distract their opposition and disapproval, which is
consistent with the strategies suggested by Lindblom (1994).
The managerial branch of stakeholder theory can be used as an example to provide possible
predictions about the impact the World Wide Fund for Nature (WWF) could have on the
environmental reporting practices of the Australian minerals industry. If it is accepted that
WWF is a ‘powerful’ stakeholder then the Minerals Council of Australia (MCA) and the
individual mining companies may feel a need to react to WWF’s expectations. As an
organisation with large membership and expertise in lobbying government, the WWF could
be considered to be a ‘powerful’ stakeholder group with the ability and resources to
influence the operations of mining companies.
Legitimacy theory
Legitimacy theory posits that organisations continually seek to ensure that they operate
within the bounds and norms of their respective societies, in an attempt to ensure that their
39
activities are perceived by outside parties as being ‘legitimate’. Legitimacy theory relies
upon the notion that there is a ‘social contract’ between the organisations in question, and
the society in which it operates (Deegan & Blomquist 2006). These bounds and norms are
not considered to be fixed, but rather, change over time, thereby requiring the organization
to be responsive to the environment in which they operate.
It is assumed that society allows the organisations to continue operations to the extent that
it generally meets their expectation. Legitimacy emphasises that the organization must
appear to consider the rights of the public at large, not merely those of its investors. Failure
to comply with societal expectations may lead to sanctions being imposed by society. For
example, in the forms of legal restrictions imposed on its operation, and reduced demand
for its products.
Under the social contract between society and an organisation the BP Mexico bay oil spill
accident can be used as an example once again to demonstrate that BP has breached the
“social contract” with society by failing to ensure the safety and health of the society and
environment at large and has threatened the legitimacy of BP. Therefore, BP’s efforts to be
consistent with legitimacy is shown through it interactions with the relevant legal and US
government department agencies and by establishing the $20 billion Deepwater Horizon Oil
Spill Trust fund, which was created by BP to settle legal obligations stemming from the
catastrophe.
Another example is that of the mining industry’s reaction to WWF’s initiative of
independently produced a Mining Company Environmental Report Scorecard, in which it
evaluated the environmental reports of eleven Australian minerals companies was an act of
legitimation. That is, the minerals industry is attempting to communicate to the WWF, as
well as any other ‘relevant publics’, that it is changing its environmental activities in
response to the concerns of the WWF. In this way, it could be argued that the industry is
attempting to legitimate its activities by seeking to educate and inform the relevant publics
about actual changes in industry behaviour, which is consistent with Lindblom's (1994) first
method of legitimation as the corporations may view the Scorecard as a threat to the
legitimacy of their operation, and are thus attempting to legitimise their activities in
response to the WWF’s concerns.
Institutional theory
Institutional theory considers the processes by which structures, including schemas; rules,
norms, and routines, become established as authoritative guidelines for social behaviour. “It
inquires into how these elements are created, diffused, adopted, and adapted over space
and time; and how they fall into decline and disuse” (Scott 2004). This theory emphasises
that although the entity can make their own decisions, they may feel it is a norm to take
40
account for social and environmental impacts as it perceived as legitimate behaviour
derived from cultural values, industry tradition, entity value etc. There are three
mechanisms underlying institutional theory, which are coercive, mimetic and normative.
Using the BP oil spill accident as an example, BP was placed in a coercive situation due to
strong concerns of society and through various stakeholders to implement business
practices in saving the reputation of BP and be consistent in social value. Following the
accident, BP’s 2012 Sustainability report is a response from coercion by various stakeholders
to demonstrate the use of safety principles to manage the integrity of hazardous operating
systems and processes to prevent accidents and oil spills in the future.
The 2010 annual report of BP, due to the society strong concern, when BP face the pressure
from the outside organization, it is the situation in coercive. BP wants to do more practices
in saving the reputation and be consistent in social value. In BP’s continue develop strategy,
deep-water resource use is an important part for future, even happened Gulf Mexico
accident.
Conclusion
Since society, politics and economies are inseparable, and economic issues cannot
meaningly be investigated in the absence of considerations about the political, social and
institutional framework in which the economic activity takes place systems oriented
theories help understand the behaviour and reporting of management, specifically when it
comes to sustainability reporting. Gurthrie and Parket (1990) states that corporate reports
cannot be considered as neutral, unbiased documents, but rather are ‘a product of
interchange between the corporation and its environment and attempt to mediate and
accommodate a variety of sectional interests.’