Welcome to ACC3116: Financial Accounting Theory Unit Leader - Julie Cotter Room - L106 Phone Home page -

Tutorials ä Tutorial times are: ä Tuesday11 – 1K303 ä Wednesday 2 – 4K308 ä Consultation times are: ä Monday1 – 3 ä Wednesday1 – 2 & ä Friday 3 – 5

Assessment ä Assignment 110%Due 20 August ä Assignment 2 10%Due 20 September ä Exam 80% ä Restricted - Translation dictionary only

Module 1 Introduction to Financial Reporting Decisions

Lecture Overview ä Definition of financial reporting (1.1) ä Financial reporting decisions (1.2) ä The fundamental problem of financial reporting (1.3 & 1.4) ä Overview remainder of unit

Definition of Financial Reporting

Forms of Accounting ä In your degree you have studied ä bookkeeping ä management accounting ä financial reporting (fin acct, comp acct, law of assoc) ä Accounting adapts to the size and form of organisation

Summary Forms of Accounting ä Form of Accounting is a function of ä separation of ownership and control (linked to size) ä diffusion of ownership ä Small business (centralised), owner-managers = bookkeeping ä Decentralised firm with tight ownership = mgmt acct + bookkeeping ä Decentralised firm with diffuse ownership = financial reporting + mgmt acct + bookkeeping

Scope of Financial Reporting ä Financial reporting covers more than just financial/company accounting (preparation of 3 financial statements). Although this is an important part of it. ä Financial reporting also includes disclosures that are not contained in the financial statements ä Examples of disclosures ä Environmental disclosures, notes to the accounts regarding the valuation of assets, press releases

Financial Reporting = Financial Accounting + Disclosures

Financial Accounting ä Profit = Cash from Operations (CFO) + accruals ä Accountants and managers apply the accrual system to convert cash flows into profits/losses (earnings) ä Examples of accruals ä recognition of sales prior to receipt of cash ä depreciation and amortisation of non-current assets ä Reported profit depends on financial accounting decisions ä There is less discretion to manage CFO than accruals (earnings management)

Financial Reporting Decisions

ä Financial reporting decisions relate to application of the accruals system (financial accounting) as well as disclosure related choices ä Five types of financial reporting decisions ä Expensing versus Capitalisation of Costs ä Accounting Methods ä Accounting Estimates ä Disclosure versus Recognition ä Disclosure Policy

Expensing versus Capitalisation ä The treatment of an outlay as an expense or as an asset affects profit, equity, and assets ä eg. a large repair / overhaul of a motor vehicle ä Dr Expense - it goes to net income, or ä Dr Asset - it goes to net income over many years as depreciation ä Long term total profit over time is unaffected but the timing of profit recognition is affected, which affects ability to pay dividends, impression of mgmt performance and other decisions made by stakeholders

Accounting Methods / Principles ä There are many accounting standards which must be adhered to, however choices are often allowed ä Eg. Depreciation involves acct policy choice ä straight line, reducing balance, units of production

Accounting Estimates ä There are many acct estimates ä Bad debts, provisions for warranties, recoverable amount test for AASB 1010, depreciation ä Eg. Depreciation involves ä estimate of useful life, estimate of residual value ä Abuse of estimates can be controlled by auditors, regulatory authorities ä eg. Reserve bank has published concerns over current levels of banks’ bad debt allowances ä not as visible as changes to accounting methods

Disclosure versus Recognition ä Recognition involves booking an item to the accounts, whereas disclosure does not affect the accounts ä Example: an asset revaluation ä The firm can have land and buildings valued by an independent valuer ä Its choices are ä Record a full or partial revaluation in the accounts ä Disclose the asset values in the notes ä Do not disclose the information at all

Disclosure Policy ä Disclosure can include ä Good news - new investment projects, discoveries ä Bad news - losses ä They can be made ä in the notes to the financial statements ä in the ‘front end’ of the annual report ä via press release or letters to shareholders ä made to financial analysts in various forums ä Certain disclosures are required (eg. ASX), Others are voluntary

Summary Financial Reporting Decisions ä Financial reporting involves decision making about application of the accruals process and disclosures ä Financial reporting decisions impact the information provided to users of financial reports - this may impact on users decisions ä Important to understand determinants of financial reporting decisions and expected impacts on decisions of stakeholders

The Fundamental Problem of Financial Reporting

Information Asymmetry ä Occurs when some parties to a business transaction have an information advantage ä Adverse selection ä one party has knowledge not possessed by the other ä Moral hazard ä arises when some parties cannot observe all the actions of the other parties to the transaction

Adverse Selection ä Key Issue: managers have considerable inside information ä about past performance of the firm & its future prospects ä Solution : financial accounting and reporting to make inside information available to stakeholders

Moral Hazard ä Key Issue: motivating manager effort ä difficult for owners to observe mgmt behaviour ä manager can shirk on effort or over consume perks of the job ä Solution: net income can be determined and utilised as an indicator of management performance

Summary: Information Asymmetry Adverse selection (Financial reporting to convert inside info to outside info.) inside info to outside info.) Moral hazard (Accounting to monitor the behaviour of managers)

What is the Fundamental Problem of Financial Accounting? ä There are conflicting roles for accounting information to solve the problems of adverse selection and moral hazard ä ie. the best measure of net income to inform investors (to control adverse selection) need not be the same as the best measure to motivate managers (to control the problem of moral hazard)

The Fundamental Problem of Financial Accounting Theory Provision of relevant info. to aid investor Decision making Provision of reliable info. to control management behaviour

The Fundamental Problem of Financial Accounting Theory ä How to reconcile the different roles for accounting information ä impacts on ä asset valuation ä income measurement ä disclosure decisions

What is the Solution? ä How do we reconcile these different roles for accounting information ä solution 1: rely on market forces ä supply (managers) and demand (stakeholders) ä can market forces control the adverse selection and moral hazard problems so that ä investors are protected and ä markets work fairly and efficiently ä Solution 2: Regulation ä to protect investors - reliance on market forces has been rejected by our society (and in US, UK...)

Historical Cost vs Present Values ä Present values involve estimation and compromise ä these estimates make the information subject to wide degree of error and therefore unreliable ä Historical cost is also a compromise between relevance and reliability ä HC asset values lack relevance, but make up for it through increased reliability

Historical Cost Revisited ä HC model is not completely reliable ä It involves matching revenue and expense to determine a net income figure ä Accruals are subject to estimation problems (earnings management)

Improving on Historical Cost ä Likely that HC will be with us for the foreseeable future ä use of PVs is not always practical ä we can observe ä greater use of market values in some areas ä greater amounts of disclosures in annul reports

Overview of Remainder of Unit

Framework of the unit ä Some areas of financial reporting are regulated ä Mod 2: current reg. environment / theories of regulation ä Much of financial reporting is unregulated, so we look at making financial reporting decisions ä Mod 3: contracting determinants of financial reporting ä Mod 4: social determinants of financial reporting ä Mod 5: critique of theories

Framework of the unit (cont.) ä We also look at the impact of financial reporting decisions ä Mod 6: impacts on share price ä Mod 7: impacts on individual financial statement users ä We finish by looking at two financial reporting issues ä Mod 8: Asset measurement ä Mod 9: Environmental Performance Reporting

Purpose of the Unit ä ACC3116 is about theories which relate to financial accounting practice ä accountants do bookkeeping ä apply technical skills (apply acct standards) ä exercise judgement / make decisions ä Theoretical frameworks help us to make decisions ä The unit is designed to ä Enhance your decision making skills ä Improve your written communication skills and your critical thinking skills

For Tutorials ä Required reading ä Selected readings 1.1, 1.3, 1.4 & 1.5 (pages indicated in your study book) ä Self assessment questions ä Questions 1 – 6 from module 1 ä Answers in tutorials ä Important - YOU ARE REQUIRED TO READ FOR THIS SUBJECT!