Financial Accounting Theory Craig Deegan

Financial Accounting Theory Craig Deegan
Chapter 1 Introduction to financial accounting theory Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives In this chapter you will be provided with evidence that shows that: there are many theories of financial accounting knowledge of different accounting theories increases our ability to understand and evaluate various alternative financial accounting practices the different theories of financial accounting are often developed to perform different functions, such as to describe accounting practice or prescribe particular accounting practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives (cont.)
theories, including theories of accounting, are developed as a result of applying various value judgements and that acceptance of one theory, in preference to others, will in part be tied to one’s own value judgements we should critically evaluate theories before accepting them there is good reason for students of accounting to study theories as part of their broader accounting education Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

What is a theory? ‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p.1). ‘A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (The Oxford English Dictionary) Based on logical (coherent) reasoning, and not ad hoc in nature. Different to a ‘hunch’ A theory could be based on numerous observations (inductive reasoning) or developed on the basis of logic (deductive reasoning) Could be ‘positive’ or ‘normative’ Theories can help us make sense of the world in which we live and can provide a structure to understand our (social) experiences Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting theories Accounting is a human activity
It would seem illogical to study financial accounting (for example, the accounting standards) without also studying accounting theory Theories of accounting consider people’s behaviour with respect to accounting information people’s needs for accounting information why people within organisations elect to supply particular information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of uses of accounting theories
Theories might: prescribe how assets should be valued predict why managers will choose particular accounting methods explain how an individual’s cultural background affects accounting information provided prescribe what accounting information should be provided to particular classes of stakeholders predict that the relative power of a stakeholder group will affect the accounting information it receives explain or predict how accounting disclosures might be used as part of a strategy to legitimise the operations of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why study accounting theories?
Learning the rules of financial accounting without considering the implications of accounting information is not recommended Accounting plays a very important and pervasive role within society ….. and our theories help to explain why Studying theories of accounting exposes students to various issues, including: how elements of accounting should be measured motivation for organisations to provide certain types of accounting information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why study accounting theories? (cont.)
motivation for individuals to support or lobby regulators for some accounting methods in preference to others the implications for organisations and their stakeholders if one accounting method is chosen or mandated in preference to others how and why the capital markets react to particular information whether there is a ‘true measure’ of income Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why study accounting theories? (cont.)
Without a theoretically informed understanding it is difficult to: evaluate the suitability of current accounting practices to develop improved accounting practices where current practices are unsuitable for changed business circumstances to defend the reputation of accounting when accounting practices are blamed for causing companies to fail (as has been the case with the global financial crisis) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Overview of theories of accounting
Many theories of financial accounting exist No universally accepted theory of accounting different perspectives about the central objective, role and scope of financial accounting No universally accepted perspective about the role of accounting theory different researchers have different perspectives of the role of accounting theory (for example, to explain and predict practice versus prescribing particular practice) a researcher’s own values will influence which theory he or she elects to embrace Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Early development of accounting theory
Relied upon the process of induction development of ideas or theories through observation 1920s to 1960s theories developed from observing what accountants did in practice codified as doctrines or conventions of accounting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of inductive method
‘… concentrates on the status quo, is reactionary in attitude and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced’ (Gray, Owen & Maunders 1987, p.66) Assumes what is done by the majority is the most appropriate practice Perspective of accounting Darwinism Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Example of inductive approach to theory development
Grady (1965) undertook research commissioned by the American Institute of Certified Public Accountants (AICPA) Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’ reflected generally accepted accounting principles at the time Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theory development—1960s and 1970s
Known as the ‘normative period’ of accounting research Sought to prescribe particular accounting practices known as normative theories (normative theories provide prescription) Not driven by existing practices, and hence not typically inductive in nature (that is, not based on observation) Rather, were deductive in nature and, based on logical argument, sought to develop new methods of accounting Theories critical of historical cost accounting Sought to provide improved approaches to asset valuation in a time of widespread inflation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Example of prescriptive theory
1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values Such research should not be evaluated by reviewing current practice (indeed, there is a general rule that prescriptions about what should be should not be evaluated by reviewing observations of what is) Not supported by AICPA as too radically different from current practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Normative theories Based on what the researcher believes should occur in particular circumstances not based on observation Example of normative theory Continuously Contemporary Accounting (CoCoA) by Raymond Chambers Conceptual Framework of Accounting Should not be evaluated on whether they reflect actual accounting practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Classifications of normative theories
True income theories make assumptions about the role of accounting then seek to provide a single ‘best measure’ of profits Decision usefulness theories ascribe a particular type of information for particular classes of users on the basis of assumed decision-making needs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision usefulness theories
Decision-makers emphasis undertaking research that seeks to ask decision makers what information they want knowledge then used to make prescriptions about what information should be supplied Decision-models emphasis develops models based on the researchers’ perceptions about what is necessary for efficient decision making Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theory development—mid to late 1970s
Research aimed at explaining and predicting accounting practice rather than prescribing particular practices Known as positive theories Contrast with normative theories Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive theories Seek to predict and explain particular phenomena
Begins with assumption(s), and through logical deduction enables prediction(s) to be made If predictions are sufficiently accurate when tested against observations of reality, they are regarded as having provided explanation of why things are as they are Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive theories (cont.)
Positive Accounting Theory developed by Watts and Zimmerman is a specific example of a positive theory of accounting seeks to predict and explain why accountants elect to adopt particular accounting methods in preference to others based on ‘rational economic person’ assumption individuals motivated by self-interest tied to wealth maximisation challenges the view that accountants will be ‘objective’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Evaluating theories of accounting
As we should now understand, there are a multitude of accounting theories available Why or how, would we select one theory in preference to another? Students should consider the merit of the argument and the research methods employed Some researchers may adopt strategies (such as overt condemnation of alternative theories) to support their own research and theoretical perspective Researchers that adopt a given ‘paradigm’ often challenge the views of people researching from a different paradigm A ‘paradigm’ can be described as an approach to knowledge advancement that adopts particular theoretical assumptions, research goals, and research methods (Kuhn 1962). Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Revolutionary scientific progress (Kuhn)
Knowledge advances when one theory is replaced by another as particular researchers attack the credibility of an existing paradigm and advance an alternative Different researchers often embrace different (and conflicting) paradigms Possible explanation of why researchers try to denigrate the credibility of alternative theories but no accounting theory has to date overthrown all other alternatives Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticism of positive theories—an example
Positive theories of accounting have been criticised for not providing prescription The decision not to provide prescription could alienate academic accountants from their counterparts within the profession Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticism of normative theories—an example
Normative theories have been criticised for lack of empirical observation they are based on personal opinion about what should happen positive theorists argue that they would prefer to provide information about expected implications of actions and let others decide themselves what they should do positive theorists also make value judgements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Can we prove a theory? Can we expect that a theory of financial accounting (and hence, about people) can provide perfect predictions in all cases? A theory might not have perfect predictive capabilities, but still be useful Saying that we have proved a theory on the basis of observations ignores the fact that subsequent observations might not be in accordance with the theory Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Can we prove a theory? (cont.)
There is a group of theorists known as ‘falsificationists’ Believe that theory develops through trial and error and ‘good’ theory should generate hypotheses or predictions that have the potential to be rejected Rejection leads to refinement of theory Falsificationists would argue that a theory can never be proved, though it might be the ‘best’ available at a particular point in time Safer to say that our evidence supports a particular theory (rather than ‘proves’ a theory) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Evaluation of theories—the position taken in this book
Theories of accounting are only abstractions of reality The choice of one theory in preference to another is based on value judgements Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Evaluating theories—logic and evidence
When evaluating theories, need to consider whether the argument supporting the theory is logical whether you agree with the central assumptions of the theory whether you accept any supporting evidence provided Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Logical deduction Acceptance of an argument must be based on the accuracy of the premises an argument is logical to the extent that if the premises on which it is based are true, then the conclusion will be true We do not need to refer to ‘real world’ observations to determine the logic of an argument However, although the argument might be logical, if it can be shown that a given premise is untrue then the conclusion or prediction may be rejected As an example, refer to the syllogism on p.19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of assumptions
Even though an argument is logical we might only accept the argument if we accept any critical assumptions being made if we reject any central assumptions we may reject the prediction no matter how logical the theory might be For example, Positive Accounting Theory (Watts and Zimmerman) is based on the central economics-based assumption that all individual action is motivated by self-interest tied to wealth maximisation. If we do not accept this central assumption then we would dismiss the explanations and predictions provided by the theory Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of assumptions (cont.)
As another example, in May 2008 the IASB and FASB released a document entitled Exposure Draft of an Improved Conceptual Framework for Financial Reporting in which it is stated that ‘the objective of general purpose financial reporting is to provide information about a reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers’ If we were not to reject this central assumption then we would reject the new conceptual framework despite how logically developed it might be So, we must consider both the logic of the argument and the central assumptions made Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Dishonest tricks in argument
In evaluating theories we sometimes need to be aware of ‘dishonest tricks’ some researchers use to support their research, or to denigrate the theories utilised by others Thouless (1974) identifies 38 dishonest tricks some writers use to support their argument including: emotionally toned words statements where ‘all’ is implied but ‘some’ is true diversion to another question or to a side issue use of speculative argument prestige by false credentials appeal to mere authority Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Dishonest tricks (cont.)
We must be careful that our acceptance of a theory has not been ‘coerced’ through the use of colourful or emotive language Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 2 The financial reporting environment Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives In this chapter you will be introduced to:
the history of the accounting profession and of regulation some of the arguments for and against the existence of accounting regulation some of the theoretical perspectives used to explain the existence of regulation how and why various groups within society try to influence the standard-setting process Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

the view that many accounting decisions are based on professional opinion an awareness of some of the theories that are used to explain what influences the accountant to choose one accounting method arguments advanced to support the view that accountants are powerful members of society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Financial accounting defined
A process involving the collection and processing of information of a financial nature for the purpose of assisting various decisions to be made by parties external to the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Users of financial statements
Users have different information needs so it is not possible to generate reports to meet individual needs Users include present and potential investors lenders suppliers employees customers government and other parties performing a review or oversight function media Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting knowledge required or expected by users
Changes to accounting standards or new standards affect the numbers within financial reports (profits, net assets) Users should ideally have sufficient knowledge to assess effect of changes to regulations the International Accounting Standards Board (IASB) Framework states that ‘users are expected to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting knowledge required or expected by users (cont.)
General purpose financial reports (GPFRs) designed for users who exercise due diligence and who possess the proficiency necessary to comprehend the significance of contemporary accounting practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Use of highlight statements
Many companies provide multi-year summaries profits, return on assets, earnings per share, dividend yield etc. Aid less accounting-literate reader to focus on important issues But management selects information so important information may be overlooked Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Management accounting
Provides information for decision making by parties within the organisation Internal not external users Largely unregulated Tends to be forward focused (while financial accounting is historical in nature) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of management accounting information
Cash flow projections Sales budgets Production requirements Inventory requirements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Development of accounting practice—first documented use
Early systems of double-entry accounting traced back to thirteenth and fourteenth century in Northern Italy Franciscan monk named Pacioli first to document double-entry accounting practice (1494) Included debits and credits and used ledgers and journals Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Formation of professional associations
1854: Society of Accountants (Edinburgh) 1880: Institute of Chartered Accountants in England and Wales (ICAEW) 1887: American Association of Public Accountants Although members required to prepare and audit reports pursuant to company laws and stock exchange requirements, no regulation about content of reports and how numbers compiled existed Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Initial regulation of accounting practice
Regulation did not commence until twentieth century Previously limited separation between ownership and management of business entities Systems of accounting were therefore designed to provide information to the owner/manager Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Initial regulation of accounting practice (cont.)
In the early twentieth century there was limited work to codify accounting principles and rules From 1920s researchers sought to identify and describe commonly accepted accounting conventions e.g. doctrines of conservatism, materiality, consistency; entity assumption; matching principle 1930: United States (US) profession and New York Stock Exchange (NYSE) developed list of broadly used accounting principles Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

History of accounting regulation
1934: US Securities Exchange Act required specific disclosures of financial information by organisations seeking to trade securities administered by Securities Exchange Commission (SEC) 1938: SEC only accepted financial statements prepared in accordance with generally accepted accounting principles of the accounting profession gave a great deal of power to accounting profession Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

History of accounting regulation (cont.)
1939: Committee on Accounting Procedure (committee of the US accounting profession) commenced issuing statements on accounting principles released 12 Accounting Research Bulletins during 1939 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Development of mandatory accounting standards
In UK not until 1970 when Accounting Standards Steering Committee established (later Accounting Standards Committee) that mandatory standards developed In US Financial Accounting Standards Board (FASB) formed in 1973 later produced mandatory standards from 1965 departures from principles had to be disclosed in footnotes Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

History of regulation in Australia
1946: Institute of Chartered Accountants in Australia (ICAA) released five Recommendations on Accounting Principles based on documents released by ICAEW 1956: a number of recommendations released by Australian Society of Accountants later years the two bodies issued statements jointly through Australian Accounting Research Foundation (AARF) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

History of regulation in Australia (cont.)
AARF collaborated with Australian Accounting Standards Board (AASB) in developing mandatory standards AARF subsequently removed from the standard setting process and with the adoption of IAS/IFRS much of the standard setting process has now been passed to the IASB Hence, accounting standards to be used in Australia are now overwhelmingly controlled by the IASB which operates out of London. Do we think that the needs of local financial statement readers within Australia are the same as the needs of all the other jurisdictions that also use International Financial Reporting Standards (IFRS)? Is a one-size-fits-all approach appropriate (we will address this issue in later weeks) There are also current efforts by the IASB and the US Financial Accounting Standards Board to converge the respective accounting standards – this will create direct impacts in Australia and other countries. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting knowledge required or expected by users
Changes to accounting standards, or the introduction of new standards, affect the numbers within financial statements (such as profits, net assets) Because these numbers are used in various ways across the community then changes in accounting standards have the potential to create significant economic and social consequences Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Rationale for regulating financial accounting practice
Initially introduced following the Great Depression argued that problems with accounting information led to poor and uninformed investment decisions Competing views as to whether regulation is necessary. There are: pro-regulation advocates, and anti regulation (free-market) advocates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Arguments in favour of regulation
Markets for information not efficient ‘On average’ market efficiency arguments ignore the rights of individuals Those able to demand information can often do so as a result of power over scarce resources, while those with limited power are generally unable to secure information without regulation (even though the organisation may impact their existence) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Arguments in favour of regulation (cont.)
Investors need protection from fraudulent organisations producing misleading information Regulation leads to uniform methods thus enhancing comparability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Arguments against regulation
We do not need accounting regulation because people will be prepared to pay for information to the extent that it has use Capital markets act to punish organisations that fail to provide information no news deemed to imply bad news Regulation will lead to oversupply of information as users who do not bear the cost of supply tend to overstate their needs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Arguments against regulation (cont.)
Regulation restricts the accounting methods able to be used so organisations may be prohibited from using methods which best reflect their particular performance and position. This has implications on the efficiency with which the firm can inform the market about its operations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theories used to describe benefits of regulation
Public interest theory of regulation regulation introduced to protect the public Capture theory of regulation although regulation introduced to protect the public, regulatory mechanisms often controlled by groups most affected by regulation Private interest theory of regulation government not neutral arbiter and will regulate based on impacts to key voters and campaign finances Discussed further in Chapter 3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Private versus public sector regulation
Private sector regulation accounting profession best able to develop accounting standards because of expertise and greater likelihood rules will be accepted by business Public sector regulation government has greater enforcement powers, hence rules more likely to be followed, may be less responsive to pressure from business and more likely to consider public interest Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of professional judgement in financial reporting
While the accounting treatment of many transactions and events is regulated, many others are unregulated Accountants expected to be objective and free from bias (although, as we will see, various theories of accounting question whether accountants will allow objectivity to determine the selection of accounting methods) Do we believe that accountants will also be objective and free from bias? In making this judgement are we utilising particular theoretical assumptions? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of professional judgement in financial reporting (cont.)
Information generated should faithfully represent underlying transactions and be neutral and verifiable When developing accounting standards the accounting standard setters give consideration to the potential economic and social implications of any changes The consideration of economic and social implications of possible accounting standards implies bias in their development and implementation standard setters face a ‘dilemma which requires a delicate balancing of accounting and non-accounting variables’ (Zeff 1978, p.62) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why are particular accounting methods applied?
Efficiency perspective different organisational characteristics explain why different firms, when presented with accounting options, will adopt different accounting methods—they will adopt the method that best reflects their performance Advocates of a ‘free market’ approach perceive that accounting regulations which restrict the set of available accounting techniques will be costly to the organisation as restricting available accounting methods will limit how efficiently an organisation is able to produce information about its financial position and performance Such arguments do not tend to consider comparability benefits that might flow from regulation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why are particular accounting methods applied? (cont.)
Opportunistic perspective assumes that selection of an accounting method is driven by self-interest would question the view that accountants (and other individuals) would be objective accounting methods which provide the desired results for preparers are selected Refer to Chapter 7 for a discussion of these perspectives Chapter 8 addresses other theoretical perspectives Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The power of accountants
Accountants are often depicted as boring individuals with limited influence on others … do we agree? An alternative perspective is that accountants are amongst the most powerful members of society Output of the accounting process impacts many decisions about wealth transfers so the judgement of accountants affect various parties’ wealth The provision of accounting information leads to power for those who receive the information – allows them to make informed decisions Accountants can give legitimacy to organisations which may not otherwise be deemed legitimate (e.g. emphasising profits) e.g. profits legitimise Commonwealth Bank (see Accounting Headline 2.1, p.49) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The power of accountants (cont.)
Profit measures ignore many social and environmental externalities caused by the reporting entity e.g. major adverse social consequences of a cigarette manufacturer Accounting does not objectively reflect a particular reality—it creates it for example, if the accounting profession develops rules that omit any consideration of various social and environmental impacts then any related social and environmental expenses will not be recorded and reported and therefore will not be brought to the attention of financial statement readers. conversely, if accounting placed a cost on environmental degradation then this would reduce profits (and subsequent dividend payments), the likely consequence of which would be pressure on the entity from financial stakeholders to reduce the expenses (and hence, the environmental degradation) in this regard, what might be the impacts of current efforts to place a cost/tax on carbon emissions? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 3 The regulation of financial accounting Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

some of the various theoretical arguments proposed in favour of reducing the extent of regulation of financial accounting some of the various theoretical arguments for regulating the practice of financial accounting various theoretical perspectives that describe who is likely to gain the greatest advantage from the implementation of accounting regulation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

the political nature of the accounting standard-setting process which seeks the views of a broad cross-section of account users the relevance of potential economic and social impacts to the accounting standard setting process Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why examine theories of regulation?
Better placed to understand why some accounting prescriptions become part of legislation while others do not Accounting standard-setting is a very political process while some proposed requirements may be technically sound and logical, they may not be mandated due to political ‘power’ or influence of some affected parties Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

What is regulation? The Oxford Dictionary defines regulation in terms of a “prescribed rule” or “authoritative direction” The Macquarie Dictionary defines regulation as “a rule of order, as for conduct, prescribed by authority; a governing direction or law” On the basis of these definitions we can say that regulation is designed to control or govern conduct Hence when we are discussing regulations relating to financial accounting we are discussing rules that have been developed by an independent authoritative body that has been given the power to govern how we are to prepare financial statements, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be available to an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

‘Free market’ perspective
Accounting information should be treated like other goods, with demand and supply forces allowed to operate to generate an optimal supply Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Arguments supporting ‘free market’ perspective
Private economic-based incentives ‘Market for managers’ ‘Market for corporate takeovers’ ‘Market for lemons’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Private economic-based incentives
Assumed that managers will operate business for own benefit and this is expected by shareholders and debtholders Therefore in interests of management to enter contracts with shareholders and debtholders to constrain managers’ actions Contracts often based on accounting information Organisations not producing information will be penalised by higher costs of capital Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Private economic-based incentives (cont.)
Organisations best placed to determine what information should be produced dependant on parties involved and assets in place Imposing regulation restricting available set of accounting methods decreases efficiency of contracting Also assumed auditing will take place in absence of regulation—reduces risk to external stakeholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Problems in presence of many different parties
May be too many parties for contracting to be feasible Prohibitive cost of negotiation if different investors want different information Costly to negotiate single contract with all investors as they need to agree on information provided Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market for managers argument
Managers’ previous performance impacts on remuneration they can command in future In absence of regulation assumed managers encouraged to adopt strategies to maximise value of firm (provides favourable view of own performance) includes providing optimal amount of accounting information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Assumptions underlying market for managers argument
Managerial labour market operates efficiently Information about past performance known by prospective employers and will be impounded in future salaries Capital market is efficient Effective managerial strategies reflected in positive share price movements However, problems arise if the manager is approaching retirement Also, we might question whether the managerial labour market is always efficient Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market for corporate takeovers argument
Underperforming organisations will be taken over by another entity with the existing management team subsequently replaced Therefore managers motivated to maximise firm value Information produced to minimise cost of capital thereby increasing firm value assumes managers know marginal cost and marginal benefits of information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market for lemons argument
No information viewed in the same light as bad information market may make the assessment that silence implies the organisation has bad news to disclose Therefore managers motivated to disclose both good and bad news Evidence that both good and bad news disclosed voluntarily (Skinner 1994) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market for lemons argument (cont.)
Assumes the market knows that managers have news to disclose may not always be a realistic assumption If knowledge of non-disclosure becomes available later, market expected to react at that stage Taken together, the various factors just discussed (market for managers, market for corporate takeovers, market for lemons, expectations about self-interest and the resulting use of contracts, and so forth) are considered to provide justification for restricting accounting regulation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Pro-regulation perspective
Accounting information is a public or ‘free’ good It should not be treated the same as other ‘goods’ In the presence of free-riders, true demand is understated pricing system does not function properly Leads to underproduction of information Regulation necessary to reduce impacts of market failure Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Should supply of ‘free’ goods be regulated?
Some argue free goods often overproduced as a result of regulation Public, knowing they do not have to pay, will overstate their need for the good or service e.g. investment analysts Could lead to accounting standards overload Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of Adam Smith’s ‘invisible hand’
‘Invisible hand’ notion used as argument in favour of free market without regulatory involvement, as if by an invisible hand, productive resources will find their way to most productive uses Some (for example, Milton Friedman) went on to argue that leaving activities to the control of market mechanisms will protect market participants Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of Adam Smith’s ‘invisible hand’ (cont.)
Free market argument ignores market failures and uneven distribution of power Smith was concerned where monopolistic powers were created by government intervention But Smith advocated regulatory intervention in some instances where in the public interest to protect the more vulnerable Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Why was Smith’s work misrepresented?
In the interests of many businesses that regulatory interference be reduced The work of acclaimed economists, such as Adam Smith, used as ‘propaganda’ to support their position Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theories to explain regulation
Public interest theory Capture theory Economic interest group theory (private interest theory) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Public interest theory
Regulation put in place to benefit society as a whole rather than vested interests Regulatory body considered to represent interests of the society in which it operates, rather than private interests of the regulators The enactment of regulation is a balancing act between the perceived social benefits and the perceived social costs of the regulation Assumes that government is a neutral arbiter Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of public interest theory
Critics question assumptions that economic markets operate inefficiently if unregulated Question the assumption that regulation is virtually costless Others question assumption of government neutrality argue that government will only legislate and groups will only lobby for regulation if it will increase their own wealth Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capture theory While regulation might be introduced with the goal of benefiting the public this goal may not subsequently be achieved The regulated seeks to take charge of (capture) the regulator Seek to ensure rules subsequently released are advantageous to the parties subject to regulation Although regulating initially in the public interest, difficult for regulator to remain independent Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capture of accounting standard-setting
Walker (1987) analysed capture of Australian standard-setting through the ASRB, arguing that the accounting profession lobbied before the board established to ensure no independent research capability, no academic as chair, to receive admin officer not a research director priorities only set after consultation with AARF ASRB fast-tracked AARF submissions but not others majority of board membership were members of the accounting profession Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of capture theory
No reason to suggest that regulated industry the only interest group able to influence the regulator No reason why regulated industries only able to capture existing agencies rather than procure the creation of an agency No reason why regulated could not prevent creation of the regulatory agency Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Economic interest group theory
The release of new or revised accounting standards have real economic and social consequences For example, consider how the adoption of AASB 138 Intangibles might have created real economic impacts within Australia The economic interest group theory of regulation assumes that groups will form to protect particular economic interests Groups are often in conflict with each other and will lobby government to put in place legislation which will benefit them at the expense of others No notion of public interest inherent in the theory Regulators (and all other individuals) deemed to be motivated by self interest Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Economic interest group theory (cont.)
The regulator is not a neutral arbiter but is seen as an interest group itself Regulator motivated to ensure re-election or maintenance of its position of power Regulation serves the private interests of politically effective groups Those groups with insufficient power will not be able to effectively lobby for regulation to protect its own interests Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of application to accounting standard-setting
Industry groups may lobby to accept or reject a particular accounting standard e.g. European Banks in relation to IASB 39 Large politically sensitive firms found to lobby in favour of general price level accounting in US (led to reduced profits) Accounting firms lobbying to protect their own interests Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting regulation as an output of a political process
The view that financial accounting should be objective, neutral and apolitical can be challenged Will inevitably be political as it affects wealth distribution within society Standard-setters encourage affected parties to make submissions on drafts of proposed standards Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting regulation as an output of a political process (cont.)
If standard-setters give consideration to views in submissions, accounting standards and therefore financial reports are the result of various social and environmental considerations tied to the values, norms and expectations of the society in which standards are developed questionable whether financial accounting can claim to be neutral and objective Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting regulation as an output of a political process (cont.)
Compliance with accounting standards usually seen to indicate financial statements are ‘true and fair’ can or should financial statements that have been prepared on the basis of accounting standards (with such standards having been developed after taking into account various economic and social consequences) be deemed to be ‘true and fair’? Users may not be aware that financial reports are the outcome of various political pressures Should regulators consider preparers’ views given that standards are designed to limit what preparers do? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 4 International accounting Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

an appreciation that there are many differences between some countries in the accounting policies and practices adopted various explanations about why countries adopt particular accounting practices in preference to others some of the arguments that suggest that it is appropriate that there are international differences in accounting practices the background to recent actions by the IASB and FASB to further standardise international accounting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

what is meant by the terms harmonisation and standardisation as they apply to international accounting some of the perceived benefits of standardising accounting practices on an international scale some of the obstacles to harmonisation and standardisation, and the criticisms that efforts to harmonise and standardise accounting internationally have attracted Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Evidence of international differences in accounting
Although many countries now adopt IFRS, if we go back a few years and apply different countries’ former accounting rules to the same transactions we can find significant differences in profits and net assets (consider Accounting Headline 4.1, p.108) The (sometimes significant) differences in accounting profits have been used by many parties to justify the ongoing efforts of the IASB to standardise international accounting But do we really need to standardise accounting on an international basis because of these differences, and if we do, what are some of the costs and benefits? This lecture covers these issues Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Standardisation versus harmonisation
In relation to international accounting, two terms that are commonly used are standardisation and harmonisation We can define ‘harmonisation’ as a process of increasing the compatibility of accounting practices by setting bounds to their degree of variation ‘Standardisation’, by contrast, appears to imply the imposition of a more rigid and narrow set of rules (than harmonisation) Therefore, the term ‘harmonisation’ appears to allow more flexibility than standardisation What is happening through the efforts of the IASB is a process of standardisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Does it really matter if different countries use different accounting methods?
Many varied views about the costs and benefits of international standardisation Some perceived benefits would include: international investors are better able to understand the financial performance and position of local companies tied to the above point, there is an expectation that standardisation will facilitate greater capital inflows also tied to the above point, standardisation will make it easier for local companies to list on foreign stock exchanges Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Does it really matter if different countries use different accounting methods? (cont)
companies listed on several stock exchanges would only need to produce one set of financial statements and this will have implications for cost savings the accounting and auditing staff employed by international organisations will be better able to move to other member companies there will be cost savings in the accounting-standard setting function—rather than individual companies duplicating the efforts of others, the majority of functions of the standard-setting process will be centralised at the IASB Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Does it really matter if different countries use different accounting methods? (cont)
a perception that IFRS will lead to more accurate, comprehensive and timely financial statement information, relative to the information that would have been generated from the national accounting standards they replaced to the extent that the resulting financial information would not be available from other sources, this should lead to more-informed valuations in the equity markets, and hence lower the risks faced by investors Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 4-107

But obviously it is very difficult to quantify any benefits associated with international standardisation There is very little empirical research or theory that actually provides evidence of the advantages or disadvantages of uniform accounting rules nationally, or internationally. For example, whilst the FRC in Australia said that real benefits would flow from Australia adopting IFRS there is no quantifiable evidence of such benefits Whether the benefits of adopting IFRS are shared by a majority of corporations within a country, or whether the benefits are confined to larger multi-national corporations, is a matter of conjecture. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Objectives of IASB The body at the centre of international standardisation is the IASB It seeks to formulate and publish accounting standards and to promote their worldwide acceptance It seeks to work on the improvement and standardisation of regulations, accounting standards and procedures The IASB does not appear to believe that the many reasons provided as to why different nations should have different accounting standards (e.g. tied to differences in culture, religion and so forth) outweigh the benefits of international standardisation (we will consider some arguments against international standardisation shortly) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

International Accounting Standards Board (IASB) (cont.)
The Institute of Chartered Accountants of England and Wales, the Canadian Institute of Chartered Accountants and the American Institute of Certified Public Accountants initially established an Accountants’ International Study Group in 1967. The Accountants’ International Study Group then formed the basis for the establishment of the IASC in 1973 The IASB replaced the IASC in 2001 Australia decided in the mid-1990s to harmonise its standards with those of the IASC But then in 2002, a decision was made by the Financial Reporting Council that Australia would adopt standards released by the IASB IFRS still not accepted by the US SEC for US domestic companies, however the US FASB and the IASB are currently working on a convergence project which might ultimately see the US adopt IFRS Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

International Accounting Standards Board (IASB) (cont.)
The FRC’s decision that Australia would adopt IFRS created a great deal of work for organisations in that they had to make quite significant changes to their accounting practices The adoption of IAS/IFRS required companies to write off a great deal of assets—particularly intangible assets Was it all worth the effort? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The United States role in the international standardisation of accounting
One notable exception to the global adoption of IFRS is the US Within the US, accounting standards are developed by the FASB The SEC has the power to override the standards developed by the FASB US was traditionally strong in its resolve not to adopt IFRS but this resolve diminished in the light of collapses such as Enron US standards are considered to be more ‘rules-based’ whereas IFRS are more ‘principles-based’ A belief grew that ‘principles-based’ standards may be more effective in reducing ‘accounting fraud’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Somewhat obviously, the IASB was seeking to standardise practice.
Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? (cont.) Somewhat obviously, the IASB was seeking to standardise practice. However, there are a number of reasons why the standardisation of accounting standards will not necessarily lead to standardisation of accounting practice (there is a difference). Hence, consistent with Nobes (2006), we would argue that the study of international differences in accounting practice (and the reasons and motivations therefore) will remain an important area of research despite the ongoing standardisation efforts of the IASB. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Does the international standardisation of accounting standards necessarily lead to the international standardisation of accounting practice? (cont.) Reasons why international differences in accounting practice will survive beyond the introduction of IFRS would include: Differences in taxation systems Tax driven accounting choices, which are domestic, might flow through to IFRS statements Differences in economic and political influences on financial reporting Powerful local economic and political forces determine how managers, auditors, courts regulators and other parties influence the implementation of rules. These forces have exerted a substantial influence on financial reporting practice historically, and are unlikely to suddenly cease doing so, IFRS or no IFRS (Ball, 2006). Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons why international differences will survive beyond the introduction of IFRS would include (cont.) Modifications made to IFRS at a national level the IASB has no ability to enforce the application of its accounting standards in countries that have made the decision to adopt IFRS. This is a key limitation. Regulatory bodies in particular countries may take the decision to modify a particular IFRS before it is released (for example, the EU in relation to their acceptance of IFRS 39). Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons why international differences will survive beyond the introduction of IFRS would include (cont.) Differences in implementation, monitoring and enforcement Unless there is international consistency in the implementation of accounting standards and subsequent enforcement mechanisms then we cannot expect accounting practices to be uniform despite the actions of the IASB. Investors might be misled into believing that IFRS adoption has created a consistency in international accounting practices. That is, the adoption of IFRS might (incorrectly) be construed as a signal that a country has improved its quality of reporting. In a sense, the adoption of IFRS brings a level of legitimacy to a country's financial reporting despite any limitations in the level of enforcement of the standards. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 4-116

International differences in implementation and enforcement
Ball discussed the ‘free rider’ problem associated with IFRS. If a 'symbol of legitimacy' - such as IFRS - can be acquired at low cost then some countries with low accounting proficiency will make the choice to adopt IFRS because of the reputational benefits such a choice may generate. Such a choice will have costly implications for countries with higher levels of accounting proficiency and who put in place appropriate implementation, monitoring and enforcement mechanisms. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

So is a belief in the international standardisation of accounting practice realistic?
Given the arguments just provided we might question the belief that the global adoption of IFRS will lead to consistency in international accounting practices. There will arguably continue to be international differences in accounting practice and such differences will continue to provide an interesting area of research for accounting academics. However, at a more fundamental level, is it really a good idea that there should be global consistency in accounting practice anyway? Is it appropriate to have a global ‘one-size-fits-all’ approach to financial reporting when there are international differences: in the nature of capital, labour and product markets; in monitoring and enforcement mechanisms; in economic and political influence; and, differences in cultures? The next part of this lecture explores various reasons why, in the absence of globalisation efforts such as those being undertaken by the IASB, we would expect to find international differences in accounting practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

International financial accounting models
Historically there have been two main models of financial accounting adopted internationally Anglo-American model strongly influenced by professional accounting bodies rather than government, emphasises importance of capital markets, emphasises true and fair, considerations of economic substance over legal form Continental European Model relatively small input from accounting profession, little reliance on qualitative true and fair, strong reliance on government Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons for international accounting differences
Underlying laws and political systems Tax systems Level of education Level of economic development Nature of business ownership and financing system Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons for international accounting differences (cont.)
Colonial inheritance Taxation Culture History Language Religion Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The effect of culture on accounting systems
Differences in national cultures has been used by many researchers to explain why, prior to the efforts of the IASB, there were fundamental differences between nation’s accounting practices (although, keep in mind the previous discussion that suggests that the global use of IFRS will not necessarily standardise accounting practice) Culture impacts on legal systems, tax systems and the way businesses are formed and financed etc. Previously used to explain differences in social systems Culture can be defined as ‘… an expression of norms, values and customs which reflect typical behavioural characteristics’ (Takatera & Yamamoto 1987) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The effect of culture on accounting systems (cont.)
‘Culture’ reserved for societies as a whole or nations ‘Subculture’ used for the level of an organisation, profession or family International differences in accounting systems may be explained by a framework incorporating culture Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Hofstede’s cultural dimensions
Four underlying societal dimensions along which countries could be positioned Individualism versus Collectivism Large versus Small Power Distance Strong versus Weak Uncertainty Avoidance Masculinity versus Femininity The value systems of accountants will be derived from and related to societal values Without the intervention of organisations such as the IASB, these societal values will in turn impact on the development of accounting standards at a national level Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Individualism versus Collectivism
Addresses degree of interdependence a society maintains among individuals Individualism refers to a preference for a loosely knit social framework wherein individuals care for themselves and their immediate families Collectivism stands for a tightly knit social framework where relatives, clan or other in-group look after each other Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Power Distance Power Distance is the extent to which members of a society accept that power in institutions and organisations is distributed unequally Large Power Distance societies accept a hierarchical order in which everyone has a place Small Power Distance societies strive for power equalisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Uncertainty Avoidance
The degree to which the members of a society feel uncomfortable with uncertainty and ambiguity Strong Uncertainty Avoidance societies maintain rigid codes of belief and behaviour Weak Uncertainty Avoidance societies maintain a more relaxed atmosphere where practice counts more than principles Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Masculinity versus Femininity
Addresses the way in which a society allocates social roles Masculinity stands for a preference for achievement, heroism, assertiveness and material success Femininity stands for a preference for relationships, modesty, caring for the weak, and quality of life Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Societal dimensions and accounting subculture
The value systems of accountants are derived from related societal values The values of the accounting subculture will in turn impact on the development of the respective accounting systems at a national level should accounting systems be developed in a ‘one-size-fits-all’ approach? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Gray’s accounting values
Gray developed four accounting values deemed to relate to the accounting subculture, with the intention of linking them to Hofstede’s four societal values professionalism versus statutory control uniformity versus flexibility conservatism versus optimism secrecy versus transparency Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Gray’s hypotheses H1: The higher a country ranks in terms of Individualism and the lower it ranks in terms of Uncertainty Avoidance and Power Distance, the more likely it is to rank highly in terms of Professionalism H2: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism, then the more likely it is to rank highly in terms of Uniformity Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Gray’s hypotheses (cont.)
H3: The higher a country ranks in terms of Uncertainty Avoidance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Conservatism H4: The higher a country ranks in terms of Uncertainty Avoidance and Power Distance and the lower it ranks in terms of Individualism and Masculinity, then the more likely it is to rank highly in terms of Secrecy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Gray’s hypotheses (cont.)
Gray further hypothesised relationships between accounting values and: the authority and enforcement of accounting systems the measurement and disclosure characteristics of accounting systems Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Other research using Hofstede’s cultural dimensions
Zarzeski (1996) used Hofstede’s dimensions to explain corporate disclosure entities with a higher international profile tend to be less secretive local enterprises are more likely to disclose information commensurate with the secrecy of their culture than are international enterprises Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Other research using Hofstede’s cultural dimensions (cont.)
Perera (1989) used Hofstede’s cultural dimensions and Gray’s accounting subcultural value dimensions to explain differences in the accounting practices of European and Anglo-American countries Baydoun and Willett (1995) investigated the use of the French United Accounting System in Lebanon Chand and White (2007) explored various cultural attributes within the Fijian society to determine whether the recent adoption of IFRS within the Fijian context made sense. Their view was that rules-based standards would be more appropriate than the principles-based standards that have been developed by the IASB. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The effect of religion on accounting systems
Another factor that has been used to explain differences in accounting is religion Religion transcends national boundaries Impacts on global harmonisation of accounting standards Hamid, Craig and Clarke (1993) examined how Islamic cultures have failed to embrace ‘Western’ accounting practices compliance with Islamic beliefs can affect the structure of business and finance many Western accounting practices are incompatible with Islamic principles relevance of IASB standards to such cultures? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The effect of religion on accounting systems (cont.)
Religion can affect how people do business and how they make decisions, for example Islam precludes debt financing and prohibits payment of interest the Western objective of financial reporting of rational economic decision making (refer to the conceptual frameworks discussed in Chapter 5) may not be a relevant objective in some societies Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legal systems Another factor that will cause international differences in accounting is the legal system in operation Legal systems can be broadly divided into common law and Roman law systems in Roman Law systems the law tends to be very detailed in Common Law systems—which is how Australia can be classified—law typically evolves from the ruling of judges In Common Law countries accounting practices tend to rely relatively heavily on professional judgment Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Business ownership and financing system
Another factor is the business ownership and financing system At a country level the financing system is relevant to the purpose of financial reporting Three types of financing systems capital market-based (e.g. United Kingdom and United States) credit-based system: governmental (e.g. France and Japan) credit-based system: financial institutions (e.g. Germany) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Business ownership and financing system (cont.)
Systems relying on equity markets will have greater demand for public disclosures Credit-based systems more concerned with the protection of creditors Colonial inheritance also a major explanatory factor Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Taxation systems Differences in accounting methods internationally have also been linked to differences in taxation systems Where there are ‘insider systems of finance’ (common in continental European countries) financial accounting practices have typically been linked to taxation law Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Impact of international agencies
Various international agencies have also had an affect on the accounting systems used within particular countries Examples of institutions or bodies which can impact on a country’s accounting policies are multinational companies international accounting firms large monetary organisations e.g. World Bank Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

So there are many forces ‘working against’ international standardisation
Hence, to this point we can see that there are many explanations for international differences Given the many factors that explain why international differences in accounting will, or perhaps should exist, then how logical are efforts towards international standardisation? Do we think that the efforts of the IASB are likely to succeed in the long-run? Will diverse countries with different cultures, religions, finance systems and so forth start to question a ‘one-size-fits-all’ approach emanating from London? Time will tell … Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 5 Normative theories of accounting—the case of accounting for changing prices Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices a number of alternative accounting methods developed to address problems associated with changing prices some of the strengths and weaknesses of the various alternative accounting methods evidence that the calculation of income pursuant to a particular method of accounting will depend on the perspective of capital maintenance that has been adopted Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Limitations of historical cost in times of rising prices
Historical cost assumes money holds a constant purchasing power Three aspects of the economy which make the assumption less valid than when historical cost was developed specific price level changes (shifts in consumer preference; technological advances) general price level changes (inflation) fluctuation in exchange rates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Limitations of historical cost in times of rising prices (cont.)
Problem of relevance in times of rising prices asset’s current value may be different from historical cost Problem of additivity (adding together assets bought at different times) Can overstate profits in times of rising prices, with distribution of profits leading to an erosion of operating capacity Including holding gains which accrued in previous periods in current year’s income distorts the current year’s operating results Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Support for historical cost accounting
Predominant method used for many years so tended to maintain support of profession If not found useful business entities would have abandoned it Nevertheless, recent accounting standards being released have embraced ‘fair values’ as the basis of measurement. However, various assets are still measured on an historical cost basis e.g. inventory, which is measured at the lower of cost and net realisable value; property, plant and equipment where the ‘cost model’ and not the ‘fair-value model’ has been adopted; many intangible assets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Definition of Income The maximum amount that can be consumed during the period, while still expecting to be as well off at the end of the period as at the beginning of the period (Hicks 1946) Consideration of ‘well-offness’ relies on a notion of capital maintenance Different notions of capital maintenance will provide different perspectives of income Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capital maintenance perspectives
Financial capital maintenance perspective taken in historical cost accounting Purchasing power maintenance historical cost accounts adjusted for changes in the purchasing power of the dollar Physical operating capital maintenance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Development of accounting for changing prices
Research initially related to using price indices to restate historical costs to account for changing prices Literature then moved towards current cost accounting the basis of measurement changed to current values not historical values Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Current purchasing power accounting (CPPA)
Also called general purchasing power accounting; general price level accounting; constant dollar accounting Based on the view that in times of rising prices, if an entity were to distribute unadjusted profits based on historical costs, in real terms the entity could be distributing part of its capital Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Calculating indices A price index is used when applying general price level accounting A price index is a weighted average of the current prices of goods and services related to a weighted average of prices in a prior period (base period) e.g. Australian Consumer Price Index (CPI) Can use a general or specific price index Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Performing current purchase power adjustments
All adjustments are performed at the end of the period Adjustments are applied to historical cost accounts Monetary and non-monetary assets considered separately values of monetary assets do not change as a result of inflation liabilities generally considered monetary items Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Performing current purchase power adjustments (cont.)
In times of inflation, holders of monetary assets will lose in real terms the assets have less purchasing power at the end of the period relative to the beginning of the period Holders of monetary liabilities gain, given the amount they have to repay at the end of the period is worth less than at the beginning Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Performing current purchase power adjustments (cont.)
No change in purchasing power arises from holding non-monetary assets non-monetary assets are restated to current purchasing power so no gain or loss is recognised Purchasing power gains or losses are included in income for the period Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Movements in net monetary assets
Must identify changes in net monetary assets as a result of revenues or expenses In times of rising prices there will be a loss in purchasing power of cash received during the year More expenses are able to be paid earlier in the year as more cash required for expenses incurred later in the year Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Advantages of current purchasing power adjustments
Relies on data already available under historical cost accounting No need to incur cost or effort to collect data about current asset values CPI data also readily available Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Disadvantages of current purchasing power adjustments
Movements in the prices of goods and services included in a general price index (CPI) may not reflect specific price movements in different industries Information generated under CPPA may be confusing to users Studies of share price reactions failed to find much support for decision usefulness of CPPA data Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Current cost accounting (CCA)
Based on actual valuations not adjusted historical cost Differentiates between profits from trading and holding gains Holding gains can be realised or unrealised Income perspective adopted will determine whether holding gains or losses treated as income Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Treatment of holding gains or losses
Financial capital maintenance perspective holding gains or losses can be treated as income Physical capital maintenance perspective holding gains or losses can be treated as capital adjustments Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

CCA under physical capital maintenance approach
Advocated by Edwards and Bell Valuations based on replacement costs Operating income represents realised revenues less the replacement cost of assets in question Generates a measure of income that represents the maximum amount that can be distributed, while maintaining operating capacity intact Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Adjustments using Edwards and Bell approach
Adjustments usually made at year end Historical cost accounts used as basis of adjustments Operating profit calculated by using replacement costs Holding gains excluded in calculating current cost operating profit not available for dividends Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Adjustments using Edwards and Bell approach (cont.)
BUT holding gains are included in calculating business profit Business profit shows how the entity has gained in financial terms from the increase in cost of its resources Depreciation of non-current assets based on the replacement cost As with CPPA no restatement of monetary assets required Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Advantages of current cost accounting
Differentiating operating profit from holding gains and losses can enhance the usefulness of information provided holding gains different to trading income as due to market-wide movements that are often beyond management’s control Better comparability of various entities’ performance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of current cost accounting
Replacement cost of assets may not be the same for all firms some firms may not choose to replace the asset If the entity requires replacement assets it may be more efficient and less costly to acquire different assets Replacement cost does not reflect what the asset would be worth if sold Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of current cost accounting (cont.)
Often difficult to determine replacement costs Allocating replacement cost via depreciation is still arbitrary as with historical cost accounting Chambers (1995) claimed products of CCA were irrelevant and misleading Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Continuously Contemporary Accounting (CoCoA)
Proposed by Chambers as well as others Based on valuing assets at net selling prices (exit prices) at reporting dates on the basis or orderly sales referred to as current cash equivalent Chambers argued that key information for decision making relates to capacity to adapt Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Continuously Contemporary Accounting (CoCoA) (cont.)
The balance sheet (statement of financial position) considered to be the prime financial statement shows the net selling prices of the entity’s assets Profit directly relates to changes in adaptive capital Adaptive capital reflected by the total exit values of assets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capacity to adapt Chambers approach focuses on new opportunities
the ability of the entity to adapt to changing circumstances The ability of the firm to ‘go into the market with cash for the purposes of adapting oneself to contemporary conditions’ (Chambers 1966, p.91) Assumes the objective of accounting is to guide future actions Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Definition of wealth under CoCoA
Present (selling) price is seen as the correct valuation of wealth at a point in time past prices are a matter of history so not relevant to current actions Profit is tied to the increase (or decrease) in the current net selling prices of the entity’s assets No distinction between realised and unrealised gains—all gains are treated as part of profit Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Definition of wealth under CoCoA (cont.)
Profit is the amount that can be distributed, while maintaining the entity’s adaptive ability (adaptive capital) Abandons notion of realisation in terms of recognising revenue revenues are recognised at point of purchase or production rather than sales Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capital maintenance adjustment
Unlike CCA there is an adjustment to take account of changes in general purchasing power (inflation adjustment) Capital maintenance adjustments form part of the period’s income with a corresponding credit to a capital maintenance reserve (part of owners’ equity) Calculated by multiplying net assets by the proportional change in a general price index over the period Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Advantages of CoCoA By using one method of valuation for all assets (exit values) the resulting numbers can be logically added together (additivity) No need for arbitrary cost allocation for depreciation as gains or losses on assets are based on movements in exit price Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of CoCoA If implemented CoCoA would involve a fundamental shift in financial accounting revenue recognition points and asset valuations could lead to unacceptable social and environmental consequences Relevance of exit prices questioned if we do not expect to sell the assets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of CoCoA (cont.)
Assets of a specific nature considered to have no value under CoCoA because cannot be separately disposed of CoCoA ignores the ‘value in use’ of an asset Questioned whether appropriate to value all assets at exit prices if the entity is a going concern Determining exit prices for unique assets introduces subjectivity into accounts Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of CoCoA (cont.)
CoCoA requires assets to be valued separately rather than as a bundle therefore would not recognise goodwill as an asset value of assets sold together can be very different from separate sale Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Demand for price adjusted accounting information
Limited evidence that stock markets react to current cost and CPPA information little or no share price reaction to price adjusted accounting information found results may have been due to limitations with research methods used reaction to other information released at the same time could not be distinguished users may have obtained information from other sources prior to release of annual reports Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Demand for price adjusted accounting information (cont.)
Surveys of managers find limited corporate support for current cost accounting cost, limited benefits from disclosure and lack of agreement as to approach are all considerations Surveys of users indicate information not helpful, not used and information does not tell users anything new Findings interesting given the extent of voluntary disclosure by corporations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons for lobbying Watts and Zimmerman examined lobbying reaction to release of FASB Discussion Memorandum on general price level accounting Found that political visibility a major factor in explaining lobbying positions large firms favour general price level accounting as leads to lower reported profits Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons for lobbying (cont.)
Supported in New Zealand by Wong (1988) corporations adopting CCA during period of rising prices had higher effective tax rates and larger market concentrations than those that did not In UK Sutton (1988) found politically sensitive firms more likely to lobby in support of exposure draft recommending disclosure of CCA Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Professional support for various approaches
Current purchasing power accounting generally supported by standard-setters from 1960s to mid-1970s From about 1975 preference shifted to current cost accounting Late 1970s and early 1980s standard-setters issued recommendations which favoured a mixture of CPPA and CCA From mid-1980s support waned (time of falling inflation) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Potential reasons for lack of continued support
May question the relevance of current cost information in times of falling inflation Drastic change to accounting conventions could cause disruption and confusion in capital markets New method of accounting could have taxation consequences Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Potential reasons for lack of continued support (cont.)
Self-interest motives of corporations Limited relevance to decision makers Nevertheless, in recent years there have been movements towards the use of ‘fair values’ as new accounting standards are being released Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 6 Normative theories of accounting—the case of conceptual framework projects Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-185

the role that conceptual frameworks (CFs) can play in the practice of financial reporting the history of the development of the various existing conceptual framework projects the various building blocks that have been developed within various conceptual framework projects Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-186

perceived advantages and disadvantages that arise from the establishment and development of conceptual frameworks recent initiatives being undertaken by the IASB and the FASB to develop an improved conceptual framework factors, including political factors, that might help or hinder the development of conceptual framework projects groups within society which are likely to benefit from the establishment and development of conceptual framework projects Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-187

What is a conceptual framework?
'A coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards' (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises 1978) Attempts to provide a structured theory of accounting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-188

Conceptual frameworks as normative theories
Conceptual frameworks provide prescription so they are considered normative theories of accounting 'Prescribes the nature, function and limits of financial accounting and reporting' (Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises, 1978) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-189

A revised conceptual framework
In recent years the FASB and IASB have been jointly working towards the development of an improved conceptual framework In 2008 they released a document entitled: Exposure Draft of an improved Conceptual Framework for Financial Reporting This phase of the project specifically addressed the objective of financial reporting and the qualitative characteristics and constraints of decision-useful financial reporting information. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-190

Rationale for conceptual frameworks
To develop the practice of financial reporting logically and consistently we need to address such issues as: what we mean by 'financial reporting' and what should be its scope; which organisational characteristics indicate that an entity should produce financial reports; the 'objective' of financial reporting; qualitative characteristics financial information should possess; what are the elements of financial reporting; and what measurement rule should be employed. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-191

Rationale for conceptual frameworks (cont.)
Proponents argue that without agreement on these issues accounting standards will be developed in an ad hoc manner Limited consistency between accounting standards in the absence of a conceptual framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-192

The 'building blocks' of the conceptual framework
The framework must be developed in a particular order some issues (or assumptions) need to be resolved or made before moving on to subsequent 'building blocks' One obvious issue that needs early agreement would be what is meant by 'financial reporting'. Other issues that would also need agreement early in the process would be: Definition of a reporting entity Definition of the users of financial statements The objective of financial reporting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-193

The 'building blocks' of the conceptual framework (cont.)
Because the rest of the framework flows from assumptions about the 'objective', if we reject the assumption, then we personally might be prepared to reject the prescriptions provided by the framework Refer to Figure 6.1 (p.213) in the text for an overview of the IASB Framework for the Preparation and Presentation of Financial Statements (which in 2005 replaced the Australian Conceptual Framework) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-194

History of the development of CFs
CFs were developed in a number of jurisdictions including US, UK, Canada, Australia, New Zealand, International Accounting Standards Committee In recent years many countries have adopted the IASB Framework given that they have decided to adopt the accounting standards released by the IASB No standard-setters had developed a complete CF; measurement issues typically unaddressed Limited or no progress in recent years, although there is now a joint IASB/FASB project to develop a new and improved conceptual framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-195

Development of frameworks of accounting in the US
1961 and 1962: Moonitz, and Moonitz and Sprouse prescribed that accounting practice should be based on current values 1965: Grady developed theory based on description of existing practice led to the release of Accounting Principles Board (APB) Statement No. 4 however, accounting profession under criticism for lack of any real framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-196

Development of frameworks of accounting in the US (cont.)
Led to formation of Trueblood Committee in 1971 which produced Trueblood Report report outlined 12 objectives of accounting and seven qualitative characteristics which financial information should possess objective 1: focused on information needs of financial statement users objective 2: need to serve users with limited ability to demand financial information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-197

Development of frameworks of accounting in the US (cont.)
1974: APB replaced by FASB which then embarked on its CF project Six Statements of Financial Accounting Concepts (SFACs) released from 1978 to 1985 Initial SFACs normative in nature, but SFAC No. 5 relating to recognition and measurement largely descriptive of current practice received much criticism since 2005 FASB and IASB have been jointly working towards the development of a revised conceptual framework that would be used by both boards—referred to as the 'convergence project' Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-198

Development of a CF in the UK
Early moves towards guidance relating to objectives and identification of users provided by The Corporate Report (1976) concerned with addressing the rights of the community in terms of their access to financial information (broader than notion of users adopted in other frameworks) ultimately contents generally not accepted by the accounting profession Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-199

Development of a CF in the UK (cont.)
1991: ASB adopted the IASC's CF IASC framework was generally consistent with the US and Australian frameworks—subsequently became known as the IASB Framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-200

Development of a CF in Australia
Degree of progression was slow Only four Statements of Accounting Concepts (SACs) were released SAC 1: Definition of the Reporting Entity SAC 2: Objectives of General Purpose Financial Reporting SAC 3: Qualitative Characteristics of Financial Information SAC 4: Definition and Recognition of the Elements of Financial Statements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-201

Development of a CF in Australia (cont.)
Fifth SAC relating to measurement was never released Had a number of similarities to the US CF project 2005: Australia adopted the IASB Framework as a result of the decision by the Financial Reporting Council that Australia would adopt IAS/IFRS by 2005 SAC 3 and SAC 4 were abandoned SAC 1 and SAC 2 were retained until such time that a revised IASB Framework was developed Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-202

Current efforts of the IASB and the FASB
From 2005 the IASB and the FASB have been jointly working towards the development of a revised conceptual framework that will be used by both parties The need for this revised framework has arisen because of the 'convergence project' in which the IASB and the FASB are working together to converge their two sets of accounting standards Will take several years to complete Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-203

Current efforts of the IASB and the FASB (cont.)
The IASB and FASB are undertaking the work on the conceptual framework in eight phases, these being: objectives and qualitative characteristics definitions of elements recognition and de-recognition measurement reporting entity concept boundaries of financial reporting, and presentation and disclosure purpose and status of the framework application of the framework to not-for-profit entities remaining issues, if any Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-204

Building blocks of the CF
The following discussion is based on the IASB Framework currently in place Where appropriate, reference will also be made to current work being done by IASB and FASB given that this gives an indication of what might come in the future Building blocks of the various CFs have addressed definition of the reporting entity objectives of general purpose financial reporting (GPFR) perceived users of GPFRs qualitative characteristics that GPFRs should possess elements of financial statements possible approaches to measuring the elements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-205

Definition of the reporting entity
The Conceptual Framework provides a definition of entities required to produce GPFRs known as reporting entities Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-206

General purpose financial reports
GPFRs are defined as reports '… intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs' (SAC 1, para.6) GPFRs are reports that comply with accounting standards and other generally accepted accounting practices (GAAPs) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-207

Special purpose financial reports
By contrast, special purpose reports are provided to meet the information demands of a particular user, or group of users Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-208

Entities required to produce GPFRs
Not all entities are classed as reporting entities SAC 1 states that GPFRs should be prepared when there are users: '… whose information needs have common elements, and those users cannot command the preparation of information to satisfy their individual information needs' (para.8) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-209

Factors indicative of a reporting entity (SAC 1)
Separation of management from those with an economic interest in the entity The economic or political importance/influence of the entity to/on other parties The financial characteristics of the entity Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-210

Objectives of GPFR Traditional objective was to enable outsiders to assess the stewardship of management Recent commonly accepted goal of financial reporting is to assist report users' economic decision making less emphasis placed on the stewardship function Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-211

Objective embraced within CFs
Objective of GPFRs in SAC 2 is deemed to be to provide information to users that is useful for making and evaluating decisions about the allocation of scarce resources Objective of decision usefulness calls into question usefulness of historical cost information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-212

Other objectives of GPFRs
Another objective is to enable reporting entities to demonstrate accountability between the entity and those parties to which the entity is deemed accountable Accountability is defined as the duty to provide an account or reckoning of those actions for which one is held responsible Accountability is not generally embraced by CFs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-213

Current thinking of the IASB and FASB
In the 2008 conceptual framework exposure draft it is stated: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. Information that is decision-useful to capital providers may also be useful to other users of financial reporting who are not capital providers. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-214

Current thinking of the IASB and FASB (cont.)
As we know from previous lectures, before we are prepared to accept the prescriptions provided by a normative theory we must be satisfied with the underlying assumptions made Hence, if we reject the assumptions about the objective of general purpose financial reporting then we would be inclined to reject the prescriptions made despite how logical the framework may appear Is this objective (above) too restrictive? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-215

Users of financial reports
SAC 2 identifies three primary user groups for GPFRs resource providers employees, lenders, creditors, suppliers, investors and contributors recipients of goods and services customers and beneficiaries parties performing review or oversight function parliaments, governments, regulatory agencies, analysts, labour unions, employer groups, media and special interest groups Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-216

International perspectives on users of GPFRs
The IASB Framework identifies GPFRs users as investors, employees, lenders, suppliers, customers, govt. agencies and the public states that information designed to meet the needs of investors will usually meet the needs of the other groups US: SFAC 1 main focus is present and potential investors and other users with either a direct financial interest or related to those with a direct financial interest UK: The Corporate Report all groups impacted by an organisation's operations have rights to information about the reporting entity, not necessarily related to resource allocation decisions Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-217

Level of expertise expected of financial report readers
Generally accepted that readers are expected to have some proficiency in financial accounting IASB Framework (para.25) … users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-218

Current thinking of the IASB and the FASB in relation to 'users'
The 2008 exposure draft stated: The primary user group includes both present and potential equity investors, lenders and other creditors, regardless of how they obtained, or will obtain, their interests…. Other users who have specialised needs, such as suppliers, customers and employees (when not acting as capital providers), as well as governments and their agencies and members of the public, may also find useful the information that meets the needs of capital providers; however, financial reporting is not primarily directed to these other groups because capital providers have more direct and immediate needs Is this perspective of 'users' too restrictive? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-219

Qualitative characteristics of financial reports
To ensure financial information is useful for economic decision making, we need to consider the attributes or qualities that financial information should have According to IASB Framework primary qualitative characteristics are understandability, relevance, reliability and comparability related to relevance is materiality IASB Framework appears to give greater prominence to relevance and reliability there are issues associated with the 'trade-off' between relevance and reliability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-220

Reliability Information is considered to be reliable if it 'faithfully represents' the entity's transactions and events Should be free from bias and undue error Reliability is a function of representational faithfulness, verifiability and neutrality Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-221

Reliability—implications for traditional accounting
Traditionally, the doctrine of conservatism and the acceptance of 'prudence' has been adopted bias towards understating asset values and overstating liabilities This doctrine is not consistent with notions of reliability or freedom from bias Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-222

Relevance Something is relevant if it influences decisions on the allocation of scarce resources if it is capable of making a difference in a decision For information to be relevant it should have: predictive value, and feedback value Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-223

Materiality A limiting factor on the disclosure of relevant and reliable material is the notion of materiality An item is material if (IASB Framework, para. 30) ... its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements …. Materiality provides a cut-off rather than being a primary qualitative characteristic which information must have if it is to be useful Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-224

Uniformity and consistency
Uniformity and consistency imply advantages in restricting the number of accounting methods that can be used by reporting entities has been argued that firms adopt particular accounting methods because they best reflect their underlying performance restricting available methods imposes costs on reporting entities Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-225

Costs vs. benefits Need to consider whether the cost of providing certain information exceeds the benefits to be derived from its provision costs include collection, storage, retrieval, presentation, analysis and interpretation benefits come from sound economic decision making by users Measuring potential costs and benefits involves professional judgement Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-226

Latest thinking of the IASB and the FASB regarding qualitative characteristics
In the 2008 exposure draft released as part of the conceptual framework project it is stated: For financial information to be useful, it must possess two fundamental qualitative characteristics—relevance and faithful representation. The draft conceptual framework has reduced the four 'primary qualitative characteristics' to two 'fundamental qualitative characteristics' Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-227

Latest thinking of the IASB and the FASB regarding qualitative characteristics (cont.)
The qualitative characteristic of reliability was replaced by 'faithfully representation' The other two primary qualitative characteristics identified in the IASB Framework, these being understandability and comparability, have been renamed as 'enhancing qualitative characteristics' in the draft document released by the IASB Two additional 'enhancing qualitative characteristics' have also been included (thereby giving a total of four enhancing qualitative characteristics), these being verifiability and timeliness Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Can GPFRs provide unbiased accounts of performance?
The practice of accounting is heavily reliant on professional judgement Prior to accounting standards being released, standard-setters attempt to determine the economic consequences of following the standards if they consider economic consequences then standards cannot be considered objective or neutral Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-229

Can GPFRs provide unbiased accounts of performance? (cont.)
If we accept the notion that preparers will be driven by self-interest (from Positive Accounting Theory) notions of objectivity or neutrality are unrealistic Political nature of standard setting process also affects neutrality and objectivity In communicating reality accountants construct reality (Hines 1988) That is, if accountants identify something and start to place a monetary value on it then it gains importance – it becomes visible (and 'real') Conversely, if accountants ignore it – such as many externalities caused by business entities – then for many people the 'issue' does not exist Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-230

The elements of financial reporting
The next building block considers the definition and recognition criteria of the elements of financial reporting Definition criteria—what attributes are required before an item can be considered as belonging to a particular class of element Recognition criteria—employed to determine whether the item can be included in the financial statements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-231

Five elements of financial reporting in the IASB Framework
Assets Liabilities Equity Expenses Income in the IASB Framework, income is further subdivided into revenues and gains ten elements identified in the US by FASB Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-232

Definition of assets '… a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity' (IASB Framework, para.49(a)) Three key characteristics must be an expected future economic benefit the reporting entity must control the future economic benefit the transaction or other past event giving rise to the reporting entity's control must have occurred Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-233

Definition of assets (cont.)
The definition refers to the benefit and not its source in the absence of future economic benefits, the object or right will not qualify as an asset The benefits can result from ongoing use, not necessarily a value in exchange Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-234

The characteristic of control
Control relates to the capacity to benefit from the asset and to deny or regulate others' access to the benefit Legal enforceability is not a prerequisite for establishing the existence of control control (and not legal ownership) is required, although controlled assets are frequently owned Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-235

Recognition of assets An asset—and all the other elements of accounting—shall be recognised when it is probable that any future economic benefit associated with the item will flow to or from the entity, and the item has a cost or value that can be measured with reliability (IASB Framework, para.83) Probable is generally considered to mean 'more likely rather than less likely' Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-236

'Current thinking' of the IASB and FASB in relation to assets
Within the 2008 exposure draft the IASB and FASB thought there were shortcomings with the existing asset definition. They stated: Some users misinterpret the terms 'expected' (IASB definition) and 'probable' (FASB definition) to mean that there must be a high likelihood of future economic benefits for the definition to be met; this excludes asset items with a low likelihood of future economic benefits. The definitions place too much emphasis on identifying the future flow of economic benefits, instead of focusing on the item that presently exists, an economic resource. Some users misinterpret the term 'control' and use it in the same sense as that used for purposes of consolidation accounting. The term should focus on whether the entity has some rights or privileged access to the economic resource. The definitions place undue emphasis on identifying the past transactions or events that gave rise to the asset, instead of focusing on whether the entity had access to the economic resource at the balance sheet date. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-237

Current thinking about assets (cont.)
The IASB and FASB developed the following draft definition: An asset of an entity is a present economic resource to which, through an enforceable right or other means, the entity has access or can limit the access of others This definition also seems to have limitations Some of the above terms seem rather ambiguous Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-238

Definition of liabilities
A liability is presently defined as '… a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits' (IASB Framework, para.49(b)) present obligations not only refers to legally enforceable obligations but also those imposed by notions of equity and fairness, or by custom or other business practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-239

Recognition of liabilities
Recognition criteria consistent with those of assets and the other elements of accounting A liability shall be recognised when: it is probable that the sacrifice of economic benefits will be required, and the amount of the liability can be measured reliably Has implications for disclosure of various provisions Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-240

Present thinking of the IASB and FASB in relation to liabilities
According to the exposure draft released in 2008 the IASB and FASB believe that the existing liability definition has limitations: Some users misinterpret the terms 'expected' (IASB definition) and 'probable' (FASB definition) to mean that there must be a high likelihood of future outflow of economic benefits for the definition to be met; this excludes liability items with a low likelihood of a future outflow of economic benefits The definitions place too much emphasis on identifying the future outflow of economic benefits, instead of focusing on the item that presently exists, an economic obligation The definitions place undue emphasis on identifying the past transactions or events that gave rise to the liability, instead of focusing on whether the entity has an economic obligation at the reporting date Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-241

Present thinking of the IASB and FASB in relation to liabilities (cont
The IASB and FASB proposed the following draft definition of a liability: A liability of an entity is a present economic obligation that is enforceable against the entity. As with the proposed definition of assets, the suggested change in the liability definition could potentially have significant implications for financial reporting. For example: The above definition could act to exclude constructive or equitable obligations that are not enforceable against the entity. This would be a major departure from existing practice Would this be a good change? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-242

Approaches to determining profit
Two common approaches to determining profits asset/liability approach links profit to changes in assets and liabilities revenue/expense approach relies on concepts such as the matching principle The definition of expenses and revenues in the CF based on asset/liability perspective Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-243

Definition of expenses
'… decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants' (IASB Framework, para.70(b)) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-244

Recognition of expenses
An expense shall be recognised when it is probable that the consumption or loss of future economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred, and the consumption or loss of economic benefits can be measured reliably Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-245

Definition of income '… increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants' (SAC 4, para.70(a)) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-246

Definition of income (cont.)
Income can be recognised from normal trading relations, as well as from non-reciprocal transfers such as grants, donations, bequests or where liabilities are forgiven IASB Framework further subdivides income into revenues and gains revenue arises in the course of the ordinary activities of an entity gains represent other items that meet the definition of income and may, or may not, arise in the ordinary activities of an enterprise not clear why there is a need to break income into two components Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-247

Recognition of income As with the other elements of accounting, income is recognised when: it is probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred; and the inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-248

Definition of equity Equity is defined as 'the residual interest in the assets of the entity after deducting all of its liabilities' (IASB Framework, para.49(c)) As a residual interest it ranks after liabilities in terms of claims against the assets Definition is a direct function of the definitions of assets and liabilities Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-249

Measurement principles
To date there is very little prescription in relation to measurement provided by CFs FASB statement provides description of various approaches to measuring elements without providing prescription Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-250

Current IASB and FASB work on measurement issues
In 2005 the IASB and FASB stated: Measurement is one of the most underdeveloped areas of the two frameworks Both frameworks (the IASB and FASB Frameworks) contain lists of measurement attributes used in practice. The lists are broadly consistent, comprising historical cost, current cost, gross or net realizable (settlement) value, current market value, and present value of expected future cash flows. Both frameworks indicate that use of different measurement attributes is expected to continue. However, neither provides guidance on how to choose between the listed measurement attributes or consider other theoretical possibilities. In other words, the frameworks lack fully developed measurement concepts. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-251

Current IASB and FASB work on measurement issues (cont.)
Phase C of the joint IASB and FASB Conceptual Framework Project is to address measurement issues. In this work the IASB and FASB have identified nine potential measurement bases, these being: past entry price, past exit price, modified past amount, current entry price, current exit price, current equilibrium price, value in use, future entry price, and future exit price It is expected that it will be a number of years before any conclusion is reached about the most appropriate measurement basis for assets and liabilities Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Benefits associated with conceptual frameworks
Accounting standards should be more consistent and logical Increased international compatibility of accounting standards Standard-setters should be more accountable for their decisions Communication between standard-setters and their constituents should be enhanced Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-253

Benefits associated with CFs (cont.)
The development of accounting standards should be more economical Where conceptual frameworks cover a particular issue, there might be a reduced need for additional standards Emphasise the 'decision usefulness' role of financial reports rather than restricting concern to stewardship Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-254

Disadvantages of conceptual frameworks
Smaller organisations may feel overburdened by reporting requirements Typically economic in focus, so ignore transactions that have not involved market transactions or exchange of property rights further reinforces the importance of economic performance relative to social performance Represent a codification of existing practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-255

CFs as a means of legitimising standard-setting bodies
Some (e.g. Hines and Solomons) have suggested that CFs have been used as devices to help ensure the ongoing existence of the accounting profession Increase the ability of the profession to self-regulate, thus counteracting government intervention Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e 6-256

Chapter 7 Positive accounting theory Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

how a positive theory differs from a normative theory the origins of Positive Accounting Theory (PAT) the perceived role of accounting in minimising the transaction costs of an organisation how accounting can be used to reduce the costs associated with various political processes how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers some criticisms of PAT Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive compared to normative theories
A positive theory seeks to explain and predict particular phenomena Positive Accounting Theory (PAT), which we explore in this lecture, is one example of a positive theory of accounting. Other examples are covered in the next lecture (when we consider theories such as legitimacy theory and institutional theories which are positive theories that can be applied to the practice of accounting) By contrast, normative theories prescribe how a particular practice should be undertaken the prescription might depart from existing practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive Accounting Theory defined
PAT ‘… is concerned with explaining accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method … but it says nothing as to which method a firm should use.’ (Watts and Zimmerman 1986, p. 7) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Positive Accounting Theory defined (cont.)
Focuses on relationships between various individuals and how accounting is used to assist in the functioning of these relationships Examples of relationships owners and managers managers and the firm’s debt providers Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Assumptions underlying PAT
All individuals’ action is driven by self-interest and individuals will act in an opportunistic manner to the extent that the actions will increase their wealth does not incorporate notions of loyalty or morality Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Origins of PAT Started coming to prominence in mid-1960s
paradigm shift from normative theories Dominant research paradigm in 1970s and 1980s shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis – something common in positive research Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Origins of PAT—capital markets research
Development of Efficient Markets Hypothesis (EMH) by Fama and others capital markets react in an efficient and unbiased manner to publicly available information Ball and Brown (1968) paper was crucial to the acceptance of the positive research paradigm investigated stock market reaction to accounting earnings announcements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Origins of PAT—capital markets research (cont.)
Price of a security based on beliefs about present value of future cash flows Ball and Brown found that earnings announcements impacted share prices evidence that historical cost information is useful to the market Literature unable to explain why particular accounting methods selected Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Origins of PAT—Agency theory
Explained why the selection of particular accounting methods might matter Focused on the relationships between principals and agents e.g. shareholders and managers Information asymmetries create much uncertainty transaction costs and information costs exist Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Agency relationship Defined by Jensen and Meckling (1976)
a contract under which one or more (principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent Relies on traditional economics literature assumptions of self-interest and wealth maximisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Price protection In the absence of contractual mechanisms to restrict agents’ potentially opportunistic behaviour, the principal will pay the agent a lower salary compensates principals for adverse actions Agents will therefore have incentives to enter contracts which appear to limit actions detrimental to agents Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Agency costs Monitoring costs Bonding costs Residual loss
costs of monitoring agents’ behaviour e.g. auditing financial statements Bonding costs costs involved in agents bonding their behaviour to expectations of principals e.g. preparing financial statements Residual loss too costly to remove all opportunistic behaviour Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of accounting in contracts
Accounting information used to reduce agency costs Used as monitoring and bonding mechanisms to control the efforts of self-interested agents Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Key hypotheses Three key hypotheses frequently used in PAT literature to explain, and predict support or opposition to, an accounting method bonus plan hypothesis debt hypothesis political cost hypothesis Research assumes managers will act opportunistically when selecting methods Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Bonus plan hypothesis Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income also called management compensation hypothesis action increases the present value of bonuses paid to management Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Debt hypothesis The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income also called debt/equity hypothesis the higher the debt/equity ratio, the closer the firm is to the constraints in debt covenants covenant violation results in costs of technical default Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political cost hypothesis
Large firms rather than small firms are more likely to use accounting choices that reduce reported profits size is a proxy variable for political attention reduction of reported income is hypothesised to reduce the possibility that people will argue that the organisation is exploiting other parties Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Two perspectives adopted by PAT research
Efficiency perspective Opportunistic perspective Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Efficiency perspective
Researchers explain how contracting mechanisms minimise agency costs of the firm Known as ex ante perspective mechanisms put in place up front to minimise future agency and contracting costs Managers select accounting methods which most efficiently reflect underlying firm performance PAT theorists argue that regulation forcing firms to use a particular accounting method imposes unwarranted costs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Opportunistic perspective
Seeks to explain managers’ actions once contracts are already in place Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth Known as ex post perspective considers opportunistic actions after the fact Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Owner/manager contracting
Assuming self-interest, owners expect managers (agent) to undertake activities not always in the interest of owners (principal) Managers have access to information not always available to principals information asymmetry further increases managers’ ability to undertake activities beneficial to themselves Costs of divergent behaviour are agency costs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Owner/manager contracting (cont.)
In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm Principals price this into the amounts they are prepared to pay the manager Managers may contract themselves not to consume perks so will receive higher salary known as bonding Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Methods of rewarding managers
Fixed basis—salary independent of performance manager may not take great risks as does not share in potential gains Salary plus remuneration is, in part, tied to firm performance known as bonus schemes Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Bonus schemes Remuneration can be tied to:
profits of the firm sales of the firm return on assets All based on output from the accounting system May also be rewarded in line with market price of the firm’s shares Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting-based bonus plans
Any changes in accounting methods will affect the bonuses paid may occur as a result of a new accounting standard in place Contracts in some circumstances may be based on the old method in place so changes will not affect bonuses Contracts relying on accounting numbers may rely on ‘floating’ GAAP Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Incentives to manipulate accounting numbers
Rewarding managers on the basis of accounting profits may induce them to manipulate accounting numbers (the opportunistic perspective) will affect their rewards Bonuses based on profits cause short-term rather than long-term focus may affect investment in positive NPV projects if returns not expected to be consistent Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Incentives to manipulate accounting numbers—evidence
Healy (1985) found: managers adopt accounting methods to maximise bonus if contract rewarded managers after a pre-specified level of earnings reached if income not expected to reach pre-specified minimum, managers shift earnings to future period (‘take a bath’) Lewellen, Loderer and Martin (1987) found: US managers approaching retirement are less likely to undertake R&D expenditure if rewards based on accounting-based performance measures short-term focus Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market-based bonus schemes
May be more appropriate to remunerate managers in terms of market value where accounting earnings fluctuate greatly e.g. mining, or high technology R&D firms Methods include: cash bonus based on share price increases shares options to shares Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market-based bonus schemes (cont.)
Managers have incentives to increase the value of the firm Problems include: share price also affected by factors beyond the control of managers (e.g. general market movements) only senior managers likely to have a significant impact on share value Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Choice of accounting versus market-based bonus schemes
More likely to be based on accounting earnings where: share returns relatively more sensitive to general market movements earnings have a high association with firm-specific movement in the firm’s share values earnings have a less positive association with market-wide movements in equity values Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Debt contracting—agency costs of debt
Agency costs of debt include excessive dividend payments, which leave fewer assets to service debt the organisation may take on additional debt, with new debtholders competing with original debtholders for repayment investment in high-risk projects may not be beneficial to debt holders as they have a fixed claim Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Use of debt contracts In the absence of safeguards to protect the interests of debtholders, it is assumed they will require the firm to pay higher costs of interest to compensate If firms contract not to pay excess dividends, take on high levels of debt or invest in risky projects, then they can attract debt at lower cost Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Australian debt contracts
In relation to Australian debt contracts, Cotter (1998) found: leverage covenants frequently used in bank loan contracts leverage most frequently measured as the ratio of total liabilities to total tangible assets prior charges covenants typically included in term loan agreements of larger firms prior charges covenants defined as a percentage of total tangible assets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Australian debt contracts (cont.)
debt to assets, interest coverage and current ratio clauses frequently in use interest coverage required to be between 1½ and 4 times current ratio clauses required current assets be between 1 and 2 times the size of current liabilities Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Australian debt contracts (cont.)
Mather and Peirson (2006) provide evidence of a change in the use of covenants relative to earlier periods. Their findings include: A reduction in the use of debt/asset restrictions; Greater variety of debt convents being used; More common covenants include minimum interest coverage; minimum dividend coverage; minimum current ratio; minimum required net worth; Use of ‘rolling GAAP’ more common – which introduces risks for the borrower; Mean number of covenants in public debt contracts less that private debt contracts – explained from an efficiency perspective Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Debt contracts—manager’s incentive to manipulate
Ex post, the incentive to manipulate numbers increases as the constraints approach violation Managers found to manipulate accounting accruals in the years before and the year after violation of a debt agreement Consider HIH Too costly to stipulate all acceptable accounting methods in contract so managers always have some discretionary ability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of external auditors
Auditors arbitrate on the reasonableness of the accounting method chosen Demand for financial statement auditing when: management is rewarded on the basis of numbers generated by the accounting system the firm has borrowed funds, and accounting-based covenants are in place to protect the investment of debtholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political costs Costs resulting from political attention from government, lobby groups etc. Commonly directed at larger firms indication of market power May result in increased taxes, increased wage claims, product boycotts etc. Firms likely to adopt accounting methods to reduce profits to lower political scrutiny Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political actions of individuals
Limited expected ‘pay-off’ results from the actions of individuals Results in formation of interest groups Information costs shared, ability to investigate government and business action increases Given self-interest, representatives of interest groups predicted to maximise own welfare as constituents have limited motivation or means to be fully informed Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Actions of politicians
Politicians know that highly profitable companies could be unpopular with members of constituency Politicians could win votes by taking actions against the companies argue that in public interest even though in own interest May rely on reported profits to justify actions provides incentives for firms to reduce reported profits Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticisms of PAT Does not provide prescription
PAT is not value-free as it asserts assumption that all action is driven by self-interest Argued to be too negative and simplistic a perspective of humankind Issues have not shown great development In undertaking large-scale empirical research, researchers ignore organisational-specific relationships Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 8 Unregulated corporate reporting decisions: considerations of systems-oriented theories Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning Objectives In this chapter you will be introduced to:
how community or stakeholders’ perceptions can influence the disclosure policies of an organisation how Legitimacy Theory, Stakeholder Theory and Institutional Theory can be applied to help explain why an entity might elect to make particular voluntary disclosures organisational legitimacy and how corporate disclosures within such places as annual reports can be used as a strategy to maintain or restore the legitimacy of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

how the respective power and information demands of particular stakeholder groups can influence corporate disclosure policies the view that a successful organisation is one that is able to balance or manage the demands, including information demands, of different stakeholder groups Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Systems-oriented theories
Legitimacy Theory, Stakeholder Theory and Institutional Theory are all systems-based theories Focus on the role of information and disclosure in the relationships between organisations, the State, individuals and groups The entity is influenced by, and influences, the society in which it operates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political Economy Theory
Legitimacy Theory, Stakeholder Theory and Institutional Theory derived from Political Economy theory Political economy is ‘the social, political and economic framework within which human life takes place’ (Gray, Owen & Adams 1996, p.47) Economic issues cannot be investigated in the absence of considering the political, social and institutional framework within which economic activity takes place Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political Economy Theory (cont.)
Corporate reports not considered neutral and unbiased, but are a product of the interchange between the corporation and its environment Two streams of Political Economy theory classical bourgeois Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Classical Political Economy Theory
Related to the works of Marx Considers class interests, structural conflict, inequity and the role of the state Accounting reports and disclosures are a means of maintaining the favoured position of those who control scarce resources Focuses on the structural conflicts within society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Bourgeois Political Economy Theory
Does not explicitly consider structural conflicts and class struggles Concerned with interactions between groups in an essentially pluralistic world Legitimacy Theory and Stakeholder Theory derive from this branch Does not question or study the various class structures within society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy Theory Organisations seek to ensure they operate within the bounds and norms of their respective societies activities are perceived to be ‘legitimate’ Bounds and norms not static so require organisation to be responsive Relies on the notion of a ‘social contract’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy versus legitimation
Legitimacy is the status or condition which exists when an entity’s value system is congruent with that of society Legitimation is the process which leads to an organisation being viewed as legitimate Legitimacy theory relies upon the notion that there is a ‘social contract’ between the organisation and the society in which it operates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy versus legitimisation (cont.)
To be considered legitimate it is not the actual conduct of the organisation that is important, it is what society collectively knows or perceives about the organisation’s conduct that shapes legitimacy Information disclosure is vital to establishing corporate legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social contract Represents the implicit and explicit expectations that society has about how the organisation should conduct its operations legal requirements might provide the explicit terms of the contract, while other non-legislated societal expectations embody the implicit terms Traditionally the optimal measure of performance was profit maximisation Public expectations have changed so organisations are now required to address human, environmental and other social issues Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social contract (cont.)
As Mathews (1993, p.26) states: The social contract would exist between corporations (usually limited companies) and individual members of society. Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products to the general environment. The organisation has no inherent rights to these benefits, and in order to allow their existence, society would expect the benefits to exceed the costs to society. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Implications of not meeting social contract
Society allows the organisation to continue operations to the extent that it meets their expectations The organisation may find it difficult to obtain the necessary support and resources to continue operations may lead to sanctions such as legal restrictions on operations, limited resources provided or reduced demand for products Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy and changing community expectations
Community expectations are not static As community expectations change, organisations must also adapt and change Legitimacy can be threatened even when the organisation’s performance is not deviating from society’s expectations perhaps the organisation has failed to make disclosures that show it is complying with community expectations Or, perhaps previously unknown information about the organisation comes to light (perhaps through the media) part of the ‘organisation shadow’ is revealed Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Actions to legitimise activities
Adapt output, goals and methods of operation to conform to definitions of legitimacy Attempt, through communication, to alter the definition of social legitimacy so it conforms with the organisation’s present practices, output and values Attempt, through communication, to become identified with symbols or values which imply legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Communication to maintain legitimacy
Seek to educate and inform the community about changes in performance and activities Seek to change perceptions but not behaviour Seek to manipulate perception by deflecting attention from the issue to other related issues Seek to change external expectations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of public disclosure
Public disclosure in such places as annual reports, sustainability reports and websites can be used to implement each of the previous strategies Perspective adopted by many researchers of social responsibility reporting Highlights the strategic nature of financial statements and other related disclosures Disclosures might be substantive or symbolic substantive disclosures would reflect actual changes in corporate activities symbolic disclosures do not reflect ‘real’ change but are made to appear consistent with social values and expectations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Empirical tests of Legitimacy Theory
Used by numerous researchers examining social and environmental reporting practices Used to attempt to explain disclosures Disclosures form part of the portfolio of strategies undertaken to bring legitimacy to, or maintain legitimacy of, the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies
Patten (1992): examined the change in the extent of environmental disclosures of US oil firms around the Exxon Valdez oil spill in Alaska legitimacy theory suggested that they would increase disclosure in the annual report after the spill found the increase in disclosure occurred across the industry Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies (cont.)
Deegan and Rankin (1996): used Legitimacy Theory to explain changes in annual report, environmental disclosure policies around proven environmental prosecutions prosecuted firms disclosed significantly more environmental information in the year of prosecution than any other year prosecuted firms disclosed more ‘positive’ environmental information than a matched sample of non-prosecuted firms Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Deegan and Gordon (1996): investigated the objectivity of environmental disclosure practices and trends over time, as well as whether environmental disclosures related to environmental group concerns found increased disclosure over time associated with increased environmental group membership disclosures mostly positive positive relation between environmental sensitivity of industry and disclosure Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Gray, Kouhy and Lavers (1995): performed longitudinal study of UK social and environmental disclosures from 1979 to 1991 related trends to Legitimacy Theory, with specific reference to Lindblom’s strategies Deegan, Rankin and Voght (2000): used Legitimacy Theory to explain how social disclosures in annual reports changed around the time of major social incidents or disasters Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Brown and Deegan (1998) emphasised the role of the media in shaping community expectations and showed that corporate disclosures responded to media attention Carpenter and Feroz (1992): undertook a US study on the government’s choice of an accounting framework related to a desire to increase the legitimacy of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How management determines society’s expectations
Legitimacy Theory proposes a relationship between corporate disclosure and community expectations Management has been found to rely on the media to provide an insight into community perceptions, with the media being observed to shape community expectations (O’Donovan 1999) O’Donovan (1999) provided evidence that corporate managers believe that: the media shapes public concerns annual report disclosures are a means of winning back the support of the community after adverse media coverage Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Impact of media attention
Islam and Deegan (2008) reviewed the social and environmental disclosure practices of Nike and Hennes & Mauritz from 1987 to 2005 found a direct relationship between the extent of global news media coverage of a critical nature directed towards particular social issues and the extent of social disclosure in the annual report Their findings supported a view that: the media is able to influence community concerns in relation to unobtrusive issues (creates a legitimacy gap) managers will make disclosure responses to the media attention Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy Theory versus Positive Accounting Theory
Legitimacy Theory has been compared to the Political Cost Hypothesis of PAT Legitimacy Theory relies on the notion of a ‘social contract’ It does not rely on the economics-based assumption that all action is driven by self-interest and wealth maximisation or make assumptions about the efficiency of markets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder Theory Two branches of Stakeholder Theory
ethical (moral) or normative branch positive (managerial) branch Many similarities between Legitimacy Theory and Stakeholder Theory should not be treated as two separate theories but two (overlapping) perspectives of the issue set within a ‘political economy’ framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical (normative) branch of Stakeholder Theory
All stakeholders have the right to be treated fairly by an organisation Issues of stakeholder power are not directly relevant Management should manage the organisation for the benefit of all stakeholders Firm is a vehicle for coordinating stakeholder interests Management have a fiduciary relationship to all stakeholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical branch of Stakeholder Theory (cont.)
Where interests conflict, business managed to attain optimal balance among them Each group merits consideration in its own right Also have a right to be provided with information, even if not used This perspective of corporate responsibilities is not validated (or rejected) on the basis of empirical observations (that is, these researchers are providing argument about what should be and not what is) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Definition of stakeholders
Any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives (Freeman & Reed 1983) There are two branches to the above definition Proponents of the ethical branch of stakeholder theory would include both branches when identifying stakeholders Proponents of a managerial perspective of stakeholder theory would only consider the first branch (that is, those stakeholder who can affect the achievement of the firm’s objectives) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Primary versus secondary stakeholders
Primary stakeholders ones without whose continuing participation the corporation cannot survive as a going concern Secondary stakeholders 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 Ethical branch does not differentiate between primary and secondary stakeholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Right to information—accountability
In considering rights to information accountability is considered the duty to provide an account or reckoning of those actions for which one is held responsible Accountability involves two responsibilities to undertake certain actions to provide an account of those actions Reporting is assumed to be a responsibility rather than demand driven Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Testing of ethical branch of theory
As the ethical branch embraces normative perspectives about how the organisation should act, it cannot be validated by empirical observation As Donaldson and Preston (1995, p.67) state: In normative uses, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead a normative theory attempts to interpret the function of, and offer guidance about, the investor-owned corporation on the basis of some underlying moral or philosophical principles. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Managerial branch of Stakeholder Theory
By contrast, this branch of stakeholder theory attempts to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders More organisation-centred stakeholders identified by the organisation extent to which organisation believes relationship needs to be managed in interests of the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Managerial branch of Stakeholder Theory (cont.)
Research undertaken under the managerial branch of stakeholder theory can be tested with empirical observation unlike normative ethical branch Specifically considers the different stakeholder groups within society, and how they should best be managed not society as a whole like Legitimacy Theory Expectations of stakeholders considered to impact on operating and disclosure policies Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder power Organisation will not respond to all stakeholders equally, but to the most powerful Stakeholder power is a function of the stakeholder’s degree of control over resources required by the organisation e.g. labour, finance, influential media, ability to legislate, ability to influence consumption of the organisation’s goods and services Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder power (cont.)
Major role of management is to assess the importance of meeting stakeholder demands so as to achieve strategic firm objectives Expectations and power relativities of various stakeholders change over time Organisation must continually adapt operating and disclosure strategies Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of information
Information, including financial accounting and social performance information, is a major element employed to manage stakeholders Used to gain support or approval Also used to distract their opposition or disapproval Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies
Roberts (1992) found measures of stakeholder power and their related information needs can provide some explanation of levels and types of corporate social disclosures Neu, Warsame and Pedwell (1998) firms more responsive (in terms of corporate environmental disclosure) to the concerns of financial stakeholders and government regulators than to environmentalists Islam and Deegan (2008) Garment suppliers in a developing country (Bangladesh) responsive to the expectations of multinational buying companies, with the multinational buying companies in turn being responsive to the expectations of western consumers (who’s expectations about working conditions, child labour, and so on – which are unobtrusive events - are influenced by the western media) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical view versus managerial view
By separately considering the two perspectives of Stakeholder theory, it could be construed that management might either be ethically aware, or focused on the survival of the organisation Management will arguably be driven by both ethical and performance considerations We need to understand the complementary roles normative and descriptive research play Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Institutional Theory Provides an explanation about why organisations tend to take on similar characteristics and form Particular organisational forms might be adopted in order to bring legitimacy to the organisation ‘Organisations conform because they are rewarded for doing so through increased legitimacy, resources and survival capabilities’ (Scott 1987, p.498) Provides a complimentary perspective to both legitimacy theory and stakeholder theory Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Institutional Theory (cont.)
Links organisation practices to societal values Organisational form tends towards some form of homogeneity ‘deviants’ will have problems gaining or maintaining legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Isomorphism and decoupling
Two main dimensions of Institutional Theory are isomorphism and decoupling Isomorphism refers to ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’ (DiMaggio & Powell 1983, p.149) Three different isomorphic processes coercive mimetic normative Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Coercive isomorphism Arises where organisations change their institutional practices because of pressure from those stakeholders upon which the organisation is dependent Related to the managerial branch of stakeholder theory Because powerful stakeholders might have similar expectations of other organisations, there will tend to be conformity in practices across organisations, including their reporting practices Consider how the World Bank has been able to influence reporting practices in developing countries (Neu and Ocampo 2007) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Mimetic isomorphism Organisations often copy other organisation’s practices for competitive advantage and to reduce uncertainty ‘Uncertainty is a powerful force that encourages imitation’ (DiMaggio & Powell 1983, p.151) Organisations within a particular sector adopt similar practices to those adopted by leading organisations—enhances external stakeholders’ perceptions of the legitimacy of the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Mimetic isomorphism (cont.)
Without coercive pressure from stakeholders, it would be unlikely that there would be pressure to mimic others—hence linkage between mimetic and coercive isomorphism Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Normative isomorphism
Pressures from ‘group norms’ to adopt particular institutional practices Particular groups with particular training will tend to adopt similar practices—non-compliance could result in sanctions being imposed by ‘the group’ Again, provides a rationale for why reporting approaches, and other corporate processes, tend to take on similar form Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Outcomes of isomorphism
Tendency towards similar corporate structures and processes Isomorphic processes do not necessarily make the organisations more efficient In practice it is not easy to differentiate between the three types of isomorphism Strategies might be more about ‘show’ or ‘form’, rather than about substance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decoupling Although managers might see a need to be seen to be adopting particular structures and practices, actual organisational practices can be very different from the formally sanctioned and publicly pronounced processes and practices For example, the organisational image constructed through corporate reports and other disclosures might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profit or shareholder value Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Concluding comments We can see that there is much overlap between the three theories just discussed Sometimes a joint consideration of different theoretical perspectives can provide a more holistic understanding of particular practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 9 Extended systems of accounting—the incorporation of social and environmental factors within external reporting Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

various perspectives of the responsibilities of business explanations of the relationship between organisational responsibility and organisational accountability the relationship between accounting and accountability various theoretical perspectives that can explain why organisations might voluntarily elect to provide publicly available information about their social and environmental performance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

some recent initiatives in social and environmental accounting the concept of sustainable development and how organisations are reporting their progress towards the goal of sustainable development the relationship between sustainability and eco-efficiency and eco-justice issues some of the limitations of traditional financial accounting in enabling users of reports to assess a reporting entity’s social and environmental performance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Introduction In recent years there has been increasing discussion about sustainable development and triple bottom line (TBL) and sustainability reporting TBL reporting is reporting that provides information about the economic, environmental and social performance of an entity Sustainability reporting represents a departure from sole economic focus that was traditional in external reporting A review of the Global Reporting Initiative’s Sustainability Reporting Guidelines provides insight into the types of social, environmental and economic information that could be disclosed in a sustainability report Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Introduction (cont.) The terms sustainability reporting and TBL reporting are often considered to be synonymous Strictly speaking however, sustainability reporting would require more than just TBL reporting and it would question three separate ‘bottom lines’ given sustainability would require social, economic and environmental aspects to be considered together Sustainability reporting would also address specifically how current activities are impacting the abilities of future generations to satisfy their own needs. Current TBL reports do not address such issues Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Responsibilities of business
Moves to provide information about social and environmental performance, whether through sustainability or TBL reports, implies management of these organisations consider they have an accountability for social and environmental performance, as well as economic performance not a view held universally Increasing community pressures for organisations to make a commitment to sustainable business practices, and corporate reporting is tending to respond to this pressure Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Responsibilities of business (cont.)
If sustainability becomes part of the expectations held by society, it must—consistent with legitimacy theory—become a business goal Providing information about social and environmental performance will increase the trust a community has in the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Sustainability Brundtland Report placed sustainability on the business worldwide agenda Sustainable development defined as: ‘… development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987) Inter-generational and intra-generational equity central to the agenda Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Sustainability (cont.)
Should organisations be responsible for the sustainability of their business practices? Will they embrace this responsibility in the absence of specific legislation? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How does an entity determine its responsibilities?
What do its relevant stakeholders consider business responsibilities to be? Based on personal judgement of the management involved as to who are the relevant stakeholders Has implications for the information disclosed Perceived responsibility and accountability go hand in hand Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accountability The duty to provide an account (not necessarily financial) or reckoning of those actions for which one is held responsible Two responsibilities or duties responsibility to undertake certain actions responsibility to provide an account of those actions Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

To whom is business responsible?
Many organisations making public statements that responsibilities extend beyond shareholders to encompass communities in which they operate and society as a whole If sustainability embraced then responsibility also owed to future generations If an organisation accepts a responsibility for the sustainability of its business practices, then it should produce an account of its responsibilities—it should provide a sustainability report Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stages of sustainability reporting
Stage 1: Why report? relates to management’s motivations Stage 2: To whom to report—who are the stakeholders? tied to managerial motivations for reporting—if motivations are based on managerial reasoning then disclosures could be aimed at powerful stakeholders Stage 3: What to report? involves dialogue with identified stakeholders Stage 4: What format for the disclosures? We will consider each of these stages in turn. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stage 1: Why report? Different accounting theories will provide alternative explanations about why an entity might decide to report social and environmental information We should remember that most social and environmental reporting is voluntary (an interesting issue in itself given the high level of regulation for financial reporting), therefore we can use various positive theories to explain or predict the voluntary decision to report As we appreciate, different theories make different assumptions and therefore will tend to give different explanation of the reporting phenomena Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theories to explain ‘why report?’ social and environmental disclosure
Legitimacy Theory and social contract disclosures linked to providing evidence that entity is complying with the expectations of society Stakeholder Theory disclosure depends on expectations of powerful stakeholders if the managerial perspective of stakeholder theory is embraced Accountability Model an acceptance of a responsibility to report Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Theories to explain ‘why report
Theories to explain ‘why report?’ social and environmental disclosure (cont.) Institutional Theory organisations will adopt particular practices because of institutional pressures Positive Accounting Theory disclosure depends on positive wealth implications consider submission of the Business Council of Australia on page 394 of the text Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

‘Why report?’ and its links to views about the responsibility of business
Consider the views of Milton Friedman—reporting is not about responsibilities; rather, it is about enhancing business profitability A broader view of business responsibilities would accept that regardless of the impacts of profitability, stakeholders have a right to know about the social and environmental implications of an organisation Where do we think corporations sit in terms of the above views? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Differing views of business responsibility
Friedman rejected the view that corporate managers have any moral obligations stated that ‘the business of business is business’ responsibility to increase profits as long as stays within the rules this view often held by the media—applauds profitable organisations Alternative view organisations earn their right to operate in the community artificial entities that society chooses to create organisations do not have an inherent right to resources consequently accountable to society for how it operates societal expectations may exceed profitability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Differing views about business responsibility (cont)
Anita Roddick, founder of the Body Shop, made the following statement (2007): In terms of power and influence, you can forget the church, forget politics. There is no more powerful institution in society than business, which is why I believe it is now more important than ever before for business to assume a moral leadership. The business of business should not be about money, it should be about responsibility. It should be about public good, not private greed. Consider how Roddick’s view contrasts with Milton Friedman or with the statement made by the Business Council of Australia (2005). The BCA stated: The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stage 2: To whom to report?
If managers overwhelmingly motivated by the desire to increase shareholder value then reporting will be aimed primarily at satisfying the expectations of powerful stakeholders If, by contrast, managers adopt a broader ethical perspective then disclosures would be aimed at stakeholders impacted by the operations of the entity—but still cannot address all information needs, so some prioritisation will be necessary It is emphasised that the decision of whom to report to is directly related to the previous issue of ‘why report?’ One cannot be considered in isolation from the other Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stage 3: What to report? First of all, establish that there is a demand for information Identify information needs through dialogue with stakeholders Negotiate a consensus among competing stakeholder needs and expectations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stage 4: How to report? Conventional financial accounting does not appear to provide a foundation for social and environmental disclosures Triple bottom line reporting is an alternative, although it is not the same as sustainability reporting. A true sustainability report would consider such issues as the carrying capacity of the eco-system, impacts on future generations and so forth An attempt can also be made to place a cost on the externalities of business Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? Limitations of traditional financial accounting
For the following reasons, financial accounting is not seen as a useful vehicle for promoting social and environmental disclosures Financial accounting focuses primarily on the information needs of those involved in resource allocation decisions. By contrast, sustainability concerns all stakeholders The notion of ‘materiality’ tends to preclude the reporting of social and environmental information, given the difficulty in quantifying costs Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? Limitations of traditional financial accounting (cont.)
Reporting entities frequently discount liabilities to present value, which tends to make future clean-up expenditures appear trivial Financial accounting adopts an entity assumption where the entity is treated as distinct from its owners and other stakeholders transactions not directly impacting the entity are ignored ignores externalities caused by the reporting entity, some relating to social and environmental implications of the entity’s operations sustainability and the ‘entity assumption’ are mutually exclusive Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? Limitations of traditional financial accounting (cont.)
Expenses are defined to exclude the recognition of any impacts on resources not controlled by the entity that is, and simplistically stated, the recognition of expenses in part relies upon the using up of assets assets are defined in terms of ‘control’, hence if something is not controlled – such as the environment - then it is not an asset of the reporting entity therefore, the use or abuse of the environment is ignored from a financial accounting perspective (unless fines are imposed) Externalities caused by the entity cannot be reliably measured, and so typically are not recognised given the recognition criteria provided in such documents as the IASB Framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? Triple Bottom Line Reporting
Triple bottom line reporting refers to the disclosure of information about the social, economic and environmental performance of an entity But … is the bottom line metaphor appropriate—can social and economic impacts be measured through a ‘bottom line’? Seems to indicate that we must manage all the bottom lines in a similar manner—appropriate? Seems to suggest that social, economic and environmental performance are separate to one another—not really the case in practice Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? Relevance of measures such as GDP
Performance of governments is related to outputs of systems of national accounts e.g. gross domestic product (GDP) Does not consider issues of resource efficiencies or equities with how resources are distributed Experiments taking place to ‘green’ GDP Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How to report? The Global Reporting Initiative
Global Reporting Initiative (GRI) established 1997 The GRI Sustainability Reporting Guidelines is the most comprehensive framework for ‘how to report’ that is currently available Third version—G3—released in 2006 Made up of various ‘core’ and ‘additional’ performance indicators Not mandatory and hence many organisations are selective about what information they select for disclosure Apart from the GRI, a number of other organisations have produced reporting guidelines Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Monetising environmental costs and benefits – accounting for externalities
As we have already discussed, financial accounting typically ignores environmental impacts, therefore experimental approaches to full-cost profit calculation are being developed Market prices do not reflect the scarcity of resources involved or harm resources cause Perception that all costs associated with the production of goods or services (including use of ‘the environment’) should be reflected in the price of the goods or services - the practice of ‘under-pricing’ the environment leads to over use and damage to the environment Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Monetising environmental costs and benefits (cont.)
If done comprehensively this would involve some life-cycle analysis consideration of the inputs and outputs from raw material acquisition to disposal Often referred to as ‘true prices’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

A ‘sustainable cost’ calculation
A number of researchers are attempting to develop approaches to place a cost on the social and environmental impacts of organisations – still very experimental For example, Gray and Bebbington (1992, p.15) state: … sustainable cost can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state (or its equivalent) it was in at the beginning of the accounting period. Such a figure would be a notional one, and disclosed as a charge to a company’s profit and loss account. Thus we would be presented with a broad estimate of the extent to which the accounting profits had been generated from a sustainable source … our estimates suggest that the sustainable cost calculations would produce the sort of answer which would demonstrate that no Western company had made a profit of any kind in the last 50 years or so. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Alternative approaches to social and environmental reporting—the example of Baxter International
Approach most conservative of those considered in the textbook Ignores any externalities caused by the business, and only includes costs and benefits directly related to cash flows Attempts to demonstrate that by explicitly considering the environment, actual cost savings can be made Still applies the usual ‘entity assumption’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

BSO/Origin Place a notional value on the environmental costs imposed on society This value is then deducted from profits (calculated using financial accounting methods) to determine a measure referred to as ‘sustainable operating income’ Although consider many externalities, ignores many eco-justice considerations required to pursue sustainability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Landcare Ltd Seeks to determine the notional costs that would be incurred if the organisation was to have zero environmental impact Sustainable cost: the amount which must be spent to put the biosphere at the end of the accounting period back into the state it was at the beginning Sustainable cost calculation involves two elements costs required to ensure inputs have no adverse environmental impacts costs required to remedy any environmental impacts that arise Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Watercare services Identifies the additional costs that would need to be incurred if the organisation was to meet the social and environmental standards that it believes are appropriate Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social auditing Purpose of social auditing is for an organisation to assess its performance in relation to society’s requirements and expectations Results form the basis of an entity’s publicly released social accounts, which in themselves are often incorporated into a triple bottom line or sustainability report Consider the Body Shop’s social performance report which is based on their social audit Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social Auditing Standards
Released in 1998 by the Council on Economic Priorities (US body) SA8000 focuses on issues associated with human rights, health and safety, and equal opportunities In 1999 ISEA launched standard AA1000 concerned with the processes of setting up and operating social and ethical accounting and auditing systems Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Concluding comments Social and environmental reporting is a rapidly evolving area Only 20 years ago, almost no companies were producing social and/or environmental reports Now many large listed companies are providing such reports As concerns for global warming, social justice and environmental protection increase we can expect this form of reporting to continually evolve Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 10 Reactions of capital markets to financial reporting Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

the role of capital market research (CMR) in assessing the information content of accounting disclosures the assumptions of market efficiency typically adopted in capital market research the difference between capital market research that looks at the information content of accounting disclosures, and capital market research that uses share price data as a benchmark for evaluating accounting disclosures why unexpected accounting earnings and abnormal share price returns are expected to be related the major results of capital market research into financial accounting and disclosure Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capital market research—introduction
Explores the role of accounting and other financial information in equity markets Involves examining statistical relations between financial information and share prices Reactions of investors evident from capital market transactions No share price change implies no reaction to particular information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Capital market versus behavioural research
Capital market research (the topic of this lecture) assesses the aggregate effect of financial reporting on investors considers only investors Behavioural research (the topic of the next lecture) analyses individual responses to financial reporting examines decision-making by many groups e.g. bank managers, loan officers, auditors Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Reasons for capital market research
Information about earnings and its components is the primary purpose of financial reporting Earnings are oriented toward the interests of shareholders Earnings is the number most analysed and forecast by security analysts Reliable data on earnings is readily available Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Underlying assumption of CMR—EMH
CMR relies on the assumption that equity markets are efficient in accordance with Efficient Market Hypothesis (EMH) Efficient market defined as a market that adjusts rapidly to fully impound information into share prices when the information is released Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Three forms of market efficiency
Weak form: prices reflect information about past prices and trading volumes Semi-strong form: all publicly available information is rapidly and fully impounded into share prices in an unbiased manner when released most relevant for accounting-based capital market research Strong form: security prices reflect all information (public and private) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market efficiency—implications for accounting
If markets are efficient they will use information from various sources when predicting future earnings If accounting information does not impact on share prices then it is deemed not to have any information value above that currently available Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Market efficiency – share prices react to information from various sources
For example, material provided within the textbook indicates that share prices have been found to react not only to earnings data but also to such things as: News about senior executive resignations Takeover rumours posted to internet discussion sites Which raises possible issues about the regulation of information provided on such sites Concerns raised by auditors, particularly in relation to going concern considerations (unless anticipated by the market) Industry-wide changes, such as the implications associated with the introduction of particular legislations (such as the Sarbanes-Oxley Act in the US) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Share prices react to information from various sources (cont.)
Again, a share price reaction indicates that the ‘news’ has ‘information content’ Conversely, no share price reaction indicates that the news or event did not act to cause the market to revise any previous expectations held about a firm’s future cash flows Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Earnings/return relation
Share prices are the sum of expected future cash flows from dividends, discounted to their present value using a rate of return commensurate with the company’s risk Dividends are a function of accounting earnings Unexpected earnings rather than total earnings expected to be associated with a change in share price Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Earnings/return relation—market model
Used to separate out firm-specific share price movements from market-wide movements derived from the Capital Asset Pricing Model Assumes investors are risk averse and have homogeneous expectations Its use allows the researcher to focus on share price movements due to firm-specific news Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Earnings/return relation—market model (cont.)
Total or actual returns can be divided into normal (expected) returns given market-wide movements abnormal (unexpected) returns due to firm-specific share price movements Abnormal returns used as an indicator of information content of announcements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—Ball and Brown (1968) study
Examined data from 261 US firms Tested whether firms with unexpected increases in accounting earnings had positive abnormal returns, and firms with unexpected decreases had negative abnormal returns Found that information contained in the annual report, prepared using historical cost was useful to investors 85 to 90% of earnings announcement is anticipated by investors much of information is obtained from other sources Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—extent of alternative information sources
Information content varies between countries and companies Compared to US markets, Australian market had slower adjustments during the year with larger adjustments at earnings announcement less alternative sources of information for Australian market Less alternative sources of information for smaller firms than larger firms Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—permanent and temporary changes
Research examined relationship between the magnitude of unexpected changes in earnings (EPS) and magnitude of abnormal returns known as the earnings response coefficient Some research has shown that a 1% unexpected change in earnings associated with 0.1 to 0.15% abnormal return depends on whether earnings increases expected to be permanent or temporary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—relative magnitudes of cash and accruals
Earnings persistence depends on proportion of accruals relative to cash flows firms with large accruals relative to actual cash flows unlikely to have persistently high earnings Share prices found to act as if investors ‘fixate’ on reported earnings without considering relative magnitudes of cash and accrual components Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—information announcements of other firms
Earnings announcements by one firm also results in abnormal returns to other firms in the same industry Related to whether the news reflects a change in conditions for the entire industry, or changes in relative market share within the industry For example, if an organisation within an industry is the first to prepare its financial results for the year, and it reports record profits that were unexpected by the market, then this would often cause share price increases across the industry For example, Accounting Headline 10.6 shows that when CBA reported record profits this was followed by share price increases in other banks even prior to their earnings announcements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—information content of earnings forecasts
Announcements of expected earnings rather than actual earnings are associated with share returns Management and security analysts both make forecasts Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—benefits of voluntary disclosure
Voluntary disclosures include those in annual reports as well as media releases etc. Firms with more disclosure policies have larger analyst following and more accurate analyst earnings forecasts increased investor following reduced information asymmetry reduced costs of equity capital Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—recognition versus footnote disclosure
Recognising an item in the financial statements is perceived differently to disclosure in footnotes Investors place greater reliance on recognised amounts than on disclosed amounts Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—size Relationship between earnings announcements and share price movements is inversely related to the size of the entity Earnings announcements found to have a greater impact on share prices of smaller firms than larger firms More information generally available for larger firms Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—unexpected changes in earnings vs
Results of CMR—unexpected changes in earnings vs. unexpected changes in expenses If ‘earnings surprises’ are accompanied by revenue surprises of similar magnitude in the same direction, then the earnings surprises are driven by revenue growth rather than by a reduction in expenses. Researchers expect earnings growth driven by revenue growth to exhibit a different level of persistence compared with earnings growth driven by expense reduction. Jegadeesh and Livnat's (2006) results indicate that the market does tend to react more to unexpected earnings when these 'surprises' are due to increases in revenues. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Do current prices anticipate future announcements?
As firm size increases, share prices incorporate information from wider number of sources relatively less unexpected information when earnings are announced May be able to argue that share prices anticipate future earnings announcements for larger firms with some accuracy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting earnings reflecting information
Rather than determining whether earnings announcements provide information, recent research examines whether earnings announcements reflect information that has been already used by investors ‘looking back the other way’ market prices viewed as leading accounting earnings Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting earnings reflecting information (cont.)
Share prices are considered as benchmark measures of firm value Share returns are considered as benchmark measures of firm performance Benchmarks are then used to compare usefulness of alternative accounting and disclosure methods Based on premise that market values and book values are both measures of firm value Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Accounting earnings reflecting information (cont.)
If market value is related to book value, returns should be related to accounting earnings per share, divided by price at the beginning of the accounting period provides an underlying reason why we should expect returns to be related to earnings over time Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—accounting earnings reflecting information
Beaver, Lambert and Morse (1980) found share prices and related returns were related to accounting earnings Because of various information sources, price appeared to anticipate future accounting earnings Supported by Beaver, Lambert and Ryan (1987) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR—accounting earnings reflecting information (cont.)
Dechow (1994) found over short intervals earnings are more strongly associated with returns than are realised cash flows the ability of cash flows to measure firm performance increases as the measurement interval increases Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Results of CMR —accounting earnings reflecting information (cont.)
Studies examining which asset value approaches provide accounting figures that best reflect market valuation found: fair value estimates of bank’s financial instruments seem to provide a better explanation of bank share prices than historical cost (Barth, Beaver & Landsman 1996) revaluation of assets results in better alignment of market and book values (Easton, Eddy & Harris 1993) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Relaxing assumptions about market efficiency
Recent years have seen a number of researchers questioning some assumptions about market efficiency Market reactions to information often found to be longer than would be anticipated from an ‘efficient market’. Also market found to sometimes ‘under-react’ to particular announcements Created new areas for research—for example what factors influence ‘earnings drift’ So, should we reject research that has embraced the EMH? Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 11 Reactions of individuals to financial reporting: an examination of behavioural research Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

how behavioural research differs from capital market research how different accounting-related variables can be manipulated in behavioural research how the results of behavioural research can be of relevance to corporations and the accounting profession for anticipating individual reactions to accounting disclosures how the results of behavioural research can form the basis for developing ways to more efficiently use accounting-related data the limitations of behavioural research Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Introduction to behavioural research
Behavioural research examines how individuals react to various accounting disclosures Grounded in behavioural decision theory Goal is to describe actual decision behaviour, evaluate its quality, and develop and test hypotheses of the underlying psychological processes Contrast to capital markets research which examines reactions at a market level Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Brunswick Lens Model Used to explain behavioural research
Perspectives about the environment are generated (observed) through a ‘lens’ of imperfect cues Statistical modelling is applied to determine the weighting (importance) of the various cues (independent variables) to the criterion event of success (dependent variable) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Brunswick Lens Model (cont.)
Right-hand side models how the individual uses cues to make an ultimate decision about the issue under investigation Left-hand side models the relationship between the actual phenomenon or event and the particular cues provided Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Applicability of the Lens Model
Structure of the Lens Model can be applied to almost any decision-making scheme e.g. lending decision explicitly considers inputs (use of cues), the decision process and outputs (ultimate decisions) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Types of issues to be considered
At input level scaling characteristics of individual cues methods of presentation context At the level of processing the information characteristics of the person making the judgement characteristics of the decision rule At the output or decision level qualities of the judgement self-insight Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Input level—use of cues
How and whether particular cues are used in decision making is particularly relevant to the accounting profession If information items in financial statements are not used, then they could be deemed immaterial and therefore not requiring disclosure The accounting profession is also interested in whether presentation (in financial statement or in a footnote) impacts decision Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Research evidence—the use of information items
In making predictions of financial returns, analysts are found to acquire earnings and sales information more often than other types (Pankoff & Virgil 1970; Mear & Firth 1987) Studies questioned the provision of current cost information, subjects relied more on historical cost information (Heintz 1973; McIntyre 1973) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Research evidence—the presentation of information
Different presentation formats found to influence users’ decisions including bar charts, line graphs, pie charts and tables Moriarity (1979) found students and accountants using Chernoff faces were able to outperform those using ratios in predicting bankruptcy and models of bankruptcy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Research evidence—the presentation of information (cont.)
Studies examining decision making by loan officers, based on whether information is incorporated within the financial statements or included as footnotes, found presentation made no difference (Wilkins & Zimmer 1983) Provision of segment information reduced subjects’ reliance on past share prices (Stallman 1969; Doupnik & Rolfe 1989) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision-making process
Studies have examined how the various cues are weighted Judgements have been found to be consistent over time Decision makers also have been found to employ simplifying heuristics when making a decision A heuristic can be defined as a simplifying ‘rule of thumb’ Simplifying rules may be employed which take a lot less time but nevertheless generate acceptable predictions or solutions It is useful to know about the use of heuristics – particular by ‘successful’ judges/decision-makers Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision-making heuristics
Three main simplifying heuristics have been identified representativeness anchoring and adjustment availability Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision-making heuristics— representativeness
Decision makers often assess the likelihood of items belonging to a category by considering how similar the item is to the typical member of the category An implication is that the subjects typically ignore the base rate of the population in question may overstate the number of cases in a particular category Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision making heuristics—anchoring and adjustment
Individuals make an initial judgement or estimate and then only partial adjust their view as a result of additional information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision making heuristics—availability
Relates to whether recollections of related occurrence or events can easily come to mind The actual base rates of occurrence of an event are ignored Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Knowledge of heuristics in research
Useful to know of heuristics in use if the heuristic results in inappropriate decisions being made, the tendency can be highlighted and action taken the use of a heuristic by experts could be efficient relative to costly data-gathering and processing novices could then be advised to use the rule of thumb Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decision output—decision accuracy
Research has considered how accurate the predictions are relative to the actual environmental outcomes loan officers found to predict bankruptcy fairly regularly (Libby 1975) bankers and accounting students also found to correctly predict bankruptcies (Zimmer 1980) decision makers working in a team can outperform individual decision makers Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Protocol analysis This form of behavioural research requires subjects to verbalise their thought processes while making decisions or judgements common in auditing research Understanding how judgements are made is important in improving those judgements Useful in examining information search Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Protocol analysis (cont.)
Disadvantages include the process of verbalising can have an effect on the decision process a considerable portion of the information utilised may not be verbalised subjects may provide verbalisations which are parallel but are independent of the actual thought process criticisms of the coding methods Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The relevance of differences in culture
We considered the issue of ‘culture’ in Chapter 4 and we learned that some cultures are considered to be more secretive than others; some cultures seek greater uncertainty avoidance than others; and so forth Differences at a national level were then related back to the international differences in accounting practices that existed prior to the International adoption of IFRS Culture has also been suggested as a factor in influencing organisational structures, legal systems and so forth It is reasonable to argue that an individual’s use of particular cues (information items) will in part be dependent upon the cultural background of the individual Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The relevance of differences in culture (cont.)
Studies that investigate decision-making processes in particular countries will perhaps not be generalisable to other countries—particularly if the respective countries have significantly different cultural attributes Determining the validity of a particular decision-making model across different cultures would be an important area for future accounting research At this point in time there is very little behavioural accounting research which explores how the usage of cues in particular decisions is affected by specific cultural attributes Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Limitations of behavioural research
Research examining similar issues has generated conflicting results difficult to determine causes of inconsistencies Settings of studies often different to real-world settings implications for generalisability Very difficult to replicate cues available in the workplace Students often used as surrogates Small number of subjects often used Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Chapter 12 Critical perspectives of accounting Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives In this chapter you will be introduced to :
particular perspectives that challenge conventional opinions about the role of accounting within society the basic arguments that suggest that financial accounting tends to support the positions of individuals who hold wealth and social status, while undermining the positions of others the fact that disclosure (or non-disclosure) of information can be construed to be an important strategy to promote and legitimise particular social orders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Critical perspective defined
Refers to accounting research that goes beyond questioning whether particular methods of accounting should be employed Questions prevailing social arrangements and how accounting practices actually contribute to inequities Focuses on the role of accounting in sustaining the privileged positions of those in control of resources (capital) while undermining or restraining the voice of those without capital Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Critical perspective defined (cont.)
Critical accounting theorists seek to highlight, through critical analysis, the key role of accounting in society Challenges the view that accounting can be construed as objective or neutral Rejects a ‘pluralist view of society’ wherein many stakeholders have power to influence government, corporations, and so forth Rather, power resides in the hands of a ‘small elite’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The critical perspective (cont.)
Accounting seen as a means of constructing or legitimising particular social structures for the benefits of those that currently have wealth Critical theorists do not seek to appear objective They seek to highlight the role of accounting in maintaining social structures that they perceive as unjust Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The critical perspective (cont.)
They believe that development of particular theories can bring about social changes in social structures and practices, that is, the promotion of a particular theory becomes a social actuality View that, if theorists have well developed theories which question the objectivity of financial accounting, and if they are able to generate sufficient support for the theory then ultimately this could create the necessary impetus for changes in the way financial accounting is practiced and how society is organised Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Philosophical basis of critical accounting research
Much of the critical research is informed by the works of Karl Marx However, some critical research adopts a ‘deep ecologist’ philosophy questions the trade-off between economic performance and ecological damage Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Philosophical basis of critical accounting research (cont.)
Other critical accounting research adopts a radical feminist perspective believe that accounting maintains and reinforces masculine traits such as ongoing quests for success, conflict and so forth without any consideration to cooperation, respect, loyalty, caring and so forth Critical theory is an ‘umbrella term’ for a wide variety of theoretical approaches perhaps more united in what they oppose than what they agree upon (Hopper et al.1995) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticism of capitalist system
Critical theorists tend to oppose aspects of the capitalist system and accounting Emphasise that systems of accounting are built around the prevailing social order—and support the social order Given the practice of accounting is in the hands of large corporations and accounting regulation in the hands of government, accounting information will never do anything but support the current system Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Origins of critical perspective
Grounded in Political Economy Theory ‘Political economy’ is the social, political and economic framework within which human life takes place (Gray, Owen & Adams 1996) Based on ‘Classical’ branch—challenges the existing nature and structure of society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Classical political economy perspective
As already indicated, much critical accounting research is related to the works of philosophers such as Marx Explicitly considers structural conflict, inequity and the role of the State at the heart of the analysis Highlights issues which may not otherwise be addressed Social welfare Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Disclosure of social responsibility information
Critical theorists argue that disclosure of social responsibility information is wasted unless accompanied by fundamental changes in how society strucutred Acts to legitimise, not challenge, those providing the information Need social reform, and not more ‘accounting’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Views on social and environmental accounting
As accounting deemed to sustain particular social structures, introduction of new forms of accounting only help to sustain that social system Considered wasted effort to use accounting to solve problems One is using the very process that caused the problem to try to solve the problem Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Criticism of critical perspective
Critical theorists often marginalised to a greater extent than others Often do not provide solutions to perceived problems inconsistent with normal training of accountants which is to provide solutions if problems are evident Critical of accountants Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of the state The State is seen as a vehicle of support for holders of capital and for the capitalist system as a whole securities acts throughout the world were designed to maintain the ideological, social, and economic status quo while restoring confidence in the existing system and its institutions (Neimark 1982, p.49) Government will take action to enhance the legitimacy of the (unjust) social system Social disclosures seen as a means of pacifying challenges against the capitalist system where corporations given many rights and powers Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of the state (cont.)
Restricting the flow of information, or availability of specific types of information, seen as a means of maintaining particular organisations and social structures Government does not operate in the ‘public interest’, but in the interests of ‘well off’ groups Contrast with ‘public interest theory’ considered in previous lectures Corporations typically lobby against regulation that could increase their accountability to society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of accounting research
‘Mainstream’ accounting researchers are seen as providing research results and perspectives that help to legitimise and maintain certain political ideologies e.g. anti-regulation stance and EMH during the late 1970s and 1980s matched the views of government at the time rise of PAT consistent with political views at the time The story of PAT can be told in such terms. Its rise was not just due to its addressal of academic threats and concerns at the time of its inception but it was also in tandem with and connected to the right wing political ideologies dominant in the 1980s (Hopper et al.1995, p.518) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of accounting research (cont.)
rise of ‘economic consequences’ research seems to have been motivated by the desire of large corporations to counter attempts to change reporting systems and levels of disclosure results supported corporations’ call for reduction in regulation research efforts into inflation accounting were seen as being motivated by a desire to alleviate shifts in real wealth from owners to higher wages, not by rate of inflation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of accounting practice
Critical theorists see conceptual frameworks as legitimising the accounting profession and of financial reports produced by reporting entities Accountants seen as imposing their own views about which performance characteristics are important or not important Attention is directed to particular measures (e.g. profits) through accounting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of accounting practice (cont.)
In communicating reality, accountants simultaneously construct reality Political economy perspective emphasises the role of accounting reports in maintaining social arrangements any accounting report will tend to present selective and biased information in a manner designed to lead to the construction of a single view of the underlying reality, with this view being the one that most favours management and providers of capital See corporate social reporting as harmful as it gives the impression of concern and change without any real change occurring Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

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