ACC703 FINANCIAL ACCOUNTING THEORY AND PRACTICE

1. ACC703FINANCIAL ACCOUNTING THEORY AND PRACTICE COLLEGE OF BUSINESS,HOSPITALITY AND TOURISM STUDIES DEPARTMENT OF ACCOUNTING

2. Lecture 1 Textbook Reference: Deegan, C. Australian Financial Accounting 5e, Chapter 2 Financial Accounting Defined Financial accounting is a process involving the collection and processing of financial information to meet the decision-making needs of parties external to the organisation Management accounting, in contrast, focuses on providing information for decision making by parties within the organisation is largely unregulated Financial accounting is heavily regulated, and a great deal of regulation changes each year

3. Users� Demand for General-Purpose Financial Reports Users include: present and potential investors shareholders employees lenders suppliers and other trade creditors customers government and its agencies the public Users lack the power to demand specific information to meet their needs � hence the need for �general purpose financial reports�

4. Users� Demand for General-Purpose Financial Reports General-purpose financial reports meet the information needs common to users who are unable to command the preparation of reports tailored to satisfy, specifically, all their information needs Example: financial statements and supporting notes included within an annual report presented to shareholders at a company�s annual general meeting Special-purpose financial reports designed to meet the needs of a specific group or to satisfy a specific purpose Example: Bank demanding as part of a loan agreement that the borrowing entity provide information about projected cash flows

5. Sources of external financial reporting regulation Bodies that formulate and/or enforce accounting regulations: In Australia The Australian Securities and Investments Commission (ASIC) The Australian Accounting Standards Board (AASB) The Interpretations Agenda Committee The Financial Reporting Council (FRC) The Australian Stock Exchange (ASX) In Fiji Fiji Institute of Accountants (FIA) www.fia.org.fj South Pacific Stock Exchange (SPSE) www.spse.com.fj Capital Markets Development Authority (CMDA) www.cmda.com.fj

6. Conceptual Framework A coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting Central goal in establishing CF is general consensus on scope and objectives of financial reporting qualitative characteristics that financial information should possess elements of financial reporting Provides guidance on key issues, such as objectives, qualitative characteristics, definitions and recognition criteria We need a conceptual framework of accounting before we start developing accounting standards

7. Conceptual Framework It stipulates: Objectives of financial reporting Qualitative characteristics of useful information Users & their needs Elements of financial reporting Definition criteria Recognition criteria

8. Benefits of a Conceptual Framework Accounting standards more consistent and logical, because they are developed from an orderly set of concepts. In the absence of a coherent theory, the development of accounting standards could be somewhat ad hoc. Increased international comparability of accounting standards Should result in the Boards (e.g. IASB, AASB) being more accountable for their decisions Enhanced process of communication between the Boards and constituents More economical accounting standard development

9. Components of a Conceptual Framework

10. What are GPFRs and reporting entities? SAC1�Definition of the Reporting Entity Defines general-purpose financial reports (GPFRs) Financial reports intended to meet the information needs common to users who are unable to command the preparation of reports tailored to their specific needs GPFRs to be produced by entities who have users who cannot command the preparation of specific information Such entities are deemed to be �reporting entities� An entity in respect of which it its reasonable to expect the existence of users who rely on the entity�s general purpose financial report for information that will be useful to them for making and evaluating decisions about the allocation of resources

11. Reporting entity If an entity is not deemed to be a �reporting entity� it will not be required to produce GPFRs�and not necessarily be required to comply with all accounting standards Small proprietary companies are frequently not considered to be reporting entities�it is assumed that most people who require financial information about the entity will be in a position to specifically demand it SAC2�Objective of GPFRs To provide relevant and reliable information to assist users to make and evaluate decisions about the allocation of scarce resources and to allow management and governing bodies to discharge their accountability

12. Usefulness of GPFR�s

13. Qualitative characteristics of financial reporting Identifies the characteristics of financial information necessary to allow users to make and evaluate decisions about the allocation of scarce resources Four principal characteristics of financial reporting identified in AASB Framework: understandability relevance reliability comparability

14. Qualitative characteristics Understandability information is considered to be understandable if it is likely to be understood by users with some business & accounting knowledge Relevance if information influences decisions about the allocation of scarce resources Information is relevant if it: assists in making predictions about future situations (i.e. influences decision-making); or helps to confirm past predictions Reliability faithfully represents the entity�s transactions and events free from bias and undue error (neutrality) verifiability Comparability Requires consistency of measurement & disclosure across time and across organisations

15. Elements of accounting Five elements of accounting are defined in the AASB Framework Assets Liabilities Equity Expenses Income

16. Definition and Recognition of Assets Definition of Asset (AASB Framework, par. 49) 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 Three key characteristics of definition: There must be future economic benefits The reporting entity must control the future economic benefits The transaction or other event giving rise to the control must have occurred An asset is to be recognized in the financial statements if (AASB Framework. par. 83): it is probable that any future economic benefit associated with the asset will flow to or from the entity; and the item has a cost or value that can be measured with reliability.

17. Definition and Recognition of Liabilities Definition of Liabilities (AASB Framework, par. 49) 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 There are three main characteristics There must be a future disposition or sacrifice of economic benefits to other entities It must be a present obligation A past transaction or other event must have created the obligation A liability is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably�AASB Framework (par. 91), consistent with asset recognition Where a liability cannot be reliably measured but is potentially material, the liability should be disclosed within the notes to the financial statements

18. Definition and Recognition of Revenues Definition of Revenues (AASB Framework, par. 70) 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 Income can be recognized in the financial statements when it is probable that the inflow or other enhancement or saving in outflows has occurred; and the inflow or other enhancement or saving in outflows of economic benefits can be measured reliably Revenues� and �gains� distinguished in AASB Framework revenue arises in the course of the ordinary activities of an entity and includes: sales, fees, interest, dividends, royalties, and rent gains represent other items that meet the definition of income and might or might not arise in the ordinary activities of an entity, e.g. disposal of non-current assets

19. Definition and Recognition of Expenses Definition of Expenses (AASB Framework, par. 70): 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 equity participants Expenses are recognized in the income statement when (AASB Framework, par. 94): a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably Definition of equity (AASB Framework, par. 49) residual interest in the assets of the entity after deducting all of its liabilities

20. Critical review of conceptual frameworks Objective of GPFRs in SAC2 implies that reports should be primarily economic in focus should social issues be ignored in the annual report? An individual's view of business responsibilities directly impacts on the perceptions of accountability Economic focus of GPFRs ignores transactions or events not resulting from market transactions or an exchange of property rights Ignores environmental externalities caused by business Financial statements included within reports reflect only financial performance and do not provide a means of assessing social performance It has been argued that Conceptual frameworks simply codify existing practice Conceptual frameworks have been used as devices to legitimize the existence of the accounting profession

21. Theories of Financial Accounting Accounting theories typically either explain and predict accounting practice (positive theories), or they prescribe specific accounting practice (normative theories) Textbook Reference: Deegan, C. Australian Financial Accounting 5e Chapter 3

22. Positive Accounting Theory (PAT) A Positive Theory is a theory that explains and predicts a particular phenomenon PAT explains and predicts accounting practice It does not seek to prescribe particular actions Grounded in economic theory Focuses on the relationships between various individuals involved in providing resources to an organisation (agency relationship) Owners (as suppliers of equity capital) and managers (as suppliers of managerial labour) managers and debt providers

23. Agency theory Agency relationship delegation of decision making from one party (the principal) to another party (the agent) Agency problem delegation of authority can lead to loss of efficiency and increased costs Agency costs costs that arise as a result of the agency relationship Monitoring costs Bonding costs Residual loss

24. Assumptions of PAT All individual action is driven by self-interest (do we think this is a realistic assumption?) Individuals will act in an opportunistic manner to increase their wealth. It assumes managers will opportunistically select accounting methods to increase their own personal wealth Notions of loyalty and morality are not incorporated within the theory Organizations are a collection of self-interested individuals who agree to cooperate to the extent it is in their interest PAT predictions Organizations will seek to put in place mechanisms to align the interests of managers of the firm (agents) with the interests of the owners (principals) Some of these mechanisms rely on the output of the accounting system for example, the owners might agree to pay the manager a bonus based on a specified percentage of profits

25. Bonus schemes Remuneration based on the output of the accounting system Very common and their existence can be explained by PAT Bonuses might be based on: profits of the firm sales of the firm return on assets May also be rewarded based on market price of shares Accounting-based bonus schemes Any changes in the accounting methods used by the organization will affect the bonuses paid (e.g. as a result of a new accounting standard) Changing the bonuses paid impacts cash flows, and this in turn is predicted to impact the value of the organization

26. Incentives to manipulate accounting numbers Rewarding managers on the basis of accounting profits can induce them subsequently to manipulate the related accounting numbers to improve their apparent performance and thus the related rewards Accounting profits might not always provide an unbiased measure of a firm�s performance � so also common to find the use of share-based reward structures, which in certain circumstances, might be deemed to be more efficient Market-based bonus schemes Market prices are assumed to be influenced by expectations about the net present value of expected future cash flows Cash bonuses might be awarded on the basis of increases in share prices Shares or options to shares might also be provided Market prices reflect market-wide factors, not just those factors controlled by the manager Only senior management will be likely to be able to affect cash flows and hence securities prices

27. Role of auditor If managers� remuneration is based on accounting numbers the auditor takes a monitoring role The auditor arbitrates on the reasonableness of the accounting methods adopted Political costs Costs that particular groups external to the firm might be able to impose on the firm, such as costs associated with: increased taxes increased wage claims product boycotts decreased subsidies Organizations are affected by governments, trade unions, environmental lobby groups or particular consumer groups

28. 3 main hypotheses of PAT The bonus plan hypothesis is that managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income The debt/equity hypothesis predicts that the higher the firm�s debt/equity ratio, the more likely managers use accounting methods that increase income The political cost hypothesis predicts that large firms rather than small firms are more likely to use accounting choices that reduce reported profits.

29. Accounting policy selection and disclosure To allow comparison between reporting entities a summary of accounting policies must be presented in the notes to the financial report (IAS 1 Presentation of Financial Statements) where an accounting policy has changed and the change has a material effect on results the notes must disclose the nature of, reason for, and financial effect of the change (IAS 1 Presentation of Financial Statements) Accounting policy choice and �creative accounting� �Creative accounting� refers to selecting accounting methods that provide the result desired by the preparers Also known as opportunistic Can be explained by PAT It is possible to be creative and still follow accounting standards

30. Criticisms of PAT Does not provide prescription so does not provide a means of improving accounting practice Not value-free but rather value-laden Underlying assumption of wealth maximization is simplistic Issues being addressed have not shown any significant development Scientifically flawed

31. Normative accounting theories Seeks to provide guidance in selecting accounting procedures that are most appropriate Prescribes what should be done The Conceptual Framework is considered a normative theory seeks to identify the objective of GPFR seeks to provide recognition and measurement rules within a �coherent� and �consistent� framework identifies the qualitative characteristics financial information should possess makes recommendations that depart from current practice

32. Other normative theories Three main classifications current-cost accounting exit-price accounting deprival-value accounting These theories addressed issues associated with changing prices Current-cost accounting Aim is to provide a calculation of income that, after adjusting for changing prices, can be withdrawn from the entity and still leave the physical capital (operating capacity) of the entity intact referred to as true measure of income True income theories propose a single measurement basis for assets and a resultant single measure of income (profit)

33. Exit-price accounting Continuously Contemporary Accounting (CoCoA) Uses exit or selling prices to value the entity�s assets and liabilities referred to as current cash equivalents Assumptions: firms exist to increase the wealth of their owners the ability to adapt to changing circumstances capacity to adapt best reflected by the monetary value of the organizations assets, liabilities and equities at balance date, where the monetary value is based on the current exit or selling prices

34. Deprival-value accounting Deprival value represents the amount of loss that might be incurred by an entity if it were deprived of the use of an asset and the associated economic benefits This method considers: the net selling price the present value of future cash flows an asset�s current replacement cost The deprival value is the lower of replacement cost and the greater of the net selling price and present value (value in use)

35. Systems-oriented theories These theories focus on the role of information and disclosure in the relationships between organizations, the State, individuals and groups The entity is assumed to be influenced by the society in which it operates and to have an influence on it Systems-based theories include: stakeholder Theory legitimacy Theory institutional Theory

36. Stakeholder Theory Two branches Ethical (normative) branch Managerial (positive) branch Ethical (normative) branch stakeholders are any group or individual who can affect or are affected by the achievement of the firm�s objectives includes shareholders, employees, customers, lenders, suppliers, local charities, interest groups, government, etc. all stakeholders have a right to be provided with information because it prescribes how stakeholders should be treated (based on various ethical perspectives), it is a normative approach

37. Managerial (positive) branch seeks to explain and predict how an organization will react to demands of various stakeholders relative power or importance of stakeholders considered relative power and importance can change across time�associated with control of resources the firm will take actions to �manage� its relationships with stakeholders Stakeholder Theory (either branch) does not prescribe what information should be disclosed, other than indicating that the provision of information can be useful for the continued operations of the entity Managerial branch financial and social information is used to control conflicting demands of various stakeholder groups

38. Legitimacy Theory Organizations continually seek to ensure that they operate within the bounds and norms of society Organizations attempt to ensure their activities are perceived to be legitimate Bounds and norms change across time Based on a �social contract� between society and the organization Where this social contract is perceived as being breached then the organization will take corrective action, and this action might include disclosure Organizations must appear to consider the rights of the public at large, not just investors To gain or maintain legitimacy, organizations might rely on disclosure within their annual report

39. Institutional Theory Explains why organisations within particular �fields� tend to take on similar characteristics and form Much overlap with Legitimacy Theory and Stakeholder Theory Two main dimensions to the theory � isomorphism and decoupling Isomorphism � a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions coercive mimetic Normative Decoupling actual practices can be very different from formally sanctioned and publicly pronounced processes and practices

40. Theories explaining why regulation is introduced Just as there are theories to explain why particular accounting disclosures are made (PAT, Legitimacy Theory, Stakeholder Theory), or why particular organisational forms exist (institutional theory), there are also theories to explain why particular regulations (for example, accounting regulations) are developed. Such theories include: Public interest theory Capture theory Economic interest group theory

41. Public interest theory Regulation put in place to benefit society as a whole rather than vested interests Regulatory body considered to represent the interests of the society in which it operates, rather than the private interests of the regulators Assumes that government is a neutral arbiter Capture theory The regulated parties seeks to take charge (capture) the regulator They seek to ensure rules subsequently released are advantageous to the parties subject to regulation

42. Economic interest group theory (Private Interest Theory) Assumes that groups will form to protect particular economic interests Different groups are often in conflict with each other and will lobby government to put in place legislation that will economically 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 The regulator is not a neutral arbiter but is also seen as an interest group Regulator is motivated to ensure re-election or maintenance of its position of power or privilege within the community Regulation serves the private interests of politically effective groups Those groups with insufficient power will not be able to lobby effectively for regulation to protect their own interests

43. Summary No single accounting theory is universally accepted Positive Theory of Accounting seeks to explain and predict accounting-related phenomena e.g. study of capital market�s reaction to particular accounting policies, what motivates managers to select a given method of accounting, reasons for the existence of particular accounting-based contracts relies upon a fundamental assumption that individual action can be predicted on the basis that all action is driven by a desire to maximise wealth (a perspective often criticised by other researchers)

44. Summary Normative theories of accounting prescribe how accounting should be practised argue typically that a central role of accounting theory is to provide prescription�inform about optimal accounting approaches and why a particular approach is considered optimal examples: Conceptual Framework Project, current-cost accounting, exit-price accounting and deprival-value accounting

45. Summary Systems-based theories Include Stakeholder Theory, Legitimacy Theory, and Institutional Theory see organisation as firmly embedded within a broader social system organisation is considered to be affected by, and to affect, the society in which it operates accounting disclosures and particular organisational forms are seen as a way to manage relations with particular groups outside the organisation� organisational activities and accounting disclosures are considered to be reactive to community pressures�how a firm operates and what it reports must be determined upon consideration of various stakeholder expectations

46. Summary Theories that seek to explain how regulation is developed Some theories suggest that regulation is introduced to serve the public interest by regulators who work for the public good Other theories of regulation assume that the development of regulation is driven by considerations of self-interest Overall, the selection of one theory over another will depend on the views and expectations of the researcher in question No one theory of accounting can be described as a �best� theory�however, different theoretical perspectives can at various times provide valuable insights in accounting issues

47. End of Lecture 1

48. Tutorial Questions for Week 2 Deegan, C. Australian Financial Accounting 5e Chapter 2 Review Questions: 1, 2, 6, 9, 10, 11, 22 Chapter 3 Review Questions: 2, 9, 10(a), 14, 19, 21, 27