Chapter 1 Contemporary Issues in Accounting

Thursday, October 29, 2015

3:32 PM

Accounting Theory
Many people say that they do not need theories; that by definition theories are not practical or useful in the
real world. However, theories are necessary for us to try to understand the world we live in.
Accounting viewed as a practical discipline
Rule focussed
With little use for theory
However, theory is necessary to
Understand the world we live in
Provide a basis for decision making
All accounting is premised on theories
Concepts of Materiality
Recognition Criteria
Relevance
Faithful Representation
The Conceptual Framework
Measurement Bases
THEORY
A belief or principle that guides actions or behaviour
An idea or set of ideas that is intended to explain something
The set of principles on which a subject is based or of ideas that are suggested to explain a fact or event
Accounting Theory
A description, explanation or a prediction [of accounting practice] based on observations and/or logical
reasoning
Logical reasoning in the form of a set of broad principles that (1) provide a general framework of reference by
which accounting practice can be evaluated and (2) guide the development of new practice and procedures

Why Is Theory Needed

To provide an explanation of what is happening
To help us predict what will happen
Even partial or inaccurate theories can be of (limited) use
The Affect Of Theories
Theories drive many real world situations
Theory informs decisions about
Tax
Interest Rates
Global Warming
Education
Construction
Almost every aspect of our lives
Different Theories
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Different Theories
Some of these theories explain
Some of these theories predict
Some of these theories conflict
Different Accounting Theories
Some accounting theories
Describe and explain current practice
Capital Market Theory
Predict practice
Agency Theory
Provide principles for decision making
Identify problems and deficiencies and offer solutions
The conceptual framework
Types Of Theories
1. positive theories
2. normative theories.
Positive Theories
Positive theories are about the world as it is.
They
Describe what is happening
Explain what is happening
Make predictions about what will happen
Based around Hypotheses
Also called empirical theories
Normative Theories
Make suggestions about
What should happen
What ought to be
Observations or facts are considered in development of normative theories

Evaluating And Testing Theories

There are often competing theories about an issue or observation
E.g. how should accounting items be measured
Which theory is correct?
A range of approached are taken
Simple: Intuitive or anecdotal approaches
Systematic Approaches
Scientific Approaches
Acceptance of Theories
A good theory should
Be logical in its construction
Be clearly articulated
Be testable
Be consistent with observation
A theory can never be proved true
A single observation can prove a theory false

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Understanding The Role Of Research

Research is the diligent and systematic enquiry or investigation into a subject in order to discover facts or
principles.
Research is often repeated and adjusted, so that knowledge is expanding.
Most research studies will not provide definitive answers
Instead each study should contribute to our understanding of the issue.
Relationship Between Theory and Research
Research is used at all stages of the theory process
Research can be
Exploratory
Experimental
Observational
Theoretical
Quantitative
Qualitative
Research Of or About Accounting
Research of or about accounting considers the role of accounting itself
It considers questions such as:
What is the role of accounting?
Is accounting information useful in investment decisions?
Should accountability or decision usefulness be the key goal of accounting?
What impact does culture have on accounting?
What role has accounting played in the rise of capitalism or environmental degradation?
Research In Accounting
Research in accounting focuses at the more micro level on issues within accounting
It considers questions such as:
What measurements are being used?
What measures should be used?
What impact do changes in specific accounting policies have on share prices?
Research Areas In Accounting
Capital Markets Research
Accounting Policy Choice Research
Accounting Information Processing Research
Critical Accounting Research
International Accounting Research

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Chapter 2 Contemporary Issues in Accounting

Thursday, October 29, 2015

3:54 PM

A Conceptual framework is a group of ideas or principles used to plan or decide something.

- It is a normative theory
- It prescribes the basic principles that are to be followed in preparing financial statements
- It is a coherent system of concepts, which are guidelines to the accounting standards used for financial reporting
Conceptual Framework vs Accounting Standard
Conceptual Framework
- designed to provide guidance and apply to a wide range of decisions
Accounting standards
- Specific requirements for a particular area
- May go beyond the framework
- Are mandatory
- Sometimes conflict with the framework

CONCEPTUAL FRAMEWORK
History And Evolution Of The Conceptual Framework
1920s and 1930s attempts to draft statements of principles to guide accounting.
1970s development of more comprehensive and formal conceptual frameworks
1989 the existing Framework for the Preparation and Presentation of Financial Statements issued by the IASB
2010 the Conceptual Framework for Financial Reporting issued by the IASB
The Structure And Components Of The Conceptual Framework
The Conceptual Framework can be seen as providing answers to questions such as:
- What is the purpose of financial statements?
- Who are they prepared for?
- What are the assumptions to be made when preparing financial statements?
- What type of information should be included?
- What are the elements that make up financial statements?
- When should the elements of financial statements be included?

Current Developments
In 2004, the IASB and FASB began undertaking a project to develop a common framework.
The project is being conducted in eight phases
a. objectives and qualitative characteristics.
b. elements and recognition
c. measurement
d. reporting entity
e. presentation and disclosure
f. purpose and status
g. application to not-for-profit entities
h. remaining issues
Purpose, Objective And Underlying Assumption
The Conceptual Framework states that it is concerned with general purpose financial reports.
- These are financial reports intended to meet the needs of users who are not in a position to require an entity
to prepare reports tailored to their particular information needs.
Not special purpose financial reports
Proposed definition of a reporting entity
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 Proposed definition of a reporting entity

A reporting entity is a circumscribed area of economic activities whose financial information has the
potential to be useful to existing and potential equity investors, lenders, and other creditors who cannot
directly obtain the information they need in making decisions about providing resources to the entity and in
assessing whether the management and the governing board of that entity have made efficient and effective
use of the resources provided.
Focus on economic events and transactions, not legal form
Designed for for-profit entities
Does not actually set out which entities must prepare General Purpose Financial Reports
- This is a matter for individual countries to decide at law

The Objective of Financial Reporting

The objective of general purpose financial reporting is to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders and other creditors in making decisions about providing
resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and
providing or settling loans and other forms of credit
Financial statements should provide information that is useful to users in making decisions.
- Help predict the future
- Provide feedback on previous decisions
- Accountability and stewardship
The Conceptual Framework identifies the following users
- Existing and potential investors
- Lenders
- Other creditors.
Very limited list when compare with previous framework
Underlying Assumption
The financial statements are normally prepared on the assumption that an entity is a going concern and will
continue in operation for the foreseeable future
Affects recognition and measurement
Qualitative Characteristics
There is a hierarchy of qualitative characteristics:
- Fundamental
- Enhancing
To be useful for decision making
- Information must have both of the two fundamental characteristics
- The enhancing characteristics are not essential
- But can improve the usefulness of the information

Fundamental Qualitative Characteristics

1. Relevance
- Aims to ensure that only useful information is included
- An important part of this concept is materiality
2. Faithful Representation
- What is shown corresponds to the actual events and transactions that are being represented
- Three key elements
i. Complete Depiction
ii. Neutrality
iii. Freedom for Error
3. Comparability
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3. Comparability
- Achieved with consistent measurement and presentation of items over time and between entities
4. Verifiability
- Information can be supported or confirmed so that users are confident in relying on it
5. Timeliness
- Users need information on a timely basis
6. Understandability
- Financial reports are prepared for users who
- have reasonable knowledge of business and economic activities, and
- will conduct a diligent review and analysis of the information

Determining the Relative Importance of Qualitative Characteristics

Ideally information will have all characteristics
In reality there are often trade-offs
- Timeliness versus faithful representation
- Relevance versus verifiability
- Relevance versus understandability
Cost Constraint on Financial Information
- Cost versus benefit
The Elements of Financial Statements
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.
Liabilities
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.
Equity
The residual interest in the assets of the entity after deducting all its liabilities.
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.
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.

Recognition Criteria
Recognition is the process of incorporating an item in the balance sheet or income statement . . . It involves
depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or
income statement totals.
Two tests for recognition
1. Probability
2. Measurability
Probability
- an element should be recognized if
(a) it is probable that any future economic benefit associated with the item will flow to or from the
entity
- Probability criteria is met if the event if more likely than not to occur.
Reliable Measurement
- an element should be recognized if
(b) the item has a cost or value that can be measured with reliability.
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(b) the item has a cost or value that can be measured with reliability.
- Estimation is acceptable
- Either a cost or a value
The Benefits Of A Conceptual Framework
Technical Benefits
- Improve the practice of accounting and to provide a basis for answers to specific accounting questions and
problems.
- It is stated that the Conceptual Framework does this in two ways:
- By providing a basis and guidance for those who set the specific accounting rules.
- By helping individuals involved in preparing or auditing or using financial statements.
Political Benefits
- Prevent political interference in setting accounting standards.
- Accounting information has significant real-world affects
Professional Benefits
- Protect the professional status of accounting and accountants.

Problems & Criticisms Of The Conceptual Framework

1. It is ambiguous
- The principles are too vague
- Too much room for alternative interpretations.
2. It is descriptive not prescriptive
- The Conceptual Framework simply describes current accounting practise.
- Should be prescriptive (normative) and try to improve practice.
3. The concept of faithful representation is inappropriate
4. Realist view:
Financial statements . . . Are representationally faithful to the extent that they provide an objective picture
of an entitys resources and obligations
5. Materialist view:
Although the underlying events and transactions do exist the accounting measures that are reported are
created by accountants and do not exist independently of them.

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Chapter 3 Standard Setting

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3:32 PM

Rules-based Versus Principles-based Standards

Rules-based standards are sets of detailed rules that must be followed when preparing financial statements.

Principles-based standards are based on a conceptual framework that provides a broad basis for accountants to follow
- The focus is on the economic substance of a transaction, engaging the professional judgement and expertise of
those preparing financial statements.
Disadvantages of Rules-Based Standards
Rules-based standards can be very complex.
Organisations can structure transactions to circumvent unfavourable reporting.
Standards are likely to be incomplete or even obsolete by the time they are issued.
Manipulated compliance with rules makes auditing more difficult.
Advantages of Principles-Based Standards
Principles-based standards are simpler.
They supply broad guidelines that can be applied to many situations.
They improve the representational faithfulness of financial statements.
They allow accountants to use their professional judgement.
Evidence suggests that managers are less likely to attempt earnings management.

Disadvantages of Principles-Based Standards

Managers may select treatments that do not reflect the underlying economic substance.
The judgement and choice involved in many of the decisions mean that comparability among financial
statements may be reduced.
Theories Of Regulation
Accounting information is a public good
Therefore some argue it is likely to be under produced without regulation
Others suggest supply would exist without regulation
There are competing theories regarding the need for and intention of regulation
Regulation is the policing, according to a rule, of a subjects choice of activity, by an entity not directly party to or
involved in the activity.
Elements of regulation
Intention to intervene
Restriction on choice to achieve certain goals
Exercise of control by a party independent of those directly involved in the activity.
Signalling Theory
Suggests reporting entities can increase their value through financial reporting.
Companies face a competitive capital market populated by sophisticated investors.
Above-average entities motivated to show that they are better than non-reporting entities.
Non-reporting entities are perceived as of even poorer quality than before.
Creates a virtuous cycle where regulation is not necessary
Public Interest Theory
Argues signalling theory relies on the function of a perfect, free-market economy.
Public interest theory assumes:
Economic markets are generally not perfect.
Regulation is virtually costless.
Concludes that regulation is supplied in response to the demands of the public for the correction of these
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 Concludes that regulation is supplied in response to the demands of the public for the correction of these
inefficient or inequitable market practices.

Capture Theory
Capture theory holds that regulation is supplied in response to the demands of self-interested groups trying to
maximise the incomes or interests of their members.
People are rational utility maximisers.
The coercive power of government can be used to give valuable benefits to particular groups.
Regulation can be viewed as a product that is governed by the laws of supply and demand.
Bushfire Theory
Bushfire theory highlights the political and public nature of regulatory influences by attempting to take into
account the reactions of users, and society in general, to failures of regulatory processes.
Regulations tend to arise from crises.
Resulting rules do not necessarily deal with the issues that caused the crisis.
Rather they gain media exposure so that politicians are more likely to gain re-election.
Ideology Theory of Regulation
Ideology theory of regulation relies on market failure but introduces the role of lobbying in influencing the
actions of regulators.
Lobbying is viewed as a mechanism through which regulators are informed about policy issues.
Predicts that the effectiveness of regulation will depend on
the political ideologies of the regulators, and
the impact of special interest lobby groups.
Advantages of Regulation
Increased efficiency in allocating capital.
Cheaper production.
Check on perquisites.
Public confidence.
Standardisation.
Public good.
Disadvantages of Regulation
Difficult to achieve efficiency and equity.
Determining the optimal quantity of information is problematic.
Regulation is difficult to reverse.
Communication is restricted.
Reporting entities are different.
There is lobbying.
Monopolisation of accounting standards.
Theory And Accounting Regulation Research
There are few accounting studies which apply regulatory theories to standards setting.
The majority of such studies support a version of regulatory capture.

the shift of accounting regulation to the private IASB has been caused by the sheer dominance of a highly
organized financial sector . . . [whose] actors are the best connected and most represented in the standardsetting network
Political Nature Of Setting Accounting Standards
There is a mix of private and public participation in the standard setting process.
Parties that have an interest in accounting standards often have conflicting interests. E.g.
Internal stakeholders may like flexibility
External stakeholders may like comparability
Auditors like objective (auditable) reporting
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 Auditors like objective (auditable) reporting

Lobbying
Those affected by accounting standards have an incentive to lobby standard setters to achieve a favourable
outcome.
Those affected must decide:
Whether they should lobby.
Which method of lobbying they should use.
When they should lobby.
What arguments they should use to support their position.
Lobby Groups
Industry and Management
Highly motivated and resourced
Casual non-professional users
Disparate interests, few resources
Full-time professional users
Secretive and non-responsive
Auditors
Accused of self-interest
Academics
Strangely quiet
Lobby Groups in Australia
G100
Large accounting firms
Professional accounting bodies
ASX
Major banks
International Lobby Groups
International Accounting Standards Board
European Union
Asian-Oceanian Standard-Setters Group
G20
International Organisation of Securities Commissions
FASB

Harmonisation
One of the functions of the AASB is to participate in and contribute to the development of a single set of
worldwide accounting standards.
Three main benefits have been identified
i. International comparability
ii. Reduced cost of capital
iii. Reduced conflicting reporting requirements
Problems with Harmonisation
Various methods of implementation leads to inconsistencies
Listed entities underestimated the complexities, effects and cost of IFRSs
Compromise leads to diversity

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Chapter 4 Measurement
Thursday, October 29, 2015

3:32 PM

Measurement In Accounting
Conceptual framework definition:
MEASUREMENT is the process of determining the monetary amounts at which the elements of the financial
statements are to be recognized and carried in the balance sheet and income statement.
May involve calculation, estimation, and/or apportionment.
Impacts quality and therefore usefulness
Benefits of Measurement
1. Makes financial statements decision useful - gives meaning to the items included
Allows users of accounting information to:
2. Assess an entitys financial performance and position
3. Compare the entitys performance and position over time.
4. Compare entities
Limitations of Measurement
1. Little or no agreement on what measures should be used.
2. The inherent flexibility and the nature of a mixed measurement approach reduces comparability.
3. Measurement can be quite subjective.
4. With flexibility comes opportunistic accounting choices.
5. The current approach results in the additivity problem.
Measurement Approaches And Accounting Standards
The Conceptual Framework does not provide guidance as to which measurement bases should be used
In reality a range of bases are used
Historic cost remains dominant
Steady shift towards fair value

Historical Cost
Assets are recorded at the amount of cash or cash equivalents paid or the fair value of consideration given to
acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in
exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or
cash equivalents expected to be paid to satisfy the liability in the normal course of business.
Current Cost - Replacement Cost
Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an
equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash
equivalents that would be required to settle the obligation currently.
Fair Value - Realizable or Settlement Value
Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset
in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash
or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Present Value
Assets are carried at the present discounted value of the future net cash inflows that the item is expected to
generate in the normal course of business. Liabilities are carried at the present discounted value of the future net
cash out flows that are expected to be required to settle liabilities in the normal course of business.

Deprival Value
Essentially the loss that would be suffered if an entity was deprived of the asset.
Determination of the deprival value of an asset may incorporate:
- present value if the item was held for use
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- present value if the item was held for use

- net realizable value if the item was held for sale
- replacement cost associated with replacing the item or the services that were received from the item.

Measurement and International Accounting Standards

IASBs use a mixed measurement model
different measurement bases are employed to different degrees and in varying combinations during the
preparation of the financial statements.
This leaves a large amount of flexibility and choice within particular standards

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Future Directions on Measurement

Measurement is an important part of the IASB Conceptual Framework Project
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 Measurement is an important part of the IASB Conceptual Framework Project

Approaches tentatively considered:
Actual or estimated current prices
Actual past entry prices with adjustment
Prescribed computations or calculations based on discounted or undiscounted estimates of future cash flows
Decision criteria and influences on choice of measurement approach
Significant influences include:
Potential users of the financial statements
- What will provide the most decision useful information
Practical considerations
- Is it possible to calculate
- Cost versus benefit
Managements motivations and objectives
- Short-term versus long-term
- Impact on incentives
- Reputational impact
Measurement choices impact include:
Relevance
Faithful Representation
Understandability
Comparability
Verifiability
Relevance

Faithful Representation

Understandability

Comparability

Historic Cost

Low:
High:
especially as time passes measures an objective
transaction

High:
concept well known
& understood

Medium:
purchasing power of
money changes

Current Cost

High:
indicative of future
potential

High:
determined by
reference to actual cost

Low:
can be subjective,
depends

Medium:
can be subjective,
depends

Present Value

High:
indicative of future
potential

Low:
can be very subjective

Medium:
assumptions used
can be complex

Medium:
involves many different
assumptions

Deprival Value

Low:
not related to business
care

Low:
can be very subjective

Low:
assumptions used
can be complex

Low:
Involves many different
assumptions

PRO Fair Value

Focuses on future
potential

Determined using
objective market prices

Simply
Focus on market value
representation of
not individual entity
current market value

CON Fair Value

Hypothetical and not

If no objective market
relevant to specific entity prices then highly
subjective

Often based on
Different models lead
complex assumptions to very different results
and calculation

There appears to have been a distinct move from historical cost to fair value accounting.
Valuation Methods
Market Approach
Cost Approach
Income Approach

Stakeholders And The Political Nature Of Accounting Measurement

Users have different and sometimes conflicting needs when it comes to accounting information.
The impact and relevance of measurement to investors and other users of the financial statements is obvious.
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 The impact and relevance of measurement to investors and other users of the financial statements is obvious.
What do users really need to know?
How do users influence the measurement approach?
Existing and Potential Investors
Concerned with the risk inherent in, and the return provided by, their investments.
They want accounting information that:
Assists them in deciding whether to buy, hold, or sell their shares.
Enables them to assess the entitys ability to pay dividends.
Therefore need forward looking information
Fair Value?
Creditors/Lenders
Interested in information that enables them to determine whether amounts owing to them will be paid when due.
Particularly interested in the entitys net position
Liabilities it has compared to its assets.
Fair value would seem to be the most useful approach, assuming that items can be reliably measured.

The Political Nature of Accounting Measurement

Different interest groups may favour different accounting measurement approaches.
Fair value has been particular focus during the GFC.
- May have made economic crisis worse
- May not be reliable
- May have hidden problems
- May be difficult to regulate
Why Measurement Is A Controversial Accounting Issue
Inappropriate choices of method.
- Tension between flexibility and potential to mislead
Variability in practice
- Tradition has led to difference
Subjectivity involved
Impact of measurement on organisation
- Short/long term impact on profit
Current Measurement Challenges
Green assets and other sustainability issues
- What needs to be measured and accounted for?
- How can the discretion and subjectivity associated with the estimation of values be managed?
- What are the consequences associated with accounting for social and environmental aspects of the entity?
Intangible Assets
- Complexity and variation exists in terms of how intangible assets are measured on recognition
Water Assets
- Water accounting standards are being developed in several countries, with no single body taking responsibility
for international standards
- Measurement and Valuation
- Wide range of stakeholders
- How should value be determined
- Water quality and recognition
- Water is a limited natural resource which needs to be managed, measured and reported.

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Chapter 5 Theories in Accounting

Thursday, October 29, 2015

3:32 PM

What Value Does Theory Offer?

Theories guide many activities
Accounting theories help us understand
Decisions of financial report prepares
Actions of financial report users
Influences of organisational environment
Potentially better measurement and reporting
Accounting is a human activity
Types Of Theories
Normative Theories
- Recommend what should happen
- Prescribe action to achieve specific objectives
- E.g. The Conceptual Framework
Positive Theories
- Describes, explains or predicts activities
- Help us understand what happens in the world
- E.g. Agency theory
Positive Accounting Theory
Used to explain and predict accounting practice.
It examines a range of relationships between the entity and
- suppliers of equity capital (owners),
- managerial labour (management)
- debt capital (lenders or debt holders)
based on the rational economic person assumption

Contracting Theory
- Suggests that the organisation is characterised as a legal nexus of contracts.
- With contracting parties having rights and responsibilities under these contracts.
- Positive accounting theory focuses on
managerial contracts, and
debt contracts,
- These are agency contracts used to manage relationships where there is a separation between management
and capital providers.
Agency Theory
- Used to understand relationships whereby a principal employs the services of, and delegates the decision
making authority to, an agent. Fiduciary relationship, trust and confidence.
- Creates a moral hazard.
- Leads to 3 costs
i. Monitoring costs, as how principal measure and observe the behaviour of the agent
ii. Bonding costs, as cost of monitoring would eventually be charged against the agent in the disguise of
low remuneration.
iii. Residual loss, at the end, it is hard or too costly to determine whether the agent will push for the
interest of the principal
OwnerManager Agency Relationships
- Agency theory identifies a number of problems that can exist between managers and owners.
- Contracts and accounting information can be used to bond the interests of owners and managers.
- Addresses 3 specific problems
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- Addresses 3 specific problems

i. Horizon problem, where stockholders may have different interest from the management
ii. Risk aversion as management might prefer conservative operation to minimize losses while
stockholders might want aggressive operation to have a better return for their investment
iii. Dividend retention, management may wish for less percentage of income to be declared as dividend
while stockholders wishes for the opposite.
ManagerLender Agency Relationships
- When a lender agrees to provide funds to an entity there is the risk that the lending party may not repay
those funds.
Excessive dividend payments may result to default payment of debts
Underinvestment
Asset substitution, commitment of asset as collateral may hinder operation and growth
Claim dilution
- To avoid higher interest costs managers have incentives to show they are acting in a way that is not
detrimental to lenders.
Role of Accounting Information in Reducing Agency Problems
- Accounting information forms one of the major components of both manager remuneration and lending
contracts.
- For managers accounting information plays two roles in the contracting process:
i. To write the terms of managerial contracts.
ii. To determine performance against the terms of the contracts and consequently the amount of bonus
and other pay components managers will receive.
- Lenders look to regular financial updates to ensure companies are maintaining the terms of their covenants.
Information Asymmetry
- Results from managers having more information about the current and future prospects of the entity than
outsiders.
- Managers can choose when and how to disseminate this information.
- Under positive accounting theory there are incentives to disclose most news, good or bad, to the market.
Institutional Theory
- Comes from management literature.
- It considers how rules, norms and routines become established as authoritative guidelines, and considers
how these elements are created, adopted and adapted over time.
- Practices within organisations can be predicted from perceptions of legitimate behaviour derived from
cultural values, industry tradition, entity value etc
Comparison of Agency and Institutional Theories

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Legitimacy Theory
- Based on the idea of a social contract
Relates to the explicit and implicit expectations society has about how businesses should act to ensure
they survive into the future.
Organisations need to show they are operating in accordance with the expectations in the social
contract.
- Organisational legitimacy
The values and norm evident in the social contract have changed over time.
In the past legitimacy was considered only in terms of economic performance.
Now businesses are now expected to consider a range of issues, including the environmental and social
consequences of their activities.
- Accounting Disclosures and Legitimation
Lindblom identifies four ways an organisation can obtain or maintain legitimacy:
1) Seek to educate and inform society about actual changes in the organisations performance and
activities
2) Seek to change the perceptions of society, but not actually change behaviour
3) Seek to manipulate perception by deflecting attention from the issue of concern to other related
issues
4) Seek to change expectations of its performance.
Disclosure of information about an organisations effect on, or relationship with society can be used in
each of the strategies.
An entity might provide information to offset negative news which may be publicly available.
An organisation may draw attention to strengths.
Public reporting through the annual report or the entity website can be a powerful tool in showing an
organisation is meeting the expectations of society.
Stakeholder Theory
- Considers the relationships that exist between the organisation and its various stakeholders.
- Stakeholders are any group or individual who can affect or is affected by the achievements of an
organisations objectives
- There are two versions of stakeholder theory
a normative theory, known as the ethical branch,
an empirical theory of management, which is a positive theory
Normative Branch of Stakeholder Theory
Argues that organisations should treat all their stakeholders fairly.
An organisation should be managed for the benefit of all its stakeholders.
Stakeholders are identified, and should be considered in organisational decisions because of their
interest in the activities of the organisation.
Managerial Branch of Stakeholder Theory
Seeks to explain how stakeholders influence organisational actions.
The extent to which an organisation will consider its stakeholders is related to the power or influence
of those stakeholders.
A stakeholders power is related to the degree of control they have over resources required by the
organisation.

Role of Accounting Information in Stakeholder Theory

One important way of meeting stakeholders needs and expectations is providing information about
organisational activities and performance.
Stakeholder theory has been used to examine disclosure of voluntary information to stakeholders,
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 Stakeholder theory has been used to examine disclosure of voluntary information to stakeholders,
most commonly relating to social and environmental performance.
Contingency Theory
Proposes that organisations are all affected by a range of factors that differ across organisations.
Organisations need to adapt their structure to take into account a range of factors such as
External environment.
Organisational size.
Business strategy.
Contingency frameworks have been used to evaluate management accounting information and internal
control systems.
They conclude that
There is no universally appropriate accounting system that can be applied to all organisations.
Features of appropriate accounting systems are contingent upon the specific circumstances the
organisation faces.

Using Theories To Understand Accounting Decisions

Accountants use judgement to make a range of accounting decisions on a daily basis.
Examples include:
- Whether to expense or capitalise costs.
- What accounting estimates to use.
- What, where and how to disclose information.
Theories offer some assistance in explaining managers and accountants decisions.
Expensing and Capitalising Costs
Agency theory would hold that
- Managers on compensation contracts which have bonuses tied to a current measure of entity performance
- Entities with lending agreements with a leverage covenant,
would prefer to capitalise costs.
Institutional theory would explain the influence of external norms on managerial compensation policy.

Accounting Estimates
Agency contracts can explain managerial decisions in this regard.
- Managers and accountants, acting in self interest, are likely to ensure their own bonuses are maximised and
the entity is not at risk of breaching debt contracts.
Legitimacy and stakeholder theory suggest there are times entities, for political reasons, will actively reduce their
reported profits.
Disclosure Policy
Disclosure policy relates to additional disclosure within the annual report or media releases.
Stakeholder theory would explain these disclosures in terms of providing relevant information to maintain
relationships with powerful stakeholders.
Legitimacy theory sees voluntary disclosure as a way of maintaining or regaining legitimacy by demonstrating how
the entity is meeting societal expectations.

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Chapter 6 Products of the Financial Reporting Process

Thursday, October 29, 2015

3:32 PM

Identification Of The Reporting Entity

a circumscribed area of economic activities whose financial information has the potential to be useful to existing and
potential equity investors, lenders, and other creditors who cannot directly obtain the information they need in
making decision about providing resources to the entity and in assessing whether management and the governing
board of that entity have made efficient and effective use of the resources provided.
When Information Is Reported
International accounting standards require financial reports to be presented at least annually.
In many countries, listed companies are required to produce interim financial accounts.
Real-time reporting opens up the possibility of non-standardised reporting periods.

Arguments for Standardisation of Reporting Periods

1. It allows investors to compare and evaluate managements of different reporting entities.
2. The requirement for dividends makes it necessary to close the books and calculate profits to declare a dividend.
3. Various company acts require entities to produce annual financial statements.
4. Accounts also are a control mechanism and this requires standardisation of the reporting period.
Arguments for a More Flexible Approach to Reporting Periods
1. Any standardised period cuts across many uncompleted transactions and therefore requires arbitrary apportioning.
2. Better to focus on natural earnings cycle of business.
3. Reduce short term earnings management.
Interim Reporting
Not mandated by IASB
Required by Australian law for some entities
Covered by AASB134 and must include:
Condensed balance sheet
Condensed income statement
Condensed statement of changes in equity
Condensed statement of cash flows
Selected explanatory notes
Comparative information
Alleged Manipulation Of Reported Earnings
Use of managements discretion to make accounting choices or to design transactions to affect the possibilities of
wealth transfer between the company and society (political costs), funds providers (cost of capital) or managers
(compensation plans).
Ongoing and serious concern
Earnings Management
Fraud
Why does management manipulate the accounts?
to influence wealth transfers among the various stakeholders. Including
Management, controlling shareholders, other shareholders and potential shareholders.
Why are accounts open to manipulation?
Information asymmetry
Earnings Management
Bottom-line profit is the most widely used indicator of performance.
Can be earnings managed.
Usually based on the timing differences that arise between accrual and cash accounting.
Often managed to meet analysts forecasts.
Good versus bad earnings management.
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 Good versus bad earnings management.

Income Smoothing
Management artificially manipulates earnings to produce a steadily growing profit stream.
Above-normal profits are artificially reduced by certain provisions.
Called taking a bath.
These provisions are called upon inflate below- normal profits.
Allows managers to increase remuneration.
Also can be politically beneficial.
Pro Forma Reports: Massaging Earnings
Pro forma results are primarily used to show as though results. Often used when
The company has not operated for a full year.
There is a significant accounting policy change.
Exclude one-time or unusual items.
Critics claim they are incomplete, inaccurate and misleading.
Firms are more likely to use them when their share price and earnings decline in order to meet analysts
expectations and to downplay bad earnings news.
Exclusion Of Activities From The Financial Reporting Process
Accounting regulations may result in inaccurate reporting.
Voluntary disclosure can be used to fill the void between what can be reported within accounting rules and the
drivers of value generation within firms.
Intangibles
Traditional accounting systems are not able to provide good information about corporate intangible assets.
As much of two-thirds or three-fourths of the real value of the company is based on intangibles, and
investors are not getting the information they need to make decisions.
This is seen to be the reason the book value of corporations has been shrinking in relation to market value.
AASB138/IAS38 specifically prohibits the recognition of brands, mastheads, publishing titles, customer lists and
expenditure on research, training, advertising and start-up activities.
Once recognised revaluations are restricted to those intangibles for which there is an active market.
Intellectual Capital
Refers to
Capital created by employees or purchased, such as patents, computer and administrative systems,
concepts, models research and development.
relationships with customers and suppliers that consist of brand names, trademarks and the like
capital embedded in employees, such as through education, training, values and experience.
Only intellectual capital that has been purchased will be recognised in the financial statements
Knowledge organisations assets are their employees because of the increasing tendency for technology to be
embodied in intellectual property and labour.
The rate of return to intellectual capital investment can be determined only through an analysis involving original
expenditure data.
Voluntary Disclosures
The annual report contains both mandated financial statements and voluntary disclosure.
Information outside the financial statements is not audited.
The annual report can be used as a marketing tool as well as a conveyor of a particular organisational image to
its readers.
Narrative voluntary disclosures in annual reports used to report activities excluded by accounting standards
from the financial statements.
Impression management used to improve corporate image.
Can be biased, even misleading.

Electronic Reporting
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Electronic Reporting
Using websites, message boards and blogs.
Both financial and non-financial information is disclosed on reporting entities websites.
Only some, or none, of this may be audited.
The IASB has developed a code of conduct for Internet reporting.
Boundaries of reports should be clear.
Content of should be the same as the paper-based reports.
Reports should be complete, clearly dated and timely.
Information should be user friendly and downloadable.
Information should be secured to ensure reliability.
Extensible Business Reporting Language (XBRL)
XBRL is a language for electronic communication of financial data.
It standardises presentation.
It makes possible continuous disclosure by reporting entities.
It offers cost savings.
It improves efficiency, accuracy and reliability.
Why Entities Voluntarily Disclose
Mandated accounting information is constrained.
Definition of users is limited.
Organisations require and desire broad support.
They have multiple responsibilities.
Variety of information is necessary to satisfy and inform range of stakeholders.
Management Motivation to Disclose
1. To comply with legal requirements
2. Because of economic rationality arguments
3. Because of accountability to stakeholders
4. Because of borrowing requirements
5. To comply with community expectations
6. To ward off threats to organisational legitimacy
7. To manage powerful stakeholders
8. To forestall regulations
9. To comply with industry requirements
10. To win reporting awards

Research into Annual Reports

Accountability Theory
Views corporations, through their management, as reacting to the concerns of external parties.
Accountability involves monitoring, evaluation, and control of organisational agents
Accountability focuses upon the relationship between the corporation and users of its annual reports.
Legitimacy Theory
The annual report is a tool with which management signals its reactions to the concerns of particular
stakeholders.
Successful legitimation depends on reporting entities convincing society that a congruency of actions and values
exists.
Stakeholder theory
Management stakeholders about entity activities through means such as the annual report

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