Topic 2 Tutorial sach Flashcards
(15 cards)
2.1 What expectations do accounting standard-setters have about the accounting knowledge of financial statement readers?
2.1 What expectations do accounting standard-setters have about the accounting knowledge of financial statement readers?
Accounting standard-setters do not specifically address the expected accounting knowledge of financial statement readers but there is an expectation that the readers of general purpose financial reports have a ‘reasonable knowledge’ of business and economics. Specifically, the IASB Conceptual Framework for Financial Reporting states that ‘financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently’. Hence, there appears to be an implied expectation that financial statements are not tailored to meet the needs of people who have not, in some way, studied financial accounting. Students should be encouraged to consider whether this expectation is in itself ‘reasonable’.
2.3 Do you believe that the media portray accounting numbers, such as profits, as some sort of ‘hard’ and objective performance indicator? Why do you think they might do this, and, if they do, what are some of the implications that might arise as a result of this approach?
2.3 Do you believe that the media portray accounting numbers, such as profits, as some sort of ‘hard’ and objective performance indicator? Why do you think they might do this, and, if they do, what are some of the implications that might arise as a result of this approach?
In making this judgement, students should consider the various articles that frequently appear in newspapers and various discussions that occur on television and radio in relation to an organisation’s profits. Rarely is any mention made of the accounting methods used, even though the profits ultimately reported are directly a product of the many decisions that would have been made regarding how particular items should be accounted for (if possible, direct reference should be made to a number of articles which discuss organisations’ reported profits). Hence, it does appear as if profits are often held out as some form of ‘hard’, objective measure of organisational performance.
In considering why the media might behave in this manner, one possibility is that those responsible for writing the stories are ignorant that financial accounting relies upon a great deal of professional judgement and they might believe that every decision made by accountants is clearly mapped out by a comprehensive system of rules. Alternatively, the writers might consider that people simply do not want to be ‘bogged down’ in the fine detail. As another possibility, the accounting profession, through such vehicles as conceptual frameworks, may have successfully cultivated an impression (with the people in the media, and others) that the practice of accounting is objective, and the output of the
accounting system is highly comparable between different entities—meaning that one organisation’s profits can appropriately be compared to another.
The implications of this approach to reporting profits in the media is that one entity’s performance as represented by its profit might simply be compared to another, and that the entity with the higher reported profit might be considered to be more successful, and therefore to represent a better investment. Its management might also be considered in a more favourable light than the management of the entity with the lower reported profits. Implications such as this however, assume that readers and media listeners do not appreciate that profits are directly related to the various accounting choices made. Advocates of an efficient market perspective might however, argue that as long as the information about accounting method selection is made public somewhere, such as in the annual report, then the market (for example, the capital market) on average, will be able to understand how the adoption of particular accounting methods affected reported profits and hence the market will not simply fixate on the final numbers reported. There are differences in opinion about the efficiency of markets, such as the capital market.
A further point that could be raised in relation to this question is that accounting ‘profits’ are not a comprehensive measure of organisational performance, given that accounting profits typically disregard many of the social and environmental implications of a reporting entity.
2.5 What is ‘creative accounting’ and why does it occur?
2.5 What is ‘creative accounting’ and why does it occur?
Creative accounting can be defined as an approach to accounting wherein objectivity is not employed, but rather refers to a situation where those responsible for the preparation of accounts select accounting methods that provide the accounting result desired by the preparers.
There can be a number of reasons why creative accounting might be employed. Perhaps it might be undertaken to hide some fraud. It might also be undertaken because the organisation might have negotiated various contractual arrangements with various stakeholders. For example, the organisation might have borrowed funds from certain lenders, and as part of the lending agreement
the organisation might have signed a contract that included various covenants that used accounting numbers and which have the aim of reducing the risks of the lenders. This also would have reduced the costs that the organisation would have paid for the finance. In this regard, the organisation might have agreed to restrict its total level of debt by means of a stipulation that its debt to asset ratio is not to exceed a pre-specified upper limit (often referred to as a debt-to-asset covenant), or it might have agreed to maintain a certain interest coverage ratio, for example, that its profits (perhaps before interest and taxes) was to exceed/cover interest expense by a minimum number of times.
When an organisation has agreed to certain accounting-based debt covenants, a failure to comply with these covenants/restrictions means that the organisation would enter what is commonly referred to as ‘technical default’. Being in technical default can be costly for an organisation and can potentially lead to the company being discontinued. To avoid this, the accountant might be encouraged to ‘creatively’ increase reported income and assets, both actions of which would lead to a reduced probability of technical default (to the extent that the creativity remained undetected).
Also, organisations often pay key people within an organisation rewards that are tied to the performance of the organisation. These management bonuses might pay a bonus based on reported profits, return on assets or perhaps sales. Such bonus schemes are common. When people’s bonuses, and therefore wealth, are linked to accounting numbers there will be pressure on the accountant to be ‘creative’ with the accounting numbers.
The above discussion has been far from exhaustive. There can be many reasons that creative accounting can occur. Not all accountants will respond to the various pressures to be ‘creative’, but to believe that accountants are always objective (and never ‘creative’) would be very naïve.
2.11 In the early part of the twentieth century accounting rules were developed based upon large-scale analysis of what methods accountants were using, and on the basis of the assumptions and conventions that they were adopting. What are some criticisms of adopting this approach to develop accounting rules and related theory?
2.11 In the early part of the twentieth century accounting rules were developed based upon large-scale analysis of what methods accountants were using, and on the basis of the assumptions and conventions that they were adopting. What are some criticisms of adopting this approach to develop accounting rules and related theory?
Developing rules based upon observing what accountants are actually doing in practice is referred to as an ‘inductive approach’ to research (that is, research based on observing particular phenomena). Some criticisms of this approach to
developing accounting rules and theory is that in studying ‘what is’ there is an implied assumption that just because most people do something then somehow it must be the ‘best’ thing to do. This is not necessarily the case. Further, it will not necessarily lead to improvements in practice as there is no direct action undertaken to evaluate the practice. As Gray, Owen and Maunders (1987, p. 66) state:
Studying extant practice is a study of ‘what is’ and, by definition, does not study ‘what is not’ or ‘what should be’. It therefore 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.
As indicated in the textbook, if we are not exposed to new ideas we might adopt commonly used approaches that are not necessarily the most efficient approaches. For example, if we have only ever been exposed to people who use a screwdriver to dig a hole, then we might think this is the best thing available – yet there could be something better … a shovel!
2.14 If regulators acted in accordance with predictions provided by the private interest theory of regulation, which assumes that all individuals ( including politicians and regulators) are motivated by their own exconomic self- interest, what is the likelihood of the introduction of regulations arimed at reducing the problems associated with climate change- pariticularly if business corporations opposed such regulations?
2.14 If regulators acted in accordance with predictions provided by the private interest theory of regulation, which assumes that all individuals ( including politicians and regulators) are motivated by their own exconomic self- interest, what is the likelihood of the introduction of regulations arimed at reducing the problems associated with climate change- pariticularly if business corporations opposed such regulations?
This is an interesting and topical question. Climate change is accepted (by most people) as being one of the greatest threats (if not, the greatest threat) to the future of mankind and other inhabitants of the planet (other key problems confronting the planet would include population growth). Quests towards ecologically sustainable development, which incorporate actions to reduce ongoing contributions to climate change, necessarily put the interests of future generations above current quests to maximise our own wealth and self-interest.
However, if we accept the basic tenets of the private interest theory of regulation then we would probably reject a view that regulators would put the interests of the planet and that of future generations above their own. They would only put in place mechanism to reduce climate change if such actions were believed to be directly beneficial to them. Since business corporations have a great deal of power within society, and because their views and support could have direct implications for the reappointment of the regulators, the opposition of business organisations might further reduce the likelihood that ‘tough’ regulation, with associated costs, would be put in place to combat climate change. For evidence of this we can consider the actions currently being undertaken by various governments to combat climate change. To many people it would appear that government actions throughout the world (or, more to the point, government inactions) are restricted by concerns of not damaging relations with business associations and because of the economic impacts such actions might take (many people consider that governments worldwide are not being active enough in addressing climate change because making policies that restrict consumption of various products, and increasing the costs of carbon intensive activities, will not be popular with many people within the community and this will lead to a loss of electoral support).
Arguably (and of course this is a value-laden belief), economics-based theories, which at their core adopt assumptions that self-interest (tied to wealth maximisation) drive the actions of individuals, do not provide great hope for real efforts to address ongoing ecological problems.
2.16 If you believed that regulators acted in accordance with either capture theory or the private interest theory of regulation, would you believe that accountig standard - setters will develop accounting standards that most fairly present information about the financial position or performance of a reporitng entity?
2.16 If you believed that regulators acted in accordance with either capture theory or the private interest theory of regulation, would you believe that accountig standard - setters will develop accounting standards that most fairly present information about the financial position or performance of a reporitng entity?
If we embraced the central tenets of either capture theory or the private interest theory of regulation then we would probably accept that ‘objective’ accounting standards (which favour no particular group) would only be developed if their creation coincided with furthering the interests of the standard-setters. This can be contrasted to the perspective we would adopt if we believed accounting standards were developed in the public interest, as would be suggested by public interest theory. However even under public interest theory, ‘objective’ accounting standards would only be developed if the overall benefits to society exceed any associated costs. Any consideration of costs and benefits also acts to undermine the objectivity of the accounting standard-setting process (cost benefit calculations inevitably include an element of subjectivity).
Hence, regardless of the theoretical basis adopted, we might question whether accounting standards will always be developed that ‘fairly present information about the financial position and performance of a reporting entity’.
2.23 Hines (1991, p. 313) stresses a view that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What does Hines mean by this statement? Do you agree or disagree with her, and why?
2.23 Hines (1991, p. 313) stresses a view that ‘financial accounting practices are implicated in the construction and reproduction of the social world’. What does Hines mean by this statement? Do you agree or disagree with her, and why?
Hines challenges the view that accounting provides an account of the performance of an entity that is a faithful representation and objective. Rather than objectively recording a snap-shot of an underlying reality, accountants actually create a reality. She believes that accountants are actually responsible for determining which factors should be recognised in the accounting process and which should be ignored. If accountants identify and record particular phenomena then the phenomena effectively become real. If accountants ignore particular issues (for example, the great majority of accountants ignore the social and environmental externalities caused by a business) then these issues are not highlighted and are therefore not, apparently, of any relevance. The practice of accounting identifies those issues for which the firm will be accountable—which issues are relevant. If managers do not want to be accountable for particular aspects of an entity’s performance then perhaps the best strategy is not to record information about those aspects. If information about those aspects is not recorded and subsequently reported, then perhaps nobody will consider the particular aspects to have any relevance, and managers will not have any associated accountability.
There is also a view that accounting numbers can themselves generate consequences. If a company elects to use a particular accounting method, which leads to it recording a substantial loss, then this loss might cause panic and a rush by investors to withdraw their funds, even though the firm might have been able to trade out of difficulties. Had different methods been used, which perhaps painted a rosier picture, there might not have been such an adverse reaction. The accounting numbers themselves, which are based on many assumptions, led to actual outcomes that were very real for investors, customers, employees and others. If accounting used other performance indicators, apart from profits (such as contributions to the local communities or to employees) then stakeholder reactions might be different.
2.25 Why might accountants be construed as being powerful individuals?
2.25 Why might accountants be construed as being powerful individuals?
This chapter has provided a number of reasons why accountants might be considered to be powerful individuals. These reasons include the following:
- Consistent with the views of Hines, accountants can select which items or events should be captured by the accounting system, and this in turn impacts the extent of accountability managers have.
- Support for a company is often related to the performance of the company from an accounting perspective. Hence, if the accountant uses particular methods that mean that a profit is reported then this may have positive consequences for a company relative to a situation where a loss is reported.
- Many contracts exist (for example, management bonus plans, debt contracts) which rely upon the output of the accounting process. Such contracts have direct cash-flow consequences for people both inside and outside the organisation and the cash-flows can be directly impacted by the accounting methods which have been chosen.
- If the accountant uses accounting methods which lead to a reported loss, this reported loss might be used as a justification for reducing the number of employees, support for community-based projects, and so forth.
- Consistent with the views of Gray (1992), for people to be able to make informed decisions and have ‘power’ to create change, they need information. The accountant often plays a part in determining how much information is to be released to the organisation’s stakeholders.
- Organisations that are profitable are often considered to be ‘good’ organisations worthy of support. They are considered to be legitimate—hence the accountant, through accounting, can have the effect of making a firm appear legitimate and thus it will attract community support.
3.4 Given the process involved in developing accounting standards, do you believe that accounting standards can be considered to be ‘neutral’ (that is, not serving the interests of some constituents over others)?
3.4 Given the process involved in developing accounting standards, do you believe that accounting standards can be considered to be ‘neutral’ (that is, not serving the interests of some constituents over others)?
As we know from reading this chapter, when accounting standards are being developed the accounting standard-setters will typically call for submissions from ‘interested parties’. Since these submissions will be taken into consideration when developing accounting standards, these submissions have the potential to influence the accounting standard that is ultimately released (and the influence of the submission will perhaps be driven by the perceived credibility of the arguments being made within the submission). Introducing public debate into the accounting standard-setting process can have the effect of reducing the neutrality or objectivity of the final standards.
Also, accounting standard-setters consider the costs and benefits of potential regulations before they are introduced. Considerations of costs and benefits are subjective exercises. If a potential accounting standard is perceived likely to create significant economic or social impacts then the standard-setters might decide against introducing the new or revised standard despite the fact that they believe it otherwise represents ‘best practice’. This could mean that an existing accounting standard is retained despite the fact that it is deemed inferior to the proposed accounting standard and despite the fact that the existing accounting standard may in itself cause potential economic and social impacts that could be challenged.
If we were to accept the economic interest group theory of regulation which provides a perspective that regulators, like all individuals, will be driven by self-interest then we might also question any belief that accounting standard-setters will develop accounting standards in an unbiased manner. Pursuant to this theory, accounting standard-setters would develop accounting standards that most benefit their own interests (perhaps because the accounting standard favours a group that has influence over the reappointment of the regulator).
3.6 What is meant by saying that financial acounting information is a ‘public good’?
3.6 What is meant by saying that financial acounting information is a ‘public good’?
A ‘public good’ is a good which, after it is first made available, others can use without paying for and which can be passed on to others that also do not pay for
its use. Public goods, or free goods as they are often called, are traditionally considered as goods which are not scarce and which do not have a price.
Relying upon market-based arguments to ensure that optimal amounts of a good are produced assumes that all users pay for the good. If free-riders exist (people who use but who do not pay) then the quantity of a good will be under-produced relative to what would be produced if all that used did pay. It is possible that users of a public good would pay for it if required, but if a good is public in nature then there is no need to pay for it. Advocates of accounting regulation use this argument to suggest that optimal amounts of information will not be produced if we are to rely upon market-based mechanisms alone.
3.11 Would you expect independent financial statement audits to exist for listed companies even in the absence of regulation requiring them to be undertaken? Why?
3.11 Would you expect independent financial statement audits to exist for listed companies even in the absence of regulation requiring them to be undertaken? Why?
The answer to this, as with most questions in the textbook, depends on the theoretical perspective we adopt. If we adopt the theoretical economics-based assumption that managers will act in their own self-interest, then we would predict that there will also be a contractual demand to have financial statements audited by an external and credible third party. Such an activity will increase the perceived reliability of the data and this in turn is expected to reduce the perceived risk of the external stakeholders, thus further decreasing the organisation’s cost of capital. That is, financial statement audits can also be expected to be undertaken, even in the absence of regulation, and evidence indicates that many organisations did have their financial statements audited prior to any legislative requirements to do so (Morris, 1984). As Cooper and Keim (1983, p199) indicate however, to be an effective strategy ‘the auditor must be perceived to be truly independent in the accounting methods employed and the statements’ prescribed content must be sufficiently well-defined’.
3.15 Why would the managerial labour market motivate the manager to provide information voluntarily to outside parties?
3.15 Why would the managerial labour market motivate the manager to provide information voluntarily to outside parties?
Arguments which rely on the market for managers assume that the managerial labour market is an efficiently operating market in which a manager’s previous performance will impact the salaries they can demand in future periods, either from their current employer or elsewhere. With such a market, managers will have an incentive to maximise the value of the organisation, because actions which prove subsequently to be successful will become known by ‘the market’. Because providing information to the various parties with which the firm contracts will be beneficial for the firm in terms of maximising its value, managers will have an incentive to provide information, even in the absence of regulation. The ‘market for managers’ argument is frequently used as a basis for an argument against regulating accounting disclosures. However, we must remember that such an argument is heavily reliant on its assumption about efficiency in the market for managers. Many people argue that such markets often show signs of inefficiency. The ‘market for managers’ argument also tends to break down if particular managers are approaching retirement, in which case they will not be demanding any future payments from the market for managers.
3.16 What is the marketfor corporate takeovers and how would its existence encourage organisations to make accounting disclosures even in the absence of regulation?
3.16 What is the marketfor corporate takeovers and how would its existence encourage organisations to make accounting disclosures even in the absence of regulation?
The ‘market for corporate takeovers’ argument works on the assumption that an under-performing organisation will be taken over by another entity that will subsequently replace the existing management team. That is, ‘the market’ will be aware of the current potential the organisation has – potential which is not being utilised by the existing management team.
With a perceived threat of takeover, it is predicted (by free market advocates) that managers would be motivated to maximise firm value and thereby to minimise the likelihood that outsiders could seize control of the organisation at low cost. The ‘market for corporate takeovers’ argument assumes that information will be produced to minimise the organisation’s cost of capital and thereby increase the value of the organisation.
The above arguments assume that management will know the marginal costs and benefits involved in providing information and in accordance with economic theories about the production of other goods, management will provide information to the point where the marginal cost equals the marginal benefit thereby maximising the value of the organisation and, as a result, making the organisation more expensive for anybody seeking to acquire it. Whilst the disclosure of accounting information will be to the interests of shareholders, it will also be in the interests of managers – there will be an alignment of interests.
3.23 Under the economic interest theory of regulation, what factors will determine whether a particular interest group is able to secure legislation that directly favours that group above all others?
3.23 Under the economic interest theory of regulation, what factors will determine whether a particular interest group is able to secure legislation that directly favours that group above all others?
If we accept the economic interest theories of regulation then whether we believe a particular group is able to secure favourable legislation will be dependent upon whether we assess that introducing such legislation will be in the interests of the regulators. Economic interest theories of regulation assume that regulation will only be introduced if it is in the interests of the regulators. Hence if a group wants to have favourable legislation introduced then, accepting this perspective of the world, they will need to demonstrate that they have resources that can be used by the regulators or perhaps that they control a block of votes that can help ensure the re-election or re-appointment of the regulators. Those people or groups without resources or votes are deemed to have little or no voice in the regulatory process (such a perspective would emphasise the need for interest groups to organise themselves as large cohesive groups of members with sufficient resources and votes to enable them to be heard). We can perhaps debate whether our own views of politicians are consistent with the economic interest theory of regulation. Do we think that politicians would place their own private interests above the public interest?
- 29 Assume that a government regulator makes a decision that all companies with a head office in Australia must separately disclose, within their annual financial report, the amount of expense incurred in relation to the training of employees. The companies must also spend at least 5 percent of their reported profits on training employees. You are required to:
(a) explain the decision made by the regulator in terms of public interest theory
(b) explain the decision made by the regulator in terms of the economic interest group theory of regulation.
3.29 Assume that a government regulator makes a decision that all companies with a head office in Australia must separately disclose, within their annual financial report, the amount of expense incurred in relation to the training of employees. The companies must also spend at least 5 percent of their reported profits on training employees. You are required to:
(a) explain the decision made by the regulator in terms of public interest theory
(b) explain the decision made by the regulator in terms of the economic interest group theory of regulation.
(a) If we embraced the public interest theory of regulation then we would tend to believe that the regulator introduced the requirement because on balance, it provided greater social benefits than related costs. That is, there was a net benefit to society (even though some parties might gain and some parties might lose). As we indicated in the chapter however, the determination of costs and benefits of particular regulation tends to be a rather subjective exercise. The public interest theory of regulation does not give consideration to the implications the decision may have on the livelihood of the regulator (that is, it would ignore the fact that industry bodies with significant electoral power might be opposing the legislation).
(b) By contrast, if we embraced the economic interest group theory of regulation then we would argue that the regulator like all individuals, is driven by self interest and the enactment of the legislation must be perceived by the regulator as being beneficial to their own interests. For example, perhaps powerful labour unions with power to effect the re-election of the regulator demanded the introduction of the legislation.
