Topic 1 Financialaccounting Theory and Regulation

1-1Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Financial Accounting Theory

Topic 1 Financial Accounting Theory and Regulation

References: Chapter 1 Introduction to financial accounting theoryChapter 2 The financial reporting environment Slides Chapter 3 The regulation of financial accounting


Learning objectives

• In this chapter you will be provided with evidence that shows that:– there are many theories of financial accounting– knowledge of different accounting theories increases our

ability to understand and evaluate various alternative financial accounting practices

– the different theories of financial accounting are often developed to perform different functions, such as to describe accounting practice or prescribe particular accounting practices


Learning objectives (cont.)

– theories, including theories of accounting, are developed as a result of applying various value judgements and that acceptance of one theory, in preference to others, will in part be tied to one’s own value judgements

– we should critically evaluate theories before accepting them

– there is good reason for students of accounting to study theories as part of their broader accounting education


What is a theory?

• ‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p. 1).

• ‘A scheme or system of ideas or statements held as an explanation or account of a group of facts or phenomena’ (The Oxford English Dictionary)

• Based on logical (coherent) reasoning, and not ad hoc in nature.

• Different to a ‘hunch’• A theory could be based on numerous observations

(inductive reasoning), or developed on the basis of logic (deductive reasoning)

• Could be ‘positive’ or ‘normative’ • Theories can help us make sense of the world in which we

live and can provide a structure to understand our (social) experiences


Accounting theories

• Accounting is a human activity• It would seem illogical to study financial accounting

(for example, the accounting standards) without also studying accounting theory

• Theories of accounting consider– people’s behaviour with respect to accounting information– people’s needs for accounting information– why people within organisations elect to supply particular

information


Examples of uses of accounting theories

• Theories might– prescribe how assets should be valued– predict why managers will choose particular accounting

methods– explain how an individual’s cultural background affects

accounting information provided– prescribe what accounting information should be

provided to particular classes of stakeholders– predict that the relative power of a stakeholder group will

affect the accounting information it receives – explain or predict how accounting disclosures might be

used as part of a strategy to legitimise the operations of an organisation


Normative theories

• Based on what the researcher believes should occur in particular circumstances– not based on observation

• Example of normative theory– Continuously Contemporary Accounting (CoCoA) by

Raymond Chambers– Conceptual Framework of Accounting

• Should not be evaluated on whether they reflect actual accounting practice


Classifications of normative theories

• True income theories– make assumptions about the role of accounting then

seek to provide a single ‘best measure’ of profits

• Decision usefulness theories– ascribe a particular type of information for particular

classes of users on the basis of assumed decision-making needs


Positive theories

• Seek to predict and explain particular phenomena• Begins with assumption(s), and through logical

deduction enables prediction(s) to be made• If predictions are sufficiently accurate when tested

against observations of reality, they are regarded as having provided explanation of why things are as they are


History of regulation in Australia

• 1946: Institute of Chartered Accountants in Australia (ICAA) released five Recommendations on Accounting Principles– based on documents released by ICAEW

• 1956: a number of recommendations released by Australian Society of Accountants– later years the two bodies issued statements jointly

through Australian Accounting Research Foundation (AARF)


History of regulation in Australia (cont.)

• AARF collaborated with Australian Accounting Standards Board (AASB) in developing mandatory standards

• AARF subsequently removed from the standard setting process and with the adoption of IAS/IFRS much of the standard setting process has now been passed to the IASB

• Hence, accounting standards to be used in Australia are now overwhelmingly controlled by the IASB which operates out of London.

• Do we think that the needs of local financial statement readers within Australia are the same as the needs of all the other jurisdictions that also use International Financial Reporting Standards (IFRS)? Is a one-size-fits-all approach appropriate (we will address this issue in later weeks)

• There are also current efforts by the IASB and the US Financial Accounting Standards Board to converge the respective accounting standards – this will create direct impacts in Australia and other countries.


Rationale for regulating financial accounting practice

• Initially introduced following the Great Depression– argued that problems with accounting information led to

poor and uninformed investment decisions

• Competing views as to whether regulation is necessary. There are:– pro-regulation advocates, and– anti regulation (free-market) advocates


Arguments in favour of regulation

• Markets for information not efficient• ‘On average’ market efficiency arguments ignore

the rights of individuals• Those able to demand information can often do so

as a result of power over scarce resources, while those with limited power are generally unable to secure information without regulation (even though the organisation may impact their existence)


Arguments in favour of regulation (cont.)

• Investors need protection from fraudulent organisations producing misleading information

• Regulation leads to uniform methods thus enhancing comparability


Arguments against regulation

• We do not need accounting regulation because people will be prepared to pay for information to the extent that it has use

• Capital markets act to punish organisations that fail to provide information– no news deemed to imply bad news

• Regulation will lead to oversupply of information as users who do not bear the cost of supply tend to overstate their needs


Arguments against regulation (cont.)

• Regulation restricts the accounting methods able to be used so organisations may be prohibited from using methods which best reflect their particular performance and position. This has implications on the efficiency with which the firm can inform the market about its operations.


The role of professional judgement in financial reporting

• While the accounting treatment of many transactions and events is regulated, many others are unregulated

• Accountants expected to be objective and free from bias (although, as we will see, various theories of accounting question whether accountants will allow objectivity to determine the selection of accounting methods)

• Do we believe that accountants will also be objective and free from bias? In making this judgement are we utilising particular theoretical assumptions?


The role of professional judgement in financial reporting (cont.)

• Information generated should faithfully represent underlying transactions and be neutral and verifiable

• When developing accounting standards the accounting standard setters give consideration to the potential economic and social implications of any changes

• The consideration of economic and social implications of possible accounting standards implies bias in their development and implementation– standard setters face a ‘dilemma which requires a delicate

balancing of accounting and non-accounting variables’ (Zeff 1978, p. 62)


Why are particular accounting methods applied?

• Efficiency perspective– different organisational characteristics explain why

different firms, when presented with accounting options, will adopt different accounting methods—they will adopt the method that best reflects their performance

– Advocates of a ‘free market’ approach perceive that accounting regulations which restrict the set of available accounting techniques will be costly to the organisation as restricting available accounting methods will limit how efficiently an organisation is able to produce information about its financial position and performance

– Such arguments do not tend to consider comparability benefits that might flow from regulation


Why are particular accounting methods applied? (cont.)

• Opportunistic perspective– assumes that selection of an accounting method is driven

by self-interest– would question the view that accountants (and other

individuals) would be objective– accounting methods which provide the desired results for

preparers are selected

• Refer to Chapter 7 for a discussion of these perspectives

• Chapter 8 addresses other theoretical perspectives


Why examine theories of regulation?

• Better placed to understand why some accounting prescriptions become part of legislation while others do not

• Accounting standard-setting is a very political process– while some proposed requirements may be technically

sound and logical, they may not be mandated due to political ‘power’ or influence of some affected parties


‘Free market’ perspective

• Accounting information should be treated like other goods, with demand and supply forces allowed to operate to generate an optimal supply


Arguments supporting ‘free market’ perspective

• Private economic-based incentives • ‘Market for managers’ • ‘Market for corporate takeovers’• ‘Market for lemons’


Pro-regulation perspective

• Accounting information is a public or ‘free’ good• It should not be treated the same as other ‘goods’• In the presence of free-riders, true demand is

understated– pricing system does not function properly

• Leads to underproduction of information• Regulation necessary to reduce impacts of market

failure


Should supply of ‘free’ goods be regulated?

• Some argue free goods often overproduced as a result of regulation

• Public, knowing they do not have to pay, will overstate their need for the good or service– e.g. investment analysts

• Could lead to accounting standards overload


Theories to explain regulation

• Public interest theory• Capture theory• Economic interest group theory (private interest

theory)


Public interest theory

• Regulation put in place to benefit society as a whole rather than vested interests

• Regulatory body considered to represent interests of the society in which it operates, rather than private interests of the regulators

• The enactment of regulation is a balancing act between the perceived social benefits and the perceived social costs of the regulation

• Assumes that government is a neutral arbiter


Criticisms of public interest theory

• Critics question assumptions that economic markets operate inefficiently if unregulated

• Question the assumption that regulation is virtually costless

• Others question assumption of government neutrality– argue that government will only legislate and groups will

only lobby for regulation if it will increase their own wealth


Capture theory

• While regulation might be introduced with the goal of benefiting the public this goal may not subsequently be achieved

• The regulated seeks to take charge of (capture) the regulator

• Seek to ensure rules subsequently released are advantageous to the parties subject to regulation

• Although regulating initially in the public interest, difficult for regulator to remain independent


Capture of accounting standard-setting

• Walker (1987) analysed capture of Australian standard-setting through the ASRB, arguing that– the accounting profession lobbied before the board

established to ensure no independent research capability, no academic as chair, to receive admin officer not a research director

– priorities only set after consultation with AARF– ASRB fast-tracked AARF submissions but not others– majority of board membership were members of the

accounting profession


Criticisms of capture theory

• No reason to suggest that regulated industry the only interest group able to influence the regulator

• No reason why regulated industries only able to capture existing agencies rather than procure the creation of an agency

• No reason why regulated could not prevent creation of the regulatory agency


Economic interest group theory

• The release of new or revised accounting standards have real economic and social consequences– For example, consider how the adoption of AASB 138

Intangibles might have created real economic imoacts within Australia

• The economic interest group theory of regulation assumes that groups will form to protect particular economic interests

• Groups are often in conflict with each other and will lobby government to put in place legislation which will benefit them at the expense of others

• No notion of public interest inherent in the theory• Regulators (and all other individuals) deemed to be

motivated by self interest


Economic interest group theory (cont.)

• The regulator is not a neutral arbiter but is seen as an interest group itself

• Regulator motivated to ensure re-election or maintenance of its position of power

• Regulation serves the private interests of politically effective groups

• Those groups with insufficient power will not be able to effectively lobby for regulation to protect its own interests


Examples of application to accounting standard-setting

• Industry groups may lobby to accept or reject a particular accounting standard– e.g. European Banks in relation to IASB 39

• Large politically sensitive firms found to lobby in favour of general price level accounting in US (led to reduced profits)

• Accounting firms lobbying to protect their own interests


Accounting regulation as an output of a political process

• The view that financial accounting should be objective, neutral and apolitical can be challenged

• Will inevitably be political as it affects wealth distribution within society

• Standard-setters encourage affected parties to make submissions on drafts of proposed standards


Accounting regulation as an output of a political process (cont.)

• If standard-setters give consideration to views in submissions, accounting standards and therefore financial reports are the result of various social and environmental considerations– tied to the values, norms and expectations of the society

in which standards are developed– questionable whether financial accounting can claim to

be neutral and objective


Accounting regulation as an output of a political process (cont.)

• Compliance with accounting standards usually seen to indicate financial statements are ‘true and fair’– can or should financial statements that have been

prepared on the basis of accounting standards (with such standards having been developed after taking into account various economic and social consequences) be deemed to be ‘true and fair’?

• Users may not be aware that financial reports are the outcome of various political pressures

• Should regulators consider preparers’ views given that standards are designed to limit what preparers do?

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Topic 1 Financialaccounting Theory and Regulation

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