Accounting Theory - Lecture notes 1-4 PDF

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Week 1 What is theory? Accounting is viewed as a practical discipline. Where accounting rules are the primary focus, there may seem to be little use for theory. However, theory is necessary to understand the world we live in, provide a basis for decisions we make and predict what may happen given actions or events. There is no one definition of theory because theories can do different things; they can describe, predict, explain and prescribe. Theory can be considered: 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 more generally, a conjecture or an opinion. •

What is accounting theory? Accounting theory in this unit is defined as either a description, explanation or prediction of accounting practice or a set of principles on which to evaluate or guide practice. Theories help us to understand and make sense of the world. They help to explain, describe, predict and guide decisions and actions. Any critical analysis should be informed by theories. In financial accounting, theories can help the understanding of current accounting practice and also provide the means by which to improve it by: describing and explaining current accounting practice • providing principles on which to base actions and decisions in financial accounting • identifying problems and deficiencies with current accounting practice • providing suggestions for change. • Some of the major research areas in accounting include: capital market research, accounting policy choice research, accounting information processing research, critical accounting research and international accounting research. Read about these in detail in you set text, '1.5 research areas in accounting' (Rankin et al. 2018, pp. 14–15). Some accounting theories describe and explain current practice for example, disclosure of nonfinancial (sustainability) information. Some predict practice, for example, agency theory (what incentives will tying executive bonuses to share price compared with accounting numbers provide). Other theories provide principles for decision-making, for example, decision-usefulness of accounting information.!Some of these theories are normative—they state what ‘should’ happen.

Evaluating theories Often alternative/competing theories about same topic co-exist, for example, alternative theories about best way to constrain corporate carbon emissions. For example: Emissions trading schemes • Carbon tax • Plant & equipment carbon mitigation tax incentives • Research and development (R&D) incentives • Just because there is a theory about something, it does not mean that it is correct. Theories are often accepted without ‘first hand’ or direct knowledge. We need logically constructed consideration of evidence that confirms or refutes the theory. A good theory should be: logical in its construction • clearly articulated • testable • consistent with observation. •

A theory can never be proved true. A single observation can prove a theory false. A range of approaches are taken to test theories: simple: Intuitive or anecdotal approaches • systematic approaches • scientific approaches: Role of research. •

Theories covered in ACC30008 Many accounting theories exist, but knowledge and application of the following are expected. Select the tabs to see them. Positive accounting theories include the following? Shareholder. • Agency. • Legitimacy. • Stakeholder. • Institutional. • Contingency. • Signalling. • Accountability. • Behavioural. • Capital market or Information. •

Regulatory theories include the following:! • • • •

Capture. Public Interest. Bushfire. Ideology.

Normative theories include the following:! • • •

Conceptual Framework. Accounting Standards. Legislation and regulations.

Understanding the role of research Research is the ‘diligent and systematic enquiry or investigation into a subject in order to discover facts or principles’ (Dictionary.com 2019). Research is often replicated and adjusted, so that knowledge expands. Most research studies will not provide definitive answers, but should contribute to better understanding of issue. Your textbook (Rankin et al. 2018) essentially comprises summaries of accounting research. !

Research of/about accounting Research of or about accounting considers the role of accounting itself, for example: Has the International Financial Reporting Standards body (IFRS) adoption lowered • companies’ cost of capital? Has IFRS adoption made analysts’ forecasts more accurate? • Is the relationship between book value and share price stronger after IFRS adoption? • What impact does the enforcement regime have on accounting transparency? • What role, if any, did accounting play in the global financial crisis (GFC)? •

Research in accounting Research in accounting focuses at the more micro level on issues within accounting, for example:

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What measurements (e.g. historical cost, fair value, net present value) are being used? What measures should be used? What impact, if any, do changes in specific accounting policies have on share prices? For example, can investors see through cosmetic changes that do not change the ◦ underlying economic substance of a company?

Research areas in accounting Research areas!in!accounting include the following:! Capital market (CM) research: For example, !do investors react to cosmetic accounting • policy change? Accounting policy choice research: For example, is fair value more relevant than HC to • share prices? Accounting information processing research: For example,!does note disclosure vs • recognition affect cognition? Critical accounting research: For example, !does accounting perpetuate wealth and power? • International accounting research: For example, has IFRS affect foreign company listings on • the Australian Securities Exchange (ASX)? Research in voluntary disclosures: For example, sustainability information. •

Week 2 Information asymmetry - Information asymmetry results from managers having an advantage over investors and other interested parties as they have more information about the current and future prospects of the entity, and can choose when and how to disseminate this information. Efficiency - Capital markets are assumed to be efficient. The hypothesis suggests that if accounting choices and changes do not affect cash flows, investors will not alter their assessment of share prices. Therefore, market efficiency is important to accounting because the assumption means that investors would see through alternative or opportunistic accounting choices. If markets are not efficient, then discretionary accruals (or earnings management) can fool investors. Capital market theories - describes how share prices react to accounting information A Summary of XBRL – what it is and how it has evolved XBRL stands for Extensible Business Reporting Language and it is a computer language for electronic communication of business data. XBRL can reduce the need for redundant data; facilitate the comparison, the transfer and the transmission of reporting & collecting processes of financial information. The way that XBRL works is that it provides a tag similar to a barcode to each unit of information; this tag is then read, understood and managed by a software application that recognizes the tag. This setup allows automated processing of information, quicker analysis and can be presented in a variety of ways for users.! The implementation of XBRL may benefit auditors and other users. Some interesting facts -! XBRL is a derivative of XML the extensible mark-up language developed 20 years ago to enable software developers to use a standard format to extract and report on data across the internet. To understand XML we need to consider HTML and how internet pages are developed. Hyper Text Mark-up Language (HTML) is simply a number of tags that define page layout on the web. Software designers convert their output into an HTML file with e.g. a tag for the header, and a tag for the body and place the data accordingly. Put simply a mark-up language is a way of defining the structure of a document and this tag concept was incorporated into XML which evolved as a standard to allow structures to be defined in a set of rules that can also be read by computers and therefore software developers and reporting entities. The most salient difference between HTML and XML is that HTML describes presentation and XML describes content. An HTML document rendered in a web browser is human readable. XML is aimed toward being both human and machine readable. (Saverio Perugini 2002) XBRL is the use of XML concepts to e.g. associate contextual information with data points in a financial statement. When formatted with tags, financial statements/data from any source can be read with consistency. XBRL is dependent on the reporting entities building output that includes the XBRL tags. Taxonomies are the created to define the tag structure. If they are registered with XBRL international then programmers can map their software to the XBRL output. Advantages / Disadvantages There are advantages and disadvantages of using this kind of technology Did you find any more in your peer reviewed journals from the library? Advantages of XBRL: Provides a standardized language for all companies reporting their financial data Allows investors and stakeholders to easily download and understand financial reports

Provides a list of definitions (taxonomies) for the financial terms used Saves time in entering and reporting financial data and increases efficiency Is very cost-effective Disadvantages of XBRL: Is not used by all publicly traded companies as of now Tags may be wrongly assigned to financial terms There is still a lack of consistency in the use of standards Wrong definitions (taxonomies) may be given to certain financial terms It may pose security risks for companies publicly reporting their financial information XBRL is not yet mandatory here.!Do you think this should be adopted in Australia?

Week 3

Week 4: Positive and normative accounting theories Theories can also assist us to understand how organisational systems and controls are contingent on both internal or environmental and internal or entity-specific factors that affect the organisation. Rather than explaining actions, other accounting theories can assist in determining what appropriate methods should be used or how accounting information should be measured and reported. These theories are designed to provide solutions or improvements. (Rankin et al. 2018) Positive and normative accounting theories Normative accounting theory is based on the idea that you can make recommendations on what should happen. 'They prescribe what ought to be the case based on a specific goal or objective' (Rankin et al. 2018, p. 143). Positive accounting theory is more focused on prediction and future thinking that 'describes, explains or predicts activities'!(Rankin et al. 2018, p. 143). Read more about positive and normative accounting theories in '5.1 What value does theory offer?' (Rankin et al. 2018, pp. 143–144). In your evaluation of positive accounting theories (where this phrase is meant in its generic sense), consider how they have been designed to explain and predict behaviour in an accounting context? Other theories that you will need to be familiar with are Ray Ball and Philip Brown's Efficient market hypothesis and Ross Watts and Jerald Zimmerman's contribution to the emergence of Positive accounting theory. Ball and Brown Theory: One generic positive accounting theory that you will touch on is the efficient market hypothesis (EMH), which will be returned to later in the unit. In the seminal paper, Ball and Brown (1968)— both Australians—heralded the beginning of a new era of research, which relied on the EMH. Ball and Brown (1968) set out to test whether HCA was useful. They examined the share price movements for many companies after release of annual financial reports based on HCA and found limited share price reaction. They concluded that annual reports based on HCA were important as confirmatory documents, with much of the information they contained already impounded into share prices, but with around 15% of the movement occurring once the annual report was issued. Since that groundbreaking study, positivist research has dominated the research journals that publish accounting-related research. Watts and Zimmerman Theory: Some time later, Watts and Zimmerman (1979)—both from the US—were responsible for the specific development of Positive accounting theory, based on Agency theory (also known as contracting theory or costly contracting theory). Under Agency theory, the firm is viewed as a nexus of contracts, and accounting numbers play a vital role in many of these contracts. For instance, contracts with managers that determine their remuneration often rely on accounting numbers when determining bonuses. The bonus hypothesis explains and predicts the practice of 'manipulating' accounting numbers to maximise bonuses Implications for lenders and borrowers Accounting information plays a number of roles in debt contracting. Lenders rely on accounting numbers in contracts that create debt agreements (covenants) with borrowers. Ratios that were learned about in first year (e.g. debt to equity ratio, times interest earned ratio, etc.) feature in these contracts and trigger serious default implications if the borrower defaults. Companies like to borrow because the after-tax cost of debt is much less than raising funds through equity with associated dividends that are not tax deductible. But too much borrowing increases the risk of not being able to service the interest plus principle. Read more about the relationship between debt contracting and agency theory in 'Role of accounting information in reducing agency problems' (pp. 150–151). Agency theory and manager decision-making

Proximity to the ratios included in debt covenants makes managers rightly nervous. The debt hypothesis under Agency theory explains and predicts that managers will 'manipulate' or 'manage' the accounting numbers to avoid such breaches, which can trigger the collapse of the company and hence, loss of their employment. This is important because Agency theory is used extensively in accounting research. The amount of company and individual manager behaviour this theory can explain and predict is phenomenal. It assumes self-interest and rational actions based on selfinterest and therefore challenges notions of altruism being a principle driver of decision-making. Legitimacy theory is a 'positive accounting theory'—it is based on the idea of the social contract. This puts the onus of acting in accordance with the public good on the operating structures of organisations. Organisational legitimation is the process an organisation uses to address its societal expectations. Consider the different approaches to accounting disclosure presented in the following positive accounting theories: Stakeholder theory (Rankin et al. 2018, p. 156). • Contingency theory (Rankin et al. 2018, p. 159). • Earnings management Managers use judgement when they approach financial reporting and sometimes they might structure 'transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence the contractual outcomes that depend on reported accounting numbers' (Rankin et al. 2018, p. 264). There are a number of earnings management techniques that you can choose to ensure that transparency in reporting is maintained. Consider the following techniques in '9.3 Methods of earnings managment' (Rankin et al. 2018, pp. 265–268): Accrual accounting. • Income smoothing. • Real activities managment. • Big bath write-offs. • Now that you have read about the various aspects of managerial decision-making, and the different theories and approaches that are associated to positive accounting theory and earnings management, consider how they relate to the quote below.

Week 1 Introduction to accounting theory (Chapter 1) – Understand the concept of theories and the role of research Week 2 Reporting; standard setting and regulation (Chapters 3 & 6) – Look at topics such as: income smoothing; voluntary disclosures; standard setting and harmonisation – Regulatory theories: signalling theory; public interest theory; capture theory and ‘bushfire theory’ Week 3 – Conceptual framework (Chapter 2) – Normative theories of accounting Week 4 – Positive accounting theory (Chapter 5 & Chapter 9) – Watts and Zimmerman agency theory – Ball and Brown efficient market hypothesis – Debt; bonus plan and political cost hypothesis Week 5 – System-oriented theories (Chapter 5) – Introduction and application of stakeholder, legitimacy and institutional theories

Week 6 – Extending corporate accountability (Chapter 11) – Relationship between organisational responsibility and accountability – Reviewing social and environmental performance Week 7 – Reactions of capital markets to financial reporting (Chapter 8)

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Normative research; capital market research and behavioural research – Efficient market hypothesis Week 8 – Reactions of individuals to financial reporting (Chapter 8) – Value relevance and capital market research – Behavioural finance and heuristics Week 9 Measurement (Chapter 4) – Concept of fair value and the various valuation techniques – Measurement challenges facing green assets; intangibles; heritage assets and water assets Week 10 International accounting (Chapter 12) – Look at standardisation of accounting and issues across different countries (i.e. culture; religion; environmental impacts; etc…) Week 11 – Critical perspectives of accounting (Chapter 7) – Looking at the role of corporate governance

Sample Exam Question 1 • “Distrust of Australia's banks will continue unless the "drip feed" of industry scandals ends and banks own up to problems rather than hoping bad news can be kept from the public eye, regulators have warned. • Three of the country's most powerful financial regulators on Friday called on banks to be more open when things go wrong, after a series of scandals that has put the spotlight on the industry's culture. • They highlighted that many of the problems dogging banks today occurred several years before the news became public, and this further fuelled the negative perception of banks. Reserve Bank deputy governor Guy Debelle said the "drip feed of issue after issue after issue" across many parts of the financial sector had exacerbated public distrust. • The chairman of the Australian Prudential Regulation Authority, Wayne Byres, said a priority for banks should be to "talk about problems and what you're doing in response to them, rather than hoping no one finds out". "If you think about many of the issues that now are generating headlines and public debate, many of them happened three or four years ago. No one revealed them," he said. "A more proactive approach is saying: 'We have an issue, we find it, we report it, we fix it, and if necessary we compensate’.” • Australian Securities and Investments Commission chairman Greg Medcraft noted that several of the country's banks had been embroiled in scandals in recent years spanning financial advice and life insurance, alongside alleged interest-rate rigging. Commonwealth Bank was accused last month by Austrac of a mass breach of antimoney laundering laws, and ASIC is investigating whether it should have told investors earlier about the allegations.! Mr Medcraft said lenders should focus on treating customers fairly, designing products that were suitable for consumers and improving how they handled complaints.”! Extract: Yeates, C. ‘Stop 'drip feed' of bad news: RBA's plea to banks’! Canberra Times, 9 September 2017, p. 28. Draw on applicable theories learned in this unit, including critical theory, to explain the behaviour of banks, regulators and the public described in this article. (12 marks) ANSWER:

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