Ch 1 Intro to Accoutnign Theory

AN INTRODUCTION TO ACCOUNTING THEORY The term theory is used in different ways – can take several meanings o A theory is a deductive system of statements o A theory is a set of ideas used to explain a set of real life observations o A theory can also be described as the logical reasoning underlining a statement of belief o theories are composed of words or other symbols…they are statements and do not have a physical form o theories are composed of words or other symbols…they are statements and do not have a physical form The Henrikson definition of theory and accounting theory o “Theory”: the coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry o “Accounting Theory”: the logical reasoning in the form of a set of broad principles that (1) provide a general framework of reference of which accounting practice can be evaluated and (2) guide the development of new practices and procedures. What functions do theories serve? o Theories which explain (e.g. accountants do not do X because of Y) o Theories which predict (e.g. cosmetic accounting policy changes will have no impact on share price) o Theories which recommend/ prescribe (e.g. current cost accounting should be used to provide more useful information How a theory will be evaluated (ie whether or not the theory is accepted) will depend on o How well it explains or predicts reality o How well it is constructed o How acceptable are the implications of theory Accounting Theory – reflection of reality – development fragmented – developed in response to practical needs o Accounting theory - not divorced from reality - main purpose is to explain current accounting practice and to provide the basis for further development of accounting practices o Accounting theory is a modern concept, when compared to other theories such as physics o Accounting theory has developed in a fragmented, ad- hoc, unstructured improvised fashion , rather than systematically from a structured theory o Accounting theory is aptly described as a disjointed/unstructured body of practices that have been developed usually in response to recording and reporting issues that presented themselves for resolution, rather than a set of practices that of come about by deliberate thinking – o Repetition and general acceptance has provided support and legitimacy to the practitioners‟ rules o o

ACCOUNTING PRACTICES: responses to information needs or external factors such as taxation or related legislation ACCOUNTING THEORY: is largely about explaining the behaviours of those who supply and demand information

Accounting standards and inconsistencies o Ad-hoc development has led to inconsistencies in practice

o o o

Inconsistencies examples : current practice of taking unrealised asset deprecations to the p&l , but taking the unrealised increments to the reserves or measuring some assets at costs, but others at fair value Demand for accounting standards to address inconsistencies - standard setters have tried to solve the problem by developing a conceptual (theoretical) framework that would lead to a more consistent treatment of like items H/e in practices this has not eliminated the inconsistencies – in fact the frameworks have been used to justify/support the differences

HISTORICAL TIMELINE OF ACCOUNTING THEORY DEVELOPMENT

Practice Development Before the double entry book keeping system was formalised in the 1400s very little was written about the theory underlying accounting practices Watershed moment Fra Pacioli – double entry book keeping o 1494 Franciscan monk Fra Pacioli wrote the first book to detail the double entry book keeping system as we know it: Review of Arithmetic, Geometry and Proportions. o Documenting the process but did not explain the basis for recording Pre theory Period – 1400s to 1800s o In the 300 years proceeding Pacoli‟s seminal work, accounting theory development concentrated on refining practice o This period in time is referred to the “pre theory period” o Goldberg: No theory of accounting was devised from the time of Pacioli down to the opening of the nineteenth century. Suggestions of theory appear here and there, but not to the extent necessary to place accounting on a systematic basis General Scientific Period 1800–1955

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Until the 1930‟s developments in accounting were rather random ill defined Developments in the 1800‟s led to the formalization of existing practices in textbooks Period of rapid expansion in technology, economic expansion eg railroads & construction etc, which was accompanied by a large separation of ownership from control – increased the demand for detailed financial and management accounting information, for improved techniques and for accounting practices such as depreciation for the accommodation of the long term nature of new assets The introduction of tax legislation at this time also led to the increased government reporting requirements During this time economic theory also grew – began to tie in with demands for accounting theory

Accounting theory in this period o During the scientific period most theory developments were concerned with providing explanations of accounting practice – emphasis was on developing an overall framework to explain and develop accounting practices o Theories were developed largely on empirical analysis – empirical analysis relies on real world observations rather than soley on logic – developing theories on the basis of observation of current practices – ie. The theories were bases on how firms already practise accounting Normative period 1956–1970 Norms for best practice - what should be v. what is Normative theory attempts to justify what ought to be, rather than what is Major criticism: based on value judgements • Two dominant groups: – conceptual framework proponents – critics of historical cost • End of the normative period started in the early 1970s – Unlikely a normative theory would be accepted – Availability of financial economic principles and testing methods – Accounting Theory Development Specific Scientific Theory / Positive Era/Descriptive • 1970–present day • dissatisfaction with normative theories • positive accounting theory – describe- explain & predict e.g. bonus plan hypothesis • Positve theories attempt to find relationships that actually exist Behavioral research: Sociological implications of accounting numbers and the associated actions of „key players‟ emerged in 1950s but despite growing acceptance, positive accounting theory still dominates Recent Events Corporate collapses e.g. Enron, Worldcom Could comprehensive theory have prevented this? Increased legislative reporting requirements Conceptual framework – 1980s 1. What is Conceptual Framework?

The Conceptual Framework AASB is responsible for the development of a conceptual framework of accounting, with the framework seeking to define the nature, subject, purpose and board content of generalpurpose financial reporting. Not alone Australia, other countries and IASB have also been involved in the development of a conceptual framework. No “absolute” definition. But FASB of USA has defined Conceptual Framework Conceptual Framework is a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards. A central goal in establishing a conceptual framework will be general consensus such as:  The scope and objectives of financial reporting;  The qualitative characteristics that financial information should possess (Relevance etc);  The elements of financial reporting, including agreement on the characteristics and recognition criteria for assets and liabilities; 2. Why Conceptual Framework is required ? It is generally accepted that it is “UNWISE‟, and perhaps “ILLOGICAL”, to develop accounting standards unless there is firstly some agreement about key issues, such as - What are the objectives of general purpose financial reporting, - What qualitative characteristics financial information should possess; - How and when transactions should be recognized; - Who is the audience of general-purpose financial reports Therefore: Conceptual Framework is developed to provide guidance on key issues such as objectives, qualitative characteristics, definitions, and recognition criteria. However, the accounting standard setters do not hold the same point that we need a conceptual framework before we start developing accounting standards. Within Australia, Policy statement No.5 defines the Conceptual Framework as a series of statement of accounting concepts finally in 1990. The paragraph 3 of Policy statement 5 set out the concepts already adopted by the AASB relating to the nature, subject, purpose and broad content of general-purpose conceptual framework, the contents of the various accounting standard should be logically consistent. 3. Benefits of a Conceptual Framework Policy Statement 5 – Para #7 explicitly highlights the benefits having a conceptual framework: a. Accounting standard are developed in the context of an orderly set of concept could make it more consistent and logical; b. Increased international compatibility of accounting standards should occur, because they are based on a conceptual framework that is similar to the explicit conceptual frameworks used by other overseas and IASB standard setters. c. AASB should be more accountable for its decision; because the thinking behind specific requirements should be more explicit d. The process of communication between the Boards and their constituents should be enhanced;

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Development of accounting should be more economical.

The conceptual Framework itself will ultimately comprise a set of statements of accounting concepts (SAC). Para #6 further notes: Knowledge of the concepts the Boards use in developing accounting standards should assist prepares, auditors and other parties with an interest in accounting standards to UNDERSTAND better the general nature and purpose of information reported in “General-purpose Financial Reports”.

4. Statement of Accounting Concept A. SAC 1 “Definition of the Reporting Entity‟ According to SAC1, general-purpose financial report (GPFRs) should be prepared by all entities. General-purpose financial reports are reports that comply with statements of accounting concepts and accounting standards. Definition: Reporting entity is determined by the information needs of the users, and relies on professional judgement. When information “relevant” to decision making is not accessible to users who are judged to be dependent upon general-purpose financial reports to make and evaluate resource reallocation decision, the entity is deemed to be a “Reporting Entity”. AASB 125 Para# 27 fpr the definition of a reporting entity means An entity in respect of which it is reasonable to expect the existence of users “dependent” on general purpose financial reports for information which will be useful to them for making and evaluating decision about the allocation of scarce resources, and includes but is not limited to the following: a. A listed company; b. A borrowing corporation and c. A subsidiary of a foreign company that is itself isted on an Australian stock exchange Parag. 6 of SAC1 further states that general-purpose financial reports “intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs. It also states that GRRPs should be prepared when there are users „whose information needs have common elements, and those users cannot command the preparation of the information to satisfy their individual information needs.‟ Point to note: If an entity is not deemed to be a reporting entity, it will not be required to produce GPERs- it will not necessarily be required to comply with all accounting standards. B. SAC2 “Objective of General-purpose Financial Reporting” It states that an objective of general-purpose financial reporting is to provide “relevant” (para.11) information to assist report users to make and evaluate decision about the allocation of scarce resources (para 26) and to enable management and governing bodies to discharge their accountability (para. 14).

Financial reports and ser of the financial information Financial report provides a means for the controllers of the resources of the company (management and the Board of directors) to report about their role as stewards of those resources. This part of the reporting process is known as disclosure. User requires information to help them assess: a. Whether the reporting entity is achieving its objectives and is operating economically and efficiently in the process; b. The ability (i.e. entity) to continue to provide goods and services in the future; c. Whether resources have been used for the purposes intended. General-purpose financial report (GPFR) The reports “intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to satisfy, specifically, all of their information needs.” GPFR is not an end in itself, but is a means of communicating relevant and reliable information about a reporting entity to users. The objective specified in this Statement derives from the information needs of those identified as the user of GPFR. Those needs depend, in turn, on the activities of reporting entities and the decisions users make about them. The focus on providing information about an entity‟s economic or financial performance, rather than about its social performance is vital as it is “Relevant” in resource allocation and accountability. B. SAC2 “Objective of General-purpose Financial Reporting” Relevant and reliable It states that an objective of GPFR is to provide relevant and reliable information (Para # 11) to assist report users to make and evaluate decisions about the allocation of scarce resources (Para #26)and to enable management and governing bodies to discharge their accountability (Para #14). Disclosure and Compliance Statement of Accounting Concept SAC 2 requires that GPRF disclose information relevant to the assessment of performance, financial position and financing and investing, including information about compliance. Additioan Readings: User related Studies (M1/4 – The usefulness of financial reports) a. Who the users are and their diverse needs; b. How financial report are used; and c. What information users want from financial reports 1. The users and their diverse needs Revsine (1970) explained the decision models of users variation Demski (1973) contended no one theory and theorized that there is a “trade-off” of some benefits to certain users against potential benefits to other users. Cushing (1977) disagreed with Demski and he came into three conclusions different from Demski.

2. Is the financial report useful? Understandability and readability of financial report are the major concern in accessing the usefulness of financial report to the user. Research studies found out that “understandability”, (i.e. the level of user knowledge of accounting) is considered by many as the ultimate quality for financial information. Research of usage of published financial report conducted by Goldberg and Clift (1968) and Lee and Tweedie (1974) support the point of FASB in the USA in “Decision Makers and their characteristic” as the survey found that the directors‟ report was the most commonly read section of the annual report. 4. Statement of Accounting Concept C. The AASB Framework ((formerly known as SAC 3 “Qualitative Characteristic of Financial Information”)) The AASB Framework seeks to identify the characteristics of financial information necessary if it is to allow users to make and evaluate decisions about the allocation of scarce resources – the objective identified in SAC 2. Within Australia this issue was formerly covered by SAC3. The four principal characteristics of financial reporting are identified in the AASB Framework as : Understandability, relevant, reliability and comparability. The primary qualitative characteristics of financial reporting are identified as “Relevance” and “Reliability”. Information is considered to be reliable if it is „faithfully represents‟ the entity‟s transactions and events (Para #16). For information to be reliable, it should be free from bias (Para #21) and from undue error (para#22). Information is considered to be relevant if it “influences” decision relating to the allocation of scarce resources. AASB Framework also states that general-purpose financial reports shall include all financial information which satisfies the concepts of relevant and reliability to the extent that such information is material. Material is further defined in the AASB Framework (Para #30) AASB Framework notes that the inclusion of immaterial information in financial reports may well impair the understandability of those reports. The framework also states that information should be comparable, be understandable and be produced in a timely manner. Considerations of cost versus benefits are also required in determining whether particular information should be disclosed. When considering the “Qualitative characteristics‟ of financial information, and particularly the issue of understandability, some assumptions must be made about the knowledge-base of readers is stipulated in paragraph 25 of AASB and it provides that: “users are assumed to have a reasonable knowledge of business and economic activites and accounting and a willingness to study the information with reasonable diligence.”

SAC 4 'Definition and Recognition of the Elements of Financial Statements