Ch 5 Accounting Veiwpoints

Ch 6: ACCOUNTING VIEWPOINTS - What this chapter covers ACCOUNTING VIEWPOINTS A function of a range of factors • History • Culture • Societal values • Nature of economic activity • Objectives of those who – Prepare – Interpret – Apply1 In order to understand, practice and study accounting - it‟s important to consider or adopt a particular perspective or viewpoint of account ing practice o Accounting exits b/c of the commercial and transaction-based activities of economies and individual entities o A society/economy (and therefore its participants/citizens/individuals etc) will typically adopt specific, unique accounting viewpoint o The adoption of an underlying viewpoint of accounting is affected by a number of factors: history, culture, societal values, and the nature of economic activity and the objectives of those who prepare, interpret and apply accounting information. o Quantifiable logic o Government o Group o Individual o Latham: Political perspectives in Australia o Left o Right o The chosen viewpoint may not necessarily be derived from quantifiable logic

o The viewpoint may affected by/derived from belief systems: commonly affected by religious or political beliefs – both of which are products of human interaction – humans are not completely rational - no belief system is representative of absolute truths o Latham gives the example of political ideologies in Australia. : the right- support market forces as the most appropriate means of achieving society‟s objectives. Alternatively the left: government intervention is appropriate and necessary. Neither of these schools of thought are correct or an absolute truth. THIS APPLIES TO VIEWPOINTS ABOUT ACCOUNTING AS WELL.

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Objective of accounting (SAC 2) – Measurement – Reporting – Economic activity • Significant changes – Reporting entities – Public and private THE ESTALISHED AND UNDERLYING OBJECTIVE OF ACCOUNTING IS THE MEASUREMENT AND REPORTING OF ECONOMIC ACTIVITY & more recently the effect of entities activities on the community and physical environment – these goals influence an accounting viewpoint adopted Many potential users of accounting info – different needs – Q: WHOSE NEEDS SHOULD BE TAKEN INTO ACCOUNTING BY AN ACCOUNTING THEORY? The question has attracted significant debate esp. in the 1950s an 1970s Though the question had been codified by SAC2: Objective of General Purpose Financial Under SAC 2: the objective of general purpose financial reports is to provide info useful for making and evaluating decisions about the allocation of scarce resources (para 43) Under SAC 2 there are 3 main categories of financial statements users 1. Resource providers (shareholders and debt holders) 2. Recipients of Goods and services (customers) 3. Parties performing a review or oversight function – independent auditors, management, govt etc.

THE BOUNDARTY ASSUMPTIONS • Activities and means of supporting an entity‟s activities need to be defined • Set of assumptions or principles about boundaries of an entity – Process of creating a reality (Hines) • Each viewpoint defines the boundaries to support perspective adopted o Boundary = the activities to be measured and reported o All discussed accounting theories define the boundaries of an entity to support the adopted perspective o Hines: the concept of accounting perspectives are basically a process of creating a reality that suits the view of those putting forth the perspective. The proponents of a given “perspective theory” create a picture of the organisation – define its traits & features etc – it‟s on this basis that people act and think – by responding to that picture they make it real. o The boundaries are human defined – subjective

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Australian Theorist – Edward Ball: Boundary of Assumption

Ball proposed a universal definition of the reporting entity concept, which = consistent with SAC 2 (but SAC 2 is more broad & is more appropriate) A Reporting entity‟s boundaries are defined by reference to ownership and control Reporting entity = any unit or activity that controls the utilisation of scarce resources in order to generate economic benefits & sufficiently significant to warrant the prep of general purpose fin reports Sufficiently significant = relevant for decision making and accountability purposes LIMITATIONS Ignores that many users of financial statements have no control Also only acknowledges entities for which it‟s appropriate to issue general purpose fin reports – not really universal The boundary assumptions SAC 1 Definition of a Reporting Entity: • Broader definition of a reporting entity • Links the reporting entity to the reporting needs of users and the objectives of general purpose financial reports But: • Definitions may be altered by organisations in response to organisational or external pressures • Increasing external demands on organisations to expand reporting to include non-financial impacts SAC 1 – defines the reporting entity and outline criteria for its boundaries Provides a more broader definition of a reporting entity than Bell Reporting entity = All entities in respect to which it‟s reasonable to expect the existence of users dependent on general purpose financial reports for which info will be useful to them for making and evaluating decisions about the allocation of scarce resources THE PROVISION OF INFORMATION IS THE SOLE BOUNDARY CRITERION PER SAC-1 (unlike Ball does not look at control) 3

NOTE: Company Law of the jurisdiction in which an entity operates will often redefine the boundaries in response to organisation or external pressures eg. Corp takeovers restrictions PROPRIETARY THEORY • Littleton: proprietorship – Substance of double-entry system – Purpose of the firm • Goldberg: – Instances where double-entry system used but proprietorship is not underlying objective Proprietorship theory = the entity is the agent/instrument through which the individual or shareholder operate. Therefore the owner is the centre of attention. All accounting concepts, procedures and rules are formulated with the owners in mind o Littleon: without proprietorship/owners there would be no point in having bothering with the dr/cr system. No reason why dr should = cr. If implemented would simply be a set of rules. o The central feature of the proprietary theory is its emphasis on the capital account and capital preservation ,and the balance sheet which had the dominant position. o In this theory the capital account was no longer considered to be a residual account but became firmly identified with the owner - just as the entire firm was considered his possession, not something apart from him. o Attention shifted from mere transactions (concentrating on the exchange of values) to making profit for the owner - a crucial step in the direction towards twentieth-century accounting theory Proprietary Theory – Balance Sheet A/c’s The viewpoint of the proprietor as the centre of interest is reflected in the ways in which the accounting records are kept the financial statements prepared. Everything is interpreted from the perspective of the proprietor. The objective of accounting policies/procedures & rules is to determine the net worth of the proprietor Therefore the accounting equation is: Assets – Liabilities = Proprietors Equity • Balance sheet accounts Assets – Liabilities = Proprietorship • Profit – Owner‟s net worth primary concern (balance sheet) – Income earned and expenses incurred due to actions of the owner The balance sheet is seen as the sheet of proprietorship, the bal sheet is a reflection of their net worth & is prepared to measure the changes in proprietary or wealth

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o Assets = belong to the proprietor o Liabilities = the obligations of the proprietor Profit = increase in the net worth of the proprietor Profit is earned & expenses are incurred b/c of the decision and actions of the owned. Income and expenses are subsidiary accounts of P which are used to determine the profit of the owner. Vatter: “The theory of double entry is based on the idea that expense and revenue accounts have the same algebraic characteristics as net worth ie accounts tending to increase net worth are increased by credits and accounts intending to decrease net worth are handled in reverse order. “ Profit is the increase in the wealth of the owner from the business operations during a given period. o Income = an increase in the proprietorship o Expense = a decrease in the proprietorship Financial Capital Concept: o there is no distinction between the assets of the proprietor and the assets of the entity o All profit is distributable to the owner o If the entity requires additional resources - they are available from the owner‟s own resources o Capital represents the cash invested by the owners plus profits reinvested by retention in the business. Effect on practice To a large extent present accounting practice is based on proprietary theory. Examples below: o o o o

Dividends = a distribution of the owners profits & therefore not an expense Interest & income Tax = an expense b/c they reduce the owners wealth Salaries paid to the owners are not an expense – are s distribution of profit Group financial statement: the parent is seen as owning the sub & any minority interest are seen as an expense

Limitations – Developed when businesses small – Increasing separation of ownership and control – Corporate entity – Accountability Theory was developed at a time where most business entities were sole traders & partnership & closely held companies – ie at a time when the ownership & control were not separated Corporation‟s legislation also stipulates that even closely held/ single owner companies have a separate legal identity to that of their owner/s

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Under the proprietary theory, „the . . . proprietor . . . [is] seen as owning the firm‟s assets and owing its liabilities‟ (Zeff, 1961, p. 105). That leads to the unsound view, for example, that General Motors does not own its factories. Besides, „ownership . . . is a nebulous concept and is extremely difficult to define‟(Goldberg, 1965, p. 162). In any event, who owns the assets and who Owes the liabilities should not even necessarily be determinative for financial reporting: „legal title is not the determinant of asset existence‟ (Vatter, 1947, p. 17). the firm . . . not its shareholders . . . makes a product or delivers a service . . . is regulated, taxed, and controlled by a wide array of government agencies and courts of law . . . it is potentially misleading to combine the interests of the firm and its shareholders in accounting reports. (Revsine, 1982, p. 77) Entity theory • Formulated to address separate legal status of company • Accounts and transactions are classified and analysed from the viewpoint of the entity as an operating unit • Accounting principles and procedures not formulated in terms of a single interest e.g. proprietorship

o The leading proponent of the entity theory believed that „the doctrines of proprietorship o have led to serious error‟ (Paton, 1922, p. 53).SEPARATION: Sees the corporations as having a separate legal identity/personality to its owner o VIEW POINT: sees accounting procedures as conducted from the viewpoint of the entity. Accounts and transactions are analysed from the view of the entity as an operating unit o The enetiyt viewpoint is well presented in h`1e corporate view point o The role of Book keepers and accountants is to record the history of the business Two Views of an Entity: Objective of accounting from entity position? 1. Business firm operates for the benefit of equityholders 2. Entity in business for itself • From either view the stewardship role is of primary significance Traditional view: the firm operates for the benefit of equity holders i.e. those that provide the firm with funds. The firm must report on the status and consequence of that investment. Sees equity holders as associates of the business Newer Interpretation: sees the entity in business for itself & interested in its own survival. B/c it‟s concerned about its own survival, the business entity reports to equity holders in order to meet the legal requirements and to maintain a good relationship with them in case more funds are needed in the future. Sees equity holders as outsiders to the business s

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2 Version of the entity theory: BOTH HAVE THE SAME CONCLUSION = STEWARDSHIP OR ACCOUNTABILITY IS OF PRIMARY IMPORTANCE. The modern approach: New forms of disclosure are being required by corporations‟ law that integrate financial, environmental, & social reporting factors – KNOWN AS THE TRIPLE BOTTOM LINE APPROACH Purpose of such = to report on the entity‟s activities on a range of stakeholders, beyond the shareholders and the information generators (i.e. managers, accountants etc) This new type of accountability has seen new type of accounting practices generated Corporate Social Responsibility is important – public suspicious /critical of the single shareholder perspective – a co exists to create wealth for its owners – best way to ensure this is to heed t broader community needs Expectations form the broader community are Shifting main stream corporate accountability Example James Hardie: • • •

Balance sheet Assets = Equities Profit – Emphasis on the determination of profit – Income statement more relevant than balance sheet Effect on practice – Proprietary view has a greater impact on present procedures

Balance sheet: net worth of the proprietor is not a meaningful concept, b/c the entity ops the centre of attention. Owners and creditors are simply the providers of funds. The business unit owns the resources of the enterprise & is liable to the claims of both owners and creditors. Therefore: Assets = Equities Assets = Liabilities + stock holders equities Assets = rights accruing to the entity. Both shareholders and creditors are equity holders. Though they each have different rights to income, risk, control and liquidation The balance sheet shows the assets of the entity which represent a “direct” statement of the value of the entity Profit: Because the business unit is held responsible for meeting the claims of equity holders, the entity theory is said to be income centred and consequently income statement orientated Income = an increase in the stock holders equity after the claims of other equity holders (for example creditors). The increase in the stock holders equity is only considered income to the stock holder if a dividend is declared . Undistributed profits remain the property of the entity . Accountability to the equity holders is measured by recording the operating and financial performance of the firm Creditors have a specifically determinable claim and shareholders have a residual claim on the assets of the company in the case of dissolution - H/e from the stand point of the entity both are just providers of funds Entity theory leads to the unjustifiable view that taxes and interest are not expenses:

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„From an entity point of view, taxes and interest represent distributions of its income from operations like dividends, rather than expenses required to earn entity income‟ (Skinner, 1987, p. 45). Physical capital concept • Under the entity view – Physical capacity of the entity to deliver goods and services is determined after taking into account changes in prices of assets and liabilities • Financial capital concept – Changes in the monetary values of assets and liabilities are included in profit If an entity view is taken – which of the following are appropriate for determining profit 1. Financial capital or physical capital? Financial Capital refers to the funds provided by lenders (and investors) to businesses to purchase real capital equipment for producing goods/services. Physical Capital comprises physical goods that assist in the production of other goods and services The traditional view of the entity theory emphasises accountability to equity holders for the funds provided by them. This relates to the investment of the equity holders & therefore a financial capital approach is implied. The newer interpretation of the entity theory would take a physical capital approach as the entity is concerned about itself. Thus the entity would naturally be concerned about its operating capability. The equation assets = equities sits well with the physical capital view b/c owners equity is not recognised directly. The focus is on assets, and the physical capital view is focused on assets & on the entity‟ productivity operating capacity 2. Historical or current cost Under the traditional entity theory any of the alternatives would fit in. H/e it has been argued that since entity holders are mainly concerned about the amount of their investment, historical cost is the logical choice. This is so b/c the use of the funds is provided by the equity holders is invested in assets , the amount of the investment price is the purchase price – the historical cost . But weher equity holders are only interested in the original amount of their investment is debateable. Many believe they are interested in changes in value. Under the new entity theory, the question at the end of the period is: How much does the entity need in order to maintain its operating capability? The amount needed at the end of the period is the amount to purchases the asset, which is current, cost 3. Nominal dollars or constant dollars The term Constant dollars refer to a metric for valuing the price of something over time, without that metric changing due to inflation or deflation. The term specifically refers to dollars whose present value is linked to a given year. Constant dollars are used to compare the "real value" of an income or price to put the "nominal value” (ie 8

value unadjusted for inflation) in perspective. For example, who was making more money, your father who made $5,000 at his first job in 1957, or you when you started at $18,000 in 1986? The answer depends on how much can be purchased by each salary. Under both versions of entity theory neither is favoured. Constant dollar accounting to correct a mathematical problem of dollars different purchasing power being added together, mathematically the numbers must be the same Domain. Quality of unit of measure is needed. If such a correlation is needed , then a general price index is pertinent to the entity‟s circumstances should be selected.

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FUND THEORY Vatter • Focuses on Impersonal „fund‟ rather than a personality • Assets = Restrictions on assets (equity, liabilities) • Frame of reference for government and not-for-profit organizations • Cash flows Purpose of fund theory = developed a framework underlying the logic of modern accounting Considers proprietary and entity theory inadequate b/c they personalize the business unit Central idea/concept is the fund which is an area of operation, a centre of interest or a centre of attention The Accounting Equation: Assets = restrictions on assets Restrictions on Assets :

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Commander theory Goldberg • Focus on control of resources • Accounting functions carried out on behalf of commanders • Financial position and performance statements • Effect on practice

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INVESTOR THOERY Staubus • Investor viewpoint • Assets = specific equities + residual • Emphasises needs of external users • Cash flow information

Enterprise theory Staubus • Investor viewpoint • Assets = specific equities + residual • Emphasises needs of external users • Cash flow information

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equity

equity