Introduction

A theory is a coherent set of hypothetical, conceptual and pragmatic principles forming a

framework of reference for a field of enquiry. Positive theories are descriptive, explanatory
and predictive. They are based on facts and describe why people behave in a certain
manner as well as predict their actions. Positive accounting research is concerned with
describing accounting processes and practices in order to explain why the current practice is
used. On the other hand, normative theories are prescriptive and based on values. They
describe how people, such as accountants, should behave in order to produce a right/moral
outcome.
Both positive and normative theories play important roles and can complement each other.
Positive accounting theory can help provide an understanding of the role of accounting
which in turn forms the basis for developing normative theories to improve the practice of
accounting. However, ultimately normative theory is superior as it is the normative questions
which are more important what should we do about this accounting issue and which policy
is best? Positive theory cannot answer these questions and it is up to use to gather the
relevant evidence in order to prescribe the most suitable course of action.
Accounting is not simply black and white and there is room for accountants to exercise
professional judgement. When accountants exercise professional judgement and make
certain decisions, they are applying a theory. Policy choices must be justifiable and reflect
the appropriate rules, available facts and professional values and ethics.
Ethics & Accounting Policy Choice
The choice of accounting policies involves ethical consideration because they do have social
and economic consequences for a wide range of stakeholders such as employees,
shareholders and creditors. Ethics is problem solving activity that looks at the power
relations between people. It is an educational process in which we consider what constitutes
a responsible moral action by taking in account the community and its rules.
We all have different approaches to ethics based on our views and experiences. However, at
our core we are all the same and herein lies the common ground in ethics. The three
common fundamental ethical principles are

Beneficence: The duty to do good and avoid harm the strong protecting the weak
Justice: The duty to treat everyone with equality and fairness
Respect for Persons: The duty to respect the rights and dignity of other people be
honest and empower them

There is tension between these principles and any focus too much on one particular principle
will present challenges. Hence, we need to emphasise different principles in different
situations.
Being competent in ethics means the development of practical skills to combine intellectual
and moral virtue. A technically competent but morally incompetent accountant is dangerous
while the opposite is too.

APES 110 Code of Ethics

Integrity
Objectivity
Professional competence and due care
Confidentiality
Professional behaviour

Measurement Issues
Accounting is considered to be a measurement disciple and measurement is commonly
viewed as an objective process, implying financial statement figures are exact and accurate.
However, accounting measurements are in fact quite subjective and relies on a great degree
of professional judgment and application of standards. Therefore, it is possible for the same
set of economic events to be represented in entirely different in terms of numbers.
Measurement requires abstraction from reality and a need for a variety of value judgements.
The chosen measurement system reflects the purpose/objective so as your goals change,
so will the desired accounting measurements. The key components of the measurement
process are:
1. Specifying the property/attribute to measure
2. Measuring according to rules and an appropriate scale
3. The temporal dimension of measurement and the need to measure a common
characteristic if individual measures are to be added
4. Are numbers assigned systematically with reference to the facts?
Economic concept of income is considered as the increase in wealth. This implies a notion of
capital maintenance as income is the surplus after capital has been maintained. The amount
of income depends on what is believed to be capital and how we measure it how we
measure assets and liabilities. Assets for example have a number of measurement bases
such was historical cost, replacement cost, market price, fair value and even present value.
When departing from historical cost for another measurement system, there is a trade-off
between relevance and reliability and aspects such as cost/benefit and volatility on reported
profits should be considered. In times of inflation, a current value measurement system will
tend to report lower profits than historical cost.
Fair Value & Practical Implementation Issues
Fair value is defined in AASB 13 as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the
measurement date. In recent years there has been a significant paradigm shift in the use of
fair value accounting which traditionally has been highly controversial.
Fair value is arguably more relevant than the other measurement approaches. In essence,
fair value reflects the market price of a particular asset or liability in an active liquid market.
The ability to represent reality is particularly useful for things such as financial assets and
biological assets which would not be possible with methods such as historical cost. Another
argument in support of fair value is the objectiveness and comparability that it provides
through its use of current values.

However, not all assets and liabilities have an active and liquid market to refer to which is
where things begin to complicate. For something that is meant to be objective, it can
become quite subjective when trying to form an estimate of the market value for an item that
is not traded or sold regularly. Fair value is simply a hypothetical based on hypothetical
factors and can only be verified when the transaction actually takes place which means
changes in fair value results in gains and losses which are not necessarily realised.
Furthermore, it is argued fair value definitions and assumptions do not reflect real market
conditions. Hence, it is not hard to see why fair value has been controversial over the years
due to its subjective nature when no active market exists, variability in valuation techniques
used by management and constant volatility in earnings.
An active market is where transactions for asset or liability take place with sufficient
frequency and volume to provide pricing information on an ongoing basis. Looking closer at
active markets and orderly transactions, standards may be forgetting to account for the most
important element human behaviour. During bear markets herd behaviour and fear lead to
a market of desperate sellers creating unrealistic low prices. On the other hand, bull markets
are full of over optimistic investors creating price bubbles bound to burst in the near future.
Therefore, intrinsic value to a certain extent is not meaningful as the price of something is
only what someone is willing to pay for today.
True & Fair View
The general consensus of a true and fair view has changed greatly over the years. During
the 1970s-1980s, accountants could provide a true and fair view without complying with the
accounting standards. From the 1980s to 1991, accountants were allowed to depart from
standards when complying with them no longer resulted in a true and fair view. Since 1991,
complying with standards and disclosing additional information leads to a true and fair view.
The meaning of true and fair view is hard to define as evident by the different interpretations
in the Conceptual Framework, Accounting Standards and Corporations Act. In the
Framework, for accounting information to be useful it must contain the fundamental
qualitative characteristics of relevance and faithful representation which is defined as
neutral, free from error and complete. In the AASB Standards, it is implied that faithful
representation is achieved through compliance with Australian Accounting Standards as per
paragraph 15, 17 AASB 101. In the Corporations Act a true and fair view is a legal concept
but not defined, simply requiring companies to give a true and fair view of their financial
statements and notes which is independent to their obligation to comply with accounting
standards.
Therefore, a true and fair view can have many interpretations depending on a persons
perspective whether it be an investor, manager, standard setter or judge.

One true/accurate position

Faithful representation
Compliance with standards and rules

Ultimately, it is up to the courts to decide what constitutes a true and fair view. It is
necessarily ambiguous to cover an infinite number of scenarios as a definition could be too
restrictive when considering all the facts.

There are four approaches to testing truths:

1. Necessary truths: a statement is true by definition e.g. assets = liabilities + owners
equity
2. Truth at correspondence: a statement supported by hard inescapable facts
3. Truth as coherence: a statement is true because it satisfies a set of rules
4. Pragmatic truth: a statement that can be verified independently
The IFRS has been transitioning from a rules based to principles based accounting
standards. Although the rules based approach provided consistency, guidance and
comparability, it was essentially a black and white approach that was no longer appropriate
in todays world. Rules cant cover every possible scenario and loopholes provided potential
manipulation from managers. On the other hand, a principles based system would
encourage accountants to exercise professional judgement in applying the principles,
promoting substance over form and hopefully leading to a more faithful representation of
information. At the end of the day, no matter whether standards are rules or principles based,
it is humans who apply them and that is the most important factor.
Economic Incentives & Choice
A corporation can be viewed as an entity which is separate from its shareholders as per the
entity concept. Conversely, a firm can be viewed as a nexus (meeting point) for a series of
contracts between the factors of production: employees, managers, shareholders and
creditors. Each party has its own rights and responsibilities. Contracts create incentives to
choose certain accounting policies meaning choices made by management are not neutral.
Accounting policies have economic consequences, shifting wealth from one group to
another.
Agency theory studies the relationship between a principal and an agent where the agent
acts on behalf of the principal. While an agent is expected to act in the best interests of the
principal, sometimes interests of both parties are not aligned. Moral hazard is when agents
act in their own interests to the determent of the principals. It occurs as a result of
information asymmetry (managers know more about the company than shareholders) and
utility maximisation (agents are rational and will seek to maximise their own utility).
Agency theory of managers and shareholders identifies three main problems that can occur
in the relationship:

Horizon problem
Risk aversion problem
Dividend retention problem

The horizon problem refers to the fact that managers and shareholders have different time
horizons with respect to the entity. Shareholders have an interest in the long term
performance of a company and want to see it grow in value through enhancing future cash
flows. On the other hand, managers are only interest in the entitys performance for as long
as they expect to be employed. Managers who are leaving or retiring often will attempt to
increase short term profitability in order to receive higher remuneration at the expense of
future growth and sustainability. This problem can be reduced through appropriate
remuneration contracts linking a managers salary and bonuses to long term performance
and share price.

The risk aversion problem arises as managers are more risk adverse than shareholders.
Managers have more invested in the entity and exposing the entity to risk could affect their
income whereas shareholders invest in a number of assets and are able to easily diversify
their risk through a portfolio of investments. Shareholders want managers to invest in high
risk projects in order to achieve higher returns but managers are cautious when deciding
investments as they have more to lose. A way to combat this problem is to include more
incentives for managers to be less risk adverse through bonuses linked to profits or share
based payments.
The dividend retention problem occurs when managers prefer to maintain a high level of
funds in the entity in order to grow the business or spend on themselves. Shareholders, on
the other hand, prefer as much dividends as possible to maximise their return. To overcome
this problem, manager contracts could include bonuses linked to dividend payout ratios.
Agency theory of managers and creditors highlights potential problems of:

Excessive dividend payment

Underinvestment
Asset substitution
Claim dilution

If managers pay excessive dividends this could lead to insufficient funds to service the debt.
To reduce this problem, banks normally have covenants restricting dividend payments
through limits on dividend payout ratio or working capital ratio.
Underinvestment occurs when managers might avoid undertaking positive NPV projects as it
would lead to increased funds being available to lenders.
Asset substitution is when an entity decides to used borrow funds for investments or projects
that are riskier than anticipated by the lender. Banks bear the downside risk but do not share
in any upside risk of the decision. Therefore, sometimes there are covenants which limit how
the entities can use the funds.
When an entity borrows from another lender which leads to the new debt taking on a higher
priority is referred to as claim dilution. Commonly, debt covenants will include restrictions on
leverage and interest coverage ratios to combat the problem.
Therefore, contracts are a tool to deal with the moral hazard problem between principals and
agents. The contracts are designed to provide incentives for agents to act in the principals
interests using accounting numbers. As contracts differ across firms so will the accounting. It
is important to understand why firms choice the accounting policies they do and in order to
do that we need to understand the characteristics of the contract and the specific firm.
However, contracting is costly and will only occur to the point where marginal costs equal
marginal benefits of contracting. Costs of contracting include monitoring, bonding and
residual.
In response to these incentives management, managers may undertake earnings
management through use of accounting policies, changing timing of accruals and income
smoothing. The term income smoothing refers to reducing the volatility of profit by shifting
profits to future periods for when profits might be lower cookie jar accounting. Economic
incentives complicate accounting policy choice and at times there are incentives to increase
or decrease profit (reduce political costs), depending on which incentive managers decide
will dominate the financial reporting.

Capital Markets & Behavioural Research

Capital market research is the study of the relationship between accounting information and
behaviour of security prices and trading volume on a macro/aggregate level. The purpose of
researching the impact of accounting information on capital markets is to see how investors
use accounting information and whether improving accounting standards have any real
benefit. We already know that current earnings of firms are used to predict future earnings
which in turn is used to predict future dividends which ultimately forms the current share
price.
Three techniques are commonly used for evaluating securities
1. Technical analysis
2. Market timing
3. Fundamental analysis
There are two main approaches to capital market research

Association studies: examines the relationship between accounting numbers and

stock returns to see if there is a correlation over a period of time
Event studies: examining the share price reaction/trading volume to the release of
accounting information

In general, changes in accounting policies will only affect share prices when the change has
real economic impacts. However, capital market research is a black box as we cannot
observe the process by which accounting information is used to reflect share prices input
and output but not process.
Behavioural accounting research is the study of the relationship between accounting
information and the decision making processes of individuals and groups. The purpose of
studying behaviour of individuals is that it provides valuable insights of how decision makers
process accounting information and what their needs are in order to improve decision
making and improve accounting standards. The study of the behaviour of accountants or
the behaviour of non-accountants as they are influenced by accounting functions and
reports The four areas of behavioural accounting research are:

Human information processing

Informativeness of alternate reporting formats
Research directed at specific users of accounting information
Research into the influences of the accounting environment on action

Behavioural accounting research data is typically gathered through interviews, questionaries

and various experiments. The data is then used to form a model which represents the
decision makers judgemental process as either a mathematical expression or decision
tree/process tracing model. Mathematical models are generally more accurate predictors of
events of interest while process tracing models captures the human decision processes
better.
In the real world, humans have limited processing abilities and often adopt heuristics and
biases in their decisions.
1. Representativeness: this type of rule of thumb relies on stereotypes that are
familiar to you
2. Availability: an over reliance on recent events or similar cases lingering in the
decision makers memory

3. Anchoring and adjustment: reluctance to change initial assessment or views

even if new information is presented
Implications of Market Efficiency & Contracting For Financial Reporting
The Efficient Market Hypothesis states that prices in the market fully reflect all relevant
information and hence it is impossible to beat the market. There are three main levels of
market efficiency:
1. Weak form: prices reflect only historical information
2. Semi strong form: prices reflect all historical and public information
3. Strong form: prices reflect all historical, public and private information
The implication of market efficiency is that no one can, on average, consistently earn
abnormal returns because prices go on a random walk. There is no pattern or trend and
prices could increase or decrease at any given time as a result of new information.
The EMH implies that the substance rather than the form of information may be an important
policy issue. It is nave to believe that merely because an item does not appear in the
financial statements that it is not reflected in share prices. Therefore, disclosures, news and
other forms of information are important consideration for managers. Cosmetic accounting
policy changes through managing accruals and changing methods should in theory have no
effect as an efficient market would be able to see through the real economic impacts.
However, EMH does not imply that randomly selecting strategies is necessarily a good
strategy, the market cannot be fooled, investors believe the market is efficient, information
intermediaries are useless or that there is no reason to establish rules to protect investors.
In an efficient market, firm value is defined as the present value of future expected cash
flows. Disclosure of accounting earnings numbers can lead to share price and trading
volume changes. Contracts and markets provide incentives for firms to voluntarily disclose
information in order to maximise firm value. Increased disclosure lowers information
asymmetry and thus lowering the cost of capital while managers reduce their risk associated
with any misevaluation of the firms share. However, this does not mean the disclosure is
necessarily always credible or unbiased. The theory predicts that even if the disclosure is
somewhat biased, on average it will be credible.
The setting of accounting standards is as much of a product of political action as of flawless
logic or empirical findings. Horngren 1973
How the current accounting standards and policies came to be requires an understanding of
political influences. Accounting effects the transfer of wealth between individuals,
corporations and governments all with differing interests. Lobbying is a set of activities
undertaken by interest groups to try and influence the outcome/contents of a proposed
accounting standard. Hence, accounting standards setting can be seen as a political process
in which each interested party has motive to see favourable outcomes. Evidence suggests
standard setters decisions are not dominated by any particular group and respond more to
reasoned arguments than campaigns. Users of financial statements rarely lobby which is
interesting as they are the main users of the accounting information. Big 4 accounting firms
lobby but tend to not push clients interests. Governments and politicians, when they lobby,
can leave standard setters vulnerable to interference and the greater the disagreement
between constituents, the longer it takes to achieve a resolution.

Revenue
Income is defined as increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants. Income includes
revenue and gains and its definition is dependent upon the definition of assets and liabilities.
In effect the recognition of income occurs simultaneous with the increase in assets or
decrease in liabilities. This balance sheet approach means that income does not necessarily
have to be earned to be recognised such as gains in revaluation. Historically, profit and
revenue were determined on the basis of increase in net worth of the firm, supplemented by
the notion that revenue had to be realised. This income statement approach meant that
revenues were the result of firm activity and revenue and expenses were matched in order to
determine profit.
AASB 118 Revenue has separate approaches for measuring goods and services. It focuses
on the transfer of risk/rewards and has limited guidance on a number of areas which leaves
room for manipulation. The proposed AASB 15 provides one approach across all industries
and better captures the consideration an entity would expect to be entitled in exchange with
customers. This is done through determining performance obligations satisfied over time or
at a point in time with more focus on control and guidance on separating elements and
determining transaction prices.
1. Identify the contract with the customer
Para 9 conditions:

Parties have approved contract

Each partys rights can be identified
Payment terms can be identified
Commercial substance
Probable vendor will collect entitled consideration

However, contract modifications could result in a separate contract or continuation of existing

contact.
2. Identify the performance obligations in the contract
Promises to transfer goods or services to customers and can be explicit, implicit or arise
from business practices. Para 22: A performance obligation is a separately identifiable
promise to transfer to the customer:

A distinct good or service

Series of goods or services

Para 25 performance obligations do not include activities that have to be undertaken to

complete the contract e.g. administrative tasks to set up a contract
3. Determine the transaction price
Para 47 the amount the entity expects to be entitled in exchange for transferring promised
goods or services to a customer.

4. Allocate the transaction price

Allocate to separate performance obligations based on relative standalone selling price of
each component para 76.
Discounts on bundled goods or services allocated proportionately to all performance
obligations in the contract para 81 unless observable evidence suggests otherwise para 82.
5. Recognise revenue when (or as) performance obligation is satisfied
Para 31 revenue recognised when asset transferred to customer when customer gains
control.
First see if performance obligation satisfied over time para 32. Para 35 control is transferred
over time if one of the following conditions is met:

The customer simultaneously receives and consumes benefits provided by the entity
as the entity performs
The entitys performance creates or enhances an asset that the customer controls
The entitys performance does not create an asset with an alternative use to the
entity and the entity has an enforceable right to payment for performance completed
to date

If point in time then recognise revenue when control passes para 38. Indicators of transfer
are:

A present right to payment for asset

Legal title has passed to customer
Customer has physical possession of asset
Customer has accepted the asset
Customer exposed to the significant risks and rewards of ownership of the asset

Corporate Social & Environmental Reporting and Integrated Reporting

Social and environmental reporting is the process of communicating the social and
environmental effects of organisations economic actions to particular interest groups within
society and to society as a whole. There is a need to do triple bottom line reporting in order
for stakeholders to judge the social and environmental value of the firm.
The benefits on reporting on sustainability are that it gives a comprehensive view of the
organisation and how it uses resources, put constraints on socially irresponsible corporate
behaviour and provide motivation for corporations to act socially and environmentally
responsible.
There are a number of factors which motivates corporations to be socially responsible such
as competitive pressures from markets (labour, capital and consumer), shareholder activism
(people investing in good companies) and international influence. Organisations these days
are much more accountable as people are more informed. Many corporations seek to obtain
and maintain legitimacy through means of compliance with social contracts, aligning values
with larger social values and communication of social responsibility. A survey done by KPMG
showed that 93% of top 250 global companies report on corporate responsibility in 2013,
showing a strong shift organisations green washing and being politically sensitive.
There is limited regulation on social and environmental reporting which is done voluntarily,
only guidelines such as Global Reporting Initiative. The GRI is emerging as a global

benchmark for corporate responsible reporting with established principles and key
performance indicators.

Integrated reporting is a new initiative designed to close the gap between reporting content
and business value and provide a global accepted integrated reporting framework. An
integrated report is a concise report about how a companys strategy, business model,
performance and prospects, within its current environment, creates value in the short,
medium and long term. It would enable and facilitate management to focus on material value
drivers, investors to better understand the company and how it creases and preserves value,
and other stakeholders to better understand the strategies, risks and performance prospects
when making various decisions.
The guiding principles of integrated reporting:

Strategic focus and future orientation: built around strategy, balance between future
and past performance
Materiality: focus on material issues, relevance, importance
Concise
Stakeholder responsiveness: quality of relationships
Reliability and completeness: balanced and complete view, combined assurance
Connectivity of information: logical structure and flow, linkage of elements
Consistency and comparability: industry benchmarks and trends

Six capitals:

Natural
Financial
Manufactured
Intellectual
Human
Social

While integrated reporting sounds like a great innovation, there are barriers to consider.
There is a lack of awareness of how integrated reporting actually assist to create value and
application has been of mixed quality to date. More importantly, managers and directors are
reluctant to disclose more than necessary and integrated reporting could increase potential
liability.

Week 7 tutorial
Review midterm test
Self-Study Set 3 & 4