Introduction to Accounting Theory

Theory
 A statement on belief expressed in a language.
 A deductive system in which observable consequences logically follow from the conjunction of
observed facts with the set of the fundamental hypotheses … (Braithwaite, 1968)
 A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework
of reference for a field of inquiry.
 A set of premises which is logically related.

Accounting
 The process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by users of the information.

Accounting Theory
 A set of interrelated concepts, definition and propositions that present a systematic view of
phenomena by specifying relations among variables with the purpose of explaining and predicting
the phenomena.
 Logical reasoning in the form of a set of broad principles that provide a general framework of
reference by which accounting practice can be evaluated and guide the development of new practices
and procedures.

Nature of accounting theory

a. Accounting as a language
• Perceived as a language of business.
• Business activities are reported in accounting statements using accounting language.
• Translate economic event and transactions into smthg that can be understood by users.
b. Accounting as a historical record
• Concern with providing a faithful record of the transactions of an entity and manager
stewardship of the owner’s resources.
c. Accounting as an economic good
• Accounting info is not costless to produce and impose compliance costs.
• Manager chooses accounting rules that minimize info costs and shareholders impose
accounting rules that improve the ability to control and monitor the actions of managers.
d. Accounting as current economic reality
• Balance sheet and income statement should be based on a valuation basis that is more
reflective of economic reality rather than historical costs. Focus on current and future
prices.
e. Accounting as communication-decision information
• Accounting is action oriented. Accounting is prepared to suit the needs of users and will
have impact on the decision-making behaviour of managers and investors.

Accounting Theory Construction and Formulation

• Accounting theory can be constructed by using deductive and inductive method.

• Acceptance of a theory depends on the ability of a theory to explain and predict the
validity / logical process of the theory’s construction, and the implication of the theory.

1. Deductive method
• Begins with basic accounting premises and proceeds to derive by logical means
accounting principles that serve as guides and bases for the development of accounting
techniques.
• From general to specific. Eg.
 Deductive method:

P1 All assets accounts have debit balances

P2 Building & machine accounts are asset accounts

C Building & machine accounts have debit balances

• Steps: a. specifying the objectives of financial statements.

b. selecting the postulates of accounting.

c. deriving the principles of accounting.

d. developing the techniques of accounting.

• Advantages- if premises are false, conclusion may also be false. Provide a basis for
practical rules.

• Criticism- misunderstands the meaning of theory. The theory not necessarily to be entirely
practical.

2. Inductive method

• Begins with observations and measurements and moves toward generalized conclusions.

• From specific to general. Eg.

Inductive method:

P1 Building account is an asset account and has a debit balance

P2 Machine account is an asset account and has a debit balance

P3 Land account is an asset account and has a debit balance

P4 Vehicle account is an asset account and has a debit balance

C All asset accounts have debit balance

• Steps: a. recording all observations.
b. analysis and classifying of these observations to detect recurring relationships
(similarities)
c. inductive derivation f generalizations and principles of accounting from
observations that depict recurring relationships.
d. testing the generalizations.
• The truth of the propositions depends on the observation of sufficient instances of
recurring relationships.
• Advantages: not necessarily constrained by a structure and free to make relevant
observation.
• Disadvantages: influenced by the idea of relevant relationship and raw data are likely to b
different.

3 types of relationships in the theoretical structure:-

1. Syntactic relationship
 • Logical relationship which has to do with the rules of the language used.

• Relates basic concepts at the abstract level.

• Emphasis on the logical reasoning and not the empirical content of the statement in the
real world.

• Refer to a flow of logic, not to the accuracy of an argument’s representation of the real
world.

• If the premise is true, the conclusion must be true. Eg.

P1 All accounts related to assets have debit balances

P2 Acc. Depreciation account is related to asset

C Acc. Depreciation account has a debit balance

Syntactically, the argument is valid

If P1 and P2 are true, then C also true: although the real world / practice, C is false
2. Semantic relationship
• Relates basic concepts of a theory with the real world.

• Verification is based on the premises and conclusion, not on the logical reasoning.

• Make a theory realistic and meaningful. Eg.

P1 All assets accounts have debit balances

P2 Sales return account is not an asset account

C Sales return account has a debit balance

P1 is false. Syntactically, the argument is not valid

However, semantically, C can be accepted because in the real world/ practice, C is true.

3. Pragmatic relationship
• Effects of words or symbols to people.
• How accounting concepts and real world corresponding events or objects affect people
behaviour and how people react to the same message in different ways.

Testing a Theory

1. Dogmatic basis
• We believe in statements made by others simply because they have been made by an
authority.
• It is a basis for accountant to accept the validity of rules and procedures.
• Weakness- introspective evidence including personal bias. Individual’s personal opinion
about the person or group making the statement.
2. Self-evidence basis

• Determination of truth- reasonableness, sensibility or obviousness of a statement based on

general knowledge, experience and observation.
• Does not matter where the idea come from when constructing a theory.
 • Weakness- untrustworthiness in the sciences. We observe smthg and believe it to be true.

3. Scientific basis

Syntactic rules and induction

• To be meaningful in science, theory must be formulated to make it testable either

syntactic rules or induction.
• In syntactic rules, examination of the logic of the argument making up the theory is the
basis of the test. The validity of argument can be established without reference to sensory
experience. Known by reasoning without verify from observation of real-world events.
• In induction, statements whose truth or falseness can be known only by reference to
empirical evidence. It is according to the correspondence with observations of real-world
phenomena.
• Inductivist believes that all sciences start with empirically observable facts and science
progresses by continual observations and experimentation.
• Logical positivism- all meaningful statements must be capable of verification. Anything
cannot be verified empirically is regarded as meaningless and theoretical statements
should be capable of being reduced to statements of immediate observation.

Popper and falsification

• Scientific endeavor is the trial and error testing of speculative hypotheses which can
never be proven absolutely true but can be rejected when shown to be false.
• In falsification view, all hypotheses proposed must be capable of falsification.
• A theory that gains acceptance is one that has not been proven false by tests that are
designed to reject the theory if it is not true.
• The clearer and more precise the hypothesis, the better. Vague hypotheses are difficult to
falsify and unacceptable.
• Theories are not to be absolutely true but are best available at the time.

Research programs

• Scientific theory consists of positive (surround the core and forms a protective belt of
auxiliary (support) hypotheses) and negative heuristic (hard core of the research
program).
• Any hypotheses challenges the core is ignored or rejected unless it has significant
explanatory power beyond the existing hypotheses.

Kuhnian paradigms or disciplinary matrices

• Very radical changes. If the theory does not fulfill the practices, it will be thrown away
and new theory develop.
• Scientific theories and progress in science have a revolutionary character.
• Kuhn’s description of the way science progresses fall into 5 stage:-
i. Pre-science- period where there are no generally accepted ideas. Focus on single
paradigm which is widely accepted by general scientific community.
ii. Normal science- attempts to articulate a paradigm with the aim of improving the
match between it and nature.
iii. Crisis-revolution- repeated failures to resolve anomalies lead to insecurity and loss of
confidence in the paradigm. New paradigm emerges.
iv. New normal science- scientists align themselves with new paradigm and it gain
support of the majority of the scientific community.
v. New crisis.

Feyerabend’s approach
 • Any approach is valid as long as follow the procedures.
• Reality and society are too complex and dynamic for any on method to dominate science.
• Good scientists are who prepared to develop and accept inconsistent ideas.
• There is no single scientific way of getting ideas where they can arise from many
intellectual pursuits (search). Any approach is valid.

Approaches to the Development of Accounting Theory

1. Pragmatic theories

Descriptive pragmatic approach

 It is an inductive approach where it based on continual observation of the behaviour of accountants

in order to copy their accounting procedures and principles.
 Criticism- does not include an analytical judgement of the quality of an accountant’s actions. Does
not provide for accounting techniques to be challenge and does not allow for change. Focus in
accountant’s behaviour not on measuring the attributes of the firm.

Psychological pragmatic approach

• Observe users’ response to accountants’ outputs (e.g. financial reports).

• Reaction by user is taken as evidence that financial statements are useful and relevant
info.

• Criticisms:- Users react in a illogical manner, have preconditioned response and may not
react when they should.

2. Syntactic and Semantic theories

• Traditional historical cost accounting largely a syntactic theory.

• Some accounting theorists argue that theory has a semantic content on the basis of its
inputs. There is no independent empirical operation to verify the calculated outputs.

3. Normative theories (prescriptive)

• Concerned with policy recommendations & with ‘what should be done’ and how
accounting should be practiced.

• Based on subjective opinion of what accounts should be report and the best way to do
that.

• Focus:

Deriving ‘true income’ in accounting period where concentrate on deriving a single

measure for assets and a unique profit figure.

Discussing type of accounting info useful in making decision (decision usefulness)

• Assumptions are rarely subject to any empirical testing

• Theory:
 Based on analytic / syntactic, and

Empirical propositions

• Make assumptions about the nature of a firm’s operations based on their observations.

4. Positive theories (descriptive)

• Referred as positive methodology (testing theories to real world).

• Focus on empirically (experimental) testing some of the assumptions made by normative

accounting theorists.

Survey opinions.

Test importance of accounting outputs in marketplace.

• Explain on what and how and predict accounting practice.

• Enable regulators to assess the economic consequences of the various accounting

practices they consider.

• Assume that accounting info is an economic and political commodity and that people act
in their own self-interest.

• Concern:

Explaining reasons for accounting practices.

Predicting role of accounting & associated info in economic decision making.

• Normative & positive theories – complement each other.

Approaches of Accounting Theory

- Traditional Approach

3. Nontheoritical Approaches
a. Pragmatic approach
 Characterized by its conformity to real-world practices (useful).

 Consists of the construction of a theory that conforms to real-world practices and

suggests practical solutions.

 Accounting techniques & principles chosen - usefulness to users of info & relevance
to decision-making process.

b. Authoritarian approach

 Used by professional organizations.

 Consists of pronouncements for regulation of accounting practices.

 Attempt to provide practical solutions.

 Pragmatic & authoritarian ---> accounting theory predicted on the basis of ultimate
uses of financial reports.
  Theory-practical (go together)

4. Deductive approach
5. Inductive approach

6. Ethical approach
• Consist of the concept of fairness (fair, unbiased and impartial representation), justice
(equitable treatment of all interested parties), equity and truth (true and accurate
accounting statements without misrepresentation).
7. Sociological approach
• Formalization of an accounting theory emphasizes the social effects of accounting
techniques.
• A given accounting principles is evaluated for acceptance.
• Accounting data will be useful in making social welfare judgements.
• Assumes the existence of established social values that may be used as criteria.
• Concepts of “internalizing” social costs & social benefits of the business; accounting
should serve public interests.

• Has contributed to the evolution of new accounting subdiscipline known as

socioeconomic accounting to encourage business entities to account for the impact of
their private production activities on the social environment through measurement and
disclosure in financial statements.
8. Economic approach
• Emphasizes the controlling behaviour of macroeconomic indicators that result from the
adoption of various accounting techniques.
• Focus on general economic welfare.
• The choice of different accounting techniques depends on their impact on the national
economic good.
• Accounting policies and techniques should reflect economic reality and depend on
economic consequences.
9. Electic approach
• Combination of approaches in developing accounting theory.

• Numerous attempts by individuals & professional & governmental organizations to

participate in the establishment of concepts & principles in accounting.

• Emerge new approaches (regulatory, behavioral, event, positive).

- Regulatory Approach

Nature of accounting standards

• Provide practical rules for accountant’s work, GAAP

• Consists of 3 part:
1. Description of the problem
2. Reasoned discussion (explore fundamental theory) or ways of solving the problem
3. The prescribed solution
• Accounting standards set by:-

a. Public-interest theories

Regulation supplied in response to demand of the public and instituted

primarily for the protection & benefits of the general public.

b. Interest-group theories
 Regulation supplied in response to demand of special groups à to maximize
members’ income and political ruling elite theory & the economic of
regulations

Should we regulate accounting standard?

No:

Firms have incentives to report voluntarily

 Financial reporting is used to solve conflict between owners & managers

 Failure to report – interpreted as ‘bad news’

Users are capable to seek for info

High cost
Yes:
Public interest
Market failures
 Firm is reluctant to disclose info, fraud, the underproduction of accounting info as
a public good
The need to achieve social goals
 Fairness of reporting, information asymmetry, the protection of investors

- Behavioral approach

• Emphasizes the relevance to decision-making of the info being communicated and of

individual and group behaviour caused by the info being communicated.
• Concerned with human behaviour as it relates to accounting info and problems.
• The objective is to explain and predict behaviour in all possible accounting contexts.

The Structure of Accounting Theory

- Accounting theory contains

i. A statement of the objectives of financial statements.
ii. A statement of the postulates and theoretical concepts.
iii. A statement of the accounting principles based on postulates and theoretical concepts.
iv. A body of accounting techniques derived from the accounting principles.
- Definition
i. Accounting postulate (assume)- self evident statements generally accepted by virtue of
their conformity to the objectives of FS that portray economic, political, sociological
and legal environments in which accounting must operate.
ii. Theoretical concepts- portray the nature of accounting entities operating in a free
economy characterized by private ownership of property.
iii. Accounting principles- general decision rules derived from both objectives and
theoretical concepts of accounting that govern the development of accounting
techniques.
iv. Accounting techniques- specific rules derived from the accounting principles that
account specific transactions and events faced by the accounting entity.
The accounting postulates

The entity postulate

• Each enterprise is an accounting unit separate and distinct fro its owners and other firms.
• Enable the accountant to distinguish between business and personal transactions.

• Recognizes the fiduciary responsibility of mgmt to shareholders.

• Mgmt will discharge responsibility in providing info to shareholders.
• Accounting entity is defined by he economic unit responsible for the economic activities and
administrative control and economic interests of various users.

The going-concern postulate

• Entity will continue its operation long enough to realize its projects, commitments and ongoing
activities.
• Assumes the entity will continue for an indefinite period of time.
• It justifies the valuation of assets on a non-liquidation basis and provides basis for depreciation
accounting.
• It may employ to support the benefit theory.
• Expectations of future benefits encourage managers to be forward-looking and motivate investors
to commit capital to an enterprise.

The unit-of-measure postulate

• A unit of exchange and measurement to account in a uniform manner that is in monetary unit.
• The exchangeability of goods, services and capital measured in terms of money.
• Limitations- limited to the production of info expressed in terms of a monetary unit and do not
communicate other relevant info. 2nd limitation is monetary unit itself as a unit of measure as it
subject to changes.

The accounting-period postulate

• Financial report should be disclosed periodically. Most companies issued interim reports for
more timely, relevant and frequent info.
• Interim report should be based on the same accounting principles and practices employed in the
preparation of annual reports.
• Imposes accruals and deferrals.

The theoretical concepts

The proprietary theory

• The entity is the agent or representative through which the individual entrepreneurs or
shareholders operate.
• Objective- determination and analysis of the proprietor’s net worth.
• Accounting equation- assets – liabilities = proprietor’s equity.
• Proprietor (manager) owns the assets and liabilities.
• 2 forms- 1st form is only common shareholders are part of proprietary. Preferred stock excluded.
2nd form is common stock and preferred stock is in proprietor’s equity.

The entity theory

• The entity as smthg separated and distinct from those who provide capital to the entity.
 • Business unit (center of accounting interest) owns the resources of the enterprises and is liable to
both the claims of the owners and creditors.
• Accounting equations, assets= liabilities + stockholder’s equity.
• It is said as income-centered or income-statement oriented.

The fund theory

• The basis for accounting is neither the proprietor nor the entity but a group of assets and related
obligations and restrictions called a fund that governs the use of the assets.
• Views the business unit as consisting of economic resources (funds) and obligations and
restrictions regarding the use of these resources.
• Accounting equation, assets- restrictions of assets
• It is asset-centered in the sense that its primary focus is on the administration and the appropriate
use of assets.
• The statements of sources and uses of funds is the primary objective of financial reporting.
• Normally use in government and nonprofit organizations.

The accounting principles

The cost principle

• Appropriate valuation basis for recognition of the acquisition of all goods, services, expenses,
costs and equities.
• Item is valued at exchange price at the date of acquisition.
• Costs represent the exchange price given to the acquisition of goods and services.
• May be justified in objectivity where acquisition cost is objective, verifiable info and going-
concern postulate where the entity will continue its activities indefinitely.

The revenue principle

a. The nature and components of revenue

 Interpret as inflow of net assets resulting from the sale of goods or services, outflow of goods
or services from firm to customers and a product of the firm resulting from the mere creation
of goods or services by an enterprise during a given period of time.
 2 views on components of revenue.
 The comprehensive view- revenue includes all of the proceeds from the business and
investment activities.
 The narrower view- revenue includes only results of the revenue-producing activities and
excludes investment income and gains and losses on the disposal of fixed assets.
b. Measurement of revenue
 Net cash equivalent or present discounted value.
c. The timing of revenue recognition
 Earned throughout the stages of the operating cycle.
 Because of difficulties to allocate revenue and income to the stages in operating cycle,
realization principle to select a critical event in the cycle is employed.
 Revenue is recognized on accrual basis (revenue to be recognized during production) or on
critical-event basis.
 Critical-event basis
a. Time of sale- the price of the product is known with certainty, exchange is been
finalized by delivery of goods.
b. Completion of production- justified when a stable market and stable price exist for
standard commodity.
c. The payment basis- sale will be made when a reasonably accurate valuation cannot
be placed on the product to be transferred.
The matching principle

• Expenses should be recognized in the same period associated with revenues.

• Accrual accounting is implied.
• 4 criteria on association between revenue and expenses.
a. Direct matching of expired cost with revenue. Eg. Cost of goods sold matched with related
sale.
b. Direct matching of expired cost with period. Eg. Salary.
c. Allocation of costs over periods benefited. Eg. Depreciation.
d. Expensing all other costs in the period occurred. Eg. Advertising costs.

The objectivity principle

• Usefulness of financial info depends heavily on the reliability of the measurement procedure
used.
• Because of its difficulty, accountants used objectivity principle to justify the choice of
measurement or procedure.
• The principle of objectivity is interpreted as external reality that is independent of the persons
who perceive it (free from personal bias of the measurers). A verifiable measurement based on
evidence. A result of a consensus among a given group of measurers. The size of the dispersion
of the measurement distribution used as an indicator.

The consistency principle

• Similar economic events should be recorded and reported in a consistent manner from period to
period.
• Same accounting procedures will be applied to similar item over time.

The full disclosure principle

• FS be designed and prepared to portray accurately the economic events that have affected the
firm for the period and contain sufficient info to make them useful and not misleading.
• No info of interest to the investors will be omitted.
• Must have full (complete and comprehensive presentation of info), fair (ethical constraints
dictating an equitable treatment of users) and adequate disclosure (indicate a minimum set of info
to be disclosed).

The conservative principle

• Acts as a constraint to the presentation of relevant and reliable accounting data.

• It holds when choosing among 2 or more accounting techniques, some preference is shown for
the option that has the least favourable impact on stockholder’s equity.
• Preferably the lowest values of assets and revenues and the highest values of liabilities and
expenses should be reported.

The materiality principle

• Transactions and events having insignificant economic effects may be handled in the most
expeditious (quick) manner whether or not they conform to GAAP and need not be disclosed.
• Serves as an implicit guide on what should be disclosed in the financial reports; enable
accountant to decide what is not important or does not matter on the basis of record-keeping cost,
accuracy of FS and relevance to the user.
• 2 criteria to determine materiality.
 • 1st is size approach where it relates to the size of the item to another relevant variables such as net
income. 2nd is change criterion where it evaluates the impact of an item on trends or changes
between accounting periods.

The uniformity and comparability principles

• Uniformity refers to the use of the same procedures by different firms.

• It is to achieve comparability of FS by reducing the diversity created by the use of different
accounting procedures by different firms.
• The principal support for uniformity are claims that it would:-
 Reduce the diverse use of accounting procedures and the inadequacies of accounting
practices.
 Allow meaningful comparisons of the FS of different firms.
 Restore the confidence of the users in the FS.
 Lead to governmental intervention and regulation of accounting practices.
• The objective is to protect the user and present the user with meaningful data.

Conceptual Framework and Standard Setting Process

What is CF?

 A coherent system of interrelated objectives and fundamentals that lead to consistent standards and
that prescribes the nature, function and limits of financial accounting and reporting.
 Serve as a guidelines to form a general rules.
 Consist of 3 levels:- Highest level- states the scope and objectives of financial reporting.
Middle level- identifies and defines the qualitative characteristics of financial
information such as relevance, reliability comparability and timeliness and basic
elements of accounting reports such as asset, liabilities, income, expenses and
profit.
Lower level- deals with principles and rules of recognition and measurement of the
basic elements and type of information to be displayed in financial reports.
 Act as a constitution for the standard-setting process.
Benefits of CF

 Guide the FASB in establishing accounting standards

 Provide a frame of reference for resolving accounting questions in the absence of specific
promulgated standards.
 Determine the bounds of judgment in preparing financial statement.
 Enhance comparability by decreasing the number of alternative accounting methods.

Overall scope of CF

 1st level is objectives which identify the goals and purpose of accounting.
 2nd level- fundamentals include the qualitative characteristics of accounting info and definitions of
the elements of financial statement.

 3rd level- operational guidelines that the accountant uses in establishing and applying accounting
standards include the recognition criteria, financial statements vs financial reporting and
measurement.
 4th level- the display mechanisms that accounting uses to convey info include reported earnings,
reporting funds flow and liquidity and reporting financial position.

Why CF is needed?

 Lack of a general theory

 Permissiveness of accounting practice- accounting standards allows alternative accounting practices
to be applied to similar circumstances.
 Inconsistency of practices
 Defense against political interference- accounting policies can be implemented by making a value
judgment but there is no way of proving that the value judgments of any individual are better for
society.

Objectives of CF

Information for decision making :

…the objective of general purpose financial reporting is to provide information to users that are useful in
making and evaluating decisions about the allocation of scarce resources.
IASB Framework – focus on information needs of a wide range of users
FASB Concepts Statement No.1, Objectives of Financial Reporting by Business Entity – emphasizes
usefulness in investment and credit decisions.

- Decision-theory approach
Overall theory of accounting ---> individual accounting system --->prediction model of user ---->
Decision model of user
- Useful in assessing cash flow prospects- about enterprise resources, claims to those resources and
changes in them.
 Both IASB & FASB
• General interest of external users of financial statement in assessing prospective net cash inflows
to the enterprise.
• The ability to generate cash inflows – determines the enterprise capacity to pay its employees and
suppliers, repay loans and make distributions to its owner.

- About enterprise resources, claims on those resources and changes in them.

• IASB Framework – performance and changes in financial position.
• FASB Concepts Statement 1
i. Performance and comprehensive income.
ii. Liquidity, solvency and funds flows.

Qualitative Characteristics

a. Understandability to decision-makers
- Ability of users to understand info. They have a reasonable knowledge of business and
economic activities and accounting.
- Both framework are focusing on financial statement user who have a reasonable
understanding and willing to study the information with reasonable diligence.
b. Relevance- when it influence the economic decisions of users by helping them to evaluate past,
present and future events.
c. Reliability- faithfully represents transactions and events without material bias.
i. Faithful Representation- correspondence or agreement between an accounting measure or
description and the economic phenomenon its purports to represent.
ii. Verifiability- the likelihood that several independent measures would obtain similar
measures.
d. Comparability
IASB & FASB emphasizes the importance of comparability between entities, including consistency
from year to year. It also discusses on completeness, timeliness, the threshold of materiality and the
constraint of cost benefit considerations.
e. Form and substance
f. Freedom from bias- neutral
g. Consistency

Elements of financial statement

• It is essential to identify and define the interrelated set of building blocks with which financial
statement are constructed.

The key achievement of this part is ;

i. To specify just how those element are interrelated.

ii. To set forth similarly interrelated definitions of those elements.

FASB and IASB

i. Asset – probable future economic benefits obtained or controlled by a particular entity as the
result of past transaction/events
ii. Liabilities – probable future sacrifices of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entities in the future as a
result of past transactions/events
iii. Equity – residual interest in the assets of an entity that remains after deducting its liabilities.

Two Views about Income

i. Assets and Liabilities View

 • income is a measure of a increase in the net resources of a enterprise during a period
• increases in assets and decreases in liabilities

ii. Revenue and Expense View

• income is different between outputs from and inputs to the enterprise’s earning activities
during a period
• FASB & IASB Framework adopted the Asset and Liabilities view.

Difficulties with current definitions:-

 Both frameworks didn’t have proved sufficiently helpful in resolving some issues. E.g. assets subject
to call options not legally enforceable.
 Boards have sometimes struggled to identify which of series of past transactions or event is the
obligating event.
 Definitions of liability insufficiently helpful in distinguishing revenues from liabilities
 Different definitions caused difficulties for both Boards in resolving various issues hinging on
uncertainty:-

a. IASB’s
•
Definition of assets begins with “resources” and only later refers to “future economic benefits
expected to flow” from those resources.
• Definition of liabilities begins with “present obligations” and later refers to expected outflows
of resources.
b. FASB’s
• Definition of assets begins with “probable future economic benefits” and does not mention
resources.
• Definition of liabilities begins with “probable future sacrifices of economic benefits” and
later mentions “present obligations”

Difficulties about How Many Elements:-

 IASB’s – “Physical capital maintenance”.

 Two elements for changes in assets and liabilities income and expenses
 FASB’s – “Financial capital maintenance”

Three elements for changes in assets and liabilities

a. Investments by owners.
b. Distribution to owners.
c. Comprehensive income- revenues, expenses, gains and losses.

Efficient Market Hypothesis

 A financial market is info ally efficient when market prices reflect all available info about value.
  Available info include past prices (weak), all public info (semi strong) and all info including inside
info (strong).
 Prices should reflect all available info- financial transactions at market price using the available info
are zero NPV activities.
 Prices should reflect available info otherwise there would be arbitrage (practice of buying in one
place and sell in others) opportunities.
 There are no transaction costs in trading securities, info is available cost-free to all market
participants and agree on the implications of current info for the current price and distributions of
future prices for each security.

Types of EMH

f. Weak form- future prices cannot be predicted by analyzing price from the past. Excess return
cannot be earned in the long run by using investment strategies based on historical prices or
data. Security price reflects the info contain in its past prices. Traders earn excess profits.

g. Semi-strong form- implied that share prices reflect all publicly available info in addition to
past events and adjust to publicly available new info very rapidly and in an unbiased fashion
that such no excess return can be earned by trading on that info. To test, the adjustment to the
previously unknown news must be reasonable size and must be instantaneous, consistent
upward or downward adjustments after the initial change must be looked for.

h. Strong form- share prices reflect all info, public and private including info that is not publicly
available and no one can earn excess returns. If there is legal barriers to private info
becoming public as with insider trading laws, strong form efficiency is impossible except the
laws are universally ignore. To test, a market need to exist where investor cannot consistently
earn excess returns over a long period of time.

Implication of EMH

a. Trust market prices- buying and selling are zero NPV activities, giving only risk-adjusted returns.
Market prices give best estimate of value for projects.
b. Read into prices- if market price reflects all available info, we can extract info from prices.
c. There are no financial illusions- market price reflects value only from an asset’s payoff and it is not
easy to trick the market.
d. Values come from economic rents such as superior info, technology and assess to cheap resources.

Practical issue about EMH

 Transaction costs.
 Regulatory restrictions.
 Taxes.

3 Important Points of the Theory

a. Market prices are efficient with respect to publicly known info.

•The possibility that the inside info is not ruled out. Persons who possess inside info know more
about the company than the market.
b. Market efficiency is a relative concept
• Relative to the quantity and quality of publicly available info.
c. Investing is fair game if the market is efficient
•Investors cannot expect to earn excess returns on a security or portfolio of securities over and
above the normal expected return on that security and portfolio.

Challenges of EMH Reporting

- Accounting policies adopted by firms do not affect their securities market prices as long as sufficient
info is given where reader can convert different policies.
- EMH go hand in hand with full disclosure- mgmt should develop and report info about the firm as
long as the benefits to investors exceed the costs.
- Firm should not be overly concerned about naïve investor- FS info need not be presented in a simple
way to make everyone understand it.
- Accountant are in competition with other providers of info- if they failed to compete, they have no
right to survive in the competitive market place for info.

Economic Consequences and Positive Accounting Theory

Economic Consequences

- Concept that asserts that, despite the implications of efficient securities market theory, accounting
policy can affect firm value.
- Firm’s accounting policies and changing in policies matter.
- The impact of accounting reports on the decisions making behavior of business, government and
creditors. Accounting report can affect real decisions made by managers and others rather than
simply reflect the results of these decisions.
- Consistent with real world experience.

The Rise of EC

- 3rd party intervention (gov, mgmt, public) complicated the setting of accounting standards.
- If accounting policies did not matter, choice of such policies would be strictly between the standard-
setting bodies and accountants and auditors. Standard-setting bodies must operate not only in the
accounting theory domain but also in political domain.
- Without a theory to guide accounting policy choice, we must find some way of reaching a consensus
on accounting policies.

Relationship between Efficient Market Theory and EC

- Efficient market theory predicts no price reacting to accounting policy changes that do not impact
underlying profitability and cash flows.
- Efficient market theory implies importance of full disclosure including disclosure of accounting
policies.
- Mgmt and investors have reacted to paper changes in accounting policy.
- Accounting policies have the potential to affect real mgmt decisions.

Hypothesis of Positive Accounting Theory

- PAT- predicting such actions as the choices of accounting policies by firm managers and how
managers will respond to proposed new accounting standards.
- Firms organize themselves in the most efficient manner so as to maximize their prospects for
survival.
- Firm is view a nexus of contract where organization can be largely described by the set of contracts
enters into.
- Firms want to minimize the various contracting costs such as negotiation costs, costs on moral
hazards and costs on contract violations. Contacts with the lowest contracting costs are called
efficient contracts.
- Mgmt has the flexibility to choose from a set of accounting policies which opens up the possibility of
opportunistic behaviour (managers choose accounting policies from the set for their own purposes
thereby reducing contract efficiency).
- Assumption of PAT- manager is rational and will choose accounting policies in their own best
interests if able to do so. Manager maximizes their own expected utility and not maximizes firm
profits.

3 hypothesis of PAT

a. Bonus plan
• Choose accounting procedures that shift reported earnings from future periods to the current
period.
• Managers like high remuneration and if it is based on reported earning, they will increase
their current bonus by reporting high net income.
• Choose accounting policies that increase current reported earnings.
• For risk-averse manager, he will prefer accounting policies that smooth reported earnings.
 • Predicted to choose less conservative and less volatile accounting policies such as full cost
accounting.
• Adopt accrual policies.
b. Debt covenant
• The closer a firm is to the violation of accounting based debt covenants, the more likely the
firm manager is to select accounting procedures that shift reported earnings from future to the
current period.
• Increasing reported net income will reduce the probability of technical default.
• As firm approaches default, it is more likely to go this.
• Manager with high debt-equity ratio will chose less conservative accounting policies and
more likely to oppose new standards that limit their ability to increase earning.
• Manager wants to maintain zero or positive slack.
c. Political cost
• The greater the political cost faced by a firm, the more likely the manager is to choose
accounting procedures that defer reported earnings from current to future periods.
• Related to big size company where manager will choose accounting procedures which defer
from current and future periods.
• High profit will attract media and consumer attention.
• Choose accounting policy that will decrease reported income.
• Manager of big company will choose more conservative accounting policies than manager of
small firms and less likely to oppose new standards that may lower reported net income.

Opportunistic and Efficient Contracting (2 Version of PAT)

- Opportunistic form- manager choose accounting policies to maximize their own expected utility
relative to their own remuneration and debt contracts and political costs.
- Ability of manager to select accounting policies for its own advantage.
- Both can predict efficient market. Eg. Straight line method best measure for opportunity cost to the
firm of using its capital assets. The SLM in reported profits reflect better manager performance. So
this will efficiently motivate the manager.
- Efficient contacting- calculate the variability over time of each firm’s covenant ratio. The more
variable a ratio, the greater the probability of covenant violation.
- Conservative accounting contribute to efficient contracting.
- The set of available policies affects the firm’s flexibility.
Earning Management and Creative Accounting

EM can be viewed from:-

a. Financial reporting- manager use EM to meet analysts’ earnings forecasts, thereby avoiding the
strong negative share price reaction that quickly follows a failure to meet investor expectation. Use it
to create a stream of smooth and growing earnings over time.
b. Contracting perspectives- used as a way to protect the firm from the consequences for unforeseen
events when contracts are rigid and incomplete.
 The choice by a manager of accounting policies so as to achieve some specific objective.

 Choose accounting policies that will help to achieve manager’s objectives.

2 types of accounting policies:-

a. The choice of accounting policies per se such as straight line vs declining balance amortization or
policies for revenue recognition.

b. Discretionary accruals such as provision for credit losses, warranty costs, inventory values and
timing and amounts of non-recurring and extraordinary items- write off and provisions for
reorganization.

Accruals reverse which relate to iron law surround the EM. Hence, manager manages earnings upwards to
an amount more than can be sustained (continuous) will find that the reversal of these accruals in subsequent
periods will force future earnings downwards just as surely as current earnings were raised.
The possibility of good EM cannot be used to rationalize misleading or fraudulent reporting.

Can be classified into 3 categories:

a. Fraudulent accounting involves accounting choices that violate GAAP.

b. Accruals management involves within-GAAP choices that try to “obscure” or

“mask” true economic performance.

c. Real earnings management (RM) occurs when managers undertake actions that
deviate from the first

best practice to increase reported earnings.

Importance in understanding EM:

a. EM enables an improved understanding of the usefulness of net income, both for reporting to
investors and for contracting.

b. It may assist accountant to avoid serious legal and reputation consequences that arise when firms
become financially distressed (often by serious abuse of EM)

Too much EM….

a. Reduce the ability of investors to interpret current net income, particularly if the EM is buried in core
earnings or otherwise not fully disclosed
 b. Reported net income reduce it usefulness

c. EM affects the manager’s motivation to exert effort, because managers can use EM opportunistically
to smooth their compensation over time, thereby reducing compensation risk.

Reasons why want to engage in EM

• Ex post aggressive accounting choices with respect to accruals are at higher risk
for SEC scrutiny and class action litigation. Avoid risk involve.

• The firm may have limited flexibility to manage accruals (i.e., limited ability to
report discretionary accruals).

Patterns of EM

1.Taking a bath

- take place during periods of organizational stress/reorganization. If firm must report a loss, mgmt
may feel it might as well report a large one – write off assets, provide for expected future costs and
generally “clear the decks”. Because of accrual reversal, it enhances the probability of future reported
profits.

2. Income minimization
- Similar to taking a bath, but less extreme. Take place during period of high profitability for firm
having high political cost. Income min include rapid write offs of capital assets and intangible
expensing of advertising and R&D exp successful efforts accounting for oil and gas exploration costs
income tax consideration.

3. Income maximization
- From PAT (bonuses purposes and firms that close to debt covenant violations) manager may report
high reported income (does not above the cap). Firms that are close to debt covenant violations may
maximize income.

4. Income smoothing
- From contracting perspective, risk-averse manager prefer a less variable bonus stream.
Consequently, smooth reported earnings over time as to receive relatively constant compensation. The
more volatile the stream of reported net income, the higher the probability that covenant violation will
occur. This provides another smoothing incentive. Manager may feel that they may be fired when
reported earnings are low. Smoothing is for external reporting purposes.

Evidence of EM for Bonus Purposes

 Healy observes that manager have info on the firm’s net income before EM.
 Based on PAT where it is to explain and predict managers’ choice of accounting policies is an
extension of the bonus plan hypothesis which state that managers will maximize current earnings. It
is known as bonus schemes which may have bogey and cap.

 Bogey- bonus is zero. The lower limit of reported earning. Cap- highest limit of reported earning.

 NI between bogey and cap – bonus increase linearly.

 NI below bogey – no bonus.

 NI above cap – bonus constant.

Do manager manage earnings? Bonus plan hypothesis

 Consider the incentives to manage reported net income faced by a manager

 If income is low (< bogey), manager will choose to take a bath. Manager might adopt accounting
policies to further reduce reported net income. In doing so, the probability of receiving a bonus the
following year is increased

 If net income is high (>cap), motivate to adopt income minimization policies because bonus is
permanently lost on reported net income > cap

 Only net income is between the bogey and cap may motivate manager to adopt accounting policies to
increase reported NI. The bonus plan hypothesis only applies when net income is between the bogey
and cap.

Other Motivation of EM

1. To meet investors’ earnings expectations

 Investor may base on earnings for the same period last year or on recent analysts’ forecasts to
predict firms’ future performance.
 Firms that report earnings greater than expected typically enjoy a significant share price
increase as investors revise upwards their probabilities of good future performance. Firms that
fail to meet expectations suffer a significant share price decrease.
 Manager has a strong incentive to ensure that earning expectations are met by managing
earnings upwards.
 Meeting investors’ earnings expectations is a powerful EM incentive.

2. Debt contact motivations

- Debt contract arising from the moral hazard problem between manager and lender which depend on
accounting variables.
- Long term lending contracts typically contain covenants to protect against action by managers that are
against the lenders’ best interests such as excessive dividends, additional borrowing, or letting working
capital/shareholders’ equity fall below specific levels.
- EM can arise as a device to reduce the probability of covenant violation in debt contracts as covenant
violation can impose heavy costs.
- EM incentives also derive from implicit contracts, called relational contracts. It arise from continuing
relationship between the firm and its stakeholders (employees, suppliers, lenders, customers) and
represent expected behavior based on past business dealings.

3. Initial public offering

- Firms making initial public offerings (IPOs) do not have an established market price.
- Financial accounting info included in the prospectus is useful info source. Eg. NI can be useful in
helping to signal firm value to investors.

- Raises the possibility that managers of firms going public may manage the earnings reported in their
prospectuses in the hope of receiving a higher price for their shares.

Good Side of EM

- It is based on blocked communication where agent obtains info as part of their expertise and info is
prohibitively costly to communicate to the principal.

- The presence of blocked communication can reduce the efficiency of agency contracts since the agent
may shirk (avoid) on info acquisitions and compensate by taking an action from the principal’s
standpoint.

- EM reveal inside info outweigh the costs.

- Supported by efficient contracting theory.

- Give manager flexibility to react to unanticipated state realizations when contracts are rigid and
incomplete.

- Serve as a vehicle for the credible communication of inside info to investors and for efficient
compensation contracts.

Bad Side of EM

1. Opportunistic EM
- Tendency for managers to use EM to max their bonuses.
- Manager intends to raise new share capital and want s to maximize the proceeds from the new issue. A
variety of discretionary accruals can be used to increase reported net income in the short run. Eg.
speeding up revenue recognition, lengthening the useful life of capital assets, under provision for
environmental and restoration costs. The accruals reversal is of less concern due to the short decision
horizon.
- Manager bonuses are based on core earnings. The non-recurring charges do not affect it but excessive
non-recurring charges will increase future core earnings.
- The upwards effect on future core earnings is very difficult to detect, since reduced future amortization
charges and other expense reductions are buried in larger totals.

2. Do manager accept securities market efficiency?

- Manager must not fully accept securities market efficiency as they rely on poor disclosure to keep the
extent of EM as inside info.

Fair Value Accounting

Definition
 Amount for which an asset could be exchanged or a liability settled between knowledgeable, willing
parties in an arm’s-length transactions.
 Often associated with market value.
 Estimate of the price an entity would realize if it were to sell an asset or the price it would be paid to
relieve a liability.
 GAAP- fair value of an asset is the price in which that asset could be bought or sold in a current
transaction between market place participants in the reference market other than in liquidation.

Objectives

 To estimate an exchange price for the asset and liability being measured in the absence of an actual
transaction and the estimate is to determined by reference to a current hypothetical transaction
between willing parties.

Techniques of FV

 Market approach- use of observable prices and info from actual transactions for identical, similar or
comparable assets or liabilities.
 Income approach- conversion of future amounts to a single discounted present amount.
 Cost approach- the amount that currently would be required to replace its service capacity.

Why FV is significant?

 Conventional historical based accounting does not provide meaningful info.

 FV provide more transparency than historical cost based measurements.
 Reliable info useful in the decision making process.
  Promote better risk mgmt policies within a company and add to the development of better risk mgmt
tools.
 The investors want FV info so as to better determine the true value of their investment.

Benefits and challenges on FV

• Reflect current market conditions.

• More transparency.
• Reliability in illiquid markets.
• Market volatility introduces uncertainty.

Advantages

• Offer a close view of the actual situation of financial markets.

• Relevant, reliable and transparency than historical costs. Reliability is as important as relevant as
relevant info which is not reliable is useless to user.
• Indicated as a market estimation of financial instruments which is what enables it to include ahead of
time all the info available at a given moment.

Disadvantages

 May entail significant cost and time.

 Lack of skills among accountants, auditors and other professionals.
 Might create preserve incentives in banks’ mgmt decisions, placing excessive emphasis on the short
term.

Issues in FV

 Market prices are not always available and the trading market for financial instruments such as bonds
is still at a nascent (growing) stage.
 Existing accounting models on financial instruments prescribe for some financial assets and
liabilities measured at historical costs while others require to be valued at FV.

M’sia View in FV

 MASB and other accounting profession are examining the issues in depth and take a related
approach in recognizing it.
 MASB issued a standard on the disclosure and presentation of financial instruments.
 IAS 39-Financial instruments: Recognition and Measurement adopt in M’sia to require more
transparency in financial instruments transactions.
Measurement

 The assignment of numerals to represent properties if material systems other than numbers, in virtue
of laws governing these properties.

 Assignment of numerals to objects or events according to rules.

 Assign numbers to the objects, events and property corresponds to the symbols with particular
objects by certain skills.

Types of measurement

 Fundamental measurement-numbers assign by reference to natural law and does not depend on other
measurement. Eg: length, number of people.
 Derived measurement- depends on 2 or more other quantity. Eg: measure on density, we need mass
and volume.
 Fiat measurement-arbitrary definition where we relate certain observable properties to a concept.
May lead to poor confidence. Eg: measure on profit, need to know revenue and expenses. Profit does
not have specific meaning.

What do we measure?

 Measure the value characteristic of assets and liabilities.

 Should reflect the risk borne by investors and lenders to the entity.

Reliability and accuracy

  Sources of errors
vi. Measurement operations stated imprecisely
vii. Measurer- misinterpret differently.
viii. Instrument- used to measure, not accurate.
ix. Environment- pressure and limited time.
x. Unclear attribute- what to be measure is unclear especially measurement involves
concept. Bias certain measurement.
1. Reliable measurement
xi. Proven consistency
xii. Repeatable- produce the same thing in other time.
xiii. Accuracy and certainty of measurement
xiv. Representational faithfulness- disclosed transaction should reflect economic.
1. Accurate measurement
xv. How close the measurement to the ‘true value’ of the attribute measure
xvi. Consistency of results
Assets

 Future economic benefits controlled by the entity as a result of past transactions or other past events.
 Future economic benefits (capable to render services) expected to flow to the entity.
 Control by reporting entity where the capacity of the entity to benefit from the asset. Must be owned
by the entity.
 Have agreement to use the asset and the item is separable from the entity.
 Recognition criteria
• Reliance on the law- legal right to the future benefit. Control is used to determine the existence of
assets.
• Determination of economic substance of the transaction or event- if the event is economically
significant, it is important enough to record and report.
• Use of the conservatism principle: anticipate losses, but not gains- report on asset when we are
certain.
• Ability to measure the value of the asset- if can’t measure reliably, the asset is not recorded.

Liabilities

 A present obligation of the entity arising from past events, the settlement of which is expected to
results in an outflow from the entity of resources embodying economic benefits.
 Has future economic sacrifice and how it arise might due to some other events.
 Obligation must be the result of a past event ensures that only present liabilities are recorded and not
the future ones.
 Recognition criteria- if it is probable that economic benefits will be sacrificed in the future and the
liability is measurable. SAME AS ASSET.
Owners’ equity
  Residual interest in the assets of the entity after deducting all its liabilities.
 It is a residual claim.
 Difference with creditors
• Rights of the parties- creditors have rights to settlement by a given date and rank priority over
owners in the settlement of the events of liquidation. Owners have rights to participate in
profits and use the asset of the entity.
• Economic substance of the arrangement- right of owners to use the assets, interest and profits.

Why have to measure asset and liability?

 Affects decision make by financial statement users.

 Affect investments and lending decisions, leverage ratio and liquidity measures.

What do we measure?

 Subjective value- preference by mgmt to measure.

 True economic value

 Cost- sacrifice incurred in the economic activities (given up to forgone to consume, save)

 Value- perceived benefits to them. Relates to satisfaction of people when they consume a good or
service.
Historical cost

 Relevant in making economic decisions- need data on past transactions concerning future events so
that they can review their past efforts.
 Affects the evaluation and selection of decision rules- past info serve as a basis for such a forecast.
 Provides input to the satisfying notion- some manager make decisions that will support expected or
satisfactory outcomes rather than seeking to optimize the firm’s value. Historical cost is an important
output.
 Impose on the decision makers by their environment.
 Based on actual not merely on transactions- a record of the actual transactions is made.
 Financial statements based on historical cost have been found useful

Criticism

 Insufficient for the evaluations of business decisions

 Going concern assumptions does not underlie the use of historical costs.
 Distortions of important company disclosures.
 Stewardship is far too narrowly construed (interpret)- more current the info more relevant.

Exit price

 Uses market selling price to measure the firm’s financial position and financial performance.
 The amount of cash for which an asset might be sold or a liability might be financed.

Criticism

 Provides relevant info only if the entity plans to liquidate its assets.
 Does not have a meaningful profit. Eg. Inventories state at exit price, the effective profit from sale is
zero.
 Too narrow in its interpretation of economic value as ignore concept value in use.
 Does not relate to the performance of the entity but concern on price changes of assets and liabilities.
Relevance and reliability

 Info must possess both qualities.

 Financial statement should reflect FV rather than historical costs as historical cost is not relevant as
FV which is more reliable.

Trade-offs

 Auditors / preparers are likely to place greater importance on the reliability of measures in the
financial statements that they audit because of their legal exposure. In contrast, investors might
place greater emphasis on the relevance of those measures in forecasting the entity’s future earnings
or financial position.

Reliability

 The quality of info that assures that info is reasonably free from error or bias and faithfully
represents what it purports (claim) to represent and rests on the faithfulness, coupled with an
assurance for the user through verification. The principal components of reliability are
representational faithfulness and verifiability (provide a significant degree of assurance that
accounting measures represent what they purport to represent).

Corporate Social Responsibilities

Meaning of CSR

 A concept whereby companies integrate social and environmental concerns in their business
operations and in their interaction with their stakeholder on a voluntary basis.
 Known as corporate responsibility, corporate citizenship, responsible business and corporate social
performance.
  Involves a broad commitment by companies to social welfare and the common good and the policies
that support them
 Involves not just the products that a company manufactures, but also being a good corporate citizen
in term of the employees that it hires and the way it looks after them
 Continuing commitment by business to behave ethically and contribute to economic development
while improving the quality of life of the workforce and their families as well as of the local
community and society at large.
 PricewaterhouseCoopers: CSR is the business of protecting and investing in our future. Thus CSR
makes good business because it’s about investing in the future good for the long run.
 CSR policy will make sure the business embrace responsibility for the impact of their activities on
the environment, consumers, employees, communities and stakeholders.

The law requires that:

b. Consumers pay a recycling fee when disposing of home appliance.

c. Retailers take back discarded appliances and pass them on to manufactures.
d. Manufactures recycle the discarded appliances.

Components of CSR

1. Basic values, ethics, policies and practices of company’s business.

2. Voluntary contributions make by a company to community development
3. The mgmt of environmental and social issues within partners, from the acquisitions and production of
raw materials, through the welfare of staff, to product sales, use or disposal.
Eg. Sony recycles televisions and personal computers in line with applicable recycling – related laws in
Japan

Theory for CSR:

1. The social contract theory

2. Stakeholder theory
3. Institutional theory
4. Legitimacy theory
5. Political economy theory

1. The social contract theory

- Aims to explain the boundaries of acceptable interaction between participant within society
- Initially, it sought to explain the powers and obligations of governments by conceptualizing a theoretical
contract among individuals (stakeholders)
- Based on the idea of ‘justice’ for individuals within society.
- Recognizes the costs to the individual, although the benefits provided must exceed the associated costs
(both financial and social)
- Corporate mgmt aims to perform socially desirable actions in return for acceptance of their entity’s
objectives.
- Corporate mgmt’s responsiveness on social and environmental issues is bound by the implicit boundaries
of the social contract, that is mgmt actions are guided by social expectations of their performance.

2. Stakeholder theory
- Offered a new way to organize thinking about organizational responsibilities.
- Suggesting that the needs of shareholders cannot be met without satisfying to some degree the needs of
other stakeholders, it turned attention to consideration beyond direct profit maximization.
- Even when firm seek to serve its shareholders as a primary concern, its success in doing so is likely to be
affected by other stakeholders.
- An inclusive stakeholder approach makes commercial sense, allowing the firm to maximize shareholder
wealth while also increasing total value added.
- Eg; when there are conflict of interest between stakeholders, should consider the basic needs of other
stakeholders.

3. Legitimacy theory
- May be among the corporate strategy theories the closest counterpart to the Public Relations theories
- Legitimacy = a generalized perception that the actions of the org are proper/appropriate within a
given social system.
= a condition which exists when an entity’s value system is congruent with the value system
of the larger social system of which the entity is a part.
= exist when the organizational goals, output and methods of operation are in conformance
with societal norms and values.
- The primary argument of legitimacy theory: external factors influence corporate mgmt to seek to
legitimized activities
- Org seeks to act based on norms, culture and being legitimate
- Make sure your action will be legitimate (reasonable) and accepted by society
- The theory provides an explanation of mgmt’s motivation to disclose environment info.
- PR is a tool utilized by mgmt to legitimize the co’s activities.
- Strategies of legitimization
a) Educate and inform relevant publics about changes in the organization’s performance and activities.
b) Change the perception of the relevant public without having to change the organization’s behaviour.
c) Manipulate perception by deflecting attention from the issue of concern to other related issues
through an appeal to.
d) Change external expectations of its performance.

4. Institutional theory
- Used as the explanatory theory.
- A widely accepted theoretical posture that emphasizes rational myths, isomorphism and legitimacy
- Isomorphism is described to understand how the environment could force one unit of the population with
shares the same environment with another to resemble (similar) each other.
- 2 types of isomorphism:
a) Competitive
− Emphasizes market competition, niche (position) changes and fitness measurement
b) Institutional
− Useful in understanding the politics and ceremony that influence modern org life.
- Isomorphism can be achieved through 3 distinct mechanisms:
a) Coercive isomorphism - originates from political influence, regulation, law and the public at large
b) Minetic isomorphism - results from uncertainty within the environment.
c) Normative pressure - stems from professionalization
- Focuses on the deeper and more resilient (flexible) aspects of social structure – considers the processes by
which structures, including schemas, rules, norms, and routines, become established as authoritative
guidelines for social behavior
- Strength – provides the reasoning for the phenomenon of the alarming homogeneity of org forms and
practices in one particular environment.

5. Political economy theory

- Suggest that accounting system act as mechanism used to create, distribute and mystify (confuse) power.
- Adopts a similar perspective to legitimacy theory – respect to the function of the annual report and a firm’s
reason for disclosing info.
- Analyzing reporting practices requires a greater emphasis on the interplay of info between the firm and
external parties.
- Suggest disclosure is pre-emptive and used to stave off intervention and the firm is an active powerful
participant whereas legitimacy theory suggests that the firm is responding to show that its actions
correspond to social expectations and reactive to social changes.

What motivates CSR?

Legal regulations and mgmt accountability

1. Aim at those who are directly responsible for the production of environmental externalities.
2. Force this entity to take responsibility for their impact.
3. Taxation deductions make available to businesses that spend money on environmental programs.

Stakeholder Activism
 Increase attention from shareholders on the social impact of companies.

Performance Reporting
Reporting requirements:
 a. Comprehensive yet flexible- there should be a flagship report that forms the ref point for all special
reports and stakeholder communications. This allow those decision maker feel confident as the info
receive is the same as those with the internal decision maker.
b. Concise yet precise- must be concise with far less volume and density that currently exists.info needs
to be sufficiently precise for effective synchronization (management) with stakeholder decision
making models.
c. Navigate but with clear linkages- there need to be linkages between the various reports. Users should
be ale to be navigated between objectives and key performance indicators.

Why performance reporting is important?

Performance measurement and reporting are intrinsic to the whole process of public management, including
planning, monitoring, evaluation and public accountability. Performance results provide an important record
of an agency’s progress towards meeting objectives and their publication makes it possible to exert pressure
for improvement. Good reports can help Parliament and the public assess how well public money is being
spent and what is being achieved with it.

Improving performance reporting

a. aligning measures with aims and objectives;

b. reporting the outcomes of activities;
c. considering the information needs of stakeholders; and
d. providing a comprehensive view of performance

Challenges

 To educate key stakeholders in terms of organization strategy and performance.

 Collaborate with them to synchronize the decision making model about the strategy and
performance.

 Company should focus o the performance and strategy to external parties.

 For the stakeholder, investor requires greater speed of info. Two-way communication.

Management Commentary
  The statement which include a reasonably rigorous (precise) explanation of an entity's current
performance and position, perhaps together with information providing an insight into its future
prospects.
 Traditional management discussions of performance were predominantly narrative, with little
quantification beyond what was already in the main financial statements but Management
Commentary seems to increase the volumes of quantified and technical disclosures.

 Explain on the trend, past and future development.

 A way on how mgmt disclose their internal aspect.

Objectives of Management Commentary

 Provide info to help investors interpret and assessment.

 Could assess what mgmt view.
 Assess the strategy adopted by the entity.

Characteristics

 Mgmt should supplement and complement in the financial statement. Provide additional info,
explanation regarding the amount in the financial statement (financial and non-financial about its
business and performance).
 Provide analysis from the management perspectives.
 Should have orientation to the future. Eg. Identification of trends that will give ideas to investors.
 Focus on quality rather than quantity. Free from bias.

Management Commentary seeking to obtain a number of benefits from the statement:

 A remedy for the defects in 'traditional' financial reporting that have contributed to the many
accounting scandals of recent years, including Enron and WorldCom in the USA and HIH in
Australia.
 A response to perceptions that 'traditional' users of corporate annual reports need new kinds of
information which cannot readily be incorporated in orthodox (conventional) financial statements,
including both quantified data, such as like-for-like sales growth, and qualitative analysis, for
example discussion of business risk.
 A response to demands that other stakeholders in the entity, such as employees and public interest
groups, should be provided with information relevant to their needs.
 A way of providing information in new areas, such as environmental impact and human capital
management, for both traditional and new categories of user.
 Case study

• Subprime crisis or mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in
mortgage delinquencies and foreclosures in the United States, with major adverse consequences for
banks and financial markets around the world.

Factors

• The rapid increase in valuations of house prices until invalid levels is known as housing bubble. The
housing bubble occurs because of the historically low interest rates. The booming market ended in
the August 2005. In 2007, the house prices began to fall and the rising of interest rates threaten to
lower the prices.

• The rising of interest rates give some impact to the world especially to the subprime borrowers.
Subprime lenders charge higher interest rates to the borrowers which lead to they do not check on the
creditworthiness of the borrowers. So, they tend to make loans to borrowers of higher risk who may
not have the ability for a mortgage.

• The action of financial firms which bought, held and insured large quantities of risky mortgage-
related assets on borrowed money. They hold the mortgage securities as they believed it were a good
assets. It is a critical mistake because the property prices went down.

• The policies of the central banks in U.S. The role of the central banks is to handle the monetary
policy and target the rate of the inflation. They have powers over the commercial banks and other
financial institutions. The reason to lower the interest rates is because U.S. wanted to alleviate the
effects of the collapse of the dot-com bubble which occur in 1995 to 2001 and the terrorists attack in
September 2001.

• The inaccurate credit rating agencies who grade the rating of collateralized debt obligations (CDOs)
and mortgage-backed securities (MBSs) based on subprime mortgage loans. The rating agencies
have conflicts of interest as they were hire by investment banks and other firms that organize and sell
structured securities to investors. On November 2007, the credit rating agency has reduced the
highly-rated CDOs price.

Impacts

• Prompt a jump in the personal savings rate, which, at less than 1% of disposable income, is currently
very low. The effect on economic growth would be swift and substantial. Besides, business
investment is also vulnerable (weak). Most companies would begin reducing staff and would cut
back on hiring.

• Job losses over the world. This unemployment problem will reduce consumption spending and fuel
further pessimism in spending, then deepening the downturn.

• Lead to falling dollar and emerged as a source of profound global macroeconomic distress. The cost
of capital in the US will soar. This incident may discourage investment and reducing consumption
spending as high interest rates depress the value of households’ principal assets.

Solutions
• Homebuyers should identify their financial security and choose or make a wise home purchase
decision. It can help to avoid losses by the rapid growth and subsequent collapse of the house prices
in this subprime mortgage 2007.

• The International Monetary Fund (IMF) and other international financial institutions have an
important role to overcome the crisis. They mobilize the international financial resources, from both
the public and private sectors in order to assist those who have stumbled and fallen, very much as
victims of the internationalization of financial markets.

• Encouraged lenders to work with borrowers to adjust their mortgages when needed and promised to
provide government intervention aimed at assisting subprime borrowers to avoid defaults on their
mortgages.