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.
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

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.

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.

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.
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.
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:

Consumers pay a recycling fee when disposing of home appliance.

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

Components of CSR

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

Voluntary contributions make by a company to community development
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:

The social contract theory

Stakeholder theory
Institutional theory
Legitimacy theory
Political economy theory
 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.

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.

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.

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.

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.