Professional Documents
Culture Documents
Accounting Theories and Practices
Accounting Theories and Practices
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 owners 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
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.
3. Scientific basis
Syntactic rules and induction
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.
Kuhns 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.
Feyerabends approach
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.
Regulatory Approach
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
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.
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.
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.
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 entity is the agent or representative through which the individual entrepreneurs or
shareholders operate.
Objective- determination and analysis of the proprietors net worth.
Accounting equation- assets liabilities = proprietors 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 proprietors equity.
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 + stockholders equity.
It is said as income-centered or income-statement oriented.
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.
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 goingconcern postulate where the entity will continue its activities indefinitely.
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.
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.
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).
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.
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
It is essential to identify and define the interrelated set of building blocks with which financial
statement are constructed.
Asset probable future economic benefits obtained or controlled by a particular entity as the
result of past transaction/events
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
Equity residual interest in the assets of an entity that remains after deducting its liabilities.
Two elements for changes in assets and liabilities income and expenses
FASBs Financial capital maintenance
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 assets 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 nave 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.
Concept that asserts that, despite the implications of efficient securities market theory, accounting
policy can affect firm value.
Firms 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 standardsetting 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.
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.
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 firms 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 firms flexibility.
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 managers 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 firms 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.
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 principals
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.
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
Advantages
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.
Msia 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 Msia 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.
vii.
viii.
ix.
x.
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?
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 firms 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
Exit price
Uses market selling price to measure the firms 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 entitys 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).
2. Stakeholder 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 entitys 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
- 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 firms
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 agencys 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.
b.
c.
d.
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).
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 mortgagerelated 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.