TUTORIAL SOLUTIONS CHAPTER 4

1. How do conceptual frameworks of accounting attempt to create a theory of

accounting? Describe the components of the IASB Framework and how they
contribute to a theory of accounting.

Conceptual frameworks (such as those developed in the United States, Australia and at the
IASC/IASB) do not employ the term ‘theory’ because of the difficulty of demonstrating
logical consistency and in gathering empirical evidence to corroborate the theory. However,
by following a structured program of inter-related concepts, accounting regulators aim to use
the conceptual framework to achieve consistent accounting standards that will replace ad hoc
solutions to specific problems. In this context, the components of the conceptual framework
can be viewed as the building blocks of a theory of accounting.

The components of the IASB/Australian Framework are: objectives of financial statements;

qualitative characteristics of financial information (such as relevance, reliability,
comparability, timeliness and understandability); and definitions of the basic elements of
accounting reports (such as assets, liabilities, equity, revenue, expenses and profit) and
principles and rules of recognition and measurement of the basic elements, and the nature of
the information to be displayed in financial reports.

2. Some people argue that there is no need for a general theory of accounting, as
established in a conceptual framework. They argue that there is no overall theory of
physics, biology, botany or psychology, so there is no need for an overall theory of
accounting. Furthermore, attempts to develop an overall theory of accounting are
futile and unnecessary, since accounting has not needed a conceptual framework so
far. Debate this view.

It is true that in the physical sciences, there is no overall theory of a given field of study.
There is no theory of chemistry, or biology, etc. Some scientists have attempted to formulate
such theories, but have failed. It is generally agreed that such theories would be beneficial
because they would provide an integrated explanation of all aspects of the given field of
study. At present, different theories in a given discipline — for example, in biology —
remain as separate categories, and often the connection of one theory to another is not known.

Theories in the sciences are descriptive, but in accounting an overall theory would be
normative, telling accountants what ought to be done. This would be very useful if it could be
formulated. It would serve as a standard by which to judge practices. Although the
probability is slim that in the near future a logically consistent overall theory can be
constructed, a theoretical framework such as the conceptual framework can be helpful.

It is true that the profession has survived without a general theory, but a theory of some sort
has always been in mind. Constant reference to generally accepted accounting principles
reveals this. It would be easier to assess accounting practices and to formulate standards
consistent with each other if a general theory existed. If a theory is empirically verified,
accounting methods for particular purposes would also have empirical evidence to support
them. In other words, we would be able to present evidence as to why a certain procedure (for
example, FIFO inventory valuation) should be used rather than another method.

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3. What does the IASB Framework describe as the basic objective of accounting? What
are its implications?

Stewardship looks primarily to the past, asking the question: What happened? Decision
making looks to consequences in the future, asking the question: What will happen? A
decision-making approach sees accounting information as inputs for the decision-making
prediction models of users. If so, then we are concerned about what kind of accounting
information is relevant to decision makers. Some believe that current value is implied. Also
that statement of financial position accounts and their amounts are as important as those in
the income statement. Traditional accounting emphasises income.

4. What type of information do you think is useful for shareholders, lenders and
creditors? Is this the type of information that is currently provided?

Useful information is both relevant and reliable. Presumably, it is also ‘fair’.

Adopting a narrow perspective, useful information provides a basis for investors and
creditors to assess the amount, timing and uncertainty of future cash flows for themselves
based on the expected cash flows of the firm. Such a basis is provided by information
concerning the profitability and financial condition of the firm. In turn, this information is
presently reported in the statement of financial performance or the statement of financial
position, and the statement of changes in financial position. For the latter, many believe a
cash flow statement is especially pertinent.

Taking a broader view, useful information helps to efficiently allocate capital in the
economy. (Question 6 deals with this.)

6. Explain the role of accounting in relation to:

(a) individuals
(b) firms
(c) the Australian economy.

Accounting information helps to efficiently allocate capital in the economy.

The successful operation of a free economy depends, to a large extent, on the good
judgements made by individuals about their investment opportunities and the investment
opportunities of firms. People need information to decide where to invest or lend, and at what
price.

In relation to firms, accounting information forms the basis for many contracts, such as debt
contracts that include covenants specifying that the firm will not allow its leverage ratio to
exceed a certain level, or management compensation plans that provide managers with
bonuses based on reported corporate earnings. As such, the firm’s cash flows are tied to
accounting numbers. Since the value of the firm is the present value of all future cash flows
and those cash flows are tied to accounting numbers, accounting numbers determine the value
of the firm.

In relation to the economy, accounting information plays a vital role in the equitable
allocation of capital, and it contributes to the effective performance of the price system. The
effective operation of our economy means that efficient and inefficient companies must be

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identified, so that resources are channelled to the former and away from the latter in order to
have a ‘successful’ economic system. What would happen, after a long period of time, if
‘incorrect’ information is reported? The economic system would become inefficient (because
of the existence of many inefficient firms), causing serious economic problems to all.

9. What is the difference between art and science? Is accounting an art or a science?
Does it matter? Why or why not?

Whether accounting is an art or a science has long been debated by accounting academics
without coming to an agreement. One position in the middle of the two extremes is that
accounting theory is a science whereas accounting practice is an art. According to Sterling,
there is nothing inherently unscientific in accounting. In fact it is the approach adopted by the
researchers in a discipline that makes the discipline scientific or otherwise.

Accountants who believe in the scientific approach seek empirical evidence to support
accounting practices so that practitioners can recommend the most appropriate methods for
given situations based on the evidence. The scientific approach in accounting is not an
attempt to make scientists of practitioners, nor is it an attempt to discuss ‘absolute truths’,
since there are no absolute truths in science.

Looking at the research in accounting, particularly during the last 30 years, one can see a
great deal of analytical as well as empirical research; both being integral parts of a scientific
theory. It is therefore inappropriate to claim that accounting is in the pre-science stage.

13. Explain the advantages and disadvantages of principle-based and rule-based

standards.

The focus of principle based standards is on an underlying principle or principles. They

require that the principle be interpreted by financial statement preparers and auditors. They
do not set out what preparers are to do in a step by step manner. Rather, they provide
guidance to be interpreted and applied in an appropriate manner. They are more flexible, as
they allow companies to apply the principles in a way that is appropriate for their situation
and business, in order to convey useful information for decision making.

Rule-based standards include detailed directions about actions required by preparers. They
are more specific than principle-based standards, and may include ‘bright line’ thresholds
such as “greater than 50%”. Rule based standards tend to be longer and more complicated,
with more amendments, as standard setters try to cover all situations in which the rules apply.

Specific rules are easier to follow and enforce so are favoured by some preparers, auditors
and regulators. However, one problem with rule based standards is that rules can be “worked
around” to give a result which is technically in compliance with the rules but does not meet
the overarching objective of the standard (the substance over form debate). It is possible to
comply with the substance of a rule based standard while not complying with its form. For
example, leases which are in substance finance leases are structured to meet the tests for
operating leases so that they can be shown as operating rather than financial leases in the
financial statements.