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By Professor Rob Bryer, Warwick Business School.1
Preface My intention in these two lectures is to give you an overview of the issues in regulating accounting that you will or can choose to explore in more depth in your second and final years at Warwick. My colleagues and I would like you to read these notes and come prepared to the seminars to discuss the questions at the end. They form the basis of my two lectures. In what follows, I will refer to the literature of financial accounting to give authority and sources for my arguments and evidence, but we do not require you to read further beyond these notes into the issues at this stage.
I would like to thank my colleagues Thomas Ahrens, Peter Corvi, Sue Deebank, Louise Gracia, Marianne Pitts and Simona Scarparo, for helpful comments.
2 Introduction Today, when governments are keener than ever to leave the provision of goods and services to competitive markets, the regulation of financial accounting services stands out as an interesting anomaly.2 In my two lectures, I will explore the question of why, despite the best endeavours of some well-known US economists to dissuade governments and others from regulating the financial accounts that public companies prepare and publish, the trend remains towards more and more detailed control over their content and their certification by professional auditors. This is a particularly interesting time to study the regulation of financial accounting because it is now extending from within nation states to cover the world. For the first time in history, we face the real prospect that the companies of all the major countries of the world whose shares are traded on one or more stock exchanges, will soon prepare their accounts using the same rules, called ‘International Financial Reporting Standards’ or IFRSs for short.3 A spectacular step towards this goal was the European Union’s (EU) decision in 2002 that all its listed companies must prepare their consolidated accounts using IFRSs.4 Following this, Australia, New Zealand, Russia and China, agreed to implement IFRSs. Japan has aligned its rules to follow IFRSs more closely. Currently, 90+ countries either allow or require IFRSs, and eventually the USA will join, allowing foreign companies listed there to use IFRSs without costly reconciliation to its numerous and complex rules, perhaps from 2007, but this seems increasingly unlikely. We used to talk about ‘international accounting’, but this is global accounting! Now, against all the expert predictions, we are on the way to globally regulated accounting – at least, that is the destination. To get there will require continued agreement by many countries, based on mutual understanding of the nature and role of accounting and the need for regulation. In my view, but I am biased because this is my research passion, there is no better way to understand accounting regulation than by studying its history. History shows us there were big differences in the way people kept accounts in the past compared to today, and it helps us to understand the reasons for the changes. IFRSs are important today precisely because there were big differences between the accounting rules of major countries. History also helps us explain international differences, why many countries are now adopting IFRSs, and why some are not and some differences remain. The financial accounting regulation we have today is the product of a long history, and history has not done with it yet. To understand its future, I think we must understand its past and the forces that drove changes and that still drive it today.
Our topic is the regulation of financial accounting, not management accounting, but, for ease of exposition, I will often refer simply to ‘accounting’. As published accounts are ‘financial reports’, I will use the terms ‘financial accounting’ and ‘financial reporting’ interchangeably. 3 ‘IFRSs’ is the collective word the IASB uses for both its inherited series of ‘International Accounting Standards (IASs) and for its own growing series of IFRSs. The Appendix provides list of current IFRSs. 4 Most listed companies are parts of groups of companies controlled by a ‘parent’ company. Accountants prepare consolidated accounts by aggregating the accounts of the parent and the ‘subsidiary’ companies in the group to present its financial position and results as though it was one company.
3 Textbooks on financial accounting often have a chapter or more on ‘regulation’, but they rarely define precisely what the word means. This is a useful place to begin our exploration of a very large subject. ‘Regular’ means ‘having a form, structure or arrangement, which follows or is reducible to, some rule or principle; characterized by harmony or proper correspondence between the various parts or elements’. To ‘regulate’ is therefore to ‘control, govern, or direct by rule or regulations; to subject to guidance or restrictions’ (Onions, 1973, Vol. II, pp.1783, 1784). To understand the regulation of financial accounting in modern society, we must first recognise that accounting is itself a ‘regulator’. How does it work? What rule or principle does it use? How does it produce ‘harmony or proper correspondence’ between the elements of our economic society? Once we understand the nature of financial accounting regulation, we can ask whether and, if so how, society should regulate it. Most people agree that accounting is a regulator, a control mechanism, but they disagree about (a) the ‘rule or principle’ to which we can reduce it, and (b) they disagree about whether society should regulate it. There are two main views. The traditional view is that we can reduce accounting to the principle of ‘accountability’, to the aim of holding powerful managers accountable to investors (shareholders and the providers of debt) for the capital it controls. Traditionalists believe that society must regulate accounting with laws and detailed rules. The alternative view of economists, which gained ground from the 1960s in the USA, is that the rule or principle we should use to regulate accounting is ‘decisionrelevance’. That is, the role of accounting should be to give individual investors information to help them value shares by helping them to forecast future cash flows. Influential supporters of the decision-relevance view argue that we should not regulate accounting, but leave it to market forces. Alternatively, they argue that, if we do regulate accounting, we should set its rules by somehow ‘trading off’ the interests of the stakeholders in financial reporting (investors, creditors, government, suppliers, workers, customers and the public) to maximize the benefits and minimize the costs to society as a whole. In other words, economists argue that we should seek an ‘optimal’ level of regulation. The most important writers of the rules of accounting today are the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). They, like their predecessors, write what accountants call ‘standards’, rules of accounting that all companies must use so that we can analyse and compare the accounts of different entities. The FASB and the IASB are currently working to make US GAAP and IFRSs ‘converge’, that is, have identical rules so that the US will recognise IFRSs for foreign companies that list there. Both bodies accept the decision-relevance aim and that their role is to produce ‘optimal’ standards that maximize the benefits and minimize the costs of financial reporting. Whether we should pursue decision-relevance in financial accounting and whether the FASB/IASB is writing standards that are in any sense ‘optimal’, are important questions I will consider. However, whether FASB/IASB standards are optimal or not, it is clear that they are much more theoretical and much more complex than the rules most countries outside of the USA currently have. We will see that they are attracting increasing criticism from
one in six FDs believed the board has a ‘poor’ or ‘very poor’ technical understanding of the rules. We will see later why managers do not like accounting regulation. Studying accounting standards in depth is the focus of the second year Financial Reporting module and the final year options in Advanced Financial Reporting and Issues in Financial Reporting. and why since then governments have increasingly intervened in various ways to regulate the financial accountant’s work. and the same is probably true for most countries. Accountancy Age. but it has never appealed to accounting practitioners or to the users of financial reports. I first present the traditional ‘accountability’ or ‘stewardship’ view of accounting to offer a neglected explanation of how accounting works. Here is how Accountancy Age (a rather sensationalist magazine for accountants) reported the survey: FDs worried at poor IFRS knowledge levels AccountancyAge. According to a report published by PricewaterhouseCoopers. This suggests that while the fundamental accountability principle has not changed.5 In these two lectures. The survey found that while audit committees are seen as generally knowledgeable about IFRS. but including the USA) accounting regulation over the last 1. Accounting firms are strong supporters of detailed regulation in part because increased regulation generates more work that is lucrative for them.000 years or so. You will find that understanding IFRSs is intellectually challenging. with many chief executives and other board directors failing to understand the new standards despite them being in force for over a year. I will argue that to understand modern financial reporting we need to understand why financial accounting emerged as a well-paid ‘profession’ in the UK in the late 19th century that grew to the multi-billion dollar service industry it is today. Second. 5 . but well worth the effort.4 the preparers and the users of financial accounts. I will argue that society should regulate accounting and that we should write rules of accounting to hold management ‘accountable’ for the ‘capital’ they control (I will define these and other terms as we need them). In what follows. I will side with the users and practitioners of accounting. what accountants regulate has changed as society has changed. companies need to spend more time to improve the knowledge of the accounting standards among senior employees. The idea that we should not regulate accounting appeals to managers and to some US economists. I give a rough guide to Anglo-Saxon (mainly UK. 17 Jul 2006 ADVERTISEMENT CEOs clueless on accounting standards The adoption of International Financial Reporting Standards is proving something of a headache for listed UK companies.com. A recent survey by PricewaterhouseCoopers (PwC) shows the average board member of UK listed companies struggling to cope with IFRSs.
Modern management control theory tells us that principals have three main ways of controlling their agents. accounting is not economics. principals often leave it to agents to make ‘non-programmed’ The word ‘principal’ is a medieval word meaning ‘first in rank or importance’ (Onions. In practice. 1958) – they can tell workers what to do and supervise or monitor their work. can rarely rely on picking dedicated agents whom they can fully trust and must also use ‘action’ and/or ‘results’ controls.g. they cannot assume that agents will diligently use their abilities in the principal’s interests and not in their own interests. consider. p. however. p. or because the relationship between actions and outcomes is uncertain or unobservable. that. My general conclusion will be that. however. This means that principals cannot rely on their agent’s full cooperation. as supervisory costs are often too high even for programmable work. Regulation by accounting – how does it work? Throughout the history of civilization. that is. Table 1 summarises the aims and methods of these three ways whereby principals seek to control agents to work in their interests.5 Then I will look at the alternative ‘decision-relevance’ view of accounting. uncontrolled behaviour Qualifications Tests Judgement Action controls Control of observed behaviour Supervision Physical constraint (e. The word ‘agent’ derives from Latin and means ‘one who or that which acts’ (Onions. One is to select and hire the ‘right’ agent for the job.1671). above all.. workers (including administrators and managers). and reject the arguments of some leading economists that society should not regulate accounting. Principals. buildings) Results controls Control of unobserved behaviour Targets Accounts Punishments & rewards Table 1: The main control techniques available to principals When principals can ‘programme’ labour – when they can accurately predict the outcomes of specified actions (March and Simon. The principal’s control problem arises because agents. Finally. a social and a historical phenomenon.37). but retain control over the work they actually do. Aim Methods Personnel controls Dedicated. while the attention of economists is flattering. and argue that their underlying cause may be the FASB’s commitment to the ‘decision-relevance’ aim. 1973. 1973. and governments. we must understand it in its own terms as. rich landowners. highlight the increasing problems US accounting regulators appear to face today. Here the aim is the direct control of the agent’s actions or behaviour. 6 . called ‘principals’. merchants.6 Principals have always faced the same problem – how to regulate or control agents to ensure that they act in the principal’s best interests. have employed others called ‘agents’ to work for them. Management theorists call this using ‘personnel controls’. Modern management control theorists call this approach using ‘action controls’ (Anthony. to understand accounting. 1965). sell their ability to work. I will briefly outline the recent history of global regulation.
of course. the agent. thereby requiring agents to make decisions consistent with the principal’s interests. they leave it to the agent to make judgements about what work to do. This motivates agents to achieve targets because the agent knows the principal will judge an objective measure of performance against the target (for example. 1973. 1986). In non-programmed situations. The usually legal requirement to produce and explain accounts constrains the agent’s choice of behaviours (plans. decisions. by reporting results. when agents use accounts to make decisions. 7 . it shapes the agent’s non-programmed decisions. Principals therefore hold agents ‘to account’ by requiring an objective reckoning and explanations of performance leading to punishments or rewards. that is. the essence of most work (and certainly that of management. 1965). we can understand the forecasts and calculations they make as ways of anticipating and planning to achieve target results to discharge their accountability. and they therefore must use ‘results controls’ (Anthony. behave in his or her interests when the agent must make nonprogrammed decisions? To control agents. Results control is. In short. you will see that management today regularly calculates the costs and revenues from pursuing different courses of action and it uses forecast accounts and cash flows to guide it towards the most profitable activities. inactions). reprove (a person)’ (Onions. but in their case to discharge accountability by demonstrating their performance against the target or. When agents make non-programmed decisions. to satisfy the principal – to avoid punishment or get rewards – agents must engage in planning and taking any necessary corrective actions to achieve targets. if not. the foundation of the ‘examination’ as a means of motivating and ‘controlling’ students. p. the principal. In subsequent courses in your Warwick degree programme. the principal ‘controls’ the agent because the agent is ‘accountable’.7 This is still the common meaning of the English word ‘control’ today – the ability to ‘call to account. Accounting is therefore vital for controlling agents because. Accounts are therefore also useful to agents. How does a superior. supervision and skilled labour). Therefore.6 decisions. use the results reported by accounts to make a subordinate. principals can only observe the outcomes of their agent’s behaviour. persuading the principal that their plans and actions were reasonable. Some scholars use the examination as a model to help us to understand accounting’s modern prominence and power (Hoskin and Macve. throughout history principals have set targets and demanded and if necessary extracted accounts from their agents. against a required return on capital) and knows that the principal will scrutinise explanations of the results and will punish poor performance and reward good performance.416). Figure 1 below outlines the accountability process using accounting results controls. actions.
it means ‘Who controls the controller’. a function performed today by the various professional accounting institutes and associations. the Institute of Chartered Accountants of Scotland (ICAS). the Institute of Chartered Accountants in England & Wales (ICAEW). Quis custodiet ipsos custodes? Literally. a specialised. always sought to control them using personnel controls. the function of ensuring the agent objectively reports results has been the work of the ‘auditor’. or ‘Who audits the auditor’? As auditors cannot be controlled by their ‘results’. Throughout history. the principal’s reliance on auditors not to collude with agents has always raised the obvious question. convicted criminals cannot be accountants). this Latin phrase means ‘Who will guard the guards’? In our terms. independent agent who the principal hires to seek to ensure that the working agent does not distort the reported results in his or her favour. the Chartered Institute of Management Accountants (CIMA). 8 . and the Certified Institute of Public Finance and Accountancy (CIPFA). the principal clearly needs the objective measurement and reporting of results that the agent cannot manipulate. selecting the ‘right person for the job’ (for example. However.7 Auditor Reports Checks • Accounts (results) • Explanations Requires Hires Hires Principal Sets financial targets Agent Produces Hands down • Judgements • Punishment/rewards Motivates Fig 1: The accountability process For the results control approach to accountability to work. of course. principals have.8 The professional accountancy bodies in the UK are the Association of Chartered Certified Accountants (ACCA).
Formulating a theory of accounting. Armed with such a theory.8 Second. Principal-agent law. Authoritative literature. Authoritative literature. To control accountants.g. Authoritative literature. Luca Summa de Arithmetica 1494. so has the focus of what accounting regulates. but much more importantly. Authoritative literature. principals regulate accountants by using action controls – by writing detailed rules of accounting and by oversight monitoring and ultimately legal supervision of their application. have always been the stuff of accounting regulation. Table 2 provides an overview of the history of regulation by and of accounting. writing. Generally accepted practice.. e. The Statute of Westminster 1285 II. e. Principal-agent law. Accrual accounting for the ‘profit’ on the ‘capital employed’ (ROCE). the principals need a theory of accounting that analyses and describes the wealth generating activities of their agents. Principal-agent law. . and against which the principal can judge the auditor’s behaviour. Generally accepted practice.. Generally accepted practice. as the following rough guide to accounting history shows. Principal-agent law. from the slave era that ended in Europe sometime before 1100. A rough guide to the history of regulation by accounting As the identity of the principal and agent has changed through history. regulators can write and enforce robust rules of accounting that leave agents and auditors with no discretion in measuring and reporting results.g. 1100 → Lord of the manor Serf/peasant Charge & discharge accounts for ‘rent’ (commodities & cash) 1400 → Merchants Traders 1600 → Farmer/manufacturer Workers Double-entry bookkeeping for the ‘profit’ on ‘capital’ (surplus of commodities and cash over the initial capital). to the modern era that begins in the mid-19th century: Period Up to 1100 Principal Slave owner Agent Slave Accounting regulation Commodity budgets Accounts regulated by Generally accepted practice. and enforcing its rules.
dairy products. wool.9 1850 → Well-diversified investors Managers & workers Modern financial reporting of ROCE 2005 → Globally-diversified investors Managers & workers Internationally comparable reporting of ROCE. Generally accepted practice. livestock. called stewards or bailiffs. in the form of free labour. Specific statute and case law. Walter of Henley wrote a widely read tract in the 14th century called the Husbandry that included advice on accounting. However. and ‘discharged’ him by allowing or refunding necessary expenses and when he paid the surplus remaining to the lord. English lords used accounts and auditors to control their agents. bailiffs and other officials working for the lord were freemen and therefore outside the jurisdiction of the manorial court where (within the bounds of customs and the peasants’ willingness to uphold them) the lord reigned. Generally accepted practice. lords of the manor collected rents from self-sufficient peasants farming their land. scholarly but worldly people wrote books to educate lords and their agents on the appropriate methods and systems to use. English manorial lords employed auditors to travel around their manors to check the ‘charge & discharge’ accounts they used. which ‘charged’ the bailiff with the rent the lord expected (or simply demanded). chapter XI of the Statute of Westminster II of 1285 required bailiffs to produce accounts. During this era. For example. commodities (corn. and it gave the lord’s auditors the power to commit them to the nearest royal prison if the auditor suspected fraud or if the bailiff did not otherwise pay what the auditor reckoned he owed. Professional institutes and associations. Stewards. Authoritative literature. Statute and case law. IFRSs Table 2: A rough guide to the history of accounting regulation and the regulation of accounting In medieval England. Detailed standards based on a theory of accounting (‘generally accepted accounting principles’ based on a ‘conceptual framework’). Professional institutes and associations. Statutory monitoring and supervision of financial reporting. English landowners continued to use this system until well into the 19th century and it . Authoritative literature. etc) or cash.
starting around 1880. The UK government began to write specific laws As every student of accounting knows. the method leaves open the question of how the accountant (the agent) should ‘value’ the capital. and originally this was simply the value of the commodities or money initially invested in a voyage or other venture. from 1611). the government began to intervene in the practice of accounting. whereas a theory of value provides its lexicon. and in the accounts of big landowners and manufacturers in the 18th century. principals have regulated their accounts by reference to ‘generally accepted accounting practice’. the ‘rate of return on capital’. Modern accounting ideas appeared in the accounts of the ‘big businesses’ of the British Industrial Revolution from the 18th century (for example. The first book on commercial accounting published in Europe was probably Friar Luca Pacioli’s text (reputedly stolen from a student) on double-entry bookkeeping (DEB) Summa de Arithmetica that he published in 1494. Fleischman and Parker.9 While we still use DEB today for this. in the accounts of the well-known Scottish iron company. who were often their own auditors.10 The question of ‘value’ in accounting first appears in the UK in the accounts of English farmers in the early 17th century (a well-known example is the accounts of Robert Loder. in large temporary partnerships. governments have passed general laws governing the relations between principals and agents. 10 DEB is the syntax of the language of business. scholars have written authoritative books that described and systematised best practice. the Carron Company. 1993a). beginning around the middle of the 19th century. which was originally. but became widespread in British joint-stock companies from the mid-19th century (Edwards and Newell. their ‘capital’. a farmer in Berkshire. and that a profit and loss account measures the increase or decrease in capital. a word that appears in accounts for the first time. simply the excess of money and/or valuable commodities over the initial investment. 2006)). Widespread use of standardised systems of DEB helped merchants. The new theory underlying DEB reflected the reality that 14th century merchants from Northern Italy pooled their wealth. The partners therefore needed a method of accounting that would track the movements of their capital and give them a measure of its performance. 1997). the dictionary of meanings. and the courts have enforced them. and in earnest from around 1880. the rules of sentence construction. 9 .10 survives today in the ‘income and expenditure’ or ‘receipts and payments’ accounts that we find produced by cricket clubs. for the first time. DEB probably first appeared in the 14th century in Northern Italy because this was the first region in Europe to need to regulate the financial relations between the increasingly large groups of merchants who pooled their wealth as partners in overseas or long-distance overland trading ventures. The means of regulating accounting itself changed little until the ‘modern’ era. which they could use to share out any surplus or to divide any loss (Bryer. from 1759 (Bryer. What is special about our modern era is that. The central rules are that debits are uses of capital and credits are sources of capital. as landlords did it. what is ‘double’ about DEB is that we record every transaction twice to show its effects on the equity interest and on net assets. to track the movements of their capital through widely understood pathways. charities and the like. DEB therefore also leaves open how the merchant should measure the surplus. 1991. and their agents (other merchants and their employees). that a balance sheet reports the sources and uses of capital. Throughout history.
To prevent this type of behaviour. etc (Bryer. easily measured and reported. the stakeholders in the regulatory process changed from being predominantly owner-manager-partners to ‘well-diversified’ investors (those holding small amounts of the shares of many companies across a range of industries). It must be impossible for the agent to manipulate accounting information to hide poor performance from ineptitude. In short. to rely on the courts for enforcement. held them accountable for capital and for profit. ‘cash is all-important’ and is objective. We have seen that if accounts are to hold agents accountable to principals. the aim of accounting became to ensure that. That the dividend was not a return of some of the shareholders’ capital disguised as profit to. the aim became to ensure that when management claimed a profit. is so good about ‘accrual accounting’? . professional investment advisors. this money came from a surplus over the value of the capital investors had entrusted to its control. after all. accounting for capital and profit (the common meaning of ‘revenue’ at that time). With the so-called ‘divorce of ownership and control’. professional auditors and the government. today we call it ‘accrual accounting’ or. Under the influence of economists. ‘save it for a rainy day’).11 regulating accounts and. This was particularly the case in the US following the Great Crash of 1929 when US share prices fell to very low levels. the aim of accounting became to protect capital employed in a wide variety of businesses – to prevent managers fraudulently distributing dividends from capital. from the 1880s. If. 1998). for example. From the end of the 19th century. managers became ‘stewards’ appointed by the shareholders who. However. Lee. Leading accountants in the 19th century called this aim ‘capital-revenue’ accounting. Many scholars today echo this view when they recommend that investors and share analysts to focus on the cash flow information in financial reports and downplay or ignore the accrual accounts. As shareholders were now outsiders who know only what management told them. the financial information they report must be objective. entice them to advance more capital which management then use to pay themselves extravagant salaries. dishonesty. etc. there really was a surplus of money in excess of the capital. as many say. many modern scholars and commentators on accrual accounting doubt accrual accounting’s objectivity. for example. or to conceal good performance (to. from the 1850s to the 1880s. and some have even argued that regulators should abolish it and require only accounts that measure and report financial performance and position using cash flows (e. which many believe ushered in the world depression of the 1930s. to emphasise management’s accountability. Lawson. 1971. ‘stewardship’ accounting. when management paid cash dividends to investors. professional managers. by requiring audited accounts.g. shirking.. it began to encourage the formation of the accounting profession and to get accountants and users of accounts to formulate and apply ‘generally accepted accounting principles’ based on an articulated ‘conceptual framework’ or theory of accounting. why do we not simply require cash flow accounting? What.. 1972).
therefore. in trade debtors and other receivables. production wages and materials each cost £50 per month. (b) It buys plant for £5. The economic resource for which management is accountable to investors is the ‘capital’. However. we produce the cash account (this assumes that management makes no distributions of cash to the owners). 11 Adapted from Bryer and Steele (1990. It acquires goods and services on credit. (f) Sales expenses are £10 a month and begin after the initial 3 months of production. (g) Sales and production are constant in each future period. machines. (d) The enterprise starts its sales when it has produced an opening stock of finished items costing £750.400 that has an economic life of 51 months (4 years and 3 months) after which the plant will have a scrap value of £300. To be in control.12 Cash flow accounting Supporters of cash flow accounting are right that cash is objective. a quantity which it always holds in stock: £ Materials 3 months x £50 = 150 Wages 3 months x £50 = 150 Overheads 3 months x £50 = 150 Depreciation 3 months x £100 = 300 ----Stock carrying value 750 === (e) Sales are £400 per month on credit and the debtors pay after one month. light and power).£300) x 12/51 months]. Accounts should (and do) hold management accountable for the cash flows of their business.500 in cash. after three months production. the ‘profit’ (or ‘loss’). not simply the surplus cash they may have available for distribution. and its increase (or decrease) for a period. not just cash. Chapter 2). First. factory heating.400 . there is much more to business than cash. and be accountable for its performance in increasing (or decreasing) the value of all these resources. etc) and in intangible assets (scientific research and development. Consider the following example:11 Example (a) An enterprise starts a business with an initial equity investment of £6. but it buys the materials on credit and settles its debts with a lag of one month.200 on a straight-line basis [(£5. buying patents and brands. investors must hold management accountable for all the resources under its control. The enterprise pays its overheads and wages in cash each month. training employees. (h) The shareholders want to withdraw the maximum annual dividend whilst maintaining the capital of the business. Management invests cash in tangible assets (buildings. etc). (c) Production overheads (including the costs of supervision. . It charges annual depreciation of £1. in stocks of materials and finished commodities. in long-term and temporary investments.
wages) 1. Here are the statements for years 1 and 2: .400 Year 2 £ 4.13 Transaction/balance Initial capital Plant purchase Opening stock Balance at start of production Sales receipts Overheads Materials Wages Sales expenses Balance at end of period 1 Sales receipts Overheads Materials Wages Sales expenses Balance at the end of period 2 Sales receipts Overheads Materials Wages Sales expenses Balance at the end of period 3 Sales receipts Overheads Materials Wages Sales expenses Balance at the end of period 4 Cash flow £ +6.800 -600 -600 -600 -120 +6.060 +4. at the end of each year management should produce a summary performance statement of realised operating cash flows. For example.940 +4. and day by day.200 For sales expenses 120 ------Realised operating cash flow Year 1 £ £ 4. management can and should compare forecast cash flow with the realised cash flow and it should seek explanations for the differences.920 ------2.800 -600 -600 -600 -120 +8.180 +4.800 600 1.480 ==== 1. Here are the statements for the first two years assuming all goes as expected: Realised operating cash flows for years 1 & 2: Receipts from customers Payments: To trade creditors (materials) 600 To expense creditors (production overheads.800 -600 -600 -600 -120 +11.400 -400 700 +4. The importance of cash flow is such that at the end of each period.400 -600 -600 -600 -120 +3.500 -5.200 120 ------- 1. management should give investors periodic statements of the cash position of the enterprise that explain the change in the cash balance over the period by highlighting its major sources and uses.880 ==== In addition.920 ------2.820 Management and investors are keenly interested in the cash flow performance and position of a business.
500 ==== Cash expenditures on assets Net cash balance 6. the cash that management could distribute whilst maintaining the capital it employs in a functioning enterprise. and (leaving aside capital injections and distributions) a statement of its increase or decrease for the period. for the accumulation of costs into stock.500 2. Management routinely produces them as part of an effective system of internal financial control.860 ===== Capital introduced Cumulative operating cash flow The cash flow statement and the statement of cash sources and uses are objective means of assessing management’s stewardship of cash. To measure this. and we observe the results over the investment cycle. it produces a statement of the sources and the uses of the capital employed in the business.860 ===== 5.500 -------6. if any.800 3. As investors are usually not happy to wait until businesses close to get their returns.14 Annual statements of closing cash position Opening £ 6. after paying over the profits.500 ------6. .180 ------8.800 6. or to reinvest in new assets and repeat the cycle if this looks the most profitable course.500 ==== Closing at end year 1 £ 6. in consequence. the balance sheet. calculating the surplus cash flow. of the realised net operating cash flow is a return of their resources or a return on those resources – how much of its cash balance management could distribute to investors whilst maintaining the value of the capital they invested. Accrual accounting for our enterprise will require its management to keep records for the purchase of the plant and its depreciation. when the enterprise closes for business. accrual accounting adjusts the cash flows by matching the cash generated from sales with the cash costs of the resources used to get them. Accrual accounting We now produce the much more informative accrual accounts for our enterprise.980 ==== 5. the profit and loss account. the management of the enterprise retains enough cash at the end to allow it to return the initial capital to the investors if the investment has reached the end of its life-cycle.500 5. is the major traditional function of accrual accounting. Nor. We are particularly interested in whether.360 --------11. do they tell investors and creditors how much.980 ==== Closing at end year 2 £ 6.060 -------11. and we now enforce the shareholder’s demand that management must distribute to them all of the reported annual profit as cash dividends. To measure the return of the resources management controls and the return earned on them.480 ------8. cash flow statements do not account for all the resources under management’s control and therefore do not report on their use in generating the surplus of cash. However. Cash flow accounts could objectively measure the distributable surplus of cash over the initial investment only at the end of the investment cycle.
.500 +5.700 +4.500 +4.400 -1.000 -600 -600 -600 -120 -1.800 -1. Accrual accounting Plant Transaction/Account £ Initial capital Plant purchase Depreciation Production overheads Materials Wages Balance sheet at start of sales Sales Depreciation Production overheads Materials Wages Cost of goods sold Sales expenses Profits/Dividends Balance sheet at the end of period 1 Sales Depreciation Production overheads Materials Wages Cost of goods sold Sales expenses Profit/Dividends Balance sheet at the end of period 2 Sales Depreciation Production overheads Materials Wages Cost of goods sold Sales expenses Profits/Dividends Balance sheet at the end of period 3 Sales Depreciation Production overheads Materials Wages Cost of goods sold Sales expenses Profit/Dividends Balance sheet at the end of period 4 +5.680 +3.800 Creditors £ Equity £ -6.400 -150 -100 -150 +700 +4.680 -4.500 +5.500).680 +3.500 -5.200 +600 +600 +600 -3.680 as cash dividends each year and retain sufficient 12 Debits are positive and credits are negative.200 +600 +600 +600 -3.200 +1.700 +750 +400 -50 -6.400 -300 +300 +150 +150 +150 +750 +400 -1.000 + 120 +1.000 -600 -600 -600 -120 -1.200 +600 +600 +600 -3.100 +3.680 +1.100 +750 +400 -50 -6.680 +5.200 +1.000 + 120 +1.000 + 120 +1.400 -2.400 -5. as well as for cash flows.680 +2.200 +600 +600 +600 -3.000 -600 -600 -600 -120 -1.000 Cumulative depreciation £ Stock £ 12 Cash £ +6.500 Profit or loss £ Debtors £ -50 -50 -6. for equity.500 These accounts tell the investors that the business earns them a rate of return on capital employed of around 26% (£1.15 for debtors and creditors.900 +4.800 +3.200 +1.400 -.500 +5.680 -4.3900 +750 +400 -50 -6. They show them that the business could pay out its annual profit of £1. for profit or loss.800 -1.000 + 120 +1.500 -4.680/£6.680 +3. and for distributions to the owners.800 +5.800 -1.500 +750 +400 -50 -6.200 +1.400 -300 +5.400 -600 -600 -600 -120 -1.
the accruals model is useful for thinking about the future precisely because every year the net profit in the accounts shows investors the amount the business could distribute in ‘steady state’. accrual accounting measures profit as the net change in capital (after adjustment for any injections of capital and any withdrawals such as dividends). 1999.13 In reality. while this is an important role for accrual accounting.42). but that it is the job of the capital markets to use this representation as a benchmark model for forecasting the future and estimating the economic value the business. This is useful even though in reality no business is in steady state. prices. Evidence of the importance of accounting net profit to shareholders is the many employment contracts that link management’s pay to the growth in earnings (net profit) per share (EPS) (Elliott & Elliott. To meet this need. It has £5. not just profit. What is capital. In addition to holding management accountable for their performance to date. its share price.14 The extensive use by stock analysts of EPS. technologies. competition. it is not their traditional prime purpose. and thereby forecast future surplus cash flows. we must therefore understand ‘capital’. the current net profit will be the long-run distributable cash flow.100 in cash and will realise £300 from the sale of the scrap value of the old plant. and how should we account for it? There are two very different answers to this question. in the face of uncertainty and changing investment opportunities.400. The benchmark is that. . To understand the principles of accrual accounting. a prudent management would pay out only a proportion of the net profit each year. 13 To repeat the cycle. Investors are primarily interested in the rate of return on capital. Accrual accounting for the past and the future Traditional accountants argue that.16 cash at the end of the cycle to return their investment or to replace the plant and repeat the cycle at the end of the first 51 months. Accounts are still useful for forecasting because investors and equity analysts can adapt the accountant’s financial model of the business – how it uses its resources to generate a profit – to reflect their expectations of future changes in sales. management must buy new plant for £5. 14 Other evidence of the importance of profit for accountability is that if management produces poor profits they are invariably ‘restructured’. p. in steady state. to ensure effective stewardship. Here I can offer only a brief introduction to the issues that divide them. exchange rates. etc. the assumption that the future will be an exact repetition of the past. political climates. See the Financial Times almost any day of the week. In short. the profit per unit of share capital shows that financial accounts hold management accountable for more than net profit. it is the prime job of the accountant to provide an accurate financial representation of a business. costs. Setting targets for net profit available for distribution and measuring results is the major means whereby shareholders exercise control over management today. therefore. accounts are useful for forecasting future cash flows because they provide a steady state model of how an enterprise generates cash that investors and analysts can use to forecast future profit and loss accounts and balance sheets. However.
p. etc). Anglo-Saxon accountants (in Australia. and they use the ‘lower-of-cost-or-market’ rule. on labour (L). 1921. Canada.17 Traditional accrual accounting for capital The traditional answer is that ‘capital’ is the money which management uses to acquire the resources it needs to produce a profit. and on the means of production (mp) such as factories and machines. non-accountants often think that accounts measure only the historical costs of the resources management uses to earn a profit.15 The word ‘capital’ derives from the Latin capitalis. particularly during the 1970s and 1980s. plant & machinery. energy. which values inventories at their selling price when this is lower than cost. valuing non-monetary resources and their consumption at current prices (Bryer and Steele. all of which it puts into a production process (P). For example. they use ‘fair market values’ when one business acquires another. and that we should measure profit as realised ‘revenues’ from sales minus the ‘expenses’ incurred in producing the goods or services sold. etc. components. Out from production come 15 Because accountants often talk loosely about ‘historical cost accounting’. and New Zealand) produced ‘current cost accounts’. M′ m Start here C′ M L P mp Figure 2: The enterprise operating cycle Figure 2 says that investors put money (M). accountants often use current costs. accounting is a ‘mixed model’ using some historical costs and some current costs. for example. such as the current cost of replacing the acquiree’s tangible assets (the buildings. 16 Thus. Traditional accountants therefore think of businesses as ‘operating cycles’ and define their work as measuring these cycles and making them visible to outside investors. In fact. the UK. Capital is the most important money in a business because management must recover it before there is any surplus and must continually re-employ it to make a stream of surpluses. the capital. South Africa. 1990). that accountants should measure the resources management employ to earn the profit at their cost. it means the “chief sum of money dealt with in a particular business” (Cannan. In past periods of high price inflation. inventories. we call the chief or most important city of a nation its ‘capital’.16 In accounting. the US.469). Currently. the substantive meaning of which was “head” or “chief”. into a business that management spends on necessary commodities such as raw materials. .
Gave power to the Securities Exchange Commission to regulate accounting. An overview of the history of modern financial reporting The UK took the first step towards the modern era of financial reporting regulation in 1844 with the passing of the Joint Stock Companies Act. including of the profit & loss account for the first time. Accounting profession began writing UK accounting standards. or it can invest it to increase the size of the capital employed in the business. Voluntary model articles and balance sheet. The cost-based accruals model of accounting underlies the modern history of financial reporting and remains the basic approach today. Implemented the EU 7th Directive covering group accounts. which it delegated to the accounting profession. Implemented the EU 4th Directive covering individual company accounts. Issued a Statement of Principles and began issuing detailed financial reporting standards. a ‘true and fair view’. and consolidated accounts. Laid down and enforced minimum standards of education. Required accounts to be audited ‘fair in accordance with generally accepted accounting principles’.. Summaries of recommended best practice on numerous issues.18 commodities or services (C’) that management must sell for more money (M’) than they cost to produce to continue in business. but ‘profits’ not defined. Growing professional and academic literature on accounting. 1900 1929 1933-34 UK Companies Act UK Companies Act US Securities Exchange Acts 1934-1959 1948 1970 1973 1978 1981 1985 1990 American Institute of Certified Public Accountants Accounting Research Bulletins UK Companies Act Formation of the UK’s Accounting Standards Steering Committee Formation of the International Accounting Standards Committee Formation of US Financial Accounting Standards Board UK Companies Act UK Companies Act UK Accounting Standards Board . Begins writing international accounting standards. it can distribute this to investors as dividends. to the government as taxes. etc. to managers and workers as wages or bonuses. Compulsory auditing. If management makes a money profit (m). Minimum detailed disclosures. Required additional detailed disclosures. competence and ethics. Required accrual accounting for the maintenance of capital. Begins issuing Statements of Financial Accounting Concepts and detailed standards. The table below presents a chronology of some major steps in the regulation of accounting in the AngloSaxon (UK and US) world from 1844 to the recent appearance of IFRSs: Year(s) 1844 1856 1850-1880 1880 Regulatory event(s) UK Joint Stock Companies Act UK Joint Stock Companies Act Judgements by UK courts ICAEW Royal Charter Requirements/consequences Required profit and loss account and balance sheets.
which increased from 5% in 1873 to 23. One measure of this is the proportion of the UK’s capital stock represented by the nominal value of quoted industrial and commercial securities on the London Stock Exchange.19 2000 2001 International Organisation of Stock Exchange Commissions (IOSCO) approves IASs. read Elliot and Elliot (2007. statisticians who play an important role in valuing insurance and pension liabilities and pension fund assets who often work closely with accountants.17 17 The Board for Actuarial Standards writes standards for the work of ‘actuaries’.9% in 1903 (Bryer. the Financial Reporting Review Panel supervises the application of accounting standards in published financial reports. In addition to statutory and professional regulation. and the Accountancy Investigation and Discipline Board does just that. 1993b. Formation of the International Accounting Standards Board EU agrees to require IASs for listed groups from 2005 2004 2005 Norwalk Agreement IFRSs Agrees to recommend IASs to its members (the world’s major stock markets) for cross-border listings. The Urgent Issue Task Force writes rules using an abbreviated process in response to emerging problems. the growth of accounting regulation from the 1880s closely correlates with the growth in importance of the capital markets and the appearance of the external and increasingly well-diversified investor. 90 + countries begin to use IFRSs. Table 2. The Committee on Corporate Governance promotes best practice in managing public companies in the interests of investors. . The UK’s system illustrates the depth and complexity of accounting regulation today.665). The rapid expansion of the US capital markets correlates with the beginning of US government inspired regulation with the passing of the Securities Exchange Acts of 1933 and 1934. p. the Auditing Practices Boards writes rules to regulate the behaviour of auditors. Table 3: Major events in the Anglo Saxon regulation of financial reporting Not surprisingly. The Accounting Standards Board writes the UK’s rules. FASB and IASB agree to converge standards. Begins writing detailed International Financial Reporting Standards (IFRSs) EU sets up the Accounting Regulatory Committee to approve IFRSs for listed European groups. For more details of the UK system of regulation. chapter 5). The globalisation of the capital markets from the 1970s and 1980s correlates with efforts to harmonise international accounting and its ultimate leap forward with IFRSs from 2000. investigate and discipline incompetent or dishonest accountants. the UK’s Financial Reporting Council supervises accounting practice through the various specialist bodies shown in Figure 2. the Professional Oversight Board supervises auditing practice.
a rational investor would pay only 90. 18 . We call the numbers calculated with this formula ‘discount factors’.uk/ To write good rules of accounting we need a good theory of accounting. and in the US from the 1930s. Unfortunately.20 Figure 3: The Financial Reporting Council Source: http://www. In general. as I said earlier. and measure profit as the realised surplus over this capital. the present value (PV) of £x in n years if the return available elsewhere is r is PV = £x/(1 + r)n.org. Enforcing this view has been the focus of UK accounting regulation since the 1840s. we calculate and compare its opening and closing capital measured as the present value of the expected cash flows at the end of each year. 19 Economists rarely talk of ‘profit’ and prefer the word ‘income’ because their model of value refers only to individuals and their consumption.frc. there are two different theories of the nature of ‘capital’. if the return available on comparable investments were 10%. The alternative view of economists that emerged in the US in the 1960s is that accountants should measure ‘capital’ as the ‘present value’ of expected cash flows and therefore they should measure profit as the change in this value through time. The ‘present value’ of a future cash inflow is the amount a rational investor would pay now for the right to receive it.9 pence for the right to receive £1 in one year because this is how much the investor could invest now to get £1 in one year. ‘economic income accounting’. We have seen the traditional theory that we should measure capital at the cost of the inputs that management employs to produce goods and services for profit.19 Economic income and the ‘decision-relevance’ of accounting To calculate the economic income of our business. For example.18 Economists call this way of valuing capital and accounting for it.
79 + 225.0000000 0. after it arises at the end of each period as accountants do.7513148 0.7513148 0.21 -------------+ 9.81 = £972. 1989). Interestingly.17 +2.618.163.380. they are the same.08 + 204. even ex post measures of economic income depend on the assumption that we know future net cash flows and required rates of return (Beaver.721.98 ======== According to this model.880 +2.55 +2.6830135 0. . at the end of year 1 the economic value of the business will be: CF1 CF2 CF3 CF4 Operating cash flow Operating cash flow Operating cash flow Operating cash flow Realise residual value of plant Realise closing stock Pay creditors Collect debtors Present value Cash flow £ +2.53 ------------+10. from the beginning of each period. It is possible to account for differences between expected and actual cash flows for the current period and changes in expectation for future periods.10 = £972. as the closing present value of capital always depends upon forecasts of the future.00 +2.9090909 0. We first calculate the opening present value of the cash flows of our business using the riskless return on capital elsewhere that we assume is 10% a year: Cash flow £ +2. In a world of certainty.163. therefore.15 + 273.721.480 +2. and investors.21 To do this we assume that the expected cash flows are certain to occur.693. find simplistic.26 34.7513148 0.880 +2.98 .6830135 0.380. (allowing for rounding) this is the income we get if we simply multiply the opening present value of £9.967.880 + 300 + 750 50 + 400 Discount factor 1.7513148 0.8264463 0. This shows us that in a simple world where we know the future. an idea that many accountants.57 + 300.81 by the required riskless return available elsewhere of 10% per annum (£9. We can measure economic income ‘ex ante’.17 +2.49 .81 x 0. that is.37. ‘income’ is an interest return through time. the economic income of year 1 is the closing capital minus the opening capital.880 + 300 + 750 .17.18 +2.39 + 563.£9. before it arises.6830135 0.6830135 Present value £ +2. or £10. to drop the certainty assumption and work with expected cash flows and risk-adjusted required returns.9090909 0.79 +1.254. However.880 +2.8264463 0.721.6830135 0.81 ======== CF1 CF2 CF3 CF4 Operating cash flow Operating cash flow Operating cash flow Operating cash flow Realise residual value of plant Realise closing stock Pay creditors Collect debtors Present value Before distributions to the owners.90 + 512.480.50 + 400 Discount factor 0.7513148 0. managers.880 +2.7513148 Present value £ +2.18).693. or we can measure it ‘ex post’.721.480 +2.
but many investors suspended disbelief along with most accountants. The apparent resurgence of support for traditional accounting in response to growing difficulties in the US in regulating accounting (typified by the Enron scandal) using the economics approach. However. in contrast to traditional accounting.22 Even supporters of economic income accounting recognise that in reality this approach would introduce a high level of subjectivity into financial reporting. Auditors could not check their accuracy. Asset-liability/fair value accounting seeks decision-relevance by defining assets and liabilities as actual and potential cash flows.75. The FASB accepts it cannot directly implement the economic income model because forecasts of cash flows are too subjective. the FASB began issuing Statements of Financial Accounting Concepts. and one for ‘not-for-profit’ enterprises) comprise its ‘conceptual framework’. 1989. after all. which it calls ‘asset-liability’ accounting to contrast it with the ‘revenue-expense’ approach of traditional accrual accounting. 101)! The economic income approach became popular amongst American academics from the 1960s. but sometimes pessimistic forecasts to conceal wealth from investors) to pursue their economic interests and ambitions. I will briefly consider the view that society should not regulate financial reporting at all. These statements together (there are six relating to the accounts of businesses. if we really did have accurate forecasts of the future. and that doing so would increase its decision-relevance. because in this model it is simply the opening present value multiplied by the required return on capital (Beaver. based on its version of the economic income approach. the ‘ideal’ of measuring income as changes in economic value underlies the FASB/IASB’s current ‘fair value’. . some US economists in particular argued that. Against the background of the growing and increasingly costly regulation of accounting. First. Anglo-Saxon regulators and managers have found this economics approach persuasive. For every class of asset and liability the FASB/IASB Framework requires managers and accountants to choose the most useful information for investors in making cash flow forecasts. however. like other goods and services. Who. pp. they think decision-relevance is the ‘ideal’ or most worthwhile aim for accounting even though they may never fully achieve it. the FASB/IASB’s economic approach requires management to make unacceptably subjective judgements and forecasts of the future when preparing accounts that undermine accountability because auditors find these judgements and forecasts difficult or impossible to regulate. will help individual shareholders make better forecasts of future cash flows. some of them would undoubtedly use the opportunity to make forecasts (usually optimistic forecasts to attract capital. and in 1978. as the results have become clear. ‘mark-to-market’ approach to writing accounting rules. many now see that. Furthermore. we should leave the regulation of financial reporting to market forces. 20 That is. there would be little point in hiring accountants to calculate ‘income’. Nevertheless. can accurately forecast the future? If we abolished accrual accounting and left forecasting in the hands of managers.20 The FASB/IASB believe that having accounts report market values and their changes will increase their ‘decisionrelevance’. is our topic in the final section of the lecture.
they conclude that ‘good’ managers have a continuing economic incentive to provide useful accounting information to investors to signal their higher than average economic value (Akerlof. 1978). However. so that the higher they perceive the risk the higher the return they demand on the capital they provide. In addition to these capital market forces. the providers of capital will ‘price protect’. As economists think that managers and the providers of capital know their own best interests. Unless management offer safeguards. creditors will charge a higher price for loans or will not make them. .. According to the economists’ story. outsiders will assume that the managers are operating the business for their own benefit. so the argument goes. price protecting will lower the value of the firm to the managers if they are significant shareholders. 1970). to avoid this. 1980). or agree to limit dividends to a certain proportion of net profit after interest. there are effective economic incentives for management to provide accurate information about their financial performance to investors because otherwise their financing costs will rise. They all presume an omniscient capital market so that managers with higher than average real economic value will produce ‘good’ accounts. In short. In the absence of regulatory or other safeguards. and economists argue that. they further conclude that we should not regulate accounting because this would inevitably restrict the possible accounting methods available to the parties and could lead them to make ‘sub-optimal’ contracts. even in the absence of regulation. 1983). the economists’ argument is that. management may and do reassure the providers of loan capital by agreeing to limit the ratio of total debts to total capital (‘gearing’) to a certain figure to limit the risk of default. economists argue that pressures from the ‘market for managers’ and the ‘market for corporate takeovers’ also enforces good accounting (Fama. Watts and Zimmerman. despite the growth in stock options. Similarly. 1976. investors will assume that management are self-interested and opportunistic and will therefore reduce the price they will pay for shares to compensate for this risk (Jensen and Meckling. which is now going into reverse. They point out that in an efficient labour and takeover markets the lifetime earnings of managers depends on their real performance in maximizing the value of the firm to investors and on their reputation for probity in accounting. In the absence of accurate information.23 Should we leave accounting to market forces? Economists argue that. without some reassurance from management. managers will voluntarily agree to contracts that reassure investors and creditors by mitigating the conflicts of interest. without safeguards.21 For example. without regulation requiring objective accounts even high-value managers have incentives to produce accounts that maximize their personal wealth at the 21 I leave aside here the problem for the economists’ story that management often do not have ‘significant’ stakes in the shares on the companies they run. All these arguments are circular. for personal gain rather than running it to maximize its value to shareholders. Hence. to reassure shareholders that they will not ‘shirk’ managers write contracts linking their pay to the rate of return on capital employed and by contracting to employ independent auditors (Watts and Zimmerman.
This is why I. and that it is the role of regulations and their enforcement to prevent this.24 expense of investors as. unlike many scholars of accounting. if there are no rules of accounting to tell managers. accountants and auditors what ‘good’ accounting is. “Unfortunately. Recognising this. which has long proclaimed its standards ‘the best’ because of their detailed comprehensiveness and their foundation in the asset-liability framework. particularly since the later 1990s: . that is. particularly in the USA. in reality. Everyone has heard of Enron and possibly of Worldcom. To explain the regulation of accounting we must recognise that ‘good’ accounting measures and reports real wealth creation. There are simply too many managers controlling too many complex operations for it to be practical to write contracts to control their behaviour. neither management nor the capital markets need ‘flexibility’ to write contracts and the standard-setter can brush off attempted ‘political’ interference and abandon the quixotic quest for ‘optimal’ standards that supposedly trade off competing sectional interests. to use action controls.416). but these were not isolated examples. 2003. while direct contracting for information production may be fine in principle. p. this seems unrealistic as no-one has shown us how the government or its standard-setter can design an economically ‘optimal’ system of regulation. suggesting that something may have fundamentally gone wrong with US GAAP. that all agents have strong economic incentives to distort this reality. The UK capital market at least seems to agree. believe we can write rules for accounting that generally give investors a ‘true and fair view’ of the companies in which they invest. it will not always work in practice… In many cases there are simply too many parties for contracts to be feasible” (Scott. in other words that the state or its standard-setting agent can achieve what the capital markets cannot! However. particularly as they approach retirement. particularly those who adopt an economics approach. so has the number of regulatory failures. how does the capital market know whether managers with high economic value have produced them? To make the judgement that accounts are ‘distorted’ implies that we know what ‘true and fair’ accounts look like. In reality. as I will argue below. However. In other words. if we know a ‘true and fair view’ when we see one. Where are we in the regulation of financial accounting? Although the number and complexity of the rules of accounting have dramatically increased in recent years. economists then explain the regulation that we see as a ‘costeffective’ contracting mechanism. investors are outsiders who know about the inside only what management tells them.
they continue to increase. companies filed 3. following the completion of its conceptual framework in the late 1980s.cfm/5591688/c_5590364?f=home_todayinfinance How can we explain the continued increase in US restatements? There are.25 Average for 1990-1997 49 1997 92 1998 91 1999 150 2000 156 2001 225 2002 250 Sources: Coffee. corrections and rewritings of what had claimed to be certified accounts. According to the study.5 percent the previous year. nearly double the previous year's mark of 650. Lewis and Co. This trend has continued sharply upwards: Restatements Surged in 2005. called ‘mark-to-market’ accounting. if we assume the increased oversight is effective and that managers have rational expectations. That compares with 4. One possible explanation of the continued erosion of quality in US financial reports is that it stems at least partly from the FASB’s growing emphasis on ‘fair value’ accounting in pursuit of the decision-relevance aim by making accounts report current market values.8.com March 03.22 22 Although the more vigorous regulatory oversight of accounting in the US following the Enron revelations may explain the increase in restatements in 2001 and 2002. The number of revisions of financial reports by publicly traded companies surged to a record 1. suddenly soared” (Coffee. Table 4: Numbers of US listed companies restating their accounts These ‘restatements’. Accountancy. that is. the upward trend began before Enron and increased regulation. and we require systematic research to uncover them. no doubt. we should expect US managers to curtail their adventures in creative and fraudulent accounting.195 companies — or 8.com/article.16.. Says Study The total number of 2005 restatements works out to one restatement for every 12 public companies. p. earnings restatements. public U.S. Increased regulation does not self-evidently explain the increases in 2004 and 2005 as. 1. are “evidence…that something led to a general erosion in the quality of [US] financial reporting during the late 1990s. 2006 Restatements are busting out all over. December 2002. . we can formulate hypotheses and test them against the evidence we have. 2002.295 in 2005. 2002. corporations — filed a restatement. Source: http://www.8). Stephen Taub.cfo. During this period. The tally is also more than triple the total in 2002. From 1997 through 2005. Until then. p.5 percent of all U. many causes. CFO. companies during the past nine years. Instead. a corporate-governance research firm. That's about 30 percent of all public U. the year the Sarbanes-Oxley Act (Sarbox) was passed.S. according to a new study by Glass.S. p. long a proxy for fraud.642 restatements to correct accounting errors.
In 2005. this legal requirement would disappear with the implementation of the EU’s eighth directive on auditing. 2002). UK investors’ reaction to the prospect of losing the legal right to demand a ‘true and fair view’. 2002).13).26 Some. it is clear that Enron based its accounting manipulations on ‘general principles’. a requirement already in IAS1: Presentation of Financial Statements (para. is a good example. However. Possible evidence of the corrosive influence on accounting regulation of the FASB’s asset-liability approach is the widely lamented fact that the work of the modern Anglo-Saxon standard setters has become a ‘political’ process where various interest groups lobby for particular accounting rules because they think they will better suit their ‘economic interests’ than alternatives under consideration. These companies wanted this rule so they could earn higher profits on government contracts that allowed them to price contracts to earn a minimum return on capital and. The eighth directive proposed introducing the US requirement for auditors to sign off the accounts as ‘fair in accordance with GAAP’. it is because the standard setters lack a robust conceptual framework that they have often found it difficult to resist capture by one powerful interest or another.g. although the IASB’s Framework makes the debatable claim to be consistent with requiring a ‘true and fair view’. Arguably. UK aerospace companies reputedly persuaded the UK’s Accounting Standards Steering Committee to write an accounting standard to let them and other similar industries account for their expenditures on research and development on their balance sheets as ‘assets’. Against this background –spectacular accounting failures in the US. and political interference in standard setting. Here is how the Financial Times reported the story: . or not to adopt standards they think will impose costs on them. UK investors demanded the retention of the true and fair view. consumer groups and others attempt to pressurise accounting standard setters to adopt standards that they believe are in their interests. For example. thereby boosting their prices and their profits (Hope and Gray. Several observers have noted that if the FASB had not accepted as a ‘general principle’ that assets are expected cash flows. blame the US problems on its apparently insatiable desire for ever more detailed and complex rules. those of asset-liability/fair value accounting (Bryer. UK investors realised that. as companies began to implement IFRSs and the EU began to change legal regulations to accommodate them. industries. but now on a global scale – it is perhaps not surprising that there appears to have been resurgence in support for the traditional view of accounting and the need for its continued legal regulation. and to allow a court to test the accounts. companies. and the UK government conceded. particularly the IASB and the EU. by increasing their capital. Benson and Hartgraves. and used it to justify regulations allowing ‘mark-to-market’ accounting. In response. Enron could not have played its accounting tricks (e. rather than a true and fair view.. and argue that statements based on ‘general principles’ would be better. 1982). There are many other examples from the US and the UK and elsewhere in the Anglo-Saxon world where the accounting profession.
which promotes accountability of directors – who are responsible for preparing true and fair accounts – to shareholders. In other words. is very different from that of the UK. in August 2005 the UK’s Financial Reporting Council confirmed that the true and fair view would remain the cornerstone of UK company law. as opposed to the UK stewardship model. the audit function is still not sufficiently valued by investors and analysts. is that Europe would move to much narrower US-style compliance-based audits in which priority was given to the rules over robust audit judgements. 22 The European Union's adoption of international accounting standards has not been a happy process. Thank goodness two of the biggest institutions are prepared to take a stand for quality audits. More trouble could be brewing as a result of the EU's plans to adopt the International Auditing Assurance Standards Board's international standards of auditing (ISAs) under the eighth company law directive. p. was more of a let-out clause for rogues than an escape from the tick-box syndrome. In November 2005. where the auditor states whether the accounts give "a true and fair view of the state of affairs" in favour of the more limited US format saying whether accounts "present fairly the financial position" in accordance with generally accepted accounting principles. which heavily influences ISAs. The true and fair "override" whereby a departure from accounting standards can be justified on grounds of substance over form would also go. the argument went. but I am instinctively uneasy about abandoning "true and fair" and not convinced that the override is redundant. it is rarely used and. In an excellent new paper for the Institute of Chartered Accountants. US reporting and auditing is about promoting market efficiency. the government published the Company Law Reform Bill which requires that “the directors must not approve accounts…unless they are satisfied that they give a true and fair view of the assets. The arguments here are complex. What is clear is that the US approach to accountancy and audit. 11 July 2005.366 (1)). This would kill off the UK-style audit report. Instead of asking whether the accounts show how efficiently a company is run on its capital resources. financial position and profit or loss of the company” (para. The moral of this story is that there is all to play for in determining the direction of global accounting. . Despite the shock of Enron and all that. Tim Bush of fund manager Hermes points out that the US regulatory reporting model created by the 1933 Securities Act is different from European regimes because of the constitutional restraints imposed by the US federal system. JOHN PLENDER. a true and fair verdict requires compliance with accounting standards. so the difference between the US and UK form of words is far less than it seems. Under existing case law.27 Battle for truth and fairness in European accounts Hermes and Morley take up cudgels JOHN PLENDER ON MONDAY Financial Times (London). expressed in the FT last week by Keith Jones. they argued. As for the true and fair override. In response to these concerns. The fear in some large UK institutions. chief executive officer of Morley Fund Management. liabilities. It is worrying that the British have already adopted ISAs and the EU is set to adopt them on the basis of so little public debate. the federal model asks whether the accounts are consistent in showing what a company may be worth when a share is exchanged. At the annual conference of the International Corporate Governance Network last week. some of the accountancy profession's heavyweights counter-attacked.
financial instruments. 3. Others will argue for an economics approach. Which view will ultimately command global acceptance is a story future historians will tell. 2. the IASB has agreed to make no new initiatives until 2009. provisions. for the first time in history. The current direction in which global regulation is heading is ‘decision-relevance’. Why might the study of accounting history be useful today? What do you think should be the aim of financial reporting? Should society regulate financial reporting? How can we explain the problems the US has experienced with accounting regulation since the 1990s? 5. I have argued that. Whatever view you choose. It has been my aim to introduce you to the important global debate in progress on the regulation of financial reporting. leases and pension accounting) to increase the use of fair values in accounts. based on the view that accounting is a branch of economics. Ultimately. and with those practitioners and non-US regulators who increasingly resist its implications. having listened to the various views and studied the issues and the evidence. I hope that I have convinced you at this early stage in your studies that financial accounting is important and interesting. business combinations.28 There is evidence of growing global opposition to FASB/IASB’s proposals for revising current IFRSs in the name of convergence with US GAAP. intangible assets. I agree with those accounting academics who increasingly question whether we can understand or regulate accounting using economics. However. the FASB and IASB are still considering and discussing proposals for radical reforms of several major IFRSs (for example. however. I have argued for a particular view based on my historical approach. In the face of this opposition. and. Questions for discussion: 1. proposals largely based on the asset-liability/fair value accounting approach. others for a legal and/or social approach or approaches. Concluding comments This is an exciting time to study financial reporting because there is much to discuss and much to play for. we face a choice in regulating financial reporting between the aims of accountability or decision relevance. the choice is yours. and is proposing to revise its conceptual framework to permit them. the debate embraces the whole world. revenue recognition. are involved in the midst of accounting history in the making and we owe it to global society to debate fully the nature of accounting and its regulation. Enjoy the rest of your studies. At Warwick. you have the opportunity to study accounting and its role in our social and economic system and to join in this debate. Is accounting a branch of economics? . I have made clear that I think this stance is fundamentally wrong. We. 4.
effective 1 January 1997. Superseded in 1989 by IAS 27 and IAS 28. all of which were issued or revised in 1998. and 38.7. IAS 4 Depreciation Accounting Withdrawn in 1999. and Errors IAS 9 Accounting for Research and Development Activities Superseded by IAS 38 effective 1. IAS 5 Information to Be Disclosed in Financial Statements Originally issued October 1976. which was withdrawn December 2003 IAS 7 Cash flow Statements IAS 8 Accounting Policies. IAS 6 Accounting Responses to Changing Prices Superseded by IAS 15. 22.99 IAS 10 Events After the Balance Sheet Date IAS 11 Construction Contracts . Superseded by IAS 1 in 1997. effective 1 Jan 1977. Changes in Accounting Estimates. replaced by IAS 16.29 Appendix: Current IFRSs International Financial Reporting Standards Preface to International Financial Reporting Standards IFRS 1 First-time Adoption of International Financial Reporting Standards IFRS 2 Share-based Payment IFRS 3 Business Combinations IFRS 4 Insurance Contracts IFRS 5 Non-current Assets Held for Sale and Discontinued Operations IFRS 6 Exploration for and Evaluation of Mineral Assets IFRS 7 Financial Instruments: Disclosures Framework for the Preparation and Presentation of Financial Statements Framework for the Preparation and Presentation of Financial Statements International Accounting Standards IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 3 Consolidated Financial Statements Originally issued 1976.
IAS 14 Segment Reporting IAS 15 Information Reflecting the Effects of Changing Prices Withdrawn December 2003 IAS 16 Property. IAS 31 Interests In Joint Ventures IAS 32 Financial Instruments: Disclosure and Presentation Disclosure provisions superseded by IFRS 7 effective 2007. IAS 26 Accounting and Reporting by Retirement Benefit Plans IAS 27 Consolidated and Separate Financial Statements IAS 28 Investments in Associates IAS 29 Financial Reporting in Hyperinflationary Economies IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions Superseded by IFRS 7 effective 2007.30 IAS 12 Income Taxes IAS 13 Presentation of Current Assets and Current Liabilities Superseded by IAS 1. IAS 33 Earnings Per Share IAS 34 Interim Financial Reporting IAS 35 Discontinuing Operations Superseded by IFRS 5 effective 2005. . IAS 23 Borrowing Costs IAS 24 Related Party Disclosures IAS 25 Accounting for Investments Superseded by IAS 39 and IAS 40 effective 2001. Plant and Equipment IAS 17 Leases IAS 18 Revenue IAS 19 Employee Benefits IAS 20 Accounting for Government Grants and Disclosure of Government Assistance IAS 21 The Effects of Changes in Foreign Exchange Rates IAS 22 Business Combinations Superseded by IFRS 3 effective 31 March 2004.
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