Accounting theory 4

Financial Accounting TheoryFinancial Accounting TheoryCraig Deegan 3rd edition Chapter 2: The Financial Reporting Environment

Prepared By: Dewan Mahboob Hossain; University of Dhaka. Prepared By: Dewan Mahboob Hossain; University of Dhaka.

Prepared by: Dewan Mahboob Hossain Page 2

Users of accounting information Users of accounting information

Diverse users:

- Present and potential investors

- Lenders

- Suppliers

- Employees

- Customers

- Governments

- The local community

- Parties performing review or oversight function

- The media


Statements Statements

The balance sheet (statement of financial position)

The profit and loss account (statement of comprehensive income)

The statement of cash flows

The statement of changes in equity

The supporting notes.


Users’ understanding and knowledgeUsers’ understanding and knowledge

Ideally, users of financial statements should have a sound working knowledge of the various accounting standards and other regulations, because without such knowledge it will be nearly impossible to interpret what the statements are actually reflecting.

Though many users of financial statements have a very poor working knowledge of accounting.

IASB:

“..users are assumed to have a reasonable knowledge of business and economic activities and accounting and willingness to study the information with reasonable diligence”.


Users’ knowledgeUsers’ knowledge

Unfortunately, many readers of financial statements have tended to consider figures such as ‘profits’ or ‘assets’ as being ‘hard’ objective numbers that are not subject to professional judgment.

The accounting results or numbers will be heavily dependent on particular accounting methods chosen as well as on various professional judgment made.


Highlighting points in the annual reportsHighlighting points in the annual reports

Many companies provide summary highlight statements at the beginning of their annual reports.

By highlighting the particular information, management could be deemed to be helping the less literate readers to focus on the important results.


Information rights of the external usersInformation rights of the external users

Financial accounting tends to be heavily regulated in most countries.

Most countries have a multitude of financial accounting standards that are often given the force of law.

It is the information rights of the outsiders who are not involved in the day-to-day management of an entity that must be protected.

It is arguably important that certain rules put in place to govern how the information should be compiled.

To protect the interests of parties external to the firm, some regulation relating to financial accounting information is required (pro-regulation perspective)


Regulation Regulation

The regulation of financial accounting in most capital market dominated industries (the USA, the UK, Ireland, Australia and Canada) generally commenced in the 20th century.

Regulation mainly came because of the separation of ownership and management.


The rationale for regulating financial accounting practiceThe rationale for regulating financial accounting practice

Arguments for regulation:

1. Market for information are not efficient. Without regulation a sub-optimal amount of information will be produced.

2. Proponents of free-market (anti-regulation) say that capital market on an average is efficient. Such ‘on average’ arguments ignore the rights of individual investors. People can loose their savings in an unregulated market.

3. Parties with limited power will generally be unable to secure information about the organization.

4. Investors need protection from fraudulent organizations that may produce misleading information.

5. Regulation emphasizes on uniformity and thus on comparability.


Arguments against regulationArguments against regulation

1. Accounting information is like other goods. Users will be prepared to pay for it to the extent it has use. This will lead to optimal supply.

2. Capital market requires information. Any organization that fails to provide information will be punished by the market.

3. Users do not bear the cost of production of information. Regulation will lead to over supply of information. Users will overstate the need.

4. Regulation restricts the accounting methods that may be used. Organizations will be prohibited from using accounting methods that they believe most efficiently reflect the particular performance and position.


Public interest theoryPublic interest theory

It proposes that regulation be introduced to protect the public.

The regulatory body/ government is a neutral arbiter of the public interest and does not let its own self interest impact on rule making process.


Capture theoryCapture theory

Although regulation is often introduced to protect the public, the regulatory mechanisms are often captured to protect the interests of particular self interested groups within society, typically those whose activities are most affected by the regulation.

That is, the ‘regulated’ tend to capture the regulator.


Economic/private interest group theoryEconomic/private interest group theory

Governments are made up of individuals who are self-interested and will introduce regulations more likely to lead to their re-election.

In deciding on a particular regulation they will consider the impacts of the key voters and also on election campaign finances.


Accounting standards: should be set privately or publicly? Accounting standards: should be set privately or publicly?

Advocates of private sector accounting standard setting:

Accounting profession is best able to develop accounting standards because of the superior knowledge in accounting.

Advocates of public/government sector accounting standard setting:

Governments have greater enforcement powers, hence the rules of the governments are more likely to be followed.


Professional judgment in financial accountingProfessional judgment in financial accounting

While the accounting treatment of many transactions and events is regulated, a great deal of accounting treatment pertaining to other transactions and events is unregulated.

Even when particular regulations are in place, for example that buildings must be depreciated, there is still scope to select the useful life of the building and the residual value.

Many such judgments must be made.

At the core of the accounting process is an expectation that accountants should be objective and free from bias when performing their duties.

The information being generated represent faithfully the underlying transactions and events and it should be neutral and complete.


How powerful is the accountant? How powerful is the accountant?

Although much accounting work requires judgment, imagination and creativity, bookkeeping is boring and routine.

Historically accountants may have been willing to accept a personally disappearing, often laughable image.

Common idea:

“……..a very dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated….”


So…why powerful? So…why powerful?

The outputs of the accounting process impacts on many decisions. The judgment of the accountant can directly impact on various parties.

Accounting information might motivate the people to take various actions that might be advantageous and disadvantageous to the organization.