Accounting theory 8

An overview of normative An overview of normative theories of accountingtheories of accounting

From From

Deegan, C. and Samkin, G., Deegan, C. and Samkin, G., Financial Accounting.Financial Accounting. McGraw-Hill Irwin, New YorkMcGraw-Hill Irwin, New York

&&Kam, V. (1990), Kam, V. (1990), Accounting Theory, Accounting Theory, 22ndnd edition, John edition, John

Wiley & Sons, NY.Wiley & Sons, NY.

Prepared By: Dewan Mahboob HossainPrepared By: Dewan Mahboob HossainAssistant Professor; Department of Assistant Professor; Department of Accounting & Information Systems; Accounting & Information Systems;

University of Dhaka; Dhaka; Bangladesh. University of Dhaka; Dhaka; Bangladesh.

Prepared By: Dewan Mahboob Hossain

2

Conventional Accounting: Basic Conventional Accounting: Basic Concepts Concepts

Conventional objectives of accounting: Conventional objectives of accounting: With the growth of corporations, accounting information With the growth of corporations, accounting information has taken greater significance. has taken greater significance. Why? Separation of ownership and managers. Why? Separation of ownership and managers. Absentee owners do not possess first hand knowledge Absentee owners do not possess first hand knowledge of operations and conditions of the firm, and therefore, of operations and conditions of the firm, and therefore, must depend heavily on accounting reports for must depend heavily on accounting reports for information. information. Also owners and creditors supply the funds to the Also owners and creditors supply the funds to the business entities, they are considered ‘outsiders’ and business entities, they are considered ‘outsiders’ and have no access to the records and accounts of the have no access to the records and accounts of the entity. entity. Accountability, therefore, is crucial. Accountability, therefore, is crucial. So, conventional accounting objective: focus on the So, conventional accounting objective: focus on the stewardship function of managers. stewardship function of managers.


3

Objectives of accountingObjectives of accounting

Paton and Littleton (1940):Paton and Littleton (1940):

““Corporation reports should rest Corporation reports should rest upon the assumption that a upon the assumption that a fiduciary management is reporting fiduciary management is reporting to the absentee investors who to the absentee investors who have no independent means of have no independent means of learning how their representatives learning how their representatives are discharging responsibilities”. are discharging responsibilities”.


4

Normative accounting theoriesNormative accounting theories

Accounting theories that seek to Accounting theories that seek to guide individuals in selecting the guide individuals in selecting the most appropriate accounting most appropriate accounting policies for given sets of policies for given sets of circumstances.circumstances.

Conceptual framework- example of Conceptual framework- example of normative theory.normative theory.


5

Normative theoriesNormative theories Normative theories are sometimes referred to as Normative theories are sometimes referred to as

prescriptive theories as they seek to inform others prescriptive theories as they seek to inform others about what practices should be followed to achieve about what practices should be followed to achieve particular outcomes. particular outcomes.

For example, a normative accounting theory might For example, a normative accounting theory might prescribe how assets should be valued for financial prescribe how assets should be valued for financial statement purposes. statement purposes.

The prescriptions about what should be done might The prescriptions about what should be done might represent significant departure from current accounting represent significant departure from current accounting practice. practice.

For example, for many years, Raymond chambers For example, for many years, Raymond chambers promoted a theory prescribing that assets should be promoted a theory prescribing that assets should be valued at market value – at a time when entities were valued at market value – at a time when entities were predominantly using historical cost.predominantly using historical cost.


6

Normative accounting theoriesNormative accounting theories

Dominant normative theories:Dominant normative theories:

1.1. Historical Cost accounting Historical Cost accounting

2.2. Current cost accounting;Current cost accounting;

3.3. Exit-price accounting; andExit-price accounting; and

4.4. Deprival-value accounting. Deprival-value accounting.


7

Historical cost accounting: Why Historical cost accounting: Why important? important?

1.1. Historical cost is relevant in decision making. Historical cost is relevant in decision making. Cost to management is an investment, a Cost to management is an investment, a calculated risk. So it should be the basis of calculated risk. So it should be the basis of judging. As managers make decisions judging. As managers make decisions concerning future commitments, they need concerning future commitments, they need data on past transactions. data on past transactions.

2.2. Under historical cost accounting, a recording Under historical cost accounting, a recording of the actual transactions is made and of the actual transactions is made and therefore, there is a supporting record of the therefore, there is a supporting record of the figures of the financial statements. figures of the financial statements.


8

Historical cost accounting: Why Historical cost accounting: Why important? (contd….)important? (contd….)

3. Throughout history, F/S based on 3. Throughout history, F/S based on historical cost have been found to historical cost have been found to be useful. If those who make be useful. If those who make management and investment management and investment decisions had not found financial decisions had not found financial reports based on historical cost reports based on historical cost useful over the years, changes in useful over the years, changes in accounting would long since have accounting would long since have been made. been made.


9


4. Accountants must guard the integrity of 4. Accountants must guard the integrity of their data against internal their data against internal modifications. Historical cost is less modifications. Historical cost is less subject to manipulation. subject to manipulation.

5. The best understood concept of profit is 5. The best understood concept of profit is the excess of selling price over the excess of selling price over historical cost. People understand this historical cost. People understand this basic notion of business success. basic notion of business success. Historical cost is based on this idea of Historical cost is based on this idea of profit. profit.


10


6. Changes in the market prices can 6. Changes in the market prices can be disclosed as supplementary be disclosed as supplementary data. Supplementary data on data. Supplementary data on current prices are a practical and current prices are a practical and sufficient way of reporting. So, no sufficient way of reporting. So, no need to change from historical cost need to change from historical cost accounting. accounting.


11

Historical cost accounting: Historical cost accounting: limitations limitations

1.1. The role of accounting is to meet the needs The role of accounting is to meet the needs of the users. The needs of users call for a of the users. The needs of users call for a forward looking position rather than a forward looking position rather than a preoccupation with the past. Investors are preoccupation with the past. Investors are also interested in knowing about the also interested in knowing about the increases and decreases in the value of their increases and decreases in the value of their investments as represented by the net investments as represented by the net assets of the company. assets of the company.

2.2. Historical cost overstates income in a time of Historical cost overstates income in a time of rising prices and could lead to the unwitting rising prices and could lead to the unwitting reduction of capital. reduction of capital.


12

Historical cost accounting: Historical cost accounting: limitationslimitations

3. One of the justifications for the 3. One of the justifications for the utilization of historical cost is the going utilization of historical cost is the going concern assumption. The high rate of concern assumption. The high rate of business failures would make it difficult business failures would make it difficult to build and evidential case for a to build and evidential case for a projection of continuity. No business has projection of continuity. No business has ever continued ‘indefinitely’. Thus, it ever continued ‘indefinitely’. Thus, it would more reasonable to assume would more reasonable to assume cessation instead of continuity. cessation instead of continuity.


13

Current cost accountingCurrent cost accounting

A system of accounting that measures A system of accounting that measures the value of their goods and services in the value of their goods and services in terms of their current costs.terms of their current costs.

The general aim of this theory is to The general aim of this theory is to provide a calculation of income, that, provide a calculation of income, that, after adjusting for changing prices, after adjusting for changing prices, could be withdrawn from the entity could be withdrawn from the entity while leaving the physical capital of the while leaving the physical capital of the entity intact. entity intact.

Such measures of income are often Such measures of income are often promoted as true measures of income.promoted as true measures of income.


14

Current cost accounting Current cost accounting illustratedillustrated

Suppose a company started the period Suppose a company started the period with assets of $50,000. with assets of $50,000.

Assume that there are no liabilities, so Assume that there are no liabilities, so that equity also equals $50,000. that equity also equals $50,000.

During the period, the business sells all of During the period, the business sells all of its assets for $70,000. its assets for $70,000.

Under historical cost accounting the profit Under historical cost accounting the profit would be $20,000 and the closing would be $20,000 and the closing equity would be $70,000, which would equity would be $70,000, which would be matched by assets of $70,000 in the be matched by assets of $70,000 in the form of cash.form of cash.


15


If the $20,000 was withdrawn in If the $20,000 was withdrawn in the form of dividends, under the form of dividends, under historical cost accounting the historical cost accounting the owner’s equity in the business owner’s equity in the business would remain the same as it was would remain the same as it was at the beginning of the period.at the beginning of the period.


16


If current cost accounting were adopted, If current cost accounting were adopted, the profit would not necessarily the the profit would not necessarily the same. same.

If because of rising prices, it cost If because of rising prices, it cost $60,000 to replace the assets that were $60,000 to replace the assets that were sold, under current cost accounting, the sold, under current cost accounting, the profit would be $10,000. profit would be $10,000.

This is because $60,000 would need to This is because $60,000 would need to be retained to keep the physical capital be retained to keep the physical capital of the firm intact. of the firm intact.


17


The maintenance of the firm’s physical The maintenance of the firm’s physical capital or the operating capacity is the capital or the operating capacity is the central goal of current cost accounting.central goal of current cost accounting.

Proponents of this normative theory Proponents of this normative theory argue that by valuing assets at their argue that by valuing assets at their current cost a truer measure of profit is current cost a truer measure of profit is provided than is reflected by historical provided than is reflected by historical cost accounting. cost accounting.


18


A criticism of current cost A criticism of current cost accounting is that it introduces an accounting is that it introduces an unacceptable amount of unacceptable amount of subjectivity into accounting subjectivity into accounting process as some assets will not process as some assets will not have a readily accessible current have a readily accessible current cost. cost.


19

Exit price accountingExit price accounting

Proposed by Australian researcher Raymond Proposed by Australian researcher Raymond Chambers.Chambers.

He labeled this theory as Continuously He labeled this theory as Continuously Contemporary Accounting (CoCoA).Contemporary Accounting (CoCoA).

This theory was principally developed between This theory was principally developed between 1955 and 1965. 1955 and 1965.

CoCoA: Normative theory that proposes an CoCoA: Normative theory that proposes an approach to accounting that relies on approach to accounting that relies on measuring the exit prices of the entity’s assets measuring the exit prices of the entity’s assets and liabilities.and liabilities.


20

Exit price accounting Exit price accounting (contd..)(contd..)

This is a normative theory of This is a normative theory of accounting that prescribes that accounting that prescribes that assets should be valued on the assets should be valued on the basis of exit prices and that basis of exit prices and that financial statements should financial statements should function to inform about function to inform about organization’s organization’s capacity to adaptcapacity to adapt..


21


Key assumptions of CoCoA:Key assumptions of CoCoA:Firms exist to increase the wealth of their Firms exist to increase the wealth of their owners;owners;Successful operations depend on the Successful operations depend on the organization’s ability to adapt to changing organization’s ability to adapt to changing circumstances. circumstances. The capacity to adapt will be best reflected by The capacity to adapt will be best reflected by the monetary value of the assets, liabilities the monetary value of the assets, liabilities and equities at balance date where the and equities at balance date where the monetary value is based on the current exit or monetary value is based on the current exit or selling prices of the organization’s resources.selling prices of the organization’s resources.


22

Capacity to adaptCapacity to adapt

A measure, promoted by Chambers, A measure, promoted by Chambers, tied to the cash that could be obtained tied to the cash that could be obtained if an entity sold its assets. if an entity sold its assets.

A central objective of accounting should A central objective of accounting should be to provide information about an be to provide information about an entity’s ability to adapt to changing entity’s ability to adapt to changing circumstances - the capacity to adapt.circumstances - the capacity to adapt.


23


Chamber’s theory advocated that an entity’s Chamber’s theory advocated that an entity’s balance sheet should base the value of all balance sheet should base the value of all assets on their respective selling prices. assets on their respective selling prices.

If an asset was not readily saleable (and If an asset was not readily saleable (and therefore did not have a selling price), it did therefore did not have a selling price), it did not contribute to an entity’s capacity to adapt not contribute to an entity’s capacity to adapt to changing circumstances. to changing circumstances.

Further, the profit for a period should also be Further, the profit for a period should also be tied to changes in the current exit prices of the tied to changes in the current exit prices of the organization’s assets, and such as, profit as a organization’s assets, and such as, profit as a measure should reflect changes in an measure should reflect changes in an organizations’ capacity to adapt. organizations’ capacity to adapt.


24


CoCoA is often referred to as a ‘decision CoCoA is often referred to as a ‘decision usefulness approach’ to accounting usefulness approach’ to accounting theory development. theory development.

According to CoCoA, organizations that According to CoCoA, organizations that cannot adapt are considered relatively cannot adapt are considered relatively more likely to fail. more likely to fail.

The more liquid or saleable an The more liquid or saleable an organization’s assets, the greater was organization’s assets, the greater was the perceived capacity to adapt. the perceived capacity to adapt.


25


Chamber recommended that all assets should Chamber recommended that all assets should be recorded at their current cash equivalent.be recorded at their current cash equivalent.

Current cash equivalents were represented by Current cash equivalents were represented by the amounts that would be expected to be the amounts that would be expected to be generated by selling the assets. generated by selling the assets.

The balance sheet should clearly reflect the The balance sheet should clearly reflect the expected net selling prices of all the entity’s expected net selling prices of all the entity’s assets – net selling prices would acknowledge assets – net selling prices would acknowledge any costs that would be incurred in making a any costs that would be incurred in making a sale.sale.


26


Adaptive capital would be represented by the Adaptive capital would be represented by the total net selling prices of the various assets, total net selling prices of the various assets, less the amount of liabilities. less the amount of liabilities.

Profit would reflect the change in the Profit would reflect the change in the organization’s capacity to adapt that had organization’s capacity to adapt that had occurred since the beginning of the period. occurred since the beginning of the period.

Because the valuation of assets will be done Because the valuation of assets will be done according to their current cash equivalents, according to their current cash equivalents, depreciation expensedepreciation expense would not be reflected in would not be reflected in CoCoA.CoCoA.


27

Criticism of exit price Criticism of exit price accounting accounting

It does not consider the ‘value in use’ of It does not consider the ‘value in use’ of assets. If an asset is retained, rather assets. If an asset is retained, rather than sold, its value in use is likely to be than sold, its value in use is likely to be greater than it current exit price. greater than it current exit price.

In valuing assets at their perceived In valuing assets at their perceived sales values, there is an implication that sales values, there is an implication that the firm intends to liquidate its assets.the firm intends to liquidate its assets.


28

Deprival-value accountingDeprival-value accounting

Recommended by the UK Recommended by the UK Sandilands committee in 1975. Sandilands committee in 1975.

It represents the amount of loss It represents the amount of loss that might be incurred by an entity that might be incurred by an entity if it was deprived of the use of an if it was deprived of the use of an asset and the associated economic asset and the associated economic benefits the asset generates. benefits the asset generates.


29

Deprival-value accountingDeprival-value accounting

Criticisms:Criticisms:

1.1. Different valuation bases in one Different valuation bases in one set of F/Sset of F/S

2.2. Valuation procedure would be Valuation procedure would be costly and time consumingcostly and time consuming

3.3. It might not clear that which It might not clear that which method will be used for which method will be used for which assets.assets.