Week 13

BAO5535 Issues in contemporary Accounting

Week 1Introduction

BAO5535 Issues in Contemporary Accounting

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Welcome to BAO5535 Issues in contemporary accounting

Subject coordinators and lecturers:Ms Helen YangContact: [email protected] (preferred)Phone: 03-9919 5265Office: G3.36 Footscray Park CampusProfessor Colin ClarkPhone 03-9919 1565Office: C10.16 City Flinders Campus

BAO5535 Issues in Contemporary Accounting

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What we are going to learn?

• Refer to your Unit of Study Guide for further details

BAO5535 Issues in Contemporary Accounting

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What Assessment is there?

• Refer to Unit Guide

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How to start with this subject?

• Prescribed textbooksDeegan, C, 2009, Financial Accounting Theory, 3rd editionDeegan, C, 2010, Australian Financial Accounting, 6th edition

Accounting Handbook 2011 available online at www.aasb.com.au

• Subject website at Blackboard (Webct)• Seminars

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How to successfully complete the course?

• Do your homework– Attempt weekly activities before each class

• Attend seminars• Be an Active learner, i.e. participating in class

discussions and online discussions• Don’t forget to ask for help

– Student learning service– Your lecturers– Librarians – Student administrators– Your peers

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Any questions so far?

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“A long journey starts from the very first step”, I wish you a challenging but a rewarding semester

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Topic 1 Professional ethics and theories in accounting – Learning outcomes

– Be able to explain the difference between deductive and inductive approaches to theory development

– Be able to explain ethical theories and their implication to accounting practice

– Be able to apply APES 110 Code of ethics for professional accountants to decision-making process

– Be aware of development of accounting theories– Appreciate that there is no single unified theory of

accounting– Be able to critically evaluate difference theories in

accounting

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The role of professional judgement in financial reporting

• While the accounting treatment of many transactions and events is regulated, many others are unregulated

• Accountants expected to be objective and free from bias (although, as we will see, various theories of accounting question whether accountants will allow objectivity to determine the selection of accounting methods)

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The role of professional judgement in financial reporting (cont.)

• Information generated should faithfully represent underlying transactions and be neutral and verifiable

• The consideration of economic and social implications of possible accounting standards implies bias in their development and implementation– standard setters face a ‘dilemma which requires a

delicate balancing of accounting and non-accounting variables’ (Zeff 1978, p. 62)

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The power of accountants

• Output of the accounting process impacts many decisions about wealth transfers so the judgement of accountants affect various parties’ wealth

• The provision of accounting information leads to power of knowledge for others

• Accountants can give legitimacy to organisations which may not otherwise be deemed legitimate (e.g. emphasising profits)– e.g. profits legitimise Commonwealth Bank (see

Accounting Headline 2.1, p. 45)

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The power of accountants (cont.)

• Profit measures ignore many social and environmental externalities caused by the reporting entity– e.g. major adverse social consequences of a cigarette

manufacturer

• Accounting does not objectively reflect a particular entity—it creates it

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Ethical theories and Ethical decision making principles

• Consequence-based (teleological)– Utilitarianism

– Egoism • Duty-based (deontological)

– Fairness

– Justice • Virtue-based (ontological)

– Aristotle virtue ethics

– Confucius virtue ethics

Please refer to: An introduction to Business Ethics, 2nd Edition, Des Jardins, 2006, McGrall Hill, Chapter 2: Ethical Theory and Business for further details

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Code of ethics for Professional accountants (Cont)

Refer to APES 110 Code of Ethics for Professional Accountants

Threats and Safeguards

Para 100.10 of circumstances. Many threats fall into the following categories:

(a) Self-interest threats

(b) Self-review threats

(c) Advocacy threats

(d) Familiarity threats

(e) Intimidation threats,

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Code of ethics for Professional accountants – Fundamental principles

Refer to APES 110 Code of Ethics for Professional Accountants Para.100.4 A Member is required to comply with the following

fundamental principles:

(a) Integrity

(b) Objectivity

(c) Professional competence and due care

(d) Confidentiality

(e) Professional behaviourNote: Please refer to Section 110 –150 of APES 110 for further details

Also refer to APES 205 Conformity with accounting standards (effective on 1 July 2008), available at

http://www.apesb.org.au/Document/Issued_Standards/APES%20205%20Conformity%20with%20Accounting%20Standards_1.pdf

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Application of ethical principles to ethical issues in business – common avoidance of professional responsibility

• Listen to your heart or to your head?• It is not my problem!• Everybody else does it!• It is not ‘cooking the book’ , it is creative accounting method! • It does not breach the law when people are sacked!• I am just doing what I have been told!• Greed is good!??

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Class activityApplication of ethical principles to ethical issues in business

• Ethical dilemma decision making tree.doc• Harris accountant jailed for $36 m fraud” Courier-

mail 27 June 2002, cited in Deegan (2009, p.276)

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What is a theory?

• ‘A coherent set of hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’ (Hendriksen 1970, p. 1)

• Based on logical (coherent) reasoning, and not ad hoc in nature

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How theories are developed

Inductive method (Bottom up)– Conducts empirical studies and form theory

Deductive method (Top down)- Develop hypothesis and test them

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Accounting theories

• Accounting is a human activity• It would seem illogical to study financial accounting

(for example, the accounting standards) without also studying accounting theory

• Theories of accounting consider– people’s behaviour with respect to accounting information– people’s needs for accounting information– why people within organisations elect to supply particular

information

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Why study accounting theories

• Learning the rules of financial accounting without considering the implications of accounting information is not recommended

• Studying theories of accounting exposes students to various issues, including– how elements of accounting should be measured– motivation for organisations to provide certain types of

accounting information

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Why study accounting theories (cont.)

– motivation for individuals to support or lobby regulators for some accounting methods in preference to others

– the implications for organisations and their stakeholders if one accounting method is chosen or mandated in preference to others

– how and why the capital markets react to particular information

– whether there is a ‘true measure’ of income

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Examples of uses of accounting theories

• Theories might– prescribe how assets should be valued– predict why managers will choose particular accounting

methods– explain how an individual’s cultural background affects

accounting information provided– prescribe what accounting information should be

provided to particular classes of stakeholders– predict that the relative power of a stakeholder group will

affect the accounting information it receives

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Overview of theories of accounting

• Many theories of financial accounting exist• No universally accepted theory of accounting

– different perspectives about the central objective, role and scope of financial accounting

• No universally accepted perspective about the role of accounting theory– different researchers have different perspectives of the

role of accounting theory– a researcher’s own values will influence which theory he

or she elects to embrace

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Overview of accounting theories development

• General scientific period (1920s-60s) – Inductive method, explanation of practice and development of

explanatory framework

• Normative period (1960s-70s)– Prescriptive approach

• Empirical period (mid to late 1970s – 2000)– Rational economic persons assumption, a framework to explain

and predict behaviour

• Mixed development (2000 – present)– Positive and behavioural theories

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General scientific period

• Relied upon the process of induction– development of ideas or theories through observation

• 1920s to 1960s theories developed from observing what accountants did in practice– codified as doctrines or conventions of accounting

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Criticisms of inductive method

• ‘… concentrates on the status quo, is reactionary in attitude and cannot provide a basis upon which current practice may be evaluated or from which future improvements may be deduced’ (Gray, Owen & Maunders 1987, p. 66)

• Assumes what is done by the majority is the most appropriate practice

• Perspective of accounting Darwinism

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Example of inductive approach to theory development

• Grady (1965) undertook research commissioned by the American Institute of Certified Public Accountants (AICPA)

• Formed the basis of APB Statement No. 4 ‘Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises’– reflected generally accepted accounting principles at the

time

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Normative Period —1960s and 1970s

• Sought to prescribe particular accounting practices– known as normative theories

• Not driven by existing practices, and hence not typically inductive in nature (that is, not based on observation)

• Rather, were deductive in nature and, based on logical argument, sought to develop new methods of accounting

• Theories critical of historical cost accounting• Sought to provide improved approaches to asset

valuation in a time of widespread inflation

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Normative theories

• Based on what the researcher believes should occur in particular circumstances– not based on observation

• Example of normative theory– Continuously Contemporary Accounting (CoCoA) by

Raymond Chambers

• Should not be evaluated on whether they reflect actual accounting practice

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Classifications of normative theories

• True income theories– make assumptions about the role of accounting then

seek to provide a single ‘best measure’ of profits

• Decision usefulness theories– ascribe a particular type of information for particular

classes of users on the basis of assumed decision-making needs

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Decision usefulness theories

• Decision-makers emphasis– undertaking research that seeks to ask decision makers

what information they want– knowledge then used to make prescriptions about what

information should be supplied

• Decision-models emphasis– develops models based on the researchers’ perceptions

about what is necessary for efficient decision making

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Criticism of normative theories—an example

• Normative theories have been criticised for lack of empirical observation– based on personal opinion about what should happen– positive theorists argue that they would prefer to provide

information about expected implications of actions and let others decide themselves what they should do

– positive theorists also make value judgements

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Example of prescriptive theory

• 1961 and 1962 studies by Moonitz, and Sprouse and Moonitz commissioned by the Accounting Research Division of the AICPA

• Authors proposed that accounting measurement systems be changed from historical cost to a system based on current values

• Such research should not be evaluated by reviewing current practice

• Not supported by AICPA as too radically different from current practice

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Positivistic Period — mid to late 1970s - 2000

• Research aimed at explaining and predicting accounting practice rather than prescribing particular practices

• Known as positive theories

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Positive theories

• Seek to predict and explain particular phenomena• Begins with assumption(s), and through logical

deduction enables prediction(s) to be made• If predictions are sufficiently accurate when tested

against observations of reality, they are regarded as having provided explanation of why things are as they are

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Positive theories (cont.)

• Positive Accounting Theory– developed by Watts and Zimmerman– seeks to predict and explain why accountants elect to

adopt particular accounting methods in preference to others

– based on ‘rational economic person’ assumption individuals motivated by self-interest tied to wealth

maximisation

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Criticism of positive theories—an example

• Positive theories of accounting have been criticised for not providing prescription

• The decision not to provide prescription could alienate academic accountants from their counterparts within the profession

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Evaluating theories of accounting

• Students should consider the merit of the argument and the research methods employed

• Some researchers may adopt strategies (such as overt condemnation of alternative theories) to support their own research and theoretical perspective

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Evaluation of theories—the position taken in this book

• Theories of accounting are only abstractions of reality

• The choice of one theory in preference to another is based on value judgements

• Cannot expect to provide perfect explanations or predictions of human behaviour or assess what types on information users actually need

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Evaluating theories—logic and evidence

• When evaluating theories, need to consider– whether the argument supporting the theory is logical– whether you agree with the central assumptions of the

theory– whether you accept any supporting evidence provided

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Logical deduction

• Acceptance of an argument must be based on the accuracy of the premises– an argument is logical to the extent that if the premises

on which it is based are true, then the conclusion will be true

– Compare the following statements All cats have fur and four legs Tom has fur and four legs Therefore Tom is a cat And All cats have fur and four legs, Tom is a cat, therefore

Tom has fur and four legs

• We do not need to refer to ‘real world’ observations to determine the logic of an argument

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The role of assumptions

• Even though an argument is logical we might only accept the argument if we accept any critical assumptions being made– if we reject any central assumptions we may reject the

prediction

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Can we prove a theory?

• Can we expect that a theory of financial accounting (and hence, about people) can provide perfect predictions in all cases?

• A theory might not have perfect predictive capabilities, but still be useful

• Saying that we have proved a theory on the basis of observations ignores the fact that subsequent observations might not be in accordance with the theory

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Can we prove a theory? (cont.)

• Falsificationists would argue that a theory can never be proved, though it might be the ‘best’ at a particular point in time

• Safer to say that our evidence supports a particular theory

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Dishonest tricks in argument

• Thouless (1974) identifies 38 dishonest tricks some writers use to support their argument including– emotionally toned words– statements where ‘all’ is implied but ‘some’ is true– diversion to another question or to a side issue– use of speculative argument– prestige by false credentials– appeal to mere authority

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Summary

• Methods to develop a theory• Ethics theory and application in accounting

practice• Accounting theories and development• Evaluation of theories

Topic references:

FAT Ch1

APES 110 Code of Ethics for Accounting Professionals

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Class activities

• Case study “Harris Accountant ” • Discussion Questions

– Ch 1 FAT: 1.1-3, 1.5, 1.8, 1.16, 1.20, 1.25, 1.27

• Additional Activities– Online discussion forum

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Relax, we are finished