TOPIC 1 PART 2 INTRODUCTION TO THE ACCOUNTING ENVIRONMENT

Pragmatic Theories
Based on observation of the behavior of the accountants or the users of the information generated by the
accountants
A. Descriptive Pragmatic Approach
Based on continual observation of the behavior of accountants in order to copy their accounting procedures
and principles
Criticisms
1. Does not include an analytical judgment of the quality of an accountant’s actions; there is no assessment of
whether the accountant reports in the way he or she should
2. Does not provide for accounting techniques to be challenged, hence it does not allow for change
3. Focuses attention on accountants’ behavior, not on measuring the attributes of the firm; not concerning
ourselves with the semantics of accounting phenomena
B. Psychological Pragmatic Approach
Depends on observations of the reactions of users to the accountants’ outputs
Criticisms
1. Some users may react in an illogical manner
2. Some users might have a preconditioned response
3. Some users may not react when they should

Normative Theories
1. Based on value judgments or personal opinion and these value judgments cannot be verified or tested.
2. Concentrated either on deriving the ‘true income’ for an accounting period or on discussing the type of
accounting information which would be useful in making economic decisions
 True Income – concentrated on deriving a single measure for assets and a unique profit figure
 Decision-usefulness – the basic objective of accounting is to aid the decision-making process of certain
‘users’ of accounting reports by providing useful, or relevant, accounting data

Positive Theories
1. Testing or relating accounting hypotheses or theories back to experiences or facts of the real world
2. Focused on empirically testing some of the assumptions made by the normative accounting theorists
3. Concerned mainly with ‘explaining’ the reasons for current practice and ‘predicting’ the role of accounting and
associated information in the economic decisions

Behavioral Theories
Derived from discipline such as psychology, sociology and organizational theories

Normative v Positive
Normative : Prescriptive, describe how accountant should behave to achieve an outcome that is judged to be
right and good income

Positive : Descriptive, explanatory or predictive, describe how people do behave regardless whether it is right,
explain why people behave in certain manner, or predict what people have done or will do
 Formulation of Accounting Theory
1. Deductive Approach – from general conclusion to logical/specific conclusion
2. Inductive Approach – from logical/specific to general conclusion
3. Ethical Approach – consists of the concepts of fairness, justice, equity and truth
4. Sociological Approach – emphasizes the social effects of accounting techniques
5. Economic Approach – emphasizes controlling the behavior of macroeconomic indicators that result from the
adoption of various accounting techniques
6. Eclectic Approach – mainly the result of numerous attempts by individuals and professional and governmental
organizations to participate in the establishment of concepts and principles in accounting
 TOPIC 2 CONCEPTUAL FRAMEWORK

The objective of financial reporting

1. Objective of financial reporting
- To provide financial information that is useful to users in making decisions relating to providing resources
to the entity

2. Users’ decisions involve decisions about

- Buying, selling or holding equity or debt instruments
- Providing or settling loans and other forms of credit
- Voting or otherwise influencing management’s actions

3. To make these decisions users assess

- Prospects for future net cash inflows to the entity
- Management’s stewardship of the entity’s economic resources

4. To make both these assessments, users need info about

- The entity’s economic resources, claims against the entity and changes in those resources and claims
- How efficiently and effectively management has discharged its responsibilities to use the entity’s economic
resources

Qualitative characteristics of useful financial information

1. Fundamental qualitative characteristics
A. Relevance
- Information is relevant if it is capable of making a difference to the decisions made by users
- Financial info is capable of making a difference in decision if it has predictive value or confirmatory value
B. Faithful representation
- Info must faithfully represent the substance of what it purports to represent
- A faithful representation is, to max extent possible, complete, neutral and free from error
- A faithful representation is affected by level of measurement uncertainty

2. Enhancing qualitative characteristics

- Comparability
- Verifiability
- Timeliness
- Understandability
These four qualitative characteristics enhance the usefulness of information but they cannot make non-
useful information useful

Prudence = exercise of caution when making judgment under conditions of uncertainty; does not allow for
overstatement or understatement of assets, liabilities, income or expenses

Measure uncertainty – does not prevent information from being useful.

 Financial statements and the Reporting entity
1. Reporting entity
- An entity that is required, or chooses, to prepare financial statement
- Not necessarily a legal entity – could be a portion of an entity or comprise more than one entity

2. Financial Statement
- Consolidated financial statement – provide financial statement of both (parent & subs) in one
- Unconsolidated financial statement – provide financial statement of parent only
- Combined financial statement – provide financial of two or more entities that not linked like parent & subs
 TOPIC 3 PART 1 ACCOUNTING REGULATIONS, FINANCIAL REPORTING AND DISCLOSURES

Theory of efficient markets

The forces of supply and demand influence market behavior and help keep markets efficient

Agency Theory
1. The demand for financial info can be categorized as being either for stewardship or for decision-making
purposes
2. It gives us a framework in which to study contracts between principals and agents and to predict the economic
consequences of standards
3. Uncertainty in agency theory can be classified as ex ante or ex post
- Ex ante – exists at the time a decision is to be made, such as uncertainty about controllable events that will
affect production or uncertainty about the skill of the manager
- Ex post – exists after the decision has been made and the results realized

Theories of regulation
A. Public Interest Theory
1. Government regulation required in the ‘public interest’ when there is market failure/inefficiency due to
- Lack of competition
- Barriers to entry
- Information asymmetry
- Public-good products
2. Based on the assumption that economic markets are subject to a series of market imperfections or
transaction failures. It is also based on three further assumptions that :
3. The interest of consumers is translated into legislative action through the operation of the internal
marketplace
4. There are agents entrepreneurial politicians and public interest groups who will seek regulation on behalf
of the ‘public interest’
5. The government has no independent role to play in the development of regulations

B. Regulatory Capture Theory

1. All members of society are economically rational; therefore, each person will pursue his/her self-interest to
point where the private marginal benefit from lobbying regulators just equals the private marginal cost
2. The government has no independent role to play in the regulatory process, and that interest groups battle
for control of the government’s coercive powers to achieve their desired wealth distribution
3. 4 situations in which capture may occur
- Control the regulation and regulatory agency
- Succeed in coordinating the regulatory body’s activities with their own activities so that their private
interest is satisfied
- Ensure non-performance by the regulating body
- Mutually shared perspective, giving them the regulation they seek
C. Private Interest Theory
1. Believe that there is a market for regulation with similar supply and demand forces operating as in the
capital market
2. There is a law of diminishing return in the relationship between group size and the costs of using the
political process
3. Regulation does not arise as a result of a government’s response to public demands
4. Regulation is sought by the ‘producer’ private interest group and is designed and operated mainly for its
benefit
5. Prefers free market/self-regulation

Free market/Self-regulation Theories

1. Political economy theory – Concerned with how people allocate resources and makes decision
2. Legitimacy theory – organizations seek to ensure they operate within the bounds and norms of their
respective societies
3. Stakeholder theory – management should manage the organization for the benefit of all stakeholders
4. Institutional Theory – provides an explanation about why organizations tend to take on similar
characteristics and form

Pro-Regulation Free Market

Information is a public good and due to free rider will Accounting info is like any other goods, and forces of
be under produced in unregulated markets. supply and demand should be left to operate in a
Government intervention is therefore necessary unhindered manner to provide optimal amounts of info

Government regulators act in the public interest Government regulators are not objective but like
everybody else are driven by their own self interest

Regulation will serve the general interests of society Regulation will ultimately serve the interest of
politically effective groups

Regulation will not captured as this would be against The political process of regulation will ultimately be
the public interest captured by the industry that is being regulated