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From Deegan, C. and Samkin, G., Financial Accounting. McGraw-Hill Irwin, New York Prepared By: Dewan Mahboob Hossain; Assistant Professor; Department of Accounting & Information Systems; University of Dhaka; Dhaka; Bangladesh.
Positive theories
Positive theories seek to explain and predict particular phenomena. They are often developed and supported on the basis of observations (that is, they are empirically based). The view is that by making numerous observations one will be in a better position to predict what will happen in future. For example, many managers within a particular industry might be studied to predict what accounting methods they will elect to use in particular circumstances.
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Normative accounting theories have criticized PAT because it does not provide practitioners with guidance, even though it does attempt to explain the economic implications that might result from the Prepared By: Dewan Mahboob Hossain selection of particular accounting policies. 3
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Agency Relationship
delegation
Principal (owner)
performance
Agent (manager)
Research that apply PAT typically adopt either an efficiency perspective or an opportunistic perspective.
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Owner/manager contracting
A manager that owns a firm bears the costs associated with their own perquisite consumption (consumption by employees of non-salary benefits), which could include consumption of the firms resources for private purposes acquiring an overly expensive company car or luxurious offices or staying in overly expensive hotel accommodation. As the percentage of ownership held by managers decreases, managers bear less and less of the cost of their own perquisite consumption. The costs begin to be absorbed by other owners of the firm.
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Concluding remarks
PAT assumes that if a manager is rewarded on the basis of accounting numbers, the manager will have an incentive to manipulate the accounting numbers in an effort to increase their own personal wealth. Rewarding managers in terms of accounting numbers might not be appropriate if management is solely responsible for compiling those numbers. The auditor will act to arbitrate on the reasonableness of the accounting methods adopted.
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Concluding remarks
It must be remembered that there will always be scope for opportunism. It would be too expensive and impossible to pre-specify a complete set of accounting methods to cover all circumstances. It should be remembered that the existing accounting standards (IAS and IFRS) do not cover all types of transactions and, as a result, significant discretion can be employed when compiling financial statements. Prepared By: Dewan Mahboob Hossain 37
Debt Contracting
When a party lends fund to another organization, the recipient of funds might undertake activities that reduce or even eliminate any likelihood of the funds being repaid. These costs, which relate to divergent behavior of the borrower, are referred to in PAT as the agency costs of the debts. For example, the recipient of funds might pay excessive dividends, leaving few assets in the organization to service debts. Alternatively, the organization might take on additional, and perhaps excessive levels of debt. The new debt holders would then compete with the original debt holders for repayment. Smith and Warner (1979) refer to this practice as 38 claim dilution. Prepared By: Dewan Mahboob Hossain
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Political costs
The term political costs is used to refer to the costs that particular groups external to the firm might be able to impose on the firm, such as the costs associated with increased taxes, increased wage claims or product boycott. Government, trade unions, environmental lobby groups or particular consumer groups affect organizations.
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Management of Income
Common labels for the financial numbers game: Label
Aggressive accounting
Definition
A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not.
Earnings management
The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream. A form of earnings management designed to remove peaks and valleys from the normal earning series, including steps to reduce and store profits in good years for use during the slower years. Intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil or criminal proceedings. Any and all steps used to play the financial numbers game, including the aggressive choice and application of accounting principles, fraudulent financial Prepared By: Dewan Mahboob Hossain reporting, and any steps taken towards earnings management or income57 smoothing.
Category
Share price effects
rewards
Higher share prices; Reduced share price volatility; Increased corporate valuation; Lower cost of equity capital; Increased value of stock options.
Improved credit quality; Higher debt rating; Lower borrowing costs; Less stringent financial covenants.
Bonus plan effects Increased profit-based bonuses. Political cost effects Decreased regulations; Avoidance of higher taxes.
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Creative accounting
Where those responsible for preparing accounts select accounting methods not objectively but according to the results desired by the preparers. Accounts preparers can be creative, yet at the same time follow financial reporting standards. Although they might not be objective, it might be difficult for parties such as auditors, with an oversight function, to claim that the financial report preparers are doing anything wrong.
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Concluding remarks
While the criticisms do, arguably, have some merit, PAT continues to be used. A number of accounting research journals continue to publish PAT research. A number of the leading accounting research schools throughout the world continue to teach it. What must be remembered is that all theories of accounting will have limitations.
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