Chapter 1Introduction

Theory in Action 1.1 — The trouble with models

1. How would an investor determine whether a model such as the Fed could be ‘trusted’?

The most appropriate determination of the value of the model will be its ability to predict future value. There has never been such a model before. Even if it could predict future value, there would be investors who would then seek to outperform the model’s estimates in order to make abnormal returns — this will ultimately impact on the model.

2. Why has Wall Street adopted this model? Why is the Federal Reserve endorsement so important? Why isn’t the Stock Exchange endorsement of the model sufficient?

The market is subject to a broad range of factors, many outside the control of investors and business management. This creates a level of uncertainty that investors seek to compensate for through such models. The endorsement of a government body such as the Federal Reserve would act to support the validity of the model, particularly given the Fed’s independent status. The Stock Exchange is also a player in determining value, and has a track record of control and compliance of corporate activities that is often not perceived as independent.

3. Is it appropriate to adopt a model that compares earnings yield across 500 companies, all adopting a diverse range of reporting measures?

This is really one for the students to debate. The point is: earnings are a function of a range of decisions, and the disclosures and methods adopted to calculate earnings will differ widely. Under such circumstances, can earnings yields be compared? Perhaps they can in terms of relative performance between industries or between individual firms in a single industry.

4. What role does history play in validating the findings of the model?

Historical data will prove valuable in testing the model and may well add support for the model as a predictor of future value. The problem is that the prediction of the future based on historical information works well in hindsight. As factors change in the market the model will need to be adjusted. A question for students is: If a majority of investors adopt the model, is it self-fulfilling?

5. Why is it so hard to determine the value of a share (stock)? Does the market price of the share reflect its value? Discuss.

The share price is meant to reflect all publicly available information and to reflect the value of the firm at that point in time. Obviously share values shift as information about the company becomes public and the expected future value of operations is adjusted. It is difficult to determine true value as not all information is available to investors, and future value requires estimates of future activity, performance and factors, most of which are out of the direct control of any one company.

Theory in Action 1.2 — No accounting for human behaviour

1. Develop an explanation for the short-term views of management, which result in ‘earnings management’ by some corporates. How could you test the validity of your explanation?

The reasons for the short-term view, include: the relative short period that managers work with one company (normally 5 years) the performance cycles used to evaluate and reward managers the focus on growth and returns by investors opportunities to manipulate earnings to satisfy performance and investor expectations.

It is very difficult to actually test the impact of the factors identified. One way would be to compare the performance of companies with long-term management contracts versus short-term ones.

2. Is the debate about accounting regulation or illegal behaviour on the part of a few senior executives? Can having greater levels of financial disclosure and rules targeted at preventing earnings management really work if the incentives and rewards aren’t changed?

The debate is about illegal behaviour and how to control it. Some will argue that the market will ensure appropriate disclosures because if managers are found to be making improper disclosures then they will be penalised in the labour market. However, they will have to be caught, and it will have to be proved that their actions were deliberate. (There haven’t been many cases along such lines, even with the recent spate of corporate collapses.) If the incentives and rewards aren’t changed (and the disclosure of the rewards are buried in share options), then increased disclosures will not stop illegal or dishonest behaviour. Does the class agree?

3. How does an earnings figure ‘gain a power all of its own’? Is it the number as such, or the behaviours and decisions it creates? Discuss.

The earnings figure has become central in evaluating the performance of management. This makes it an important figure to investors and management, which then creates the expectations and behaviours discussed in the chapter. The number is an outcome of decisions made by management, both in operating the business and in determining the basis for the calculation and disclosure of revenues.

4. Should a new theory of accounting disclosures encompass concepts like ‘trust’ and ‘honesty’? Explain, with reference to the need to reach a common definition of both terms across a broad range of stakeholders.

Trust and honesty are concepts that are meant to underlie market economies. It is a matter of opinion as to the degree they currently operate in in the market economy, and one for students to consider in the context of each stakeholder — investors, management, community, employees, government. It may well come down to a matter of perspective and degree.

Chapter 2Theory and method

Theory in Action 2.1 — A range of accounting theories: the federal Budget

1. Why can accounting (budgeting in this case) be described as ‘sleight of hand’?

Accounting (budgeting in this case) can be described as sleight of hand on the basis that it involves estimations, assumptions and forecasts. The article implies that the government is able to use the estimation and judgement process to conjure the budget outcome it desires for political purposes. The article refers to the budget as enabling the government to manage its ‘war chest’. This is equivalent to the argument pertaining to firms’ use of provision accounts as ‘cookie jars’. The programs and activities of the government result in revenues (expenditures) that increase (decrease) the war chest. The implication of the article is that the government is exercising conservatism in its forward estimates to justify its current fiscal stance. The conservatism deflates the forecast surplus and provides less ammunition for lobby groups to demand additional government spending. The expectation is that the actual growth rate and taxation revenue will exceed what has been forecast, thereby increasing the war chest. As the election year approaches, the government will be able to use the increase in the war chest (accumulated surpluses) to relax fiscal restraint and make appealing election promises.

2. Explain the federal Budget in relation to the following theories of accounting:(a) accounting as intracorporate politics(b) accounting as communication–decision information(c) accounting as a social commodity(d) accounting as ideology and exploitation.

(a) The federal Budget is used by the government as a means by which the government has, and will, conduct its decision making. The Budget forecasts are used to justify the current policies of the government. The Budget (more particularly the lack of a budget surplus) is a defence to demands for greater government spending. Funding can be denied on the basis that it would result in budget deficits and be irresponsible financial management. The conservative budget estimates can subsequently be used as a political tool to enable the government to deliver favourable policies in an election year. Future fiscal spending can be justified on the basis of the greater than predicted surplus due to higher than expected economic growth and taxation revenue.

(b) Accounting as communication–decision informationThe federal Budget communicates the cumulative effects of the Commonwealth’s financial management to its constituents. The Budget conveys to taxpayers and other interested parties the summary of actions to be taken during the forthcoming fiscal year and future years as a result of intended policies. Subsequent deviations of actual versus forecast surplus (deficits) provide the government with a tool to relax (tighten) fiscal spending. Changes in policies can be justified and communicated to constituents on the basis of the change being responsive to the budget deviations. This is used by constituents to make their own voting decisions.

(c) Accounting as a social commodityThis theory purports that accounting affects the welfare of different groups in society and can be an agent for social change. The Budget outcome reflects the fiscal policies of the government, and the fiscal policies clearly can result in a redistribution of wealth in society. For example, future increases in income tax rates could be used to fund an increase in social welfare payments. The accounting underlying the Budget can hinder or aid government policies in fulfilling their social mandate.

(d) Accounting as ideology and exploitationThis theory contends that accounting is part of the ideology apparatus of capitalist society. Supporters of this theory would argue that the federal Budget is a mechanism for powerful and elite interest groups to lobby the government and extract wealth at the expense of employees and society at large. A Budget that is sympathetic to business (that is, through favourable tax reforms) at the expense of individuals (that is, through increases in personal taxation) could be viewed as the budgeting process being ideological and exploitive.

Theory in Action 2.2 — Role of accounting and importance of pragmatic, semantic and syntactic elements

1. From the report, use a syllogism to develop a very brief inductive theory arguing why the Ford plant needs to close down.(a) Explain the role of syntactics in your theory.(b) Explain the role of semantics in your theory.(c) Explain the role of pragmatics in your theory.

The article discusses Ford’s decisions to close some of its assembly plants in the USA including the Hazelwood plant. The decision is a result of Ford’s restructure plan aimed at restoring the firm’s profitability. An inductive theory can be formulated as follows:

Premise 1: The Ford’s Hazelwood plant assembly is unprofitable and will be closed.Premise 2: Other unprofitable Ford assembly plants are to be closed.Conclusion: Ford will close all unprofitable assembly plants.

(a) Syntactics refers to the logical relations in this theory. This concerns the rules of the language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory.

The syllogism stated is illogical in that the analytical proposition that Ford will close all unprofitable assembly plants is not a logical, or necessary, conclusion from the series of individual observations of closure. The syllogism recognises that unprofitable assembly plants are being closed, leading to the conclusion that all unprofitable operations will be closed. Given that the Hazelwood plant and other plants targeted for closure are unprofitable, the conclusion drawn (that is, the closure of the unprofitable plants) is an inductive approach. If the premises espoused are true then the conclusion derived is not necessarily true because there may always be one unprofitable plant that does not close. This is the problem of the ‘inductive leap’.

(b) Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. The semantic accuracy of a premise needs to be established by reference to real world descriptive accuracy. The syllogism stated above may not satisfy the semantic test. Ford may not necessarily be closing all unprofitable assembly plants. It is the rationalisation of assembly plants that will restore Ford’s profitability. The policy of the Ford Company may not necessarily be to close all assembly plants that are contributing to the company’s operating losses. The accounting records suggest that the Hazelwood plant is economically unviable, and, accordingly, the decision has been made to close the assembly plant. However, other factors may enter into the decision-making process and the same fate may not apply to all assembly plants currently operating unfavourably.

(c) Pragmatics pertains to the effect of words or symbols on the behaviour of people. The accounting records for the Hazelwood assembly plant reflect operating losses. This information has been the basis of, and justification for, management’s decision to close the plant. The decision prompted by the accounting information has resulted in Missouri rallying to try and convince Ford that the operations can be viable. The US Department of Commerce’s Economic Development Administration has provided $500 000 to the State in their quest to make Ford reconsider its decision. In doing so, the State will be suggesting strategies that will restore the Hazelwood plant to a profitable state.

2. From the report, use a syllogism to develop a very brief deductive theory arguing why a government should provide a grant to Ford.(a) Explain the role of syntactics in your theory.(b) Explain the role of semantics in your theory.(c) Explain the role of pragmatics in your theory.

The article discusses the grant of $500 000 received by Missouri from the US Department of Commerce’s Economic Development Administration to help develop a strategy to convince Ford to reverse its closure decision. A deductive theory can be formulated as follows:

Premise 1: The fundamental task of government is to protect jobs.Premise 2: Ford’s decision to close its unprofitable Hazelwood operation will result in 2600

job losses.Premise 3: Jobs can be protected by the government providing subsidies and grants to allow

firms to continue unprofitable operations.Conclusion: The government will provide a grant to Ford to enable the Hazelwood plant to

continue operating so that jobs can be protected.

(a) As previously discussed, syntactics refers to the logical relations in this theory. This concerns the rules of the language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory.

The syllogism stated in the deductive theory is logical in that the analytical proposition that the government should provide a grant to Ford can be logically derived from the premises formulated. The syllogism recognises that government’s fundamental obligation is to protect jobs. If grants protect against job losses then the Ford Company should receive a government grant to enable it to continue operating in Missouri and protect workers’ jobs. The conclusion is logical based on the grammatical rules linking the

premises to the conclusion. If the premises espoused are true then the conclusion derived would necessarily follow.

(b) Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. The semantic accuracy of a premise needs to be established by reference to real-world descriptive accuracy. The syllogism stated above would not satisfy the semantic test. The fundamental objective of the government is not to protect jobs. There are many objectives of government, including economic growth and development, and the provision of services such as health and education. It is not representative of the real world that any firm facing financial difficulty has the right to receive a government grant in order for it to continue operating so that workers will not lose their jobs. Although the closure of the Hazelwood plant will have a devastating impact on the local economy, it would not be financially responsible for the government to fund all unprofitable and unsustainable businesses.

(c) Pragmatics pertains to the effect of words or symbols on the behaviour of people. Ford’s decision has prompted the state of Missouri to try and convince Ford that the operations can be viable. The US Department of Commerce’s Economic Development Administration has provided a $500 000 to the State in their quest to make Ford reconsider its decision. The decision by Ford would have a devastating effect on the people employed at the Hazelwood plant, businesses in the supply chain and the local economy. The response of the government in providing grant funding to assist in the development of a strategic report aimed at reversing Ford’s decision can be interpreted as impression management on behalf of the government. They hope to be seen to be proactive and supportive of the State in the State’s attempts to protect the livelihoods of its residents.

Theory in Action 2.3 — Alternative theory development approaches applied to Australian reporting system

Explain how you could incorporate Greg Larsen’s comments into the following approaches to theory development:(a) Kuhn’s revolutions(b) Lakatos’s research programs(c) Popper’s falsificationism.

Before considering how the comments attributable to Greg Larsen, CEO of CPA Australia, can be incorporated into theory development approaches, it will be useful to revise the theory development approaches with students.

(a) Kuhnian revolution. According to this paradigm, scientific theories and progress in science have a revolutionary character. Larsen comments that ‘it’s time to comprehensively rethink this approach so that we not only address current issues but also build a system that is more robust and capable of meeting future challenges’. Such comments could be interpreted as recognising that financial reporting is in crisis, given the lack of confidence in accounting information and poor corporate governance practices. This crisis warrants a complete rethink of the financial reporting framework, ultimately

producing a new financial reporting framework and new corporate governance mechanisms.

(b) Lakatosian. This theory suggests that scientific theory consists of a negative and positive heuristic. The former represents the hard core of the research program that is unquestionable and the latter the outer core that is subject to refinement. Larsen’s comment — that Australia’s financial reporting system has served Australia well — suggests that the basic objectives, qualitative characteristics and accounting definitions form the negative heuristic. What is needed is a tinkering with the positive heuristic, particularly in relation to simplifying and improving the framework, which will restore confidence in the financial reporting process.

(c) Popper’s falsification. Development of theory according to this philosophy involves testing hypotheses that are capable of rejection. Once falsified, the hypotheses can be rejected and the knowledge base is advanced. The existence of financial reporting fraud and corporate collapses suggests that the accounting theories underlying the preparation and presentation of financial information are inappropriate. Before these premises are dismissed, Popper argues that testable hypothesis capable of falsification would have to be developed and tested. Larsen’s comments related to the need for reform are based on a few corporate collapses, albeit significant companies, and there would need to be scientific evidence that the current reporting framework is too complex and fails to provide a clear and consistent process that is understood by the average stakeholder. Popper’s notion of theory development would require CPA Australia’s assertions to strengthen individual factors that are impacting on the reporting framework (for example, greater rigour in the roles of corporate directors, audit committees and financial accountants) to be tested.

Questions

1. What is theory? What role(s) can theory play in relation to accounting?

A theory is concerned with predicting or explaining some phenomena or with prescribing a course of behaviour. It is a collection of propositions and conclusions that are designed to illustrate the principles of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often used instead of theory. The simplest form of a theory is a statement of a belief expressed in a language, such as written language or mathematical language.

One definition of a theory is a deductive system of statements of decreasing generality connected together logically (see the definition by Braithwaite in the text). Other definitions emphasise the empirical nature of theories (see the definition by Popper in the text). Theory formulation is usually the first stage of the scientific method.

There are three recognised parts to a theory: the syntactic, semantic and pragmatic relations (see figure in text). Instructors should briefly review and explain each part.

At this point instructors may use a number of theories that have evolved in accounting and which probably reflect the different ‘views of the world’ or the way accountants see problems as individuals. For example, theories of accounting can be described and classified as: an historical record-keeping activity (pragmatic or syntactic theory)

political theories (pragmatic theories) communication — decision making (pragmatic, syntactic and semantic theories) accounting as an economic good (pragmatic) accounting as magic or mythology (pragmatic) accounting as a social commodity to exploit or aid policies or as a social club for

accountants (pragmatic)

See the chapter for further brief descriptions.

2. What are the following relations in a theory: syntactic, semantic, pragmatic? Must all relations exist?

Syntactic. This represents the logical relations in the theory. This concerns the rules of the language employed — for example, the rules of grammar for English or the rules of mathematics for a mathematically expressed theory. Syntactical relations connect together and explain the important concepts of the theory.

A syntactical methodology relies on the construction of a syllogism that forms an analytical proposition and requires a logical test to validate its truth. An example in accounting is the double-entry system. A trial balance will always balance by virtue of the construction of the rules of debits and credits and the logic of the mathematics. Other examples should be given to students to illustrate some syntactic theories, which are the mathematical relationships in accounting — such as the theory of matching, cost allocation, income determination and balance sheet theories.

Semantics. Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. In accounting, semantic theory concerns itself with the correlation of propositions to objects or events and manifests itself in terms of measurement theories — for example, measuring the effects of inflation on assets and liabilities and adjusting the accounts reflects these adjustments. Theorists in this area argue that by applying these adjustments, the accounts now have semantic content and can be related to the real world (which they see as being market prices).

Pragmatic. This relation pertains to the effect of words or symbols on the behaviour of people. Not all theories have a pragmatic orientation, but the nature of accounting makes this relation an important one. One objective of accounting affirms that we are interested in how users react to accounting information. For example, the analysis of the reactions of investors and other users to published financial reports is an important area of research in accounting theory. Also the study of pragmatics in accounting leads us to form political and social theories about the reactions of people to financial information and the effects that published accounting reports have on individuals and society at large.

No, strictly speaking, not all relations are required in theory formulation. We may have separate syntactical, semantic and pragmatic theories and a number of branches of scientific enquiry can be classified under each heading — for example, mathematics (syntactical), physics (semantic), political science (pragmatics). However, the instructor should now pose a question on whether all these relations exist in accounting. The answer is yes, to varying degrees, and also according to the perceptions of the student (and the instructor) of the

importance of each relation. Students should then have some understanding of the complexity of defining and studying ‘accounting theory’.

3. What are the roles of ‘explanation’ and ‘prediction’ in an accounting theory?

There are alternative interpretations in accounting theory. An overall theory of accounting can be an ‘instrument’ for recognising and measuring income and capital. Essentially, it is a set of rules, a ‘blueprint’, for constructing specific accounting systems for the recognition and measurement of the income and capital of the particular entity. The results of a specific accounting system of a particular firm provide an ‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of what may happen, but the overall theory itself provides no explanation or prediction of the economic events of any particular firm. This is in contrast to a theory in the sciences where theory provides an explanation of a given phenomenon and/or serves as a basis for prediction.

An alternative interpretation given under positive theories of accounting is that the place of ‘explanation’ is to provide logical answers to the reasons why accountants adopt certain accounting procedures. For example, ‘explanation’ offers reasons as to why accountants use an apparently outdated historical cost system to measure assets and liabilities and provides reasons for the political reactions of accountants to alternate inflation accounting systems. ‘Prediction’ provides an ex ante estimate of the behaviour or reaction of accountants to the imposition of certain accounting standards. In an ex post sense ‘prediction’ provides a prediction of the unobserved behaviour of accountants — that is, how many accountants use LIFO versus FIFO; how many accountants use conservative procedures; etc.

4. Label each of the following arguments (see pages 43–4) as:• positive or normative• valid or invalid• providing true, untrue, or possibly true conclusions.

(a) The argument is normative, in that the conclusion argues that we should change the accounting methods and output report produced according to the prescriptive judgement of the writer. Compare this to a positive approach, which would ask the empirical questions: Why do accountants manipulate data under the accrual system? or Is accrual data more useful than cash flow data? The argument is also deductive, making a general conclusion from two premises.

The argument may or may not be valid. Both premises need to be more rigorously examined before any conclusion is warranted. At the moment, they are both untested, based on anecdotal argument and far from scientific.

A better conclusion would be to hypothesise that cash flow data provides (potentially) different accounting information that may be incrementally valuable. Or else cash flow data may be more useful in different circumstances, such as the prediction of financial distress. A positive theorist would also formulate empirical hypotheses that are capable of empirical observation or falsification.

(b) The argument is positive in that it is descriptive (‘share prices are affected by earnings’) in nature and also the hypothesis is testable — that is, we can test to see if share prices are positively correlated with future expected earnings.

The argument is constructed from inductive reasoning — beginning with specific observations (that is, 100 Australian firms) to form a general theory or conclusion regarding the impact of accounting earnings on share prices.

The argument or syntactics used is invalid in that the reasoning used follows a logical order, but the conclusion does not necessarily follow from the premises.

Evaluating the validity of the argument that constitutes the theory is not an evaluation of the ‘truth’ of the theory in terms of accuracy to real-world observed phenomena. But rather, if the premises were true, then the conclusion would necessarily follow. In this case, the premise is only based on 100 observations. Further, even if it did, as long as one company did not experience a strong correlation between share prices and earnings then the general conclusion (all) does not follow. To be completely valid, the argument must state that the whole population of listed companies has been observed and tested. Another flaw in the argument is that the premises may only refer to a ‘one-off’ situation where share prices and earnings are associated. The conclusion refers to the general situation. It is possible that share prices and earnings are only associated in certain time periods or economic conditions. This is a prime example of inductive research where the researcher must be careful not to make generalisable conclusions.

The argument also provides a possibly true conclusion. If the companies examined are representative of all Australian companies, then the hypothesis stated would be, prima facie — true in general, but not necessarily all the time. Repeated tests supporting the conclusion would have to be performed to confirm the truth of the statement. As long as there is one Australian company whose share price does not follow earnings, the conclusion is false.

To improve the argument, simply state that the argument is supported for the population examined. Note: Other situation specific arguments can also be developed.

(c) This argument is positive, as it is testable and descriptive.

The argument is also deductive. It reasons from the general to explaining/predicting a specific accounting method choice.

The argument is valid in that if accountants adopt methods that increase income and expensing interest decreases income relative to capitalisation, then it logically follows that accountants would capitalise interest payments made.

The conclusion reached is clearly untrue in that interest payments are generally expensed unless they relate to a qualifying asset.

Also, while positive accounting theory suggests that in the presence of debt covenants and bonus schemes managers may have an incentive to increase reported income, it is only in some situations for some firms. There are other contracting incentives (for example political costs) for firms to reduce reported earnings.

(d) The argument is pragmatic positive as it is observable and descriptive of the behaviour of accountants over a number of centuries.

It is also true that historical cost accounting provides a system of allocating costs over different reporting periods (accrual accounting). In this sense it is a deductive argument. A point of logical contention, however, is whether the allocation of costs is truly systematic (in a deductive sense), because a number of the ways in which the costs are allocated appear to be done in an ad hoc fashion without inductive reference to events that occur in the real world of asset valuation.

The conclusion is not valid without undertaking a contextual analysis. What is the best measure? Does this vary over time? For different industries?

However, it may be valid if we precisely define what purpose accounts are used for — for example, taxation purposes. Then historical costs may be the simplest and most cost efficient system developed in the practical marketplace.

5. Which of the following are valid arguments and which are true predictions? Comment on the syntactic, semantic and pragmatic relations with respect to each argument.

(a) The argument is valid since the syntactic relations, if true, would mean that the conclusion reached would also be true.

However, the ‘truth’ or falsity of the conclusion that Firm X should report the selling prices of its assets in its accounting reports to indicate the firm’s ability to meet its debts is a matter of contention among accountant theorists. For example, Chambers contends that exit price accounting, whereby assets are reported at their current selling price, is the most appropriate method of asset valuation as it demonstrates a firm’s ability to operate in the ‘real world’ in terms of meeting financial constraints, obtaining credit and the like. Gynther would advocate use of current buying prices.

However, under GAAP, historical cost is the accepted means of asset valuation.

As such, the conclusion reached cannot be affirmed as true or false. Rather, it is a matter of opinion. Note, also, that this normative theory cannot be tested to demonstrate the truth or otherwise of the hypothesis.

With regard to semantics, clear definitions/terms have been used that correspond to generally understood real-world meanings.

With regard to the pragmatic relations, the argument takes on a prescriptive view of what accounting reports should communicate. Particularly ‘accounting reports should indicate …’ presumes that users of financial reports seek information regarding a firm’s ability to meet debt commitments.

(b) The syntactics are valid. The argument follows a logical and clear reasoning. However, the hypothesis is clearly untrue as we know that accounts payable is not an asset account but rather a liability account, and that the accounts payable account will have a credit balance. After all, if it has a debit balance it is effectively an account receivable.

Thus the semantics used are clearly incorrect in that the classification of accounts payable as an asset is inconsistent with the observed classification of payables as a liability.

No pragmatic relations are specified.

(c) The argument is valid as the syntactic relations follow a logical and sound reasoning. The conclusion, or prediction reached, is ‘true’ in that we know from real-world observations that land and buildings are classified as assets and assets have debit balances. Thus, the semantic relations are also valid as the classifications developed in the argument correspond to observed classifications of land and buildings as assets and assets as debit balances.

No pragmatic relationships are specified.

(d) The hypothesis, or prediction reached, is true in that we observe that the creditor’s account does not have a debit balance. However, the argument is invalid. Just because the creditor’s account is not an asset account, it does not necessarily logically follow that it doesn’t have a debit balance. Assets are not the only accounts that have debit balances. For example, expense accounts also have debit balances.

Thus, the syntactic relations could have been more appropriately specified to: Assets and expenses and distributions of owners’ equity are the only accounts with

debit balances. The creditor’s account is not an asset or an expense or a distribution of owners’ equity. The creditor’s account does not have a debit balance.

The semantic relations used correspond to observable classifications, and no pragmatic relations are used.

6. On casual observation, the meaning of ‘scientific method’ seems to be generally understood. Philosophers of science, however, have put forward different interpretations of what they understand to be ‘scientific method’. In your own words, describe what you think is meant by ‘scientific method’.

The answers given by students to this question will be varied, but the tutor should aim to impart a knowledge of the different forms of scientific methods and the way in which science is seen to advance: syntactics induction falsification research programs paradigm revolution anything goes different ontologies (see next chapter).

A discussion of the methods used and the advantages/disadvantages would be analysed. (See the text for a more detailed description.)

7. According to falsificationists, some theories and hypotheses are better than others. According to their view of science, what makes some theories better than others, and why?

Not all hypotheses are of equal value under the falsificationists’ view of science. Vague hypotheses are difficult to falsify and add very little to knowledge. Cautious hypotheses, even if confirmed, add very little to the current state of knowledge. On the other hand bold hypotheses that are controversial and/or conflict with the current state of scientific knowledge, and which cannot be falsified, may lead to a revision or expansion in scientific thought or research.

Examples of vague hypothesis: Aderian psychology, many principles in accounting (for example, matching).

Examples of cautious hypothesis: all accounting should be conservative, the lower of cost or market rule, revenue realisation.

Examples of both hypotheses: Darwinian hypothesis, inflation adjustments to accounting, positive hypotheses (for example, the efficient market hypothesis, market accounting).

8. Is observation reliable? Give examples involving accounting reports.

Observation is the cornerstone of an inductivist’s approach to science. According to induction, science starts with observation. Observation (which is neutral and objective) supplies a secure basis on which scientific knowledge can be built; and scientific knowledge is derived from observation statements by induction. However, observation is not always reliable. Observation can be an interpretative activity, which can be influenced by the individual’s personal biases or perceptions, or a function of cultural or social upbringing. Students may give examples such as the measurement of the lengths of different objects or even measuring the ‘value’ of assets or income (discussion can then centre on whether observed income is reliable). Tutors should also discuss the possibility of making large and

repeated observations to get a measure of central tendency. This is called the retreat to probability and is a modified version of induction.

Under this viewpoint, scientific knowledge is not proven knowledge, but it represents knowledge that is probably true. The greater the number of observations forming the basis of an induction and the greater variety of conditions under which these observations are made, the greater the probability that the resulting generalisations are true.

This, however, raises the further problem of how to specify acceptable probability parameters, and in this case the fallback is usually to analytic statistics and standard errors.

9. What is a paradigm? Give some examples from accounting.

A paradigm is a model for the formulation and resolution of research problems. It can be a theory, hypothesis, frame of reference, school of thought, or a principle by which a group of investigators operate. It offers an approach, a mode of thinking, a way to raise questions and to frame answers. In accounting, examples are historical cost, current cost, exit price, the efficient markets hypothesis, agency theory and information economics. Each serves as a basis for research.

10. Outline and discuss the problems associated with induction, syntactics and falsification. How does science progress under each of these methods?

Induction. One problem with induction is that truth or falsity can only be known by reference to empirical evidence. However, empirical evidence is subject to bias because of: – the conditioning of the observer– the preciseness of measurement– defining the composition of the evidence– the number of ‘suitable’ observations.

Repetition of the experiment in a wide variety of conditions and evidence should not conflict with the derived universal law. In this sense the way we observe, gather data, conduct the experiment and evaluate the results will limit the generalisation of any inductive research. Science progresses by incremental and cautious steps that are reinforced by further repeated experimentation. Progress can be slow under this approach and tends to be cautious. (See also question 6.)

Instructors can also illustrate the process of induction to accounting by reference to descriptive and psychological pragmatics:– descriptive pragmatism — continually observes the behaviour of accountants and

perpetuates their accounting rules and principles. Criticisms include:(i) no logical assessment of rules and principles(ii) preconditioned responses(iii) focus on pragmatics not semantics (measurement).

– psychological pragmatism — observe the reactions of users to financial accounting outputs. If users react then this is construed as evidence of useful information. Criticisms include:(i) some reactions are illogical(ii) preconditioned responses

(iii) may not be any responses when there should be.

Syntactics. The major problem with syntactics is that the truth value of any proposition is ascertained by logic or reasoning alone. If the underlying accepted premises of the logic have no reference to the real world or are false, then the conclusions have either no pragmatic usefulness or the conclusion is incorrect. The tutor should mention here the reaction of logical positivism against metaphysical or abstract theorising (see text). Logical positivism argued that all theoretical statements should be capable of being reduced to statements that can be immediately observed and that anything that cannot be empirically verified is meaningless. The reaction was against romantic theorising that had no practical application. Logical argument should be precise and serviceable.

Science progresses via logical debate and counter-debate — the proof or disproof of assumed premises or by domination of different schools of thought (see Kuhnian revolution) and the rejection or acceptance of logical points. However, syntactics alone cannot act as a source of true statements about the world. Syntactics alone are only concerned with the derivation of statements from other given statements. This is the real weakness of syntactics as a stand-alone method.

As an example of syntactics in accounting theory, the instructor can use the theory of double-entry and historical costs that has been confirmed and verified by auditors many times. The criticisms of this approach are:– all manipulations are correct as long as the rules of mathematical bookkeeping are

applied– there are many acceptable sets of ‘equations’– no semantic verification — not descriptive of real world objects or events.

Falsification. Falsification emphasises bold or speculative hypothesis. Under this approach science progresses by trial and error. The non-falsification of bold hypothesis or the falsification of cautious hypothesis mark significant advances in science.

11. (a) What are the differences between a Kuhnian revolution and a Lakatosian research program, and how does science progress under each?

(b) What is ‘normal science’ within Kuhn’s framework for scientific development?(c)Do your answers to (a) and (b) have any relevance to accounting theory? Explain.

(a) The descriptions of a Kuhnian revolution and a Lakatosian research program should be a component of tutorial discussion. Refer to pages 39–41 of the text to support discussion. The former argues that scientific theory is revolutionary with the abandonment of one theory and acceptance of another. The Lakatosian research program is progressive, involving a refinement process rather than an abandonment process.

(b) According to Kuhn, a scientific progress occurs in stages. The stages are identified below: Pre-science: period where there are no generally accepted ideas or scientific principles

— disorganised and unstructured. Normal science: domination by a single paradigm that is generally adopted by the

scientific community — much of the work is involved in puzzle-solving activity within the accepted paradigm. This stage is compatible with the Lakatosian research program as there is an accepted paradigm equivalent to the negative heuristic in Lakatosian research programs.

Anomalies: a period occurs when the number of anomalies grows and there is a loss of confidence in the dominant paradigm, and different schools of thought begin to emerge.

Schools of thought emerge and a crisis revolution occurs with competing debate and research between alternative schools of thought.

Crisis revolution and the emergence of a new dominant paradigm. One paradigm eventually replaces the old paradigm in a ‘revolution’ as scientists support the new paradigm. Dominance by the new paradigm ushers in another period of normal science.

(c) The Kuhn and Lakatosian research programs are applicable to accounting theory development. The Lakatos approach permits research programs to be inactive rather than dismissing alternative theories when reshaping the positive heuristic. An example of this as it relates to accounting theory is the normative theories regarding measurement that abounded in the 1960s and 1970s. In recent times attention on measurement has been revived with fair value accounting being advocated. The use of various paradigms (for example capital market based, contracting and behavioural) is also an example of refining the positive heuristic using different research methods that contribute in different ways to theory development.

The Kuhn research paradigm involves replacing one theory with another when the anomalies associated with the dominant theory at the time become too systematic and large to dismiss. This can be applied to accounting theory development once again, in the context of historical cost accounting being the accepted paradigm. The failure of historical cost to reflect economic reality and enhance decision making, as documented via recent corporate collapses, will re-ignite the debate as to whether this paradigm is appropriate.

12. What does Feyerabend mean by the statement ‘anything goes’? Do you think that Feyerabend’s interpretation can be applied to accounting theories and research?

The meaning of Feyerabend’s statement ‘anything goes’ is a belief that there is no universal scientific method that will guide scientific research or knowledge gathering. There are two major strands to this argument — methodologies within science and methodologies outside accepted science.

Comparative scientific methodologies: Within science it is hypothesised that none of the methods of science that so far have been

proposed are successful and have failed to provide rules that are adequate for guiding the activities of scientists. Furthermore, it is unrealistic to believe that science can and should be run according to fixed and universal rules and methods. This is unrealistic because it takes a simplistic view of the talents of man and the varied circumstances that encourage or cause development.

Any attempt to force universal rules or methods is detrimental to scientific endeavour that attempts to explain and predict dynamic variables (this is especially the case in social theories) and makes science less adaptable and more dogmatic. Therefore, all scientific methodologies have their limitations and the only rule that survives is ‘anything goes’; or as Chalmers has interpreted the statement — ‘everything stays’. This approach is even expanded to include methodologies outside of the scientific approach.

Outside of accepted scientific methodologies: Feyerabend also complains that defenders of the ‘scientific methodology’ typically judge

it to be superior to other forms of knowledge without adequately investigating those other forms. He observes that critical rationalists examine scientific method in great detail but their attitude to other forms of knowledge gathering is very different — even superficial. As examples he argues that when evaluating such areas as Marxism, astrology or witchcraft, scientists usually make superficial examinations or use shoddy arguments to dismiss these theories — in contrast to the rigorous examination of scientific methodology.

Feyerabend, by contrasting science with other less structured forms of knowledge gathering, contends that the latter cannot be ruled out by recourse to some general criterion of scientificity and rationality.

Feyerabend is basically arguing for a freedom of individuals to research without methodological constraints, and in a broader context encourages individuals to choose between scientific and other forms of knowledge gathering. Institutionalisation of science and research is seen to be inconsistent with the complexities of the world and a humanitarian attitude.

Applied to accounting: The Feyerabend approach can be applied to accounting if we accept that there is no

universal scientific method to which all forms of accounting research should conform. This is especially the case if the version of the scientific method applied in accounting is some crude form of empiricism or inductivism, or an incomplete and naive syntactic model.

In fact the observation of a variety of accounting theories that follow different methodologies may be seen as a healthy outcome of the ‘anything goes’ philosophy. The instructor should recall the varied theories of accounting (which include accounting as magic) described in the text.

13. Describe the following authoritative bases: dogmatic, self-evident, scientific. Which category do you think accounting standards fall into?

The dogmatic basis is used when we believe in a statement because of confidence in the person or group issuing the statement. This confidence may be due to religious or political belief, or to the credentials, position or charisma of the speaker or writer. We employ this basis frequently, since we cannot be expected to personally ‘test’ everything. We believe in what we read in the newspapers, in textbooks we use in school, in what our teachers tell us, etc. The weakness of this basis is that personal opinion, rather than evidence, is the critical factor. Introspective evidence is acceptable.

The self-evident basis is used when we believe in a statement because it appears to be sensible or obviously true, based on our general knowledge and experience. For example, the

statement ‘children love to eat candy’ would be accepted as self-evidently true by most people. They would not feel an empirical study needs to be conducted. The weakness of this basis is that what is sensible or obvious to one person is not to another. What appears to be so obvious may turn out to be incorrect.

The scientific basis is used when we believe in a statement because of the logical relationship of the terms and the objective, empirical evidence in support of the statement. The demand for objective, empirical evidence is the significant factor. The scientific basis was formulated to overcome the weaknesses of the other two.

14. What is ‘truth’ in science? What is truth in accounting?

Truth refers to a statement that has been confirmed through scientific testing. If the statement is ‘analytical’, the testing is a logical one. Mathematical statements are of this type. Their truth is determined by proving that mathematical rules have been followed. This testing reveals whether the analysis is valid rather than true. If an argument is valid and its premises are true, then the conclusion is also true. If the statement is empirical, then persuasive, objective empirical evidence exists to support it. A decision must be made by the experts of the given field of study from which the statement evolves concerning the persuasiveness of the evidence. If by ‘absolute’ we mean ‘certain’, then truth in science is not absolute, because it is inferred knowledge based on a finite amount of evidence.

From a behavioural point of view, certainty is a matter of degree and conviction. We behave as though a statement is absolutely true, because we are personally convinced by the evidence. But this type of behaviour can occur with the dogmatic and self-evident bases as well.

15. An issue that has troubled the business community in recent years is whether the provision of non-audit services by auditors impairs auditor independence. Using the steps described in figure 2.4 on page 36, develop a research program to test whether auditors are less likely to qualify a client’s accounts the greater the level of non-audit services that they provide to the client.

To answer this question it is suggested that the students critique academic literature investigating the extent to which the supply of non-audit services results in reduced auditor independence as measured by the extent to which the probability of a qualified audit report is reduced. By reviewing the literature students will gain an appreciation of the research programs and methodologies employed to test the proposition. The relevant articles to which students can be assigned to critique and present their critique are:

Case Study 2.1 — Selected company profile: Microsoft

1. Draw from the article to explain how accounting can be seen to provide techniques for exploiting and extracting wealth in support of elite groups at the expense of society at large.

One accounting theory is that accounting is part of the ideological apparatus of capitalist society, providing techniques for exploiting and extracting wealth in support of elite groups at

the expense of society at large. Microsoft is an enormous company with significant market power. The financial position and performance of the firm indicates this — its market capitalisation is $270 billion, sales turnover is $25 billion and its net profit is $7 billion. The sheer size and market dominance of Microsoft enables it to exert influence over its suppliers and customers. Positioned as such a dominant firm in the computer industry, it has the ability to set prices. It can extract favourable contracts with suppliers on the basis that the suppliers would be reliant on Microsoft’s business. Similarly the strong demand that they have created for their products provides them with market power to ensure that computer manufacturers and retailers carry and support their products. Being the dominant player in the supply chain provides the leverage for Microsoft to gain favourable supplier terms and selling prices thereby generating high contribution margins and profits for the firm.

Another example of accounting allowing Microsoft to extract wealth is its success in arguing against the break-up of the group. Arguing that any imposed break-up would be detrimental to shareholder value creation and customers, Microsoft was able to avoid the break-up. The argument for the proposed break-up was that Microsoft had assumed too dominant a position in the computer industry and this was resulting in anti-competitive behaviour.

These points illustrate how it could be perceived that Microsoft’s dominant position and hypergrowth has resulted in enormous wealth creation for shareholders, including its founders, at the expense of its customers, suppliers and competitors.

2. How can accounting have served as an agent for social change in the antitrust investigation that Microsoft faced?

The hypergrowth of the company as represented by its turnover, profitability and cash resources can be used to support Microsoft’s dominant market position. The industry is restricting because competitors are unable to compete on equal terms with Microsoft. The firm has been accused of colluding with PC manufacturers, stealing competitors’ ideas and turning them into money-spinners, and putting competitors out of business. The growth in Microsoft’s key financial indicators, relative to those of its competitors, can be used to support this view and push for reforms to reduce Microsoft’s industry dominance. This is illustrated by the agreement reached allowing manufacturers to include competing software (to Windows) on machines with a Microsoft licence.

3. How can accounting serve as an historical record in relation to Microsoft?

The financial reports of Microsoft can be used as a means by which the company conducts its decision making. The financial reports also indicate the success accruing to the firm as a result of pursuing its strategic direction.

4. If you were a competitor of Microsoft, how would you react to the accounting information contained in this article?

A competitor of Microsoft would use the accounting information to illustrate the monopolistic position of Microsoft, citing Microsoft’s excessive profits, substantial turnover and cash stockpile. Competition is viewed as being healthy, with the gains accruing to consumers. Competitors have expressed discontent at the standover tactics employed by Microsoft and their ability to profit from concepts, ideas and products developed by competitors.

Accordingly they are arguing for the activities of Microsoft to be curtailed to introduce greater competition into the computer industry.

Case Study 2.2 — Ripples from Enron

1. What were the accounting and auditing problems associated with the collapse of Enron?

The accounting and auditing problems at Enron have been well documented and essentially result from conflicts of interest. They include: inadequate accounting rules governing the use of special purpose entities to shield

liabilities from public observation undetected financial abuses including accounting policy changes greedy managers with significant stock-based compensation ineffective corporate governance, particularly by the board of directors and audit

committee lack of auditor independence — for Enron, Arthur Andersen’s audit and tax service fees

were US$34.2M whereas non-audit service fees were US$13.3M.

2. Many argue that Enron and several other high-profile corporate financial crashes demonstrated major problems inherent in accounting standards and the way audits are conducted.(a) Are these arguments developed inductively or deductively? Explain. If possible,

provide a syllogism that demonstrates your answer.(b) Given your answer to (a), what are the problems in accepting the arguments that

there are major problems inherent in accounting standards?

(a) Arguments that Enron and several other high profile corporate financial crashes demonstrate major problems inherent in accounting standards and the way audits are conducted are developed inductively. The arguments are based on observing corporate collapses and investigating the factors contributing to the unsuspected demise of the corporations and then extrapolating the findings to the general population. A syllogism that demonstrates this inductive theory development is:

Premise 1: Enron and HIH auditors lacked independence.Premise 2: Enron and HIH falsified accounting records to portray a healthy financial

performance.Conclusion: Accounting records will be falsified in all firms where audit independence is

lacking.

(b) The syllogism is neither syntactically correct, in that the conclusion does not necessarily follow logically from the premises, nor is it semantically correct. There are many judgements and estimations to be made in the preparation of financial statements. Auditing is a risky business and the failure rate of the auditing task is very low despite this risk. The conclusion stated above may not be representative of real world experiences — auditors may lack independence in appearance but this may not impair their competency and findings in relation to the audit function (that is, independence in fact). Similarly it does not imply that firms, cognisant of a lack of audit independence, will engage in misleading and fraudulent accounting practices.

In defence of auditing, it is cited that up until October 2002, 99.9 % of the audits in American companies were okay. Critics of such a statistic claim that the true proportion of good versus bad audits is unknown. It is not until a company is financially distressed that a bad audit is unveiled. Many people believe that the Enron scandal is symptomatic of accounting irregularities, poor corporate governance and unethical business and personal practices.

3. What role has accounting played in the collapse of Andersen? Is this an example of dogmatic, self-evident, or pragmatic criteria being applied to assess the reputation of Andersen as a professional organisation?

Auditors are one of the key corporate governance agents, and stakeholders rely on their professional and independent assessment as to the financial state of firms. As the auditor of Enron, Andersen failed to report accounting irregularities (despite being aware of such irregularities). Their apparent preoccupation with protecting their own revenue base and business at the expense of looking out for the investor ultimately lead to their demise. Arthur Andersen was barred from conducting and reporting on the audits of SEC-registered companies after August 2002 as a result of shredding documents related to the Enron collapse. The shredded documents would have been damning to Arthur Andersen as they would have exposed their contribution in assisting Enron to perpetrate the accounting deception. Despite the documents being shredded, the mere fact that the firm had engaged in unethical behaviour resulted in irreparable damage to their credibility and reputation.

The role of Andersen in assisting Enron’s misrepresentations as to its financial performance and position is based on dogmatic criteria. The reputation costs imposed on Andersen are a result of people believing the criticism levelled at Andersen from authoritative sources such as regulators and financial commentators.

4. The Enron case has caused revisiting of accounting regulation and theory. Is this an example of Kuhn’s revolutions applied to accounting? Explain.

The fallout from Enron and other high-profile corporate collapses and questionable accounting practices has resulted in proposed reforms (some of which have been implemented) to accounting standards, corporate governance and auditing practices and principles. The reforms are aimed at restoring investor confidence in the accounting, auditing and financial system by removing obvious conflicts of interest that have been detrimental to investors. This can be interpreted as an example of Kuhn’s revolutions. The corporate scandals resulted in a crisis in investor confidence, thereby prompting a rethink of the accounting, governance and auditing paradigms. This has forged the profession into a new stage of theory development with new auditing, regulatory, governance and accounting rules being pronounced. The ability of the new paradigms to protect investors from future corporate collapses and consequences associated with unethical behaviour is yet to be tested. As noted by Kuhn and reproduced on page 41 of the text: ‘new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it’.

5. Drawing from this chapter’s description of theories of accounting, explain whether and/or how the Enron case can be viewed in terms of:(a) accounting as an historical record

(b) accounting as magic(c) accounting as ideology and exploitation.

(a) The Enron facts do not support accounting being an historical record. The accounts were falsified and misleading to investors and resulted in sub-optimal decision making. It was subsequently revealed that Enron’s accounts were not a faithful portrayal of the entity’s transactions and were not prepared adhering to qualitative characteristics of objectivity, consistency and conservatism. The professionalism of the Enron executives was lacking and their unethical and unscrupulous behaviour, stemming from greed, contributed to the dissemination of unreliable and unfaithful accounting information.

(b) The Enron case can be viewed as a case of accounting magic. The interpretation of the appropriate accounting for Enron’s special purpose reporting entities could be viewed as a sleight-of-hand accounting trick to present the firm’s financial position in a particular way. Accounting treatments were selected on the basis on presenting the financial information in a favourable manner to support the firm’s share price. The accounting choices meant that the Enron accounts were made to appear to be something that they were not. This has been described as ‘smoke and mirrors’ accounting.

(c) The accounting practices at Enron can be viewed as exploitation. The partnerships created to hide Enron’s financial problems also enabled company executives to gain financial rewards at the expense of investors. A number of Enron executives partly owned the partnerships in which corporate debt was hidden and were provided with handsome rewards as a result of their involvement. For example, the former chief financial officer made more than $30 million from the two partnerships that he ran, and other Enron employees profited greatly from these entities. All of the partnerships were approved by the board of directors, the external auditors and Enron’s lawyers. These legal structures put in place permitted the executives, auditors and lawyers to extract wealth at the expense of the investors. The cost of a corporate collapse of such magnitude is also borne by society at large.

Chapter 3Accounting theory construction

Theory in Action 3.1 — A positive approach to poor performance

1. The article describes a market reaction to accounting profit news. To describe this involves an example of which approach to theory:(a) pragmatic, syntactic or semantic? Explain your answer.(b) positive or normative? Explain your answer.

Share prices react to unanticipated increases or decreases in earnings, because these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of future cash flows. The article describes how the shares in Sonic Healthcare declined by 16.1% after the firm unveiled a first half-year profit reflecting a material decline in performance that had not been expected by the market.

(a) Describing this reaction to a profit announcement is an example of a semantic approach to theory, in particular output semantics. An output of the accounting system (that is, the profit figure) is being tested against an external reference (that is, share price).

(b) A positive theory of accounting refers to testing or relating accounting theories back to the ‘experiences’ or ‘facts’ of the real world. Describing, explaining and predicting the reaction of share prices to the release of accounting profits is an example of positive accounting theory set within a capital-market-based paradigm. The article describes the share price reaction of one firm (inductive reasoning) and it is not necessarily generalisable to claim that all share prices react to the release of accounting profits. The fact that the share price of Sonic Healthcare has reacted to accounting information supports the contention that, in this instance, accounting profit, calculated using historical costs principles, is useful to the capital market.

2. EBITA is said to be a better measure of underlying performance than net profit after tax because it excludes a highly subjective, non-cash expense that does not relate to operations items (goodwill amortisation), and because it excludes interest and tax, neither of which are affected directly by the operating activities of the firm, and both of which are affected by financing decisions as well as (or more than) operations.(a) Do you agree that EBITA is a better measure of underlying performance than

profit after tax? Explain your answer.(b) Is your answer to (a) mainly pragmatic, syntactic or semantic in nature? Explain.(c) Is your answer to (b) normative or positive in nature?

EBITDA represents earnings before interest, tax, depreciation and amortisation. It is often used as a proxy for cash flows when assessing firm performance. The rationale for its use in determining the profitability of firms’ investment decisions is that interest expense will reflect firms’ financing decisions, taxation is exogenous to firms, and depreciation and amortisation are non-cash items that do not relate to operations items.

(a) Analysts often use EBITDA when assessing underlying profitability and the success of firms’ investment decisions. This suggests that EBITDA has properties superior, or complementary to profit after tax. Students can argue the merits of both profit metrics (see also Case Study 3.2). Essentially this discussion should entail (1) advantages and disadvantages of cash-based versus accrual-based performance measures, (2) the nature of depreciation and amortisation, and (3) the use made of underlying performance measures (for example, in assessing financial performance and firm value). If EBITDA is being used to reflect a cash-based profit figure, then cash flow from operations would be a more objective measure.

(b) The traditional focus and emphasis on profit after tax is an example of pragmatic reasoning. The behaviour of accountants in focusing and emphasising profit after tax is descriptive pragmatics — future accounting procedures are ‘copied’ from existing accounting procedures. Given that profit after tax is a statutory profit line item (whereas EBITDA is not required to be disclosed on the face of the statement of financial performance) suggests that regulators, concerned with user information demands, regard profit after tax as more useful in reflecting underlying performance. However, the attention and emphasis given to EBITDA suggests that it is more reflective of underlying performance and useful when trying to ascertain future cash flows and estimate firm

value. This would be an example of semantic theory — it is reflective of real-world phenomena. It is also pragmatic if ‘usefulness’ is the criterion by which the value of the measure is assessed, rather than its correspondence with real-world phenomena.

The exclusion of depreciation and amortisation in measuring underlying profitability is consistent with criticisms associated with the imprecision of accounting definitions.

(c) The answer to (b) is normative. It is a value judgement as to whether EBITDA is a better measure of underlying performance relative to profit after tax. Although normative, the assertion that one is superior to the other could be empirically tested. If it can be explained and predicted why one measure is used relative to the other, the theory becomes positive. For example, it may be that the correlation between EBITDA and share price is greater than that between profit after tax and share price. Such empirical testing results in positive theories as to the more useful measure of underlying accounting performance that is most reflected in investors’ decisions.

Theory in Action 3.2 — Normative and positive theories of Enronitis

1. What is ‘Enronitis’?

Enronitis is a generic label (a metaphor) used to describe the ‘disease’ attributable to recent corporate collapses (for example, poor corporate governance and inappropriate accounting). Investigations as to Enron’s collapse found that weak corporate governance, greedy managers, questionable accounting and lack of audit and analyst independence contributed to the collapse. Other firms in many countries have since been identified as afflicted with this disease. The loss of confidence accompanying corporate collapses and the unveiling of accounting irregularities is the consequence. Investors generally penalise any firm suspected of using deceptive accounting practices similar to Enron.

2. Pick two of the ten points covered by President Bush.(a) For each of the two points, develop a theory in simple steps that gives rise to

them.(b) Explain whether each theory is more positive or normative in nature.(c) How could you test each theory?

The article cites ten points covered by President Bush in the plan to improve corporate governance in America. In attempting this question, students can select any two of the ten points listed. The following suggested solution discusses (1) corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain; and (2) investors should have complete confidence in the independence and integrity of companies’ auditors.

Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain.

(a) The theory giving rise to this statement is that information asymmetry exists with corporate leaders having access to a superior information set regarding the company relative to that possessed by the market. Disclosing information relating to trading in a firm’s shares by corporate leaders signals information to the market place. If the corporate

leader is selling (buying) company stock, this suggests that he or she believes the stock is overvalued (undervalued). This expanded information set reduces the information asymmetry in the market place and should result in a more efficient market with share prices reflecting publicly available information.

(b) The premise that corporate leaders’ should make trades in their firms’ shares publicly available to promote market efficiency is a normative statement. By assessing the timing and rapidity of changes in share prices around the release of information about corporate leaders public/private announcements of trade, it is possible to test the positive theory hypothesis that public announcement of corporate leaders’ trades in their firms increases market efficiency.

(c) Following the empirical accounting research program outlined in chapter 2, the validity of an assertion that publicly informing the capital market of corporate leaders trades in their companies increases market efficiency could be tested as follows: The research problem to test is whether share prices will respond to ‘new’ information

associated with the public release of share trading in a firm by the firm’s management. This can be examined by conducting an event study investigating the share returns associated with the release of information relating to share trades. The event study methodology is developed in chapter 9. To support the contention, it would be expected that the share price responds to the release of such information. To support the theory, abnormal gains (losses) would be associated with buy (sell) trades. Explanations for the market not responding (no abnormal gains/losses) include (1) the information is already impounded into share price, (2) the study has failed to control for contemporaneous events, or (3) the signal lacks clarity or strength to reduce information asymmetry.

Investors should have complete confidence in the independence and integrity of companies’ auditors.

(a) The theory giving rise to this statement is that auditor independence and integrity improves the quality of the external audit, and investors perceive the audited financial statements to be more credible and reliable.

(b) This theory is more normative in nature as it suggests that auditor independence and integrity results in enhanced investor confidence in audited financial statements. It is prescriptive. The attempts to strengthen auditor ‘independence in appearance’ in recent corporate governance reforms suggest that this is a desirable quality. Most of the reforms aimed at strengthening auditor independence have been accepted by the business community suggesting consensus agreement as to the desirability of auditor independence.

(c) It is impossible to test empirically whether investors should have confidence in anything (normative). However, it is possible to test if they do have confidence (positive). To empirically test this proposition requires operationalising investor confidence and auditor independence. There are several studies in recent times that have investigated hypotheses emanating from this proposition. Auditor independence could be operationalised by the percentage of non-audit versus audit fees provided to the client. An alternative measure of auditor independence would be the relationship between the firm’s directors and the audit firm (for example, are any of the directors ex-audit-partners of the firm’s audit firm?) To examine investor confidence associated with auditor independence requires an empirical

proxy for the effect of reduced auditor independence. This has been empirically examined using auditor litigation, probability of qualified audit reports, the identification of ‘managed earnings’ and earnings conservatism. All of these are associated with accounting information of a sub-standard quality, and hence would be expected to have an adverse impact on investor confidence.

3. The then SEC chief accountant, Walter Scheutze (since retired), argues against the use of historical cost accounting.(a) Is his suggestion of a new approach to measurement normative or positive in

nature?(b) In criticising historical cost, does Scheutze rely on theory that is mainly

pragmatic, semantic or syntactic in nature? Explain.(c) What roles can normative and positive theories of accounting play in the

development of accounting standards?

(a) Walter Scheutze, former SEC accountant, suggests that financial reporting should be based on an ‘exit price’ measurement model. He argues that assets should be recorded at their current selling price, as the ‘best’ notion of future economic benefits is whether assets can be sold at a market value or exit price. This view is a normative view synonymous with the measurement debate surrounding the ability of historical cost to provide information that is useful for decision making. Scheutze is arguing that the measurement system ought to be based on exit values, as this is presents the most desirable information. The arguments for and against alternative valuation systems will be explored in chapters 5–7.

(b) In criticising historical cost, Scheutze relies on syntactic and empirical propositions. It is not a descriptive pragmatic approach — as such an approach relies on observing accountants’ behaviours (real-world practices) rather than focusing on measuring firm attributes such as assets. His suggestion is premised on the basis that historical cost accounting has failed users of financial statements (systematic evidence of such failure would be a psychological pragmatic approach to the development of an alternative theory of measurement). Critics of historical cost argue that historical cost is syntactically flawed. It is syntactically incorrect to add elements that are not measured by the same rules (that is, historical cost amounts related to different time periods are added). Scheutze’s argument is based on the lack of decision usefulness to the users of accounting information rather than syntactic problems associated with historical cost accounting.

(c) There is a role for both normative and positive theory in the development of accounting standards. The theories are not mutually exclusive, as positive accounting theory can help provide an understanding of the role of accounting to assist in the development of normative theory; and normative theory can suggest alternative accounting that can be tested empirically. This view is reinforced by the international view presented on page 60. Normative theory provides the suggestion and theoretical arguments as to why something should be recognised, disclosed or presented in a particular way in financial statements. These claims can then be tested empirically (positive theory development). The problem is that often for empirical testing to occur, regulators must first prescribe the normative approach so that the information is available to test empirically. Empirical testing can be conducted if the information is being provided simultaneously (as was the case when historical cost reports in addition to inflation adjusted reports were being prepared), or if supplementary information in addition to mandatory information is provided.

Questions

1. ‘A theory that is purely syntactic is sterile.’ Comment. How can this statement relate to accounting?

A syntactic theory is one that is capable of testing on the basis that it is valid in terms of its logical consistency. Thus the calculation of accounting profit and determination of asset valuation can be valid in relation to their conformity with rules prescribing the measurement of accounting profit and asset valuations. This can be described as sterile as it does not necessarily relate to the real world. Historical cost accounting has been represented as being purely a syntactic theory, with the semantic inputs to the system being the transactions and exchanges recorded in the accounting system, which are then aggregated and classified on the basis of the premises and assumptions of historical cost accounting. Examples of ‘rules’ include the duality of the accounting entry system and assigning costs to assets and liabilities rather than market values. The output is verified via the auditing process. The sterility of this approach is based on the lack of imprecision of accounting concepts and the lack of association between the rules and how they produce output that is relevant to users of financial statements.

2. A pragmatic theory of accounting involves observing the practices and techniques of working accountants and teaching these to successive accountants.

(a) Argue the advantages and disadvantages of such an approach.(b) Do you believe this method of teaching accounting is ‘correct’?

(a) A pragmatic theory is where we observe the behaviour of practising accountants and then copy their accounting procedures and principles.

Advantages: the solutions of practising accountants are related to the requirements of the business

world they have developed (and been handed down) over a number of centuries it is a pragmatic approach to solving the problems of accounting.

Disadvantages: no logical assessment (not deductive) does not allow change (or change occurs slowly) we perpetuate current practice concentrates on pragmatics and ignores the measurement issues (semantics).

(b) Tutors should be aware that this debate is a common one argued between practising accountants and some normative accounting theorists, and will invoke a number of responses from students. A number will argue that an approach that lacks a theoretical component (syntactics) will have the danger of becoming dogmatic or self-fulfilling. A pragmatic approach may mean that too much emphasis is placed on the practices and techniques of accountants, and little emphasis is placed on the meaning of the actual ‘financial statements’. Accounting then may revert to a procedural art.

On the other hand, others may rightly argue that accounting theory may become too obtuse if a completely theoretical approach is taken without regard to the facts of the real

world. Theoretical argument without pragmatic application is likely to be of little benefit to business and society.

Another point worth noting in this question is the meaning of ‘the facts of the real world’. Our analysis of testing a theory suggests that the above statement should be subjected to a number of tests.

Tutors should use this question to point out the problems of taking extreme positions. To ignore any theoretical framework or to ignore pragmatic implications may be equally dangerous. Students should be encouraged to combine analytics with pragmatics.

3. (a) Describe the semantic approach to accounting.(b) Do you think that the outputs of the accounting system should be ‘verified’? How

could this be achieved?

(a) A semantic approach to accounting is the assignment of numbers to the components of accounting. It has two arms: Input semantics — assigning numbers to the transaction inputs of accounting (for

example, assets, liabilities, revenue, expenses). This transactions-based approach is often criticised as a mathematical system divorced from logical analysis or output semantics.

Output semantics — testing the outputs of the accounting system against some external reference (for example, increases in profits against share price changes — see also Theory in Action 3.1).

(b) This is a difficult question as there are very few external referents other than the stock market. Further, market prices exist for a minority of businesses. In most cases the financials determined by accountants are the sole determinant of a firm’s financial health. Many students, recognising this problem, will revert to a ‘reasonableness test’.

4. Give two examples of accounting ‘doublethink’. How do traditional accountants counter this criticism?

The practice of summing together assets using different valuation methods and believing that the sum (total assets) is an exact measure of asset ‘value’

The practice of using conservative accounting techniques and different allocation techniques to derive net income, which is then compared across different industries

See also the examples on p. 54.

Accountants counter by arguing that the purpose of accounting is to match (allocate) historical costs, and is not a measurement system. Also, accountants argue that diverse techniques are required to account for different business situations.

5. (a) What is normative accounting? Give two examples of the major issues debated in this area.

(b) Do you think that the effects of inflation on financial statements are important? Why or why not?

(a) Normative accounting research is more concerned with policy recommendations and with what should be done in contrast to explaining why current practice is carried out in the manner that it is.

Normative theorists usually attempt to derive either the ‘true income’ or adopt the ‘decision-usefulness’ approach whereby accounting reports are an input into users’ decisions (for example, to buy or sell shares, and management decisions on the financial wealth of firms).

The major issues are the impact of the changing price environment (prices) and the impact on income, assets, liabilities and equity. As a consequence many normative theorists are measurement theorists who attempt to incorporate the effects of inflation into accounting reports. In this sense they take a semantic viewpoint — relating the figures in the accounting reports to actual objects (assets, liabilities) or events (changes in inflation).

Whether accounting should be purely a semantic science (or a syntactic or pragmatic science) is in itself a normative statement, and whichever way students answer this point should be brought to their attention.

Inflation may matter to some accountants but not to others. For example, a management accountant who is trying to control costs or projects may have to pay a great deal of attention to the inflation rates in various sectors; an accountant who is responsible for hedging money market funds will be interested in the real rate of return on funds or look to inflation induced hedges (for example, in real assets). On the other hand, taxation accountants, auditors or record keepers may have very little interest in the effects of inflation.

(b) Tutor should lead discussion on this issue.

6. (a) Describe the decision-usefulness approach and its relation to accounting data.b) Provide three examples of decisions that require accounting data. Do you need to

know if the values of assets have changed for any of your decisions?

(a) The decision model approach is an instrumentalist approach (see diagram on p. 57). In a narrower sense, one direct test of an overall theory of accounting would be to determine whether the output data of the accounting systems, which are constructed on the basis of the overall theory, are useful to users. The data of the accounting systems are utilised by users in their prediction models, and the conclusions (predictions) are then used in their decision models. The problem is that if the prediction is verified, it verifies the prediction model, not the accounting system and its output. There are other variables besides accounting data that affect the prediction. We do not know how the accounting data were utilised. Also, if the decision turns out to be right, it verifies the decision model, not the accounting system.

Interpreting the evidence on decision making is extremely difficult. We do not know how to interpret the evidence to determine that accounting information is useful. Thus, a direct test is virtually impossible. Accounting standard setters usually determine usefulness with the weaker, more direct tests that are usually advanced by accounting committees and include: relevance, verifiability, freedom from bias, timeliness, comparability, reliability and understandability.

(b) Decisions: to invest in a firm’s stock to loan funds to a firm to purchase or buy an asset.

Yes, inflation is important in these decisions.

7. In general, what is ‘positive theory’?

Positive accounting theory was a reversion to testing or relating accounting theories back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were questionnaires and surveys of bank officers or investors regarding their use of financial reports for decision making; or whether inflation-adjusted accounting reports actually aided decision making. Current positive accounting research is aimed at explaining the reasons for actual accounting practices and in predicting the role of accounting data in economic, political and social decision making. Positive theory has expanded accounting theory from the purely decision-making focus of normative theorists into analysis of political and economic factors.

8. How does an ontological assumption affect an accounting theory?

An ontological assumption is the way we see the world. Using the Morgan and Smircich six-way classification, we may assume reality as being anything from a concrete structure (realist-objectivist viewpoint) down to reality as a projection of human imagination (unstable, human specific).

If we have an ontological viewpoint that the accounting world is relatively concrete and stable then it is more appropriate to choose a scientific approach to accounting theory. That means that we are more likely to have a structured, prior theoretical base and use empirical validation. On the other hand if we view the world of accounting as being a product of human imagination we are more likely to have an unstructured research methodology with no prior theory.

9. What is the difference between scientific and naturalistic research?

The difference between scientific and naturalistic research is set out in table 3.2 on page 63. The tutor should aid students’ understanding by briefly categorising accounting research into scientific and naturalistic.

10. What type of a theory is historical cost? How has it been derived? Do you have any criticisms of historical cost accounting?

Historical cost is usually described as a pragmatic theory whereby premises are determined by observing the practice of accountants. Criticisms include: no logical analysis of accountants’ actions does not allow for change does not focus on measurement circularity of logic in the rules outputs not verified doublethink

conventions not subject to falsification.

11. Explain the psychological pragmatic approach to accounting theory. Give an example of how it can be applied.

The psychological pragmatic approach to accounting theory observes users’ responses to the accountants’ outputs (such as information contained in financial reports or the presentation of information in financial reports). If the response suggests that the information is useful and relevant then a theory prescribing the usefulness of the particular accounting information can be derived. Students should be able to contrast the psychological pragmatic approach to accounting theory with that of the descriptive approach, with the latter observing accountants’ behaviour in contrast to users’ behaviour in deriving accounting theory. An example of the psychological pragmatic approach would be ascertaining if the presentation of financial information (such as changing the format of the statement of financial performance to provide comprehensive earnings in addition to operating earnings) is more meaningful to a user and enables them to make better decisions. The criticism of this approach to theory construction is that the response of individuals may be illogical and not representative. To test users’ responses more systematically, positive accounting theory development in the form of capital market, contracting or behavioural research approaches are used.

12. Give an example of an accounting convention usually adopted in historical cost accounting. Conventions govern the way accounting is practised, and conventions are, by definition, known from practice.(a) What theoretical approach is used to derive conventions?(b) What does your answer to (a) imply about the potential for accounting theories

based on conventions to be innovative in providing useful information?

The principles underlying the use of historical cost accounting are: (1) the appropriate unit of measurement is historical cost; (2) the monetary unit is stable; (3) the matching principle; and (4) the realisation principle. A specific accounting convention adopted in historical cost accounting is depreciation. The depreciation expense represents the allocation of an asset’s cost over the estimated useful life of that asset and is consistent with the matching principle.

(a) The theoretical approach used to derive the convention of depreciation is the dogmatic basis. Accountants use historical cost accounting (or a modified version) on the basis that this is what the accounting rules have traditionally required them to use. Similarly, physical assets are depreciated on the basis that the accounting rules require such assets to be depreciated. Thus accounting practices gain acceptance as a result of the accepted rules, and in many cases the rules involve a codification of practice.

(b) In answering this question, it is useful for students to first consider the criticisms of historical cost accounting. Included amongst these criticisms are the production of irrelevant financial information and errors in measuring units. Consider the case of depreciation. This is an accounting entry that involves an allocation process. Depreciation does not attempt to reflect the diminution in asset value that has occurred in the reporting period. If rules were simply a codification of existing accounting practices, the ability of accounting to be innovative and to produce information that is potentially more relevant would be minimal.

In recent years the divergence between stalwart accounting practices and accounting rule prescriptions has increased. For example, historical cost is not the preferred measurement system in recent standards covering topics such as SGARAs, insurance companies and financial instruments. Movement to fair value accounting would see traditional accounting conventions such as depreciation disappear, as assets would be recognised at their fair value each reporting period, with movements in fair value from the start to the end of the reporting period recorded as revenue or expenses. This is intended to be a more accurate portrayal of the measurement effect of occurrences during the reporting period and to provide more useful information.

13. How do you think the massive amounts of data now available from information technologies will affect:(a) the development of accounting theories?(b) the testing of accounting theories?

(a) & (b) The technological advances enhancing the capture, extraction, collation and analysis of data, will assist in accounting theory construction. An important part in the construction process is the ability to validate or verify the theory espoused. The availability of financial information databases and analysis packages will facilitate the verification process. It will be possible to test theories on data sets and this can be accomplished in a relatively short period of time. The availability of data has assisted scientific research in accounting.

14.What are the key differences between normative and positive theories?

‘Normative’ and ‘positive’ are the labels given to the accounting theories. A normative theory of accounting is a prescriptive theory that specifies what ‘ought’ to be. A normative theory is based on the values, ideas and beliefs of the theory developer; and, as people have different ideas, values and beliefs, consensus is unlikely. For example, espousing current cost accounting as the appropriate measurement system to derive ‘true income’ is a normative theory. This was not universally accepted as other theorists supported alternative measurement models to derive ‘true income’ (for example, exit value accounting, historical cost accounting).

A positive theory of accounting is one that describes, explains or predicts accounting practices. The theories are developed and tested with reference to real-world experiences using empirical methodology. The fundamental differences between positive and normative accounting theories are identified in the table below. It should be noted that the theories can co-exist.

Normative Theory Positive Theory prescriptive descriptive, explanatory or

predictive value laden non-value laden does not involve empirical

methodology empirically based

15.What are some common criticisms of scientific approaches? Are they valid? Why or why not?

The criticisms of scientific and naturalistic research stem from the differences in their ontological assumptions, epistemological approaches, methodology and methods. It is useful to review these differences with students by referring to table 3.2 on page 63.

The scientific approach to theory construction is a very structured approach, and critics of this approach focus on its rigidity. The criticisms of the scientific approach to accounting theory construction can be summarised as follows:

testing environment is not representative of the real environment

lacks relevance to practitioners reliance of large scale statistical testing data richness ‘lost’ through the aggregation process relies on preconceived assumptions or theories it seeks the absolute truth.

Case Study 3.1 — New regime taxing for foreign corporates

1. Explain what you think are the problems described in the article.

The article describes the change in taxation rules for foreign corporations operating in Australia. The new consolidated tax regime requires groups to lodge a single income tax return (rather than all entities within the group lodging returns) with one nominated Australian subsidiary being responsible for all tax obligations. The problems associated with such taxation treatment, as described in the article, are:

overseas parent entities losing valuable foreign tax credits lack of autonomy of entities within the group operating in Australia access to commercially sensitive information by independent firms in the group

operating within Australia differences in the substituted accounting periods or financial year ends of

subsidiaries, resulting in grouping benefits between their year end and tax consolidation date being lost.

2. Do you think a normative approach to regulation led to the problems described in the article? Explain your answer.

The revised taxation regulation relating to foreign-owned corporate groups is most likely to be a result of a normative approach to regulation. The regulators have legislated what they believe the taxation arrangements should be. Presumably this has been done in consultation with business. The article suggests that most corporate groups will take up the new taxation arrangements suggesting that their applicability and relevance to the real world has been duly considered (a case of psychological pragmatic theory development).

3. What role can positive theory play in resolving the issues described in the article?

The impact of the new taxation arrangements is only capable of being tested empirically once the arrangements come into existence and the economic consequences can be systematically investigated. Investigating the economic consequences will enhance the theory of how foreign group structures should be taxed, as it will describe and explain the consequences associated with the new taxation arrangements.

4. What role can normative theory play in resolving the issues described in the article?

Normative theory prescribes how the income of foreign-group structures within Australia should be taxed. When considering the appropriate taxation treatment, attention would have been paid to issues such as the equitableness of the taxation rules, their ease of application and level of understandability. Current arrangements are not necessarily optimal; and by suggesting alternative taxation schemes, the theory of how foreign group structures operating in Australia should be taxed can be advanced. It is desirable but difficult to achieve Pareto optimality when proposing amendments to accounting or taxation rules, and the article gives examples of situations where individual firms and the group may be worse off.

5. Describe the roles the following approaches to accounting theory can play in resolving the problems described in the article:(a) pragmatic(b) syntactic(c) semantic.

Taxation theory, like accounting theory, is a social science as well as a measurement and technical process.

(a) Pragmatic: This relation pertains to the effect of words or symbols on the behaviour of people. Not all theories have a pragmatic orientation, but the nature of taxation and accounting makes this relation an important one. One objective of accounting and taxation affirms that we are interested in how users react to accounting and taxation information, and how preparers respond to accounting and taxation rules. For example, the analysis of the reactions of preparers and investors and other users to the taxation arrangements of firms is an important area of research in accounting and taxation theory. Also, the study of pragmatics in accounting and taxation leads us to form political and social theories about the reactions of people to rules and the output from the system.

Pragmatics, syntactics and semantics are the three types of relationships in the theoretical structure, although not all relations are required in theory formulation. The instructor can now pose the question whether all these relations exist in accounting and taxation theory and how they can be used to resolve the issue discussed in the article. The answer is ‘yes’ to varying degrees, and also according to the perceptions of the student (and the instructor) of the importance of each relation. Students should then have some understanding of the complexity of defining and studying ‘accounting theory’.

(b) Syntactic: This represents the logical relations in the theory and concerns the rules of the language employed — for example, in this case, the taxation rules related to how foreign structures operating in Australia are taxed. A syntactical methodology relies on the construction of a syllogism that forms an analytical proposition and requires a logical test to validate its truth. An example in relation to this question is the determination of taxable

income and the mathematics associated with aggregating the assessable income and allowable deductions of entities within the group.

(c) Semantic: Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. In accounting and taxation, semantic theory concerns itself with the correlation of propositions to objects or events and manifests itself in terms of measurement theories — for example, measuring the taxable income when the income is realised. Theorists in this area argue that by applying these adjustments, the accounts now have semantic content and can be related to the real world.

Case Study 3.2 — Rough Guide

1. What is EBITDA?

EBITDA is the acronym for earnings before interest, tax, depreciation and amortisation. It is used as an earnings measure that excludes asset diminution charges, financing costs and tax expense.

2. How can a pragmatic approach lead to an explanation of the use of EBITDA and why should it be used?

EBITDA is a financial measure that is extensively accepted and utilised in financial markets. It has applications in the areas of financial statement analysis, credit analysis and valuation. A pragmatic approach explaining its use is that EBITDA was initially used as a more accurate measure of the debt-servicing capacity of highly levered firms in the late 1980s when leveraged buyouts were popular. The use of EBITDA as a financial indicator of operating earnings, debt-servicing capacity and operating margins has continued (despite cash flow information now being publicly available), as analysts pass on their analytical skill base and tools (including the use of EBITDA) to new industry entrants.

3. Give the main arguments in a normative theory explaining why EBITDA should be replaced by a different measure in analysing firms’ financial performances.(a) Where does ‘decision-usefulness’ feature in this theory?(b) What is the role of positive accounting theory in this normative theory

development?

(a) There are numerous reasons why EBITDA should be replaced with an alternative metric for analytical and valuation purposes. The strengths of EBITDA include: provides a benchmark against which the quality of a firm’s reported earnings can be

assessed by reconciling this metric to the firm’s gross cash flows from operations is a comparable figure, as it is not distorted by different depreciation methods and

rates, effects of financial leverage and taxation effects provides the commencement point in determining a firm’s free cash flow is respected as a metric to be used in assessing a firm’s debt capacity is a key input to valuation analysis.

The weaknesses of EBITDA include:

does not reflect the actual cash flow generation capacity of a firm, as it fails to capture capital requirements and there are other non-cash items for which EBITDA makes no corrections

calculation is susceptible to ‘earnings management’, as it is based on accrual accounting (but less so than other measures such as net profit)

is not an all-encompassing measure of corporate earnings and financial performance does not incorporate working capital requirements.

These weaknesses provide the normative arguments as to why EBITDA is not the most useful metric to use in performance and valuation assessment. Warren Buffet, one of the world’s most successful investors, provides the following normative statement in relation to the use of EBITDA:

…we do not think so-called EBITDA is a meaningful measure of performance. Management that dismisses the importance of depreciation — and emphasises cash flow or EBITDA — are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions.

(b) Positive theory can be used to test the validity of the usefulness of EBITDA in valuation and liquidity assessments. The ability of EBITDA, relative to an alternative metric, to more accurately predict financial distress can be empirically tested. Similarly, the usefulness of EBITDA in forecasting future cash flows and firm value can be assessed via empirical testing. As discussed in previous questions, this illustrates the simultaneous role played by normative and positive theories in advancing accounting theory.

4. Can a naturalistic research approach apply to the debate about the usefulness of EBITDA? If so, how? If not, why not?

The difference between scientific and naturalistic research is set out in table 3.2 on page 63. The naturalistic research approach to theory formulation is based on the ontological assumption that reality is socially constructed and a product of human imagination. When viewed as such, individuals will have different beliefs as to the appropriateness of one metric versus an alternative metric in financial analysis and valuation. The naturalistic research approach accommodates individuals’ perceptions and preferences with respect to valid metrics. If decision makers genuinely believe that EBITDA is an appropriate measure of financial performance based on the strengths of this metric then its use is justified and valid.

5. Can a scientific approach apply to the usefulness of EBITDA? If so, how? If not, why not?

The scientific approach would test the validity of EBITDA as a suitable metric in financial analysis and valuation decisions in a structured empirical manner. The approach would involve hypothesis development (for example, developing the hypothesis that EBITDA is positively correlated with a firm’s future cash flows or EBITDA discriminates between financially distressed and healthy firms) and hypothesis testing based on statistical analysis of the data collected. Compared to naturalistic research, scientific research is highly structured and based on large data sets making it generalisable and resulting in general theories of accounting. Critics of this approach argue that the research is conducted in the absence of its natural real-world setting.

Chapter 4Measurement theory

Theory in Action 4.1 — The historic cost assumption

1. What is the fundamental measurement problem alluded to by Powers?

The fundamental measurement problem alluded to by Powers is the divergence of historical cost values from outside influences such as inflation, changing market prices and the attributes of the asset being measured. Embedded in these arguments is the influence of the going concern and conservatism principles. Powers also cites a number of other attributes that might be measured (current cost, market value, net realisable value, present value), but does not allude to the ‘correct measure’ that can be applied in all circumstances.

Examples are also given for valuation that depend on the attributes of the asset being measured, such as monetary assets (cash), assets traded in established markets (market price) and intangibles (value derived from continued operations).

2. How would you assess the reliability and accuracy of assets reported in a statement of financial position (balance sheet)?

Measurement, reliability and accuracy depend on a number of factors: the level of inflation the divergence of monetary items from market prices the level of subjectivity in measuring non-monetary items the degree of conservatism in the accounts general economic conditions.

As mentioned above, the attribute of the asset would play a strong role in determining the valuation method.

3. What role, if any, does the environment play when measuring assets for reporting in the statement of financial position?

Under current rules (historical cost), the environment will affect the value of monetary items and conservatively affect the value of non-monetary items. Whether the external market environment should have more influence was the subject of much debate during the SEC short-lived initiatives of the late 1970s and 1980s.

Part of the environment includes those who demand the financial position statement. For example, investors demand current market prices, creditors or potential lenders demand conservative estimates of value, taxation authorities require adherence to tax rulings, society demands externalities to be measured, and short-term traders require cash equivalents.

4. What type of measurement would be used to value assets for statement of financial position purposes?

Tutors should lead discussion on this question. I suggest that the answer would depend on what type of market environment the firm faces — for example, industrial, production, trading or the type of assets held (monetary or non-monetary). The overall point is to ask students to consider measurement issues, to accept that the world is not black and white, and that we potentially have in accounting practical measurement rules that are appropriate for different circumstances. That is, there are answers, but they are complex. A number of times students will argue for one general solution or claim that ‘it is all too theoretical’ rather than practical. The question then is: Should we make formal changes through legislation and accounting bodies, or be aware of the shortcomings and adapt to different circumstances as they arise?

Questions

1. Technically, what do we mean when we say ‘X was measured’?

First of all, we know that properties or characteristics of things are measured. That is, we do not measure people, but we might measure their weight or height. When we say, ‘X was measured’, we mean that a number (numeral) has been assigned to X according to certain rules governing the property, of which X is one. Therefore, X must be a characteristic of something. The number system used reveals the relationships involved, of which X is one. For example, if X is the income of Y Company, we mean that a number such as $115 000 has been assigned according to the accounting rules for determining income. The number system employed, having to do with dollars in this case, reveals the relative relationship of the $115 000 figure to other income figures.

2. How is a scale related to the process of measurement?

To measure is to establish a scale — that is, every measurement is made on a scale and the set of operations used to assign the numbers creates a scale. The type of scale depends on the rule(s) that have been formulated to relate the numbers and the property of the things being measured. A scale shows how much information the numbers represent; it gives meaning to the numbers. For example, to measure the income of Y Company we follow the accounting rule on how this is to be done. By following these accounting rules, a scale is created in dollars, which relates the number (say $115 000) to the property being measured (income). The scale used in accounting is historical dollars.

3. Describe the following scales: nominal, ordinal, interval, ratio. Give an example of each. Which scales are applied in accounting and where?

Nominal scale. Numbers are used as labels or names. The number does not indicate a quality or characteristic of the thing measured. The numbering of football players is a simple example. The use of this scale does not constitute an act of measurement.

Ordinal scale. The number assigned to each object of a set indicates its rank order with respect to a given property. An example is the assignment of numbers to investment alternatives according to their profitability (rate of return); or the assignment of numbers

to candidates for a certain job according to the measurer’s preference. The weakness of this scale is that the intervals between the numbers are not necessarily equal, and the number does not indicate the ‘quantity’ of the property.

Interval scale. For an interval scale, the numbers show the rank order of the objects with respect to a given property, but unlike the ordinal scale the distance between the numbers is equal and is known. A ‘zero’ point is selected arbitrarily. An example is the Fahrenheit scale of temperature, where the freezing point (the ‘zero’ point) is arbitrarily set at 32 degrees. The weakness of the interval scale is that the zero point is arbitrarily established. In accounting, standard costs are based on an interval scale, since the ‘capacity’ is arbitrarily selected.

Ratio scale. The ratio scale conveys the most information. A ratio scale is one where:the rank order of the objects with respect to a given property is knownthe intervals between the objects are equal and are knowna unique origin or a natural zero point exists.

An example is the measurement of length. Zero is naturally no length. Another is the use of dollars to represent cost or value — zero is naturally no cost or value.

Ratio scales are applied to accounting. All measures used in the financial statements have a natural origin ($0.00). Intervals between measurement units are identical amounts of currency, and are known. And the rank order of the objects or events measured with respect to their values is known. However, to the extent that different measurement methods are applied — historical cost, net realisable value and present value, for instance — the scale is the same. But while the scale is ratio, the relative measures are not always meaningful because the attributes being measured are not the same.

4. Determine whether the following statements are correct and state why:(a) The historical cost of inventory is $60 000 at year-end. When it is converted to

constant end-of-year dollars by multiplying by 110/100 to get $66 000, the $66 000 is still the historical cost of the inventory.

(b) Last month the quantity variance was determined to be $12 000 favourable, and this month it is $24 000 favourable: therefore, the efficient use of materials has been doubled.

(c) On the basis of saving income tax, Company X ascertained that the double-declining-balance depreciation method is better than the straight-line method. By using the double-declining-balance method for depreciation rather than the straight-line method, Company X saved $10 000 in income tax this year; therefore, the former method is 10 000 times better than the latter.

(d)On the basis of the amount of assets, we can say that Company X is twice as large as Company Y, because its total assets amount to $1 000 000 compared with $500 000 for Y.

(a) Correct. A ratio scale is used, and thus it remains invariant over all transformations when multiplied by a constant, which in this case is 110/100. The invariance of the scale makes the rule (historical cost) the same even though the scale is expressed in different units, such as from nominal dollars to constant end-of-current year dollars. However, the value of inventory may or may not have appreciated at the same level as general inflation. Therefore this scaling is not an appropriate measurement tool for assets but is a base that can be used as a benchmark for the maintenance of purchasing power.

(b) Incorrect. Variances are based on an interval scale, because the ‘zero point’ is arbitrarily selected — that is, it is not natural. The efficiency basis (capacity) could be theoretical, average, practical or normal. One of these is selected by the company according to its preference. For the interval scale, we cannot multiply or divide with respect to the particular numbers. For example, if the temperature in a given room is 40 degrees Fahrenheit and in another room it is 80 degrees Fahrenheit, we cannot say the second room is twice as hot as the first. It is not mathematically permissible and empirically misleading. In this particular case, the point of ‘no efficiency’ is a matter of conjecture; it is not measurable by variance analysis.

(c) Incorrect. An interval scale is being used to determine which method is ‘better’ for saving income taxes. For the reasons given in (b) above, Company X cannot say the double-declining-balance method is 10 000 times better than the straight-line method.

(d) Correct, in theory. A ratio scale is used where zero means no value. For a ratio scale, it is correct to multiply and divide the numbers (that is, to speak in ratio terms). However, we know that, technically, because of inflation (or deflation) the dollars of the historical costs are not the same comparatively over the years, and therefore this causes a problem. We can correct this problem by adjusting for the change in the specific value of the assets. The statement would be correct without qualification if the two companies purchased their assets on the same day and those assets were exactly the same (with the same usage).

5. Describe the following types of measurement: fundamental, derived, fiat. In what sense are fiat measurements ‘weak’? What type of measurement is inventory costing?

Fundamental measurement is one where the numbers can be assigned to properties based on natural laws (confirmed empirical theories), and which does not depend on the measurement of any other variable. Examples are length, electrical resistance, number and volume.

According to Campbell, derived measurement is one that depends on the measurement of two or more quantities. However, perhaps it is better to say that it depends on at least one other quantity. In any event, the measurement is still based on natural law. An example is density, which is based on the measurements of mass and volume. An example in accounting is income, which uses asset values as a basis to estimate cost (depreciation, bad debts, etc.).

A fiat measurement is one that depends on an arbitrary or stipulated definition rather than on a confirmed theory. The weakness is that because there is no confirmed theory underlying the measurement, there can be numerous ways to construct a scale for the measurement of the given property. For example, there are different ways to measure income. Which is the proper or best way? This type of measurement is prevalent in accounting. This basis was formulated by social scientists in order to justify the measurements in the social sciences; otherwise, there can be no measurement. There are some who do not believe in fiat measurement, and therefore question the use of the term ‘measurement’ in accounting and the social sciences. If accounting theory can be empirically validated, then instead of fiat measurements, we can have fundamental measurements.

Inventory is a derived measure from fiat.

6. What are the sources of error in measurement?

All measurements involve errors. The sources of error are: Measurement operation (rule to assign numbers) stated imprecisely. Measurer. The measurer may misinterpret the rule, or be biased, or apply or read the

instrument incorrectly. Instrument. The instrument may be flawed. The instrument could be physical (for

example, a thermometer) or something abstract (such as a chart, graph or index or accountant’s judgement).

Environment. The setting in which the measurement operation is performed can have an effect on the result, such as weather conditions, noise, pressure exerted by other people, or imperfect or numerous markets.

Attribute unclear. What is to be measured may be unclear. For example, is the value of an asset the present value, acquisition cost, current cost or selling price?

7. Explain whether the following statements are facts:(a) Canberra is 320 kilometres from Sydney.(b) Depreciation expense for Kambah Pty Ltd for 2001 was $1 294 000. (This is the

amount reported on the statement of financial performance.)(c) Smoking leads to lung cancer.(d) Sales revenue for Telex Ltd for 2002 was $2 800 000. (This is the amount

reported on the statement of financial performance.)(e) Equipment (net of accumulated depreciation of $400 000) for McNair Ltd for

2000 was worth $1 800 000. (This is the amount reported on the statement of financial position.)

(a) Since all measurements involve error, the question is: How much error are we willing to accept? This depends on the purpose of the measurement. The statement, for general purposes, can be considered factual. Canberra is, roughly speaking, 320 kilometres from Sydney.

(b) Unlike the first statement, which had to do with length (a fundamental type measurement), this statement pertains to economic cost or value. This involves a fiat type measurement. Accuracy of a measurement relates to how close a number is to the ‘bull’s eye’ (the true standard). In a fiat type measurement, we do not have supporting evidence on the true standard, and so we cannot really say that $1 294 000 represents the true amount of depreciation, or how close it is to the true amount. The figure is simply that which is derived by use of generally accepted accounting methods. The statement is a factual statement in the sense that the amount was actually reported by Kambah Pty Ltd. But whether the amount is the ‘true’ amount, no-one knows. There is no objective, empirical evidence supporting the accounting measurement of depreciation. This question reveals one weakness of applying fiat measurements.

(c) There is empirical evidence to support the statement, but whether the evidence is persuasive is a matter of judgement. For some, the evidence is very persuasive; for others, it is not. The statement reveals the probability character of general statements. First, nothing is mentioned about the amount of smoking. The implication is that the greater amount of smoking (say, five packs of cigarettes a day as opposed to one pack), the truer the statement. Second, actual evidence will show that there are specific individuals who smoke, say, 10 packs of cigarettes a day and have done so for 50 years and have not yet

contracted lung cancer. Yet, this does not necessarily negate the statement. The statement is a statistical one, appropriate to a large number of people. In reference to a particular person, this entails ‘subjective probabilities’. The theory of subjective probabilities is not presently supported mathematically. Considering the statistical nature of the statement, it can be regarded as factual if we believe the evidence is sufficiently persuasive.

(d) Although the amount is derived by accounting methods, unlike the statement on depreciation in (b) above, this statement is based on observable data that can be verified. Assuming that this verification has been made by the auditors, this statement is factual.

(e) Because the amount of $1 800 000 is mixed with accumulated depreciation, it cannot be accepted as a factual statement of market value except in the sense that it is the amount reported by McNair. The term ‘worth’ is used, which implies that the equipment can be sold for $1 800 000. It is doubtful that the book value is the same as the market value of the equipment. It is not a statement of fact with regards to value unless this is the case. The verifiable facts are that the equipment was purchased at a cost of $1 800 000 and that after amortising depreciation its book value is $400 000.

8. What is the difference between accuracy and reliability in measurement? How are these notions related to the testing of a theory?

Reliability refers to the proven consistency of a measurement or the operations from which the measurement is derived. We can speak of a measurement (the number) being reliable, or of the set of operations (instrument) being reliable. In statistics, reliability refers to the agreement of the results — consistency — among repeated application of the operation to a large number of cases. In statistics, the variable must be random; therefore, reliability relates to the random error in measurement, the unsystematic error component. If the random error is minimal, then the measurement is reliable.

Reliability does not necessarily lead to accuracy. The reason is that accuracy has to do with how close the measurement is to the ‘true value’ of the attribute measured. In statistics, the true value is presented by the mean. In accounting, ‘true value’ pertains to the pragmatic notion of usefulness, which is expressed in the objective of accounting. Because the term ‘accuracy’ is so often misunderstood, the term ‘validity’ has been suggested to denote the same idea.

We can speak of a valid measurement in the sense that it is appropriate for the stated purpose — that is, the measurement hits the ‘bull’s eye’ or is sufficiently close to it. Another way of putting it is to say the measurement is relevant. Accuracy or validity relates to the relevance of accounting information.

The testing of a theory involves the determination that the numbers involved in the theory are reliable and accurate (valid). In accounting, we say that the data must be reliable and relevant — that is, useful.

9. Discuss whether accounting measurement is fiat or fundamental. Can accounting numbers ever be related to fundamental values? If so, what are they?

This question underlies a good deal of the debate in accounting theory and will provoke a number of different answers from students. The tutor should lead discussion according to the response of students. Some discussion points are: Accounting measurement, to a great degree, is determined by fiat, and is generally

imposed on society by accountants or government committees dominated by accountants. However, accounting outputs must have some fundamental value because there is a

correlation between outside referents such as stock prices, current prices, expected future cash flows and risk.

Accounting theorists cannot agree on fundamental value because it changes according to the nature of the asset, the use of the asset and the use to which the demanded value is put. Is it historical cost, buying price, selling price, discounted value or a variant of these?

Some empirical researchers have examined these values to try and determine which ones are more reliable or have the highest correlation with market or stock prices.

Case Study 4.1 — 12 ways to value intangibles and brands

1. Evaluate the advantages and disadvantages of each suggested measurement technique.

Tutors should note that all methods of valuing brands and intangibles are highly subjective, because by their very nature they must be estimates of future cash inflows. Some observations on each method follow: Net present value. This technique is derived from finance and requires the valuer to

estimate the proportion of future cash flows (or earnings) attributed to the brand and its impact on risk. You need to question how to sort out the relative cash flows and how to derive the discount rate.

CAPM. CAPM will provide the discount rate to apply to the NPV method, but requires stock prices to estimate. Most firms are not listed, and this requires the valuer to use a surrogate for unlisted firms (such as a similar firm that is listed).

Cost of creation. This, in its simplest form, just means adding up all the costs of creating a brand. But some costs are sunk, some are irrelevant and some should be expensed.

Market based comparisons. Comparisons with listed brand values used by other corporations are valid if the techniques used by them are also valid and the asset being compared is the same. This technique may be acceptable for tangible assets, like land or buildings; but intangibles are not strictly comparable and values are subjective.

Royalty relief method. This method is valid if the brand can be leased or licensed because the payments are incremental cash flows. However, the market for these is limited and cash flow payments are unique to individual brands or intangibles.

Relative value. This method is subjective and qualitative, and difficult to estimate quantitatively.

Balanced scorecard. This method adds additional (mostly) qualitative measures. It enables the valuer to obtain a greater sense of the brand’s worth, but does not provide value by itself.

Competency models. These suffer from the subjective problems of determining who are the most successful employees determining market value.

Benchmarking. This provides an assessment of your performance against market leaders, but does not provide a market value. It assumes that the scorecard can be linearly transposed.

Business worth. Again, this technique provides benchmarks and has the same problems. Business process auditing. This method is subjective and lacks structure. Knowledge bank. This involves valuation by fiat that simply reverses the rules of

accounting.

2. Make a recommendation as to which measurement technique should be used.

The most structured technique is the use of a discounted net present value model that applies CAPM to estimate the discount risk rate (techniques 1 and 2). These techniques are grounded in finance theory and the theory of diversification. It is suggested that the economic value-added model is the most appropriate model to apply to intangibles (see chapter 9 and the Ohlson model).

3. Would you consider using more than one measurement technique? Why or why not?

Yes. Given the subject nature of the estimations, the more information gleaned the better the feel for the ultimate value. The use of qualitative factors — such as perceived customer loyalty, retention rates of staff, demand for staff, intellectual property, internal business processes and relative value — provide support for your ultimate calculations.

Case Study 4.2 — Market forgives and looks to the upside

1. Analyse the quarterly EPS figures before one-off items and after one-off items, and comment on the time-series distribution.

The time-series distribution is more flat for the EPS before one-off items than it is for EPS after one-off items, and shows a rising trend over the last three years. Moreover, after one-off items the EPS is negative for the last two quarters.

2. Is it important to separate the measurement of operating items from abnormal items? Why or why not?

It is important to separate out both components because they give a measure of the permanent and temporary components. They also give a measure of the management activities that may be occurring in the firm. For example, the write-down of unprofitable areas signals that management is aware of non-performing sectors and is prepared to recognise and tackle the problem.

3. At the time of release of the negative EPS quarterly figure, the share price surged by 13.9%. Why do you think this occurred and what implication does it have for measurement of accounting profit and share prices?

The market recognised the one-off source of the profit decline and the initiatives to increase future profitability — for example, the consolidation of operations, the increase in profit margin, the reduction of working capital and the recognition of non-performing areas. The classification of profit into temporary and permanent components is important for valuation. The share price is focused on long-term issues.

Case Study 4.3 — No US crisis, just corporate cleansing

Measurement entering the 21st century: a clear or blocked road ahead?

1. What is the fundamental measurement problem alluded to by Miller and Loftus?

Accounting measures transactions at historical cost. Hence, the fundamental measurement problem alluded to is the divergence of written-down historical cost values from outside influences such as inflation, changing market prices and the attributes of the asset being measured. Historical cost accounting is a derived measurement system.

2. What do you think of the principle ‘…accounts must reflect economic reality’ as a core principle of measurement in accounting?

Tutors should lead this discussion in order to challenge perceptions that there is only one measurement system.

3. How would you measure economic reality?

This question boils down to: What is economic reality? It is a slippery concept that will vary. For example: Valuation depends on the attributes of the asset being measured — monetary assets (cash),

assets traded in established markets (market price) and intangibles (value derived from continued operations and future cash flows).

Further, economic reality changes according to who demands the information. Economic reality for investors is future cash flows or earnings; for traders it is current market selling price; for manufacturers it is current buying price;, for auditors it is historical transactions.

4. Reconcile the two arguments by Sheridan and by Miller and Loftus. What other attributes do you think accounts should measure?

The arguments are essentially the same — both appeal to an alternative other than historical costs. Sheridan adds the argument that transaction accounting in the United States is based on technical rulings (divorced from economic reality). Miller and Loftus recognise the (political) reality that previous accounting principles based on current values have been rejected but that we should be aware of the lessons learned by their enforced introductions. Other attributes could be risk of asset class, permanent and temporary earnings, intangible and tangible assets, and liquidity.

Chapter 5Adopting an accounting perspective

Theory in Action 5.1 — Changing the boundaries

1. Who would have made the decision to break the group into at least three pieces —transport, logistics and health?

The decision to split a single operating entity was made by the board of Mayne Group. But, the decision was a response to external pressures. Part of the objective was to create separate entities for sale, but also to delineate between the returns on core and adjunct business activities. This reinforces the argument that accounting is about defining the reporting boundaries, which can be defined to suit the purposes of those who control the entity. Basically, an entity can be defined in any way required, and the Mayne decision certainly lends significant weight to this view.

2. How can a company which has operated as a single entity simply decide to split into three or more separate entities? How will this change the reporting boundaries?

The boundaries are defined by those who control the entity. Mayne has elected to adopt a division of the firm based on activity; however, many firms will elect to draw geographic boundaries. The organisational split will require that the owners calculate the total value of the three subsets. But the point is that this split does not change the overall reporting requirements of the group, because there is no change to ownership or real reporting lines.

3. Explain the external factors which have motivated the decision to break the group up. Why should such external factors influence the structure of reporting entities?

External factors always influence a firm’s decisions and structures. Except in this case, the factors have become acute because of the political and legal issues. Organisations do not live in a vacuum, and the boundaries they draw are functions of internal and external factors. In this case it is quite clear that external events have led to new boundaries, as the firm is keen to sell all or part of some of its activities.

4. Explain why the company’s shares were trading ‘at a discount to sum of parts valuations’.

The major reason is that the earnings forecasts have been reduced, and the expected return on assets has therefore declined. Simply unravelling an entity into three entities does not necessarily change the market value.

5. There appears to be a significant variance ($370 million to $560 million) as to the estimated value of the logistics entity to be created by the Mayne break-up. Why would there be such variance in the value of the new logistics entity?

The only way to find the value of the entity is to find an ‘arms-length’ buyer. The value of assets held in an entity will not normally provide a simple base for value, but instead the perceived value of the use of the assets will be factored in. The interpretation of this value will be subjective and as such a significant variance in value will result.

Theory in Action 5.2 — The shifting perspective of accountability

1. How does reporting information to satisfy the interests of a broad range of interests or viewpoints relate to the entity view, with its main focus on the owner (shareholder)? Is it really possible to satisfy the demands of these competing interests?

It is not possible to satisfy completely the interests of all parties who focus on the performance of public companies. The shareholders have a direct interest and provide the risk capital; however, firm reporting is a complex exercise as different groups will respond to reported information and these responses may directly affect firm performance. The primary focus will remain on shareholder perspectives, but it may be in the shareholders’ interests to report information sought by lobby groups and other external stakeholders. Shell is a highly visible (large) organisation in a very political industry. It is seeking to signal a commitment to the green lobby and the broader community that it is a ‘good’ corporate citizen. It is certainly in the interests of Shell shareholders to avoid the introduction of legislation (as a result of lobbying by interest groups) that constrains activities and impacts on profits.

2. The Shell Group engages in activities that are environmentally and socially sensitive. Will the nature of the industry in which a firm operates fundamentally drive its view of stakeholders? If so, discuss the possibility of viewpoints of accounting being classified along industry lines.

The nature of the industry in which a firm operates is already affected by disclosure requirements. Firms operating in environmentally sensitive industries are required to provide for and report on redevelopment and related costs. Requiring certain minimum disclosures directly classified by industry sector would allow for some level of inter-firm comparison, each financial period and across time. There are size and industry effects associated with disclosures (see the discussion on political costs pp. 344–7). A firm with a higher political visibility will seek to provide disclosures that support the demands of those groups likely to influence the firm’s operations. As such, the disclosures by this firm may not represent the information necessarily required, but the information the firm considers will reduce lobbying to restrict existing or future activities.

3. What type of bottom-line indicators would be of greater interest to shareholders compared with members of the ‘green’ political parties?

We could adopt the classic dichotomy of profits, dividends and capital growth for shareholders; and impact on environment, commitment to environmentally friendly activities and minimisation of the effect of activities on the environment for green political parties. This is the case in reality, which to some extent places the two groups in inherent conflict. However, it is in the interests of shareholders that firms engage in sustainable behaviour. Encourage a class discussion as to whether the two groups have any points of common interest, and how common disclosure measures might be achieved. It would be interesting to ask whether the lobby groups should pay some of the cost of additional measurements, and disclosures or whether the firms have a debt to society to make such disclosures.

4. Visit the Shell web site and undertake a review of the environmental and social sections of the Shell 2000 and 2001 annual reports. How can the disclosures be improved and what type of additional information could

be included to improve our understanding of the impact of Shell’s operations on both the environment and society?

This question is designed to generate discussion and is based on the views and interpretations of students. Prepare a list of all the students’ suggestions and have the class discuss how effective the suggestions may be. It is important to reinforce that ‘usefulness’ will be a matter of perspective and interest, so consider alternative stakeholders’ preferences and what would drive them.

Theory in Action 5.3 — Trimming shareholders

1. Why would a company want to buy back its shares? Is buying back shares consistent with entity theory?

Buying back shares will reduce the overall level of residual claimants against the company and allow for consolidation of dividend and related policies. It also can reduce the threat of takeover. Buying back shares is consistent with the entity theory, as the company is considered to be completely autonomous to equity holders and therefore there would be no issue with buying back or trading in its own capital.

2. Instead of buying back shares, should IAG invest the funds it would spend on the buyback in generating greater returns for all shareholders?

This is really a decision for the management of the company. Will an additional investment result in appropriate returns? Will reducing the level of equity actually lead to greater returns for the remaining shareholders? The question really revolves around the best interests of the company under entity theory versus the best interests of owners under proprietary theory.

3. How does IAG justify ‘trimming’ the share register at the same time that it makes a $350 million reset preference share offer?

Ordinary share capital is very different to reset preference shares. Ordinary share capital has voting rights, rights to dividends and the capacity to trade shares. This is different to reset shares, which are initially a form of debt capital (no voting rights and a fixed dividend level, with priority over payment of dividends to ordinary shareholders). Depending on the terms on which the reset shares are issued, they could be converted to ordinary capital at some point in the future. However, not all reset shareholders might take up this option, selling the shares back to the company at an agreed rate instead.

4. The share value consists of a capital component and a dividend component. Explain what this means in terms of the entity theory.

Of primary concern under the entity theory is profit. However, there are also other issues such as tax credits and benefits that also need to be factored into the value of a share. The capital component relates to the value of assets used by the firm; whereas the dividend component relates to the firm’s capacity to pay dividends from current or previous accrued profits.

Questions

1. Do accountants really construct their own reality with respect to what is measured and reported by an entity? In a sense, hasn’t the accounting profession codified acceptance of this in broadly defining reporting entities in AASB 1025? Discuss.

The answer to this question with respect to AASB 1025 is found below at question 14. Accountants have considerable discretion in classifying, measuring and reporting the economic activities of an entity. They can define the boundaries of an operating entity and, as highlighted in several cases in this chapter, can at any time divide the firm into any number of operating entities in accordance with their preferences. Although there are legislated accounting standards and disclosure requirements, there is considerable discretion as to the nature and extent of both measurement and disclosure of accounting information. At the basic level, accounting is a function of human activity, an extension (function) of our existence — so we define it.

2. With respect to the proprietary theory:(a) What is the objective of the firm?(b) How important is the concept of ‘stewardship’?(c) What is the relationship between assets/liabilities and the owner?(d) How would you define revenues, expenses, profit?(e) What are three effects on current practice?(f) What are the theory’s limitations?

(a) The firm essentially is the proprietor. The firm is simply the proprietor’s instrument to achieve his or her purpose, which is to increase his or her wealth. Income represents the increase in the wealth of the proprietor in a given period.

(b) Stewardship is relatively unimportant, because accountability to outside parties is not critical. The proprietor is, in effect, the firm, and therefore is in a privileged position to know what is happening. Liabilities are usually short term, and therefore there is no need to give a continual accounting to creditors.

(c) The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner. This shows that there is no separation between the firm and the owner. In the accounting equation, P stands for the net worth of the owner.

A – L = P

(d) Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and profit is the net effect of proprietorship, excluding additional investments and withdrawals by the owner. Revenue and expense accounts are truly subsidiary accounts of P. They have the same algebraic characteristic as ‘net worth’ — increases in net worth are credits and decreases in net worth are debits. The proprietary theory focuses on P in viewing income. Revenues and expenses are caused by the decisions and actions of the proprietor. The profit of the firm belongs to the proprietor and that is why P is affected in the accounting equation.

(e) The following are examples of the effect of the proprietary theory on accounting practice:

Dividends paid are a distribution of earnings, not an expense; and interest charges are an expense.

In a sole proprietorship or partnership, salaries to owners who work in the firm are not considered an expense of the business. The reason is that the firm and the owner are not separate entities; they are the same.

The equity method for long-term investments focuses on the proprietary interest of the investor company in the invested company.

The parent company theory for consolidating financial statements views the parent as ‘owning’ the subsidiary. Minority interest is considered an ‘outside’ claim, and logically should therefore be a liability on the consolidated statement of financial position.

The pooling of interests method for business combinations emphasises the uniting (pooling) of the owners’ interests of the two combining companies.

Common terms used reveal the proprietary interests of owners are: book value per share, earnings per share and income to shareholders.

The use of the consumer price index for general price level adjustments shows that the ‘consumer desires’ of owners are considered.

The financial capital view is pertinent to owners.

(f) The proprietary theory does not accord with the realities of the large corporation. The law recognises the corporation as a separate entity, distinct from the owners. The corporation — not the shareholders — owns (controls) the assets, and is liable for the debts. For the large corporation, withdrawals of cash or other assets by shareholders cannot be made without running afoul of the law. This shows that the ownership rights of shareholders are limited. Accountability to shareholders is significant; otherwise, shareholders have no knowledge of the status and operations of the business. The assumptions of the proprietary theory are not relevant to the shareholders of large firms.

3. With respect to the entity theory:(a) What are the reasons for concentrating on the entity as a unit of accountability

rather than the proprietor?(b) What is the objective of accounting?(c) How important is the concept of ‘net worth’?(d) What is the reason for modifying the accounting equation to Assets = Equities?(e) On what side of the equation in (d) would retained profits appear?(f) Why is there a stress on profit determination?(g) How do the concepts of revenues, expenses and profits differ from the

proprietary theory? What about interest charges, dividends and income tax?(h) What are three effects on current practice?

(a) Emphasis is on the entity, because in the 20th century the separation of owners from management in the corporate form of business is common. Shareholders of large corporations have little power to make decisions for the company. The corporation, the entity, has a life of its own. It is therefore more realistic to view the entity as the unit of accountability — that is, to see the accounting process from the point of view of the entity. It is the entity (through its management) that has the power to make decisions that affect the financial status and operations of the business.

(b) Stewardship or accountability to equityholders is of primary significance. The entity needs to give an accounting to those who have supplied funds (shareholders and creditors). There are two views of the entity theory, but both stress accountability to equityholders. The conventional view emphasises stewardship because equityholders are seen as ‘associates’ in business. The newer view focuses on stewardship because of legal, contractual requirements, and also to maintain good relations with equityholders in the event the company may need more funds.

(c) The net worth of the owner is not a meaningful concept, because the owner is not recognised as such but as an equityholder, a provider of funds. So-called owners are not seen as having the power to make decisions for the firm. The net assets belong to the entity. However, net worth can be a meaningful concept. An argument can be made that the entity needs to know the worth of its net assets for its own purposes.

(d) The reason is that the entity is the focus of attention, and therefore creditors and owners are seen simply as those who supplied the funds to the entity. Their financial interest in the company is ‘equities’ — claims on the assets. Thus, they are seen as equityholders. Their relationship with the company is a contractual one.

(e) Paton and Littleton argue that the shareholders have a contractual residual claim on the assets, and it is for this reason that income is placed in the retained earnings account. Shareholders get the leftovers after the creditors have been paid, in the event of liquidation of the company. The newer view of the entity theory sees retained earnings as the firm’s equity or investment in itself.

(f) Profit is stressed for two reasons: Profit is what equityholders are interested in, because it represents the results of

their investment in the company The firm is in business to make a profit — profit is essential to the firm’s survival.

(g) Revenue is the inflow of assets (increase in total assets) due to the events undertaken by the firm with regard to its output. Under the proprietary theory, revenue is the increase in proprietorship. Expense is the decrease in assets or increase of liabilities due to the consumption of assets and services by the firm to generate current revenue. Under proprietary theory, expense is the decrease in proprietorship.For both the entity and proprietary theories, profit is the difference between revenues and expenses. The entity theory, however, emphasises the left side of the accounting equation (assets), whereas the proprietary theory concentrates on the right side (proprietorship). The entity theory focuses on what the entity does, its performance; whereas the proprietary theory focuses on the effect on proprietorship.For the traditional entity theory, interest charges, dividends and income taxes should be distributions of earnings. The theory considers these as payments to the equityholders for the use of their funds. Of course, the government does not provide funds as the others, but provides intangible services (funds?) such as protection from foreign powers. The newer version of the entity theory sees

interest charges, dividends and income taxes as payments to ‘outsiders’, and therefore they are expenses.

(h) Although conventional accounting theory subscribes to the entity theory, the theory has had little effect on actual practice. The reason is that the theory was formulated in the 20th century, and many current practices were devised since the time of the Italian city–states and are based on the proprietary theory. The following show the effect of the entity theory on practice: The physical capital view is in consonance with the entity theory. Salaries to corporate employees who are also shareholders are expenses, because the

company is a separate, distinct entity from the holders. In consolidating financial statements, an entity theoretical approach can be taken.

Instead of concentrating on the proprietary interest of the parent (parent company theory), the entity theory sees the consolidation from the point of view of the consolidated entity.

The use of profit and cost centres for internal purposes is based on the entity theory. The centre is seen as an individual entity.

4. With respect to the fund theory:(a) What are ‘restrictions on assets’?(b) How is the statement of financial position viewed?(c) How meaningful is the statement of financial performance?

(a) Restrictions on assets are liabilities and owners’ equity. Usually liabilities and owners’ equity are seen as claims on the assets, but Vatter argues that claims do not arise against assets, but against people. The fund attempts to be impersonal. Liabilities represent future payments; therefore the significance of liabilities is the restriction they place on the assets, the earmarking of a certain portion for future payment. The owners’ equity represents a final, residual restriction on the assets.

(b) The statement of financial position is seen as an ‘inventory statement’ of assets and the restrictions on them.

(c) The statement of financial performance is not considered meaningful. There are too many problems in determining income. The general-purpose statement of financial performance is limited in its usefulness, because different types of users need different kinds of information. Information should be reported in such a way that users, if they wished, can calculate their own income figure. But the focus should be on the flow of funds rather than income.

5. With respect to the commander theory:(a) Who is the ‘commander’?(b) What is the role of ‘ownership’?(c) How are the statement of financial position and statement of financial

performance viewed?

(a) A commander is any person who has command or control over resources. The general manager of a company would be the top commander, and the other officers would be his or her staff, who in turn may be commanders over a smaller set of resources. A holder is a commander over his or her own resources. The

point of the commander theory is economic control over resources, and such control is in the hands of people; thus, the theory focuses on people — people who are commanders.

(b) Ownership is not meaningful in this theory. Rather, it is control over economic resources. The emphasis should be on the economic function of people rather than their legal relationship to the firm.

(c) The financial statements are reports from the commander of the company to commanders of the funds that were provided to the company. The statement of financial performance is an explanation of the results of activities in a given period initiated by the commander and staff. The results are from the commander’s point of view. He or she is explaining what types of expenditure were incurred and what the result is. The statement of financial position is truly a statement of accountability of the commander of the company. It shows the sources from which the commander has received resources and the applications of these resources. The statement of financial position is a statement of stewardship rather than of ownership; it is a statement of accountability.

6. (a) Can there be an ‘investor theory’, given the broad range of investor objectives?(b) Do investors have uniform information needs that fit within a single theory?

Investors want information so that they can predict the future cash receipts to themselves due to their relationship with the company. Future cash receipts depend on: the company’s ability to disburse cash the willingness of the company to pay investors the legal priority of the investor’s claim. Financial statements can provide information especially on the first and second factors.

7. With respect to the enterprise theory:(a) What is profit?(b) What relevance do you see in the ‘value added’ statement of financial

performance?(c) How realistic are the implications of the theory?(d) Explain the relationship, if any, between enterprise theory and triple bottom-line

accounting.

(a) Profit is value-added income. The figure shows the company’s contribution to society — that is, the wealth created by the company in a given period. Another way of looking at this is to say value-added income measures the distribution to the participants in the entity — employees, holders, creditors and government. Of the total sales of the output of the company, the amount is divided as follows: wages and salaries to employees, dividends to holders, interest to creditors, income taxes to government, and the residual to the company itself for future expansion or replacement of assets.

(b) This is an opinion question. In the United Kingdom, it is estimated that at least 20% of the listed corporations now publish a value-added statement as supplementary data. Some believe that the value-added income is becoming more important because it reflects a social change — holders have become less powerful and organised labour and government more powerful. Many people in

society want to know what the contribution of a company is to the economic wellbeing of society, and how the ‘pie’ (the contribution) is divided for a company. What is a ‘fair’ division is a matter of opinion, and ultimately depends on the values of the people of the given society.

(c) The theory implies that the participants are to cooperate in their endeavour to create profit. Management is to serve as mediator. The participants need to cooperate if the firm is to survive. The idea of the cooperative effort of holders, creditors, employees and government does not appear to be realistic at present in Australia. History, tradition and values are such that cooperation does not appear likely in the foreseeable future. However, economic stress could change people’s attitudes. It is interesting to note that the Japanese model of the enterprise does take seriously the need for employees to have a participatory role in decision making in the company; and the representatives of government do appear to feel obligated to help companies with basic research and tax relief, and to create an environment that is ‘pro’ business.

(d) Enterprise theory and triple bottom-line accounting are very similar in the underlying view that a corporation has social responsibilities that should be reported. Enterprise theory has been more focused on quantifying these impacts, whereas triple bottom-line accounting has opened out reporting to both quantitative and qualitative information.

8. Based on information from the conventional statement of financial performance of Inberg Ltd for the current year, prepare a value-added statement.

Sales revenue $5000 Income tax $800Materials used 1200 Electricity expense 300

Salaries and wages expenses 900 Interest expense 200

Depreciation expense 400 Dividends paid 300

Although not asked for, a conventional statement of financial performance is also prepared for purposes of comparison.

STATEMENT OF FINANCIAL PERFORMANCE(conventional)

Sales $5000Less:

Materials used $1200Electricity 300Salaries and wages 900Depreciation expense 400Interest expense 200 3000

Profit before tax $2000Income tax 800

Net profit $1200Less dividends 300

Retained profits $900

VALUE-ADDED STATEMENT

Sales $5000Less: materials, depreciation and services used

($1200 + $400 + $300) 1900

Value added $3100

Distribution of value added:To employees $900To providers of capital

Dividends $300Interest 200 500

To government 800To enterprise for expansion

Retained profits 900$3100

9. (a) Triple bottom-line reports seek to detail the activities of an entity as they relate to society, the economy and environment. Is the annual report of an entity an appropriate vehicle for such a broad base of information?

(b) List the type of information that you consider would be relevant to the triple bottom-line approach. What would be the ‘bottom line’ in such a statement?

(a) Annual reports initially began as legal documents, which reported financial position and performance and fulfilled legislative requirements such as names of key office holders and directors. In more recent times the annual report has been seen as a key device not only to summarise past performance, but also to signal the future activities and minimise political costs, and perhaps influence perceptions of firm value. With quarterly reporting and the requirement to report immediately on significant factors that can affect a firm’s value (under stock exchange listing requirements), information concerning financial performance is more immediate and readily available. This means that the annual report is increasingly used as a signalling device to key lobby groups. Is it appropriate for this purpose? It represents a formal communication from the firm and therefore carries a basic authority. It provides a clear channel of communication and allows firms a platform in which to legitimise communications pertaining to their activities, both actual and proposed. However, it should be considered whether lobby groups and key stakeholders accept the information provided in good faith. The instructor might like to take some examples of annual reports to class and ask students to consider whether they are effective communication devices or simply political statements.

(b) Get students to classify the information according to categories such as social, employee, environmental, economic and community-based. In terms of an actual ‘bottom-line’, this does not exist because it is not about deriving a single outcome, such as profit, but about identifying the positive and negative impacts of the entity’s activities on a broad range of stakeholders.

10. A company declares a 10% dividend. Discuss the nature of the dividend to the recipients from the point of view of the following theories:

(a) proprietary theory (d) fund theory(b) entity theory (e) investor theory(c) commander theory (f) enterprise theory.

(a) Under the proprietary theory, the firm is considered an instrument of the holders to achieve their objective of increasing their wealth. Holders’ equity belongs to the holders, and therefore a dividend, which is simply a redistribution from retained earnings to capital, is just another ‘piece of paper’ to represent the same dollar amount of ownership interest. The dividend is not income to the holders; they are not receiving anything beyond what they had before in the company.

(b) Under the entity theory (either traditional or ‘newer’ view), since the corporation is a separate ‘person’ from the holders, the dividend would be considered income to the recipients. The income of the company does not belong to the holders but to the company. Therefore, since the dividend comes out of retained income, the holders are receiving something they did not have before. The issuance of dividends is one entity transferring something of value to other entities (shareholders).

(c) The commander is a steward who has been entrusted with the funds of the company and given the right to operate the company. The issuance of a dividend is due to his or her influence and decision. But who has given the commander authority?The commander acts on behalf of the entity, not the shareholders. Thus, the theory assumes that the commander receives authority from the entity. Because shareholders do not have economic control over the resources of the company, the theory implies that they do not have much power in the company. The theory also implies that the company on the one hand and the holders on the other, are distinct, separate entities. If so, then dividends are income to the shareholders, because they are receiving something that they had no control over before.

(d) The fund theory sees the firm as an impersonal fund. Owners’ equity is the restriction on the assets. In this sense, shareholders do not have any claims on the assets; their amount in the company is viewed as a sum that the company may have to pay in the future. A dividend does not change the sum that is ‘owing’ to the shareholders; it simply shifts an amount from one holder’s account to another. It would seem that under the fund theory, dividends are just more ‘pieces of paper’ to represent the same amount of restriction on the assets. Thus, dividends are not income to the recipients.

(e) The investor theory is an extension of the entity theory, except that accountability to shareholders is emphasised. The ‘separation’ of the firm from holders is taken for granted. Similar to the entity theory, dividends would be considered income to shareholders, because they are receiving something they did not ‘own’ before.

(f) The enterprise theory sees shareholders as one group of participants to help generate income from the enterprise. In particular they provide funds, and dividends are the compensation to shareholders for their contribution. Dividends constitute their share of the total value-added income. Since dividends reduce retained earnings (regarded as a distribution of income to the enterprise for expansion purposes that benefit all

participants), they would be considered a distribution to shareholders. Thus, dividends are income to the recipients.

11. The point of view advocated depends on the particular user: the owner, manager, investor and provider of funds. Which perspective should take preference?

This is an opinion question. Conventional theory opts for the entity theory. The FASB and the AARF appear to accept this view, but with the inclusion of the entity’s responsibility for reporting information to users, mainly shareholders and creditors, which is the investor theory’s emphasis.

12. If an entity theory viewpoint is taken, which of the following do you believe is appropriate in determining profit:

(a) financial capital or physical capital?(b) historical cost or current cost?(c) nominal dollars or constant dollars?

(a) Financial or physical capitalWhat is capital in the entity theory? The right-hand side of the accounting equation is equities. This can be divided between specific equities (liabilities) and residual equity (shareholders’ equity). The traditional view of the entity theory emphasises accountability to equityholders for the funds provided by them. This relates to the investment of the equityholders, and therefore a financial capital view is implied.The newer interpretation of the entity theory would definitely take a physical capital approach, because the entity is seen as concerned about itself. Thus, the entity would naturally be concerned about its operating capability. In fact, the accounting equation, Assets = Equities, fits well with the physical capital view because owners’ equity is not recognised directly. The focus is on assets, and the physical capital view is concerned about assets, of the entity’s productive and operating capability.

(b) Historical cost or current costs Under the traditional entity theory, any of the alternatives would fit in. However, it has been argued that since equityholders are mainly concerned about the amount of their investment, then historical cost is the logical choice. This is so, because the use of the funds provided by the equityholders is invested in assets, and for non-monetary assets the amount of the investment is the purchase price — the historical cost. This is the argument in conventional accounting. But whether equityholders are only interested in the original amount of their investment is debatable. Many believe they are also interested in changes in value.Under the newer entity theory, following along the physical capital alternative, then current cost is the logical choice. For physical capital, the question at the end of the period is: How much does the entity need in order to maintain its operating capability?. The amount needed at the end of the period is the amount to purchase the assets, which is current cost.

(c) Nominal or constant dollarsUnder both views of the entity theory, neither is favoured. Constant dollar accounting attempts to correct a mathematical problem, of dollars of different purchasing power being added together. Mathematically, numbers must be of the

same domain (same quality or unit of measurement) to be additive. If such a correction is desired, then a general price index that is pertinent to the entity’s circumstances should be selected.

13. What is deprival value accounting? On what basis are non-current assets measured? Why would users of financial reports consider deprival values useful?

Under the deprival value concept, assets are valued at an amount that represents the loss that might be expected to be incurred by an entity if that entity were deprived of the service potential or future economic benefits of those assets at the reporting date. Thus the value to the entity in most cases will be measured by the replacement cost of the services or benefits currently embodied in the asset, given that deprival value will normally represent the cost avoided as a result of controlling the asset and that the replacement cost represents the amount of cash necessary to obtain an equivalent or identical asset. In the case where it is expected that the asset will not be replaced, the asset should be valued at the net present value of the cash flows expected from continued use and subsequent disposal of the asset.

Deprival value allows users of financial reports to consider the ‘real’ value of assets in use, and how the relative importance of these assets changes over time.

14. What is the reporting entity concept? What impact does the reporting entity concept have on Australian financial reporting? Explain in the context of AASB 1025.

AASB 1025.27 defines a reporting entity as:

…an entity (including an economic entity) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources, and includes but is not limited to the following:

(a) a listed corporation;(b) a borrowing corporation; and(c) a company which is not a subsidiary of a holding company incorporated in Australia and which

is a subsidiary of a foreign company where that foreign company has its securities listed for quotation on a stock market or those securities are traded on a stock market.

In terms of the above definition, the key factor in determining whether a reporting entity exists or not is whether or not there are users dependent on general-purpose financial reports of a particular entity as a basis for making and evaluating decisions about the allocation of scarce resources.

The application of AASB 1025 means that a significant number of entities are no longer required to disclose full GAAP statements. However, in terms of published financial reports, publicly listed companies will continue to report under full GAAP, so very little, if anything, will change for investors trading in shares in listed companies.

Statement of Accounting Concept SAC 1, ‘Definition of the Reporting Entity’, suggests several indicators that may be used in determining whether a reporting entity exists. These factors include:

separation of management from economic interests (paragraph 20) economic or political importance/influence (paragraph 21)

financial characteristics (paragraph 22).

Further guidance is provided in Australian Professional Statement APS 1, ‘Conformity with Accounting Standards and UIG Consensus Views’. According to paragraph 16 of APS 1, the following types of entities will always exhibit the characteristics of reporting entities:

companies whose securities are publicly listed listed trusts and other trusts which raise funds from the public government-controlled business undertakings federal, state and territorial governments local governments.

Conversely, according to paragraph 18 of APS 1, the following types of entities will often not exhibit the characteristics of reporting entities and, therefore, would generally not be required to prepare general-purpose financial reports:

exempt proprietary companies family trusts partnerships sole traders wholly owned subsidiaries of Australian reporting entities.

The above are examples only, and the classification of a particular entity will depend on the circumstances surrounding that entity. The classification could also change over time.

When deciding whether a reporting entity exists, it is important to consider whether any financial report users are able to command the preparation of financial reports as and when requested by them, rather than relying on the general-purpose financial reports of an entity.

AASB 1025 also requires the application of all existing AASB accounting standards to non-reporting entities that purport to prepare general-purpose financial reports. A general-purpose financial report is defined in AASB 1025.27 as a financial report intended to meet the information needs common to users who are unable to command the preparation of reports tailored so as to specifically satisfy all of their information needs.

A diagram outlining the decision criteria is found on p. 126.

15. Why have government entities in Australia moved to accrual accounting? What perspective should government departments and agencies adopt?

Until the recent adoption of the accrual system of accounting by government agencies, the cash flow model was adopted and revolved around an annual budget of funds available. This was because of the annual allocation of funds for both ongoing and capital expenditures. The shift to accrual accounting was supported by the accounting profession, because a single framework of accounting for organisations could be adopted in Australia. Possible reasons for its introduction, include: to introduce a corporate model of evaluation of the performance of agencies and

departments to allow a base for valuation of assets to support the privatisation of certain government

activities and assets held

to provide a common platform for accounting education as a political device to bring forward expenditures of future periods, largely through

capitalisation methods, in order to signal commitments by governments in a defined political cycle.

Case Study 5.1 — Nike claims clean slate on rights

1. How would Nike account for the ‘millions of dollars’ it has spent to ‘remove itself from the protesters’ spotlight’? Nike was acting to maximise returns to the company by operating in Third World countries. Is any change to this in conflict with shareholders’ interests? Comment.

It would expense the costs in the year incurred. It is probably impossible to estimate the period over which Nike might get a benefit from investing in the PR activities designed to minimise the political and social fallout from its business practices and so the expense will be written-off in the period incurred. Companies are encouraged to operate with the objective being to maximise the value of the company and ongoing returns to shareholders. This would obviously attract Nike to Third World economies where labour costs are very low. Keep in mind that making clothing and shoes is a fairly labour intensive exercise. The ultimate question is an ethical one: Should a US-based company taking profits from the Western marketplace employ workers well below the standards required in Western countries in order to make profits?

2. Nike uses the word ‘pressured’ when discussing its social disclosures. Is Nike adopting an enterprise view, or simply seeking to minimise pressures to change work practices, which are having some effects on the demands for their products?

The answer requires a response from Nike. However, it would be interesting to consider whether Nike would have undertaken such social disclosures if pressure wasn’t being applied by the broader community. They probably would not have agreed to incur such costs, as these would detract from profits.

3. Why is Nike so concerned that other companies should be ‘pressured’ for social disclosures?

Nike would be feeling unfairly disadvantaged, in that their cost structure now includes PR costs that other companies do not appear to be incurring. Also, if a number of companies engage in such exercises, this may well drive down the average cost (and therefore total spend by Nike).

4. Philip Knight wants ‘all companies to be held accountable for their social responsibilities’ and has called for ‘global reporting standards’. What form would such standards take? Outline the type of social disclosures appropriate for a manufacturing firm such as Nike compared with a firm mining coal in Australia.

The standard would need to recognise quantifiable and non-quantifiable issues, and to some extent would need to allow for a degree of discretion as to what is disclosed and how. The main issues would relate to work practices and the effects on the environment, local economies and communities. Instead of a standard, perhaps a guidance statement might be

more appropriate, allowing for adaptation depending on the types of activity a business undertakes. Disclosures for a manufacturing firm such as Nike would relate to impact on local economies and employment practices, and would have relatively less concern with environmental issues when compared to a coal-mining firm.

5. Philip Knight suggests the social reports should be an appendix to a firm’s annual report. Can this be achieved without mandatory disclosure standards? Find an example of a social or triple bottom-line report and discuss the content and value of the information provided.

If it isn’t mandatory then there certainly will be a mixed level of compliance and disclosure. However, mandating disclosures may also limit the information available. If students cannot find an example, they could refer to the Shell web site. Alternatively, have them discuss how a traditional annual report might be improved with a triple bottom-line report.

Case Study 5.2 — Open all hours, but not to all comers

1. Since it appears that small business owners are focused on controlling their businesses, would the commander theory be the best approach to small-firm accounting?

The commander theory focuses on the concept of effective economic control. The control viewpoint applies to most small firms and the commander theory (outlined on pages 118–19) uses control as the key variable in reporting economic activity.

2. The small-business owners responding to the survey indicated that they were concerned that new shareholders may shift the focus from family business objectives to reporting profits. As such, do we need a viewpoint for small business that reports on achievement of family objectives rather than profits?

Most small businesses are an extension of the financial profile of the owners. Most debt is personally guaranteed, funding options constrained by owners’ personal preferences and ability to offer security. However, in order to gauge the performance of the business and to contribute to effective decision making, a distinct entity viewpoint should be adopted. This allows for owners to understand how business activities contribute to the personal wealth. The family business objectives should be used to interpret performance, but not to measure it.

3. Is the proprietary view the most appropriate model for small-business accounting and reporting, especially if owners have all their wealth tied up in their businesses?

The proprietary view is appropriate as it draws a distinction between personal and business activities, assets and liabilities, while focusing on the owner as the residual claimant. See pages 103–6 for a summary of the key point

Chapter 6Historical cost

Theory in Action 6.1 — Falling out on equity value

1. How can a company with ‘substantial cash and securities, which are worth $59 million’, be subject to a $54 million takeover bid?

The offer is below the value of cash and securities, which will (it is assumed) be committed to the operation of the mine. Over time this may lead to a reduction in net assets if the mine is not operating profitably. However, the article suggests that the offer is an ‘opportunistic grab’ and this may well be the answer. The offer could be based on the premise that many shareholders will not be aware of the total net value of the company and would be prepared to take an offer. The offer may not therefore have any relationship to the ‘real value’ of the company.

2. What do the company’s directors mean when they state that such an offer is ‘inadequate and value-destroying’?

If the company has cash and securities valued at $5 million greater than the offer and, presumably, other assets and future returns from trading, then the $54 million would appear to be inadequate. The directors are concerned that the offer may signal a shift in perceived value of the company and drive down share prices.

3. How would an independent expert determine that the offer is ‘neither fair nor reasonable’? Comment on the difference in value range of Ranger shares determined by the independent expert report (between 74c and 79c) and the assessed bid value of between 45c and 79c. How does this compare with the reported share price — steady at 62c?

An independent expert might have access to internal information that is not publicly available and hence not included in the share price. The valuer would review the net value of assets held and the value of these assets both at resale and also from trading. The value range of 74c to 79c would reflect the uncertainty and risk associated with the mining sector. The bid value reflects a broad range and reinforces the view that it is about gaining control of the company on the best terms possible.

4. Explain what the independent directors of Ranger mean when they refer to ‘discretionary capital’.

Discretionary capital is access to funds that are available for investment in business activities and opportunities, and will also support dividend payments and share buyback options. They aren’t tied to any one specific activity and are therefore available for allocation at the directors’ discretion.Theory in Action 6.2 — Allocating the cost of a web site

1. Is the Urgent Issues Group adopting a costs attach perspective in the accounting approach proposed for web sites?

Basically, the cost of web sites are ‘attached’ or attributed to the cost of their development across the period that the web site will support economic returns associated with the site. Paragraph 7 of the abstract indicates that the costs attach to future economic benefits, provided they can be reliably measured.

2. Under paragraph 7 of the abstract, web site costs should be recognised as an asset where they result in future economic benefits. This is consistent with SAC 1. But if we accept that a web site is basically a marketing and communication device, is it possible to measure future benefits and to determine an appropriate amortisation period?

While the approach proposed is consistent with SAC 1, and the underlying approach (adopted in Australian accounting standards) of allocating expenses to the period when a benefit results from the expenditure, recognition of future benefits is rarely clear cut when it comes to marketing expenses. As a marketing and communication device, the site may attract customers who become long term. However, how do we draw a line between an effective web site and future benefits? It is probably almost impossible and will lead to a write-off of web site expenses in the period incurred, as future benefits cannot be reliably measured.

3. Are paragraphs 6 and 7 in conflict, both with the objectives of accepted accounting practice and the abstract itself? Basically, paragraph 6 requires that all planning and maintenance costs be expensed in the period incurred, but such costs may result in future economic benefits. Discuss.

Paragraph 6 is referring to initial development and feasibility costs, and the view has been adopted that a reliable estimate cannot be derived as to the relationship with future benefits and an appropriate amortisation period. Such costs may well result in future economic benefits — the issue is how the relationship can be reliably established. So the two paragraphs are not necessarily inconsistent. Paragraph 7 adopts the same approach in that web site costs are expensed in the period incurred, except where they can be reliably measured as providing a future economic benefit. It would be interesting to encourage students to discuss how they might determine if there will be a future economic benefit and how they should amortise the capitalised expenditure.

4. Why is splitting costs for recognition as expenses and assets so important to the costs attach principle which underlines the historical system? Consider the information value of adopting the accounting approach for web sites advocated.

The fundamental basis of historical cost accounting is that expenses are reported in the periods that they relate to the generation of revenues — the matching principle. The value of expenditures is split into an expenditure and asset component. The asset component will be transferred to an expense item in the period that part or all of the asset is used to support business activities. As discussed in question 3, the recognition of the expense and asset components requires a basis of reliable measurement. Where the future economic benefit cannot be measured reliably, the accepted approach is to expense the item in the period incurred. This might distort financial performance, but there is little choice if a future value cannot be determined.

Theory in Action 6.3 — New boss, new values

1. What criteria would management use to decide when to ‘write down’ assets on the statement of financial position?

When assets have a value that is significantly lower than that reported in the accounts, an accounting entity can write-down these assets to their ‘true’ value. Normally this would require some level of independent valuation and an outline of the basis for the write-down decision. However, in reality, management has considerable discretion to determine which assets are written-down and when. If it appears that a significant write-off is required, management will ‘clear the cupboard’ and write-down any assets it feels has the potential for future losses in value, as it is better to lump the ‘bad news’ into one accounting period.

2. Why did St George management wait so long to adjust the value of its ‘dotcom’ investments, when it was clear from the share prices of these companies that their values had fallen significantly? How does this fit with the argument that historical cost is objective?

One can assume that these assets had values that were falling across a number of accounting periods. However, the aggregated losses were lumped into a single year. This is inconsistent with the underlying matching principles of the historical cost system. The second part of the question raises the general issue of comparability of historical cost profits. Historical cost profits are not necessarily (I would suggest rarely) comparable between years for the same entity, as a number of assumptions are required in determining historical cost profit, of which a number change in any one year. In addition, the discretion to adjust values in a period that seems appropriate to management certainly distorts performance. Refer students to pp. 160–8. The other side of the argument could be that the bank was hoping that continued operation of the entities may have seen an improvement in asset values, and so it would have been premature to write-down assets that have only been held for a relatively short period of time.

3. Why would the share value for St George increase immediately after such a significant downward adjustment to the value of its assets?

The share price might rise because the market was of the view that the assets were going to continue to decline in value and impact negatively on the value of the overall assets held by the bank.

4. Do alternative measurement rules for valuing and reporting assets underlie management’s discretionary approach to adjustments and disclosures, or is it the performance measures used to reward management? Discuss. (Remember, there may be a range of factors that influence the timing of adjustments to the recognised value of assets. In the current case, St George has been the subject of speculation concerning a possible takeover bid by one of the ‘Big Four’ Australian banks, and moving the share price upwards may reduce this speculation.)

The alternative measures for measuring and reporting assets provide management with considerable discretion and opportunities to influence the value of assets reported. Some argue that it is certainly inconsistent with the objectivity basis of historical cost. Increasingly in Australia, managers are being rewarded for performance against agreed historical cost profits and asset values. Such reward structures create added incentives to manipulate asset

values. Perhaps this is why Australian firms are such strong advocates of historical cost accounting?

Theory in Action 6.4 — When news of performance travels

1. Why is it that the profit is reported before deducting interest, depreciation and amortisation charges? Under the historical cost system these are important cost allocations, designed to match expenses against revenues in the periods incurred.

Reporting profits before interest, depreciation and amortisation charges is based on a traditional and standardised approach to reporting earnings. Under the historical cost system, all relevant expenses should be deducted in the calculation of profit; and in fact the interest, depreciation and amortisation charges are deducted separately for reporting purposes. One argument is that interest is a cost of capital, not an operating cost, whereas depreciation and amortisation are accounting adjustments that should be shown separately. However, with the requirement of a cash flow statement in the annual return, such adjustments seem less appropriate.

2. The directors reported in March 2002 that the company was looking to make profits this half-year. Why did this fail to attract the same level of response as the 9 May letter to the ASX? Has the value of the company really increased by over 100% in the space of 2 months based on one profit announcement?

a) Simply because the profit expectations became public at 9 May and were at that point factored into the value of the company.

b) This depends on what information has been made available and whether this information has been interpreted as explaining or supporting a change in value of the firm. The firm’s value consists of a component concerned with the future value of revenue streams. Obviously the market values those future streams and the value of assets held with that value increasing by 100% in two months.

3. Travel.com.au’s market capitalisation before 8 May approximated the cash assets of the business. What does this mean? Should the directors have considered writing down the value of operating/physical assets?

The share value approximates the cash assets, as the market was not able to place a trading value on the company. The company was new and was in a development phase. In addition, the market had experienced a number of dotcom failures and, as such, was perhaps showing caution in the value of another new dotcom operation. The directors have the discretion to write-down the value of assets, but would have been holding off until the development phase was completed and the viability of the company reviewed.

Theory in Action 6.5 — When the recoverable amount is zero

1. If the plant closure was a strategic decision which, according to the CEO, was part of a ‘three-year consolidation program’, why wasn’t the investment in the plant written off across such a period?

The timing of write-offs is really at the discretion of the directors. It may be part of a ‘three-year consolidation program’, but the point at which the write-off actually occurs can be at any time during that consolidation period. The issue is: When is in asset of no further economic value to a firm? The issue for investors is: How did the value expire?

2. Explain how writing off an operating asset results in a significant net increase in cash profits in the next financial year.

Writing off assets in one period means that in future periods, and in particular the period immediately after a write-off or write-down, the need to write-off/down is not there and not impacting on profit calculations. In addition, operating inefficient assets or assets that are not contributing to economic value will provide costs that impact on profits.

3. The CEO has not finalised a buyer or selling price for the company’s chemical storage and industrial vinegar business, but expects the price they will receive ‘will be greater than the book value’. Why aren’t these assets revalued to reflect the perceived higher value?

This is a very good point and reinforces the discretionary basis of the historical cost system, particularly the recognition of changes in value that are not from arms-length transactions. Further, the question could be asked: Is the CEO trying to talk-up the value of assets? If the assets are to be revalued, on what basis? When should the value be adjusted?

Questions

1. According to the historical cost system, what is the objective of accounting?

Stewardship is emphasised as the objective of accounting in traditional theory — enunciated by Paton and Littleton. Accountability to equityholders is primary. Owners and creditors are considered to be especially interested in what the firm (management) has done with the funds they have entrusted to it. Therefore, information should be provided to give an accounting of the performance of the firm in using the funds. Determining ‘net worth’ to owners is not of importance.

Critics say that stewardship is too narrow an interpretation of the objective of accounting. The stewardship emphasis causes a preoccupation with the past. Users want information for decision making, which calls for a ‘forward looking’ position. In SAC 1–3, the AARF agrees with critics, but present practice has not yet caught up with the view.

2. What is the role of profit in the historical cost system? What criticisms are made of profit calculated under the historical cost system?

Because accountability is emphasised, the belief is that equityholders are primarily interested in the results of the use of their funds. The results, of course, refer to earnings; thus, the statement of financial performance is more important than the statement of financial position. After all, the objective of the firm is to make a profit; that is why it is in business. The statement of financial position is a link between two statements of financial performance. It is a repository (dumping ground?) of unamortised costs.

Critics charge that we claim the statement of financial position is a statement of financial position; but, in effect, traditional theory downplays it. We should be more serious about making the statement of financial position a meaningful statement, one that fits the claims we make about it. Useful information for decision making implies that the statement of financial position items should be as income statement items. Current values would be more relevant.

3. Explain the concept of ‘costs attach’. How do the terms ‘embodied cost’ and ‘displacement cost’ relate to costs attach? What do critics say about the concept?

The theory is that the dollar amount of the historical cost of purchased goods and services ‘attaches’ to those goods and services. As the goods and services are used in the production of the product, the cost of the product can be determined by counting the attached costs of the goods and services that constitute the final product. As Paton and Littleton said, ‘it is as if costs had a power of cohesion’.

‘Costs attach’ is the same as ‘embodied costs’. Instead of saying costs attach, it is said that costs are embodied in the good or service. Embodied cost is what goes into something. Displacement cost is the same as opportunity cost; it is what is given up, displaced, sacrificed. The costs attach theory creates a new concept of cost. It is not only a sacrifice; it can also go into something. Attaching of costs or the embodiment of costs refers to historical cost only.

Critics believe the notion of ‘sacrifice’ is the only meaningful cost. This is supported by economic theory. There is no evidence that dollar amounts of historical cost attach themselves to physical times. This is purely an abstract view, not supported by evidence. Why this attaching takes place only for acquisition (historical) cost is not clear. If an item is valued at replacement cost because of the lower of cost or market method, then cost suddenly ‘detaches’.

4. What is meant by the terms ‘unexpired cost’ and ‘expired cost’?

These terms relate to the theory of costs attach. If the dollar amount of cost attaches to the physical items, then assets can be seen as ‘unexpired’ or ‘unamortised’ costs. Assets (or portions of them) and services that have been expensed are ‘expired’ costs. Paton and Littleton said the destiny of all costs is to ‘expire’ on the income statement.

5. Why has adoption of the historical cost system prevailed? What are the main arguments used to support adoption of the historical cost system?

Since equityholders are interested in what happened to their funds, the argument is that this leads to the use of historical cost. For example, assume that $100 000 is used to purchase equipment. Accountability of the $100 000 invested leads to the purchase price (historical cost) of the equipment. There are, of course, other reasons for the use of historical cost, but this particular argument is based on the objective of accounting, which emphasises accountability to equityholders.

6. Outline the arguments against the historical cost system. In your answer, consider issues associated with asset valuation, profit measurement and expense allocations.

Historical cost is relevant in making economic decisions. Management needs data on past transactions when making decisions concerning future commitments. Historical cost data are based on past transactions.Critics say that decision making is exactly why current data are needed. Whether a past decision was right or wrong must ultimately be ascertained by what happened in the marketplace; therefore, changes in market values must be tracked. For investors, the use of historical cost conceals important values that are needed in order to make intelligent investment decisions about a company. Income is also distorted by matching current revenues with ‘old’ costs.

Historical cost is based on actual, not merely possible, transactions. Actual transactions are recorded. Not only is there a record of actual transactions, but also the figures are reliable (objective). For current cost or exit price accounting, changes in prices are recorded and these are not based on actual transactions.Critics admit that, in general, historical cost is more objective — just not as much as many believe. Consider, for example, the book value of fixed assets after depreciation. Although changes in prices are considered in current value accounting, and these are not necessarily based on external transactions in which the firm is a participant, they are not as ‘non-objective’ as many suppose. They are based on market events. Trading off between objectivity and relevance must sometimes be made.

Financial statements based on historical cost have been found to be useful. For years, financial statements on a historical costs basis have been used. If they are not useful, they would have been abandoned long ago. Empirical evidence indicates that people find the conventional statements useful.Critics say that people have not had access to current-value financial statements, and therefore have had to make use of what they received — historical cost financial reports. Supplementary data furnished under SAP 1 are relatively new, and users may not be sufficiently familiar with them to greatly use such data. As far as the empirical studies are concerned, which indicate that many users prefer historical cost information, it is similar to asking Australians: Which do you find more useful, kilometres or miles? Obviously, they will select the former, because most Australians are not familiar with the latter.

The best understood concept of profit is the difference between sales price and historical costs (expenses). People understand the notion of profit under historical cost. It is simply the difference between what you sell something for less what expenses you actually incurred. This is sensible and logical.Critics admit that the historical cost notion of profit is familiar to people, but this does not make it better or proper. Such a view of profit is understood because of the long use of historical cost. Is it proper to match current revenues with ‘old’ costs? There is evidence, based on the disclosures under SAP 1, that some companies are paying out dividends in excess of income on a current cost basis. The greatly understood historical cost income can be misleading.

Accountants must guard the integrity of their data against internal modifications. The use of current cost or exit price opens the door to manipulation of these numbers.Critics admit that the possibility of manipulation exists, but the profession can formulate rules on how current values are to be ascertained. This has not been done because current value accounting is not acceptable practice.

Income based on current cost or exit price is not very useful. Why should changes in value of fixed assets be included in income if the company has no intention of selling these assets? If the market price of an asset declines in a given year (say, $200 000), what difference does it make if the company expects to generate a greater amount (say, $300 000) by the use of the asset over its remaining life?

Critics argue that the notion of income calls for consideration of changes in the value of assets and liabilities. If an asset will generate a certain amount of revenue, this will be shown in the calculation of income, but the change in the value of the asset is an important variable that should be considered in that calculation also. The intention and expectations of a company are not ‘real’ yet, but the change in value is. Price changes are significant economic events. Expectations of amounts from the use of an asset may not be realised. Usefulness of an income figure eventually boils down to the predictive value for assessing future cash flows. Logically, since current values are closer to the future than historical costs, they should be more useful to users in assessing future cash flows.

Changes in market prices can be disclosed as supplementary data. If there are people who want current value data, these can be disclosed as supplementary data without having to abandon historical cost accounting.Critics say this is really not an argument in support of historical cost. If such data are important enough to disclose, why not in the text of the financial statements? Why not have both sets of financial statements?

7. In reviewing the empirical evidence on the usefulness of accounting data, how useful is historical cost in predicting (a) future cash flows and (b) future profits?

As a means of predicting both future profits and cash flows, the best that can be said is that the more recent periods’ performance are normally more useful in predicting future performance than information for a significant period of time. Ball and Watts found that accounting information from across a number of periods represented a ‘random walk’ and that on this basis was not useful in predicting future performance. A full discussion of the predictive value of more refined information (such as quarterly data) and of some components of the financial statements (such as segment profit and sales) can be found on pages 153–5, which provide a useful summary of the key issues.

8. What are your conclusions concerning the empirical studies on the following? Do they provide convincing evidence?(a) Past profits used to predict future profits.(b) Quarterly data used to predict annual profit.(c) Financial ratios used to predict financial distress.

(a) Studies in this category are attempts to describe a firm’s earnings series by constructing a statistical model. The research studies mentioned in this book conclude that the ‘random walk’ is a good description. In other words, the earnings series is such that the best estimate of future earnings is the preceding one. Whether the research studies provide convincing evidence is a matter of opinion. There has been no research study that denies the random walk conclusion.

(b) The conclusions of research in this area are that quarterly data are useful for predicting a firm’s annual profit, and that successive quarterly profit makes the prediction increasingly accurate. Foster concluded that a ‘parsimonious Box–Jenkins’ model best describes the series. The implication is that successive changes in profit are positively correlated, such that if profit increases in one quarter there is a high probability that profit in the next period will also increase. Others have done research on this and agree with Foster, although one person (Lorek) believes it is premature to single out any particular model. The evidence appears to be sufficiently convincing that using quarterly data to predict

profit, such as Foster’s, is a better predictor of annual profit than the more complex ones using annual data.

(c) The evidence indicates that certain financial ratios have the ability to predict financial distress. The studies conducted by Beaver and Altman reveal a high predictive capability. The study by Ohlson implies that the predictive power of financial ratios may not be as high as previously believed. But all studies show that financial ratios have predictive value with respect to financial distress.

9. What system of accounting is supported by the AASB conceptual framework project? Discuss.

Conventional accounting theory is not the same as the AASB’s conceptual framework. What is referred to as conventional accounting theory can be traced (in Australia and in the United States) to the authoritative pronouncements of the ACA in the 1940s, 1950s and 1960s; to the statements of principles by the American Accounting Association (1936, 1941, 1948); to the monograph by Sanders, Hatfield and Moore (1938); and to the monograph by Paton and Littleton (1940), among others. Although these writings are not in agreement on all points, they express a consistency of thought to warrant the term ‘conventional accounting’. The Paton and Littleton monograph is the most articulate and well known in the enunciation of conventional theory.

The AASB conceptual framework is in agreement with much of conventional theory (for example, revenue recognition, matching), but it does view accounting somewhat differently. Examples of these differences are: The conceptual framework emphasises information for decision making, whereas

conventional accounting emphasises information for stewardship purposes. The conceptual framework does not stress conservatism. The conceptual framework disagrees with particular current practices, although these

practices are acceptable under conventional accounting. (For example, the AASB does not like to include certain deferred credits as liabilities.)

The conceptual framework was established in a series of concepts statements (SAC1–3) during 1990. These statements are authoritative but, as outlined in chapter 17, will do little to change actual practice.

10. Compare and contrast the traditional stewardship/accountability objective of accounting with the objectives outlined in SAC 2. In your opinion, would these separate objectives be better served by different measurement bases? Give reasons for your answer.

The traditional stewardship objective focuses on reporting that management has deployed assets in the interests of equityholders. Managers are responsible for maintaining the capital base of the entity and generating appropriate returns on the capital base. SAC 2 adopts a far broader set of views and considers alternative perspectives. This will represent a trade-off between the specific needs of individual sets of users. Paragraphs 3 and 4 of SAC 2 refer to the ‘common information needs of users and the broad types of information consistent with those needs’. Accountability is about information for decisions, rather than reporting on stewardship. This is reinforced by the definition of ‘performance’ in paragraph 45 of SAC 2.

Different measurement bases are appropriate and relate to the decision to be made and the objectives of statement users. However, consideration needs to be given to the costs of serving individual user sets and the potential confusion resulting from contrasting information on sets being reported.

11.Do you believe that different measurement techniques within the same statement of financial position and between types of assets violate the stated ‘comparability’ objectives as outlined in SAC 3?

According to SAC 3, information should not only be relevant, but also comparable. This comparability refers to both at one point in time and across time. According to paragraph 3 of SAC 3, this requires consistent measuring and reporting methods. At face value, this view would imply that different measurement techniques within the same statement of financial position and between types of assets would violate the notion of comparability. However, even where consistent techniques are adopted for individual categories of assets, the potential exists for comparability problems — as within single techniques a range of decisions/assumptions are required to facilitate the measurement and reporting method adopted. Additionally, comparisons are possible provided methods are used relatively consistently for each category of assets. With respect to comparisons over time, an issue remains concerning the failure of most reporting standards to require some consideration of the time value of money.

12.Would market value-adjusted statements be more ‘decision-useful’ than those prepared applying traditional measures? Would using current market values reduce the number of decisions required to prepare financial statements, compared with the historical cost approach?

The answer to this question is a matter of viewpoint. This question can be used to encourage class debate on the relative advantages and disadvantages of each approach. The solution to question 6 outlines the traditional historical cost viewpoint. The discussion of ‘historical cost under attack’ on pages 141–2 of this chapter summarises the alternative view.

13. Explain the concept of ‘fair value’ as defined in AASB 1041 and outline the benefits to financial statement users of continually revaluing assets to their current value.

Fair value refers to the value of an asset were it to be sold at arms-length to another party — that is, its current market value. Researchers such as Barton and Edward and Bell argue that market values, or their equivalent are ‘fine’ measures of performance that are more highly valued by the marketplace. Others have argued that reporting market values provides a more effective means of communicating financial stress and future earning capacity. However, despite these findings, there has not been widespread acceptance of the need to value assets/liabilities at market. This has been particularly so in periods of low inflation. When standard setters have sought to introduce market/current-value approaches they have tended to meet with strong resistance from public entities and the accounting profession. However, where it is viewed as fundamental in gauging performance, standards have adopted market-value approaches. AAS 25 and AAS 26 are examples of such approaches, which may lead the way for a more widespread shift to adoption of measurement and reporting techniques beyond historical cost.

14. The following questions relate to the apparent divergence in view between the AASB and the private sector, with respect to the need to shift from historical cost to current value accounting:(a) In your opinion, why are the Australian standard setters moving away from

traditional historical cost accounting?(b) Why do think that the business community and the public accounting firms are

so strongly opposed to a move away from historical cost accounting?(c) Measurement principles are fundamental to any accounting system. Why hasn’t

the AASB issued SAC 5?

The answer to these questions relies on the students’ perspectives. Like question 12, these questions can be used to facilitate debate on moving from historical cost to market/current-value approaches.

(a) Standard setters in Australia do not share agreement on the move to market-value-based standards. However, the recent trend with SAC 5 and AAS 25 and AAS 26 indicates a growing acceptance by the AASB to alternatives to historical cost. This is largely a function of international trends and the increasing number of standards dealing with specific reporting and measurement issues. This is also consistent with the adoption of the conceptual framework, developed as a guide to appropriate reporting and measurement outcomes, which focuses on the most appropriate solution and which is outside the traditional constraints of the historical cost system.

(b) Reasons for the opposition to move away from historical cost include: the potential risk associated with auditing reports based on alternative

measurement systems costs associated with changing knowledge and audit techniques costs associated with current-value systems potential to reduce reported profits and in some cases asset values significant changes which may be required to reporting systems.

(c) This is subjective and a matter of perspective. Students should discuss this from the perspective of each key group, including management, shareholders, the Australian Securities & Investments Commission and the accounting profession.

15. If historical cost reporting is as objective as many in the private sector say, why aren’t corporate collapses more readily predictable?

Most will argue that beyond recording the initial transaction, historical cost is far from objective for the following reasons: there is considerable choice and discretion concerning the accounting methods and

measures adopted changes to those measures and methods levels of disclosure and explanatory information the timing of expense and revenue recognition the timing of disclosures. This means that statements are often not comparable between years and across different firms (even those in the same group). However, often the problem is that information is deliberately manipulated and the manipulations deliberately (and well) hidden.

16. Has the complexity of alternatives to historical cost approaches become an excuse for keeping the historical cost system?

With the level of technology available, the complexity of alternative measurement and reporting models is not really an issue. The reasons could include: both academics and practitioners cannot agree on what is an appropriate model end users may not understand more complex information the overall costs of reporting may prohibit adoption of alternative models such models are still subject to the weaknesses of the historical cost system, particularly in

terms of the ability of directors to pick and choose applications and the timing of disclosures.

Problems(for full outline of problems, please see text)

6.1The following events (see pages 171–2) occurred in 2004 for Bruce Ltd of Brisbane. Record the transactions according to generally accepted principles of accounting.

This is a fairly long problem. The purpose of this problem is to indicate that determining historical cost is not as simple as many believe. The question of the ‘objectivity’ of historical cost is also to be considered. The fact is that subjective elements are involved in the determination of historical cost.

1. Purchases $47440Freight in 800

Accounts payable $47040Cash ($800 + $400) 1200

The trade discount of $2000 is never considered in an account. Students should be reminded of the difference between a trade discount and a cash discount. The calculation of the cost of the units purchased is as follows:

$50 000 = 5000 units 10– 2   000 trade discount$48 000 invoice price

– 960 cash discount of 2% of invoice price400 insurance while merchandise in transit

800 freight$48   240 cost of 5000 units purchased

It is customary to put the freight cost in a separate account when the merchandise is first purchased, and therefore the purchases account is debited for $47 440. Later, the freight will be added to the cost of the inventory. Theoretically, storage cost, consisting of the depreciation cost of the warehouse, should be added to the cost of the inventory, but most companies do not do so because of the difficulty of determining this cost. If some students insist on the inclusion of storage cost, they would not be incorrect; however, storage cost would be allocated to inventory at a later date — not at the time of purchase of the items. The net method is used — the cash discount will be taken — since it is Bruce’s policy to take discounts.

2. The cost of the property purchased is to be put into the land account. The cost is computed as follows:

$800 000 sale price of property1 000 title fee

400 recording of the deed2 200 unpaid rates3 000 legal fees

30   000 demolishing old building$836   600

Most accountants argue that the cost of demolishing the old building is part of the land cost, because it was a necessary expenditure in order to put the land into suitable condition for construction.

Land $836 600Cash or accounts payable $836 600

The cost of the newly constructed building is computed as follows:

Direct costs:Architectural fees $ 5 000Excavation 10 000Direct labour 300 000Materials 200 000

Indirect costs:Fixed overhead (6% $300 000) 18 000Variable overhead 40 000

Interest during construction(10% $200 000 1/2) 10   000

$583   000

Absorption costing must be used to determine the cost, which means that fixed costs are included. The cost saving of $117 000 (that is, $700 000 – $583 000) is ignored. The cost saving will be realised indirectly by the lesser amount of depreciation over the life of the building.

Building $583 000Cash, materials, etc. $573 000Interest payable 10 000

3. (a) The lower of cost or market should be used. The only entry for 2004 is the following:

Cash (10% $12 000) $1200Dividend revenue $1200

(b) According to ASRB 1016 the equity method is to be used.

March 1 Investment in Memory $300 000Cash $300 000

Dec 31 Investment in Memory 24 000Investment income 24 000(60% $48 000 10/12)

Dec 31 Cash (60% $8000) 4800Investment in Memory 4800

The equity method requires an entry similar to the one below, because of the difference between cost and book value acquired at the time Bruce purchased the shares of Memory. The entry below would account for the presumably higher depreciation amount or amortisation of goodwill, thus reducing the income for Bruce. However, many companies do not record the entry below but include it in the consolidation process.

Investment income xInvestment in Memory x

The entries for the equity method show that it is not a historical cost method.

(c) According to ASRB 1016 the investment is to be accounted for as a pooling of interests and the equity method is to be used.

July 1 Investment in Ryan (at book value) $360 000Ordinary shares (3800 $50) $190 000

Paid-in capital excess of par 10 000Retained earnings 160 000

Dec 31 Investment in Ryan $48 000Investment Income $48 000

Dec 31 Cash $8000Investment in Ryan $8000

For pooling of interests, the acquisition cost (3800 shares $63 = $239 400) is ignored. Only the book value received is pertinent. Long-term investments by the cost method (part (a)), the equity method (part (b)) — both of which were ‘purchases’ — are to be contrasted with the book value method (part (c)) under a ‘pooling’. Since Bruce has all three, the question is: Are the investments comparable?

4. ASRB 1011 applies. Either the successful efforts method or the full cost method can be used. The estimated value of $2 000 000 is not recorded.

If the successful efforts method used:(a) Exploratory costs (asset) $360 000

Cash, etc. $360 000

(b) Oil reserve (asset) 200 000Exploratory costs 200 000

(c) Exploration expense 160 000Exploratory costs 160 000

If full cost method used:(a) Exploratory costs $360 000

Cash, etc. $360 000

(b) Oil reserve (asset) 360 000Exploratory costs 360 000

Both are historical cost methods, yet each gives very different results concerning the cost of the oil reserve. Is it $200 000 or $360 000?

5. ASRB 1015 is pertinent. This is an exchange of similar assets. The calculation of gain or loss depends on whether the fair value of the asset given or the asset received is more objectively determinable. In most cases, the value of a brand new asset is more reliable than the value of a secondhand asset. This appears to be the case here; the cash price of $11 200 is more objective than the company’s estimation of the value of its old machine, $15 000.

Value received:Cash price of new machine $11 200Cash received 4 800Total $16 000Value given:Book value of old machine –  14   000 Total gain implied $   2   000

$4800/$16 000 $2000 = $600 gain to be recognised.

Cash $4 800Machine 9 800Accumulated depreciation 16 000Machine (old) $30 000Gain on exchange 600

In what sense is the $9800 the acquisition (historical) cost of the new machine? It is the fair value ($11 200) less the unrecognised portion of the gain ($1400). The main point is that an exchange of similar assets does not substantially change the economic position of the company, and therefore gains should not be recognised except to the extent cash is received. When cash is received, as in this case, we have a ‘hybrid’ transaction — part exchange (swap), part sale. To the extent cash is received, it is as though a sale was made, and therefore $600 can be recognised as gain. The by-product of this rule, the $9800 of value for the new machine, is a strange figure, but conventional accounting is more concerned with the income statement than the statement of financial position.

6.2 Record as journal entries the following transactions (see page 173) for Lee Ltd according to generally accepted accounting principles.

1. The ‘proper’ accounting for these expenditures in large part is based on tradition — what most people do about them.

(a) The future benefits are too elusive to consider this an asset. The $25 000 should be charged to expense, such as consulting expense.

(b) It is acceptable to consider this an intangible asset, because it enhances efficiency. It can be called ‘rearrangement cost’, and should be amortised.

(c) The $150 000 can be charged to the building account, and the $20 000 to furniture and fixtures.

What is the possibility of creating one asset for all the expenditures and amortising it as one? Although an argument can be made to consider the total cost of $295 000 to be one asset, most accountants would feel uncomfortable about it. The reason is that the elements are too diverse; furniture and fixtures are traditionally classified as property and plant and equipment; whereas the rearrangement cost is an intangible.

2. ASRB 1011 is relevant: $500 000 is a research and development cost, because the equipment is for this one

research project only. $200 000 is an asset to be depreciated, because the equipment has alternative uses. $250 000 for the patent is a research and development cost, because the patent is for

this one research project only.

6.31. How would SoftStuff Ltd account for the development costs incurred in each year 2004–05 to 2006–07 and the pre-launch marketing costs incurred in 2006–07, under the existing Australian accounting standards?

2. Given your answer to (1), and the matching concept advocated by the historical cost system, is there a more appropriate basis of accounting for these costs? In your answer, consider that, without these costs, there would be no revenue stream for the 5 years of the exclusive software copyrights.

1. The costs are to be expensed in the period incurred, unless the expense can be reliably matched against the future revenues that the initial expenditure generates. The problem may be in establishing a causal relationship between the research and development costs and future revenues. Obviously other operating expenses will be incurred that may support the majority of revenue achieved. It is even more difficult with marketing costs because it is normally very difficult to determine a direct relationship between marketing costs incurred at a point in time and future revenue streams. The point is that management will have the option of an immediate write-off or a carried forward, depending on its view as to whether the future revenues can be reliably matched.

2. The underlying view of the historical cost system is that wherever possible expenses are matched against revenues in the period that the revenues relate to the expenses incurred. The problem is that the historical cost system does not provide any definitive rules for reliably measuring the relationship where expenses are incurred in one period and revenues flow in another. Given that the five-year licence agreement is a direct function of the development costs, then there would be a strong argument to assign the expense across

the five-year period of the licence, perhaps on a proportionate basis (proportion of revenue in each year as a function of total revenue).

6.4 1. What valuation methods and supporting information could the directors use to establish a ‘fair value’ for the collection? (Consider gallery prices, auction prices, overall trends for the specific artists in the collection, and the most appropriate indexes.)

2. How would the company record the measurement of ‘fair value’ of the collection? Is ‘fair value’ a more appropriate measure than historical cost?

3. Should the directors move to fair value for all assets or just the groups of assets they feel would most suit the application of fair value techniques?

1. The directors could consider a mix of available secondary data — auction prices, gallery prices etc. The difficulty would be getting a value that relates to the value of the actual works. Perhaps they could adopt some average measure from a mix of valuation methods. They would also need to adjust values for the transaction costs associated with realising an artwork.

2. If an asset is appreciating in value then it should be revalued to reflect the real value of the asset. The problem is, as indicated in (1) above, attaining a fair and reasonable value, particularly for unique items like art works. The problem that arises when some assets are revalued and others are not is that the statement of financial position reflects a mix of values. Perhaps all assets should simply be valued each year at their disposal value — the problem then being one of determining what the disposal values are and the costs associated with annual adjustments. Remember also that management prefers to have discretion over the timing of losses or gains on holding assets.

3. This is really a matter of perspective and will depend on the objectives and incentives that impact on management’s decision making regarding disclosures and reported asset values.

6.5As a class or group exercise, take the role of the AASB and provide an outline of the measurement principles you feel are appropriate in developing SAC 5 ‘Measurement of the Elements of Financial Statements’.

Encourage a broad discussion of measurement issues and ask the class to consider the alternatives as they relate to the traditional economic concept of income and assets, compared to the historical cost and current cost models. Which method does the class consider will be accepted by shareholders, management, government bodies regulating company reporting, stock analysts and the broader community?

Case Study 6.1 — SingTel to cut Optus cable $1bn

1. How can the value of an investment change so dramatically from one accounting period to the next, to the extent that SingTel is writing off $1 billion of its investment in Optus, amid rumours that the value of the investment might be cut by as much as 70%? Should SingTel have reviewed the value of assets before paying $14 billion for Optus? How do such write-downs relate to the stewardship function?

The historical cost system measures and reports assets at cost. The assets held are subject to revaluation at irregular time intervals and often adopting a range of valuation methods. The market value of the firm is reflected in the total market value of the traded equity of an entity that will not normally be correlated with historical value. It is the value of the application of net assets to business activities that is being valued, not the static value of the assets purchased and held to operate and undertake business activities. It is surprising that a major investment can decline by such a significant amount so quickly. Shareholders should be asking for a full explanation. However, directors have every right to write-down assets when they consider they are significantly over or under valued in the financial statements. SingTel should have reviewed the value; however, not all relevant information may have been available and the value of a combined entity may not have been measurable. Under the stewardship function, directors should protect the net value of the firm.

2. Explain what you think the terms ‘conservative accounting’ and ‘aggressive accounting’ mean.

The term ‘conservative accounting’ is normally associated with underestimating or providing for revenues of increases in asset values and overestimating or providing for expenses and reduction in asset values. Whereas ‘aggressive accounting’ is the reverse case.

3. SingTel plans to increase the goodwill recognised in the purchase of Optus by $1 billion (this will effectively offset the $1 billion write-down of the investment). Is this approach valid? Under the historical cost system, can such adjustments be made to purchased goodwill?

The approach would be valid if SingTel can show that the $1 billion is purchased goodwill and not just a figure they have determined in house. Under the historical cost system, such adjustments cannot be made to goodwill unless an external transaction is involved.

4. The article indicates that Optus has changed its method of recognising expenses and will now recognise expenses ‘up front rather than over a period of time’. This would appear to be in conflict with the matching concept and costs attach approach. Discuss.

The initial question that students should consider is: On what basis can management justify changing the method of expense recognition? Again, doesn’t this show how lacking in objectivity the historical cost system is? This would appear to be in conflict with the matching principle adopted under the historical cost system. However, the future benefits may not be reliably measurable and hence the decision to recognise ‘expenses up front’. It is difficult to believe that such a blanket view is appropriate, as each expense category should be considered.

5. Under the matching concept, how should Optus account for the introduction of a new $30 million sales process? How is Optus accounting for it?

This approach provides a good example of the discretion management has in recognising expenses. The historical cost system would require that consideration be given to matching

system costs to the periods in which benefits accrue to the entity. This will vary, but management has opted for an immediate write-off.

Case Study 6.2 — Murdoch’s magic turns the bad into good News

1. The historical cost system is the accepted measurement and reporting system in corporate accounting. As such, why does the financial press consistently refer to a firm’s market value and how is such a value ascertained?

The historical cost system provides a basis for measuring, recording and reporting financial information. It is based on the actual outlays or costs associated with a transaction, and provides for revisions to asset values where there is a significant difference between the actual value of an asset and the value reported. However, there is no requirement that such adjustments are made on a regular or systematic basis. Market value refers to the value of the entity as reflected in its traded share price. This value takes into account the perceived value of operations of the company, not just the standalone value of the net assets held by the company. Consequently, the market value will not normally be the same as the historical cost values reported in the financial statements. In making an investment decision, the key value is market value, which reflects the expected returns (both capital and dividends) from applying the business’s assets to business activities.

2. If News had not performed as strongly in the March quarter, do you think Murdoch would have written down Gemstar to the extent he did? The article indicates that the value of News increased almost by the amount of the Gemstar write-down. Why would this occur? Is it, as the article suggests, good timing to announce the good and bad news at the same time?

It is hard to know what Murdoch may have done if News had reported a higher or lower profit. In financial reporting, timing of the recognition of write-offs is important. There is empirical evidence to suggest that companies will seek to ‘smooth’ income so that it fits within expected industry and market performance. Also, where large write-offs are required, a company will ‘save them up’ and take a ‘bath’ in one period, rather than spreading losses across several periods. Murdoch may well have waited if the losses could not be offset. The point to be made is that under the historical cost system he has this discretion. How could we prevent such deliberate income offsets? Ask the class to suggest options.

3. Murdoch considers the focus should be on the company’s cash flows. Is it because he wants to shift the focus from the write-off of bad investments or that the cash position is a better indicator of future performance than accounting profit?

Obviously Murdoch would be seeking to shift the focus from the write-down of bad investments to the underlying performance of the group. It is fortunate that some parts of the business are able to generate cash, which offsets some of the significant poor investments made by News in recent years. Over the medium term, cash flows will provide a better understanding of the overall performance of the firm, but may not distinguish between

operating cash returns versus capital transactions. Students should also consider that the write-off does not have any cash implications, and that Murdoch uses media statements to seek to influence the perceived value of his firm. Perhaps students could be asked why Murdoch would seek to signal information through the media, rather than through the financial statements?

4. Explain the term ‘on-paper writedown’ and outline how such adjustments affect both the statement of financial position and statement of financial performance. How can an asset lose 60% of its value within the space of a year?

An ‘on-paper write-down’ means that there are no cash implications or changes to the value of other assets or liabilities. The write-down would normally be reported after the calculation of operating profits. The write-down would reduce the overall value of assets held with an equivalent reduction in the value of owners’ equity. It was more than a year, but the decision to write-down was held until the current year. The loss of value has occurred over the period the asset was held, but the decision as to when to recognise the loss is at the discretion of management.

5. It would appear that News is capitalising its pay TV development costs, to ‘be burnt against planned profits’. Is this consistent with the matching concept, where future revenues are uncertain? Outline how these costs should be allocated to future pay TV revenues.

It would appear that News is acting in a manner consistent with the matching principle, provided the future economic benefits can be reliably measured and matched. Again, under historical cost, management has a choice. If News hadn’t been experiencing such write-offs, would it have simply written the acquisition costs off? Given previous practices this seems highly likely.

Case Study 6.3 — Ivanhoe Mines writes off Savage River investment

1. Changes in price for iron ore pellets have reduced the value of the Savage River Mine. How has this reduction in price flowed through to the statement of financial position of both Savage River and the parent company, Ivanhoe?

The companies are holding stockpiles of ore. The value of ore falls and therefore so does the value of the stockpiles. Also, as contracts are written in foreign currencies, when these values change against the Australian dollar, then losses in the exchange will also be experienced.

2. How would Ivanhoe record and report the US$7.9 million foreign exchange loss? What will happen if the exchange rates shift next quarter and Ivanhoe makes an exchange rate gain of US$2.2 million?

The foreign exchange loss is recorded as a normal operating expense in the statement of financial performance. If in the next quarter an exchange rate gain is achieved, then this is reported in the revenue section of the statement of financial performance.

3. It now appears that Savage River has inventories greater than a year’s production of pellets. This may mean that Savage River will be affected by exchange rate exposure, declining ore prices and the cost of holding an enormous inventory of ore pellets. Should Savage River adjust its books to reflect the significant difference which appears to exist between the realisable value and carrying amount of its assets?

It appears that Savage River should make the necessary adjustments or at least foreshadow them in the notes to the financial statements. However, under the historical cost system there is no requirement to make any adjustments.

4. What do the directors of Ivanhoe mean when they say that the written-down book value of the Norway investment is ‘reasonable and appropriate’? Consider this in light of the expected fall in ore prices by at least 5% in the next quarter.

The directors are using the term ‘reasonable and appropriate’ to refer to the write-down because it is consistent with market expectations and global trends with respect to ore mining and ore prices.

Chapter 7Current cost accounting

Theory in Action 7.1 — Market value accounting

1. What type of market values is Ravlic arguing for?

Ravlic is arguing for the market values that reflect the current buying prices (current costs) of assets. That is, assets would be valued at current market buying prices and depreciated in the income statement at those values. It is not mentioned how the increase in current costs would be handled. There are two ways: as an unrealised holding gain or as a capital maintenance reserve. Historically, Australia has favoured the capital maintenance reserve concept (physical capital) and therefore this approach would be the one proposed.

2. Why do you think a relative current value accounting model fits between the two extremes?

This model fits between the two because it retains the going concern and realisation concepts of historical cost by not recognising gains in market prices as profit, and assumes that assets will be replaced at their current input prices. (That is, accumulated depreciation becomes a replacement reserve after backlog adjustment.) Hence, operating income (rates of return) using current costs becomes a current opportunity cost rate of return assuming continuance of operations. It is a compromise with selling price accounting because it recognises one measure of current prices and values assets at those current prices (as in selling value accounting), while not recognising the changes in asset prices as income. See also the section financial capital versus physical capital (pp. 188–93).

3. What are the advantages/disadvantages of historical cost and market selling price accounting systems?

The main disadvantage with historical cost accounting is the valuation of assets in the statement of financial position at outdated prices and the adding together of different dated dollars as though this is a legitimate valuation process. This means that financial statements between firms are not comparable. On the other hand, not every asset has an active selling market and in some cases it is difficult to find a selling price. Also the concept of value in use is ignored. Some assets do not have a selling price but are extremely valuable as assets that generate future income within the firm.

4. Why do you think there is opposition by accountants to the introduction of the relative current value model?

The reasons include: the costs involved in updating and auditing accounts the reduced flexibility associated with current costs it switches accounting from an income perspective to a statement of financial position

perspective

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accountants have placed a great amount of personal effort into supporting the current system as a stewardship system rather than as valuation system

it may not be cost effective for most of their clients who operate small businesses.

Theory in Action 7.2 — CSR’s asset valuations and firm rating

1. Why do you think CSR decided to sell off or divest itself of some of its assets and acquire further assets?

Presumably, the assets were underperforming and not worth replacing at current market prices. A rational financial decision would follow these steps:1. calculate cash equivalent as the price equal to the selling value of assets2. calculate the present value of expected future income stream3. compare the results to the opportunity value of continuing to operate the assets (buying

prices).

Tutors should point out that a number of accounting systems were employed in order to come to the decision and that no one accounting system can give all the information required.

2. If you assume that the $1.5 billion divestments were recorded at $0.9 billion in the statement of financial position of CSR, how much profit would be made under:(a) historical cost accounting?(b) current cost accounting?

(a) $0.6 billion under historical cost (b) zero under the current cost system.

3. How would you reconcile an historical cost abnormal profit (calculated above) with the previous $565 million worth of write-downs?

This question raises a fundamental issue with historical cost accounting. Assets that have market values less than cost are recognised as losses and written off in the accounts as abnormal losses; whereas assets that have values above historical costs are ignored. This example illustrates the conservative principle in practice.

4. Given the fluctuation in CSR’s asset values, how would you value the assets of CSR and determine profit?

This is the debate illustrated in this chapter and subsequent chapters. At this stage, it would be useful for tutors to briefly raise some of the relevant issues. For instance, the point that some assets can change character according to the purpose for which it is held could be raised. For example, if one purchases a house to live in, then knowledge of current cost is not that important. However, the same house purchased as a financial investment requires continual price monitoring in order to determine whether one should switch investment into other more productive assets. Similarly, current costs are important for assets purchased to continue a manufacturing process (value in use), whereas selling prices might not be.

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Questions

1. What are the three types of decisions managers are faced with in running a business? How does accounting enter the decision-making process?

The three types of decisions pertain to the allocation of resources within the firm in order to maximise profits. They are:1. Those relating to the expansion of the firm. What amount of assets should be held at any

particular time?2. Those relating to the composition of the assets. What should be the form of the assets?

How much working capital, how much of equipment, of plant, etc.?3. Those relating to financing. How should the assets be financed? How much debt

financing, of new equity, of retained equity, etc.?

To make decisions regarding the three problems mentioned above, managers need to form expectations about future events. Expectations are based on past events, and therefore past decisions relating to the past events must be evaluated. Accounting information helps managers to evaluate their past decisions. In so doing, accounting information serves as a basis for forming expectations.

2. Explain the Edwards and Bell concept of ‘business profit’.

Business profit = Current operating profit + Realisable cost savings

Current operating profit = Excess of the current value of the output sold over current costs of related inputs

Realisable cost savings = Increase in the current cost in the current period of assets held

Instead of using the term ‘realisable cost savings’, we prefer the term ‘holding gain’. There are a couple of questions that need to be dealt with concerning holding gains/losses: do these involve all assets, and are liabilities to be also considered? Although Edwards and Bell defined realisable cost savings in terms of assets, it is clear from a reading of their book (chapter 7) that they also included liabilities — they meant all assets and liabilities. However, because short-term monetary assets and liabilities are similar to cash, and the value of cash is constant (except in terms of purchasing power), they said that as a practical matter these could be ignored. Therefore, holding gains/losses refer to non-monetary assets and long-term liabilities.

3. What are the benefits of separating out the holding gains (or losses) in profit determination? What are some shortcomings of this separation?

This question assumes the financial capital view. Benefits include: Can determine if holding activities are successful. Holding a certain composition of assets

and liabilities is one way management tries to enhance the firm’s market position. The evaluation of holding activities can be made because it is separated from operating activities.

Gives credit where credit is due. The managers at certain periods are given credit for purchasing non-monetary assets when they were cheaper, or incurring debt when the interest rate was lower.

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Can better evaluate the performance of management. Management usually has more control over operating activities than holding activities. Management is hired in order to direct the operating activities of the firm. Changes in current cost of non-monetary assets are not always within the control of management. However, in some firms (for example, traders, builders) profit from holding activities is an important component of profit activities and it is economically desirable to be fully aware of the market prices and movements of these activities.

Can better predict future cash flows. Changes in the current cost of assets (that is, holding gains/losses) reflect changes in future cash flows that will occur because of the use of assets. These changes in cost relate to the ‘unexpected’ component of economic profit.

Shortcomings include: Some decisions of management affect both the operating and holding components.

Therefore, separating the holding gain or loss from operating profit may be misleading. For example, a company may purchase a machine this year where the cost falls, incurring a holding loss; but the use of the machine is expected to decrease operating expenses in the future. Management may be criticised for the holding loss this year, when in the long run, due to the decrease in operating expenses, they have actually made a ‘good’ decision.

The rationale for separating out holding gains/losses and including them in the statement of financial position is debatable. Questions 4 and 6 below deal with these issues.

4. There are several explanations to justify the inclusion of holding gains as profit. Discuss them.

The explanations to justify the inclusion of holding gains as profit are given below. Although not asked for, criticisms of each are also given.

Holding gains represent a cost savings due to having purchased the assets at a lower price. The comparison is between the actual acquisition cost of the asset and the current cost.

Critics say that this argument implies that the cost savings are an ‘opportunity gain’. This means that a comparison should be made between what actually occurred and what might have happened. Theoretically, what might have happened is unlimited in number. Critics say that the opportunity gain concept also implies that a comparison should be made between what the firm did and what other firms did, because a cost saving measures the firm’s cash position relative to other firms. This would be extremely difficult to perform.

Holding gains represent an increase in the value of the assets. This is an economic event that has an effect on profit. The company is economically ‘better off’, because its assets are worth more.

Critics say that this argument is inappropriate, because in most cases the asset is expected to be used in the business, not sold. Therefore, the current exchange price is not relevant.

Holding gains represent changes in the future cash inflow expected to be generated because of the use of the assets. (This is the argument used by the FASB in Statement 33.) This theory believes that increases in current cost help investors in assessing the future cash flow of the company. Theoretically, holding gains relate to the unexpected profit component of economic profit.

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Critics say that his argument is an empirical one, and there is no persuasive evidence to indicate that changes in the current cost of non-monetary assets relate to future changes in cash inflow.

It would be worthwhile to have students analyse each argument, pro and con, to determine how reasonable each is.

5. Explain the difference between financial capital and physical capital.

The financial capital concept is the traditional view. It keeps track of capital in terms of the dollar amount invested in the company. A return on financial capital means that there is an excess of the dollar amount of capital at the end compared with the dollar amount of capital at the beginning, excluding the effect of transactions with owners. In other words, there has been an increase in the value of money capital.

The physical capital concept looks at capital in terms of its physical aspect, and then translates it into dollars. Usually, the physical aspect relates to the firm’s producing capacity. A return on physical capital results only if the physical productive capacity at the end of the period exceeds the physical productive capacity at the beginning of the period, excluding effects of transactions with owners. For example, if at the beginning of the year, X has the capability of producing 10 000 units of product, then profit occurs only after the current dollar amount of that capability at the end of the year is maintained. The capability to produce 10 000 units may be expressed in terms of plant and equipment. Only current cost (or replacement cost) is relevant for a physical capital view.

The main difference between the two is the placement of price changes of non-monetary assets and long-term debt during the period. Under the financial capital view, these price changes are included in profit as holding gains/losses. Under the physical capital view, these are placed directly into shareholders’ equity as a capital maintenance adjustment.

6. Explain Samuelson’s argument for changes in current cost as a capital maintenance adjustment.

Samuelson argues first that the separation between holding activities and operating activities is not clear-cut; therefore, holding gains/losses should be excluded from income. Second, cost savings (holding gains) are an opportunity gain resulting from taking one course of action as opposed to another. But the alternative has already been forgone by the actual course of action taken. Once the asset is acquired, its cost is a sunk cost that cannot be avoided by any future action. The only choice is to sell or continue using the asset, but holding gains are not based on these choices. They are based on the course of action not taken and which no longer exists. Third, income relates to net cash flows, realised or expected. Cost savings (holding gains) are neither realised cash flows nor expected cash flows, but forgone cash flows. For these reasons, the physical view is more rational.

7. According to Sterling, what are the weaknesses of the physical capital viewpoint?

Assuming physical capital is represented by units of inventory, Sterling points out the following weaknesses:

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If a firm purchases at the end of the period a different type of physical unit from that at the beginning, the question is: which set of physical units should be used to determine income?

When the cost of inventory for a firm decreases, it may still show a profit even if the product is sold for less than the purchase price. A holding loss would offset the operating profit but, from a physical capital view, holding losses are not part of the statement of financial position. Simultaneously, although the company may be as well off at the end as at the beginning of the period, the owners are worse off (less dividends).

If a company buys and sells in the same market — such as a mutual fund — whether the price of the goods increases or decreases, the gross profit will be zero because revenue and cost of sales will be the same.

If a company is not fully invested in physical units because of the existence of working capital, and assuming the cost of the physical items increases, physical capital will not be maintained unless a holding loss for the working capital is included in income. But a number of theories that favour the physical capital view do not advocate this approach.

8. What are some of the ways suggested by the FASB in Statement 33 to ascertain current cost?

The FASB (as well as SAP 1) allows the use of a variety of methods to determine current cost. The information may be gathered and applied internally or externally and to single items or to broad categories. Examples are: indexation direct pricing.

For used assets, the current cost may be found by: an estimate of the purchase price of the asset an estimate of the purchase price of a similar new asset less an allowance for depreciation an estimate of the purchase price of a new improved asset, less an allowance for

depreciation and less an allowance for the operating advantage of the new asset. (These allowances would be deducted from the price of the new asset to derive the current cost for the old.)

A discussion of the feasibility and objectivity of each alternative by students would be worthwhile.

9. What value does N. V. Philips Industries use? How is it determined for property,plant and equipment?

Philips Company used to use ‘replacement value’, which is the value of the economic services to be replaced. The new asset that replaced the old did not need to be technically identical to the old. Replacement value was in accordance with the term used in present accounting literature: replacement cost (as opposed to current cost). The current price of the specific asset was used, if possible, otherwise index numbers of groups of assets were employed. A system of standard cost was used for inventories and includes the cost of capital. This system was withdrawn after 40 years of use, and an interesting exercise for students would be to research the reasons for the withdrawal.

10. Explain the meaning of ‘value to the business’ embraced by the Sandilands Committee. How do we account for holding gains under this system?

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‘Value to the business’ is similar to the value to the owner or deprival value discussed in chapter 5 (pp. 123–4). The emphasis is on the business firm as an entity separate from the owners. The point of view of value is that of the entity. The assets are the means by which the firm generates a profit and is able to continue in business. Operating capacity, which relates to assets, is to be maintained. This is a physical capital view. Current cost is the relevant basis for valuation, unless the present value or NRV of an asset is less, then that should be used.

11. What are the criticisms of current cost accounting from advocates of historical cost? How do proponents of current cost defend these criticisms?

Criticisms from historical cost advocates are: The traditional revenue-gain recognition principle is violated when unrealised holding

gains are reported (financial capital view).

Current cost advocates argue that holding gains represent an actual economic phenomenon. By definition, a change in the net value of assets is profit if profit is an increase in wealth or ‘well-offness’.

Changes in the price of fixed assets are not relevant, because the firm intends to use the assets, not sell them.

Proponents of current cost say they believe in the concept of value in use, but it is the current entry value that is relevant. The cost of using the asset in the current period should be a current cost, rather than a past cost. The fact that the price of the asset has changed in the current period is significant. The determination of profit should be based on what actually happens in the current period.

Determining the current cost of items, especially fixed assets, is subjective.

Current cost supporters assert that the thrust of the argument concerning the subjectivity of current cost is that current cost is not based on a transaction in which the firm is a participant. Objectivity or subjectivity, however, is relative. For items whose market prices are relatively easy to obtain, the objectivity of their current cost appears to be acceptable to accountants. For example, current cost in the lower of cost or market method is acceptable.

The current cost of fixed assets is more difficult to obtain. For some standard equipment, current cost can be obtained from secondhand dealers. For fixed assets where no market prices are available, appraisals, reproduction costs and use of index numbers will be necessary. As markets become thinner, the subjectivity of current cost is said to become greater.

The usefulness of current cost data is questionable.

Supporters of current cost say that the actual statistics indicate that the difference between current cost profit (physical capital view) and historical cost profit is significant. The empirical evidence on whether current cost data is used is mixed. It is also argued that current cost data may reveal significant trends, but only over a period of time longer than the time period employed in the empirical studies.

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12. What are the criticisms of current cost accounting from advocates of exit price? What reasons are given by proponents of current cost in reply to these criticisms?

Criticisms by exit price advocates include: Current cost is not the opportunity cost. The next best alternative forgone is almost always

to sell; therefore, the purchase price or current cost, is not the logical choice. Exit price should be used.

Current cost proponents argue that the ‘normal’ method of valuation is to use an entry price. For assets where the firm is normally the buyer, using exit price would be to report ‘unusual’ values. Some assets have value in use, but little if any exchange value. Current cost is more realistic as an indication of current value.

Sellers of products do not often know what the market will bear. They cannot be constantly ‘experimenting’ to see what the market will accept as a selling price. But a change in current cost is a signal that demand has probably changed and the selling price should change. The current cost, therefore, serves as a feasible minimum current value.

The allocation problem continues. Instead of historical cost, current cost is allocated (exit price accounting uses the difference in exit prices as a measure of depreciation rather than of allocation methods).

Current cost advocates argue that allocation is part of accounting as we know it today. It is still debatable whether allocated data are not useful, as exit price supporters contend.

Current operating profit is based on the existing mode of production. When technology is changing, predictions based on current operating profit can be misleading.

Supporters of current cost say that if conditions change, and especially if they are due to external factors, the production process of all firms will be affected, more than likely in the same way. An alternative production process (to the existing one) would be adopted only if it is expected to generate higher profits. Determining accounting measures based on actions not yet taken (new technologically advanced equipment not yet purchased) is fraught with difficulties. Limiting accounting measures to what the firm has actually done conforms to the conventional role of accounting information.

The claim that current cost profit, based on existing facilities, ignores the impact of technological improvements is false, because such improvements will also affect the price of the old (existing) facilities.

Current cost accounting involves the problem of the ‘additivity’ of numbers. Logically, current cost cannot be added to or deducted from the amount of cash or the present value or NRV of other items.

Current cost proponents say this is a debatable point. It depends on the purpose for which calculations are made. People find these different figures added together or subtracted from each other to be meaningful. (More on this in the next chapter.)

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13.Summarise the evidence concerning current cost accounting, categorising points you believe to be favourable and unfavourable.

Favourable evidence: Data on companies subject to Statement 33 for 1980 compiled by the FASB show a

significant difference between historical cost income and current cost income (physical capital view). Income from holding activities exceeded income from operating activities. This is information not found in the conventional statements, and this type of information should help users in making predictions about a company. The study shows that some companies are not paying back enough profits to pay for more costly inventory and plant and equipment in the future. At least for 1980, physical capital was not maintained by many companies.

Norby’s study, which pertained to the period 1973–80, shows that current cost income is significantly different from historical cost income.

The study by the University of Texas research team shows that current cost measures perform better than historical cost income as a predictor of next year’s operating cash flow in most situations. The study also shows what the FASB statistics for 1980 reveal: that dividends in many cases exceed current cost income.

Studies indicate that the cost of implementing current cost accounting is minimal. One study (Schwarzbach and Swanson) shows that for internal purposes current cost data

are employed by many companies. The Louis Harris study shows that many believe current cost data will gradually become

more important than historical cost data, if inflation continues, and that this is a desirable trend.

Evidence of share market price reactions to current cost data is suggestive of incremental information content (Friedman, Buchman and Melicher; Grossman, Kratchman and Welker; Lobo and Song; Peaswell, Skerratt and Ward).

An Australian study (Barton) has shown that share prices, when lagged by one year, are highly correlated with current cost income and not historical cost income. This may mean that current cost is more descriptive of actual performance and a better base for financial ratio analysis. The New Zealand study by Duncan and Moores adds to the evidence on relevance.

Unfavourable evidence:

A number of studies showed that current cost data had no or little information impact on share market prices (Ro; Beaver, Christie and Griffin; Gheyara and Boatsman); or that current cost data provide no incremental information content over that provided by historical cost data (Beaver and Handsman; Schaefer).

Some evidence shows that very few firms voluntarily produce current cost data (Ferguson and Wines), that it is not useful for making dividend decisions (Thompson and Watson), or that it would only be used for political purposes.

Current cost data do not seem to be the driving force or descriptive of long-term returns (Peasewell, Skerratt and Ward).

Problems (For a full outline of problems, please see text.)

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7.1 Required:Record the transactions as journal entries under the following methods:A. conventional accounting (historical cost)B. current cost accounting.

ABCConventional Current Cost

1. Inventory $20 000 $20 000Accounts Payable $20 000 $20 000

2. (a) Accounts Receivable 36 000 36 000Sales Revenue 36 000 36 000

(b) Inventory (100 $3) + (4000 x $2) 11 000Unrealised Holding Gains 11 000

(c) Cost of Goods Sold 14 000 21 000Inventory 14 000 21 000

(d) Unrealised Holding Gains 7000Realised Holding Gains (see below) 7000

3. (a) Building 25 000Unrealised Holding Gains 25 000

(b) Depreciation Expense (see below) 10 000 13 750Accumulated Depreciation 10 000 13 750

(c) Unrealised Holding Gains (see below) 3750Realised Holding Gains 3750

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(d) Unrealised Holding Gains (see below) 3750Accumulated Depreciation 3750

4. Land 20 000Unrealised Holding Gains 20 000

5. Discount on Bonds Payable 3832Unrealised Holding Gains 3832

6. Inventory 2000Unrealised Holding Gains 2000

7. Operating Expenses 12 000 12 000Interest Expense (see below) 3520 3761

Cash 15 520 15 520Realised Holding Gains 241

Computation of realised holding gain for inventory:Current Cost of Goods Sold $21 000Historical Cost of Goods Sold 14   000

$ 7   000

Computation of current cost depreciation:($150 000 + $125 000)/2 = $137 500 average gross current gross of building$137 500 10% = $13 750.

Computation of backlog depreciation:$150 000 20% = $30 000 Total accumulated depreciation, 2 years

needed on statement of financial position– 13 750 Depreciation recorded this year (second year)– 11 250 Depreciation recorded last year (first year)– 1   250 Backlog depreciation recorded last year (first

year)$26   250 Total accumulated depreciation already

recorded.

$     3,750 amount needed to catch up to new basis of $150,000

Computation of current cost interest expense:Find present value of bonds at beginning of year, using average rate of 9%.Present value of $44 000, 7 periods, 9% (0.54703) = $24 069Present value of ordinary annuity, $3520, 7 periods, 9% (5.03295) = 17   716 Total $41   785

$41 785 9% = $3761 interest expense.

7.2Required:

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A. Prepare journal entries to record the events mentioned, as well as the statement of financial performance for the year ended 30 June 2004 and the statement of financial position as at 30 June 2004, under the following methods:(a) conventional accounting: historical cost, financial capital, nominal dollars(b) current cost accounting: current cost, financial capital, nominal dollars. Distinguish between realised and unrealised holding gains or losses.

B. Convert the current cost financial statements to a constant dollar (end-of-current-year) basis.

Reflex Limited.

Part AConventional Current Cost

1. Inventory $30 000 $30 000Accounts Payable $30 000 $30 000

2. (a) Accounts Receivable 75 000 75 000Sales Revenue 75 000 75 000

(b) Inventory (5000 $3) + (1000 $4) 19 000Unrealised Holding Gain 19 000

(c) Cost of Goods Sold 30 000 45 000Inventory 30 000 45 000

(d) Unrealised Holding Gains 15 000Realised Holding Gains ($45 000 – $30 000) 15 000

3. (a) Inventory (1000 $3) 3 000Building ($200 000 – $100 000) 100 000Land ($20 000 – $10 000) 10 000Investment in Y stock 5 000Discount on Bonds Payable 4 968

Unrealised Holding Gains 122 968

(b) Depreciation Expense (see below) 10 000 15 000Accumulated Depreciation 10 000 15 000

(c) Unrealised Holding Gains (see below) 5000Realised Holding Gains 5000

(d) Unrealised Holding Gains (see below) 15 000Accumulated Depreciation 15 000

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4. (a) Cash 10 000Land 5000 10 000Gain on Sale of Land 5000 10 000

(b) Unrealised Holding Gains (see below) 5000Realised Holding Gains 5000

5. Operating Expenses 15 000 15 000Interest Expense (see below) 5 000 5 195

Cash 20 000 20 000Realised Holding Gains 195

Computation of current cost depreciation:$200 000 + $100 000/2 = $150 000 average gross current cost of building$150 000 10% = $15 000 depreciation.

Computation of realised holding gain for building:Current cost of depreciation $15 000Historical cost of depreciation     10   000

$ 5   000

Computation of backlog depreciation:$200 000 20% = $40 000 Total accumulated depreciation, for 2 years

needed on statement of financial position– 15 000 Depreciation recorded this year (second year)– 10 000 Depreciation recorded last year (first year)

0 No backlog depreciation recorded last year, because no change in current cost

$25   000 Total recorded accumulated depreciation

$15   000 Amount needed to catch up to new basis of $200 000

Computation of current cost interest expense:Find present value of bonds at beginning of year, using average rate of 11%.

For 9 periods, 11%:principal of $50 000 0.39092 = $19 546annuity of $5000 5.53705=     27   685 total $47   231

$47 231 11% = $5195 interest expense.

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REFLEX LIMITEDStatement of Financial PerformanceFor Year Ended June 2004(conventional)

Sales revenue $  75 000Cost of goods sold         30   000 Gross profit $  45 000Operating expenses:

Depreciation $10 000Other operating     15   000         25   000

Operating profit $  20 000Other items:

Interest expense $5 000Gains on sale of land (5   000) 0

$     20   000

REFLEX LIMITEDStatement of Financial PerformanceFor Year Ended June 2004(current cost)

Sales revenue $  75 000Cost of goods sold         45   000 Gross profit $  30 000Operating expenses:

Depreciation $15 000Other operating     15   000     30   000

Profit from regular operations 0

Other items:Interest expense         5   195

Loss from operating activities $   (5 195)Realised holding gains $     25   195 Realised profit $  20 000Unrealised holding gains     101   968 Net profit $121   968

Comparing the two statements of financial performance, we see that the realised profit is the same. This is always so. What the current cost statement of financial performance shows, which the conventional does not, is that the profit is all due to holding activities. Operating activities resulted in a loss.

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Statement of Financial PositionJune 2004(conventional)

Cash $  10 000 Accounts Payable $  50 000Accounts Payable 75 000 Bonds Payable 50 000Inventory 5,000Investment in Y 20 000 Paid Up Capital 75 000Building $100 000 Retained Earnings 20 000 Accum. Depreciation     20   000 80 000Land     5   000                               Total $195   000 Total $195   000

Statement of Financial PositionJune 2004(current cost)

Cash   10 000 Accounts Payable $  50 000Accounts Receivable 75 000 Bonds Payable $50 000Inventory 12 000 Discount         4   968 45 032Investment in Y 25 000Building $200 000 Paid Up Capital 75 000 Accum. Depreciation         40   000 160 000 Retained Earnings 121 968Land         10   000                         Total $292   000 Total $292   000

Part BStatement of Financial PerformanceFor Year Ended June 2004

Nominal dollars Constant dollars

Sales Revenue $75 000 120/105 = $85 714Cost of goods sold 045 000 120/105 =     51   429 Gross profit $34 285Expenses:

Depreciation 15 000 120/108 = $16 667Other operating 15 000 120/120 =   15   000 31   667

Profit from regular operations $  2 618Interest expense 5 195 120/108 =     5   772 Loss from operating activities $ (3 154)Realised holding gains 25 195 (see below) 25   249 Realised profit $22 095Unrealised holding gains 101 968 (see below) 91   301 Profit before purchasing power loss 113 396Purchasing power loss (see below)       6   428 Net profit 106   968

Realised holding gains:For inventory sold:

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Current cost of goods sold $45 000 120/105 = $51 429Historical cost of goods sold     30   000 120/105 =     34   286

$15 000 $17 143

For building used:Current cost depreciation $15 000 120/108 = $16 667Historical cost depreciation     10   000 120/90 =     13   333

$  5 000         $  3 334

For land sold:Current cost $10 000 120/120 = $10 000Current cost (beginning year)         5   000 120/100 =         6   000

$  5 000 $  4 000

For use of money (interest):Current cost of interest $  5 195 120/108 = $ 5 772Historical cost $     5   000 120/120 = 5   000

$     195 $ 772

Computation of total raised holding gains:$17 143

3 3344 000

    772 $25   249

Nominal dollars Constant dollarsUnrealised holding gains:Ending inventory:

Current cost $12 000 120/120 = $12 000Historical cost 5 000 120/100 =         6   000

7 000 $ 6 000Since beginning inventory is the same for both current cost and historical, there is no need to calculate it.

Building:At December 31, Year 10:

Net current cost $160 000 120/120 = $160 000Net historical cost 80   000 120/90 =     106   667 Unrealised holding gain $ 80 000 $ 53 333

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At January 1, Year 10:Net current cost $ 90 000 120/100 = $108 000Net historical cost 90   000 120/90 =     120   000 Unrealised holding loss 0 $ (12   000) Unrealised holding gain for year $ 80 000 $ 65 333

Land (unsold)Current cost $10 000 120/120 = $10 000Current cost (beginning of year)         5   000 120/100 =         6   000 Unrealised holding gain $ 5 000 $ 4 000

Investment in YCurrent cost $25 000 120/120 = $25 000Historical cost 20   000 120/100 = 24   000

$ 5 000 $ 1 000

Bonds Payable:Current cost $45 032 120/120 = $45 032Historical cost 50   000 x 120/100 = 60   000

$ 4 968 $14 968

Computation of total unrealised holding gains:$ 6 00065 3334 0001 000

    14   968 $91   301

Computation of purchasing power loss:Nominal dollars Constant dollars

Beginning balance of net monetary items: 0 0Sources:

Sales of merchandise $75 000 120/105 = $85 714Sale of land     10   000 120/120 =     10   000 Total $85 000 $95 714

Uses:Purchases of merchandise 30 000 120/105 = 34 286Expenses (including interest)     20   000 120/120 =     20   000 Total uses $50   000 $54   286

Ending balance $35   000 $41 428Deduct nominal amount     35   000 Purchasing power loss $ 6   428

The computation above does not include bonds payable, because it was considered in the calculation of holding gains previously.

7.3Required:

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Determine the holding gains/losses for Year 2, net of inflation (i.e. on a constant dollar basis) for the inventory, land and equipment. Use average-for-year dollars. Distinguish between realised and unrealised holding gains (or losses).

Murray Pty Ltd

Nominal dollars Constant dollarsRealised holding gains:

For inventory sold:Current cost of goods sold (50 $500) $25 000 123/123 =$25 000Historical cost of goods sold (50 $400)     20   000 123/100 =    24   600 Realised holding gain $ 5 000 $25,400

For equipment used:Current cost depreciation[($12 000 + $15 000)/2 = $13 500 10%] $ 1 350 123/123 = $1 350Historical cost depreciation         1   000 123/100 =     1   230 Realised holding gain $ 350 $ 120

Unrealised holding gains:For inventory not sold:Inventory on December 31, Year 2:

Current cost (100 $520) $52 000 123/130 =$49 200Historical cost (100 $480)     48   000 123/115 =    51   339

$ 4 000 $ (2 139)

Inventory on January 1, Year 2:Current cost (40 $480) $19 200 123/115 =$20 536Historical cost (40 $400)     16   000 123/100 =    19   680

$ 3 200 $ 856

Unrealised holding gain (loss) for Year 2 $400 $ (2 781)

For Equipment:On December 31, Year 2:

Net current cost $12 000 123/130 =$11 354Net historical cost         8   000 123/100 =        9   840

$ 4 000 $ 1 514

On January 1, Year 2:Net current cost $10 800 123/115 =$11 551Net historical cost 9   000 123/100 =    11   070

$ 1 800 $ 481Unrealised holding gain for Year 2 $ 2 200 $ 1 033

For Land:On December 31, Year 2:

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Current cost $68 000 123/130 =$64 338Historical cost     50   000 123/100 =    61   500

$18 000 $ 2 838On January 1, Year 2:

Current cost $60 000 123/115 =$64 174Historical cost     50   000 123/100 =    61   500

$10 000 $ 2 673Unrealised holding gain for Year 2 $ 8 000 $ 165

Since the historical cost for the land is the same for December 31 and January 1, the following calculation would suffice:

Current cost, December 31, Year 2 $68 000 123/130 =$64 338Current cost, January 1, Year 2 60   000 123/115 =    64   173 Unrealised holding gain for Year 2 $ 8 000 $     165

7.4Required:A. Present a set of financial statements in accordance with the requirements of

SAP 1 for the 2003–04 reporting period.B. Show all calculations and appropriate general journal and ledger entries.C. Explain why you calculated the adjustments for backlog depreciation and the

gain/loss on monetary items in the manner which you chose.

(Tutors should note that the initial statement of financial position in the text should be at 30 June 2003 and not 2004.)

Sharp Ltd financial statements

SHARP LTDStatement of Financial Performancefor the year ended 30 June 2004

Sales $2 330 000Less Cost of Goods SoldOpening Inventory $ 204 000Purchases   1   490   000

1 694 000Closing Inventory         220   000 Cost of Goods Sold 1   474   000 Gross Profit $ 856 000Less Operating Expenses 227 000Wages 461 000Depreciation of Plant 31 200Depreciation of Building 8 200Depreciation of Vehicles 24 500Interest 25 000     776   900 Current Cost Operating Profit before Tax $ 79 100Add Gain on Holding Monetary Items             2   018

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Current Cost Entity Profit $ 81 118Less Tax       75   850 Current Cost Entity Profit after Tax $ 05 268Less Dividend         6   000 Entity Profit for 2002 ($054 732)Add Retained Profit, 1 January 2003           9   800 RETAINED PROFIT CARRIED FORWARD ($044 932)

A proprietary result may also be calculated as follows:

Current cost operating (entity) profit after tax $ 5 268Add gain on loan capital     25   000 Current cost proprietary profit after tax $30   268

SHARP LTDStatement of Financial Positionas at 30 June 2004

Current Assets Current LiabilitiesBank $ 58 000 Accounts Payable $ 156 000  Accounts Receivable 183 000 Tax Payable 75 850  Inventories     284   000 Dividend Payable         60   000   

$ 525 000 $ 291 850  

Long-term Assets Long-term LiabilitiesMotor Vehicles $160 000 Debentures 250 000  Less Accum. Depn         78   000 82 000

Plant 369 000 Shareholders’ equityLess Accum. Depn     150   750 218 250 Paid-up Capital 400 000  

Share Premium Reserve 70 000  Building 420 000 Current Cost Reserve 545 932  Less Accum. Depn 92   400 327 600 General Reserve 40 000  Land           400   000 Retained Earnings           (44   932)

$1   027   850 $1   011   000   TOTAL $1   552   850 TOTAL $1   552   850  

June 30 Inventories (172 000 – 182 000) Dr 10 0002003 Motor Vehicles ( 85 000 – 115 000) Dr 30 000

Plant (188 000 – 260 000) Dr 72 000Buildings (220 000 – 400 000) Dr 180 000Land (160 000 – 380 000) Dr 220 000Accum. Depreciation Motor Vehicles Cr 12 000Accum. Depreciation Plant Cr 28 800Accum. Depreciation Buildings Cr 36 000Goodwill Cr 40 000Current Cost Reserve Cr 395 200

Initial revaluation of non-monetary assets at 30 June 2003 buying prices.

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Dec 31 Inventories (182 000 – 204 000) Dr 22 0002003 Current Cost Reserve Cr 22 000

Revaluation of July 2003 inventories at MOY Dec prices.

June 30 *March Inventories (220 000 – 284 000) Dr 64 0002004 Current Cost Reserve Cr 64 000

*Revaluation of non-monetary assets at June 2004 prices (includes December assets plus those during the year).

Motor Vehicles (145 000 – 160 000) Dr 15 000Plant (330 000 – 369 000) Dr 39 000Buildings (400 000 – 420 000) Dr 20 000Land (380 000 – 400 000) Dr 20 000Current Cost Reserve Cr 94 000

Revaluation of non-monetary assets at June 2004 prices (includes July 2003 assets plus those acquired during the year).

Depreciation of Motor Vehicles Dr 24 500Accum. Depreciation of Motor Vehicles Cr 24 500Depreciation at 20% on Dec value of Motor Vehicles(115 000 + 15   000 = 122 500)

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Depreciation of Plant Dr 31 200Accum. Depreciation of Plant Cr 31 200Depreciation at 10% on Dec value of Plant(260 000 + 34   000 = 277 000) = 27 700

2+ 6 months depreciation on new plant =     3   500

31   200

Depreciation of Buildings Dr 8200Accum. Depreciation of Buildings Cr 8200Depreciation at 2% on Dec value of buildings(400 000 + 20   000 = 410 000)

2

Current Cost Reserve Dr 7500Accum. Depreciation of Motor Vehicles Cr 7500Backlog depreciation charged on motor vehicles to cover shortfall on 2002 and 2003 and December–June 2004.Calculation: 3 yrs depreciation at 20% on cost 130 000 = 78 000

Less: amount charged in Accum. Deprec. 70   500 7 500

NOTE: December 2004 new cost excludes new vehicles.

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Current Cost Reserve Dr 15 550Accum. Depreciation of Plant Cr 15 550

Backlog depreciation charged on Plant to cover shortfall over past 4 years and December–June 2002.

Calculation: 5 yrs depreciation at 10% on costof existing plant 294 000 = 147 0006 mths depreciation at 10% on costof new plant 75 000 =         3   750

150 750Less: Amount charged in Accum. Deprec. 135   200 Backlog depreciation     15   550

Current Cost Reserve Dr 4 200Accum. Depreciation of Buildings Cr 4 200Backlog depreciation charged on Buildings to cover shortfall over past 10 years and December–June.Calculation: 11 yrs depreciation at 2% cost 420 000 92 400

Less: Amount charged in Accum. Deprec. 88   200 Backlog depreciation     4   200

Gain on monetary items:

(a) Loss of monetary assetsBank 46   000 + 58   000 110 – 100 = $ 5 200

2 100

Accounts Receivable 112   000 + 183   000 0.35 = $51   625 2

$56   825

(b) Gain on monetary liabilities (excluding long term)

Accounts Payable 110   000 + 156   000 0.35 = $46 550 2

Other Payables 110   000 + 135   850 110 – 100 = $12   293 2 100

(assume not related to the purchase of inventories)

Gain on monetary liabilities $58   843

Net gain on monetary items $2 018

Journal EntriesCurrent Cost Reserve Dr 2018Statement of financial position Cr 2018

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Current Cost Reserve Ledger AccountDebit Credit

1 July 03 Initial adjustments for Current Cost 395 20030 June Inventory 22 00031 Dec Inventory 64 00031 Dec Adjustments Current Cost 94 00031 Dec Depreciation Motor Vehicles (backlog) 7 50031 Dec Depreciation Plant (backlog) 15 55031 Dec Depreciation Buildings 4 20031 Dec Net monetary items 2 018

$545 932

Case Study 7.1 — Bruised BHP on global alert

1. Is BHP Billiton going to continue operations at the same level during the remainder of the financial year? Explain your answer, considering alternative interpretations of operating capacity.

All indications given by the article suggest that BHP is consolidating by downsizing its operations and becoming a ‘niche player’. Comments like ‘cost reductions’, ‘spin-off of BHP Steel’ and ‘reduced debt’ all point to expected lower levels of operating capacity in the future.

BHP seems to be reducing its operating capacity in terms of physical capital — in other words, divesting its operations away from less productive assets by converting them into financial assets (through downsizing and restructuring) in order to become more focused, adaptable and effective. The merger is spoken of in terms of a one-off, suggesting that there are no further expansion plans.

Total operating capacity will be reduced but efficient operating capacity should be enhanced. That is, the re-evaluation of assets in terms of current costs provides an opportunity benchmark for value in use.

2. Explain how and why the new phase of restructuring would affect the level of earnings reported under current cost accounting.

The new phase of restructuring would increase the level of earnings by: reducing the volume of physical depreciable assets switching into monetary/financial assets that may have realisable/holding gains becoming more efficient.

There will be some offsets from buying assets at current prices and revaluations if they are carried out.

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3. What effect, if any, would the restructuring have on future dividends under(a) the historical cost system?(b) current cost accounting?

(a) Generally, dividend policy is related to or lagged to income. Under the historical cost system the level of reported earnings will be a function of the level of cost savings and the write-down of assets.

(b) Under current cost accounting any write-down of assets is adjusted for at the end of each year. Hence, the impact on earnings under current cost would be lower, and, consequently, if dividend policy is related to earnings then dividends are more likely to increase this year under current cost accounting.

4. Consider other information that analysts would find useful to indicate sustainable operating earnings.

Other useful information would include: the terms of the negotiated price agreement (long term or short term) the labour relations and contracts in place the potential for more write-downs and consolidations the future management outlook for BHP the future economic expectations the current economic returns on assets.

Case Study 7.2 — Boag writes down $8.2m

1. Why do you think J. Boag & Sons wrote down $8.2 million of its assets shortly after being taken over by San Miguel?

This practice is commonly called taking a ‘big bath’. There are a number of potential purposes: to recognise loss making areas and revalue assets at their market values to distance current management from past decisions and operations to reorganise the statement of financial position so as to provide better results in the future to calculate opportunity costs of return on these operations.

2. How will this affect future return on assets and future income?

Current write-downs will reduce future depreciation expense and increase the possibility of subsequently realising a one-off profit on sale if these assets are sold. In short, they will reduce asset values, increase profitability and hence increase return on assets.

3. Should asset values be recognised when they increase as well as when they decrease?

This question raises a fundamental issue with historical cost accounting. Assets that have market values less than cost are recognised as losses and written off in the accounts as abnormal losses, whereas assets that have values above historical costs are ignored. This example illustrates the conservative principle in practice.

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Chapter 8Exit price accounting

Theory in Action 8.1 — An example of adaptive behaviour

1. How do the actions of Newmont Mining constitute ‘adaptive behaviour’ as defined by Chambers?

Newmont Mining is engaged in the process of buying and selling assets — trading in assets. Assets are determined, like any price, by demand and supply. By trading markets, corporations are reacting and adapting to the signals provided by the marketplace.

2. When Murdy refers to assets as being on the ‘grow or go’ list, what does he mean? How would these assets be assessed as meeting the ‘grow’ test?

Murdy means that the assets must increase in value or else they will be relaced by assets that promise a greater capital gain. They would be assessed by calculating the rate of return (from income) plus the rate of return from increases in value (capital gain). This would then be assessed against a hurdle required rate of return. This is how financial assets are assessed (for example, bonds, shares).

3. Assess the actions of Newmont in funding takeovers through the sale of non-core assets. Is this more or less risky than other forms of funding?

The sale of assets that are not performing up to the required rate of return is a legitimate business practice. However, trading assets efficiently will depend on the transaction costs of trading and the impact on income and risk. Assets that are in non-core business, because of a less than unitary correlation will reduce the risk of the firm. However, if the firm is not efficient in operating these assets then returns will be lowered. Thus, there is a trade-off between the two. MacNeal, Chambers and Sterling make no reference to the risk impacts of sales or the means by which prices are set. They simply accept current selling prices as an empirically verifiable event and make financial decisions based on that fact. The question of whether selling non-core assets is more or less risky thus depends on an analysis of the above issues.

4. After reading the criticisms of exit price accounting later in this chapter, return to this case and consider the concept of adaptive behaviour. Is it appropriate for accounting measurement issues?

The main criticism that is relevant here is the recognition of profit on assets held. A number of theorists argue that no profit should be recognised until realised. This naturally leads on to a discussion on what is the critical event in revenue (profit) recognition — for example, production, storage, sale, percentage of completion, cash receipt (see also SAC 4). One of the weaknesses often cited of exit value accounting is that it recognises profit at the time that the price moves and not at some other critical event, such as at sale. However, if a firm wishes to adopt adaptive behaviour then selling prices are highly relevant.

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Theory in Action 8.2 — Deciding on one comprehensive measurement system

1. Refer to chapter 2, ‘Theory and method’. To what theory of scientific advancement do you think that Al-Hogail and Previts are referring?

The scientific advancement theory referred to is the Kuhnian theory of paradigm shifts. Anomalies are highlighted, new theory is developed and this eventually overthrows the existing dominant theory.

2. Why would exit price accounting be more acceptable in inflationary times than in periods of low inflation?

The reasons include: valuation purposes, as prices diverge at a greater rate capital gains become more accepted as a measure of income politically it becomes more acceptable as professional bodies, government and the general

public are affected by inflation.

3. To what anomalies are the authors referring? How does the system of CoCoA overcome these anomalies?

The anomalies include: Historical costs are limited for economic decision making. comparability additivity Allocation of historical costs does not provide residual asset values related to real value. There are no empirical referents. Allocation methods are determined by subjectivity from a myriad of rules. The measures of risk are incomplete.

4. Read the section [pp. 250–2] on a mixed system of accounting. Would you now modify Chambers’s observation that exit value concepts were never adopted?

There are a number of areas that adopt net market value or ‘fair value’ as the primary measurement concept including: foreign currency financial assets superannuation fund assets investments self-generating and re-generating assets life insurers.

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Questions

1. According to MacNeal, why was the ‘going value’ theory, which assumes the firm is a going concern, formulated?

During the 18th and 19th centuries, the practice arose whereby creditors required owners to submit a statement of net worth and a statement of earnings prior to extension of credit. To ensure their reliability, creditors insisted that the statements be prepared by an independent accountant. Business firms were mostly owned by one person or a small group of partners. The independent accountant had an obligation only to the owner and creditor. The accountant soon learned that a conservative posture satisfied both parties. Creditors were mainly interested in knowing that the net worth and income were at least as great as reported. Since the owner was knowledgeable of their business, they could make their own personal adjustments to determine a more correct picture of their financial status. Creditors came to view with great esteem those businesspersons who made a practice of understating their net worth and earnings, and accountants began to see it as their duty to prevent overstatements of net worth.

However, when an understated asset was sold for a higher price, especially immediately after the issuance of financial statements, the accountant had to explain this discrepancy. To justify the valuation at original cost, the ‘going value’ theory was created.

Is the theory realistic? Consider specific corporations, such as BHP, GMH, Bond Company. How long have these companies existed? What is the probability that they will still exist 50 years from now? Sterling argues that history shows that the lives of companies are finite.

2. According to MacNeal, why are conventional accounting principles not suitable for present conditions? Do you agree or disagree with him?

Conventional accounting principles are not suitably presented, because they were formulated for conditions that existed many years ago, but which have now changed. The principles were for conditions in the first (12th to 17th centuries) and second (18th and 19th centuries) eras. Today, the corporation is dominant, and shareholders know little about the company, except what is reported to them.

MacNeal linked the use of historical cost to the first and second eras. In the first era, a big business transaction was likely to be a joint venture, of a limited life, and the main accounting task was to keep track of that cost, which was to be deducted from revenue to determine profit. In the second era, original cost was related to the desire for conservatism.

MacNeal favoured the use of exit price, and believed that the present use of historical cost was due to the conditions in the first and second periods, as mentioned above. However, MacNeal does not consider the evidence of the use of current valuation employed prior to World War 1 and through the 1920s. The conservative accounting posture and the use of historical cost were reactions to the abuses of current valuation, especially in the 1920s.

It must be remembered that financial statements did not have to be certified before the 1930s. Therefore, companies did as they pleased — they used both historical cost and current value.

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3. Explain the concept of ‘adaptive behaviour’ of the firm by Chambers, and how ‘financial position’ relates to it.

Chambers sees the firm as an adaptive entity engaged in buying and selling goods and services. The notion of adaptive behaviour implies a continual attempt to adjust to the environment for the sake of survival. Through its managers, the firm is aware of the expectations of the interested parties associated with it (for example, owners, customers, employees, creditors). A condition of a firm’s existence is that expectations of all interested parties are satisfied, at least to a greater degree than the satisfaction perceived in alternative courses of action. Ultimately, they are interested in cash receipts to themselves due to their association with the firm.

To continue in business, a firm must have the capability to engage in transactions. This capability is revealed by its financial position. This relates to the firm’s capability to go into the market with cash for the purpose of adapting itself to present conditions (to buy, sell, etc., whatever is necessary to survive). In the last analysis, the survival of the firm depends on the amount of cash it can command. Adaptive behaviour, therefore, calls for knowledge of the cash and current cash equivalents of the firm’s net assets at any particular time.

4. Why is Chambers critical of the notion of ‘value in use’?

Chambers says value in use is basically a calculated amount of a present expectation. It represents beliefs about the future, not facts about the present. It is personal to the owner or firm, and therefore it is subjective. On the other hand, market value is determined by the market, and therefore is objective. Market value represents a firm’s capability to buy things and pay its debts, as of a given date. Market value is seen to be necessary for an evaluation of the financial position of a firm.

5. What reasons can you give to defend the ‘value in use’ concept?

Solomons points out that an asset that is held, rather than sold, must be worth more to its owner or firm than its exit price, otherwise it would be sold. For example, a fixed asset may be designed specifically for a company and may have no resale value, because it is of no use to others. Because it has no alternative use and has no resale value, Chambers would have the company record a loss. But the asset would not have been purchased if its purchase meant a loss to the company. The problem with exit value accounting is that the recording of a loss for a sound investment in an asset that is helping to create revenue is due to the refusal of Chambers to recognise that value depends on expectations, not just exchange.

6. What is the basis of Sterling’s conclusion that exit price should be used for the valuation of items?

Sterling used a simple model, a wheat trader in a perfect market with a stable price level, to determine which valuation method is superior to all others. Valuations are made because information is desired. The valuation method that provides the most information is the best method.

The decision model of users reveals what information is relevant. The problem then is to select the appropriate decision model, and the way to determine this is to consider the

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problematical situation and the ability of a model to predict the consequences of alternative courses of action. For the wheat trader, Sterling posed three decision problems:1. to enter and stay in the market2. to hold either cash or wheat3. to evaluate past decisions.

Sterling’s analysis shows that one bit of information is relevant to all decisions: the present market (exit) price. Other pieces of information may be relevant to one or more decisions, but not to all. Even when the assumption of perfect competition and stable prices is relaxed, the present market (exit) price is superior to all other kinds of information.

7. What is Chambers’s argument concerning the question of ‘additivity’? Is it fundamentally important to be able to add together ‘like’ valuations in the statement of financial position?

One cannot add together the purchase price of an asset to an amount of cash if the total is to be meaningful. The total should relate to the firm’s ability to enter the market and engage in transactions. To be meaningful, the parts which make up the total should all be on the same basis — that is, refer to a single characteristic. Liabilities are expressed at their current cash equivalent — what the company must pay to settle the liabilities. To be comparable, assets should also be on the same basis — cash or current cash equivalent (exit price). Any amount whose basis is a future event or object is hypothetical, not objective, and cannot be added to a current cash amount. Present value and net realisable value are examples. If all items on the statement of financial position are on a current cash equivalent basis, then the financial condition of the firm and its ability to adapt to the environment can be better seen.

Critics charge that the current cash equivalent of an asset is to be determined on the assumption of a gradual, orderly liquidation, and therefore something of the future is assumed. If anticipations cannot be avoided, then the current cash equivalent (exit price) violates the principle of exclusion of anticipatory calculations.

Larson and Schattke argue that the cash equivalents of individual assets sold separately, and the same assets sold as a package, may be quite different. On this basis, they maintain that cash equivalents are themselves not additive. The logic of their argument needs to be considered. The price received on the sale may vary under different circumstances — does this fact preclude the additivity of the amounts?

The results of the different indirect valuation methods are approximations of present value; they may be imperfect but they do refer to a common property — present value. Therefore, in this sense, the results of the different methods are additive. Or we can also say that the different methods are all attempts to approximate ‘true’ value.

8. What are the criticisms of the profit concept under exit price accounting?

Profit is a measure of how effective the performance of the company is in a given period. Performance has to do with the operations of a company. Exit price accounting puts emphasis on changes in the exit price of assets rather than operations. In most cases, the firm has little control over these price changes.

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Performance relates to the decisions made by management, which are formulated into plans. An evaluation of the expected plans against the actual outcome must be made; then the firm can decide whether to continue to use the assets for the purpose they were acquired. One concept of profit is to measure performance in terms of what was originally intended. Only after the plan that resulted in a given profit is evaluated is it then rational to decide whether the plan should be changed. Chambers’ concept of profit, it is argued, ignores this type of evaluation. The plan for each period is to maximise the current cash equivalent of the net assets for that period. Exit price accounting does not match costs with revenues to measure the performance of the firm.

9. Assume that you favour exit price accounting. Give at least three reasons for your support.

In support of exit price accounting: Exit prices are objective because they are market determined. If there is no market price,

then the item is stated at zero. Current (exit) values reveal the financial condition of the firm, its ability to adapt to the

environment — that is, to go into the market to buy and sell. All the values in the financial statements are additive — that is, they refer to one

characteristic: cash or current cash equivalent. Current values are relevant to users for their decision models. There is no problem concerning the allocation of costs. Exit price accounting is based on events that actually happened — increases and decreases

in values as determined in the market, as well as items purchased, sold or paid. Values in the financial statements are based on reality.

Research studies show that in many cases current (exit) values are more objective than historical cost. In any event, current values are less subjective than most people believe.

10. Assume that you are opposed to exit price accounting. Give at least three reasons for your opposition.

Criticisms of exit price accounting: The profit concept does not measure performance of the firm, in the sense of operations

undertaken. The emphasis is on price changes over which the firm, in most cases, has little or no control. If the firm was actually contemplating liquidation, the information reported would be relevant; but this is not true for most firms.

Value in use is ignored, and value in exchange is employed exclusively. If a particular asset has no resale value it does not necessarily mean the firm has incurred a loss if the asset is useful to its operations. Exchangeability is not necessarily a condition of value, nor of the existence of an asset.

Market values are not simple to determine, especially of fixed assets. There can be variations. Assuming a gradual liquidation (as does Chambers) as opposed to forced liquidation (as does Sterling) makes a difference in market values. Selling the assets as a package rather than individually also makes a difference.

The insistence of additivity of numbers in the financial statements does not necessarily lead to current exit prices. Although different methods may be used in conventional accounting and current cost accounting to determine these numbers, they all have one aspect in common — they are attempts to determine ‘true’ economic value. In this respect, it can be argued that the numbers are additive.

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Chambers is inconsistent in his treatment of bonds as assets and as liabilities. As assets, he insists on market value, but as liabilities he maintains they should be stated at face value. By his own definition of financial position, the firm should be able to purchase its own bonds in the market at market price.

Chambers is also inconsistent in his treatment of receivables. They should be stated at the price the firm would receive if sold to a factor, instead of subjectively determining how much is uncollectible and deducting this from the gross.

Exit price accounting is seen to be too radical an approach to be acceptable to accountants or understood by users.

11. Is exit price accounting retrospective or forward-looking in its approach?

Exit price accounting is forward-looking in its approach. It provides information concerning the amounts that could be realised from an orderly sale of assets in the future. The aim is to report the current cash equivalence of those assets in order to show the extent of the resources available to the firm should it need to change its operations in the future.

12. Describe how exit value accounting can be used to assess the financial risk of a statement of financial position.

The difference between entry prices and exit prices indicates the liquidity (financial) risk of investing in an asset. If this difference is high then the operating risk of the asset should be lower as the value in use becomes the primary income recovery mechanism.

13. Evaluate the argument that a mixed or piecemeal approach to standard setting is required in order to ‘better’ measure profit and financial position.

If the firm has assets that are mixed — financial, operating, intangible — then valuation would require the utilisation of different concepts. This appears to be the way that standard setting bodies are headed. However, the conceptual nature of the system becomes more and more complex, and gives the impression that the output is a result of compromise rather than being driven by one conceptual general model.

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Problems

(For a full outline of problems, please see text.)

8.1 Required:Record the transactions as journal entries under the following methods:(a) conventional accounting (historical cost)(b) exit price accounting.

Conventional Exit Price1. Inventory $20 000 $20 000

Accounts Payable $20 000 $20 000

2. (a) Accounts Receivable 36 000 36 000Sales Revenue 36 000 36 000

(b) Price Change Adjustment (see below) 8 000Inventory ($8 1000) 8 000

(c) Cost of Goods Sold 14 000 14 000Inventory 14 000 14 000

3. Building 25 000Price Change Adjustment 25 000

Depreciation Expense 10 000 0Accumulated Depreciation 10 000 0

4. Land 20 000Price Change Adjustment 20 000

5. Discount on Bonds Payable 3 832Price Change Adjustment 3 832

6. Price Change Adjustment 1 000Accounts Receivable 1 000

Cash (amount not specified)Accounts Receivable

7. Inventory [($14 – $5) 2000] 18 000Price Change Adjustment 18 000

8. Operating Expenses 8 480 8 480Interest Expense 3 520 3 520

Cash 12 000 12 000

For the exit price alternative, the books are assumed to be kept on an exit price basis for the previous year. It is assumed that an adjusting entry at the end of the previous year for inventory was made to record the 1000 units at the exit price of $12 each. Since the cost was

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$4, the difference of $8 per unit, or $8000 was recorded. The entry here (2(b)) is to reverse the previously recorded adjusting entry. The reversing entry should be made at the beginning of the period. Replacement cost in this problem is irrelevant.

8.2Required:Prepare journal entries to record the above events, as well as the statement of financial performance for Year 10 and statement of financial position as at 31 December Year 10, under the exit price method.

1. Inventory (5000 $6) $30 000Accounts Payable $30 000

2. (a) Accounts Receivable 75 000Sales Revenue 75 000

(b) Price Change Adjustment 10 000Inventory (1000 $10) 10 000

(c) Cost of Goods Sold(1000 $5) + (4000 $6) 29 000Inventory 29 000

3. Inventory (1000 ($19 – $6)) 13 000Building ($200 000 – $90 000) 110 000Land ($20 000 – $10 000) 10 000Investment in Y Stock 5 000Discount on Bonds Payable 4 968

Price Change Adjustment 142 968

4. Cash 10 000Land 10 000

5. Operating Expenses 15 000Interest Expense 5 000

Cash 20 000

6. Purchasing Power Adjustment 17 000Capital Maintenance 16 667Retained Earnings 333

January 1 December 31 AdjustmentYear 10 Year 10

Capital Stock $75 000 120/100 = $ 90 000 $15 000Capital Maint. Adjustment 8 333 120/100 = 10 000 1 667Retained Earnings         1   667 120/100 =             2   000               333 Stockholders’ Equity $85 000                 $102 000 $17 000

Circle LtdStatement of Financial Position

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as at 31 December Year 10Cash 10 000 Accounts Payable $ 50 000Accounts Receivable 75 000 Bonds Payable 50 000Inventory 19 000 Less: Discount     4   968

45 032Investment in Y 25 000 Ordinary Capital 75 000Building 200 000 Capital Maint. Adjustment 25 000Land         10   000 Retained Earnings     143   968 TOTAL $339   000 $339   000

Statement of Retained Earningsas at December 31 Year 10

Beginning balance $ 1 667Add net income     141   968

$143 635Add purchasing power adjustment                   333 Ending balance $143   968

Circle LtdStatement of Financial Performancefor the year ended 31 December Year 10

Sales Revenue $75 000Cost of Goods Sold:Beginning Inventory (at historical cost) $  5 000Purchases     30   000 Available for Sale $35 000Ending Inventory (at historical cost)         6   000     29   000 Gross Profit (at historical cost) $46 000Price Change Adjustment — beginning inventory (10 000)Price Change Adjustment — ending inventory     13   000 Gross Profit (on exit price basis) $49 000Sale of land $10 000Less cost of land         5   000         5   000

$54 000Changes in value:

Investment in Y 5 000Building 110 000Land 5 000Bond Payable 4   968     124   968

$178 968Less:

Operating expenses paid 15 000Interest paid     5   000         20   000

$158 968Less Purchasing price adjustment         17   000 Net income $141   968

The format above is recommended by Chambers. Because of criticism that the exit price income statement does not concentrate on operations, he has attempted to show the gross

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profit on an historical cost basis first, before adjusting to an exit price basis. This is the reason for journal entry 2(b). There are no accruals and deferrals of expenses.

Case Studies 8.1 — Brambles close to selling shipping arm

1. The sale of Brambles’ Bass Strait cargo operations is estimated to be approximately $80 to $100 million. How do you think this sales figure was arrived at?

The assets in question are relatively specialised in nature but can also be used in other operations. So estimates of value can be obtained from valuers. The assets can also be valued at the expected earnings from continued operations. For example, the price/earnings ratio that (ignoring tax) is about 4 to 1. This is very low and should be adjusted by lower expected earnings and tax (that is, margins under pressure). Regardless, the price appears to be on the low side and requires further investigation.

2. Assess the specialised nature of these assets as a factor influencing the financial risk of Brambles’ asset structures.

The difference between entry prices and exit prices indicates the liquidity (financial) risk of investing in an asset. If this difference is high then the operating risk of the asset should be lower, as the value in use becomes the primary income recovery mechanism. Specialised assets in the asset structure of a firm will increase the financial risk of any firm.

3. Why do you think Brambles released this information offshore on the London market rather than in Australia?

Brambles, quite simply, believes that the Australian share market does not reflect information in prices well. This is an interesting point given that it is selling a substantial proportion of its assets in a much less liquid market than the stock market.

4. Do you believe that the sale of these assets will increase or decrease the share price?

The answer to this question depends on a number of outcomes. It depends on whether the opportunity returns are higher from selling the assets or are higher from value in use. It will also depend on the synergies from sale to other areas of the firm, such as increased specialisation and increases in returns.

Tutors may wish to discuss the arguments for buying and selling assets. It can be argued that the acquisition cost of an asset is only incurred by an entity where it is less than or equal to the present value of future cash inflows that are expected to be derived from owning the asset as at the date of acquisition. Where such estimates change, an entity is permitted to revalue such assets to reflect the service potential embodied in ownership of the asset. However, the upper limit to the revaluation is constrained by market prices, regardless of value in use.

The price paid for an asset is unlikely to fully reflect all future service potential since it is a negotiated price based as much on the seller’s perspective as the buyer’s.

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A rational buyer will pay less than the service potential of the asset, but how much less depends on the seller’s negotiations as well as the buyer’s.

These are the circumstances of distressed acquisition cost (‘bargains’). Further, the subjective basis for determining an asset’s ‘useful life’ means that historical cost is not necessarily a good estimate of service potential either at date of acquisition or later dates.

Current cost accounting values assets according to the cost of the expected future service potential embodied in the asset, as represented by the current cost that would be incurred by the entity to obtain such benefits and service potential. As such, the current cost of a replacement property does not measure the service potential embodied in the asset the entity is using; but it does measure the cost of acquiring that service potential under current market conditions. As with historical cost, this is not necessarily the value of the service potential itself.

Exit price accounting assumes that an entity will only retain an asset to be used in operations if the expected value of future service potential is greater than or equal to the amount for which the asset can be sold. In effect, the exit price of an asset is the minimum value of the embodied service potential and benefits to the firm. Since the asset remains in the control of the reporting entity, it is not the value of service potential itself, but a lower bound.

The value of the service potential of an asset is its present value. However, it is a subjective measure that is rarely used in asset measurement. Historical cost, current cost and exit price all provide measures that are lower limits to the service potential at some point in time.

Case Study 8.2 — Escaping from the performance reporting quagmire

1. What are the problems associated with having comprehensive statements of financial performance that accommodate mixed measurement systems when reporting components of profit?

If the firm has assets that are mixed — financial, operating, intangible — then valuation would require the utilisation of different concepts. This appears to be the way that standard setting bodies are headed. However, the conceptual nature of the system becomes more and more complex, and gives the impression that the output is a result of compromise rather than being driven by one conceptual general model. Moreover, users must be sophisticated enough to understand the different components of the comprehensive system; and because it is a mixed system, the additive principle may be questioned.

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2. If preparers and analysts are opposed to a single performance statement, what statements do you think should be produced?

Students may argue for a single (simple) system or various combinations. Tutors should lead the discussion in order to evaluate the advantages/disadvantages of each system(s) and the synergistic effects of adding together different systems.

3. What are the problems associated with departure from the realisation model and a movement towards ‘fair value’ accounting?

Departure from the realisation principle is covered in the criticism section (learning objective 3, pp. 245–9). The problems are: liquidation vs going concern concept recognition before confirmation by sale definition of profit and meaningful profit problems of obtaining selling prices value in use concept of an asset.

4. What system do you think a financial analyst would favour?

Financial analysts would favour a current value system of accounting that is provided to them without cost. They are interested in valuations that are more closely associated with the expected economic returns of assets.

Chapter 9

Positive theory and capital market research

Theory in Action 9.1 — Measuring share price by the use of profits

1. ‘Jupiters’ shares are now valued at more than 17 times expected earnings’. Show how this statement can be verified by using equation 9.7 (p. 282). What interest rate would be imputed?

Equation 9.7 can be restated as a function of the price/earnings ratio as follows:

V = P =

where is the imputed interest rate or discount factor and is =

therefore

V = =

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Discount interest rate is 5.9%.

2. What other factors might be taken into account in valuing Jupiters’ share price? Explain.

Other factors to be taken into account are: potential cost synergies probability of takeover which could boost price opportunities to diversify which would reduce the discount rate growth potential.

Growth potential would modify the above equation by:

V = P =

where g is the expected growth factor.

3. Do you think there are temporary or permanent factors in the equation? What are they?

In equation 9.7, earnings are assumed to be permanent. If there are temporary earnings then this would be reflected in the P/E ratio, which would be lower for earnings that had temporary components or volatile components (hence increasing the discount rate). Based on the overview information supplied, because of the efficiencies previously supplied and the prognosis for the gambling industry, earnings now appear to have been stabilised. Thus, permanent current earnings with potential for growth is a reasonable scenario. Some students may observe that the P/E for Jupiters is below Tabcorp (17 vs 19) and this signifies some perceived less stable earnings for Jupiter.

Theory in Action 9.2 — A fall in fundamental accounting metrics and a rise in share price

1. Despite a 23% reduction in profit and reduced dividends and sales, the share price of WAN increased. Can you explain this?

Share prices take into account information other than that published in financial reports. Share prices are determined partly by general market conditions and partly by firm-specific information (of which accounting information comprises a subset). Therefore, any share price movements experienced may be partly in response to fluctuating market conditions and partly in response to the release of new information about the firm itself. Firm-specific information that is price relevant may include accounting information (such as news about the firm’s earnings and/or cash flows) as well as non-accounting information (such as news about new product lines or markets, technological developments and management changes) that cause investors to revise their expectations about the firm’s future performance. Figure 9.6 suggests that 50–60% of price is associated with published financial reports. Mentioned in the article are cost cutting measures, the expected increase in advertising revenues and the Chinese contract that will provide a macroeconomic boost to the WA economy.

2. Is the evidence presented in this article consistent with efficient markets?

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Market efficiency is related to the reaction of markets to information. If the good news from the information set outside of the published accounting reports offsets the negative information contained in the financial reports, then the share price reaction is consistent with efficient markets. Also, according to the efficient markets model, share prices react to unanticipated information. If the negative news in the financial reports were known, then there would be no price reaction to this. But some of the other news may represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of future cash flows.

3. What role do the accounting reports play in determining share prices?

The role of accounting reports is to report on current and past cost events, such as transactions of the firm and possibly some market price adjustments. That is, they provide a snapshot of past events: earnings, assets and liabilities. Whereas many argue these snapshots do so imperfectly for valuation purposes, accounting reports explain about 60% of the information impounded in prices (and thus are the single most important pricing input). Earnings account for 15%, statement of financial position for 45–50%, whereas cash flows add only 2–3% and are dominated by earnings.

4. Do you think there may be a degree of optimism incorporated in the share price? Why or why not?

Optimism assumes that there are behavioural influences on share prices, and there is evidence that prices are affected by behavioural effects (see the section on mechanistic and behavioural effects in the chapter). Many students will assume that stock markets are irrational (this is the common perception), but tutors should encourage students to argue based on research evidence rather than anecdotal perception.

Theory in Action 9.3 — Accounting manipulations and the price of shares

1. How would the following affect the earnings response coefficient (ERC):(a) cosmetic accounting?(b) the actions of financial analysts?(c) the quality of management?

Impact on the ERC:(a) Cosmetic accounting lowers the quality of the reported earnings and will lower the ERC.

Much of cosmetic accounting will try to smooth earnings or boost earnings to give an impression of permanence at higher levels.

(b) If financial analysts are efficient in gathering and impounding information in share prices, then their actions will reduce the short-term impact of financial statement releases. If not, the opposite will occur and the short-term ERC will become higher as accounting reports become more valuable as a source of price information. However, the longer term ERC (as in association studies) should not be affected.

(c) The quality of management, in that it will have an influence on the credibility of the accounting reports and the risk and uncertainty of firm operations, will either increase the ERC (high quality) or decrease the ERC (low quality).

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2. Comment on the role of financial analysts in valuing corporations and how their advice might be compromised.

This question considers the role of financial analysts in the marketplace and the economic incentives they face. Recent research (including this article) suggests that analysts are not arbiters or assessors of firm quality and do not provide independent advice. They are compensated by IPO and M&A capital raising deals and face certain economic conditions, which could compromise the advice given, such as: they function as an arm of investment banks they face competition from the Internet their rewards are mainly driven by the trading behaviour of clients (commissions) rather

than the quality of advice they hold inventories of stock, which must be cleared from time to time they have close personal connections with some firms.

Questions

1. What is positive accounting theory? How does it differ from normative accounting theory? What was/were the major dissatisfaction(s) with normative accounting theory which led to the development of a positive theory of accounting?

Positive accounting theory is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. This approach can be compared with normative accounting theories, which dismiss conventional historical cost accounting as being meaningless or not-decision-useful, and which prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. One technique that can be used to show students the different approaches is to contrast the assumptions used by each theory as follows:

Normative PositiveObjective of accounting Decision making Stewardship or agency

relationship

Behavioural assumptions Functional fixation or fooled by cosmetic accounting

Rational economic man, able to analyse and distinguish

Economic assumptions Little comment on historical costs

Financial reports are an economic commodity. Information has a price.

Semantic assumptions Accounting serves a measurement role.

Measurement role is a secondary function to monitoring and bonding.

Pragmatic assumptions Accounting is neutral/unbiased. Accounting is a political economic or social commodity.

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The dissatisfactions with normative accounting are: To be normative, one must specify an objective function — for example, efficiency,

decision usefulness, estimation of future share prices, improved quality of financial reports. However, many of the above objectives are conflicting, and it is difficult to decide which one is a superior objective. It should be noted that the definition of an objective of accounting continues to be a contentious issue. (Note that the objective is usually defined in a very broad, non-specific manner.)Popper also makes the point that no amount of empirical testing can prove or disprove the validity of normative accounting prescriptions — they are irrefutable — therefore they are weak hypotheses.

There was usually no attempt to justify — empirically — that the prescriptions from normative theories are ‘better’ than the status quo. For example, the redefinition of the objective of financial accounting from the traditional stewardship role into a decision-making role (usually to aid investors) was never justified by empirical research.

Before condemning the usefulness of conventional accounting as a decision-making tool, it would be more scientific to analyse and compare the decision-making processes induced by conventional accounting and the proposed alternatives. Part of this research would encompass whether cosmetic manipulations fooled market participants and the role that financial accounting played in economic decision making.

Normative inflation models have been widely known in the literature for over 30 years, and have not been readily accepted by the marketplace. Positive theories sought to obtain a rational explanation for the status quo.

This leads positivists to attempt to model the connection between financial accounting, firms and markets in a rational economic framework, rather than to take the stance of normative theorists who dismissed current practice and took a prescriptive attitude.

2. Explain the meaning of an efficient market. What is meant by the following terms: weak-form efficiency, semistrong-form efficiency and strong-form efficiency? Which form is the most important to accounting research? Why?

An efficient market, in the context of the share market, is a market that adjusts rapidly to new information and fully reflects the available information in an unbiased manner. The implication of this theory is that if share markets fully reflect all the available information in prices, then there is no marginal benefit in collecting and analysing information that bears on the price of any individual share.

Market efficiency only refers to information efficiency and does not relate to exchange efficiency or production efficiency.

Furthermore, it does not mean that all financial information has been ‘correctly’ presented by firms or ‘properly’ interpreted by individual analysts. Nor does it imply that managers make optimal management decisions or that investors can predict future events with certainty. EMH means that, in aggregate, all information that is relevant is impounded into security prices in an unbiased and rapid manner (hence the term) — market prices are a fair game.

To accommodate different types of information sets and to enable empirical testing (capital market research), Fama distinguished between three information sets (past price movements, publicly available information and all information, both public and private) as follows:1. The ‘weak form’ of market efficiency implies that a security’s price at a particular time

fully reflects the information contained in its sequence of past prices — that is, there are

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no trading strategies based on cycles in prices (Dow theory), price patterns (head and shoulders) or other rules such as oddlot behaviour, moving averages and relative strength which will give excess profits.

2. The ‘semistrong form’ asserts that a security’s price fully reflects all publicly available information, which includes past prices. This means that there are no trading strategies available to make excess profits from analysing publicly available economic, political, legal or financial data.

3. The ‘strong form’ suggests that a security’s price fully reflects all information, including information that is not publicly available — for example, insider and private information.

Of the three, the semistrong form is the one most directly related to the accounting profession, because accounting information, when released, is part of the subset of publicly available information. Normative accounting theorists and accounting standard-setting bodies give quite considerable effort to arguing the merits of the form in which accounting statements are disclosed to the public. However, if prices already reflect all publicly available information, which includes current values and general inflation, then their arguments for ‘proper’ measurement are considerably weakened.

It is also important to distinguish the market-related effects that different accounting standards may have on share prices. These effects may be caused by a higher cost structure (for example, more complex accounting systems or regulation) or by the imposition of political, social or renegotiation costs by participants who are located outside the relatively efficient security market.

3. Explain the importance of examining the impact of profits on share prices for financial analysis. Can this analysis be used to make abnormal returns from share markets?

In general the empirical research on the information content of accounting earnings has the following implications: Historical cost income releases have significant information content for the marketplace in

terms of CARs and the effect on volatility and trading volume. There is a continuous information set that is employed by the market and, therefore,

accounting reports are not the only source of information. There are limited opportunities for abnormal returns after the release of earnings — hence

the analysis of financial reports well after the release of those reports is unlikely to result in abnormal returns for the analyst.

Empirical research on the mechanistic and no-effects hypotheses is inconclusive, but these tests were hampered by the lack of a well-formed predictive theory about accounting policy choice.

Current earnings are correlated with contemporary movements in share prices. Most of the research has been undertaken on large firms in the US stock market. There is

evidence that financial analysts who concentrate on small firms may earn excess returns. Furthermore, there is no mention of the important role that financial analysts play in keeping the market efficient or in making the market when the stock is unlisted.

Further, Beaver argues that CMR has the following implications for accounting standard setting:

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Many accounting issues are capable of a simple disclosure solution (for example, by footnote).

The role of accounting data is to prevent superior returns accruing to insiders and can be achieved by a policy of fuller disclosure.

Financial statements should not be reduced to the level of naive investors. Accounting policies should take into account excessive costs and their economic

consequences.

Additionally, Deitrick and Harrison believe that the EMH and CMR have important implications for practising accountants, such as: counselling clients against making costly accounting changes if their sole purpose is to

‘fool’ share markets the fact that the substance of an accounting disclosure is more important than its form or

location a defence against claims for damages in courts of law and to quantify estimates of

economic loss.

There is some evidence that superior analysts can make abnormal returns. If the actions of the analyst actually adds information to publicly released accounting reports (by the quality of the analysis), then superior returns can be achieved. However, the counter argument is that these superior returns simply cover the high opportunity costs of education and experience gained.

4. Does a study of the information content of profits announcements explain why firms use particular accounting practices? Does it help to predict which firms will use particular accounting practices?

No. This is one of the major shortcomings of this type of research which simply looks at the aggregate effects of accounting practices (earnings) on share prices. There is no theoretical background to explain why firms use particular accounting techniques or no predictive theory as to the circumstances in which a firm would be expected to change its accounting policy (see Leftwich 1990). This leads into the second stage of positive theory (covered in chapter 10), which encompasses rational economic models of voluntary and mandatory changes of accounting techniques.

5. Give reasons that non-linear models relating unexpected returns to share prices would provide a more precise estimate of the earnings response coefficient (ERC).

Non-linear models would provide a more precise estimate for the ERC because: high persistence earnings have a greater valuation impact (arctan model) as surprise in earnings increases, the likelihood that earnings surprise is permanent will

decrease (arctan model) bad news and good news have differential impacts (exponential model).

6. Why would share prices have a greater reaction to the profit announcements released by small firms compared with those released by large firms? Do you think this research has any implications for ‘measurement’ issues in accounting or to the regulation of accounting standards?

Large firms have greater potential information sources other than accounting reports from: analyst research

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information releases media coverage interim reports private information trading institutional investment.

Therefore, small firm financial reports (earnings) will have greater impact on release because information from alternative sources is less. If small firm accounting reports contain more price-relevant information then there may be an argument for differential accounting standards. However, more detailed reporting may impose higher preparation costs on small firms. Instructors should encourage discussion for and against.

7. Outline the research that has been undertaken on the impact of permanent and temporary increases in profits. Why is this research important?

Research is summarised in the chapter. Permanent and temporary earnings will have differential impacts on share prices in an efficient market. This has important impacts on research design (linear vs non-linear models) and assessing the sophistication of the market in analysing the impact of earnings on stock prices (see the next question).

8. How will risk and uncertainty affect the valuation of a firm and, through this valuation model, the ERC?

Risk and uncertainty will impact the discount rate, the certainty of the prediction of future economic benefits, the credibility of the financial reports, firm growth and the degree of financial leverage. General macroeconomic conditions will also affect general interest rates. Tutors should take students through equation 9.7 and explain how each affects the valuation model. Also refer to Theory in Action 9.1.

9. The impact of profits for valuation has diminished over the years. What is the impact? How has the research adjusted to reflect this fact?

See figure 9.6. Profit has declined in relevance whereas the statement of financial position has increased in relevance. Tutors should note, however, that this research relates to the United States and not Australia. The research has adjusted by using the Ohlson model, which takes account of both earnings and statement of financial position components.

10.Outline a research project which explains how share prices are determined. Would this project include factors other than accounting data?

There are numerous examples in the text, and tutors should briefly discuss a research project and relate this to the activities of financial statement analysts. Other factors include firm specific factors (management, cost cutting, investments, innovations), industry factors and general economic factors.

11. Briefly explain and outline the research on the ‘mechanistic’ hypothesis. What are the implications of this research?

Even though not specifically requested, both the no-effects hypothesis and mechanistic hypothesis are covered.

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In the no-effects hypothesis, the market ignores accounting changes that have no cash flow consequences. That is, accounting changes that are carried out solely to window-dress profit figures are discounted by the marketplace. This hypothesis accepts the marketplace as being economically rational and efficient, able to see through cosmetic accounting changes.

In the mechanistic hypothesis, the market is systematically deceived by accounting changes that increase reported profit. In other words the market is misled by cosmetic accounting techniques.

The tests of the two hypotheses considered the behaviour of abnormal rates of return at and around the time of a change in accounting policy. According to the no-effects hypothesis, there should be no abnormal returns when there is a ‘cosmetic change’ in accounting policy, since there will be no effect on cash flows. This is because the creative accounting change is understood by capital market participants, and they are able to unravel and determine its effects at zero cost. On the other hand, if an accounting policy has an effect on cash flows (for example, as a result of tax regimes), then we would expect to see positive abnormal returns at the date of announcement. Therefore, the no-effects hypothesis is a joint hypothesis of the EMH, the CAPM and zero monitoring costs. In contrast, under the mechanistic hypothesis we would expect to see positive abnormal returns at the date of announcing an accounting change, even though the change has no effect on cash flows — that is, cosmetic or creative accounting can fool market participants.

Empirical evidence cited in this text grouped under the hypothesis supported

Inconclusive No Effects MechanisticKaplan & Roll, 1972 Biddle & Lindahl, 1982 Ricks, 1982Sunder, 1975 Brown & Hancock, 1977 Sharpe & Walker, 1975

Brown, Finn and Hancock, 1977

This research is important in considering behavioural influences on stock prices.

12.Why would financial analysts be fooled by accounting numbers and provide optimistic and biased estimates of profits? Can you offer a positive economic reason for their actions?

These issues are also covered in Theory in Action 9.3. Financial analysts can be ‘fooled’ in the short term by cosmetic accounting. See the answer to 11 above. This question considers the role of financial analysts in the marketplace and the economic incentives they face. Recent research suggests that analysts are not primarily assessors of firm quality and do not provide independent advice. They are compensated by IPO and M&A capital raising deals and face certain economic conditions which could compromise the advice given, such as: They function as an arm of investment banks. They face competition from the Internet. Their rewards are mainly driven by the trading behaviour of clients (commissions) rather

than the quality of advice. They hold inventories of stock that must be cleared from time to time. They have close personal connections with some firms.

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Case Study 9.1 — Record result for Centennial Coal

1. Research the share price movement at this time.

According to the Ball and Brown model, share prices react to unanticipated increases or decreases in earnings, since these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of future cash flows.

2. Does the upward share price movement of Centennial Coal fit with the Ball and Brown model?

The upward share price movement does not strictly fit with a pure Ball and Brown model. The previous upward movement from other coal mining companies, together with known specific information for Centennial, should mean that information would already be impounded in share prices. This is not the case. However, the previous conservative profit outlook by management might mean that price had to be confirmed by the release of the accounting reports. Moreover, post-announcement drift was previously found by Ball and Brown and thus it could be argued that they fit with an empirical Ball and Brown model.

3. Comment on any aspect that might have affected the share price.

Other aspects that might have affected the share price are: previous results from the coal industry expanded production productivity gains and cost improvements stronger coal prices and sales revenue.

4. Is the share price movement consistent with the EMH?

An empirical exercise for students would be to ask them to research the share price movement of Centennial Coal around the announcement and also around the announcement from MIM the week before. It can then be assessed if the share price movements are consistent with the EMH. This will depend on reactions to MIM and post-earnings drift for Centennial.

Case Study 9.2 — Local accountants still have too much discretion

1. The argument for greater prescriptive accounting standards ignores the research on capital markets regarding market efficiency. Discuss.

The argument for greater prescriptive standards assumes that: accountants will not use professional judgement honestly (the market for accountants and

managers is not efficient). This relates to the writing of agency contracts, covered in the next chapter.

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cosmetic accounting will induce a mechanistic price adjustment and will not be seen through by investors and analysts

a prescriptive solution is required that reduces subjectivity (black-letter-based accounting).

2. What are the arguments for and against allowing accountants to have discretion in the use of accounting standards?

Arguments for: Accountants have the education and professional training to make these decisions. Subjectivity is required because the business world is complex and requires judgement in

assessing appropriate rules to fit the circumstances. The market is semistrong-form efficient, and standards are more or less irrelevant for

pricing and valuation decisions.

Arguments against: Accounting data is the primary driver of value and prices, and correct accounting is

critical for an efficient stock market. Accountants and managers have short-term incentives to mislead the market. The market is not completely efficient and needs accounting reports to make it efficient. There are economic externalities from a stock market that does not have confidence in

reporting practices.

3. Even though the United States has 145 accounting standards, there are still ‘problems’. How do you reconcile this with the call for further standards by Professor Walker?

The argument in the United States is that the focus on a large number of accounting standards is technically oriented. That is, form is emphasised rather than substance and this is why black-letter accounting is not necessarily a factor in preventing accounting malpractice. The call for further standards may be counter-productive if they are not effective standards. However, Walker argues that US-based standards are more comprehensive than international standards and Australian standards. The argument could boil down to whether we have fewer, but more effective standards, or a large body of standards that are aimed to cover all contingencies (with the obvious drawbacks).

4. Tony Berg has called for the ‘reasonable person’ test. What does he mean with regard to accounting standards?

The reasonable person test is usually the interpretation by the ‘common person’ of what is reasonable practice. This is applied by a professional person who puts himself or herself in the shoes of the common person. Given that accounting has argued about these issues for at least the last 50 years, the question becomes: What point of view would be attributed to a common person? Tutors should solicit viewpoints given the last nine chapters of the book.

Chapter 10A positive theory of accounting discretion

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Theory in Action 10.1 — Executives’ compensation an expense?

1. Why would remuneration committees structure the CEO’s remuneration package to be heavily equity based?

Equity-based compensation combats the horizon agency problem by aligning shareholders’ long-term interests in the firm (share price equals present value of all future expected cash flows) with managers’ shorter term interests (their interest is in relation to the period of their expected tenure with the firm).

A compensation package should be structured such that the interests of the management team are aligned with the interests of the shareholder. From a shareholder’s perspective, the objective of the firm is to maximise firm value. An appreciating share value is consistent with this objective. Accordingly, compensation that is heavily equity based means that an appreciation of share price benefits both shareholders and managers. Recent surveys of CEO remuneration packages for Australia’s Top 100 firms indicate an increasing trend towards use of options and performance rights. Attention is now focused on the performance hurdles and timing of exercise attached to such instruments because some CEOs reap large rewards on the back of market rises rather than improvement in the firm’s underlying performance. Some firms’ performance hurdles are related to the firm’s performance relative to the performance of an index or group of firms.

An equity-based compensation plan is a means of restricting management from making decisions that are beneficial to their own interests at the expense of shareholders. However, imperfections in the financial markets can still provide scope for managers to make decisions to increase share prices in the short term at the cost of long-term performance. The alternative to a heavily equity-based compensation plan is to have a package that is cash based. The cash-based package does not give managers an ownership stake in the company and therefore is not as effective in aligning shareholder and manager objectives unless the cash bonus is linked effectively to share price appreciation.

2. Do you think that remuneration packages will be restructured as a consequence of any accounting standard requiring executive options to be expensed?

The requirement to expense share options will reduce the reported earnings of Australian firms. This could have implications for firms’ market valuation and contractual arrangements with debtholders. Rather than renegotiating debt contracts, firms can restructure their compensation plans. This would occur if firms believe the ‘costs’ associated with expensing options outweigh their use as a means of aligning shareholders’ and managers’ interests. It can also be argued that the absence of a prescribed accounting treatment has perpetuated the use of executive options in compensation contracts, and the resultant compensation structures may be inefficient.

Anecdotal evidence suggests that restructuring of executive compensation packages will occur in response to the proposed accounting treatment. Recently, major Australian companies such as AMP, Commonwealth Bank, Qantas and Western Mining Corporation have suspended share options schemes. (Note: At the time of writing this solution, the AASB had issued ED108 for comment on the proposed treatment of share-based payment in response to IASB ED2).

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3. What are the potential problems associated with prescribing an appropriate accounting treatment for executive options?

Accounting for executive share options is contentious. Arguments cited by firms against the expensing of options include: The granting of options does not involve a sacrifice of cash or other assets, therefore no

cost is involved. The options may never vest and hence recognising an expense prior to vesting is

inappropriate. The options value cannot be reliably estimated. Expensing share options would be double-counting because the dilution effect of granting

options is recognised by an increase in the number of shares in the denominator of a fully diluted earnings-per-share calculation.

Counterarguments include the following: If executives were given cash and they then used that cash to buy options, an expense

would be recognised in the first cash transaction. The options are awarded as a result of the provision of employee services and hence

should be recognised (akin to providing for other employee benefits). Option valuation models exist (for example, Black-Scholes, binomial) and these can be

used to determine a reliable measure of value.

The technical issues associated with prescribing the expensing of options include: At what time should the expense associated with issuing options be measured? What valuation model should be used?It is expected that the AASB accounting pronouncement on share-based compensation will require the granting of executive options to be treated as an expense to be recognised over the vesting period.

4. Outline the arguments for and against the full disclosure of executive salary packages.

Disclosures concerning director and CEO remuneration packages have been topical for some time. The concern was that Australia’s disclosure rules lagged those of other countries such as the USA and UK. Community concern also focused on the apparent lack of correlation between the increase in payments to top executives and firm performance. Stakeholders are interested in knowing the basis on which executives are compensated and the process involved in establishing and reviewing such packages because the remuneration (a) reduces the dividends to which they are entitled, but (b) should be structured to ensure that managers maximise the value of equity. Transparency in relation to executive packages is now required as a result of disclosure requirements passed in the Company Law Review Act (CLRA). It is now necessary to disclose the salary packages of top executives in detail as per Section 300A of the Corporations Act. Such disclosures also assist in the monitoring task.

The requirement to disclose such information was subject to intense lobbying against the disclosures by firms and company directors. The argument put forth was that the information required was of a proprietary and personal nature. The pressure exerted resulted in the Treasurer establishing a Federal Parliamentary Joint Standing Committee inquiry to review the requirement to disclose such information. The recommendations of the inquiry affirm the requirements of the CLRA. Section 300A

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of the Corporations Law requires firms to disclose broad policy in determining the remuneration of executives and the relationship between the policies and firm performance.

Theory in Action 10.2 — What value profit?

1. Explain the role of profit announcements as a signalling device to capital markets. Do you think that Australia’s continuous disclosure rules have increased or decreased the importance of profit announcements?

According to the Ball and Brown (1968) model, share prices react to unanticipated increases or decreases in earnings, since these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. Earnings announcements convey information to capital market participants that may cause the market to reassess firms’ expected future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of expected future cash flows.

Australia’s continuous disclosure rules require directors to disclose price-sensitive information to the ASX immediately it becomes available. This should decrease the importance of profit announcements (semi-annual and annual), as information concerning a firm’s expected future cash flows is progressively provided to the capital market throughout the reporting period. It would be expected that earnings response coefficients (ERCs) associated with annual profit announcements will be lower than those in a non-continuous disclosure environment.

2. The article reports that there are several new chief executive officers reporting to the market for the first time. Explain the various incentives facing a new chief executive officer in the determination of profit.

The incentives facing a new CEO will vary depending on the structure of the compensation plan. Evidence suggests that new CEOs often take an ‘earnings bath’. This earnings management technique involves minimising earnings in their first year (via asset write-downs) and reporting high growth in earnings in subsequent years. In a CEO’s first year of appointment, the lower earnings can be ‘blamed’ on previous management decisions. In subsequent periods, the CEO can claim responsibility for earnings growth. If this corresponds with an increase in share price, the CEO is enhancing wealth accumulation via the share-based compensation arrangements. Furthermore, if the CEO’s bonus is based on reported earnings, this is unlikely to be a significant component of the bonus in the CEO’s first (partial) year. Therefore taking a bath then (a) defers profit to when it can be used to increase the CEO’s bonus, and (b) reduces compensation committee expectations for future profitability, thereby providing potential for a low compensation bonus threshold and increased management compensation, especially in the CEO’s first full year, when the present value of the earnings-based bonus is greatest.

3. The reduction in the corporate tax rate from 1 July 2001 is expected to artificially inflate earnings per share across all sectors. How should such a change be accounted for, and reported, to make the profit announcements comparable?

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The reduction in the corporate tax rate from 1 July 2001 will result in higher reported earnings and cash flows. The market should respond only to unexpected information that constitutes ‘news’. Capital markets focus on ‘persistent’ earnings to form their expectations of future cash flows, and the share price of a firm is the present value of all expected future cash flows. Pre-tax earnings are the focus of market participants, as taxation is essentially an exogenous factor beyond a firm’s control. The higher earnings are a marketwide factor due to a change in taxation policy rather than being due to firm-specific factors. There would be a greater price response to firm-specific unexpected earnings that are believed likely to persist into the future and to translate into permanent earnings increases, than to marketwide unexpected earnings that are perceived to be only transitory (temporary). Hence, the market reaction to the earnings announcements should not be significant, as the market is anticipating higher earnings associated with a change in taxation policy. To ensure that the increase in earnings is not mistaken as a change in the firm’s underlying earnings, the information should be reported in such a way to enable investors to distinguish pre and post tax earnings and the change in corporate tax rate should be disclosed.

4. Discuss the impact of the following accounting treatments on the present and future profits and share price of the firms in question:(a) News Corp’s significant write-down on NFL and baseball programming

contracts(b) United Energy’s interest capitalisation associated with shareholder loans(c) Southcorp’s cutback in corporate capital expenditure.

For firm-specific accounting information to be price relevant, it should impact on the firm’s expected future cash flows by causing investors to revise their expectations about the firm’s future performance. The impact of each scenario on present and future profits and share price is as follows:(a) News Corp’s significant write-down on NFL and baseball programming contracts would

reduce the current year reported profit. The need to write-down these assets suggests that the future cash flows News Corp expected to generate from these contracts are less than originally anticipated. If these write-downs were unexpected, investors will revise the firm’s future earnings and cash flows downwards, resulting in a share price reduction. If the write-down was expected, as per a previous announcement, such a revision would already be incorporated into News Corp’s share price.

(b) Interest capitalisation versus interest expense results in higher profits being reported in the current period, but lower profits will be reported in the future as the capitalised interest is expensed. The capitalisation versus expensing accounting treatment has no direct cash flow implications. Accordingly, investors should not revise their expectations regarding the firm’s future cash flows and, hence, firm value unless the firm is involved in major contracts whose values depend significantly on earnings or leverage measures whose values are materially affected by the capitalisation/expense decision. No share price reaction is expected.

(c) Firms need to invest in profitable projects in order to generate future earnings and cash flows. Whereas the announcement of a cutback in capital expenditure conserves cash in the short term (and depreciation charges are reduced thereby increasing earnings), it is likely to have a detrimental impact on earnings and cash flows in the future. Viewing the announcement as such, there would be a negative share price reaction associated with this real decision.

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Theory in Action 10.3 — Airport aeronautical charges

1. The political cost hypothesis recognises that accounting plays a role in political cost allocation. Discuss how the Australian Competition and Consumer Commission is using the accounting numbers of Australian airport operators.

Accounting is a source of information in the political process and the political market is assumed to be less efficient than capital markets. Therefore, there is greater opportunity for wealth transfers in political markets due to the use or misuse of accounting information. Politically sensitive firms will tend to understate income in order to avoid or reduce political costs — for example, higher cost regulation by politicians, public demands for price or rate decreases, union pressure for wage increases.

In the case presented, the Australian Competition and Consumer Commission is using accounting numbers to retain strict price controls, ensure price caps are adhered to and protect consumers of aeronautical services. The airports, most of which are now privatised, are subject to price caps for terminal and other service fees as a result of their monopoly. The ACCC is using the accounting numbers to monitor adherence to the agreed price caps.

2. Explain how Brisbane Airport Corporation is using accounting numbers in the political process.

Brisbane Airport Corporation is using accounting numbers in the political process to demonstrate the unprofitable nature of their operations and therefore the need for the price cap to be removed or renegotiated. The BAC argues that the ACCC’s specification as to the items to be included in the aggregate aeronautical charges (for example, inclusion of taxi levy) is why their reported fees exceed the price cap. Following the recommendation of the Department of Transport such fees should be excluded. Furthermore, BAC is using the poor return on aeronautical assets (derived from the accounting system and numbers) to demonstrate what they believe are unrealistic pricing levels producing unacceptable ROI.

3. Using the example of Westralia Airport Corporation, discuss how the debt hypothesis and political cost hypothesis can create conflicting accounting choice incentives.

The incentives created by the debt hypothesis (for example, to increase reported earnings) and the political cost hypothesis (for example, to reduce reported earnings) conflict. Westralia Airport Corporation (WAC) is subject to debt covenants. Gearing and interest coverage ratios are the typical accounting-based covenants in debt agreements for Australian firms. The WAC has violated such covenants, resulting in restrictions placed on its spending. To avoid costly breaches of debt covenants, managers try to increase assets, reduce debt and increase earnings. WAC’s revenue base is being eroded, but its privatisation contract restricts it from increasing revenues derived from aeronautical services.

Questions

1. What is the difference between normative and positive accounting theory? Give examples of each.

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Positive accounting theory (PAT) is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. Examples of PAT include: explaining why firms select specific accounting policies predicting which firms will oppose new or revised accounting rules explaining share price reactions associated with accounting information releases.

This approach can be compared with normative accounting theories that dismiss conventional historical cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. Examples of normative theories include: specification of the preferred measurement system theories as to the objective of general purpose financial reporting defining elements of financial statements.

2. How do descriptive, explanatory and predictive theories differ in relation to positive accounting theory?

Descriptive theories describe or outline accounting practices. Explanatory theories explain (ex post) firms’ accounting discretionary choices. Predictive theories suggest (ex ante) what accounting choices will be made by firms.

3. Agency relationships give rise to agency costs that are borne, at least initially, by different parties. Briefly explain how agency relationships arise and give rise to agency costs.

Agency theory is based on the more general contracting theory that the most cost effective form of organising economic activity is through a firm-based structure. Using this structure and assuming that contracting is a costly activity, then a firm-based structure leads to a reduction in the number of contracts written (factor suppliers and consumers only contract with the firm rather than directly). The firm thus becomes a nexus of contracts between suppliers of factors of production and consumers of their productive efforts.

In agency theory attention is concentrated on the specific contracts involving agency relationships. The main agency relationships are between shareholders/managers and shareholders/debtholders. In agency theory, agents have incentives to not always act in the best interest of the principal. The principal is aware of the possibility of such aberrant behaviour and therefore introduces constraints into the principal–agent contract to modify such behaviour. The costs of such controls are called agency costs.

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4. Explain the three types of agency costs and their relationships to each other in the context of:(a) debt contracts(b) equity contracts.

The three types of agency costs are: monitoring costs bonding costs residual loss.

Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the principal (that is, shareholders, debtholders) to monitor the agent (that is, the manager). For example, shareholders or lenders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders or lenders would reduce the remuneration to the agent by an amount that increases as monitoring costs increase. In the case of a shareholder–manager agency relationship, the manager’s remuneration will be reduced by the monitoring costs incurred by the shareholders. In the case of a lending contract, the lender (principal) will impose higher costs on the agent (management acting on behalf of shareholders) by demanding lower interest rates or other lending terms that are favourable to the lender. Either way, costs are incurred initially by the principal, but are then passed on to the agent.

The agent, as an insider who has access to information about his or her performance, is deemed to be a wealth-maximiser. Therefore, they are likely to bond their actions to align them with the interests of the manager. The agent will incur bonding costs (for example, the costs of providing audited financial statements and voluntarily providing financial information to lenders) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the principal. As such, bonding costs are incurred by the agent.

Generally it is not possible to eliminate all agent behaviour that is inconsistent with principals’ interests. The cost of this remaining behaviour is known as residual loss. The residual loss is borne by the principal in the first instance. However, if the principal anticipates the level of residual loss that eventuates, the residual loss will be priced into the agency contract. For example, the residual loss could be ‘charged back’ via reductions in the amount of management remuneration or the interest rate on debt in the case of shareholder–manager contracts and lending contracts respectively. The extent to which the principal or the agent bears the residual loss depends on the completeness of the ‘pricing’ in ex post settling up or ex ante price protection.

5. Although managers have incentives to transfer wealth from shareholders to themselves or from lenders to shareholders, there are various factors that can limit the wealth transfers. What are those factors, and how do they work to constrain the wealth transfers?

Opportunistic behaviour by management can be constrained by: monitoring costs bonding informed and efficient markets.

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Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the shareholders to monitor managers. For example, shareholders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders would reduce the remuneration to the manager by an amount that increases as the monitoring costs increase. The manager’s remuneration will therefore be reduced, relative to what it would be in the absence of the need for monitoring, by the full amount of the monitoring costs incurred by the shareholders. The monitoring costs are incurred initially by the principal, but are then passed on to the agent.

The greater the shareholders’ expectations that managers will opportunistically transfer wealth from the shareholders, the greater the monitoring costs are likely to be. Since monitoring costs are ultimately borne by management, management has less incentive to behave opportunistically the higher are the monitoring costs.

Managers, as insiders who have access to information about their performance, are deemed to be wealth-maximisers. Therefore, they are likely to bond their actions to align them with the interests of managers if that reduces monitoring costs. Managers will incur bonding costs (for example, the costs of providing audited financial statements) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the shareholders. As such, bonding is initiated by managers, and is designed to reduce the potential for them to opportunistically transfer wealth from shareholders.

If markets are informed and strongly efficient then the market has full information regarding the incentives and opportunities for managers to act in a manner that is contrary to the interests of shareholders, and the managerial labour market will impound that information into the agent’s price of remuneration. As such, if managers behave opportunistically, this will be known to the internal and external labour markets, and the potential remuneration for the managers will be reduced accordingly. Hence, managers have incentives to protect their reputations by not engaging in wealth transfers from shareholders.

If we relax the assumption of strong form efficiency then there will be incentives for the joint sharing of agency costs, and this will differ according to the degree of efficiency and the respective costs and the specificity of the relationship.

6. Because of ex post settling up and price protection, much opportunistic behaviour is prevented or compensated for. What is price protection, and how does it reduce the cost of opportunistic behaviour?

Price protection occurs when markets are efficient and impound all relevant information into the agent’s price of remuneration (for example, management salary, rate of interest on debt). Thus, the agent bears the cost of the principals’ expectations regarding the agent’s behaviour. The principals are protected because the value of the expected dysfunctional behaviour of managers is built into reducing the salary that the principals pay to the agent. The agent bears the costs of agency. Therefore, the agent has incentives to behave in a manner that is aligned to principals’ interests because this will reduce principals’ expectations of opportunism, and will impose a lower cost of price protection on the agent.

Complete price protection is only achieved when markets are fully (information) efficient. Where markets are less than fully efficient then we will observe some price protection and a sharing of costs between principals and agents (this seems to be more descriptive of reality).

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7. Who bears agency costs?

In a perfectly efficient market, agency costs are borne by agents either through price protection mechanisms implemented by principals and/or ex post settling up. In a market that is not perfectly efficient, agents perceive that they will not be fully penalised for dysfunctional behaviour. The incomplete price protection and ex post settling up results in the residual loss being partially borne by the principal.

8. Bonus plans are used to reduce the agency costs of equity. Describe the agency relationship giving rise to the agency cost of equity and explain how bonus plans can reduce particular types of agency problems.

The separation of ownership and control means that managers can act in their own interests, which may be contrary to the interests of shareholders. This can be broken down into a number of specific difficulties: Risk aversion problem. Managers prefer less risk than shareholders because their human

capital is tied to the firm. They prefer to diversify their own risk rather than maximising the value of the firm through higher risk projects.

Dividend retention problem. Managers prefer to pay out less of the company’s earnings in dividends in order to pay for their own perquisites.

Horizon problem. Managers are only interested in cash flows affecting their remuneration for the period they remain with the firm, whereas shareholders have a long-term interest in the firm’s cash flows because share prices equal the present value of shareholders’ expectations of all future cash flows.

Bonus schemes can reduce these problems by tying the manager’s remuneration to an index of the firm’s performance that has a high correlation with the value of the firm (for example, share prices, earnings). This aligns managers’ and shareholders’ interests by tying managerial compensation to performance ex ante without the need to rely on ex post mechanisms, such as renegotiating salary. Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers only after they have achieved an ‘expected’ level of firm profits for a period — then the remuneration will increase as profitability increases, thereby providing incentives for managers to increase their bonuses by increasing firm profitability. There may also be a ceiling on the amount of bonus paid to managers, to reflect the fact that profits can sometimes be increased to artificially high levels by actions that are not in the shareholders’ long-term interests (for example, by reducing repairs and maintenance, not undertaking research and development).

9. Explain the role, if any, played by accounting numbers in specifying the contractual terms of bonus plans designed to reduce agency problems.

The major role that accounting numbers play is to provide a measure of the firm’s performance and to provide input to shareholders’ expectations of future cash flows. As different accounting policies and estimates yield different accounting profits, and accounting numbers are used in the determination of bonuses, managers have incentives to manage reported earnings through accounting practices.

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10. Assume you have been appointed as a consultant by Hi-Tec Designs (Oz) Ltd, a firm in the furniture design and manufacture business, to develop a management compensation scheme that will motivate managers to maximise the value of the firm for shareholders. You are permitted to construct individual agreements for the senior executives. Write a short report to the firm’s compensation committee, covering the following issues:(a) How can the individual executives’ remuneration packages be structured to

motivate managers to maximise equity value?(b) To what firm and manager characteristics could different forms of compensation

be linked?(c) How can Hi-Tec Designs (Oz) Ltd be assured that the remuneration packages are

structured to provide appropriate incentives and monitoring?(d) What scope will remain for managers to engage in ex post opportunistic

behaviour?

Students’ responses should be in a report format. The following is a list of points that should be included in that report.

(a) Management compensation packages should be structured to maximise shareholders’ interests and have a positive correlation with maximising share values by structuring compensation to: the long-term time horizon of the firm — for example, part of the executives’

remuneration could be based on rolling 3–5 year profits. Alternatively, the executives could receive stock options or shares according to their performance (both the managers’ and the shares’ performance!)

the maximum risk–return profile of the firm — for example, executive remuneration by way of options provides incentives to engage in high-risk activities to maximise the value of the option, while bearing little or no downside risk (the downside risk reduces the value of the options)

the optimum dividend payout ratio — for example, to ensure that managers do not attempt to empire-build at the expense of high returns to shareholders, managers might receive bonuses only after achieving a certain dividend payout ratio.

(b) Characteristics of firms. Share prices and reported earnings (generally before interest and tax to ensure that the earnings figure reflects the type of earnings that managers can control) are the main attributes that managers’ remuneration is likely to be linked to. Volatility of reported earnings, growth prospects, financial slack and the presence/terms of share-based remuneration are also likely to affect those weightings. Characteristics of managers include age, existing investment in the firm relative to personal wealth, employment record (period for which jobs have been held in the past) and apparent risk aversion. To reduce the time horizon agency cost, compensation packages can be linked to the

share value of the firm by using shares, options or warrants, or by deferring a portion of cash payments and making them dependent on future cash flows:

– the greater the portion of long-term investments, the smaller should be the proportion of immediate compensation– the older the executive, the smaller should be current-form rewards; such as rewards based on current period profits– the smaller the personal investment in the firm by the executive, the higher should be share-value-linked compensation.

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To reduce the risk aversion agency problem, risk–return profiles need to be aligned.– Incentives for managers to underinvest in risky projects can be compensated for by tying compensation to share values or issuing executives with options as remuneration.– The incentive to maintain low debt–equity profiles (because of a high interest in the firm’s cash flows) can also be overcome by tying compensation to share values; and for profit-based remuneration it is important to use a measure of profit that does not have the interest deducted (for example, operating profit before interest and taxation).

The dividend problem can be overcome by tying pay increases to the firm’s dividend payout ratio, or stipulating that bonuses are not to be paid unless a certain dividend level or payout ratio is achieved.

(c) The integrity of payments can be assured and monitored by instigating decision hierarchies (higher level managers monitor subordinates); mutual monitoring (managerial interaction); and supervision by boards of directors. The market for managerial services can discipline managers by pricing their services according to previous opportunistic actions via takeover.

(d) As long as there is scope for managers to artificially manage the basis on which their remuneration is paid (for example, profits) instead of managing the underpinning economic basis, there is scope for opportunistic behaviour ex post by managers who: shift future earnings to current earnings (for example, by choosing an extended

depreciation period) manipulate debt–equity accounting ratios (increase assets, reduce liabilities via

revaluation of non-depreciable assets) shift earnings numbers into the accepted bonus pool (using discretionary accruals) ‘take a bath’ if the bonus pool was below the lower bound (vice versa if above the

upper bound)

11.Explain the main agency costs of debt, and how debt contracts can be designed to reduce those costs. In particular, explain how accounting specifications within the contracts can be used to reduce the agency problems.

The main agency problems involved in debtholder–shareholder relationships are: Excessive dividend payments. This lowers the value of debt because it reduces available

funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders.

Claim dilution. When further debt is issued, this makes the original debt riskier and lowers its value to the original debtholders.

Asset substitution. When debt is issued that reflects (and subsequently projects) a particular risk, a higher risk is undertaken.

Underinvestment. This occurs when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders.

Debt covenants can be structured to restrict conflicts by bonding managers and shareholders to act in the interest of creditors, such as: covenants to restrict the production-investment opportunities of the firm (asset

substitution and underinvestment) covenants restricting dividend policy to a function of net income

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covenants restraining financing policy, usually expressed as gearing ratios bonding covenants — such as increased financial reporting.

Accounting would play a primary role if the above covenants were expressed in terms of accounting numbers. Whittred and Zimmer (1986) and Stokes and Tay (1988) found that debt covenants in Australia were mainly expressed in the form of accounting numbers.

12.When Lester Ltd approached Hardy Loans Banking Corporation Ltd for an unsecured loan of $100 million, Lester Ltd had a good credit rating. However, the economy was depressed and Hardy Loans Banking Corporation Ltd was concerned about lending such a large sum. You have been asked by Hardy Loans Banking Corporation Ltd to provide a short report to the finance manager, explaining how debt agreements and restrictive covenants can be used to safeguard debt in general. The finance manager wants the report to explain which agency costs of debt are controlled by specific covenants. Furthermore, she is interested to know how accounting numbers can be used in the debt covenants to help control any opportunistic behaviour on the part of Lester Ltd.

Students should provide an appropriately formatted report in answer to this question. The following are points that should be covered in such a report:

Shareholder–debtholder agency problems, discussed in detail in the text, can be categorised as relating to:– excessive dividend payments — this lowers the value of debt because it reduces

available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders.

– claim dilution — when further debt is issued this makes the original debt riskier and lowers its value to the original debtholders

– asset substitution — when debt is issued which reflects a particular risk a higher risk is undertaken.

– underinvestment — when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders.

In general, a default covenant allowing debtholders to insist on immediate repayment of the debt or renegotiation of the terms of the loan (including interest rates) can be implemented. Some possible ways in which debt agreements and restrictive covenants can be used to safeguard debt include:– the dividend problem may be controlled by tiering dividend payments to net income

where the income calculation is stipulated, or by restricting dividends to a function of the debt–equity ratio

– the claim dilution problem may be controlled by restricting the amount of debt that is allowed to be issued with priority over the existing debt, by controlling the debt to equity ratio, or by controlling the times–interest-earned ratio

– the asset substitution problem can be controlled by restricting the ability of management to undertake high-risk projects (for example, not allowing merger or takeover activity without the explicit approval of the lenders), or by having as a condition of the debt agreement that the interest may be altered with the changing risk profile of the firm

– the underinvestment problem can be controlled by tying management compensation packages to a risk-adjusted measure of performance, or by using covenants that restrict

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or control the production-investment activities. Constraints on dividend distributions ensure that funds are retained within the firm, thereby encouraging managers to invest in positive NPV projects rather than leaving cash idle. The underinvestment problem is the most difficult agency problem to control since underinvestment is unobservable

Overall, bondholders can be protected by making debt rank higher than other repayments in the event of winding up. Regular financial reporting using pre-specified accounting methods can be used to control opportunism by managers. Furthermore, most of the covenants should be more effective if they are tied to accounting numbers.

See also the empirical evidence in Whittred & Zimmer (1986), Stokes and Tay (1988), Stokes and Whincop (1990), Williamson (1988) and Begley (1990).

13.Assume the same circumstances as in question 12. Lester Ltd has a wholly owned subsidiary, Tickell Ltd, and another subsidiary, Rice Ltd, which is closely controlled. Lester Ltd provides management services to these firms. Among the other investments of Lester Ltd are four associated companies. One of these, Alhab Ltd, is a listed company. How can these investments be used to transfer wealth from Lester Ltd in a manner that jeopardises the value of the loan from Hardy Loans Banking Corporation Ltd? How might the advice offered in question 12 differ, given these arrangements? How will you calculate the restrictive covenants in the debt contract?

The introduction of subsidiary and associated companies means that the debt covenants and the numbers used in them may need to be altered to take into account a number of different factors which include: the degree to which individual firms contract directly with lenders and the support or

degree of liability that the holding companies have with the subsidiary or associated company. For example, are there cross-guarantees such that if the borrowing corporation (Lester) defaults, other entities within the group will be obliged to meet the debt? Are there cross-guarantees that mean that Lester would be required to support a less financially viable subsidiary within the group, thereby diminishing the level of resources available to meet the borrowing corporation’s debt?

the materiality of intra-group transactions that can transfer funds to another entity within the group and, depending on the nature of guarantees, leave Lester unable to pay its debts and lenders with no recourse (for example, because of limited liability) to the entity to which the funds have been transferred

the homogeneity of operations — if Lester is in a fairly stable industry but its subsidiaries are in high-risk industries, what does that imply about the nature of the security over the debt provided by Lester, who may be regarded as higher risk by virtue of its investments?

the geographical location or the ‘appropriate’ accounting treatment (especially for multinationals where there can be problems with national constraints on cross-border payments)

the reputation and past performance of the individual company and each of its guarantors within the group.

The introduction of subsidiary and associated companies also raises the possibility of ‘manipulation’ of income figures by the use of accounting techniques that have no material or cash flow consequences. They can be eliminated by removing unrealised intra-group profits, intra-group asset transfers or intra-group borrowings. Whittred (Journal of Accounting &

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Economics, 1986) provides an excellent study of the relevance of consolidation accounting to debt contracting.

14. In the context of positive accounting theory, political costs can reduce the value of firms significantly.(a) Give examples of how firms can be exposed to political costs.(b) Give examples of how a firm’s exposure to political costs can influence the

nature and/or content of the firm’s annual report, particularly in relation to its accounting information.

Political costs arise because a firm has a high public profile and is deemed to be an appropriate ‘target’ for political action that transfers wealth away from the firm. The ‘politician’ who initiates actions to transfer wealth from the firm to another group in society does so because he or she is rewarded with votes. Votes may be interpreted liberally to mean political votes or financial reward, depending upon the circumstances.

(a) Examples of how firms can be exposed to political costs: high sustained profits that indicate, over time, that they are earning non-competitive

monopoly rents at the expense of consumers volatile profits whose peaks draw attention and public concerns about excessive profits —

again, at the expense of consumers operating in publicly sensitive industries such as tobacco growing/manufacturing or

highly polluting industries use of a militant labour force that campaigns actively to increase labour’s remuneration or

to improve working conditions dealings with governments of countries engaging in politically sensitive activities such as

war, human rights violations, trade sanctions, etc.

(b) The political process is assumed to be a less efficient market than capital markets. Accounting is a source of information in these markets. Therefore, there is greater opportunity for wealth transfers in political markets due to the use or misuse of accounting information. Politically sensitive firms tend to understate income in order to avoid or reduce political costs — for example, higher cost regulation by politicians, public demands for price or rate decreases, union pressure for wage increases. Also, they tend to smooth reported income to ensure that, as a long-term strategy, they draw less attention than they would with volatile earnings and high earnings peaks.

Examples of how a firm’s exposure to political costs can influence the nature and/or content of the firm’s annual report include: High tariff or quota-protected companies have political cost incentives to reduce

reported earnings or smooth reported income at a low level so that their industry appears in need of protection.

Companies that have a high degree of unionisation of the workforce also have incentives to reduce reported income or smooth reported earnings at a low level in order to avoid attracting attention to high profits that might be deemed to be earned through the exploitation of labour.

Government business enterprises that have monopolies on services are expected to employ accounting techniques to reduce reported income to ensure that they are not deemed to be exploitative, and in need of competition from other entities.

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Companies in politically sensitive areas (for example, banks in high interest rate years) are more likely to employ income-reducing accounting techniques.

15. Positive accounting theory has been criticised by many. Outline the criticisms and comment on their validity.

Statistical criticisms:– explanatory variables in a number of studies are insignificant and not of the predicted

sign– established R2s of the models are low– colinearity among explanatory variables– cross-sectional models not well specified– the use of crude proxies (for example, firm size as a proxy for political costs) are not

well defined in a theoretical or measurement sense.

However, when the evidence is aggregated (Holthausen and Leftwich, 1983; Watts and Zimmerman, 1990; Christie, 1990) there are six variables that have statistical validity, namely:– managerial compensation– interest coverage– leverage– size– dividend constraints– risk.

Theoretical and measurement criticisms:Leftwich (1990) points out that positive theory is driven by contracting and monitoring costs but until the mid 1990s there was no real attempt to operationalise or measure these costs (such as the costs caused by covenant defaults). This leads to two risks — high correlation of significant variables and the risk of rejection because of the use of poor proxies (even if the theory is correct).

Single versus portfolio accounting policy choices:Zmijewski and Hagerman (1981) were the first to formally recognise that accounting policy choices may relate to portfolios rather than single policies in efforts to affect total income rather than components.

Philosophical criticisms:– positive research is value laden — the topics chosen, methodology, methods and

assumptions are value laden (Merino & Neimark)– positive theory is a sociology of accounting rather than a semantic or measurement

approach (Christenson)– the logical positive philosophy is outdated and inappropriate as a philosophy of

science (Christenson)– positive theory is constrained to analyse ‘what is’ rather than what ‘could be’ —

doesn’t encourage change or improvement.

Other criticisms:

– little or no analysis of anomalies

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– testing positive theories against competing theories– dismissing other theories (such as normative) out of hand, and giving the impression

of a biased presentation of arguments and evidence– assumptions of positive theory should be more rigorously tested and established.

Validity of criticisms.

This is something that should be debated in class. Researchers clearly have their own views, largely conditioned on their own research interests and exposures. Statistical criticisms are valid. Research is continuing to refine statistical specifications. Philosophical criticisms are more subjective. It appears that all research in science is value

laden and myopic to varying degrees. (See Watts and Zimmerman (1990) for some counter views.)

The criticism of the validity of assumptions in our view is also valid. Research is being undertaken in this area.

Positive theory has sometimes rejected competing theories out of hand when they have a role. Some prefer to be more eclectic in their approach. A key role for positive theory is as the basis of normative theoretical debate. Normative debate should be informed by an understanding of how, and why, particular accounting practices occur.

The increasing empirical evidence points to positive theory as a fundamental hypothesis of accounting, and at the moment it is our view that competing theories do not have superior explanatory or predictive power.

16. Positive accounting theory does not prescribe how accounting reports should be prepared. How, then, can it make any contribution to the advancement of accounting as an information system? Do you think that positive accounting theory has played any role in the development of accounting practices or regulation?

The contributions made to accounting theory by the positive approach can be categorised along the lines of chapters 9 and 10 as follows:

Capital market research (chapter 9): Historical cost income figures have information content for capital markets. Capital markets use a continuous information set (accounting is only one source of

information). There are few opportunities for abnormal results in markets after the release of accounting

reports. Many issues about ‘proper’ income measurement are relatively unimportant to capital

markets. There is no compelling evidence to suggest that markets are mechanistic (or fooled by

cosmetic accounting numbers).

This research played a major role in testing a number of assumptions made by normative theorists and led to a greater understanding of the relationship between accounting numbers and pricing in capital markets.

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Later positive research (chapter 10): The major contribution made by this research is to offer a market based explanation as to

why we have ended up with the historical cost accounting system as practised by accountants:

Agency theory provides an explanation of the role of accounting in agency contracts. The contention is that other markets (such as political markets) are relatively less efficient

than capital markets and will lead to attempts to maximise wealth by manipulation of accounting figures through those markets.

An understanding of these forces enables positive theorists to offer explanatory and predictive theories to accountants about the role of accounting numbers in market places.

Probably, the overall contribution made by positive research has been to lead to a greater questioning of the incentives and effects of prescriptive (normative) theories. The call for more empirical research before implementing changes to accounting methods, which have been derived in a market environment, has led to more analytic and empirical argument about accounting standards.

A major role of positive accounting research should be to inform normative debate. By providing an understanding of the effects of alternative accounting practice, positive accounting research has the capacity to contribute to the development of appropriate regulations in the area. Positive research has been used in this capacity, and in the development of regulation — the AARF has examined some of the relevant positive accounting research in relation to key issues. However, regulation is essentially a political process itself (see chapter 12), and the benefits of positive research are not always evident in regulatory pronouncements.

17. Are the contracting and information perspectives of positive accounting theory different in any significant ways? If so, how and why? Which of the two perspectives is more consistent with the efficient market hypothesis, and why?

According to the information perspective of positive accounting theory, accounting information is produced to enable investors to make ‘good’ investment decisions. That is, accounting information helps investors, amongst others, to ascertain likely cash flows and wealth transfers accruing to them as a result of their investment.

According to contracting theory, accounting is a way in which the various claims on an entity’s resources are affected. Contracts are struck between various parties, and some terms of the contracts are specified in accounting numbers (for example, management bonuses paid as a percentage of reported earnings before interest and tax (EBIT) if EBIT exceeds a given level). Accounting is a mechanism by which contracted wealth transfers are affected between the various parties who have an ‘interest’ in the entity.

The above two functions are not mutually exclusive — the parties with claims on an entity’s resources, such as shareholders and lenders, use accounting information not only to monitor wealth transfers but also to provide information about the effects of accounting choices on their welfare. That is, accounting information has a role for providing information in both the capital and political marketplaces.

The information function of accounting sits more easily with the efficient market hypothesis (EMH) because this paradigm views accounting numbers as providing information regarding

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future capitalisation of cash flows to investors, rather than viewing accounting as contributing directly to monitoring and bonding activities. That is, the EMH sees accounting numbers as having information content that assists in making investment decisions, rather than viewing accounting numbers as fulfilling a wider function of explaining why accounting reports are prepared. The EMH, in its strongest form, relies solely on accounting reports being prepared to fulfil the information function. However, many observations regarding the preparation and use of accounting reports and accounting policy choices could not be explained by the EMH’s view that accounting served the information needs of investors.

Case Study 10.1 — Sick emperor of capitalism needs urgent treatment

1. Explain how executive compensation contracts are supposed to align the interests of shareholders and management. Drawing on your reasoning, rationalise why remuneration contracts include the following components: fixed salary, short-term incentives based on profit targets, and longer term incentives based on share price. What are the author’s reasons for claiming that remuneration contracts have failed to achieve the alignment of shareholder and management interests?

Executive compensation contracts are supposed to align the interests of shareholders and managers and thereby reduce dysfunctional behaviour by managers. The following details the typical components of executive compensation contracts and the rationale for their inclusion.

Fixed salary ensures that there is a base income paid to the manager, regardless of the success of their managerial efforts. It provides a secure income relative to incentive bonuses, etc. Providing a fixed salary caters to the fact that managers are generally risk averse, and therefore require some ‘guaranteed’ level of income before they will accept a position of management, or to induce them to remain during periods when they are not paid incentive income. In this particular case, the new CEO would need to be paid a significant salary to take on a high-profile position where the effects of good management might not be immediately reflected in either reported earnings or share prices.

Short-term incentives based on profit levels or profitability ratios provide managers with term incentives to take on risky short-term projects that risk-averse managers might otherwise not undertake. In this case, they provide the new CEO with short-term goals to earn profits, thereby aligning managers’ and shareholders’ short-term interests. This assumes that shareholders prefer profitable performance. It also assumes that those profits are not earned at the expense of future profits (For example, future profits can be forgone at the expense of short-term profits if managers reduce maintenance expenditure, research and development expenditure, or other discretionary expenditure). To guard against transferring profits from the future to the present, long-term incentives are also used by many firms.

Long-term incentives based on 3-year return-on-investment objectives align managers’ and shareholders’ interests by reducing the horizon problem. To the extent that project riskiness reduces over extended periods, it also encourages longer term investment and reduces the risk aversion problem.

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2. Compensation packages have become more heavily weighted towards equity-based compensation rather than cash-based compensation. Discuss whether equity-based and cash-based executive compensation provide different incentives for managers’ accounting policy choices and profit management decisions.

The fixed remuneration provides no incentives to manage reported earnings. The short-term incentive remuneration can provide incentives to manage reported earnings. This is particularly the case if the incentive remuneration is based on profit levels or profitability ratios. In this case, the manager clearly has incentives to manage earnings to achieve or exceed the target or threshold for the incentive plan (increase reported income). If the manager’s bonus is an increasing function of the firm’s profits, the incentives are to maximise reported earnings above any threshold, and up to any ceiling on the bonus. However, if the profits are unlikely to achieve a sufficient base level to earn the manager a profit-based or return-on-investment-based bonus, the manager has incentives to reduce reported earnings since there is a greater present value from being paid a higher incentive income in following years on the basis of those deferred profits. If profits exceed the ceiling to the manager’s compensation plan, the manager has incentives to use income-reducing earnings management to the stage where the profits just equal the ceiling to that plan.

Long-term incentives may provide incentives for managers to manage reported earnings, depending on the basis for those incentives. If the long-term variable remuneration is based on 3-year profits or returns on investments, then it provides incentives to manage earnings so that they are maintained at a high level over the three years. The time value of money implies that managers have incentives to bring earnings forward. However, managers also have incentives to smooth reported earnings to ensure that the entity does not appear to be operating in a volatile fashion that reflects badly on their performance. The longer term variable income mitigates incentives to transfer profits from future periods to current periods through value-reducing methods such as cutting back on repairs and maintenance expenditure.

It should be recognised that earnings management is not the only way to boost incentive income to managers if they are rewarded on the basis of returns on investment. For example, managers are provided with incentives to reduce the reported value of the asset base that underpins the returns measure, perhaps through not revaluing assets.

At a more general level, it is worth noting that incentives may vary, according to the specifications of the management incentive plans. For example, remuneration based on share price movements provides incentives to manage earnings if the manager believes that profitability will impact on the share price, but not if the manager does not believe that the earnings management will impact on the share price.

3. Explain what the author means by the following:(a) excessive, poorly structured option packages(b) timid accounting treatment of executive options(c) institutional obsession with short-term performance.

The author claims, as many others do, that remuneration contracts have failed to achieve incentive alignment as the long-term incentives have been poorly structured. Often the share-based rewards contain no performance hurdles and encourage short-term share price maximisation at the expense of long-term sustainable share price maximisation.

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4. What features and components would you include in an executive compensation plan to maximise the alignment of the long-term interests of companies and their shareholders?

Drawing on the points in questions 1, 2, 3 and 10, students can discuss what they believe is an appropriate executive compensation structure.

Case Study 10.2 — New standards add confusion

1. Identify the profit measures that are referred to in the financial press and/or used by analysts. Why is it important to be able to segregate profits into different components? Which profit measure is likely to provide a stronger signal to capital markets?

Numerous measures of profit are referred to in the financial press and/or used by analysts. The measures include: gross profit profit from ordinary activities before tax profit from ordinary activities after tax net profit net profit after extraordinary items net profit attributable to members of the parent entity earnings before interest and tax earnings before interest, tax, depreciation and amortisation comprehensive (or residual) income.

Essentially the different measures attempt to segregate earnings into (a) operating versus non-operating, (b) pre- and post-tax, and (c) pre- and post-interest. Prior to the introduction of the trilogy (AASB 1040, AASB 1018 and AASB 1034), the distinction between normal and abnormal earnings was made. The new AASB 1018 has removed the concept of abnormal earnings, replacing it with a requirement to disclose the significant items in the profit determination.

The profit measure most likely to provide a strong signal to capital markets is the one that best reflects underlying future cash flows that are sustainable (for example, profit from ordinary activities).

2. Which of the profit measures you mentioned in question 1 are required to be identified in the statement of financial performance?

The statutory profit line items required to be disclosed on the face of the statement of financial performance as per AASB 1018 are: profit from ordinary activities before income tax expense profit from ordinary activities after related income tax expense net profit net profit attributable to members of the parent entity

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total changes in equity other than those resulting from transactions with owners as owners (comprehensive income).

As long as all the items listed above are disclosed, companies can use a format they deem appropriate. This means that other line items could be shown on the face of the SOP (for example, gross profit, EBIT, EBITDA). However, AASB 1018 requires that the inclusion of such line items is not given undue prominence. For this reason, the statutory line items are often bolded with additional profit line items unbolded.

3. Do you think that capital markets place more emphasis on the statement of financial performance or on the statement of cash flows? Given the attention focused on questionable accounting practices by large corporations, do you think that the financial statements satisfy the capital markets information demands?

With the requirement to prepare statements of cash flow, accounting researchers have examined the value relevance of cash flows from operating activities versus profit from ordinary activities. The research suggests that both information sources are value relevant. With corporate collapses and attention on earnings management, the required reconciliation of the cash flows from operating activities with operating profit is useful. The reconciliation enables users to identify the magnitude of the accruals (discretionary and non-discretionary) included in the profit determination.

The objective of general purpose financial reports is to provide information that is useful for decision making. Evidence suggests that information contained in the statements of financial performance and cash flow is relevant to capital market participants. However, accounting scandals can undermine the credibility of the information contained in the financial statements and therefore reduce the reliance investors place on such information.

Case Study 10.3 — Reserve Bank challenges credit card fees

1. Discuss whether you regard firms operating in the banking industry as politically sensitive firms.

The services provided by banks are used by the majority of Australians. The banks are owned by shareholders and therefore the banks need to balance the need for shareholder wealth creation with the need for social responsibility. In recent years, Australia’s largest banks have reported high profits with strong growth rates. These high profits have led to accusations of customer exploitation since the profits are earned largely through the differential between interest charges by the banks and the interest that they pay on deposits. Criticism has also focused on the transaction fees banks charge consumers. In turn, the accusations have contributed to political interest in the issue, and the potential for a political ‘white knight’ to advocate banking customers’ interests by introducing regulations that constrain the potential of the firms to exploit customers.

2. Given that the reforms to the credit card market proposed by the Reserve Bank of Australia are expected to result in an annual revenue reduction of at least $300 million to card-issuing banks, what could have motivated the major banks to accept the reforms? How are the banks likely to respond to the new requirements?

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The banks initially opposed the Reserve Bank’s credit card reforms as it is expected to result in an annual revenue reduction of at least $300 million. The banks’ motivation for accepting the reforms, designed to introduce transparency into the marketplace, could be driven by political considerations. Non-acceptance of the reforms could ultimately lead to greater regulation of the banking industry, so it is in the banks’ interests to be accommodating. Accepting the reforms saves the banks from further attacks concerning the exploitation of their customers.

Confronted with a need to find extra revenue due to that lost as a result of the credit card reforms could see banks increase fees for other services. The banks have also indicated that the structure of the reward schemes attached to credit cards would also be reviewed.

3. What are the likely financial implications of the reforms for card associations such as Visa and MasterCard?

Visa and MasterCard have been very vocal in their opposition to the reforms. The reforms have the potential to reduce their business if banks switch to other scheme providers (such as AMEX and Diners) that are excluded from the reform requirements. Visa is threatening to sue the Reserve Bank of Australia should the reforms commercially disadvantage their organisation relative to other card service providers.

4. According to a research study published by Macquarie Equities in May 2002, the cost to the four major banks of operating reward programs linked to credit cards in 2001 was $458 million. How would the banks account for this cost? What is the likely impact?

The cost to banks of operating reward programs attached to credit cards has been estimated at $458 million for 2001. This cost needs to be weighed against the financial benefits derived by banks as a result of offering card services to their customers. The banks would expense the costs of rewards redeemed when redemption occurs. Some would argue that the banks should record a liability as the points accrue. However, at that point in time no present obligation exists as the banks could suspend or cancel the reward scheme or the points may not be redeemed and expire.

Chapter 11

Behavioural research in accounting

Theory in Action 11.1 — The power of interest group perceptions

1. On what type of information would the ASA decide that a company board or chairperson should be censured for poor performance?

According to the article, the ASA rates the relative performance of management and directors on the basis of returns to shareholders. This ignores past performance, industry-wide issues

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and the manipulation of accounting information (through timing and other accounting differences) in the calculation of returns. The ASA would have considered the overall business performance of management and the expected future returns based on the decisions of current management. In more recent times, the ASA, among others, has also focused on the link between company performance to executive share options and other forms of reward to managers. It has publicly attacked several high profile cases where the rewards to senior managers do not seem to be justified by their company’s performance.

2. What is motivating shareholders to operate as a group to censure company boards which do not appear to be managing the company in an appropriate fashion?

Within Australia there is a growing number of small investors. They see that acting as a group will have greater influence on companies than acting in isolation. Obviously there is strength in numbers and this is, in effect, the only way they can actually influence the company. They are joining forces with a lobby group that benefits from support from shareholders, and in effect they seek the power and control associated with any lobby group. Given recent high profile corporate collapses, acting as a group is one means of enforcing good corporate governance.

3. In the article, the ASA is accused of ‘moving into business judgement issues’. What does this expression mean? How would the ASA determine what was a ‘good’ or ‘bad’ business judgement?

Operating a business or making investment decisions ultimately comes down to the decision-making processes of those involved. Regardless of the accounting and reporting system adopted, decisions about future (and current) activities reside with management — a set of individuals. They are not interchangeable blanks, but individuals with behaviours and decision processes influenced by their characters and experiences. This is what the term ‘business judgement’ refers to and why there is a market for managers. How the ASA determines good and bad judgements depends on the individuals involved with the ASA and how they apply their own individual skills, experiences and inherent biases to evaluating management performance. They then have to convince the balance of the lobby group that their evaluations are valid. This will be influenced by the nature and manner in which arguments are presented and the credibility of these individuals within the group. Good and bad will also be a function of the agenda underlying a lobby group such as the ASA. As the ASA is a group ‘external’ to the organisations that it monitors, its ability to judge the appropriateness of any managerial decision is likely to be limited by having less than full information about the circumstances surrounding that decision. That is, the ASA must take care that it is in full possession of the facts (and recognise that it usually has the benefit of hindsight) before being too quick to make judgements about managers’ decisions.

4. Is the ASA concerned about corporate governance or raising its own profile to increase its membership and relative power? What type of value judgements did you make to answer this question?

The ASA is an organisation in its own right. It has employees and elected representatives. Its activities are the net sum of the resourcing and power plays that operate within any organisation. It is funded based on performance and its profile among sponsor groups, such as minority shareholders. Its actions will be influenced by how they will attract support. The students should be asked to discuss whether the motivation of the ASA is evaluation of the

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performance of companies or identifying the issues that will maximise publicity and ongoing survival. In this regard, are they any different to the management of the companies they seek to review? Can they be truly independent? On the other hand, it would be too extreme to summarily dismiss the notion that the ASA is not genuinely concerned about good corporate governance.

Theory in Action 11.2 — The value of the assets and operating capacity or the people in control?

1. According to this article, the decision to invest by some shareholders in a particular company is heavily weighted on the profile and perceived performance of the CEO. How does this fit with the capital market view of firm value? The companies referenced have thousands of employees and many layers of management. Why, then, would it come down to the perceived ability of one individual?

The value of a firm is meant to take into account all of the aspects of the firm that lead to future performance. However, the focus tends to be on the return on purchased assets (including assets subject to regular revaluation). As far as financial reporting systems are concerned, there is limited, if any, formal focus on the human capital that operates the firm and makes decisions about current and future investments and activities. Some would argue that the capital market view factors in the perceived capacity of an entity’s management. However, the basis for evaluation and measurement has not been reported. The CEO is responsible for overall strategic direction and communicating effective strategies to management. The role of a CEO is complex and involves a range of functions. One of those functions is communicating with shareholders and the public. Effective CEOs are those that can signal the key aspects of a firm’s performance. Given there is a market for CEOs, they often invest in signalling their individual performance and competence and this becomes integrated into expectations about firm performance. Organisations consist of layers of management with overlapping and distinct responsibilities. It is the role of the CEO to recruit, evaluate and motivate the management team — hence the focus on the CEO. However, firms operating in industries with volatile industrial records or a recognised paucity of required skills will involve consideration of such issues when ascribing an overall value for an individual firm. In addition, the CEO is often the only visible human link to a firm and hence the heavy weighting on his or her performance.

2. Is the article suggesting that companies exist only because of decisions made by individuals? If this is so, how could BAR be expanded to understand the link between accounting and related information and key decision makers within an organisation? It would also seem that traditional corporate valuation methods are incomplete, because they are not including this people factor. Comment.

Companies exist by virtue of human activity. We create the structures and processes, and management is responsible for business decisions. BAR is a difficult research area because there is very limited access to actual decision environments, and we often can only observe secondary data, such as share prices, which are the product of interactions. At present, BAR relies primarily on case studies and isolated testing or investigation of decision processes.

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BAR could be extended by engaging in ongoing review of the processes that individuals engage in to make decisions and the degree to which they rely on past information and decisions, existing information and perceptions of future outcomes. How can we really understand the cognitive processes of individual managers, shareholders and key decision makers? Even if we could gain unlimited and ongoing access to study these processes, the fact that they are being reviewed may influence behaviour and our own interpretations will be required. Traditional models cater for the performance of individuals by factoring this into expectations about the overall performance of the firm. However, in reality the formal models do not cater for, say, the relative performance and skills of CEOs. The class should debate how such factors could be included into investment appraisal models. A starting point would be to ask whether a CEO’s prior performances represent future capacity to operate an entity.

3. In the case of ecorp, Donnelly’s Investing Times argues that the ecorp valuation is based on the management potential of the Packer family. In this case, how would analysts determine an objective present value of ecorp?

The IT industry has introduced a new phase of corporate valuation, which appears to be divorced from the traditional return of asset measures and guidelines. The market is being driven by our expectations of the future potential of the industry and often requires belief in our capacity to continue developing appropriate technologies at the current rate. It is clear from the article that the market ‘trusts’ the judgement of business operators who have had very successful ‘track records’ (such as the Packers). In markets where the information and activities are new or very uncertain, human nature will drive us to seek references of support for our decisions. In this case the previous performance of the Packers is one such reference. In evaluating the IT industry, what other references might be used?

Given the great uncertainty with the new venture, analysts may look to similar entities that are already in business as a starting point for their analysis. The various forecasts and projections contained in ecorp’s prospectus would also need to be carefully studied to see whether the assumptions on which they are based are reasonable given our understanding of the economy, industry and other factors.

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Questions

1. Consider a decision task, other than a bankruptcy prediction task, that uses accounting information (for example making recommendations for share investors). Assume that you are intending to conduct a Brunswik lens model experiment on your selected decision task. List seven information cues you think would be important variables to use in making your decision. Why did you choose these cues? Compare and contrast your list of information cues with a colleague. Discuss with each other the similarities and differences in your choices.

Example 1Event Information Cues Decision Maker‘Will the Company pay a dividend this period?’

Past dividend payments Past dividend payout ratios Budgeted operating results Liquidity — Quickratio, Cash

flow budgets Quarterly operating results

released so far in the reporting period

Past operating results Current claims on the

company’s liquidity/current liabilities

Investors, investment analysts and advisers

Example 2Event Information Cues Decision Maker‘Sell or hold an asset’ Estimated useful life of asset

Significance of asset to operations

Impact of new technologies Alternative uses of the asset Present value of expected cash

inflows or savings from the current asset

Current selling price for the asset held

Legal requirements — for example, is the asset needed for occupational health and safety, or to satisfy environmental laws?

Company management division managers in which asset held

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Example 3Event Information Cues Decision Maker‘Should we loan money to the company?’

Past credit history and present credit rating

Outstanding liabilities (current or non-current)

Past profits and cash flow statements

Budgeted operating results and cash flows

Current and projected interest rates

Liquidity ratios — Quickratio, T.TA:TL, working capital

Saleability and expected proceeds from assets: inventory, receivables financial instruments

Bank managers; debenture purchasers

Students should be encouraged to explain and justify the causal links between the cues they selected and the event of interest. The question could be extended by asking students to rank the relative importance of these cues and to justify their ranking.

2. Most human judgement research is undertaken in an experimental setting. How would you respond to the assertion that experiments cannot be generalised to the real world? What are the weaknesses and strengths of this research method? (Hint: See R. J. Swieringa and K. E. Weick, ‘An assessment of laboratory experiments in accounting’, Journal of Accounting Research, vol. 20, Supplement, 1982, pp. 56–93.)

Swieringa and Weick (1982) identify two types of ‘realism’ of interest in accounting laboratory experiments: Experimental realism. Are the laboratory experiments ‘believed’ by the subjects? Are

these experiments attended to and taken seriously by the subjects? Mundane realism. Are the laboratory events similar to real world events?

Swieringa & Weick argue that all experimental research should have present experimental realism. However, in terms of the correlation of events and results to the real world, they identify several reasons why mundane realism need not be a prerequisite for laboratory experiment research designs. The following reasons are also strengths of the experimental method: Experiments can be undertaken to create conditions that do not presently exist in the ‘real

world’ of accounting practice to deal with ‘what if?’ issues — for example, effect of a change in disclosure requirements, change in valuation of assets.

The experimental setting enables the isolation of specific variables affecting a subject’s decision. Such factors are often difficult, if not impossible, to detect and/or isolate by observing ‘real world’ practice.

The experimental setting may reveal relationships between variables that are not readily observable in the ‘real world’ because of the influence of many other forces that may cloud the visibility of such relationships. That is, by making settings more real world, the experiments may conceal or remove much of which researchers wish to observe.

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A definition of behavioural research in accounting: ‘The study of behaviour of individuals as they are influenced by accounting functions and reports’.

Studies are undertaken generally by observing people (individually or in groups) in either the field (the real world) or in an experimental laboratory setting.

Often, to be able to explain and predict the influence of accounting upon decision-making processes, certain non-accounting influences need to be controlled or removed. When such other (non-accounting) influences exist, experimental research designs are necessitated. Similarly, to study the effects of accounting influences not yet observed in the field, experimental settings are required.

There is a danger, however, that the experimental setting is too far removed from conditions in which accountants and auditors operate. That is, the effect of non-accounting influences on individual behaviour is so great that an experimental setting, while explaining and predicting the impact of accounting, cannot explain or predict real world actions and decisions that are largely determined or influenced by non-accounting influences.

Nonetheless, provided that experimental realism is present, the experimental research design is a strong indicator of behaviour influenced by accounting. That is, experiments generally give a good indication of how we could expect decision makers and members of the profession to behave under certain conditions and given certain assumptions.

3. Use the probabilistic judgement framework to describe an accounting or auditing related decision task

Students should be encouraged to think of examples in accounting or auditing in which they have to assess the likelihood of some event occurring. This occurs all the time in financial reporting when we are required by the Statement of Accounting Concepts or relevant accounting standards to apply the recognition criteria — for example, ‘probable’, ‘virtually certain’. All sorts of examples suggest themselves in this context — for example, the recognition of various liabilities and provisions, the extent to which provision should be made for bad debts, whether assets have been impaired, should research and development costs be carried forward. Students should be asked to identify what decision rule is to be used and what evidence and information cues might be important in making the probabilistic judgement decision.

Another example is given of auditors’ determination of control risk assessment pertaining to the valuation of inventory. Prior research has found: Ten per cent of inventory items are not valued according to the lower of cost or NRV rule Probability that the internal control pertaining to inventory valuation will prevent an

incorrect valuation of an inventory item is 94% Probability that the internal control will identify and prevent a valuation which is correct

is 7%.

What is the probability that if the internal control in question identifies and prevents an incorrect inventory valuation, the item is in fact valued incorrectly?

Posterior odds = Likelihood ratio Prior odds

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Posterior odds = 0.94 0.10.07 0.9

= 1.492

Probability = 1.492/2.492

= 59.87%

4. Explain the implications for accounting if decision makers in an accounting context display any or all of the representativeness, availability, or anchoring and adjustment rules of thumb.

The key thing for students to recognise in this question is that although heuristics are a practical means of coping with a complex world, their uncritical use can lead to less than optimal decision making on the part of accountants and auditors. This in turn increases the risk of financial loss and unfavourable legal consequences.

Representativeness. The base rate or model provided to decision makers is misused in many instances, or even ignored altogether. This implies that the usefulness of such ‘base’ information to decision makers is largely ignored and rarely used. Rather, auditors and accountants employ their own judgements and rules when making decisions.

Availability. Decisions related to ‘sensational events’, and the probability assessments thereof, are likely to be overestimated. For example, consider a financial report of a company. Most information indicates the firm is profitable and liquid. Now assume that a news story is aired that suggests an individual is seeking to sue the company. Users of the reports, particularly shareholders, may weigh this piece of information very heavily and assess the company as being close to collapse — even though no writ has been issued, no disclosure of the amount claimed, nor an assessment made of the grounds on which the claim is alleged and the likelihood of success.

Anchoring and adjustment. In the light of changed circumstances, insufficient adjustments are made. Assume that an auditor’s prior period control risk assessment (as very low) is used as the anchor for the current period’s assessment. Changes in the internal control structure of the client indicate a higher assessment is needed, but the auditor, using an initial very low risk anchor, does not adjust upwards enough. This low anchor may lead to ineffective and/or inefficient auditing.

5. Describe how (and why) the information processing systems of expert accountants might be different from those of accounting students. How might the expertise of experienced accounting practitioners be effectively passed on to accounting students?

Experts appear to increase memory capacity by employing ‘standard’ models, checklists, strategies and trends, or representativeness heuristics to recognise a familiar pattern and prompt the recall of one such standard model or prototype from memory. From this model, the information given to an ‘expert’ is then compared to isolate deviations from the standard or expectation. Thus, experts need only to know or remember such strategies, models or checklists, and the constant use of such models improves the experts’ memory recall and ability to integrate learned models with current situations and faults.

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Furthermore, the more situations such models are applied to, and the more experienced the expert becomes, the easier it becomes to recall such models and recognise more diverse situations in which to apply such models.

Experts clearly have had more time and experiences to assist them in developing their ‘expertise’ relative to most accounting students. Experts can pass on their expertise to students by mentoring, formal training sessions, seeking opportunities to broaden the range of experiences available to students (for example, auditing firms in different industries), and regular supervision of the work of the novice.

6. ‘Most people are not good intuitive statisticians.’ Discuss this statement in an accounting context, drawing on research using the probabilistic model.

Probabilistic judgement theory and research suggests that most individuals are not good intuitive statisticians because tasks employing probability assessments and reassessments require multiplicative rules, such as Bayes’s Theorem, to be used. However, individuals do not readily ‘think’ multiplicatively, but rather use additivity or employ heuristics to simplify the task at hand. Students might be asked to think of specific examples (not necessarily accounting examples) of the accuracy of their own likelihood judgements (for example, will it rain today?, ‘how well will I do in the exam or assignment?’). What factors influence the accuracy of these judgements?

Research in the accounting context of probabilistic judgement, particularly auditing, indicates that probability revisions are made by employing the heuristics of representativeness, availability, and anchoring and adjustment. Furthermore, research suggests that auditors tend to revise probabilities to a lesser extent in the light of changed circumstances than Bayes’s Theorem suggests, due to the use of heuristics and judgement bias that are adopted to simplify complex judgement tasks.

For example: Representativeness. Joyce and Biddle’s (1981) study of auditors’ judgements regarding

the incidence of management fraud. Auditors did not consider the ‘base rate’ (basis of using Bayes’s Theorem is to consider explicitly the base rate or prior odds) sufficiently.

Availability. Maser (1989) found some environmental event pertaining to a particular company that led to disproportionate news coverage may systematically affect or influence the predictive judgements of investors.

Anchoring and adjustment. Joyce and Biddle (1981) found no evidence of anchoring and adjustment in auditors’ adjusting the scope of the audit following changes in internal control systems. Kinney and Uecker (1982) found evidence of anchoring and adjustment in analytical review and compliance test tasks.

7. Compare and contrast the efficient markets hypothesis and human judgement theory. Are they inconsistent with each other? Explain.

Both the EMH and HJT deal with the production of accounting information and reactions to information. However, this is where any similarity between the two paradigms ends.

The EMH focuses on the utility or information content of accounting information whereas HJT generally deals with the usages of accounting information by focusing on the input perspective of accounting. That is, accounting as an input in human decision-making

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processes. Furthermore, the EMH differs from the HJT in that the EMH deals with aggregate (‘on average’) behaviour of the capital market, whereas HJT deals with individual or group decision-making processes of reaching a decision with given information. Also, EMH focuses on behaviour of capital market participants only. HJT applies to all users of information. Rather than saying that the two perspectives are ‘inconsistent’ with each other, it might be more useful to recognise that they are complementary. EMH identifies ‘new’ information and then the reaction (if any) of stock prices to that news, but not what goes on in between those two events. HJT offers the possibility of learning how decision makers take the ‘new’ information and process it to arrive at their share price or valuation decisions (as ultimately reflected in their share market activity).

The assumptions underlying the two theories also differ, as shown below:

EMH/CMR HJT Homogeneity of users’ expectations Rational users Efficient impounding of

information into share prices Does not assume correct or perfect

usage and/or interpretation and/or presentation of information

Does not assume nor suggest optimal decision making and trading

Is accounting information useful?

Heterogeneity of users’ assessments

Irrationality of users allowed and controlled for

Imperfect use of information Seeks to identify the processes by

which information is analysed and judgements formed

How is accounting information used?

8. Does consensus always imply accuracy in studies of accounting decision making? Justify your answer.

In the absence of a correct or model solution to a judgemental task, researchers within the sphere of accounting, and in particular auditing, assess accuracy in terms of a level of consensus achieved by subjects in a given judgement task. Consensus is argued to be indicative of accuracy, especially in auditing where a high degree of consensus is a desired characteristic between members of the profession.

However, since accuracy in the absolute sense cannot be readily determined, the question of whether consensus will equal accuracy in judgement tasks is arguable. Studies such as Campisi & Trotman (1985), which looked at the level of auditor consensus in going-concern judgements, justify the use of consensus as a measure of the quality of the audit decision-making process. That is, even though consensus may not always mean accuracy, it is suggested that consensus, at a given point in time with a given set of facts among auditors, indicates that the judgement made at the time was ‘correct’. However, there is always a risk that consensus can mean consistently incorrect judgements as well as consistently ‘correct’ judgements. For instance, it may be that a group of auditors has all been taught the same methods for making internal control assessments. When asked to make their assessments in a particular case, all the auditors may apply the same method and arrive at the same judgement. However, if the method is flawed in the first place (for example, it consistently understates internal control risk), there may be a consensus but the auditors will be consistently wrong!

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9. Why is a ‘model of human behaviour’ generally superior to human judgements?

A model of man is essentially a mathematically developed decision-making model based on individual patterns of information use. Such a model is then applied to various analytical or judgement tasks. Because this model of man consistently applies the decision rules and weightings of information cues (it doesn’t tire or become bored and distracted), studies have found that such a model consistently outperforms the human ‘experts’ on whom it is based. This outperformance stems from the model of man being free from inherently ‘human factors’, which see inconsistent application of decision rules and emphasis or weightings placed on various pieces of information. Note, however, as in the solution to question 8, the superiority of the mathematical model relative to human judges does not necessarily mean that the model is error-free (if it consistently applies the ‘wrong’ rule).

10.What alternatives exist for improving the format and presentation of accounting information? What is the research evidence regarding the merit of the various alternatives?

Chernoff Faces. Moriarty (1979) found subjects using financial information represented diagrammatically by Chernoff faces outperformed a well-accepted financial distress model. However, Chernoff faces are not yet seen in practice as a ‘serious’ alternative form of presentation.

Tables and colour graphics. Blocher, Moffie and Zmud (1986) found that the effectiveness of different forms of presentation of financial information is a function of the amount of information presented to and processed by the decision maker. Graphic reports are better suited to low levels of task complexity. Tabular reports are better suited to high levels of task complexity.

Davis (1989). No form of graphical presentation is superior/better in all situations. Desanctics & Jarvenpan (1989). The researchers found only a small or modest improvement in

the accuracy of forecasting judgements associated with the use of graph formats. They suggest that this indicates that users have to go through an adjustment or learning process before graphical information becomes meaningful.

The above results confirm Wainer and Thiessen’s (1981) findings that no well-developed and tested theory exists that can be used to determine the circumstances under which different forms of presentation are most appropriate at least in part.

These findings are more recently confirmed in the So and Smith (2002, 2003) papers.

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11. Human judgement theory does not purport to penetrate the ‘black box’ of cognitive processing. Verbal protocol research, however, has that ability. What are the strengths and weaknesses of this research methodology? (Hint: See G. F. Klersey and T. J. Mock, ‘Verbal protocol research in auditing’, Accounting, Organizations and Society, vol. 14, no. 1/2, 1989, pp. 133–51.)

Strengths Weaknesses Can trace the connection between the

decision makers, decision process and the actual decision made or action taken, thus enabling researchers to understand subjects’ cognitive processes.

Good description of decision-making process

Findings enable tentative conclusions and recommendations to be drawn regarding:

the quality of subjects’ decision making

identification of decision rules for use in expert systems or to be taught to others in the profession

why a decision is reached influences on the decision,

other than the process and information considered.

Information derived regarding deliberately selected decision-making strategies is useful, but not for more initiative decision-making processes

Predictive ability re the use of decision-making strategies is low

Subjects may fabricate answers as to ‘how’ they reached a conclusion and assessed the evidence using prior knowledge of how the task ‘should’ be performed

Questionable statistical validity as typically small sample sizes are used

Difficulty in coding verbal responses

Time consuming nature of codification dictates use of small sample sizes.

The comments in the above table need to be seen in the context of the level of the decision maker’s familiarity with the decision task. Research suggests that verbal protocols are typically incomplete for tasks with which decision makers are highly familiar because some of the decision steps are so familiar that they do not even recognise them when asked to explain their decision. On the other hand, where the decision makers are asked to describe their decision steps in a highly unfamiliar task, they tend to give far more comprehensive and explicit descriptions.

12.Reconcile normative accounting studies and human judgement theory.

Normative accounting theories seek to prescribe what should be, whereas HJT and associated research seek to explain what is and what could be.

That is, HJT can focus on explaining the effect of information disclosures, formats and presentations on a decision maker’s assessment of the information and conclusion reached. HJT, however, also deals with as yet unobservable accounting practices to consider the issue of ‘what would be the impact on users if this requirement were to be changed’?

Furthermore, normative theory seeks to develop a ‘theoretical blueprint’ or prescription of what ought to be done based on what information users should need. However, HJT can be

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distinguished from the normative paradigm in that it looks to users to explain what users’ needs are — and then to observe the impact of various accounting practices and changes thereof to observe such information fulfils this need.

One point of reconciliation between these two schools of thought is that HJT studies can be undertaken to handle ‘what if?’ questions. If the effect of the change studied indicates an improvement to the satisfaction of users’ information needs (as perceived by users), then there may be a normative argument that emerges to prescribe what should be, based on the results derived from experimental research in HJT. In this sense, HJT research ‘informs’ the normative decisions of accounting regulators. For instance, accounting standard setters usually have to make rules about what disclosure provisions should be included in accounting standards — HJT research could help tell the standard setters what types of information are the most informative or that facilitate their decision-making processes. A normative argument may then follow that such practice should be adopted.

13. Why do individuals form lobby groups to influence companies’ behaviour and information disclosures? What types of information would shareholder groups require to determine whether company directors should be censured for poor performance?

Lobby groups are formed to influence the behaviour of lobby group targets. This may directly focus on the individual companies, on an industry or through political means by way of government and government regulations. Often the formation of a lobby group is a sufficient signal to garner change on the part of those responsible for disclosures or the actions of target companies. The level of response will depend on the perceived capacity of the lobby group to affect the firm. Responses to lobby groups are not costless and are considered carefully by the management of a firm. Individuals form lobby groups as their individual concerns are not considered. They do not rate as a stakeholder of interest — but as a group they warrant attention. The information sought to evaluate management will depend on the focus of the group. If the focus is equitable behaviour toward all shareholders, the focus will be on management’s activities with respect to majority or institutional shareholders compared to the minority shareholders. The focus may be on overall performance and future returns; it may be on environmental issues; or it may be on contributions to the community through the tax system. Lobby groups have every right to sanction performance inconsistent with their objectives, just as management has the right of response. Again the definition of poor performance will depend on the focus of the lobby group. It is perhaps worthwhile recognising that it will usually be the case that shareholder (or other lobby) groups will be less informed than managers (except, perhaps, after the fact when it is too late — consider Enron, for example). The question could be extended to ask students whether the provision of information to shareholder groups can realistically improve corporate governance or whether other mechanisms are as, if not more, important — for example, role of auditors.

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14. What is more important for an organisation — the ‘right’ physical assets or the ‘right’ people? Explain.

Both physical and human assets are essential to the effective operation of organisations. Without any physical assets, firms have no means of production or service delivery. But, the assets are purchased, applied and maintained by humans. If the physical assets are appropriate, but human capital is underskilled or lacks motivation, then the firm will not operate as well as if it had a skilled and motivated workforce. The same applies with respect to the assets of a firm. If they are not a good fit with respect to the activities of the firm, then the best human intervention will normally result in less than optimal performance. The research literature has tended to focus on the investments by firms in physical assets and in returns on those assets. The class might like to consider how we could value and measure the return on investment in people. Answers to this question should also focus on the growing importance of intangible assets that might, for some companies, form the majority of the ‘assets’. Many of these intangibles represent intellectual capital, but conventional accounting is highly limited in how it ‘captures’ the value of these intangibles in financial statements — for example, capitalised costs do not represent ‘value’. This issue could open into a discussion as to how accounting could be modified to reflect the value of intellectual capital.

15. Accounting is a function of human behaviour and activity. As such, is not all accounting research behavioural? Justify your answer.

The answer to this question is a matter of theoretical perspective. Most research in accounting and finance focuses on measuring the readily measurable, and ignoring or assuming away all else. The readily measurable is usually the net product of human activity and interaction, such as return on assets and share price. In this sense, all accounting research is behavioural — the performance of the firm, the information measured and disclosed is a function of human judgements and application. As such, perhaps more emphasis should be placed on understanding the decision processes and the performance of individuals in generating economic returns. In a sense, we are engaging in an exercise in historical studies in that we observe past performance and interpret the factors underlying the performance of firms and the factors motivating reporting and disclosure practice.

Have the class discuss how we could improve on our current knowledge of accounting choice decision making and perhaps design a research project to consider the issues discussed. Alternatively, students could be asked to compare and contrast HJT with EMH and agency theory. The latter two models may be interested in the consequences of behaviour (for example, share price or choice of accounting policy), but they assume a particular model of behaviour (that is, rational wealth maximisation). As such, they do not explain behaviour at all and so could be argued not to be behavioural research.

16. List nine or more factors that will influence the accounting system adopted by a firm and the information disclosed. Which of these factors are a direct function of human behaviour?

There are any number of factors that will influence the accounting system adopted including: technologies available industry management performance and compensation schemes historical practice and market expectations

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government legislation requirements of the accounting profession requirements of the stock exchange relationship to other entities, both foreign and domestic organisational reporting and management structures requirements of debt providers and funding institutions.

All of these factors are a function of human behaviour. A management accounting focus could also be adopted here by considering more explicitly the internal factors that shape an accounting system — for example, the performance measurement and reward or sanction processes; budgeting; control and the assignment of responsibility.

Case Study 11.1 — QBE seeks to master its own destiny

1. Why do you think the author included the various graphs in his story on QBE? What messages are conveyed by these graphs and how do they compare with the messages in the text of the article?

The inclusion of graphs in the article is one means by which the author can summarise a lot of data in an efficient form. The use of graphs also can assist those readers who tend to process information ‘visually’ rather than via text. The graphs are a convenient means of signalling trends or differences that might be less accessible if they were only described by way of text.

The messages contained in the graphs reflect the subject matter of the text, but both forms can provide information that is not contained in one alternative vis-a-vis the other. For instance, although the text tells us that ‘foreign operations account for 81% of gross written premiums’, the pie chart provides us with more detail about how that 81% is distributed across different geographical regions. Presumably, these different regions face different levels of risk, and so the pie chart potentially offers information additional to that in the text.

2. With which of the two formats, graphics or text, do you feel most comfortable? Why?

Students should be encouraged to describe why they prefer one format to another. This may simply reflect different ‘learning styles’ or ‘information processing styles’.

3. Having read the article and studied the graphics, if you were a shareholder in QBE, how relevant are the graphics to your assessment of whether to hold on to your shares? How relevant is the written analysis to your assessment?

This question should spark a discussion about the relative informativeness of text versus graphs. Typically students will say that the graphs were easier to use but that the text contains more detail that would be important to a serious investor. (The contrary example as mentioned in question 1 could be noted, however). Needless to say, a serious investor would do a lot more research into the company too!!

4. Do you think the inclusion of the graphics improved your decision making?

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Again, students should be asked to justify their response. They could be asked whether they feel that they would have been as informed about QBE if the graphs were not included in the article.

5. If you were a director at QBE, why might you want to present the information graphically?

A director might be genuinely concerned about informing less-skilled investors and might believe that graphs are a good way of achieving this. Financial statements are becoming increasingly complex as accounting standards and new forms of transactions proliferate, and this might be a beneficial approach for some investors.

The more cynically minded could also point to the ability to manipulate the message by playing around with the scales and colours so as to, for instance, under- or over-emphasise trends or differences.

Case Study 11.2 — UAL CEO announced

1. Why would the UAL (United Airlines) board appoint Glenn Tilton to the positions of chairman, president and CEO of UAL when he comes from ChevronTexaco Corp. (reportedly the world’s fourth largest oil company) and is reported as having ‘no airline experience’?

This question is a good opportunity for students to reflect on what constitutes ‘expertise’. On the surface of the facts, Mr Tilton may seem like an unusual choice to head United Airlines (UAL) given that ‘he has no airline experience’. However, when the facts are considered in more detail, his selection might be more understandable. UAL is in very serious financial difficulties that will require ‘tough’ measures to implement a financial recovery. The article notes that Mr Tilton has ‘strong leadership skills’, which might be a way of saying that he is prepared to take clear and decisive action that might be unpopular with employees.

Although Mr Tilton comes from a different industry, he clearly also has significant senior management experience that would be transferable to a variety of contexts (for example, people management skills would be valuable no matter what the industry).

In summary, the ‘crisis’ at UAL may require someone who has expertise in managing crises rather than airlines. In the longer term, however, if UAL’s fortunes were to improve, then Mr Tilton may no longer be the ‘best’ manager for an airline that is a going concern.

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2. Why might Glenn Tilton have been preferred to John Walker, a current UAL board member and CEO of another company?

As implied in the answer to question 1, having no association with the people who work at UAL would be a decided advantage when it came to pruning back on costs — Mr Tilton would not have to worry about divided loyalties between ‘friends’ and retrenchments, for instance. Further, Mr Tilton would bring a ‘fresh’ perspective to the situation at UAL and would not be burdened by an association with its past history. A new manager might also be a source of inspiration to UAL employees if he was to offer hope of a successful financial turnaround.

3. The article reports that Glenn Tilton started as a sales trainee in 1970. How might his skills set have changed since that time and what might have been his main means of learning new skills?

Early in his career, Mr Tilton’s skills would likely have been relatively narrow and focused on detailed technical matters. However, as he rose through the ranks, higher positions would have brought with them more responsibility and a requirement to take a more strategic and ‘broad brush’ approach to his job. As CEO, it is very unlikely that he would be concerned with the minutiae of the day-to-day running of a firm (although this may be necessary to some extent in the case of turning around a firm in financial crisis). Rather, he would be responsible for setting the broad strategy and direction of a company and overseeing its operations.

As a result, his skills set would now be very different, with an emphasis on things like strategic management, planning and people management. Many of these skills he will have learnt on the job, either through direct experience or by being mentored (‘groomed’) by other managers. It is likely that he would also have developed some of these skills through formal professional development, such as an MBA or short courses.

Case Study 11.3 — Cash flow the key to a beautiful bottom line

1. If cash flow is the best measure of performance, why have the accounting profession and regulators persevered with accrual accounting?

There is far less discretion as to the timing of disclosures under the cash flow model. See chapter 6 for a discussion of the differences between the accrual and cash flow methods. Adoption of cash flow can distort earnings and reduce the capacity of management to smooth income. From an HJT perspective, the argument might be that accrual accounting allows investors to form unbiased or more informed judgements about the long-term prospects of a company, or that accrual-accounting-based information cues are better predictors of future cash flows than current cash flows.

2. What do the analysts mean by the term ‘good quality’ earnings?

‘Good quality earnings’ are reported profits that have resulted from appropriate mainstream trading activities, not from manipulating timing differences or recognising abnormal or extraordinary returns. They reflect an appropriate return on the fair value of invested assets.

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3. Why can the market so readily ‘see through’ these abnormal adjustments today, but was apparently fooled by the practice for a number of decades?

The literature indicates that the market was never ‘fooled’ by such adjustments. The market adjusts value for such arbitrary adjustments to value in order to provide a measure of actual value. However, there is a lot of noise associated with the accrual system and some firms have been able to defer the market’s recognition of their real value by manipulating information. However, the manipulations tend to take place in determining accounting methods and in minimising disclosures as to the methods adopted. Markets can still be wrong (‘fooled’) in their assessments of companies of course — if there is fraud or unexpected risk — but this is not always the fault of the accounting system.

4. The article refers to the need to beat ‘expectations’. How are such expectations developed?

Expectations about performance are based on: industry trends and past performance current and expected factors impacting on the industry and the individual firms statements made by the firm about expected performance media commentary past performance of the firm independent evaluations by analysts statements by the ASX.

HJT research, of course, has the potential to help us understand the process and information cues by which these expectations are formed (at least at the level of individual investors).

Chapter 12

Standard setting in a political environment

Theory in Action 12.1 — Public interest, flexible accounting and industry differences

1. Do you believe that generic accounting standards can be applicable to all companies irrespective of the industry in which they operate? Are there any examples of industry-specific accounting standards? If so, what are the characteristics of those industries that warrant specific accounting standards?

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Generic accounting standards can be applicable to all companies irrespective of their industry classification. Essentially, the general-purpose financial reports are capturing the firm’s performance, position and cash flow during the period, and it is appropriate that one set of rules applies to all firms irrespective of industry classification. For comparability purposes it would not be desirable to have financial reports that are industry specific, as investors spread their investments over a range of industries for diversification purposes.

In instances where transactions are industry specific and in need of accounting clarification, industry specific standards have been developed. Examples include: extractive industries firms with self-generating and regenerating assets financial institutions insurance companies.

Students should be encouraged to consider the type of business risk and accounting issues confronting these industries, to explore the need to develop industry-specific standards. As mentioned in the article, there are also some industry-specific rules within the ASX listing rules (for example, more onerous cash-related disclosures for particular Internet firms).

2. What is the role of ASIC in enforcing accounting standards, and why does this role exist?

Section 292 of the Corporations Act 2001 (Cwlth) applies to all disclosing entities, all public companies, all large proprietary companies and all registered schemes, and requires: proper financial records to be kept preparation of a financial report for each financial year (and half-year) financial report consisting of statement of performance, statement of position, statement of

cash flow, director’s declaration and notes presentation of a true and fair view (but no override of AASB, only additional disclosures) compliance with accounting standards.

The ASIC is the corporate watchdog and has responsibilities for enforcing the Corporations Act 2001. As part of its enforcement process, it conducts surveillance programs to ensure firms are complying with accounting standards.

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3. What relationship should exist between the AASB or the IASB and ASIC?

Students may differ in their views regarding the role of national standard-setting bodies in relation to the IASB, but it is likely that they will argue that standard setting is likely to be more effective and more efficient if national standard-setting bodies are represented on the IASB.

If national standard setters are attempting to harmonise with international accounting standards, there are at least two perspectives regarding the appropriateness of national involvement. One view is that if the national standard setters are attempting to harmonise with the international accounting standards, they have a vested interest in ensuring that the best standards are developed, and a vested interest in providing strong input to the process in order to reap the benefits of IASs that suit them. The other view is that if they are attempting to harmonise with the IASs, they have no negotiating power on the IASB since it will be generally known that they will adopt any IAS being debated, at least in modified form, even if it does not suit them. If the first view is deemed to be stronger than the second, there is a strong argument for national standard setters being involved on the IASB. If the latter view is deemed stronger, the role of national standard setters is weakened.

With the restructure of the IASC in 2000, national standard setters are represented on the IASB. This relationship will ensure that there is a more direct linkage between what happens nationally and internationally, and greater scope for input from national standard setters to the international regulations. This also facilitates a two-way flow of information and debate, which should contribute to the development of standards at both levels and minimise differences that could arise because of miscommunication or unresolved differences of opinion. It should also inform the international debate so that appropriate flexibility is retained in accounting standards and ensure there is little discrepancy between national and international accounting requirements. The commitment reached between the FASB and the IASC (Norfolk Agreement) commits both parties to minimising differences between US and international accounting standards.

4. The disagreements relating to reporting practices between companies and ASIC often arise due to flexibility provided to financial statement preparers by the accounting regulators. Do you think such flexibility is desirable or should the regulations be more prescriptive? What alternative to court action does ASIC have the opportunity of pursuing when it believes accounting regulations have been incorrectly interpreted and/or applied?

The answer to this question is a matter of opinion, depending on whether the students think that the preparers of accounts (a) opportunistically distort accounting reports in order to mislead users or misdirect resources whose allocation is determined by accounting numbers (for example, debt covenant leverage ratios, or earnings-based management compensation plans); or (b) use the flexibility in accounting regulation to better reflect their own firm’s economic performance. To some extent, the answer also depends on the students’ weighting of the arguments for regulation. Arguments for and against regulation are outlined below.

In favour of the free-market approach: As with other products, information about a company is subject to the factors of demand

and supply, with price as the operating mechanism. An equilibrium price can be found — this is the price where the supplier still finds it advantageous to furnish information, and users believe the price is equal to the benefits (value) of the information.

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Free-market forces would determine what type of accounting data to provide, and therefore what standards are necessary in order to gather such data. In this way, unnecessary information is avoided — that is, information where the cost exceeds the benefits. This can be determined because people will not be willing to pay the price.

[The question could be raised — will regulation necessarily prevent fraud or flag the corporate collapses we have seen in recent years?]

Against the free-market approach (and in favour of the regulatory approach): It is highly unlikely that existing authoritative, regulatory bodies will relinquish their

present power in accounting. Therefore, the free-market theory is unrealistic. The theory is unworkable, because a socially optimal equilibrium price for accounting

information cannot be achieved. This is true for the following reasons:– Accounting information is a public good. Once the information is released, it is available to everyone, not just those who paid for it. Since not all users can be charged for the information, suppliers will have little incentive to provide it.– A firm has a monopoly on the supply of information about itself, and therefore the tendency will be for the firm to underproduce and sell at a high price.

A regulatory board is still necessary even if a free market existed, because accountants will not agree on the procedures to use to derive the desired information. A regulatory board is necessary to make the required decisions.

In answering question 2, it was noted that the ASIC has responsibility for enforcing adherence to accounting standards. If the ASIC believes that accounting regulations have been incorrectly interpreted or applied, and the offending firm accepts their stance, the firm can enter into an enforceable undertaking with ASIC. This undertaking is a legally enforceable document stipulating that the ASIC disagrees with the firm’s interpretation or application and agrees to adopt ASIC’s preferred position. In some cases it may also require the financial statements to be restated. If no compromise is reached the matter needs to be adjudicated in court.

Theory in Action 12.2 — Australian Senate enters standard-setting arena

1. The proposed AASB 1015 permitted internal reconstructions to be accounted for using the carrying amount or fair value methods. Describe the two accounting treatments and the effect of the alternative treatments on users of financial reports. Was the proposed standard consistent with the conceptual framework?

Using the purchase method of accounting, when there is a reconstruction the acquiring entity within the group records the acquisition at cost; and on consolidation the acquired assets are recorded at their fair values. As such, the net effect is to debit assets with their fair values current at the date of acquisition, credit shares/cash/other consideration with the cost of the acquisition, and debit goodwill. This treatment is the same as if the reconstruction occurred outside the entity.

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Accounts of the acquiring entity (Y) within the group:Dr Shares in XCr Cash/shares/… (consideration given by Y)

Consolidation journal entry after X revalues its assetsDr PUC, Reserves (Y’s ownership proportion of X equity).As this is measured relative to fair values at date of acquisition, it exceeds the value of ‘Shares in X’ reported by Y at acquisition.

Dr GoodwillCr Shares in X

Using book value accounting, the acquiring firm records the acquisition at cost, in exactly the same manner as under the purchase method of accounting. However, upon consolidation, the assets of the acquired entity are not revalued. Rather, they are carried at their previous carrying amounts, and the consolidation journal entry would effectively just reverse the acquisition entry so that the two entities together would have the same total asset value as if the restructuring had not taken place.

Consolidation journal entryAccounts of the acquiring entity (Y) within the group:

Dr Shares in XCr Cash/shares/… (consideration given by Y)

Consolidation journal entryDr PUC, Reserves (Y’s ownership proportion of X equity).

As this is measured relative to book values at date of acquisition, it equals the value of ‘Shares in X’ reported by Y at acquisition.

Cr Shares in X

The conceptual framework does not provide direct guidance for the accounting treatment of internal reconstructions because it does not deal with measurement issues. Nonetheless, the early concepts in relation to qualitative criteria are relevant in the debate.

2. Given the closeness of the AASB vote on this proposed standard, what theory (or theories) of regulation explains the preferences of individual AASB members on this accounting matter? What do you think was an appropriate voting process for the AASB, and why?

Internal reconstructions involve reorganising the corporate structure — for example, by splitting it into several companies rather than one company, or by merging companies within the group. Business people lobbied for the use of book value measurement in accounting for reconstructions. In many cases, this was because the book value method avoids recognising goodwill and therefore avoids the need to amortise goodwill in the future. As such, the book value measurement method is income-increasing by virtue of avoiding the expense, goodwill amortisation. The method is also asset-reducing, thereby increasing measures of returns relative to asset base, or to equity.

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The regulation theory explaining the preferences of individual AASB members on this accounting matter is private-interest theory. AASB board members associated with businesses that have, or are likely to consider, future reconstructions tended to vote for permissiveness in terms of how the transaction could be accounted for. The arguments were premised on what their clients would prefer rather than on technically pure grounds.

It is interesting to note that while the UIG requires 11 out of 16 votes in favour of a pronouncement before it becomes a consensus view, the AASN operates on a simple majority bases.

3. AASB 1015 is the first accounting standard to be disallowed by Parliament. How and why do you think this proposed standard came to the attention of the Senate?

The issue of accounting for internal reconstructions came to the attention of the Australian Federal Parliament because: the issue was highly contentious in the business community the issue received a lot of high profile media attention business people lobbied both sides of government with respect to the issue, and lobbied

parties influential in the political process ASIC involvement in the issue ensured that it attracted political attention politicians could perceive that dealing with the issue could be vote-winning.

Theory in Action 12.3 — Functional currency: a functional standard?

1. The International Accounting Standards Board (IASB) is an independent private sector group with no legal backing or affiliation with any particular country. Given this, how has its global prominence in influencing reporting practices occurred?

The prominence of the International Accounting Standards Committee (IASC) has been increased through intensive publicity throughout, and subsequent to a concerted effort, via the IASC Improvements Project, to improve the rigour of international accounting standards. The rapid improvement of the international accounting standards as a consequence of the project won the IASC a lot of respect. Worldwide, the IASC has also engaged in a pro-active public relations campaign to raise awareness of its role, and to promote that role and an increase in its scope and significance. This has involved lobbying through national business leaders particularly, and politicians. Furthermore, it has occurred at a time when national standard setters have been dealing with difficult and controversial issues, making it possible for the IASC to be seen as providing solutions that are more palatable to the business community. IOSCO’s interest in endorsing IASs for lodgement purposes has given even greater prominence to the IASC role.

Recognising the need to converge national accounting standards and practices and legitimise its role, the IASC was restructured in 2000. The IASC is now an independent organisation with two main bodies — trustees and board (the IASB) — and a Standing Interpretations Committee and Standards Advisory Council. The structural changes effectively ensure greater involvement in the IASB’s deliberations by national standard setters and a more workable board. Its revised constitution stipulates the IASC’s objectives include the development of

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IASs that require high quality, transparent and comparable information and the promotion of IASs by working with national standard setters to bring about convergence. The restructure of the IASC is to ensure high quality and acceptable IASs.

2. Reilly, as a representative of the Institute of Chartered Accountants in Australia, represents the interests of chartered accountants. Would the influence of this organisation be an example of regulatory capture, private-interest or public-interest theory? Give reasons.

Students may differ as to whether they believe the influence of either of the professional accounting bodies is an example of regulatory capture, private-interest or public-interest theory.

Reilly’s comments could be consistent with the public-interest perspective, because they are couched in terms of ensuring that all stakeholders contribute to the due process associated with accounting standard setting. His comments could also be interpreted as consistent with private-interest theory. The ICAA represents the accounting professionals — and Reilly is encouraging accountants to participate in the standard-setting arrangements to ensure that their views are espoused — and standard setters may accommodate the profession’s preferred position. It could also be argued that Reilly’s comments are also consistent with a regulatory capture theory. Because he is the Institute’s technical director, Reilly could be seen to have had a vested interest in promoting an influence by the professional bodies rather than national standard setters. His concerns may be interpreted as reflecting a view that the IASB should liaise more with professional bodies than with national standard setters. Since the professional bodies represent the regulatees, this is consistent with the regulatory capture perspective.

3. The proposed change discussed in this article involves allowing companies with high offshore earnings to lodge their accounts in the currency in which they conduct most of their business. What advantages could accrue to Australian companies if they are permitted to report in their functional currency? Can you envisage any disadvantages associated with this change in reporting requirements?

Reporting in their functional currency would reduce financial statement preparation costs as the requirement to translate into Australian dollars would not exist. However, this apparent cost advantage is reduced given, that firms will have to record Australian dollar equivalent transactions for taxation purposes.Another claimed advantage is that firms’ profit volatility would reduce as firms’ foreign currency risk would be lower. However, natural hedges are used by firms (for example, borrowings in overseas denominated currency the same as the principal earnings stream to minimise earnings volatility).Having Australian firms report in different currency denominations will impede the comparability of financial information for users.

4. What user groups would you expect to participate in the consultative process and comment on this proposal?

Any stakeholder is permitted to participate in the consultative process and comment on proposals. Large corporations are most prominent in this process (students should discuss the ‘free-rider’ effect). The large companies most likely to participate in this process are the ones most affected, favourably or unfavourably, by the proposal. The companies with significant offshore operations would be the primary interested parties. As the proposal further diverges

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the tax and accounting rules, other interested parties include the tax office and accounting firms.

Theory in Action 12.4 — Costs and benefits: economic and ethical dilemmas for standard setting

1. What contribution do the financial statements make to a company’s communication with users? What aspects of performance do the financial statements convey?

As per SAC 2, the objective of general-purpose financial reports is to provide information that is useful for decision making concerning the allocation of scarce economic resources. The financial report is the mechanism by which the firm formally communicates its performance and financial state to interested parties. The general-purpose financial reports contain information as to the firm’s performance and cash flows for the reporting period and its position as at the end of the reporting period. To be recognised, the information contained in the reports must be quantitative. However, firms often also communicate qualitative information via the notes to accounts.

The usefulness of information contained in financial reports has been supported by empirical research. As discussed in previous chapters, the information is used in monitoring the firm’s contractual relationships and forming expectations as to the firm’s future expected cash flows and hence share price.

2. Do you believe that the AASB has placed too much emphasis on recognition at the expense of disclosure? Give examples to support your argument.

The relative importance that users place on recognised versus disclosed items warrants further empirical research. In recent years the AASB has placed due importance on disclosure issues in accounting standards. Standards exist requiring: disclosure to support recognised items (for example, reconciling PPE at start and end of

period) disclosure of information not recognised (for example, derivative financial instrument

disclosures) disclosure as an alternative to recognition (for example, provisions and contingencies).

Students should be encouraged to find further instances of disclosure requirements.

3. When determining standards, the AASB has been required to consider the costs and benefits associated with the regulation and any economic consequences. Explain these concepts and how these considerations may impede the degree of transparency and clarity in financial statement reporting.

The costs versus benefits associated with financial reporting requirements are discussed in SAC 3 (par. 42–45). Costs include those related to collection, storage, retrieval, presentation, analysis and interpretation of information, possible loss or diminution of competitive position and, if the information is not reliable, misdirection of resources and other related undesirable

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consequences. Costs would also include those related to renegotiating and/or respecifying a firm’s contracts utilising financial information. The benefits of information contained in financial reports relate to more informed economic decision making to an improved information set associated with improved credibility, reduced costs associated with greater uniformity, reduced contracting and monitoring due to greater uniformity.

Questions

1. General acceptance of accounting standards is important to the accounting profession. By whom does the profession require general acceptance of the standards, and why is it important to the profession?

Until the establishment of the ASRB and subsequent legislative support for accounting standards, compliance with accounting standards could not be legally enforced. The profession could take disciplinary action against members for non-compliance; however, large-scale monitoring was impossible, and so discipline was on a very ad hoc basis. The problem of enforcing standards detracted from the professional status of the accounting profession and also meant that the standard-setting process may be lost to a third party. As such, the profession sought legislative backing for standards in order to enforce compliance and increase the professional status of the accounting bodies. The profession did not want to lose control of this standard-setting process, but sought to use legislation to enforce compliance.

The profession sought to make its standards ‘generally accepted’: to ensure control of accounting outcomes and the regulatory process and to maintain

effective barriers to entry to the accounting profession to legitimise the accounting process, particularly in the face of increased criticisms of the

standards of accounting information reported to increase status by virtue of association with legislative support to increase demand for full GAAP statements and for interpretation of accounting

standards and financial statements to reduce risk associated with abidance with a set of legislated rules.

2. The standard-setting process is highly political. Describe an accounting regulation that would be politically controversial, and the types of political pressures that could be brought to bear in the standard-setting process.

Students might choose any accounting issue as long as they can explain why it is political in the sense of affecting the wealth of parties in the political process.

Legislating for accounting standards reduces the outcomes to one of political trade-offs of competing interests. The political process, as identified by Watts & Zimmerman (1978), involves competition for wealth distributions between different interest groups. In the accounting arena it involves politicians who have incentives to increase government resources and retain their political positions; companies who have an incentive to avoid political costs, such as increased taxes or regulations; and voters whose participation in the political process is a function of the cost of interpreting and processing vast amounts of information. Managers

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have incentives to adopt procedures that would decrease the political sensitivity of reported earnings and/or increase their personal wealth.

There are many groups who will lobby in the standard-setting process for preferred outcomes. The groups include trade unions, financial institutions, analysts and social groups. Individuals also lobby in the process

Overall, the political process is seen as a means of pursuing individual or group self-interest (Watts & Zimmerman, 1979).

Some ways in which organisations have lobbied to affect the requirements of an accounting standard include: writing responses to exposure drafts writing to members of the accounting standard boards putting forward their views making oral presentations to the boards, or to individual members of the boards holding meetings where key issues are discussed and ensuring that members of the

accounting standard boards are invited, or get to hear of the meetings holding demonstrations against a proposal that they do not favour — as occurred in the

Silicon Valley where executives demonstrated against proposals for accounting for executive stock options

releasing media releases expressing their disagreement with proposed accounting regulation; these releases would then result in articles in the media or announcements over the news

forming groups to lobby for using any or all of the above methods offering to provide funding to the regulatory bodies for an accounting standard that suits

them.

The lobbying may also be indirect and framed in a manner that draws attention away from the direct benefits of those lobbying.

3. The text describes a theory of regulatory capture.(a) What is regulatory capture?(b) How can standard-setting bodies such as the AASB avoid regulatory capture?(c) If a standard-setting body is ‘captured’ by the profession, are there any steps that

the government can take to make the body independent? If so, should the government take those steps? Justify your answer.

(d) Do you believe that the current Australian accounting standard-setting arrangements will prevent regulatory capture? Why or why not?

(a) Regulatory capture is the domination (capture) of a regulatory agency by the industry it seeks to regulate, thus rendering it unable to balance competing interests when making social decision choices. The industry can then direct topics for possible legislation and reject others, which are not seen as important or in the interests of the industry. Walker (1987) argues that the ASRB was effectively captured by the accounting profession (see discussion in text, pp. 419–21).

(b) The ASRB was a panel of seven of which six members were or had been accountants. A possible means of avoiding capture for the AASB is to: expand the number of members on the panel and/or restrict the number of members

that can come from any one industry. However, a large panel may still see groups

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concentrate as a voting block, and the larger the panel, the greater the organisational costs and the potential for ineffective of inefficient decision making.

provide the board with adequate resources to promulgate and review standards so that the board is truly financially independent. The ASRB was restricted by severe funding constraints.

adopt a more relaxed format for proposed standards. This will allow non-technical groups to make submissions for standards. However, this approach is also likely to result in less effective standards because of greater scope for misinterpretation, etc.

subject the board and the constitution of its members to annual review.

(c) If the AASB is captured or there is a perception of capture, the government should conduct a review to determine the source of the capture. Then, it should take appropriate steps to remedy this particular problem. However, where will it end? One would expect an ongoing cycle of capture–adjustment–capture adjustment.

(d) The Financial Reporting Council was established as a result of reforms to accounting standard-setting arrangements pursuant to CLERP1. The Council is responsible for setting the AASB’s agenda, but it is not to get involved in technical deliberations. The establishment of the FRC is designed to give more stakeholders a say in the accounting standard-setting process. The FRC comprises members representing interests such as public and private entities, regulators, directors and shareholders. This reform reduces the possibility of regulatory capture as parties other than accountants are included in the accounting standard setting arrangements.

4. In under 500 words, provide an argument for the regulatory approach to standard setting. Then, in under 500 words, provide an argument for the free-market approach to standard setting. Finally, analyse the arguments and conclude in favour of one approach rather than the other (which approach you favour is up to you, but you must decide which approach is better, at least under a set of assumed circumstances).

In favour of the regulatory approach (and against the free-market approach): It is highly unlikely that existing authoritative, regulatory bodies will relinquish their

present power in accounting. Therefore, the free-market theory is unrealistic. The free-market theory is unworkable, because a socially optimal equilibrium price for

accounting information cannot be achieved. This is true for the following reasons:– Accounting information is a public good. Once the information is released, it is

available to everyone, not just those who paid for it. Since not all users can be charged for the information, suppliers will have little incentive to provide it.

– A firm has a monopoly on the supply of information about itself, and therefore the tendency will be for the firm to underproduce and sell at a high price.

A regulatory board is still necessary even if a free market existed, because accountants will not agree on the procedures to use to derive the desired information. A regulatory board is necessary to make the required decisions.

In favour of the free- market approach (and against the regulatory approach): As with other products, information about a company is subject to the factors of demand

and supply, with price as the operating mechanism. An equilibrium price can be found — this is the price where the supplier still finds it advantageous to furnish information, and users believe the price is equal to the benefits (value) of the information.

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Free-market forces would determine what type of accounting data to provide, and therefore what standards are necessary in order to gather such data. In this way, unnecessary information is avoided — that is, information where the cost exceeds the benefits. This can be determined because people will not be willing to pay the price.

[The question could be raised — will regulation necessarily prevent fraud or flag the corporate collapses we have seen in recent years?]

5. If the AASB concludes that the economic consequences of a standard it is about to approve will disadvantage a powerful lobby group, what should the AASB do about the situation?

Since this is an opinion question, there is no right or wrong answer.

Die-hard proponents of the incrementalist view would argue that the AASB should withdraw its proposal and seek a compromise solution. The AASB needs to be political for its own survival, and compromise is a part of the political game. Depending on the circumstances, if an opponent is too powerful, the wise course of action is to retreat, because the possibility of defeat is great. As long as an incremental step forward is made, they would argue that the accounting profession should be satisfied. A series of incremental steps over time could result in eventual victory.

Others would argue that if a proposal has theoretical merit, and especially if there is also empirical evidence to support it, the AASB should seek to establish the proposed standards. The proposal would result in more relevant and reliable accounting information, which should be the primary consideration in the formulation of standards. Incrementalists argue that the AASB should retreat for its survival, but it is for the sake of survival that it should not back off. People are watching the profession to see if it favours special-interest groups. If the integrity of the AASB is tarnished, its survival will be jeopardised. However, if the theoretical-empirical support for a proposal is weak, a wait-and-see attitude may be justified.

6. How do you think accounting standards should be set? Is that the approach currently taken by the AASB?

Here is one possible answer. The most feasible way may be to be aware of both the politics of the environment and the significance of scientific evidence in the formulation and implementation of standards. Where there is substantial theoretical and empirical evidence in support of a proposal, the AASB should be resolute in seeking to establish the standard. But presently such strong support does not occur often.

The fact is that pressing issues need to be resolved immediately, and there may be little, if any, empirical evidence pointing to any particular direction. In such cases, the AASB needs to follow a theoretical (rational) argument, based on the objective of providing more useful information.

There is no question that the AASB needs to be politically aware. To be aware of the political environment means different things to different people. If it means to do a better (marketing) job of explaining to all interested groups why a given proposal is being made, then that is acceptable. To receive and be aware of the points of view of various groups of a proposal should be helpful to the AASB because the proposed standard may not be as rational as the

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AASB believes. The due process procedure should be taken seriously and not be a perfunctory routine. Contrary arguments may have salient, legitimate points.

The AASB does attempt to be independent in the formulation of accounting standards, especially after the criticisms of the ASRB that it was dominated by the Big Six firms and favoured big business. Because the support of its standards is mainly theoretical (rational arguments), and interpretation of theory can result in different viewpoints, strong opposition is seriously considered and is likely to cause a change in the proposed standard. Empirical evidence is considered, but does not seem to be always critical in the AASB’s decisions. Perhaps the reason is that the evidence is often not persuasive; alternatively it is because it is not understood by the non-academic community.

The AASB’s formulation of a conceptual framework (SAC 1–4) shows that it leans towards the theoretical-scientific view. But its authoritative standards show partiality for the incrementalist view. At times, the standards seem to contradict what is said in the concepts. It could be said that for the long run, the AASB favours the theoretical-scientific position, but for the practical short run, it finds it necessary to employ the incrementalist approach.

With the adoption of international financial reporting standards (IFRS), the AASB will expose IASB ED to the due process; but many believe that the ability of interested parties to influence the outcome is limited.

7. What are ‘free-riders’? How can a system ensure that those who benefit most from an accounting standard requiring certain disclosures also bear the greatest costs of it?

Free-riders are people that can utilise information once it is publicly available. Although information may be sold to certain people only, others who did not pay cannot be easily excluded from using the information. Examples of free-riders are financial analysts and potential investors. There is no simple solution to the problem.

Students should be encouraged to offer ideas. Companies may act to restrict access to the financial statements to shareholders and associated parties. Companies may establish a user-pays system where financial information is available to non-shareholders on a fee-for-information basis. If the fee was sufficiently high, those who pay are less likely to share the information. Nonetheless, such systems would be difficult to administer and control, and are unlikely to be successful.

8. The setting of accounting standards requires some assessment of economic and other benefits and costs. What are the ethical issues involved? Is it possible to avoid ethical issues in developing accounting standards?

There will always be ethical issues associated with the development of accounting standards because there are ethics involved in deciding between providing information that is representationally faithful for users and requiring information that may be detrimental to the interests of preparers. The most obvious example of this is where information is proprietary (that is, information that competitors could use to the disadvantage of the reporting firm) — the information may be useful to investors but disadvantage the firm that provides it. Furthermore, the provision of additional accounting information may provide information that is useful to investors and other users of accounts, but it may be expensive to acquire the data

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and process it, thereby imposing costs upon firms and reducing the value of the shares held by existing shareholders.

Accounting standards have the potential to affect levels of wealth and its distribution because they affect: decisions made by individuals who rely upon the accounts the terms of contracts that rely upon accounting numbers (for example, debt covenants

requiring that a company not exceed a certain ratio of debt to total tangible assets) decisions made by regulators who base assessments of ability to pay or of the harm felt

from regulation on the financial statements of the firms.

As long as accounting has economic consequences, some people gain from certain regulations and others stand to lose. As such, its regulation necessarily has ethical implications. Even the decision to ensure that the accounts always give a faithful representation of the firm’s economic circumstances involves an ethical assessment that needs or preferences of the users of the accounts have primacy over the preferences of the preparers.

9. You have been appointed as chief accountant of a firm that will be adversely affected by the method of accounting that is proposed in an exposure draft. Write a report of 500 words or less explaining to your Board of Directors how you could lobby the AASB to change its mind and adopt an accounting practice other than the one proposed in the exposure draft. Also comment on the costs and benefits of each to the firm.

There are many ways in which organisations might lobby to affect the requirements of an accounting standard: write responses to exposure drafts write to members of the accounting standards boards putting forward their views make oral presentations to the boards, or to individual members of the boards hold meetings where key issues are discussed and ensure that members of the accounting

standards boards are invited, or get to hear of the meetings hold demonstrations against a proposal that they do not favour — as occurred in the

Silicon Valley where executives demonstrated against proposals for accounting for executive stock options (the ‘Rally in the Valley’)

release media releases expressing their disagreement with proposed accounting regulation; these releases would then result in articles in the media or announcements over the news

form groups to lobby using any or all of the above methods offer to provide funding to the regulatory bodies for an accounting standard that suits

them.

The preceding methods have all been employed, and instructors may be able to think of others. Other less acceptable methods that have been employed include threats made to individual members of standard-setting bodies. Both financial and non-financial costs and benefits of each should be discussed, including reputational effects, the time and effort costs of organisation, and potential benefits from a standard that reduces information, bookkeeping, and contracting costs.

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10. In 2001 and 2002 there were several high-profile US corporate collapses associated with misleading financial statements and accounting practices. Following these collapses there were numerous calls for revisions to the US standard-setting process, and for more prescriptive accounting standards.(a) In your opinion, are more prescriptive standards likely to prevent deliberately

misleading reporting? Explain.(b) Are more prescriptive accounting standards likely to prevent corporate

collapses? Why or why not?(c) Are more prescriptive accounting standards better standards? Why or why not?

Students’ opinions as to the benefits associated with principle-based versus prescriptive-based standards will differ. The discussion, covering (a), (b) and (c) can be lead as follows.

Advantages of prescriptive-based standards: less interpretation required rules developed as a result of years of development and practical experience and

refinement.

Disadvantages of prescriptive-based standards: results in complex and voluminous standards cannot accommodate every conceivable transaction companies and auditors focus is on ‘complying with the letter of the law’ rather than

capturing economic substance of transactions and entities’ operations literal compliance may result in misleading information.

Advantages of principle-based standards: easier for preparers and auditors to evaluate whether the overall impact is consistent with

the objectives of the standard less complex regulation more responsive to emerging issues.

Disadvantages of principle-based standards: involves greater judgement in applying concepts and principles court challenges may result in greater refinement and inclusion of more rule-based

requirements.

Critics of FASB standards (for example, prescriptive-based standards) contend that the strict adherence to the rules contributed to the accounting scandals such as Enron. Enron exploited the rules to such an extent that, despite its having the controlling stake in about 900 special purpose entities floated by Enron, it managed to keep the entities and debt off the statement of financial position. This treatment did not violate US GAAP but principle-based rules (such as those issued by IASB and AASB) would have made it difficult to present consolidated accounts reflecting a true and fair view without these entities appearing on the statement of financial position.

Irrespective of whether the accounting standards are rule-based or principle-based, fraudulent financial reporting can result. It is not a consequence of the financial reporting standards but due to the unscrupulous, fraudulent and unethical behaviour of preparers.

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11.Each of the three theories of regulation discussed in this chapter has its strengths and limitations in describing accounting standard setting, either past or present. What do you believe are those strengths and weaknesses? Provide an example of where you believe each of the theories has applied, or is likely to apply.

Three theories of regulation are outlined in the text: Public-interest theory. Legislation is intended to protect consumer interests by

securing improved performance when compared with an unregulated situation. This assumes that there is market failure and consequently some groups will need to be protected from the opportunistic behaviour of others.If there is a market failure and the legislation can redress the failure’s impact then the public interest will be served. However, this assumes that the legislation will redress the failure and not introduce alternative forms of market failure. It ignores the fact that equity will often be a matter of viewpoint, and legislation is often the outcome of a complex lobbying process. Further, the theory assumes that the regulators do not have their own interest set.

Private-interest theory. Private-interest theorists believe that there is a market for regulation with supply and demand forces operating as in the capital market. Within this political market, while there are many bidders, only one group will be successful, and that is the group that makes the highest bid. Theorists believe that regulation does not come into existence as a result of a government’s response to public demands, but rather (as a rule) regulation is sought by the producer private-interest group and is designed and operated primarily for its benefit.But even if a group has a strong incentive to organise, there must still be a mechanism by which the group acquires and uses its influence. It also assumes that players are always seeking to maximise their wealth.

Regulatory capture theory. This theory argues that those who are regulated have an incentive to dominate the process, or in some way manipulate it to their advantage. Four such situations have been identified:– where the regulated entities control the regulation and the regulatory agency– where the regulated entities succeed in coordinating the regulatory body’s activities,

so that their private interest is satisfied– where the regulated entities manage to neutralise or insure non-performance by the

regulating body– where the regulated entities use a subtle process of interaction with the regulators to

ensure a mutual perspective.The concept assumes that the parties subject to regulation can form into a group or subgroup capable of capturing the process. In addition, capture will normally become apparent to observers in the community.

12. What are the key differences between US standards, Australian standards and international financial reporting standards?(a) Do you think Australia should adopt IASB standards? Why or why not?(b) Who stands to gain when Australia adopts IASB standards? Explain.(c) Who stands to lose when Australia adopts IASB standards? Explain.

Australian accounting standards and international accounting standards are principle-based, whereas US standards are more prescriptive and rule-based. With the harmonisation program Australia embarked on, there are

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many similarities between IAS and Australian standards. Major areas of difference requiring changes in Australian financial reporting pursuant to IAS adoption include intangibles, share-based remuneration and financial instruments.

(a) Australian accounting standard boards first articulated their goal of working towards harmonisation of Australian standards with international standards since 1996. The desire for uniformity is premised on the following advantages: preparer preparation costs reduced reduced investor confusion increasing cross-border competition consistency in external and internal reporting (How many firms affected?) enhances credibility of financial reporting lowers cost of capital.

Barriers cited against uniformity are: different business environments legal systems culture political considerations.

The restructure of the IASC has resulted in greater involvement in the IASB’s deliberations by national standard setters and a more workable board. Its revised objectives are (a) the development of IAS (to be known as IFRS) that require high quality, transparent and comparable information and (b) the promotion of IAS by working with national standard setters to bring about convergence.

(b)Adoption of IFRS will benefit: The users, as financial statements will be more comparable thereby enhancing their

usefulness in decision making Multinational companies may no longer have to prepare dual sets of accounts

providing that the exchange on which they are listed accepts financial statements prepared using IFRS without the need for reconciliation.

The resources dedicated to standard-setting arrangements in Australia may be reduced as a consequence of IFRS adoption, representing a cost saving to the Commonwealth Government.

(c) If adoption of IFRS results in changes to preparers’ financial reporting then firms are potential losers if there existing choices are efficient and optimal. It will be necessary to restructure contracts to accommodate the financial reporting consequences associated with adoption.The future of the AASB is uncertain given the commitment to adoption of IFRS. It can be argued that Australia’s intellectual capital in relation to accounting standard setting will be jeopardised.

13. What is the role of the Financial Reporting Council?

The responsibilities of the FRC are: to oversee the operations of the AASB (not involved in technical deliberations)

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to monitor the development of international accounting standards to promote adoption of international best practice accounting standards to monitor the operation of Australian accounting standards to assess their continued

relevance and effectiveness to seek contributions towards the costs of the Australian accounting standard-setting

process.

Members are appointed by the Treasurer and are to be representative of stakeholder organisations.

14. Do you think that all members of the Financial Reporting Council should be qualified accountants? Why or why not?

The FRC does not get involved in technical deliberations so it is not necessary that members be qualified accountants. (This would create the impression of regulatory capture theory.) It would be expected that the members of the FRC have significant business experience and be aware of accounting issues and the economic consequences associated with regulation. In their capacity as Council members they are interacting with the various stakeholders and should have an understanding of contemporary accounting issues.

Case Study 12.1 — Failures of character, not rules

1. The author comments that Australia has a long history of setting rules in response to periodic crises of confidence arising from events. Discuss which view(s) of regulatory theory this comment supports.

Setting rules in response to periodic crises of confidence arising from events is an example of public-interest theory. Legislation is intended to protect consumer interests by securing improved performance when compared with an unregulated situation. Such a response also seeks to restore confidence in financial reporting and the accounting profession and to legitimise the profession.

If there is a market failure and the legislation can redress the failure’s impact then the public interest will be served. However, this assumes that the market failure was a result of inadequate accounting rules and that legislation will redress the failure and not introduce alternative forms of market failure. It ignores the fact that equity will often be a matter of viewpoint and legislation is often the outcome of a complex lobbying process. Further, the theory assumes that the regulators do not have their own interest set.

2. Give some examples of accounting regulation initiated in response to crises of confidence arising from events.

Examples of accounting regulation initiated in response to crises of confidence arising from events include:

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presentation and disclosure of financial instruments, including derivatives, as a result of significant corporate losses associated with such instruments

re-examination of consolidation standard, particularly in relation to special purpose entities as a result of the Enron collapse

accounting standard requiring finance leases to be recognised on statement of financial position due to concerns with corporate collapses and significant debt obligations that were not recognised

accounting for provisions and contingencies due to the criticism of using provision accounts as ‘cookie jar’ reserves to manage earnings.

This list is not exhaustive. There are other examples that students may raise.

3. Do you think that the Australian professional accounting bodies have a role to play in fostering personal integrity and competency? How might the bodies promote personal standards?

The Australian professional accounting bodies do have a role to play in fostering personal integrity and competency (as do most professional organisations). It is in the interest of the professional bodies to ensure that the public has confidence in the services provided by their members. The bodies promote personal standards via codes of professional conduct, ethics and best practice guidelines. For example, CPA Australia’s Code of Professional Conduct (CPC) explicitly states that the objectives of the accountancy profession are to work to the highest standards of professionalism, to attain the highest levels of performance, and generally to meet the public interest requirement. The four basic needs to be met are credibility, professionalism, quality of services and confidence. Compliance with CPA Australia’s CPC is mandatory for all members and affiliates, with non-compliance subjecting the member or affiliate to disciplinary proceedings.

Case Study 12.2 — Time for debate

1. Explain the relationship between AASB and AAS accounting standards. What is the future of the AAS standards?

The PSASB was established in 1983 with responsibility for issuing accounting standards applicable to public sector reporting entities (AAS series). Consequent to the accounting standard setting reforms in CLERP1 this function was transferred to AASB, and the PSASB became defunct. Expected benefits from merger of AASB and PSASB included: consistency in private and public sector standards enhanced efficiency in the standard setting arrangements reduced duplication of time, effort and financial resources.

As a result of the merger, the AASB issues one set of standards (AASB series) applicable to both public and private sector organisations.

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2. Comment on whether you think accounting standards are equally applicable to private and public sector organisations.

The AASB has actively sought to make AASB standards applicable to both public and private entities. This attempt has been successful suggesting that accounting standards are generally equally applicable to private and public sector organisations. When circumstances would suggest differential treatment is required, the AASB standards address such issues. There are only three AAS with no equivalent AASB standard namely: AAS 29 Financial Reporting by Government Departments effective December 1996

requires production of general-purpose financial reports and consolidated reports. No other specific requirements override this one (additional not instead of).

AAS 31 Financial Reporting by Governments effective June 1999 requires Commonwealth, State and Territory governments to prepare general-purpose financial reports on an accrual basis.

AAS 27 Financial Reporting by Local Government deems each local government a reporting entity requiring production of general-purpose financial reports (other requirements additional to not in lieu of).

3. Given the objectives of general-purpose financial reporting as specified in SAC 2, do you believe the ‘most useful’ information is provided by a cash or an accrual accounting system?

There is far less discretion as to the timing of revenue and expenses under the cash flow relative to the accrual model. Accrual accounting is accepted as the means of best measuring performance during a reporting period. Cash flow is not necessarily a good measure of performance, as cash received and paid does not necessarily bear resemblance to whether the revenue is earned or expense incurred. The practice of firms to use the timing of revenue and expenses to achieve desired earnings results (for example, Internet firms) has renewed debate concerning the usefulness of the accrual process. There is a lot of noise associated with the accrual system and some firms have been able to defer the market’s recognition of their real value by manipulating information.

The overriding objective of general-purpose financial reports is to provide information that is useful for decision making. Users, relying on public sector financial statements to make decisions include ratepayers, taxpayers, Parliament and benefactors. Their decisions will be enhanced under an accrual system, as such a system: improves performance monitoring assists decision making by focusing on efficiency and effectiveness enhances and extends accountability by reporting on full cost and benefits of services

provided.

4. Referring to accounting concepts such as depreciation, capital assets, and unfounded liabilities, discuss why the author believes that accounting ‘is a bit of a dark art’.

The author believes that accounting ‘is a bit of a dark art’ as it involves judgements. More discretion and judgement is involved in an accrual system relative to a cash system. Students can examine the judgements to be

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made by a preparer in financial reporting, considerations related to depreciation (for example, useful life, residual value), capital assets (for example, expense or asset) and unfunded liabilities.

Case Study 12.3 — Aiming high from a low profile

1. Explain the role of the Financial Reporting Council (FRC).

The responsibilities of the FRC are: to oversee the operations of the AASB (not involved in technical deliberations) to monitor the development of international accounting standards to promote adoption of international best practice accounting standards to monitor the operation of Australian accounting standards to assess their

continued relevance and effectiveness to seek contributions towards the costs of the Australian accounting standard-

setting process.

Members are appointed by the Treasurer and are to be representative of stakeholder organisations.

2. The article comments that the FRC has been criticised for failing to raise money from the business community to fund the AASB. Do you think the AASB should be funded by the business community, and if it is, do you think this is likely to have increased, decreased or not affected the likelihood of:(a) regulatory capture? Why?(b) private interests prevailing? Why?(c) public interests prevailing? Why?

The article comments that the FRC has been criticised for failing to raise money from the business community to fund the AASB. The FRC is responsible for organising funding for itself and the AASB from (1) the Federal Government (2) business and (3) the accounting profession. AASB members are appointed in their own rights, not as representatives of any organisation (and this is impressed on the members), and the people who achieve the status to be members of the AASB are likely to be independent thinkers. As such, concerns about their decision making being affected by funding considerations should be minimal. Nonetheless, the AASB members who are high profile within their organisations do have a loyalty to their organisation. As such, it is likely that there can be some professional influence in the decisions of the AASB that would be compounded if businesses were contributing to the costs of running the AASB. It could be argued that businesses financially supporting the AASB would be more influential in the consultative process with a greater likelihood of achieving their preferred outcomes. Funding of the AASB by the business community would be likely to increase private interests prevailing. Funding of the AASB by the accounting profession would increase regulatory capture prevailing.

3. Jeffrey Lucy comments that all views on exposure drafts are considered. Given that the AASB is being criticised for moving too slowly, do you think the stages involved

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in issuing an accounting standard, as described in Policy Statement 1, are too rigorous? Why or why not?

A rigorous and consultative due process is followed prior to the pronouncement of an accounting standard. This due process is necessary as the AASB should be made aware of the implications of its determinations for corporations, despite its first obligation being to users of the accounts. If the interests of users and those of the corporations are at variance, the AASB needs to determine accounting issues on their merits, not according to corporate popularity. It is also fair to say that corporations generally do not all have the same view on all accounting matters, and that sometimes the strongest lobbyists in the consultative process are not totally representative of the corporations affected by an accounting regulation. As such, it is unlikely that all corporations will be happy to implement the decisions that are favoured and advocated in the consultancy process.

As with most issues in relation to accounting regulation, the answer is not clear-cut and a rigorous process is necessary. Remember that the UIG can issue pronouncements as a means of shortening the due process associated with issuing or revising an accounting standard dealing with the issue. The due process is a transparent one, with the AASB meeting in public and comment letters being publicly available via the AASB web site.

4. Do you think the AASB’s credibility is damaged if revisions to recently issued accounting standards are made?

The AASB’s credibility is not necessarily damaged if revisions to recently issued accounting standards are made. The revision could be a result of a number of circumstances including unintended consequences not foreseen in the consultative process, misuse of discretion afforded to preparers thereby compromising the comparability of financial information and/or international developments. Any revisions made by the AASB to make the information more useful for decision making should be applauded.

5. Provide some justifications for the revisions referred to. Do the revisions reflect the ‘impractical’ nature of standards that Tim Jonas refers to?

*Note: specific revisions are not referred to in the article.

6. Australia will adopt international financial reporting standards (IFRSs) from 1 January 2005. How will that affect the role of the FRC? (Students are advised to refer to the federal government web site to find the Corporate Law Economic Reform Program (CLERP 9).)

The decision to adopt IFRSs for accounting periods beginning on, or after 1 January 2005, was announced by the FRC in July 2002. CLERP 9 supports this move and proposal 14 states the FRC and AASB will have to consult stakeholders on the measures that they regard as necessary between now and 2005 to ensure a smooth transition to IASB standards.

The responsibility of the FRC is outlined in question 1 above. These responsibilities and institutional arrangements for standard setting do not change as a result of CLERP 9. However, CLERP 9 does recommend that the FRC’s expertise and responsibilities be

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extended to the audit area. Proposal 1 of CLERP 9 specifies that the Government intends to expand the responsibilities of the FRC to oversee auditor independence requirements in Australia. It is proposed that the responsibilities be extended to:

overseeing auditing standard setting arrangements advising the accounting professional bodies on issues of auditor independence monitoring and reporting on the nature and adequacy of the systems and processes

used by audit firms to deal with issuers of auditor independence monitoring and reporting on the response of companies in complying with audit

related disclosure requirements advising on continuing steps to enhance auditor independence promoting and advising on the adequacy of the teaching of professional and

business ethics by the professional accounting bodies and tertiary institutions monitoring and assessing the adequacy of the disciplinary procedures of the accounting

bodies maintaining responsibility for oversight of the accounting standard setting process

Chapter 13

The conceptual framework

Theory in Action 13.1 — Bovine assets and measurement in concept

1. Mark-to-market accounting improved AACo’s half-yearly profits by $28.1 million. Its third-quarter results have been negatively affected by mark-to-market accounting requirements. Do you think that mark-to-market accounting is consistent with the objective of general-purpose financial reports and the qualitative characteristics identified in the conceptual framework?

The desirable qualitative characteristics identified in the conceptual framework (SAC 3) are relevance, reliability, understandability, materiality and comparability. Advocates of mark-to-market accounting argue that it provides information that is more relevant to users’ decision making. The decision-making process is more informed, and hence likely to produce superior decisions, if users are aware of the ‘current’ value of firms’ assets. Mark-to-market accounting would also assist in achieving comparable information. The principal assets of firms such as AACo would be stated at their net market values at each reporting date, thereby making the information for such companies more comparable relative than if the assets were recorded at the cost of acquisition.

Critics of market value accounting cite the qualitative characteristic of reliability is compromised if market values cannot be determined by reference to an active and liquid market. SAC 3 recognises that relevance and reliability can involve a trade-off; however, SAC 3 does not rank one of these qualitative characteristics more important than the other.

2. AASB 1037 ‘Accounting for Self-Generating and Regenerating Assets’ (SGARAs) is applicable only to companies with living non-human assets. Do you think that the development of a conceptual framework will contribute to or reduce the growth in industry-specific standards?

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AASB 1037 ‘Accounting for Self-Generating and Regenerating Assets’ (SGARAs) is an industry-specific standard. The development of the conceptual framework, in particular a Statement of Accounting Concepts, dealing with measurement, could reduce the growth in industry-specific standards because a uniform measurement system would apply to all items. Conversely, the need for industry-specific standards arises due to the specific nature of the transactions involved or the unique and specific attributes of the assets and liabilities associated with the industry. As a conceptual framework can only consider issues at a general level, specific standards may be necessary to deal with how the general principles are to be applied to non-generic transactions.

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3. Do you agree that the change in the value of SGARAs should be recognised in the statement of financial performance? Why or why not?

The AASB determined the appropriate way to measure SGARAs is at net market value. The following arguments supported this conclusion: Net market value best reflects the future economic benefits embedded in SGARAs

because it captures the biological transformation that is inadequately reflected if historical cost accounting is applied.

Historical cost ignores price changes. Net market values enable the statement of financial performance to reflect a more relevant

measure of periodic performance based on decisions to hold SGARAs whose values might change for a range of reasons. This particularly applies to SGARAs involving a long production cycle.

Recognising net market values in the statement of financial position better reflects economic reality and provides information that is more useful for decision-making purposes.

4. How and why do you think firms with SGARAs initially reacted to the requirements of AASB 1037?

Any firm with SGARAs using conventional historical cost accounting principles is affected by this accounting standard. Students can be asked to include a list of industries whose existing practices are likely to be fundamentally changed by AASB 1037. The list should include industries with the following inventories: vineyards plantations (forests, orchards, crops) livestock (cattle, sheep, stud farms) aquaculture.

Firms with such inventories lobbied the AASB and former PSASB via written responses and presentations. Pursuant to the release of the exposure draft, such lobbying was quite intense. Respondents to the exposure draft (ED83) expressed concern at the requirement to measure SGARAs at net market value, particularly in relation to SGARAs with short-term production cycles (that is, wheat crops), bearer-SGARAs (that is, vines) and the relationship between some SGARAs and non-SGARAs (that is, trees and land). Some respondents also expressed concern about recognising unrealised revenues and expenses and the volatility this introduces into the statement of financial performance. The determination of assets’ net market value was also a concern to entities.

Other general concerns expressed by respondents included the departure from historical cost accounting principles in the absence of a statement of accounting concept dealing with measurement and whether Australian standard setters should pre-empt the issue of an international accounting standard on agriculture.

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5. Could the length of the due process in standard setting be reduced if an SAC 5 on measurement existed? Why do you think SAC 5 has not yet been developed?

The conceptual framework provides guidance on the existence of assets, liabilities, revenues and expenses. The subsequent recognition of these items in the financial statements depends on whether they have a measurable value. To date, no Statement of Accounting Concept on measurement has been developed; however, a theory monograph has been issued. This represents the initial formal stage in the development process. The monograph’s objective is to evaluate alternative bases and techniques for measuring elements of financial statements. As such it focuses on conventional historical cost accounting and alternative models based on current values. The monograph concludes that an asset’s (liability’s) carrying amount should not exceed (be less than) its value to the entity. The parameters for establishing value to the entity for assets include maximum value, minimum value and present value from use. Value to the entity for liabilities are maximum value, minimum value or value based on earning rate. The monograph supports relative current value accounting. This represents a departure from conventional historical cost accounting. Obtaining consensus amongst AASB members, regulators, professionals and the business community as to the ‘correct’ measurement bases will be a difficult (perhaps impossible?) task. The enormity, the difficulty and the contentious nature of the task have hindered the development of SAC 5. The AASB’s focus on harmonisation issues, and now adoption issues, has also restricted the availability of time and effort to devote to generic measurement issues.

Theory in Action 13.2 — Economic, social and environmental reporting — conceptual or not?

1. Do you think that the conceptual framework does, or should, embrace economic, social and environmental reporting?

Social and environmental reporting is the dissemination of information on the interaction between the entity, society and the environment, including information on performance and management. The traditional accounting system is premised on money as the unit of measurement. Assigning monetary amounts to social and environmental transactions or events is problematic, given that for many of these transactions there is unlikely to be a market enabling the transaction to be measured reliably. Hence, these ‘assets’ cannot be reliably measured using traditional techniques. It does raise the question as to whether we should only be seeking to measure economic benefits, when other real, but intangible, benefits flow from such assets (that is, biodiversity and retaining an asset for future generations). Traditional accounting seems inappropriate as a means of measuring the ‘worth’ of these assets. The limit of the scope of the conceptual framework to economic transactions does not preclude firms from reporting social and environmental performance separately to economic performance using measures that do not necessarily involve the assignment of monetary figures.

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2. The conceptual framework identifies various stakeholder categories. What are the categories? Do these stakeholders require information other than economic performance? If so, what type of information would be desirable and is the annual report an appropriate means of disseminating such information?

The stakeholders identified in the conceptual framework fall into three categories: suppliers of capital (for example, shareholders and lenders) recipients of goods and services (for example, customers) parties performing a regulatory review or oversight function (for example, ASIC, ATO).

Primarily the stakeholders identified by the conceptual framework have an economic interest in the entity, and the emphasis in the conceptual framework is on economic decision making and the provision of financial data. Expanding the scope of stakeholders interested in a firm’s performance, financial and non-financial, would necessitate the provision of information not currently required. This would include social and environmental performance. Examples of social performance information would include staff turnover, relative pay for female and male staff, and sponsorship of community programs. Examples of environmental performance would include penalties and fines for breaches of environmental laws, electricity and gas consumption, and consumables recycled. The most appropriate medium for disseminating social and environmental information would need to be evaluated. A number of Australian companies have embraced reporting to diverse stakeholder groups and provide environmental and social information via detailed reports in addition to financial reports. For example, Westpac has produced a comprehensive social and environmental report to supplement the financial performance conveyed in its financial reports. (Students should be encouraged to look at the report available on the company’s web site.)

3. The article refers to a survey conducted in which only 5% of companies surveyed were prepared to put environmental issues before the bottom line. Explain the meaning of ‘the bottom line’. Why do you think all the companies stating that they do this are resource companies?

The ‘bottom line’ refers to the economic performance of the entity for a particular period as reflected in the statement of financial performance. The term ‘triple bottom line’ refers to reporting the entity’s economic, social and environmental performance for a particular period. Given the difficulties associated with measuring environmental and social performance in quantitative dollar units, a separate social and environmental report can be produced to complement the financial performance report. Performance is assessed in quantitative non-dollar amounts or qualitatively.

The article refers to a survey in which only 5% of companies surveyed were prepared to put environmental issues before the bottom line. Often the attainment of desirable social and environmental performance compromises short-term economic performance. Hence the survey results are not surprising given that the traditional focus has been on a firm’s economic performance. Non-financial stakeholder activism has increased the information demands on entities. The strength of the activism, particularly environmental activism for resource companies, has resulted in some firms identifying additional stakeholders and responding to the information demands of such stakeholders. Failing to be responsive could impact negatively on the long-term value and sustainability of entities.

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4. Do you think that social and environmental responsibility facilitates the creation of shareholder value?

Reporting by some firms has extended to social and environmental reporting in addition to financial performance. For firms to expend costs associated with the production and dissemination of such information implies that they believe the benefits of doing so exceed the costs. Stakeholders are increasingly interested in a firm’s social and environmental performance, and a firm’s sustainability is related to such performance. A firm that is unsustainable is unable to create shareholder value! It is questionable whether a direct short-term effect on the share price can be observed associated with the provision of social and environmental information; but there are longer term intangible benefits, such as a firm’s reputation and credibility, that should enhance long-term value creation.

Theory in Action 13.3 — Understanding concepts

1. Paul Batchelor, the CEO of AMP, argues that AMP’s accounts need to be easier to understand and more comparable. Does the conceptual framework identify these characteristics as desirable? If so, how does the conceptual framework define these terms?

Understandability and comparability are qualitative characteristics of financial reporting identified in SAC 3. Understandability refers to ‘that quality of financial information which exists when users of that information are able to comprehend its meaning’. Information should be presented in an understandable manner without compromising relevance and reliability.

The conceptual framework defines comparability as ‘that quality of financial information which exists when users of that information are able to discern and evaluate similarities in, and differences between, the nature and effects of transactions and events, at one time and over time, either when assessing aspects of a single reporting entity or of a number of reporting entities’. Users should be able to ascertain if it is valid to compare the financial information for an entity over time or from one entity to another entity. This is the premise behind the requirement for firms to disclose the accounting policy choices and estimations they have made in preparing the financial information. Although comparability implies consistency it should not be regarded merely as consistency, because doing something consistently may impede improved financial reporting practices.

2. Can financial reports be understandable to all users? How does the conceptual framework face this issue? Are there any mechanisms in place to produce financial reports that cater to different levels of users’ understanding?

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The financial expertise of financial report users varies on a continuum from naïve to sophisticated. What level of financial literacy can preparers assume when judging if the financial information is understandable? SAC 3 specifies that determination of understandability should be in relation to ‘users who are prepared to exercise diligence in reviewing those reports and who possess the proficiency necessary to comprehend the significance of contemporary accounting practices’. This implies that understandability is judged in relation to sophisticated investors rather than naïve investors. SAC 3 commentary notes that users of general-purpose financial reports can always seek professional advice when interpreting the information conveyed.

Users have the option to request concise financial reports rather than full general-purpose financial reports. Allowing firms to produce concise financial reports is a mechanism catering to less sophisticated investors. The concise financial reports do not contain the financial information detail that accompanies full financial reports.

3. Do you think that the lack of comparability in accounting standards adopted by different countries hinders foreign investment in companies?

Proponents of harmonisation of accounting standards argue that the lack of comparability in financial accounting by different countries confuses investors. Consequential benefits flowing from consistent accounting standards are expected to be: more direct investment in Australian companies as overseas investors would be better able

to understand the financial reports lower the cost of multi-listed Australian firms preparation costs lower cost of regulation lower cost of capital as cross border competition would increase.

Given that SAC 3 interprets understandability with reference to a sophisticated investor, such investors could be expected to have an accounting knowledge that includes being familiar with accounting standards operating in other countries. Accordingly, adjustments could be made to reported accounting numbers by any entity or person contemplating investment offshore to eliminate the effect of accounting rule differences. Furthermore, any decision to invest offshore should be based on economic fundamentals. In markets that are perfectly efficient, differences in financial reports due to accounting rules should not have an impact on firms’ expected future cash flows and hence should not affect the economic fundamentals of the investment being considered. This argument would not apply if the market is naïve and can be fooled by accounting numbers.

4. Explain the concept of ‘vesting of options’. Do you think that vested options should be treated as equity or liabilities in the statement of financial position?

Firms can issue options to employees, executives and directors with time and/or performance criteria restricting when and if the options can be exercised. The term ‘vesting’ refers to options that have satisfied the time and/or performance criteria and therefore can be exercised immediately at the holder’s discretion. The International Accounting Standards Board (IASB) exposure draft on share-based payment (ED2) was released in November 2002. The exposure draft intends for the fair value of stock options granted to be recognised as an expense in the statement of financial performance over the options’ vesting periods. FASB has also announced its intention to reassess the flexibility provided in FAS 123 to either expense or disclose

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the fair value of stock options. The Australian Accounting Standards Board (AASB) has issued exposure draft 108, an invitation to comment on IASB ED2. Given that AASB standards will be converged with the IASB standards existing at 1 January 2005, it is expected that future reporting and recognition rules for stock options will be consistent with IASB pronouncements.

5. Given that the performance-based remuneration of AMP’s CEO is related to total shareholder returns rather than profit numbers, no incentive to manage profit is created. Discuss.

Total shareholder return (TSR) refers to share price growth and dividend income. Various performance-based criteria can be, and are, used by firms to decide performance-based pay; although the frequency of long-term incentives being linked to TSR is increasing. Alternative criteria include accounting profits, performance relative to peer companies, performance relative to an index and economic value added. The incentive to manage profit does not necessarily disappear when performance is assessed using TSR. Accounting income is useful in predicting future earnings and cash flows and thereby influencing share price. In turn, the opening and closing share price affects TSR. Another incentive to manage accounting profit could be associated with the desire to maximise dividend distributions. The dividend return is a component of TSR. As dividends can only be distributed from accounting profits, maximising accounting profits would enable higher dividends to be distributed.

Incentives to manage profits may also exist via the existence of contracts other than the compensation contract (for example, debt contract and social contract). Therefore, the removal of explicit profit-based performance remuneration will not necessarily eliminate the incentive to manage earnings.

Theory in Action 13.4 — Concepts in substance

1. Explain the meaning of ‘substance over form’. Do you think the conceptual framework promotes substance over form?

Substance over form generally refers to the economic substance of the transaction/item as distinct from its legal form. A good example to illustrate this distinction is in relation to redeemable preference shares. Legally, a redeemable preference share is a share and hence regarded as equity. For accounting purposes the characteristics of the security — in this example, its redeemability — render the security more akin to a debt instrument. Hence its economic substance would be debt requiring it to be classified in the liability section of the statement of financial position.

The other interpretation that David Murray appears to be referring to is that of principle-based rules as distinct from prescriptive-based rules. Australian standards rely on principle-based rules whereby the form of the transaction is considered in determining the appropriate accounting treatment rather than applying prescriptive rules and a check box mentality to determine the accounting treatment.

2. Explain how analysts ‘use’ financial reports and the role analysts play in influencing firms’ reporting practices.

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Analysts use financial reports as a tool to assist them to derive a firm’s intrinsic value. Based on the valuation derived, a buy/hold/sell recommendation can be made. In determining the value of a company, analysts employ fundamental analysis. It is necessary for analysts to project expected future cash flows and earnings, and the historical financial reports are often a good starting point. Analysts form expectations as to the future profitability of firms, and often these forecasts are published. This creates an incentive for firms to either beat or meet the forecasts. Empirical studies demonstrate that negative share price reactions are generally associated with earnings forecasts below that expected by the market. To avoid negative market sentiment, firms use accounting discretion to manage the earnings numbers.

3. Analysts expressed concerns over a number of the accounting treatments adopted by CBA including:(a) the $5.3 billion in the statement of financial position attributed to the excess of

net market value over net assets of the life insurance controlled entities(b) the $65 million write-back against the general provision to keep the provision for

bad debts to $290 million.4. With reference to the conceptual framework and any applicable accounting

standards, can you justify these accounting practices of CBA?

For questions 3 and 4, students should contemplate the impact of CBA’s accounting treatments relating to recording the excess of the net market value over the net assets of the life insurance controlled entities and the write-back against the general provision. These accounting treatments have increased the asset base of CBA permitting a greater asset backing to be reported. The conceptual framework is devoid of a measurement standard so the appropriateness of recording the $5.3 billion excess of net market value over net assets of the life insurance controlled entity can only be assessed in terms of qualitative characteristics specified in SAC 3. CBA could argue that this accounting treatment produces a more relevant line in the statement of financial position and is consistent with being permitted to record non-current assets at fair value. However, the fact that the other banks do not account for similar transactions in the same manner jeopardises the comparability of financial reports. The reliability of the net market value determination could also be questioned.

The provision for bad debts should be used to ensure that the debtors are recorded in the statement of financial position at their cash equivalent (that is, the money that is expected to be received by the entity). Banks have been accused of using the provision account to manage their earnings. The provision account should reflect the estimate of the debts unlikely to be collected. This estimate should be based on the age of the debt and economic conditions at the time. CBA’s write-back implies that previous bad debt estimates, in the light of new evidence, were overstated. Alternatively, the provision could be interpreted as a ‘cookie jar’ that can be used to bolster and store ‘earnings’ in particular reporting periods.

5. The bank indicated its capacity to increase its level of hybrid securities. What are hybrid securities? In terms of capital adequacy requirements and risk weightings imposed on financial institutions, hybrid securities are a separate classification. Does the conceptual framework differentiate between ‘straight’ and ‘hybrid’ securities?

Hybrid instruments display characteristics resembling both debt and equity (for example, redeemable preference shares, convertible securities). By

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combining various debt and equity attributes, instruments can be tailored with varying risk–return characteristics. For capital adequacy purposes, hybrid securities are treated as a separate category. However, the conceptual framework and various accounting pronouncements prescribe a dichotomous classification system: debt or equity. SAC 4 defines equity as ‘the residual interest in the assets of the entity after deduction of its liabilities’. The essential features to examine in distinguishing liabilities and equity are the: rights of the parties economic substance of the transaction.

The distinction between liabilities and equity should be based on economic substance rather than legal substance, with the classification of these securities in the statement of financial position reflecting their economic substance. The economic substance needs to be assessed by considering the characteristics of the securities. AASB 1033 specifies various hybrid instruments and their appropriate classification. Particular attention is given to the exposure of the holder of the security to the issuer’s equity price. If the holder is exposed to changes in the value of the issuer’s equity, then the security is more likely to resemble equity and needs to be classified accordingly. AASB 1033 does recognise that some hybrid securities contain both a debt and equity component (that is, convertible note) and each component should be valued and split accounting used.

Questions

1. How does the Australian conceptual framework of accounting attempt to create a theory of accounting? Describe the components of the conceptual framework and how they contribute to a theory of accounting.

The Australian conceptual framework, like its US counterpart, does not employ the term ‘theory’ because of the difficulty of demonstrating logical consistency and in gathering empirical evidence to corroborate the theory. However, by following a structured program of inter-related concepts, accounting regulators aim to use the conceptual framework to achieve consistent accounting standards that will replace ad hoc solutions to specific problems. In this context, the components of the conceptual framework can be viewed as the building blocks of a theory of accounting.

The components of the Australian conceptual framework are shown in figure 13.1 (p. 451). At its highest theoretical levels the conceptual framework states the scope and objective of financial reporting. At the next and most fundamental conceptual level, the qualitative characteristics of financial information (such as relevance, reliability, comparability, timeliness and understandability) and the basic elements of accounting reports (such as assets, liabilities, equity, revenue, expenses and profit) are identified and defined. At the lower operational levels the conceptual framework deals with the principles and rules of recognition and measurement of the basic elements, and the nature of the information to be displayed in financial reports.

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2. Some people argue that there is no need for a general theory of accounting, as established in a conceptual framework. They argue that there is no overall theory of physics, biology, botany or psychology, so there is no need for an overall theory of accounting. Furthermore, attempts to develop an overall theory of accounting are futile and unnecessary, since accounting has not needed a conceptual framework so far. Debate this view.

It is true that in the physical sciences, there is no overall theory of a given field of study. There is no theory of chemistry, or biology, etc. Some scientists have attempted to formulate such theories, but have failed. It is generally agreed that such theories would be beneficial because they would provide an integrated explanation of all aspects of the given field of study. At present, different theories in a given discipline — for example, in biology — remain as separate categories, and often the connection of one theory to another is not known.

Theories in the sciences are descriptive, but in accounting an overall theory would be normative, telling accountants what ought to be done. This would be very useful if it could be formulated. It would serve as a standard by which to judge practices. Although the probability is slim that in the near future a logically consistent overall theory can be constructed, a theoretical framework such as the conceptual framework can be helpful.

It is true that the profession has survived without a general theory, but a theory of some sort has always been in mind. Constant reference to generally accepted accounting principles reveals this. It would be easier to assess accounting practices and to formulate standards consistent with each other if a general theory existed. If a theory is empirically verified, accounting methods for particular purposes would also have empirical evidence to support them. In other words, we would be able to present evidence as to why a certain procedure (for example, FIFO inventory valuation) should be used rather than another method.

3. What does the Australian conceptual framework describe as the basic objective of accounting? What are its implications?

Stewardship looks primarily to the past, asking the question: What happened? Decision making looks to consequences in the future, asking the question: What will happen? A decision-making approach sees accounting information as inputs for the decision-making prediction models of users. If so, then we are concerned about what kind of accounting information is relevant to decision makers. Some believe that current value is implied. Also that statement of financial position accounts and their amounts are as important as those in the income statement. Traditional accounting emphasises income.

4. What type of information do you think is useful for shareholders, lenders and creditors? Is this the type of information that is currently provided?

Useful information is both relevant and reliable. Presumably, it is also ‘fair’.

Adopting a narrow perspective, useful information provides a basis for investors and creditors to assess the amount, timing and uncertainty of future cash flows for themselves based on the expected cash flows of the firm. Such a basis is provided by information concerning the profitability and financial condition of the firm. In turn, this information is presently reported in the statement of financial performance or the statement of financial position, and the

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statement of changes in financial position. For the latter, many believe a cash flow statement is especially pertinent.

Taking a broader view, useful information helps to efficiently allocate capital in the economy. (Question 6 deals with this.)

5. The expressions ‘truth’, ‘justice’ and ‘fairness’ have all been applied to describe desirable characteristics of accounting information. What role do you think they play in practice? Are they included in the conceptual framework? If so, how? If not, why not?

Truth, justice and fairness are socially desirable goals. Accountants should be concerned that the information they report is true, just and fair. The audit opinion indicates a concern for the above-stated goals. Useful information is relevant and reliable, and these latter terms encompass the broader ones of truth, justice and fairness. However, we should understand that what is true, just and fair often depends on who is making the judgement. The company may believe that its financial statements meet the criteria of truth, justness and fairness, but the shareholders may not think so. Accountants are often caught in the middle. This is all the more reason why a general theory of accounting, especially one that is supported by evidence, is important to accountants.

Students should be asked if the following procedures cause information to be ‘true, just and fair’: LIFO inventory valuation; historical cost of land purchased 20 years ago.

6. Explain the role of accounting in relation to:(a) individuals(b) firms(c) the Australian economy.

Accounting information helps to efficiently allocate capital in the economy.

The successful operation of a free economy depends, to a large extent, on the good judgements made by individuals about their investment opportunities and the investment opportunities of firms. People need information to decide where to invest or lend, and at what price.

In relation to firms, accounting information forms the basis for many contracts, such as debt contracts that include covenants specifying that the firm will not allow its leverage ratio to exceed a certain level, or management compensation plans that provide managers with bonuses based on reported corporate earnings. As such, the firm’s cash flows are tied to accounting numbers. Since the value of the firm is the present value of all future cash flows and those cash flows are tied to accounting numbers, accounting numbers determine the value of the firm.

In relation to the economy, accounting information plays a vital role in the equitable allocation of capital, and it contributes to the effective performance of the price system. The effective operation of our economy means that efficient and inefficient companies must be identified, so that resources are channelled to the former and away from the latter in order to have a ‘successful’ economic system. What would happen, after a long period of time, if

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‘incorrect’ information is reported? The economic system would become inefficient (because of the existence of many inefficient firms), causing serious economic problems to all.

7. Can accounting ever provide an unbiased map of economic reality? Why or why not?

Yes. Criticisms of neutrality or freedom from bias take two forms. First, some argue it is a state of mind that is not attainable, because all of us are affected by personal values that have been shaped by our particular beliefs, traditions, environment, background and personality. Granted that this is true, it is still meaningful to speak of neutrality or freedom from bias. We recognise the existence of these influences on our perceptions. The idea is to control them within an acceptable range.

Second, some contend that neutrality or freedom from bias is not operational, because we cannot be expected to read other people’s minds. However, it is possible to translate neutrality or freedom from bias into operational terms by establishing specific control devices that are external and subject to examination.

Control devices are the means by which the notion of objectivity receives operational meaning. Control devices have to do with making public or external what is essentially internal or introspective. Rules and procedures under the heading of disclosure, consistency, comparability, and materiality as well as GAAP are practical control devices.

In the accounting literature, practical control devices under the heading of objectivity have taken the following three forms: to make specific and precise the concepts and procedures of accounting, and to obtain

general agreement on them to determine a consensus of the measure among a number of experts to improve the standards of competence and ethics of the profession.

Accountants must construct unbiased or neutral financial maps of economic reality. Otherwise, as Solomons warns, ‘If it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed’.

8. Some argue that the development of a conceptual framework is inappropriate because accountants constantly deal with specific issues that will not be envisaged by an overall, general conceptual framework. In particular, a conceptual framework makes no allowance for differences in the social contexts where accounting is applied. They also argue that it would be preferable to develop case-specific solutions to accounting issues, based on case study research, and bearing in mind the social contexts of all accounting decisions. Discuss this view, presenting arguments for and against it.

Determining ‘best’ accounting methods for situation-specific problems can be accomplished in a more systematic and consistent manner if there exists an underlying theory to guide solutions to problems.

In the absence of an overall theory, the results of a micro or case study approach cannot be generalised to other situations. There is also the possibility that the same or a similar problem might be solved in an entirely different and contradictory manner if there is no overall theory

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or set of generally accepted principles to restrict the ad hoc subjectivity of the decision maker. The results of case studies can, however, be used as empirical evidence in constructing a theory of accounting.

9. What is the difference between art and science? Is accounting an art or a science? Does it matter? Why or why not?

Whether accounting is an art or a science has long been debated by accounting academics without coming to an agreement. One position in the middle of the two extremes is that accounting theory is a science whereas accounting practice is an art. According to Sterling, there is nothing inherently unscientific in accounting. In fact it is the approach adopted by the researchers in a discipline that makes the discipline scientific or otherwise.

Accountants who believe in the scientific approach seek empirical evidence to support accounting practices so that practitioners can recommend the most appropriate methods for given situations based on the evidence. The scientific approach in accounting is not an attempt to make scientists of practitioners, nor is it an attempt to discuss ‘absolute truths’, since there are no absolute truths in science.

Looking at the research in accounting, particularly during the last 30 years, one can see a great deal of analytical as well as empirical research; both being integral parts of a scientific theory. It is therefore inappropriate to claim that accounting is in the pre-science stage.

10. What are provisions? How are they to be accounted for under Australian accounting standards? Is this consistent with the conceptual framework?

At the time of writing, provisions are defined in a draft accounting standard as ‘liabilities for which the amount or timing of the future sacrifice of economic benefits that will be made is uncertain’. Liabilities are defined in SAC 4 as ‘future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events’. As such, provisions are a subset of liabilities. They are at the ‘more uncertain end of liabilities’.

However, it must be recognised that all liabilities have some degree of uncertainty attached to their incurrence and/or payment. Provisions are described as involving a greater degree of uncertainty than other liabilities. Provisions that fail the criteria for recognition as liabilities are contingent liabilities. These contingent liabilities are provisions for which it is improbable that the future sacrifice of economic benefits will ever be required, and provisions whose amounts cannot be measured reliably.

At the time of writing, under Australian accounting standards, provisions are not granted a separate status, so their accounting is not prescribed in a general sense. Assuming that the current draft accounting standard on provisions and contingencies is approved, it will require reporting a separate class of liability as provisions. This is not entirely consistent with the conceptual framework, which does not categorise assets or liabilities according to degrees of certainty. There is no need for a separate class of liabilities called provisions.

11. The conceptual framework has not proceeded to SAC 5 concerning measurement.(a) Why do you think that is the case?

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(b) Do you think that accounting standards have been moving towards a particular measurement method? If so, what is that method?

(c) How can standards lead the development of a formalised conceptual framework?

(a)SAC 4 was highly controversial. SAC 5, dealing with measurement, would be even more controversial. As such, it is fair to say that standard setters worldwide have felt that the business community is not yet ready to accept a standard prescribing measurement methods. Furthermore, while the majority of the AASB might agree on a particular general approach to measurement (for example, current market values) it is likely that the AASB would have great difficulty obtaining agreement on more specific issues (such as how to treat transactions costs, discounts, etc.). It has been deemed prudent to defer development of SAC 5 until the community will be more accepting, and AASB agreement is more likely.

(b) Increasingly, accounting standards have been requiring use of net market values, which are current market selling prices less transactions costs. Some regard this as ‘back-dooring a current market SAC 5’.

(c) Standards can contribute to the development of a formalised conceptual framework. If they introduce concepts or methods that become more accepted once they are prescribed in an accounting standard, this provides a lead-in to a more general document such as a Statement of Accounting Concepts for the conceptual framework. For example, the more standards require measurement at net market value or disclosures of net market values, the more acceptable the method becomes, and the easier it is likely to be to gain general acceptance of a Statement of Accounting Concepts that requires measurement at net market values.

12. Give reasons for your answers to the following questions.(a) How important is it that standard setters agree on objectives, concepts and

definitions before they develop a conceptual framework of accounting?(b) How important is it that the conceptual framework is generally accepted by the

business community before it is applied to develop accounting standards?

Although it is important that prior agreement be reached on concepts and definitions in the conceptual framework programs so that there is no confusion in understanding the subject matter, one must remember that substantive knowledge comes from investigation of the subject matter, not from prior agreement on definitions. We should take care that statements we make should never depend on the meaning of our terms. Unfortunately, this is not the approach of the conceptual framework projects. For example, when they define ‘assets’, ‘liabilities’ and so on, they intend that the valuation decisions should depend on the definitions. Similarly, prior agreement on the objective of financial reporting may be biased towards a particular valuation system.

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13. Explain the ‘constitutional’ approach to accounting standard setting. Does it contrast with any other approach? If so, how? If not, why is it the only approach? What are the implications of adopting a constitutional approach?

The ‘constitutional approach’ to accounting standard setting is the approach whereby principles are derived from axioms — that is, self-evident truths. This approach to accounting standard setting will largely re-endorse pre-existing principles resulting in standards of conceptual frameworks that will be a reflection of either the will of the dominant group or a consensus between competing and conflicting political influences. Moreover, standards and conceptual frameworks will perpetuate accounting conventions and doctrines because these conventions and doctrines will be regarded as self-evident truths.

14. Discuss whether the Australian conceptual framework is merely a policy document based on professional values and self-interest, without scientific foundation. In your discussion, state your opinion on whether the conceptual framework should serve as a policy document in this manner.

This question covers the last part of the chapter under the heading ‘Professional values and self-preservation’. Students can expand on the following major points: Accountants have a special status in the society. In Australia this is witnessed by the

Royal Charter endowed on the Institute of Chartered Accountants, the profile associated with the CPA program of CPA Australia (formally the Australian Society of CPAs), and the professional monopoly by the two major accounting bodies.

The ability of the accounting profession to retain legitimacy as a profession will be judged by society, in terms of the apparent coherence and theoretical defensibility of the profession’s body of knowledge; hence the need for a conceptual framework (Hines, 1989).

The conceptual framework plays a vital political role in maintaining self-regulation and in lobbying against increased regulation by government bodies.

A conceptual framework program alleviates the criticism of the diversity of accounting standards — a major threat to the profession’s loss of control of the standard-setting process.

The conceptual framework project is not about setting rules for accounting practice; rather, it is about legitimising the process of accounting practice.

15.Assume that you have been contracted by the Australian Accounting Standards Board to develop a proposal regarding whether to issue an accounting standard on accounting for the costs of environmental damage. Draft a proposal of 1500 words or less outlining why you think it is appropriate, or inappropriate, to develop an accounting standard on this issue. Also outline the key issues that would need to be covered by the standard and how the conceptual framework can contribute to resolution of those issues.

The purpose of this question is that the students should be able to apply what they have learnt from the conceptual framework project and other readings to the general issue of standard setting. The best way to approach the question is to address the following key points: alternative approaches to standard setting the scope of the proposed standard reference to academic accounting research

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potential benefits or drawbacks of the standard.

Students could begin with a classification of various approaches to an accounting theory: empirical inductive approach the deductive approach (true income, user needs, information economics) new empiricism.

They could then discuss the implications of these approaches for the standard setting bodies — for example, problems (or impossibility) of measuring true income; economic consequences of accounting standards; and the political nature of the standard setting process.

This should then lead into a discussion of the topic itself: What is meant by the ‘costs of pollution’? What type of pollution are we talking about:

air, water, noise? Does costs mean costs actually incurred by the company to avoid polluting the environment, or is it a valuation of the pollution costs to the company/society through the company’s operations? How can one measure these costs?

The subject matter is important as it has clear implications for the scope of the proposed standard. Is it to be a valuation standard (requiring auditors to check the company’s valuation of pollution costs) or is it a disclosure standard (requiring the company to disclose fines or reports by inspectors, etc.)? Students should include some comments on the past success of the standard-setting bodies on inflation accounting, research and development expenditure, etc.

This will eventually follow into a discussion about the political nature of the accounting standard-setting process. Does the standard-setting body have enough power to set such a standard? Will the powerful lobby groups frustrate any change? What is the benefit of loosely worded, vague and subjective standards? Would the standard achieve anything or is it just an exercise to show that something is being done so that the accounting profession’s self-regulation is not threatened?

16.Write a report of 1500 words or less to the chairpersons of the Financial Reporting Council and the Australian Accounting Standards Board, commenting on the following argument:

Attempts to bring about radical change through the introduction of a conceptual framework have failed. When it appeared as though SAC 4 would require firms to report their true liabilities, lobbying began in earnest and business ensured that any innovation was quashed. As such, the best that can be hoped for from a conceptual framework is that it legitimises current practice, maintains existing social and economic status, and staves off public sector attempts to control accounting standard setting.

This question covers the whole chapter. In addition to the answer to question 7, students should summarise the scientific criticisms levelled at the conceptual framework projects, and should also cover the material under the heading ‘The conceptual framework as a policy document’. In their answer, students should discuss the following points: The purpose of the conceptual framework was that prior agreement on fundamental terms

would minimise inconsistencies. SFAC No. 5 states that concepts are to be developed as the standard-setting process evolves. The question is: How can a conceptual framework guide choices from among alternative principles and rules if the elements of the framework are defined in those very same terms? (Dupuch and Sunder)

Definitions are general and vague.

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Recognition criteria are couched in terms of (subjective) probabilities. The measurement problem is open-ended. Contrary to Popper, the FASB sought for the definitions to bear as much weight as

possible (Gerboth). This is true, also, of SAC 4’s role in Australia. Ontological assumption. The conceptual framework adopts an economic realism–

measurement approach. According to Hines, ‘we communicate constructed reality’. Hence, can we provide information that is neutral, independent and free from bias?

Demski’s impossibility theorem Epistemological assumption:

– scientific truth has no absolute truth (Feyerabend).– accounting researchers believe in a (confused) notion of empirical testability (Chua).

Circularity of reasoning — for example, reliable information depends upon recognition and recognition depends upon reliability.

Conceptual framework ignores findings from capital market research. Conceptual framework is a policy document. According to Tinker, it is merely an attempt

to legitimise an ideological position at the theoretical level. Conceptual frameworks appear to reinforce existing principles.

17.What are ‘bright lines’? Why do many argue that the bright lines approach to developing accounting standards may have contributed to corporate collapses in the United States? (To answer this question fully, you will need to think beyond the text.)

‘Bright lines’ refer to a rule-based approach to standard setting followed by the FASB, with the bright lines being the specified rules. This approach to standard setting can be contrasted with the principle-based approach adopted by the IASB and the AASB. Supporters of the rule-based approach argue that a principle-based approach leaves too much interpretation and preparer discretion. Supporters of the principle-based approach retaliate by noting that the voluminous guidance and complexities contained within FASB standards did not prevent corporate collapses and scandals such as Enron and WorldCom. To illustrate this point, Enron was able to keep debt off the statement of financial position held in special purpose entities due to the rule-based percentage approach used to determine control and recourse. The AASB and the IASB use qualitative rather than quantitative approaches to the determination of control. Principle-based rules focus on the economic substance of transactions rather than comparing the form of the transaction with adherence or otherwise to the rules. It is also contended that principle-based standards are less complex and responsive to contemporary and emerging issues.

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Case Study 13.1 — Time to reflect reality

1. On what basis is the author arguing that accountants are addicted to fiction? Is the author’s view supportive of the views espoused in the normative era of accounting theory?

The author’s claim, that accountants are addicted to fiction, is premised on the divergence between the carrying value of net assets on the statement of financial position and the market value of a firm’s equity. The difference (MVE > BVE) could be attributable to: missing or undervalued assets overstated liabilities.

The author is critical of the statement of financial position not reflecting a firm’s economic reality. He cites the practice of recognising assets at their historical cost with no consideration being given to changes in the purchasing power of money as fictitious. This supports the views espoused by normative accounting theorists. The proponents of alternative measurement systems argue that the purchase price of assets added and stated in dollar amounts at the date of acquisition is not meaningful. To be meaningful, the parts that make up the total should all be valued on the same basis — that is, refer to a single characteristic.

2. Can the conceptual framework be used to resolve the issue as to whether ‘the more complex intangibles’ should be recognised on the statement of financial position?

The conceptual framework can, and should, be used to tease out the issue as to whether the more complex intangibles should be recognised on the statement of financial position. The conceptual framework cannot necessarily resolve the issue as application of SAC 4 requires professional judgement and interpretation.

Students should be encouraged to debate this issue by applying the asset definition and recognition criteria to various intangible assets such as customer lists, goodwill, brand names and mastheads. The contentious issue will resolve around opinions as to whether the recognition criteria are satisfied (for example, are the future economic benefits probable and can they be measured reliably?) The recognition debate should draw out issues such as geneology, identifiability and appropriate valuation techniques. When debating, due consideration should be given to the desirable qualitative characteristics namely relevance and reliability.

3. In developing SAC 5 on measurement, do you think that standard setters would specify rigorous and explicit measurement requirements?

To date, the conceptual framework ‘pyramid’ does not include a statement of accounting concept dealing with measurement. Over the past few years, measurement is being addressed via individual accounting standards. Recent pronouncements suggest a movement towards fair value accounting (for example, SGARAs, financial instruments). As noted in the solution to question 13, standards can contribute to the development of a formalised conceptual framework. If they introduce concepts or methods that become more accepted once they are prescribed in an accounting standard, this provides a lead-in to a more general document such as a Statement of Accounting Concepts for the conceptual framework. The more pronouncements dealing with fair value, the more acceptable the method becomes, and the

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easier it is likely to be to gain general acceptance of a Statement of Accounting Concept that requires such measurement. The Standards issued that depart from historical cost are fairly liberal in terms of determining fair value when an active and liquid market is absent. Standard setters would be unlikely to specify rigorous and explicit measurement requirements in a Statement of Accounting Concept, as this moves towards a rule-based approach to regulation and would move beyond providing a measurement framework for users and preparers to reference.

4. What is the ‘four pillars of banking’ policy referred to in the article? The author concludes with a dismissive comment that the banks should have a value in their statement of financial position for the oligopoly rent awarded to the licence holder. Applying SAC 4 criteria, does this constitute an asset?

The Australian Government’s ‘four pillars’ policy is regulation that prohibits any mergers between the four largest Australian banks. It is designed to ensure competition in the banking sector, and to protect the interests of banking customers. In the opinion of some/many, if the largest banks merged in any way, the dominance of the merged entity would ensure its ability to out-compete the remaining banks, function with many monopolistic powers, and potentially exploit customers through high interest rates and other terms. As such, the policy exists to protect customers from these effects. In the past, Australia’s largest banks have reported high profits. These high profits have led to accusations of customer exploitation since the profits are earned largely through the differential between interest charges by the banks and the interest that they pay on deposits. In turn, the accusations have contributed to political interest in the issue, and the potential for a political ‘white knight’ to advocate banking customers’ interests by introducing regulations that constrain the potential of the firms to exploit customers.

The author’s dismissive comment that the banks should have a value in their statement of financial position for the oligopoly rent awarded to the licence holder is referring to the ‘excessive profits’ that the banks can generate due to their captive customer base. To be recorded as an asset this would have to satisfy the asset definition and recognition criteria. SAC 4 defines an asset as being service potential or future economic benefits controlled by the entity as a result of past transactions or other past events.

Licences are granted to banks and it can be argued that the licence provides the banks with future economic benefits as it can generate cash flows via its privilege to offer services. It could be argued that the banks control the benefits as they determine whether they comply with the licence requirements. Presumably the licence cannot be withdrawn unless there is a breach of the requirements. Alternatively some would argue that the banks do not control the licence as this rests with the prudential regulator and ultimately the Treasurer. The past event would be the granting of the banking licence. Should the licence satisfy the asset definition criteria, the issue of measurement needs to be considered. Students should recall that assets acquired at no cost are still recognised if their value can be determined. Incorporating the oligopoly rent into the value of the licence fee would be problematic as it does not trade, hence there is no observable value — and attaching a value to the rents would be unreliable and lacking in substance.

5. In your opinion, should a statement of financial position reflect economic reality? Why or why not?

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Standard setters have a difficult task in trying to ensure that information in financial statements is useful for decision making while satisfying the relevance and reliability criteria. To maximise decision usefulness the information contained in the financial report should represent economic reality. Accordingly it follows that assets and liabilities should be valued at their ‘economic value’, where value is represented by the discounted future cash flows associated with the items. Accounting standard setters are moving towards this approach as evident by mandatory standards governing leases, employee entitlements, superannuation and insurance reporting, SGARAs and financial instruments. However, subjectivity associated with constructing economic reality is a reason cited for statement of financial position values to reflect historical cost and/or an objective value. The recording of assets at their economic value will need to be accompanied by increased disclosure with respect to the method used to determine such a valuation. Users of general-purpose financial reports can then make a more informed assessment as to the subjectivity involved and the degree of conservatism in such an approach. From a financial statement preparer’s perspective, the concern with recording economic values is the volatility that it introduces into reported earnings figures. The inability for constituents to form a consensus view on the appropriate measurement of assets and liabilities will impede the development of SAC 5.

Case Study 13.2 — Share-based remuneration: the root of all corporate evil

1. When deliberating proposed accounting standards, what should be the overriding objective? Do you think that the FASB’s actions in relation to executive share options are consistent with the conceptual framework?

The overriding objective to be considered when deliberating proposed accounting standards is whether the proposed requirement will produce information that is useful for economic decision making. When pronouncing accounting for stock options, the FASB permitted a choice: recognise the options granted as an expense or disclose this information in the notes to the accounts. Regardless of recognising or disclosing (all but 2 US firms disclosed), the information is being provided to users via the financial reporting process. The issue effectively becomes whether the value relevance of information is dependent on the information being disclosed or recognised.

2. In relation to the issue of executive share options, who would be interested in the disclosures and why would they find this information useful?

Many parties would be interested in options granted, and the performance hurdles linked to such grants. Interested parties include: shareholders, employees, competitors, other managers in the organisation, executives of other firms, executive placement organisations, researchers, and other parties identified by students. The information would be useful in forming opinions as to: Shareholders: Are they getting ‘value for money’? Is there a wealth transfer from them to

the managers entrusted to generate wealth for the shareholders? Is the option component likely to provide appropriate incentives (alignment with those of the shareholders)?

Employees: Is there a fair distribution of remuneration across the employees of the organisation? Who is able to participate in option schemes? This is the sort of information

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that the employees would want to use for purposes of lobbying for wage/salary increases or better working conditions.

Competitors: What components and level of remuneration do they need to pay to attract equivalent executive expertise? What level of remuneration might attract executives away from the firm? What is the trend in compensation structure?

Other managers: Is there a fair distribution of remuneration across the managers of the organisation? This is the sort of information that the managers would want to use for purposes of lobbying for wage/salary increases or better working conditions, or in dealing with other organisations in their negotiations for higher remuneration if they are in the job market.

Executives of other firms: This is the sort of information that the executives would want to use for purposes of lobbying for increases in their own remuneration, or in dealing with other organisations in their negotiations for higher remuneration if they are in the job market.

Executive placement organisations: Executive placement firms use this information to assess the appropriateness of the nature and amount of executive remuneration for particular executives, or to determine who they ought to head-hunt in order to find someone whose remuneration expectations match the remuneration on offer for a particular position.

Researchers: Researchers use this data to analyse the firm and the effectiveness of its remuneration policies.

3. Do you think that it is appropriate to give corporations a choice regarding recognition or disclosure in relation to executive share options? Reconcile your argument with the recognition versus disclosure approach adopted in the conceptual framework.

The recognition versus disclosure choice in the conceptual framework centres on the reliability of the measure. If a reliable measure cannot be formulated, the recognition criterion is not satisfied. The remaining alternative to recognition available to firms is disclosure of the information. Thus, disclosure is an alternative to recognition. The FASB permitted firms to either recognise or disclose. Choice in accounting standards is often associated with a reduction in accounting quality on the presumption that choices will be made for opportunistic reasons rather than efficiency reasons. As cited in the article, expensing stock options granted would have reduced the earnings of the S&P 500 companies by an average of 13%. The FASB’s decision to allow firms to disclose or recognise the value of stock options granted appears to be a result of bowing to political pressure and lobbying efforts.

4. Why do you think that business people are objecting to the requirement to expense the value of executive share options issued? Can you suggest why two US firms would have recognised the value of the executive share options and all other US firms disclosed the information?

The proponents for expensing stock options argue their case as follows: The firm is gaining an economic benefit in the form of employee services. The firm is giving something of value to employees therefore it is compensation and

should be treated like any other form of compensation or employee entitlement. There are appropriate valuation models to value the options granted to employees and

thereby provide the value to expense.

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The arguments against expensing stock options include: The issue doesn’t involve a cash outlay. There is a double counting because the dilution effect is recognised by an increase in the

number of shares in EPS dilution measure. Cost to company does not equal value to employee. The fair value of the options granted cannot be measured reliably (expensing an estimate). Disclosure is always an option to recognition.

The overwhelming majority of US firms have disclosed rather than expensed the value of options granted. Why two US firms would have elected to expense is problematic. Plausible explanations could include: the value of the options granted being immaterial in relation to the profit a fundamental belief in the granting of options being a compensation expense that should

be recognised the pressure from external parties such as major shareholders.

Students may be able to come up with alternative explanations. The fact that there is not lot of variation (nearly all firms disclose) suggests that the choice is not systematically associated with firm characteristics.

5. Explain how this accounting issue:(a) demonstrates the political nature of standard setting(b) has an implication for the internationalisation of accounting standards.

The article mentions that the FASB capitulated to corporate bullying in allowing a recognition versus disclosure choice in relation to the value of options granted. The original stance of the FASB required the recognition of an expense associated with such grants in the statement of financial performance. This requirement was strongly opposed by the business community. The business community lobbied extensively, particularly appealing to politicians to take up their cause. Politicians lobbied on behalf of their constituents (the corporations) and these efforts were effective with the FASB’s final position being aligned with that of the corporations.

Accounting for stock options is currently being reconsidered by accounting standard-setting bodies. At the time of writing, the IASB has issued an exposure draft (ED2) requiring the expensing of options granted in the statement of financial performance. The AASB has also issued an exposure draft (ED108), consistent with that of the IASB. The FASB has also indicated that it is reconsidering the suitability of permitting firms a choice in relation to this issue. It is generally accepted that stock options will have to be recognised as an expense in the future. The commitment to convergence of accounting rules means that a consistent accounting practice is likely to be pronounced. The corporate collapses and demands for good corporate governance practices have fuelled the need for an accounting standard that establishes principles relating to accounting for stock-based compensation.

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Case Study 13.3 — Macquarie’s tollway revenue raiser

1. What is the purpose of AASB 1030, the accounting standard referred to in the articles? Should this standard be necessary in light of the conceptual framework?

The purpose of AASB 1030 ‘Application of Accounting Standards to Financial Year Accounts and Consolidated Accounts of Disclosing Entities other than Companies’ is to prescribe requirements for the preparation and presentation of financial year accounts or consolidated accounts required by the Corporations Act of disclosing entities that are not companies by extending (with some exceptions) the applicability of other accounting standards. The exceptions being the application of AASB 1027 ‘Earnings per Share’ and for financial assets of undertakings to which prescribed interests relate in relation to the application of AASB 1041 ‘Accounting for the Revaluation of Non-Current Assets’. MIG is relying on the latter exception allowing them to recognise revaluation increments and decrements in the statement of financial performance.

This question highlights the distinction between a reporting entity (as specified in SAC 1), a disclosing entity (as specified in Part 1.2A of the Corporations Act) and a large company (required to lodge and prepare accounts under the auspice of the Corporations Act using approved accounting standards). A disclosing entity would be a reporting entity. Without AASB 1030, disclosing entities would be required to prepare accounts but not consolidated accounts.

2. Does the conceptual framework differentiate between accounting for tangible, intangible and financial assets? Comment on:(a) whether different measurement techniques are appropriate for different types of

assets(b) whether accounting practices should vary according to the type of entity(c) whether accounting practices should vary according to the industry in which the entity operates.

The conceptual framework is a ‘one fits all’ approach rather than an exception approach. All assets, whether financial, tangible or intangible, are assessed according to the same definition and recognition criteria. Similarly, all principles enunciated in the framework apply equally to all reporting entities, irrespective of the type of entity or the industry in which the entity operates.

3. MIG’s practice of booking non-cash revenue is criticised on the basis that it does not give investors a ‘clear enough picture of its overall health’. How does Anthony Kahn defend this treatment? Is conservatism a desirable qualitative criterion?

Booking non-cash revenue is criticised on the basis of not providing investors with a ‘clear enough picture of a firm’s health’. The reported profit includes unrealised gains and is not supported by cash available for distribution. The traditional accounting treatment for non-current asset revaluations is to book revaluations via the asset revaluation reserve (take them straight to equity) and recognise devaluations as an expense. Such accounting treatment is asymmetrical, but has traditionally been supported on the basis of conservatism.

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Conservatism is not a qualitative characteristic specified in SAC 3 and the conceptual framework promotes symmetrical accounting treatments.

MIG’s accounting treatment is justified by its executive director, Anthony Kahn, on the basis that: it is not engaging in accounting treatments that are disallowed by Australian GAAP its accounting treatment is consistent with market value accounting that is being

increasingly required (for example, insurance companies, SGARAs) the market is able to distinguish realised and unrealised profits.

4. Explain the role the conceptual framework could play in resolving how to deal with the following issues concerning asset revaluations:(a) whether assets should be revalued(b) whether, once revalued, assets should be required to be revalued on a regular

basis(c) whether, if assets are revalued, upward revaluations and downward

revaluations are both treated in the same way.

When explaining the role of the conceptual framework in dealing with the issues stated in this question, students should pay particular attention to the desirable qualitative characteristics articulated in SAC 3. In discussing the appropriateness of revaluing assets, the trade-off involves relevance and reliability. Are current values more relevant to decision making than historical cost values? Are current values more reliable than historical cost values? In debating this issue, students should recall that Australian GAAP provides preparers with a choice: assets can be recorded at fair value or at cost. The requirement to revalue on a regular basis also involves discussing whether this makes the information more relevant, and also considering the impact the requirement has on comparability. Referring to AASB 1041, if electing to revalue non-current assets, the revaluation should be undertaken regularly. The conceptual framework does not apply differential accounting treatment to revaluations and devaluations. The critical decision is whether the revenue and expense definitions are satisfied. The conceptual framework promotes symmetrical accounting treatment, and the asymmetrical treatment in AASB 1041 would not be regarded as consistent accounting.

5. MIG management claim that they never focus on the bottom-line profit, focusing instead on the value of assets. Do you think that the conceptual framework adopts more of a position statement or a performance statement approach?

The conceptual framework adopts more of a position statement. This contrasts with the traditional income focus of financial reporting. The position approach is evident with the elements of the financial statements being defined in terms of assets and liabilities. Applying the definition, one cannot distinguish if an expense (revenue) exists without first applying the liability (asset) definition, given that an expense (revenue) has to reduce (increase) assets or increase (reduce) liabilities. Dissenting views on SAC 4 noted the lack of attention given to the income statement and the traditional ‘matching principle’.

CHAPTER 14

ASSETS, LIABILITIES, AND OWNERS’ EQUITY

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Theory in Action 14.1 — R&D: implications of capitalism versus expensing decisions

1. Explain the accounting treatment of research and development expenditure required by AASB 1011 ‘Accounting for Research and Development Costs’. Compare and contrast this with the accounting treatment prescribed by the International Accounting Standards Board.

AASB 1011 ‘Accounting for Research and Development Costs’ affords preparers discretion with respect to accounting for research and development (R&D) expenditure. The standard permits R&D expenditure to be capitalised provided the future economic benefits associated with the R&D expenditure are beyond reasonable doubt. For firms complying with Australian GAAP, it is not unusual to find R&D recognised as an asset on the statement of financial position.

IAS 38 ‘Intangibles’ distinguishes expenditure incurred in the research and development phases. Different accounting treatment is prescribed for research expenditure relative to development expenditure. No intangible asset arising from the research phase should be recognised as an asset. Such expenditure is to be expensed in the statement of financial performance in the year incurred. The rationale for this accounting treatment is that it is not possible to ascertain if the future economic benefits associated with research expenditure are probable. IAS38 allows expenditure associated with the development phase to be capitalised on the premise that by moving to the development phase the future economic benefits are more likely than less likely.

2. Do you see any inconsistencies between the accounting treatment prescribed by AASB 1011 and the definition and recognition criteria in SAC 4?

According to SAC 4, ‘an asset should be recognised in the statement of financial position when and only when: (a) it probable that the future economic benefits embodied in the asset will eventuate; and (b) the asset possesses a cost or other value that can be measured reliably’ (SAC 4, para. 38). In the context of SAC 4, probable means ‘the chance of the FEBs arising is more likely rather than less likely’ based on the available evidence or logic (para. 40).

As noted previously, AASB 1011 permits R&D expenditure to be recognised as an asset provided the future economic benefits associated with the R&D expenditure are beyond reasonable doubt and exceed or are equal to the R&D costs and any subsequent costs necessary to give rise to the future economic benefits. The phrase ‘beyond reasonable doubt’ is a more stringent recognition criterion test relative to the ‘more likely than less likely’ test. This means that the recognition criterion in SAC4 is inconsistent with the recognition criterion applied in the accounting standard dealing with accounting for R&D expenditure.

Encourage students to think of any other accounting standards using a recognition criterion different to ‘probable’.

3. In the case of research and development expenditure, do you think that Alfred Berkeley is suggesting that accounting regulation is affecting firms’ real decisions? If so, should this be of concern to regulators?

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In the USA, accounting standards do not permit R&D expenditure to be capitalised. Such expenditure must be expensed in the statement of financial performance in the reporting period it is incurred. Berkeley is suggesting that firms are reducing expenditure on R&D because it is detrimental to their ‘bottom line’. Expenditure on R&D is essential if firms are to grow and create value. If the accounting treatment of R&D (for example, the requirement to expense) is altering firms’ R&D investment decisions, then long-term benefits are being sacrificed for short-term gains (for example, higher profits). If firms are reacting as suggested by Berkeley, the accounting treatment of R&D is creating economic consequences in the form of sub-optimal investment decisions and compromising long-term value creation.

Theory in Action 14.2 — Providing for liabilities

1. Explain the meaning of a foreign currency hedge and the reason behind Newcrest Mining’s foreign currency hedge transactions.

A foreign currency hedge is designed to lock in the price today at which a future transaction in a foreign-denominated currency is to occur. The purpose of a hedge is to remove price uncertainty by having a derivative position that will offset any gains/losses associated with the underlying physical position.

Newcrest have significant forward US dollar sales. They are exposed to fluctuations in the US dollar – Australian dollar exchange rate. Given that their future revenue stream is in US dollars, an appreciation of the Australian dollar against the US dollar would reduce their revenue stream because less Australian dollars would be received per US dollar. To reduce this foreign currency risk, Newcrest have entered into forward contracts locking in the Australian dollar they will receive in the future per US dollar of revenue. If the Australian dollar appreciates, Newcrest’s Australian dollar receipts per US dollar fall; however, this is offset by the favourable forward contract position. Conversely, if the Australian dollar depreciates, Newcrest’s revenue stream increases when the US dollars are converted to Australian dollars at the spot rate. However, the depreciation of the Australian currency creates an unfavourable position in relation to the forward contract. If the firm was able to create a perfect hedge, the gains/losses would offset each other and foreign currency risk would be eliminated.

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2. Discuss whether you believe the provision for losses associated with the foreign exchange hedging positions constitutes a liability, applying the definition and recognition criteria in:(a) SAC 4(b) AASB 1044 ‘Provisions, Contingent Liabilities and Contingent Assets’.

According to SAC 4, liabilities should be recognised: if the firms are presently obliged to make future sacrifices of economic benefits to a third

party as a result of past transactions or other past events (liability definition) the future sacrifice of economic benefits will probably be required and the amount of the

liability can be measured reliably (recognition criterion).

The definition and recognition criteria for liabilities as per AASB 1044 ‘Provisions, Contingent Liabilities and Contingent Assets’ is consistent with those in SAC 4. A liability is defined in the standard as a future sacrifice of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions, or other past events.

Provisions are distinguished from other liabilities on the basis of the timing or amount of the future sacrifice of economic benefits being less certain (although the probable criterion would still be satisfied).

AASB 1044 clarifies, interprets and discusses the definition and recognition criteria stipulated in SAC 4. Specifically, for the present obligation criterion to be met, the entity must have no realistic alternative but to make a future sacrifice of economic benefits.

The consistency in the definition and recognition criteria in SAC 4 and AASB 1044 means that the same decision regarding whether the provision for losses associated with the foreign exchange hedge positions constitute a liability should be reached. It is not truly a liability because it does not meet the definition of a liability given that the present obligation requirement is not met. Given that the contract has not expired, there is no present obligation for Newcrest to settle the difference. Between the current period and contract expiry, rates could move such that favourable (unfavourable) positions become unfavourable (favourable) positions. A contrary view that could be espoused is that there is a potential inflow of future economic benefits (foreign currency asset) or a potential reduction in outflows of future economic benefits. It should be noted that transactions excluded from AASB 1044 coverage include: (1) financial liabilities carried at fair value, (2) derivatives other than financial guarantee contracts (including letters of credit) that provide for payments to be made of the debtor fails to make payment when due, and (3) agreements equally proportionately underperformed except where the agreement is an onerous contract. Consequently, accounting for a forward exchange contract is not bound by AASB 1044.

Foreign currency hedging contracts are covered by AASB 1012 ‘Foreign Currency Translation’. Exchange differences on foreign currency monetary items hedging unspecific foreign currency purchases or sales are to be recognised as revenue and expenses in the statement of financial performance in the reporting period corresponding to the period in which the exchange rate change arises.

3. Do you think AASB 1044 clarifies the definition and recognition criteria in SAC 4 in relation to liabilities?

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AASB 1044 adds clarity to the liability definition and recognition criteria in SAC 4. The standard succinctly distinguishes liabilities, provisions and contingencies. Provisions are a subset of liabilities and separately tagged on the basis that there is greater uncertainty associated with the amount or timing of the future sacrifice of economic benefits. Contingencies fail the recognition criteria on the basis that they cannot be measured reliably and/or the future sacrifice of economic benefits is less likely than more likely. AASB 1044 discusses the meaning of ‘present obligation’ in the grey letter paragraphs, noting that only ‘obligations arising from past events and existing independently of the firm’s future actions or conduct of its operations’ satisfy the definition (para. 3.1.10). It notes that the mere intention to make a future sacrifice is insufficient to give rise to a present obligation. Accordingly, provisions for future losses (as per Newcrest) would not qualify as liabilities due to the absence of a present obligation.

Students should be encouraged to examine the examples of applying the criteria for the recognition of provisions contained in Appendix 2 of AASB 1044.

4. Can you suggest some alternative accounting treatments for foreign currency hedges?

There are numerous alternative accounting treatments for foreign currency hedges, including fair value accounting, cost or lower of cost and net market value, and hedge accounting.

Using a fair value approach, gains and losses associated with changes in fair values are recognised as revenues or expenses in the period the changes occur. Interest payments and receipts related to financial instruments are also recognised as expenses or revenues in the period in which they occur.

The cost or lower of cost and net market value methods of accounting for financial instruments reflect conservatism, and defer recognition of gains resulting from the instrument until settlement.

The three broad means of hedge accounting are deferral hedge accounting, mark-to-market hedge accounting and comprehensive income hedge accounting. In general, hedge accounting involves mirroring the accounting treatment of the hedged item in the accounting treatment of the hedge instrument. Deferral hedge accounting involves ascertaining if the hedge instrument hedges a specific commitment or an anticipatory commitment. Accounting for the former can require the gain/loss on the hedging instrument to be deferred and incorporated into the carrying amount of the hedged item. For example, if the hedge is of a specific foreign currency commitment and involves establishing the price for the purchase or sale of goods and services, exchange differences occurring up to the date of sale or purchase and at the time of entering into the transaction are deferred and included in the measurement of the sale or purchase. Should the transaction hedge a net investment in a self-sustaining foreign operation, the exchange differences relating to monetary items are brought to account in the statement of financial performance in the period they relate to and, on consolidation, transferred to a reserve account — foreign currency translation. It can alternatively involve taking gains and losses to the current period’s earnings if the gains and losses on the hedged item are also taken to earnings. On the other hand, if the hedge is associated with an unrecognised anticipated commitment, the gain/loss

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is normally deferred as a separate item on the statement of financial position until the future transaction eventuates.

Mark-to-market hedge accounting involves marking to market both the hedged item and the hedging instrument, with associated gains/losses being recognised in earnings of the same period. It is based on the premise that the effects of changes in market rates or prices of the hedging instrument and hedged item should be recognised concurrently in the statement of financial performance. Theoretically, a perfect hedge results in the gain (loss) on the hedged item being exactly offset by the loss (gain) on the hedging instrument. Given that perfect hedges are unlikely, issues arise in respect of the extent to which gains or losses on hedged items should be matched with those on hedging instruments.

A comprehensive income approach to hedge accounting requires the hedging instrument to be marked to market with the accounting treatment differing according to whether the gain/loss is realised or unrealised. Realised gains and losses are taken to earnings in the period they are realised, as are the gains and losses on the hedged items. Unrealised gains/losses are taken to equity and transferred to earnings when realised, along with the gains/losses on the hedged items.

The three accounting approaches discussed — fair value, cost or lower of cost and net market value, and hedge — are not exhaustive of all approaches that could be adopted. Alternative approaches based on them are possible.

5. The justification for the provision is that it reflects ‘proposed tougher accounting standards’. Presuming this comment refers to ‘mark-to-market accounting’, is the creation of a provision account consistent with such a measurement and recognition model?

Prior to accounting regulation governing provision accounts, firms were criticised for using provision accounts as ‘cookie jar reserves’. In ‘surplus’ (‘deficit’) earning years, firms bought forward (deferred) expenses via the provision accounts. As discussed above, AASB 1044 prescribes the requirements to be satisfied in order for a provision account to be created. This accounting standard has reduced flexibility associated with recognising provision accounts thereby imposing ‘tougher rules’ on preparers. As argued above, the tougher rules would most likely prohibit Newcrest recognising a provision for foreign exchange hedging positions if such transactions were within the standard’s scope.

An accounting standard dealing with the recognition and measurement of financial instruments (including derivatives) is expected in the future. It is anticipated that this standard will require financial instruments to be marked to market, with the gains/losses recorded as revenue/expenses in the reporting period unless strict hedge criteria are satisfied permitting gains/losses to be deferred. It could be argued that Newcrest has created a vehicle (the provision account) that will allow it to reduce expenses in future periods by reducing the provision account and thereby have the flexibility and mechanism for reporting higher earnings in future periods.

Theory in Action 14.3 — A taxing issue

1. Does the conceptual framework shed light on the appropriate classification of convertible notes in the statement of financial position?

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SAC 4 defines elements of financial statements, namely assets, liabilities, owner’s equity, revenue and expenses. It provides the generic definition and recognition criteria but does not apply the criteria to particular transactions or instruments. Given that SAC 4 defines equity as the residual interest in the assets of the entity after the deduction of its liabilities (para. 78), the liability definition would need to be applied to the convertible note instruments. If the definition and recognition criteria for a liability were satisfied then classification as a liability would be appropriate. If the liability definition were not met then the instrument would be classified as equity. SAC 4 does recognise that the distinction between equity and liabilities can be blurred in practice. Particular reference is made to preference shares, convertible debt and ‘perpetual capital notes’ in SAC 4, paragraph 97, stating that the classification should be based on considering the instrument’s risk and return attributes.

2. What is the appropriate classification prescribed by AASB 1033 ‘Presentation and Disclosure of Financial Instruments’? Are there any difficulties in implementing these classification requirements?

AASB 1033 (operative for reporting periods post December 1997) requires a firm to report the economic substance of claims against the firm rather than their legal substance (where there is a difference) when classifying items in the statement of financial position.

AASB 1033 requires the terms and conditions of instruments to be examined and the instrument to be classified as debt or equity, or its components to be classified as debt or equity. This standard has implications for preference share and convertible instrument classifications.

For a converting instrument, the standard setter’s position is that classification depends on whether the holder of the instrument is exposed to equity risk. If the conversion price is fixed at the time of issue, the holder of the instrument is exposed to equity risk and thus the instrument has an equity component. If the conversion price is based on the market price at the time of conversion, no equity risk results until conversion, and the instrument would be classified as a liability. The treatment of the interim cash flows to the instrument holder as interest or dividends must conform to the instrument’s classification in the statement of financial position.

AASB 1033 requires that for instruments containing both a financial liability and an equity element, the issuer must classify the instrument’s component parts separately. With respect to a convertible note where conversion is fixed at the time of issue, the instrument is effectively a debt instrument with an equity option attached.

The difficulty in implementing the requirement to split accounts arises in relation to valuing the separate components. AASB 1033 does not prescribe how to value and assign a carrying amount to the respective components; although it suggests the following two approaches: (1) the residual approach where the more easily measured component is valued and the difference between the amount raised and this value is assigned to the less easily measured component; and (2) measure both components separately and pro rata any difference in the amount raised and the sum of the component values across the components.

3. The conceptual framework and specific accounting standards specify economic substance over legal form. Do you believe this is appropriate?

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Given that one of the objectives of financial reports is to provide information useful for decision making, it is appropriate that the financial report reflect economic reality. Accordingly, prescribing economic substance over legal form is warranted. This approach is criticised on the basis that determining economic substance introduces judgement and subjectivity and inconsistency, whereas legal form is objective.

4. Discuss the implication for firms of having differences in accounting and taxation treatments.

Economic and legal form is often consistent; however, the case at hand illustrates a difference in accounting treatment and taxation treatment. Prior to the change announced in the federal Budget, the taxation treatment of convertible notes relative to other convertible securities was inequitable because the point at which a tax liability accrues was earlier for a convertible note (for example, at the time of conversion). The taxation changes announced mean that convertible note holders are no longer liable for capital gains tax at the point of conversion. A liability will not accrue until the instrument is sold. Modigliani and Miller (1961) argued that in perfect capital markets the firm’s financing decision is irrelevant to firm value. However, market imperfections, such as taxation, alter the risk–return attributes of instruments and thereby affect the firm’s cost of capital and hence firm value. This means that firms need to be cognisant of taxation and accounting treatments of financial instruments when making financing decisions. When considering raising finance, firms need to assess the impact on their statements of financial position and performance pursuant to the prescribed accounting treatment for the instrument. Differences in taxation and accounting rules mean they also need to consider the taxation implications of the instrument, as this will affect the rewards and risks attached to the instrument and the demand for the instrument in the market place. As suggested in the article, the previous taxation treatment of convertible notes made them less attractive to potential investors relative to alternative instruments, and this impacted on firms’ financing choices.

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Questions

1. The conceptual framework defines the elements of financial statements by reference to elements of the statement of financial position, particularly assets. What attributes must something possess in order to be defined as an asset? Why?

For something to be defined as an asset, it must possess the following attributes: future economic benefits or services be controlled by the entity be the result of a past transaction or event.

These attributes ensure that whatever is defined as an asset is ‘worthwhile’ to the entity. Although future economic benefits or services are the essence of an asset, the definition ignores the present existence of an asset. The FASB’s view in ABB Statement No. 4 — that assets are economic resources — provides a more current perspective. In time, economic resources are capable of rendering future benefits or services.

2. SAC 4 defines assets, liabilities and equity by reference to economic benefits.(a) What are the economic benefits that would be assets for SalzanCorp, a

government business enterprise that constructs the physical infrastructure (roads, bridges, etc.) for the city of Huntersville?

(b) Must economic benefits be revenue-generating, or can parks, roads or statues provide economic benefits?

(a) An economic benefit is ‘scarce’ and has ‘utility’. Utility pertains to the future economic benefits or services. Because the resource is scarce and has future benefits, it has economic value. SalzanCorp — a government business enterprise constructing physical infrastructure for the city of Huntersville — would have assets comprising productivity resources to build the infrastructure (that is, equipment) and claims to receive money associated with contracts and money. If SalzanCorp retains ownership of the infrastructure assets and they are leased to the city of Huntersville, the infrastructure assets provide economic resources to SalzanCorp (that is, lease receipts) and constitute assets.

(b) Within the USA, the FASB in Statement No. 4 defined economic resources as ‘the scarce means available for carrying out economic activities’. The term, as used by accountants, is somewhat broader in meaning than used in economics. For example, economists prefer to distinguish between products of an enterprise, unless they are capital goods, and resources. Examples of economic resource benefits are: productivity resources (such as raw materials, equipment, patents, or contractual rights

to the use of resources of other entities) products money claims to receive money ownership interests in other enterprises.

Economists do not insist that an economic resource be the result of a past transaction or event of an entity.

Monuments, parks and/or roads provide service potential to the authorities providing and maintaining them because they enable those authorities to pursue their objectives.

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However, to the extent that the monuments, parks, and/or roads do not generate inflows or reduce outflows of cash (other than indirectly from increased rates or donations, etc.), they do not contribute economic benefits.

3. The SAC 4 definition of assets requires future economic benefits to be controlled by an entity before they can be regarded as an asset. How does ownership differ from control? Which criterion (ownership or control) do you think should be applied in defining assets? Why?

The term ‘owned’ means different things to different people. Ownership is usually associated with legal ownership or entitlement. A criterion to meet the asset definition is that the entity controls the future economic benefits. The term ‘control’ is used rather than ‘owns’. Control is associated with the right to regulate access to, and use of, the future economic benefits. This implies that the entity has a legal right to receive the benefits. For example, for an operating lease, the lessee does not legally ‘own’ the asset, but it does have the legal right to receive the benefits or services of the asset.

4. According to SAC 4, assets do not exist unless they result from past transactions or events. Determining whether a past transaction or event has occurred to give rise to an asset is not always straightforward. Explain the past transaction or event that triggers the existence of the following assets:(a) accounts receivable (d) work in progress(b) prepaid insurance (e) finance lease of manufacturing plant(c) inventory (f) goodwill (internally generated or purchased).

(a) accounts receivable — the sale of the product or service

(b) prepaid insurance — the purchase of the insurance policy

(c) inventory — the purchase of the inventory

(d) work in progress — the production activity

(e) financial lease of manufacturing equipment — the signing of the lease agreement; or if the equipment is to be constructed, when the construction is completed

(f) goodwill — the purchase of a company (purchased goodwill); the activity/activities generating reputation (internally generated goodwill).

Instructors might discuss the ‘reasonableness’ of the accepted past transaction or event for each of the assets mentioned above. For example, the relevant event for inventory could be the physical receipt of the inventory, especially because the timing of order, invoicing, receipt and payment, can vary in order and separation.

5. What is an agreement equally proportionately unperformed (AEPU)? According to strict interpretations of SAC 4 definitions of assets, liabilities and equity, should AEPUs be reported on the statement of financial position? Why or why not?

Wholly executory contracts (agreements equally proportionately unperformed, or AEPUs) are not recorded because they involve only an exchange of promises. There is no performance yet

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to give ‘economic substance’ to the contract. That is to say, the signing of the contract is not regarded as the relevant past transaction or event to give rise to an asset or liability. Yet they are in question 4 above. The instructor may wish to discuss the reasons why. For a financial lease, there is a transfer of the asset to the lessee for his or her use. For a forward exchange contract, the contract may be sold and therefore the contract itself has value. In both cases, as far as accountants are concerned, something of value has been exchanged, not just promises.

Most wholly executory contracts would be recorded by firms complying with SAC 4 because the statement requires the recognition of both the asset and liability involved in such contracts. Given that the asset and liability definitions in SAC 4 would require AEPU to be recognised, firms opposed SAC 4 in its original form because existing reporting practices would alter. However, in its revised format, SAC 4 specifically excludes certain AEPUs from its scope.

6. Under some market-based systems of accounting, asset definitions require that to be defined as an asset, an economic benefit must be both ‘severable and saleable’, sometimes described as ‘exchangeability’. Is that a requirement in the SAC 4 definition of assets? Why or why not? Do you think that severability is necessary to a definition of assets? Why or why not?

Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the statement of financial position is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items.

Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Because benefits received from using resources are unaffected by whether or not they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset. Economic value depends on scarcity and utility, not exchangeability.

To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events.

SAC 4 does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under SAC 4.

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7. Are the following assets? If so, whose assets, and why?(a) Members of the Australian netball team(b) A 12-month lease agreement to rent a business office(c) Expenditure on research and development(d) An unsigned, documented contractual agreement to build specialised equipment

for a client(e) A building bequeathed to a firm(f) A 5-year option to acquire property, where the option was purchased by the

company a year ago

(a) Human resources. They meet the definition of assets, but because of the difficulty of placing a value on them they are not recognised. They meet the definition, but fail the recognition test. (If they are on a losing streak, are they still assets? As long as they generate future economic benefits, they remain assets whose measurement and probability may not warrant capitalisation as assets.) It can also be argued that as executory contracts they ought not to be recognised.

(b) Operating lease. For the lessee (tenant), there are no future benefits which he or she has control over unless the rent is prepaid or there is a contract specifying the rights to benefits. According to AASB 1008, there is no intent by the lessor to transfer substantially all ownership benefits and risks to the lessee. Nonetheless, once a contract is in place there is a right to control the inflow of economic benefits, and an obligation to pay for them. As such, both an asset and a liability do exist under SAC 4 definitions.

(c) Research and development. AASB 1011 allows certain R&D costs to be capitalised if the technical feasibility of the product or process that they relate to has been demonstrated, and there is a clear indication of a future market for the product; or if the item is to be used internally, its usefulness can be demonstrated. Under SAC 4, if future economic benefits are probable, an asset exists.

(d) Contract. There is no basis for believing future economic benefits exist. Because there is no performance, it is possible that the buyer (client) may get out of the contract. The law does not recognise a sale for custom-made goods unless performance has begun. In this case, the contract for performance has not even been signed. There is no asset.

(e) Bequest. An asset does not need to have a cost. The land is now under the control of the company, it has future benefits, and it arose from a past transaction (the donation) — therefore, by definition it is an asset. The company should record it at fair market value.

(f) Option. At the time the option is purchased, it should be considered an asset. It gives the company the right to purchase the building and therefore has future benefit. If the building is actually purchased, whether the option should be considered part of the cost of the building is another issue. It can be argued that the option was purchased as part of an integrated plan to acquire an appropriate building, and therefore it is part of the cost of the building. On the other hand, does the purchase of the option make the building more valuable than the actual bargained price of the building? If the option lapses, it should be expensed.

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8. Liabilities are all ‘obligations’ under the SAC 4 definition of liabilities. What is an obligation, and why does SAC 4 rely heavily on it in the definition?

A liability is a present obligation. An obligation may be legally enforceable in the courts or simply ‘equitable’ or ‘constructive’. The SAC 4 definition emphasises the future sacrifice, but it should be remembered that a liability exists now — it is a presently existing obligation.

9. If a liability is a present obligation, does that mean that a legally enforceable claim must exist before a liability exists? Explain. Conversely, if a legally enforceable claim exists, does that mean that a liability must exist? Explain.

A liability need not be legally enforceable. According to SAC 4, it may be equitable or constructive. Most liabilities are legal liabilities, but company policy of a ‘moral obligation’ may give rise to a recordable liability as long as the intent is to transfer assets or render a service to settle the obligation. Examples are Christmas bonuses that may be accrued if not paid in December, or vacation pay. The past transaction or event is not as clear for non-legal liabilities as for legal liabilities, and thus may be more difficult to recognise. For such liabilities, the future sacrifices cannot be avoided without significant penalty, such as a decrease in employee morale. Interpreting the meaning of significant penalty is a matter of opinion.

A legally enforceable claim need not exist for an asset to exist according to SAC 4. Control is the main criterion, not ownership.

On the other hand, if a legally enforceable claim against the entity exists, it is clear that there is a present obligation, and presumably a liability.

10. Under some countries’ accounting regulations, unrealised foreign exchange gains and losses are not immediately recognised in a firm’s statement of financial performance. Instead, unrealised gains are put into a deferred credit account. Is this a liability? Why or why not?

It is not truly a liability because it does not meet the definition of a liability. There is no present obligation to sacrifice future economic benefits. To the contrary, there is a potential inflow of future economic benefits (foreign currency asset) or a potential reduction in outflows of future economic benefits.

11. Hunting Ltd is attempting to bring its accounts in line with Australian accounting standards and statements of accounting concepts. Advise the accountant of Hunting Ltd whether a liability exists in each of the following cases and, if so, what the liability is:(a) The company is being sued for environmental contamination. The outcome of the

lawsuit is highly uncertain.(b) An order for raw materials has been placed with the firm’s regular supplier.(c) There is a signed contract for the construction by Sugaz Ltd of a major item of

plant for Hunting Ltd.(d) The firm has unsecured notes of $1 000 000 outstanding. Interest is payable 6-

monthly in June and December. It is now August.(e) At the end of the year, half of the firm’s employees have non-vested sick leave

owing.

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(a) Contingent liabilities are not recorded, but are disclosed. A decision must be made on whether these items are ‘straight’ liabilities or contingent liabilities. This decision is based on two criteria: (1) it is probable that a liability has been incurred; and (2) the amount can be estimated reliably.

In this case, there is no liability. According to SAC 4, the event must make it ‘probable’ that a liability has been incurred and the amount must be ‘estimable’. These two conditions are not met.

(b) No liability. The pertinent event is not placing an order but receiving title to the goods. When title passes, then a purchase has been made, and accounts payable is recorded.

(c) No liability. The contract is wholly executory. Until there is performance, there is nothing to record.

(d) Interest payable for two months. Accrued interest is to be recorded. The event is the passing of time; the company is using the money that was borrowed each day.

(e) No liability exists for the non-vested rights. The following four conditions can be considered for the recording of an accrued liability for sick pay: the sick pay is based on services already rendered rights to sick pay are vested or ‘accumulated’ (earned but unused) payment is probable the amount can be reasonably estimated.

If sick pay benefits vest, an accrual should be made. If they ‘accumulate’ but do not vest, accrual is not required.

12. What is ‘off-balance-sheet financing’, and why is it deemed to be a problem? How can it be prevented?

Off-balance-sheet financing refers to an arrangement whereby a company obtains financing, but no liability is reported on its balance sheet. Not recording a liability improves the outward appearance of the capital structure in terms of the relationship between debt and owners’ equity. Companies are able to avoid the recording of a liability through various manoeuvres.

Australian standard setters have recognised the problem by requiring the capitalisation of financial leases (AASB 1008); consolidated reporting — where liabilities may be ‘shifted’ to subsidiaries (AASB 1014); and foreign exchange liabilities (AASB 1012). Disclosure requirements have also mandated disclosures designed to restrict off-balance-sheet financing activities.

Other solutions are: disclosure through footnotes use of current cost accounting so companies would not be tempted to hide their liabilities

— the greater amount of assets would offset the greater amount of liabilities strengthen the rules of AASB 1008 to make it more difficult for the lessee to report a lease

as an operating lease when it is a finance lease for the lessor.

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13. Does SAC 4 adopt the principle of conservatism? Why or why not? Do you think that conservatism is desirable in the definitions of assets, liabilities and equity, or in their recognition criteria? Why or why not?

Conservatism calls for the recognition of liabilities on less stringent grounds than assets. According to SAC 4, if it is ‘probable’ that a liability has been incurred and the amount can be reasonably estimated, then it is to be recorded.

SAC 4 is not conservative in its approach. As such, liabilities (like assets) are to be recognised when they are more likely than not to require a flow of service potential or economic benefit, and when they can be measured. Since conservatism is a virtue according to general practice, it is likely that SAC 4 will lead to less conservative recognition of liabilities than general practice.

14. How does owners’ equity differ from liabilities? Give examples where they are closely aligned, and examples of where they are not.

Owners’ equity represents the owners’ claim on the assets of the company. The owners have a residual interest in the firm. The accounting equation (Assets – Liabilities = Owners’ equity) expresses in mathematical terms the relationships involved. The amount of net assets equals the amount of owners’ equity. We should remember that the valuation of owners’ equity is not necessarily the same as the concept of owners’ equity. Owners’ equity can be described without reference to a sum of money.

Owners’ equity differs from liabilities in that liabilities are claims that the entity is presently obliged to settle with an outflow of economic resources. Owners’ equity is a residual attributable to the owners after liabilities are discharged. Preference shares and convertible notes possess characteristics of both liabilities and owners’ equity. Accounts payable and general reserves are examples where liabilities and owners’ equity clearly differ.

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15. When should the following be recognised as assets or liabilities?(a) Accounts payable (e) Finance lease obligations(b) Put options (f) Operating lease obligations(c) Call options (g) Warranty commitments(d) Raw materials inventory

Recognition rules are the GAAP, which give rise to recordable assets and liabilities. The following accounts are discussed in terms of when they are first recorded.

(a) Accounts payable — a purchase has occurred on account; payment is probable.

(b) Put options — when option is sold.

(c) Call options — when option is sold.

(d) Raw materials inventory. If a perpetual system is used, a purchase has occurred. If a periodic system is used, a physical count has occurred, indicating the amount of inventory that the firm has title to.

(e) Finance lease obligations. According to AASB 1008, for the lessee, the following rules must be met. First, there must be a non-cancellable lease. Second, one of the following four criteria must be satisfied for a capital lease to exist, which therefore creates a liability:

The lease transfers ownership of the asset to the lessee. The lease contains a residual purchase option. The lease term is 75% or more of the estimated economic life of the asset. The present value of the minimum lease payments is 90% or more of the fair value of

the asset.

(f) Operating lease obligations — do not meet the criteria in AASB 1008 for the leased assets to be recognised as assets and the lease obligations to be recorded as liabilities.

(g) Warranty commitments — sale of the product, and existence of warranty contract. Amount can be reasonably estimated.

16. When, if ever, should a firm recognise a superannuation liability, and why?

Superannuation commitments meet the definition of a liability. The important elements of a liability are: present obligation asset or service to be transferred at a future date to another entity past event.

Superannuation is based on services already rendered by employees, but compensation will be paid to them in the future in the form of pension benefits. Therefore, a present obligation exists as the employee renders service.

The obligation is settled by payment of cash in the future.

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The liability is created by a past event, the rendering of services by the employees. Under the terms of most superannuation agreements, not only is the superannuation payment probable, but also its measurement is reasonably reliable; so recognition, according to SAC 2, should occur as the obligation accrues by virtue of the employee’s provision of service.

17. Explain the concept of capital maintenance, and how it can apply to different concepts of capital.

The main source of income for an entity is an increase in the wealth of a firm resulting from operations for the period. It was often described as the maximum amount that can be distributed to owners and still leave the firm as well off at the end of the period as the beginning. This is the concept of capital maintenance. So, capital cannot be distributed to owners as dividends, only income.

Current cost accounting aims to ensure the firm’s physical/operating capital base is not eroded during periods of inflation, as the otherwise inflated profits reported can result in increased dividends that actually result in reducing the ‘real’ capital of the firm.

Under a general price level accounting system (GPLA, or CPP), income is recognised only after the purchasing power of the start-of-period owners’ equity has been maintained.

Under CoCoA, the concept of capital is ‘adaptive capacity’ so income is not recognised until the firm earns enough to maintain its operating adaptive capacity, as reflected in the net realisable value of its assets, less liabilities.

18. A benefactor pays off a loan for a university. How should the university record the transaction, and why?

As a donation. The entry is:

Loan*Revenue

* According to SAC 4, donations should be classified as revenue because they are inflows of probable future economic benefits other than contributions by owners.

19. How should a mining company account for a contract which stipulates that on maturity of a cash loan to the company, it must pay the principal in cash or provide a given quantity and grade of extracted minerals, whichever is the higher?

The recording of a liability is justified, because: a present obligation exists. The company is using borrowed money. the company will pay cash (an asset) or minerals (an asset) at a future date to settle the

obligation. the obligation arose out of a past event — the use of the borrowed money.

The liability meets recognition criteria in that a future outflow of economic benefits is probable. Also, there is a reliable measure, even if it is not exactly the amount that will be required to be repaid if the minerals extracted have a high value.

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DR CashCR Loan (PV of expected cash outflows)

20. How should Shannondoah Ltd account for a cash loan to the company where the contract requires that the principal will be redeemed in common shares at maturity? Ten shares will be given for each $1000 bond. The current market value of the shares is $120.

Because shares are to be given on the date of maturity, two questions arise:1. Is the issuance of the bonds that convert to company shares a liability?2. What amount should be recorded now?

According to the definition of a liability, a liability must be settled by transferring assets or services at a future date. The ordinary shares of the company are not assets or services. Therefore, the bonds do not appear at first to qualify as a liability. However, the classification is not that straightforward, as explained below, and in AASB 1033 ‘Presentation and Disclosure of Financial Instruments’, paras 4.1–4.5.

If the converting notes convert to a variable number of shares, depending on the market value of the shares at the time of the conversion, then the issue of the converting notes is equivalent to an issue of debt that is then repaid in cash, which the lender then invests in the shares of the borrowing entity. The lender is not exposed to residual risk at all during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as liabilities.

On the other hand, if the converting notes convert to a fixed number of shares, then the issue of the converting notes exposes the holder of the notes to residual risk from the outset. As such, the converting notes are equivalent to an issue of equity, with a fixed dividend stream. The lender is exposed to residual risk during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as equity.

In this case, the loan converts to a fixed number of shares, so it should be treated as equity. The holder is subject to residual risk: if the value of the firm changes, they receive the same number of shares on conversion (10 per $1000 bond), so they bear the risk of changes in the value of the shares, and in the value of the equity.

What amount should be recorded? If we knew what the market value of the shares should be on the date of maturity, we could find the present value of the amount of the total market value of all the shares involved. But we do not know that.

Although the bondholders must have taken into account the current market price of the shares when they purchased the bonds, and probably expected the market price to increase, the recording of the sale of the bonds should be based on the value of the shares. The reason is that it is too difficult to estimate market values of shares. The method used when a large share dividend is declared provides a guideline.

On a per-bond basis, the following appears to be an appropriate record:10 shares $120 par = $1200

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Cash $1000Deferred discount on converting note issue $200

Share capital $1200

Interest will be paid each year based on the principal of $1 000 000. Should this be considered interest expense or dividends? The interest is a periodic payment on an equity instrument Therefore, it should be treated as a direct debit to equity, and as dividends.

Perhaps this bond issue is attractive to investors, because a specific amount of ‘interest’ each year will be received by contract as opposed to actual dividends that may or may not be paid, and the expectation of receiving more than the stated principal amount because of the likelihood of the market value of the shares increasing in value.

21. Skipper Ltd financed the construction of its new office block by issuing securities for $50 000 000 in 2000. Buyers of the securities received a 30% ownership interest in the office block, and receive 30% of the rent revenue related to letting the offices. The securities mature on 30 April 2015, when Skipper Ltd must redeem the securities at 30% of the value of the office block or $50 000 000, whichever is higher. What should Skipper Ltd have recorded in its accounts on 30 April 2000, and what other journal entries should be recorded throughout the term of the securities?

The $50 000 000 issue constitutes a loan. It has the features of a loan because of the following: It has a definite maturity date — 30 April 2015. It has a specified amount to be paid on the maturity date — either $50 000 000 or 30% of

the appraised value of the shopping centre, whichever is higher. It does not confer a residual claim to the value of the firm. The variable component of the

value of the loan is in relation to one specific asset, buildings.

Although an interest rate is not stated, there is something similar, which is 30% of the income per year. The amount each year would not be the same, but this is true also for variable rate bonds.

The 30% ownership of the shopping centre by the holders of the securities is, in effect, the collateral on the loan. The ownership of the holders is temporary, only until the maturity date, unless the company defaults.

Entries:30 April 2000

Cash $50 000 000Loan payable $50 000 000

When payment of the 30% of income is made each year:Interest Expense x

Cash x

If the value of the probable payment on maturity exceeds $50 000 000, the loan should be restated:

DR Buildings

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CR Asset Revaluation ReserveCR Loan Payable

Upon maturity:

DR Loan PayableCR Cash

22. Pyjamas for Bananas Ltd spent $6 000 000 on television advertising of its new range of sleepwear during the year. Market research indicates that the advertising has definitely boosted sales. Is the advertising an asset? If so, should it be recognised?

The three essential features of an asset are: (1) probable future economic benefits, (2) control by the entity, and (3) origin due to a past transaction or event. We will discuss each in reverse order.

First, the advertising is definitely due to a past transaction or event. Pyjamas for Bananas Ltd has already spent money for advertising.

Second, the firm has control over the content of the commercials and obtains the benefits of the commercials.

The third feature of ‘probable future economic benefits’ is the most germane. Does the advertising have future economic benefits beyond the current year? Since the product is new, the product has become familiar to consumers through the advertising campaign; therefore, there do appear to be future benefits. The increase in sales revenue since the promotional campaign is evidence of the effectiveness of the advertising. The cost, in this case, is to help establish a market for the company’s product.

The definition of an asset appears to be met. But that does not mean that an asset should be recognised (recorded). The question is whether identification can be made of the length of time of the future benefits, and the amount expected each year of increased sales. The uncertainty makes any estimate of future benefits arbitrary. But is this any different from the estimates of R&D costs or goodwill?

There is no authoritative statement that expressly forbids advertising costs to be capitalised. However, because of the uncertainty concerning the length of time and the measurability of the future benefits, most companies expense advertising costs. It is conventional to do so. A few companies, however, capitalise their advertising expenditures.

Problems(For a full outline of problems, please see text.)

14.1 Su Lamp Ltd, an electrical goods manufacturer, entered into the following transactions during the year 2000 (see pp. 523–4). Show how they should have been recorded by Su Lamp Ltd under Australian accounting regulations that year, and comment whether there are any differences in that reporting from what would be recorded if the company reported solely on the basis of SAC 4 requirements.

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1. This problem demonstrates the difficulty of determining whether an asset or liability exists. There is an asset if the realisation of the tax benefits will occur because of future income. AASB 1020 and SAC 4 are relevant. The reason for the loss can be identified as an isolated incident. The company has been continuously profitable over a long period of time, and assuming that it is more probable than not there will be sufficient taxable income in the future that the benefit will be realised, and an asset can be recorded.

Deferred tax asset $144 000Income tax benefit from loss carry forward $144 000

2. This is a wholly executory contract. No entry to be made. There is no performance.

3. SAC 4 is pertinent. At this point, there is insufficient evidence to say that it is ‘probable’ a liability has been incurred. There is no entry to record. Footnote only.

4. Is there a liability? Su Lamp Ltd plans to appeal, and there is a possibility the decision could be reversed. However, there is presently an obligation as a result of past events, the payment is probable, and the amount is reliably determinable. As such, there is sufficient evidence to say it is ‘probable’ a liability has been incurred, and the amount can be reasonably estimated.

Loss from lawsuit $400 000Lawsuit liability $400 000

On the other hand, if the outcome of the appeal is favourable with more than 50% probability, then a liability should not be reported, although a contingency should be disclosed.

5. No entry is to be made. The contract has only been signed. The fact that the contract is with the city hall and is a cost-plus contract makes no difference.

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6. AASB 1012 is relevant. Although the contract is signed only and there is no ‘performance’, there is an entry to record. The reason is that the contract can be sold. The contract itself has exchange value.

Investment in forward exchange contract (asset) $70 423(¥100 000 1/1.42)Deferred loss on forward exchange contract$3 757

Forward exchange contract payable (100 000 ¥ 1/1.5) $66 666

When the equipment is acquired, the deferred loss is capitalised into the cost of the equipment.

7. A liability does not have to be a ‘legal’ liability. Company policy can be the basis of an obligation. The bonus is based on past services rendered by the sales manager, and therefore an expense should be accrued.

Salaries and wages expense $15 000Salaries and wages payable $15 000

14.2 Zanadriana Ltd is a start-up pharmaceuticals company with 50% of its operations in research and development. The following transactions and events occurred in year 1 (see pp. 524–5). Record them in the company’s accounts in accordance with Australian accounting regulations. If needed, an appropriate rate of interest is 8% p.a. (See compound interest tables in the appendix at the back of the book.)

1. According to AASB 1011 this can be expensed; alternatively, it can be capitalised where future benefits are probable.

Research and development expense $250 000Cash or Accounts payable $250 000

or

Research and development cost (asset) $250 000(The asset will be amortised in line with receipt of the future benefits.)

Cash or Accounts payable $250 000

2. This is a 100% purchase of Austin Power Ltd. Austin Power Ltd will be merged with Zanadriana Ltd, and therefore Zanadriana Ltd absorbs the former’s assets and liabilities. Because the transaction is a ‘purchase’, there is a new basis of accountability.

Current assets $ 140 000Land and buildings 1 700 000Goodwill 310 000

Liabilities $ 150 000Cash 2 000 000

It should be noted that goodwill is recorded. The accounting principle is that it can only be recorded when it is paid for. It may be interesting to discuss why. One reason is the

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cost principle. Another is the problem of measurability. It is difficult to know what the value of goodwill is until there is an actual transaction.

3. Cost of purchase $1 900 000Market value of net assets acquired 1   990   000 Excess of market value over cost $ 90   000

The $90 000 excess must be absorbed by the long-term assets.

Current assets $ 240 000Land and buildings $1 810 000

Liabilities $ 150 000Cash 1 900 000

In order to avoid the recording of negative goodwill, the excess of book value over cost, after recognising the market value of current assets, serves to reduce the value of the long-term assets (except investments). This entry contradicts the market values placed on the building and land.

4. The secret formula appears to meet the definition of an asset. But it will not be recorded, unless (a) a patent is taken out, or (b) a market valuation can be obtained. This is because it was not purchased and the research and development costs have been expensed. A reliable measure needs to be obtained, and control ascertained.

5. According to AASB 1008, this is a capital lease if there is a transfer of the rights and obligations of ownership, otherwise it is an operating lease. It is not possible to tell from the information given whether the lease is operating or capital, because the life of the machinery is not given, nor is the normal price of the machinery. Thus, it is impossible to tell whether the machinery can be acquired at a bargain purchase price at the end of three years, or whether the machinery is leased for a significant portion of its useful economic life.

If the machine is leased under an operating lease:Lease expense $50 000

Cash $50 000

If the machine is leased under a capital lease:Leasehold asset (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount)

Lease liability(PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount)

Note that the tables at the back of the text (and most tables) do not offer the appropriate monthly compound interest rate to yield an 8% annual return, which is assumed at the start of this problem.

6. The executives obviously represent future economic benefits to the company. The contracts with them are regarded as executory contracts, however. Despite the contracts

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being in place, the firm does not control the executives in a total sense, and when the services are received by the company an expense will be recorded. Unless the salaries are prepaid, there is no asset to record.

14.3 Kalmers & Meehan, a taxation partnership, is preparing its 30 June 2005 financial statements, and seeks advice from PK & Slug, a firm of reputable accountants. What advice would PK & Slug offer in relation to accounting for each of the following situations (see p. 525)? If a journal entry is required, what should it be?

1. At the time that Kalmers & Meehan provided taxation advice to Petermans Ltd, Kalmers & Meehan would have deemed it probable that there would be an inflow of $70 000 for taxation advice. As such, there was a probable inflow of economic benefits as a result of a past transaction (taxation advice provision), and revenue would have been recognised. It is only now that the firm realises that the inflow is unlikely. As such, there is a reduction in probable future economic benefits as a consequence of the debate about the appropriateness of the advice offered by Kalmers & Meehan (this is the past event, along with Petermans Ltd’s refusal to pay). The firm should recognise a reduction in the revenue receivable asset, and recognise an expense (doubtful debts) to offset against the previously recognised revenue. Possibly, the expense should be bad debts rather than doubtful:

When advice was provided and it appeared probable that Petermans Ltd would pay:Dr Accounts receivable 70 000

Cr Taxation advice revenue 70 000

30 June 2005

Dr Doubtful debts expense 70 000Cr Accounts receivable 70000

2. The fact that Jilsonade Jolly Vineyards Ltd has not yet delivered the wine does not mean that it is unlikely that the firm will do so. If Kalmers & Meehan deem it probable that the wine will be delivered, they have an asset in the future economic benefits: the wine can either be used within the firm, or sold. Furthermore, it is measurable. If it is deemed probable that the wine will be delivered, the asset and associated revenue should be recorded.

When advice was provided and it appeared probable that Jilsonade Jolly Vineyards Ltd would pay (whether in money or in wine):

Dr Accounts receivable 5000Cr Taxation advice revenue 5000

The fact that the accounts are being prepared six weeks after the invoicing and the wine has not been received is not necessarily unusual, and should not necessarily trigger doubts about receiving the wine. However, it if is deemed improbable (less than 50% probable) that the wine will be delivered, then no revenue or asset should be recorded. If

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they have already been recorded, they should be written-down or written-off, in the same manner as the entries recorded for part 1 of this problem (Petermans Ltd).

3. The fact that Kalmers & Meehan was prepared to pay the cost of a walkway indicates that the firm deems it likely that the walkway will increase revenues (perhaps being more enticing to clients, or because it provides a more sophisticated/successful image). As such, it would be deemed an asset.

Dr Land & buildings 3000Cr Bank/Loan payable/… 3000

14.4 Pip Lax Ltd manufactures high-quality sports equipment and sells it under a 2-year warranty. The company guarantees to replace any defective parts and repair equipment at no cost to its customers. Record the following events of 2003 (see p. 525). The company has a calendar reporting year.

The purpose of this problem is to discuss what constitutes a liability, and when it is recorded. Two methods to account for warranties are available to accountants. One of them involves the establishment of a liability account, and the other does not. As the circumstances are the same, is there or is there not a liability? Given historical trends, it is likely that there should be a liability recorded for probable future outflows of economic benefits related to labour, parts, etc. As such, option (a) below is the preferable answer. Option (b) is shown for comparative purposes only.

(a) Accrual method entries for 2003 year:

Warranty expense $500 000Estimated liability on product warranty $500 000

Estimated liability on product warranty $800 000Cash, Parts inventory etc. $800 000

For ease of accounting, each year a warranty liability is increased for the probable warranty expenses based on the period’s sales. This liability is reduced as costs are incurred so that the balance should always be somewhere close to the expected cost of warranty repairs for the last two years’ worth of sales. There is no point reversing the warranty expense entry each year and starting afresh if warranty expense estimates are reasonably accurate.

(b) Cash-basis method for 2003:

During year Warranty expense $800 000Cash, Parts inventory, etc. $800 000

The cash basis can be used if the amount of the warranty cost is not material, or the two criteria mentioned in SAC 4 — probability of incurrence of a liability and ability to estimate the amount — are not met. In this case, the company should be using the accrual method. At least to a limited degree, both methods are acceptable. The question is: Why does one method yield a liability, and for the other, there is none? The

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circumstances of giving customers a warranty are substantially the same, so that the condition of SAC 4 should be met. If there is a liability, then only the accrual method should be used, and the cash method should be declared unacceptable.

14.5 Sleech Ltd operates an information systems company. The firm is preparing its 30 June 2003 financial statements, and requires advice concerning the proper treatment of the following situations (see pp. 525–6). Explain how to deal with each situation, and prepare any required journal entries.

1. As of the balance sheet date, there is no particular event to cause the company to believe that an asset has been impaired or a liability has been incurred. Expected losses, even if subject to reasonable estimation, do not satisfy the requirements of AASB 1044. The company may record an appropriation for self-insurance.

Retained earnings $500 000Retained earnings appropriation — self-insurance $500 000

When the loss actually occurs, then the following entry is to be made:

Loss from casualty xAsset (specific asset damaged) x

The appropriation should not be debited for the actual loss.

2. Salary expense (bonus) $500 000Paid up capital $500 000

3. Labour strikes are considered a general risk contingency inherent in business operations. Although negotiations have terminated at present, they will probably continue at a later date. The threats and bluster of labour negotiations are common. No entry should be recorded. Disclosure is not necessary in the balance sheet.

4. It is probable that a liability has been incurred, and the amount is reasonably determinable. The company knows the cause of the demand for refund (for example, overcharging of items). Therefore, the following entry should be made.

Loss from Danlon & Dolland contract $75 000Liability on Danlon & Dolland Contract $75 000

5. There is sufficient evidence of impairment of asset values at the balance sheet date, because the foreign government has actually given notice of intent to expropriate. The amount is subject to reasonable estimation. Therefore, according to SAC 4, a loss should be recorded. At the time of actual expropriation, the specific assets would be written against the allowance for expropriation account.

Book value of subsidiary $12 900 000Expected amount from government 9   000   000 Loss $ 3   900   000

Loss from expropriation $03 900 000

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Allowance for expropriation $3 900 000

Case Study 14.1 — Business wins tax break on debt

1. Explain how the following satisfy the definition and recognition criteria to be included as assets:(a) capitalised costs(b) deferred tax balances(c) leases(d) prepayments.

To be defined as an asset, the following need to be satisfied: (1) existence of future economic benefits, (2) controlled by the entity, and (3) the result of a past transaction or event. To be recognised in the statement of financial position, the future economic benefits must be (1) probable and (2) possess a cost or be capable of being measured reliably. The list of items in this question are permitted under accounting rules to be recognised as assets on the basis that each satisfied the definition and recognition criteria.

(a) Capitalised costs. Examples of capitalised costs are research and development and capitalised borrowing costs. In the case of R&D, if the technical feasibility of the product or process to which they relate has been demonstrated, and there is a clear indication of a future market for the product, or if the item is to be used internally, its usefulness can be demonstrated. Under SAC 4, if future economic benefits are probable, an asset exists and the expenditure on the R&D represents the cost to be assigned to the asset. In the case of capitalised borrowing costs, if the costs incurred are associated with a qualifying asset then they can be recognised as part of the cost of the qualifying asset. Borrowing costs would be avoided if the qualifying asset were not proceeding so the borrowing costs are integral to the asset. This accounting treatment is permissible on the basis that the incurrence of the borrowing costs will result in future economic benefits embodied in the qualifying assets. The costs can be measured reliably as the actual borrowing costs incurred on that borrowing during the reporting period.

(b) Deferred tax balances. The future economic benefit is the realisation of the tax benefits (future economic benefits) — the entity controls the tax benefits and they have arisen as a result of a past transaction. To satisfy the recognition criteria, it must be more probable than not that there will be sufficient taxable income in the future that the benefit can be realised and the tax benefit is capable of being measured reliably. AASB 1020 stipulates that deferred tax assets represent income tax recoverable in future reporting periods from deductible temporary differences and carried forward unused tax losses. To recognise such an asset relating to the unused tax loss, it must be probable that future taxable amounts will be available to enable the tax losses to be recovered.

(c) Leases. The future economic benefit associated with leased assets is the ability to use the assets to generate the future economic benefits. SAC 4 does not require legal ownership but the ability to control the future economic benefits. Provided the lease is structured in such a way that the risks and rewards of ownership are effectively transferred to the lessee, the lessee can control the access to, and use of, the asset. The past event would be the signing of the lease contract. It is probable that the leased asset will provide future

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economic benefits (otherwise why would the asset be leased) and the leased assets possess a cost or value that can be measured reliably (the value of the lease payments). AASB 1008 ‘Leases’ permits leased assets to be recognised on the statement of financial position where the lease terms transfer substantially all the risks and benefits incidental to ownership of the leased assets to the lessee (that is, a finance lease).

(d) Prepayments. A prepayment represents something that has been paid for, yet the future economic benefits as at the end of the reporting period have not been used. The firm controls the future economic benefits and they arise as a result of a past transaction (that is, the payment). The recognition criteria are satisfied as the future economic benefits will be realised, normally within the next reporting period; and as they have been paid for, the asset has a cost value.

2. Why will treating these items according to accounting concepts boost most companies’ equity levels?

The Australian Taxation Office ruling permits these items recognised as assets for accounting purposes to also be recognised as assets for taxation purposes. The double-entry system of accounting means that recognising such items as assets could result in an increase in equity. Duality ensures that recognising one asset must have the dual effect of either (1) reducing another asset (in which case equity would remain unchanged), (2) increasing a liability (in which case equity would remain unchanged), or (3) increasing equity. Students should be encouraged to work through the dual effects of the transactions in question 1.

3. The article suggests that the tax ruling will reduce the need for additional asset revaluations. Discuss.

The tax ruling discussed in this article relates to interest deductibility restrictions imposed of certain firms. If a firm’s debt-to-equity ratio exceeds 3, then deductibility of interest on excessive borrowings will be denied. The rule changes mean that certain accounting assets that were precluded from inclusion as assets when calculating a firm’s debt-to-equity ratio for taxation purposes are now able to be included in the asset base. The effect of asset revaluations is to increase assets and increase equity (via the asset revaluation reserve). The increase in assets and equity due to the rule change means that firms will be less reliant on asset revaluations to increase their equity in an effort to avoid breaching the prescribed gearing ratio.

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4. Compare the implications for a firm of breaching the Australian Taxation Office’s debt covenant with that in a loan agreement.

Breaching either the ATO’s debt covenant or the loan covenant has economic consequences for firms. Breaching a debt covenant in a loan agreement is a breach of contract. The ramifications associated with such a breach will depend on the magnitude and reasons for the breach. A technical breach may involve the debt contract being renegotiated. The consequence of a more extreme breach could be the contract being rescinded and the firm losing access to the debt facility. In either situation, costs are imposed on the firm although the magnitude of the cost imposition differs.

Breaching the ATO’s debt covenant denies the firm a tax deduction in relation to interest on borrowings. This will increase their tax liability and increase the tax payable.

The existence of debt covenants creates incentives for preparers to use the discretion and judgement afforded to them in accounting regulations to portray the financial statements in a particular manner. The alignment of taxation and accounting rules intensifies the incentives because accounting numbers are now specified in both lenders’ borrowing contracts and ATO rules.

Case Study 14.2 — A patent is like having a safety net

1. How does a patent differ from a trademark?

Intellectual property rights is the term collectively given to rights such as trademarks, mastheads and patents. A patent is the right to an invention, design or product appearance. A trademark is the right to use a name in association with goods and services (for example, Coca Cola). A trademark denotes the origin of a product or service. Both patents and trademarks are recognised as intellectual property rights issued by a national government body to identify a firm’s goods and services (trademark) or right to an invention, design or product appearance (patent).

2. Are patents and trademarks assets as defined under SAC 4? Should patents and trademarks be recognised in the statement of financial position? If so, how could they be measured reliably?

To qualify as an asset it is necessary that a future economic benefit that is controlled by the entity exists as a result of a past transaction. There is no doubt that the registration of trademarks and patents constitute past transactions. The registration conveys rights to the owner (in this case, intellectual property) and prohibits others from using the rights. The trademarks and patents are controlled by the entity. The issue with respect to deriving future economic benefits is more contentious. The recognition of trademarks as identifiable intangible assets is premised on the notion that consumers identify goods and services based on their trademark and this creates a demand for the goods and services that would not be parallelled in the absence of those naming rights. The future sales expected to be derived, as a result of consumer awareness with a trademark conveys future economic benefits to the firm. The derivation of future economic benefits associated with a patent is associated with the future revenue stream derived and protected from the sale of products governed by the patent. Satisfying the recognition criteria is more problematic. Future economic benefits are probable

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if the trademark is well established and recognised in the marketplace. The probability of future economic benefits associated with a patent is less obvious given that many patents do not result in successful products, and protecting future revenue streams via patents is not always successful. Patent challenges in court have often deemed patents to be invalid due to ineffective drafting.

SAC 4 does not allow recognition of any assets unless there is a cost or other value that can be measured reliably. In the context of trademarks and patents, the cost is readily measured — firms pay a price to register the trademarks and the patents.

3. Given that Safe-T-Netts are not for sale, but custom-made for a particular site and then leased, should the nets be recognised as an asset?

The fact that the Safe-T-Netts are not for sale, but custom made for a particular site and then leased should not impede recognition of the nets as assets. The definition and recognition criteria do not include saleability; and so long as the specified asset definition and recognition criteria are met, the nets are assets of the firm. The Safe-T-Netts provide future economic benefits to the firm in the form of lease rentals. The future economic benefits arise as a result of a past transaction — the lease contract. The key issue is whether the firm controls the nets and future economic benefits that they generate once they are leased to the building and construction firms. If the lessor (the net manufacturer) effectively transfers the substantial risks and benefits of ownership to the lessee then the nets would be assets of the lessee rather than the lessor. The fact that the nets are custom made suggests that control of the nets effectively passes to the lessee.

4. A major corporation has exclusive interstate and overseas licensing rights for the nets. Are the licensing rights assets as defined under SAC 4 and should they be recognised in the statement of financial position of the licensee?

Licensing rights would satisfy the asset definition and recognition criteria. The rights convey future economic benefits to the licensee as the rights would be expected to generate cash from future revenue streams for the licensee. The rights are controlled by the firm — as while they have the rights other parties are denied access to the rights. The signing of the agreement conferring the rights to the licensee constitutes the past transaction. The future revenue stream would be probable and the value of the rights can be measured reliably based on what the licensee paid for the rights. Many Australian firms recognise rights (for example, management agreements) and licensing agreements (for example, television licences) on their statement of financial position. (Recall that as at 30 June 2002, there is no Australian accounting standard prescribing the recognition and measurement of identifiable intangibles.)

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Case Study 14.3 — Smarten up on intellectual property

1. Using the information in the article, provide arguments and counter-arguments to each of the following to debate whether intellectual property might be regarded as an asset:(a) whether the intellectual property generates future economic benefits that are

probable(b) whether the intellectual property is controlled by the firm(c) whether the intellectual property can be measured reliably.

The following table summarises the arguments in the article relating to recognising intellectual property as an asset.

Arguments for asset recognition Arguments against asset recognition(a) Future economic benefits that are probable Protects future revenue stream Market values intellectual property

Success of intellectual property such as patents is questionable

(b) Future economic benefits are controlled by the firm Registration results in an enforceable

legal right Monopolistic right created by

registration

Only 20% of patents tested in court are successful suggesting the control is not present in the majority of cases

Registering in one country does not mean that the control exists worldwide

(c) Future economic benefits can be measured reliably Costs to register intellectual property Application fees and associated costs do

not reflect the economic value of the intellectual property

2. Do you believe that additional criteria, such as separate identifiability and exchangeability, should be considered when deciding if an asset should be recognised?

In considering exchangeability and identifiability, the suggested solution to question 6 is reiterated.

Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the balance sheet is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items.

Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a

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misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Since benefits received from using resources are unaffected by whether they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset. Economic value depends on scarcity and utility, not exchangeability.

To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events.

SAC 4 does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under SAC 4.

3. The international accounting standard on intangibles (IAS 38) prescribes that purchased and internally generated intangibles should be treated differently. Do you think the different accounting treatments are warranted? Why or why not? Is this approach consistent with the conceptual framework’s definition and recognition criteria for assets?

Separate treatment of intangibles based on their genealogy appears to be inconsistent with SAC 4 on the basis that whether an asset is or is not acquired at a cost does not form part of the definition and recognition assessment criteria. When deliberating IAS 38, asymmetrical accounting treatment for purchased versus internally generated intangibles was justified on the basis that genealogy does impact on the recognition criterion being satisfied. The justification for not permitting internally generated intangibles to be recognised is premised on their not having a cost or value that can be measured reliably. This treatment of internally generated identifiable intangibles is consistent with Australian firms not being permitted to recognise internally generated goodwill on the statement of financial position. Others would argue that the existence and acceptance of valuation methodologies (based on discounting revenue streams associated with the identifiable intangibles) suggests that such assets can be measured reliably. The subjectivity involved in the valuation process is of concern to regulators, as it is inconsistent with the requirement that financial statements be objective.

Students may also comment on the value relevance of intangible assets. Empirical studies suggest these assets are value relevant and their recognition is therefore providing useful information for decision making. This highlights the trade-off between the qualitative characteristics of relevance and reliability.

4. Explain the reason behind the Group of 100’s statement that ‘intangible assets are by far the most important assets in the market capitalisation of most companies irrespective of whether they are recognised in the financial statements’.

The Group of 100’s statement is suggesting that the market recognises the importance of intangible assets and incorporates the future cash flows associated with such assets into the

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firm valuations. Students should be encouraged to use empirical evidence to support the Group of 100’s claim. If the market values intangible assets and if the financial reports are trying to provide information that is useful for decision making and reflective of economic reality, then an argument for recognising intangibles on the statement of financial position can be supported. The counter-argument is that the market is considering such assets despite their not appearing on the statement of financial position. Accordingly, there is no need to introduce subjectivity and compromise the reliability of financial information by recognising them in the financial statements.

Ideally this question could be set as a classroom debate exploring whether identifiable intangibles should be recognised on the statement of financial position; and, if recognised, how they should be accounted for.

5. Given the comment by the Group of 100, what do you think their position on accounting for intangible assets is likely to be?

The Group of 100’s statement demonstrates the value of intangible assets to firms. The Group of 100 comprises financial executives from leading Australian public and private sector organisations. The Group usually engages in the lobbying process associated with accounting standard setting. The adoption of IAS 38 requirements has implications for the carrying value of a firm’s assets and reported earnings. Many Australian firms, including those represented in the Group of 100, recognise internally generated intangible assets and revalue such assets. A more restrictive treatment of intangible assets, such as that prescribed by IAS 38, would no longer permit such accounting practices. Consequently firms’ reported assets would be lower.

The inability to reflect the ‘value’ of the intangible assets in the statement of financial position may have implications for a firm’s value. The inability to purport the economic value of the assets in the balance sheet may impact on the market’s assessment of the firm’s growth opportunities. A more restrictive treatment also has implications for firms’ contractual arrangements. Firms with debt contracts containing covenants based on accounting numbers could be placed in a position of breaching such covenants. A technical breach of the covenants, imposed by a new accounting treatment, imposes costs on the firm that reduce firm value. It should be noted that covenants based on assets often exclude intangible assets due to the subjective nature of the valuations. If this is the case, the change in accounting treatment may have no implications for the covenants contained in the firm’s contractual arrangements. Remuneration contracts may also contain performance measures based on accounting income numbers. Thus, the compensation of managers may be adversely affected given that amortising the assets will reduce profit. Similarly, if the manager has shares or options and the inability to revalue intangibles affects the market’s assessment of the firm’s growth opportunities, the manager’s equity portfolio could reduce in value.

The Group of 100 has strongly supported harmonisation and international convergence. The Group of 100 developed their own Statement of Principles of Intangible Assets in 1995. In responding to the AASB’s request for comments on IASB’s proposed amendments to IAS 38, the Group of 100 noted that they were concerned about the adoption of IAS 38 and entities that recognise and revalue internally generated intangibles. Specifically they stated: ‘for some companies these assets represent a significant portion of total assets which under IAS 38 would be derecognised. This would have severe impacts on these entities…’.

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CHAPTER 15

MEASUREMENT OF ASSETS AND LIABILITIES

Theory in Action 15.1 — Measuring and reporting intangibles

1. Are intangibles really assets? Why or why not? If so, should they appear on the statement of financial position? Why or why not?

Intangibles are assets if they are future economic benefits controlled by the entity as a result of past transactions or other past events. Intangibles such as mastheads, trademarks and brand names are future economic benefits that the entity controls via ownership and management. They arise as a consequence of past transactions or events such as quality reporting, invention and marketing. As such, they are assets. Whether they should appear on the statement of financial position depends upon whether they meet the criteria of SAC 4: it is probable that the future economic benefits embodied in the asset will eventuate they possess a cost or other value that can be measured reliably.

In many cases, there is a high degree of certainty that the future economic benefits embodied in the assets will eventuate, although there may be a high degree of uncertainty as to the exact amount or its timing. Generally, a value can be attributed to the assets, although the reliability of the measure may be debatable. It is likely that a valuer can place a value on the assets, or that there is a market value for some assets such as trademarks or mastheads.

In discussing this question, instructors could ask students about the reliability of a measure of a tangible asset such as a building that can be rented out and generates future income. This could then be followed by investigating whether the students think it is more appropriate to recognise a tangible or an intangible asset on the statement of financial position if both meet the asset definition and recognition criteria equally.

2. What measure best estimates what intangibles are ‘worth’ to an entity? Why?

This is a question about different valuation concepts. For example, the ‘worth’ of an asset should generate debate about present value, which is the discounted value of future cash flows (or earnings). Alternatively, the net realisable value of the asset is the net amount for which it could be sold and the value that the firm could invest; or current cost, which is the amount required to replace the asset. Presumably, the fact that the asset is held by the firm means that its present value exceeds its current cost which in turn exceeds its net realisable value, and therefore is a ‘truer’ measure of value of the asset to the firm. Hence, present value is the value in use. On the other hand, if current cost is less than net realisable value, the loss to the firm if it was deprived of the asset is only the cost to replace the asset — and this is its value to the firm. The net realisable value is the value to the firm of the asset should the firm seek to adapt its operations and is the cash value that the firm would receive to invest in other operations or assets.

There are a number of environmental factors regarding intangible recognition. The point made by the article is that CEOs now need to be up to speed on these valuation issues and that several categories of intangibles have been identified by the FASB and the

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valuation on the principle of current market rates. These valuations are also required to be revisited each year, thus introducing volatility into the valuation exercise. There is also considerable pressure to recognise that brand intangibles will increasingly drive the value of corporations and that CEOs are responsible for share prices.

3. Assume that intangibles are to appear in the financial statements. How should intangibles be measured for purposes of those financial statements?

This is an area of intense debate in accounting theory, and students should be aware of the issues. Intangibles appearing on the statement of financial position should be measured at something approximating a current value that is meaningful to users of the reports and to the market place. That said, how do we do this? The current cost is indeterminable for many intangibles, and while net realisable value can be more objectively determined in some cases this is not feasible if the intangible is not severable from the firm. Cost is difficult to estimate, given that many intangible assets are internally generated by a series of activities that indirectly give rise to their presence, and those activities often will not have been recorded. Thus, by default we are left with estimating the net present value of the discounted incremental earnings (or free cash flows) from the activity.

4. Some intangibles have values that increase over time. Examples are abalone licences, taxi licences, mastheads and brand names. If these intangibles are recorded in the financial statements, should they be amortised? In answering this question, consider whether (a) they have an active and liquid market for resale and (b), if they have a limited useful life. If they are to be amortised, what pattern of amortisation is appropriate?

This is a controversial issue. While it is generally accepted that some assets may increase in value for a period of time, it is also generally accepted that most assets ultimately lose value — and this is true of both tangible and intangible assets. The argument in relation to intangibles is different from the argument in relation to tangibles in the sense that tangible assets generally deteriorate physically, whereas there is no such deterioration in the case of intangibles. Nonetheless, it is difficult, if not impossible, to think of any asset that does not, at some stage, lose value. Even Cobb & Co lost value as a brand name, albeit after many years. Tangible assets completely lose value when their physical form no longer enables them to be used to generate economic benefits. Intangibles sometimes lose the value that exists at a point in time, but this loss of value is compensated for by an internally generated increase in value. In that case, it is arguably appropriate to amortise the asset and capitalise expenditure within the firm that gives rise to the additional value, just as physical assets are depreciated and capital expenditure is capitalised into the asset value.

Even though some assets increase in value over time, if the assets are recorded at cost, the increase in value is not really relevant. Under the historical cost model, depreciation and amortisation are cost allocations, not entries designed to reflect current values of the assets. Under the historical cost model, the asset should be amortised over its useful life. Increases in value can be accommodated by asset revaluations. Under a current valuation system, the asset should be revalued. If the system is current cost, the asset should be amortised. If the system is a present value system, the asset should be amortised; and if it is a net realisable value

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system, it should not. Instead, changes in value would be taken directly to earnings (or to a capital maintenance reserve, depending on the concept of capital that is adopted).

The pattern of amortisation of an asset should reflect the decline in the asset, according to the firm’s measurement system. Under an historical cost or current cost model, the pattern should reflect the pattern of use of the asset; under a present value method, it should reflect the decline in the present value of the asset. Some argue that it is more difficult to estimate the amortisation pattern for intangibles than the depreciation pattern for tangibles, but there is no a priori reason why that is necessarily so. There is no reason to suggest that straight-line amortisation is better than reducing balance amortisation or inverted sum-of-the-years amortisation. The pattern should be consistent with the objectives of the firm’s measurement system.

The reason that standard setters have required straight-line amortisation is because they have adopted a pragmatic approach to the issue and have attempted to remove reporting flexibility.

5. Why do you think the most common treatment of intangibles is to measure them at cost and amortise them on a straight-line basis? Is this theoretically defensible for all assets?

The most common measurement of intangible assets is cost, presumably because firms adopt historical cost measurement for most of their assets. Furthermore, they are likely to have difficulty revaluing intangibles because there is not always an active and liquid market they can refer to for measures of identical assets. For example, brand names may have values but they will be specific to the product, just as mastheads are specific to the media firm.

Straight-line amortisation is probably used because it is no less defensible than any other amortisation pattern given the difficulties of determining patterns of use, and because it is easiest to apply. It is less conservative than the reducing balance method of amortisation, and given that many intangibles increase in value, managers may feel that it is appropriate to use the less conservative approach.

6. Imagine that you are a financial analyst. Write a two-page report outlining the importance of valuing intangible assets.

This question is designed to give students the opportunity to assess the growing importance of intangible assets in the service and knowledge-based industries. Some statistics of these would be appropriate. The problem is that they are growing in importance for CEOs, but the measurement of them is difficult and controversial. Here are some of the issues: the fact that intangibles can increase in value and in many cases do not have known lives the argument that there is no measurement standard or concept in the SACs so it would be

premature to require a measurement method for any assets, let alone something so controversial as intangibles

the impact on firms’ profits and statements of financial position, and the likelihood that firms will breach interest coverage and other earnings-based debt covenants when they are valued

the political and market costs to CEOs who overvalue assets and performance (especially since the Sarbanes-Oxley Act 2002 in the USA)

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the question whether intangibles do add value to the firm and whether particular firms are spending too much, too little or about the right amount in generating intangibles and potential future cash flows. The question about undervaluing assets (both tangible and intangible) gives rise to whether firms are potential takeover targets or not.

The inability to reflect the ‘value’ of the intangible assets in the statement of financial position may have other implications for a firm’s value. The inability to purport the economic value of the assets in the statement of financial position may impact on the market’s assessment of the firm’s growth opportunities. Amortisation reduces profits and it could give individual investors and other users of financial statements a less favourable image of the firm. This assumes that users are unsophisticated and unable to distinguish the accounting change from a change with cash flow consequences. However, given that firm value is based on the discounted value of expected future cash flows, the reduction in profit associated with amortising intangibles should have no impact on the firm’s future expected cash flows.

The recognition of intangibles also has implications for firms’ contractual arrangements. Firms with debt contracts containing covenants based on accounting numbers could be placed in a position of breaching such covenants. A technical breach of the covenants, imposed by a new accounting treatment, imposes costs on the firm that reduce firm value. It should be noted that covenants based on assets often exclude intangible assets due to the subjective nature of the valuations. If this is the case, the change in accounting (and valuation) treatment may have no implications for the covenants contained in the firm’s contractual arrangements. Remuneration contracts may also contain performance measures based on accounting income numbers. Thus, the compensation of managers may be adversely affected given that amortising the assets will reduce profit. Similarly, if the manager has shares or options and the inability to revalue intangibles affects the market’s assessment of the firm’s growth opportunities, the manager’s equity portfolio could reduce in value.

Theory in Action 15.2 — Applying methods to estimate property values

1. Briefly compare the three different methods described by Crabb. Which method do you think is superior?

This question goes back to the purpose for which the house is put. A few scenarios are as follows: If the house is purchased for an investment then method two is more appropriate.

However, the rate of return of 4.5–5.5% is very low and is set at approximately the risk-free rate. Further no capital gains are factored in and this would have to be estimated.

If the purpose of the house is to live in and consume the resource then it is not a business deal. All sorts of externalities now have to be factored in, such as owning one’s own house, the suburb, proximity to schools and conveniences. An alternative is to calculate the cost of rent versus cost of owning and the benefits of owning. Current market price (method 2) is required for this calculation.

Method one is very conservative and is usually applied by banks that wish to factor in liquidation (firesale) type values.

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2. How would you calculate the net present value of your house? Show workings.

Net present value is theoretically sound in measuring the value of the house. You will need to take account of all future cash flows (in the form of opportunity cost of rent saved), including tax benefits, the value of intangibles associated with owning a house, etc. Problems are in estimating future cash flows for a number of years out, expected terminal value and the required discount rate. However, it is superior to historical cost, which does not measure the current ‘worth’ of the investment to the firm, and it is superior to net realisable value where there is not an active and liquid market for the asset. Instructors could ask students how long the present housing price boom will last.

3. Show how your calculations would be different if your house was bought as an investment (use a tax rate of 40%).

All investments need to calculate a discount rate that reflects the risk of the investment. The house could be shown at its net present value of rent receipts, capital gains and tax benefits.

4. What other external factors might be used to modify your valuation estimates?

This question relates to the fundamental question of how to value future economic flows. For example: Is the market overvalued or undervalued? (Is the market affected by irrational

exuberance?) That said, relative value is a good measure that is probably more reliable in many

instances by reference to real estate values for similar properties. What are your estimates of future interest rates and the demand for housing? The intangible value of owning and living in your own property.

Questions

1. Explain what is meant by ‘subjective value’ and how it differs from discounted present value.

Subjective value is the value a firm (as represented by its management) places on a particular plan of operations. A plan of operation involves a pattern of expected net receipts. If a firm is seeking to maximise profits, it should select that arrangement of assets and equities (the plan) that has the greatest subjective value.

A plan is subject to adjustments and modification through time as more information is available. Present value is the formal procedure for determining subjective value. Although a firm may not actually use the present value method in determining subjective value, the present value method requires formal incorporation of the essential variables that must be considered. According to Edwards and Bell, subjective value and present value should be exactly the same if implemented by economically rational managers.

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2. Assume that you are in the process of buying a new house. What is the true economic value of that house? What attributes affect its true economic value?

There are numerous variables that affect the value of a house. These include size of house, number of bedrooms and bathrooms, existence of a family room, appliances, general condition of the house, age, proximity to working place and shopping, neighbourhood, quality of schools, architecture of the house, landscaping and market value of nearby houses. The point is that ‘true economic value’ involves many variables that affect people’s preferences, and we do not know the relative importance of each for all cases. Therefore, it is impossible to determine true economic value objectively. Because we are unable to ascertain true economic value, we have numerous approximations of it. Each is relevant for given purposes. Conventionally, we divide these approximations as either falling under the category of ‘cost’ or ‘value’. (See also Theory in Action 15.2.)

3. It is often argued that cost and value are different concepts. Are they? How do they interrelate?

Cost is a sacrifice. It is something that a person or entity does. In economic theory, the sacrifice pertains to the next best alternative forgone (opportunity cost). We can measure the sacrifice by determining what was sacrificed, if that is quantifiable. If money is used, then this is simple to determine, because the sacrifice is the amount of money given. Cost relates to value because one must sacrifice something of value. If the item acquired has no value, there will be no sacrifice. At the time the sacrifice is made, we can say that value is at least equal to cost. Something has value because it is desired — that is, preferred to something else. In economic theory, the sacrifice pertains to the next best alternative forgone. We can measure the sacrifice by determining what was sacrificed, if that is quantifiable. If money is used, then this is simple to determine, since the sacrifice is the amount of money given.

Something has value because it is desired — that is, preferred to something else. By their behaviour, people and entities give things economic value. If no-one wants item X, then X has no economic value. It is possible that in some societies diamonds have no value, because no-one wants them. Objectively, value is quantified by the market price system.

In accounting, we usually think of cost as represented by the amount of money or other consideration given (sacrificed) to acquire something. Value is that amount of money representing future benefits or services.

It is important for students to realise that cost and value are fundamentally very subjective concepts. Because cost and value are all approximations of ‘true’ value, there are disagreements about the ‘proper’ amount to use for specific purposes. Disagreements should not be surprising.

4. Why is cost relevant to accounting?

Paton argued that the significance of cost is that it approximates fair value (current cost) at the time the acquisition of the item is made. It is important because it is a measure of value. In other words, it is value that we are interested in, and cost is an objective representation of value at the time of acquisition of an item (but only at that time).

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5. Susan, planning for her retirement, purchased an investment property on 1 January year 1. The price paid for the property was equally split between the land and house components (approximately $30 000 each). When she purchased the house, she expected to rent it out for 5 years, then live in it for another 15 years before building a new home on the same property. Real estate prices in the area have moved such that she expects the market value of the property to exceed its original cost at the time she plans to build the new home. At the start of year 2, she has been renting the house out at $800 per month, paying rates of $1500 p.a. Occupancy rates have been low, so she has decided to take a holiday and stay in the house herself for the month of August. Power and gas cost $80 for the month, only $50 of which is variable. Ignoring all tax implications, what is the cost of her stay in the house for the month?

If cost is the sacrifice of the next best alternative forgone, then the cost of her stay in August is the $800 rent she could have received but did not. The depreciation, property taxes and utilities would have been incurred regardless of whether she stayed in the home or not, except for the variable portion of $50 of utilities. However, the $50 would have been incurred if she had rented out the house. If utilities are covered by the $800 rental fee, the $50 is not a ‘unique’ cost and the cost of

her stay at the vacation home is therefore $800. On the other hand, if utilities are the responsibility of the tenant, the cost of her stay is

$850 less the variable cost of utilities that she would otherwise have incurred at her usual residence.

Conventional accounting would determine the cost differently. It would probably calculate the cost as follows:

$125 Depreciation for one month ($30 000 ÷ 20) ÷ 12 125 Rates 80 Electricity$330

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6. Jack Johns Ltd is an electrical goods manufacturer that owns a manufacturing machine purchased on 1 January 2004 for $50 000. The machine had an expected 6-year life when it was purchased. Jack Johns Ltd’s operations manager expects to replace the machine with a new machine in 2009. At present, the price of the new machine is $72 000 and the machine also has an expected 6-year life. Its only advantage over the existing machine is that it saves raw materials and labour costs of $5000 p.a., on average.a) What is the replacement cost of the existing machine at the end of 2006?b) What is the current cost of the existing machine at the end of 2006?

(a) Replacement cost:Cost of new asset 72 000Economic life 6 yearsDepreciation $12 000 a year

Cost of existing asset, which is 3 years old:$72 000 cost, new–36   000 accumulated depreciation, 3 years$36   000

The replacement cost of the existing asset at the end of Year 3 is $36 000.

(b) Current costReplacement cost (3 years old) $36 000Less operating advantage for next 3 years (3 × $5000) $15   000

$21 000

The current cost of the asset at the end of Year 3 is $21 000.

7. There are numerous concepts of value. What is value to the owner? How does it differ from other concepts of value?

Value to the owner is argued to be deprival value. Deprival value is the loss the owner would suffer if the owner were deprived of the asset.

The upper limit is current cost. The lower limit is net realisable value.

The loss that results from being deprived of an asset cannot exceed the cost of replacing it (current cost, since the focus is on the actual existing asset). The loss must be at least equal to the amount the owner could sell the asset for, less costs of selling it, which is NRV, otherwise he would dispose of the asset.

Value to the owner in most cases is current cost. It would be less than current cost if (1) an asset held for use has a present value that is less than current cost, then present value should be employed; or (2) an asset to be sold has a NRV that is less than current cost, then NRV should be used.

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The term ‘cost of replacement’ is used in this book, which may lead some students to believe value to the owner is replacement cost.

8. Stephen Hicks is contemplating starting up an equipment leasing firm. He is currently assessing whether it is worth buying a machine that he knows he can lease out in return for the following cash flows over the next 4 years:

2004 $25 0002005 20 0002006 15 0002007 12 000

At the end of 2007, Hicks expects to be able to sell the equipment for $10 000. Ignoring taxation implications and assuming that interest rates relevant to Hicks are 12% p.a., what is the maximum price that Hicks should pay for the equipment? (You may need to use compound interest tables.)

The price should be the present value of the annual net cash receipts. Using the factor for present value of a single sum at 12%:

for 2004 0.89286 × $25 000 = $22 321.502005 0.79719 × 20 000 = 15 943.802006 0.71178 × 15 000 = 10 676.702007 0.63552 × 12 000 = 7 626.242007 0.63552 × 10 000 = 6   355.20

$62   923.44

9. Barry Vickers is preparing the accounts for his company and is unsure how he should measure the assets in the accounts. Advise him how he should measure the following assets:(a) shares in other companies (his company trades these shares)(b) notes receivable(c) accounts receivable(d) inventory(e) inventory that has been repossessed from customers who have defaulted on their

payments(f) investment in corporate bonds(g) equipment.

The valuation methods are:(a) lower of cost or market(b) if long term, use present value; if short term, use expected cash(c) expected cash (gross amount less allowance for bad debts)(d) lower of cost or market — cost may be by an assumed flow (FIFO, LIFO, Av.)(e) net realisable value(f) the cost would be stated initially — for a long-term investment, the present value method

is preferred for amortisation, although the straight-line method is acceptable(g) cost (less accumulated depreciation), or net realisable value, which is revalued according

to an established frequent revaluation program.

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10.In her will, the general manager of X Ltd donated shares and other marketable securities to X Ltd. The cost of the securities to the general manager was $50 000. Their current market value is $80 000. To buy them, X Ltd would need to incur transactions costs of around $1000. To sell them, X Ltd would need to incur transactions costs of around $1500. When the securities are first reported in X Ltd’s accounts, at what amount should they be measured?

Record $80 000, the current value. The entry would be to debit investments and credit a revenue account since this represents an inflow of economic benefits to the entity.

11. Nikole Ltd is planning to start up manufacturing operations. At the start of this year, two buildings were found that appeared suitable for the business. The buildings are on adjacent blocks of land. Management took out a 1-year option on each building while they made a range of decisions, including where to locate their administrative and transport buildings. The cost of the option was not applicable to the contract price of either property. In the latter part of the year, Nikole Ltd purchased one of the buildings for $2 000 000. The cost of the option for that building was $100 000. The option over the other building was $120 000. What is the cost of the building that Nikole Ltd purchased? Explain your answer.

The cost of both options was part of a plan to purchase one building. The intent of the company was to purchase only one building, but it needed more time to make its decision. In this light, the cost of both options was a necessary expenditure to acquire the one building:

$2 000 000 + $100 000 + $120 000 = $2 220 000

12. Carlin Lim Research Placements Pty Ltd is a small research organisation that specialises in placing researchers to work on the premises of their business clients. In keeping with its upmarket image, the firm uses an expensive European car to drive the researchers to their new work locations. The firm recently paid $5000 to have its logo tastefully painted on a rear panel of the car. Should the cost of the painting be capitalised, or should it be expensed? Why?

An argument can be made for either capitalising or expensing. The question provides an opportunity to discuss the rule for capitalising expenditures.

It could be argued that as far as Carlin Lim Research Pty Ltd is concerned, the car is ‘incomplete’ until its name and logo are painted on the car; therefore, the expenditure should be capitalised. The logo will generate future cash flows. Therefore, it meets the definition of an asset. The cost should be added into the Motor Vehicle account.

It could be argued that this is a form of advertising and should be expensed in the period it is incurred because it is uncertain whether there will be future economic benefits from the advertising beyond the end of the current period. Materiality of the amount could play a role and lead to expensing, although $800 could be material for some small companies.

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13. Goodwill may be either generated internally or purchased. What, exactly, is the difference between purchased goodwill and internally generated goodwill? Ignoring the requirements of existing accounting standards, do you believe that it is appropriate to use the inverted sum-of-the-years-digits method to amortise purchased goodwill?

Purchased goodwill arises as the difference between the purchase consideration when the reporting entity acquires an entity by purchasing the assets or, in the case of a subsidiary, purchases some or all of the ownership rights in that subsidiary. It is the future economic benefits expected from unidentifiable assets that, because of their unidentifiable nature, are not brought to account. This goodwill reflects future benefits that are internally generated by the vendor prior to the date of acquisition and are expected to flow to the acquirer.

Internally generated goodwill, on the other hand, is generated within the entity rather than purchased. Again, it is the set of unidentifiable assets that provide future economic benefits to the firm.

Many argue that the inverted sum-of-the-years-digits-method (ISOYD) of amortisation of purchased goodwill is inappropriate because it is impossible to find solutions where acquired goodwill loses its future economic benefits more in later years than in earlier years. It is argued that the only way this is likely to occur is if the asset is maintained more in earlier years. If that is the case, then the maintenance creates internally generated goodwill rather than purchased goodwill. Assuming that this is the case, then nothing should be recognised since accounting standards prohibit the recognition of internally generated goodwill.

Others argue against the ISOYD method because they feel that firms only want to use it to window-dress their accounts. They feel that this represents manipulation of the accounts that should not be allowed.

Yet others argue that, because goodwill is unidentifiable, the patterns of benefits from it are also unidentifiable, and it is inappropriate to adopt a pattern of amortisation that is less likely to apply in most circumstances.

14.Accounting standards currently require straight-line amortisation of purchased goodwill. Why? Do you believe that the reason offered in the relevant standards is appropriate? How do you think that purchased goodwill should be amortised? Why?

The AASB prescribed the straight line method of goodwill amortisation mainly to prevent the use of the inverted sum-of-the-years-digits (ISOYD) and similar methods for all of the reasons outlined in question 13 above. It is probably impossible to establish a ruling that precludes methods similar to ISOYD, so the AASB opted for a relatively arbitrary choice: to require straight-line amortisation. The reason for choosing straight-line amortisation was that most firms adopted this amortisation pattern. The AASB recognised that it might be possible to estimate a value for goodwill in a firm; but that requires recognition of internally generated goodwill, since the value of the acquired goodwill cannot be assessed with accuracy in periods following the period in which the goodwill was purchased.

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We would argue that it might not be possible to identify particular components of goodwill, but that it might be possible to know the approximate pattern of their benefits as the benefits are obtained. As such, some firms may be in a position where they can estimate the pattern of amortisation most appropriate to them. In this case, they should, perhaps, be allowed to use that pattern, even if it is not straight line However, we do not consider that it would be easy to develop a standard that precluded managers from opportunistic manipulation of their accounts through goodwill amortisation policies.

15. There is some debate regarding whether internally generated goodwill ought to be recognised in financial statements. If it were to be recognised, would its measurement be controversial? Would its amortisation pattern be controversial? Why or why not?

If internally generated goodwill was recognised in financial statements, the issue of the choice of goodwill amortisation methods would probably be even more controversial than it is at present. Recall that goodwill is the set of unidentifiable intangible assets. If internally generated goodwill was shown as a separate asset, how could its value be

estimated? If internally generated goodwill was shown as a separate asset, how could internally

generated goodwill be separated from the purchased goodwill? If it is unidentifiable, how could the pattern of consumption or loss of future economic

benefits inherent in either goodwill be established? What potential would exist for opportunistic exploitation of an opportunity to reflect

relatively costless assets (those internally generated) on the accounts, and what level of opportunism would exist in relation to its amortisation? Note that goodwill is unlikely to be included in the asset base of leverage debt covenants, but amortisation is likely to reduce the interest coverage ratios used in debt covenants.

16. Do you believe that all intangible assets should be amortised? Why or why not?

It is generally accepted that most assets ultimately lose value, and this is true of both tangible and intangible assets. The argument in relation to intangibles is different from the argument in relation to tangibles in the sense that tangible assets generally deteriorate physically, whereas there is no such deterioration in the case of intangibles. Nonetheless, it is difficult, if not impossible, to think of any asset that does not, at some stage, lose value. Even Cobb & Co lost value as a brand name, albeit after many years. Tangible assets completely lose value when their physical form no longer enables them to be used to generate economic benefits. Intangibles sometimes lose the value that exists at a point in time, but this loss of value is compensated for by an internally generated increase in value. In that case, it is argued to be appropriate to amortise the asset and capitalise expenditure within the firm that gives rise to the additional value, just as physical assets are depreciated and capital expenditure is capitalised into the asset value.

Even though some assets increase in value over time, if the assets are recorded at cost, then the increase in value is not really relevant. Under the historical cost model, depreciation and amortisation are cost allocations, not entries designed to reflect current values of the assets. Under the historical cost model, the asset should be amortised over its useful life. Increases in value can be accommodated by asset revaluations. Under a current valuation system, the asset should be revalued. If the system is current cost, the asset should be amortised. If the system is a present value system, the asset should be amortised; and if it is a net realisable value

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system, it should not. Instead, changes in value would be taken directly to earnings (or to a capital maintenance reserve, depending on the concept of capital that is adopted).

The pattern of amortisation of an asset should reflect the decline in the asset, according to the firm’s measurement system. Under an historical cost or current cost model, the pattern should reflect the pattern of use of the asset; under a present value method, it should reflect the decline in the present value of the asset. Some argue that it is more difficult to estimate the amortisation pattern for intangibles than the depreciation pattern for tangibles, but there is no a priori reason why that is necessarily so. There is no reason to suggest that straight-line amortisation is better than reducing-balance amortisation, or inverted sum-of-the-years amortisation. The pattern should be consistent with the objectives of the firm’s measurement system.

The reason that standard setters have required straight-line amortisation is because they have adopted a pragmatic approach to the issue and have attempted to remove reporting flexibility.

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Problems(For a full outline of problems, please see the text.)

15.1 During 2004, the following events occurred in relation to Jessica’s Revals Ltd, a property developer and real estate valuation firm.(a) Jessica’s Revals Ltd purchased land from Denis Gibson for $1 000 000. This

land was adjacent to, and otherwise identical to, the block of land that Jessica’s Revals Ltd had bought for $1 000 000 3 years ago and had then spent an extra $50 000 improving to now have the same value as the land bought from Gibson. Record the two blocks of land in the accounts of Jessica’s Revals Ltd.

(b) Jessica’s Revals Ltd bought 500 ordinary shares in Charmers Construction Ltd for $18 000 cash on 7 September 2004. This was 5% of the shares on issue by Charmers Construction Ltd. The shares are held for investment purposes. The parcel of shares had a market value of $16 000 at 31 July 2005. Record all the transactions that Jessica’s Revals Ltd should record in relation to the shares.

(c) At 31 July 2004, Jessica’s Revals Ltd valued its current assets at $20 000 above carrying amount and its fixed assets at $600 000 above carrying amount. In both cases, the valuations were based on market values. How should the firm account for the increase in values?

(d) Jessica’s Revals Ltd purchased a development site for $81 000 and immediately sold that site to Kathy Pratt Real Estate for $130 000. The payment consisted of a 10-year non-interest-bearing note for $130 000. The first equal payment ($13 000) is due 1 year after the sale. The normal rate of interest for such a loan is 10% p.a. Record the sale of the land.

(e) Jessica’s Revals Ltd bought bricks with a recommended retail price of $18 000 and a cash price of $16 500. The firm paid for the bricks by paving part of the roadway leading into the brick manufacturing plant. The cost of the paving was $12 000 and the regular contract price to provide the paving was $17 000. Record the transactions.

(f) Jessica’s Revals Ltd issued 1000 of its ordinary shares in payment for a tract of land. The market price of the shares was $83 per share at the time of acquisition but the seller had offered to sell the land for $82 000 cash. What journal entry should the firm make to record the land purchase?

The purpose of this problem is to show that determining cost or value in practice is not always simple.

(a) The question indicates that the two blocks of land have identical values. As such, the appropriate entries would be:Land $1 000 000

Cash/other consideration $1 000 000

Unrealised loss on land value 50 000Land 50 000

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(b) This is a short-term investment, because Jessica’s Revaluations Pty Ltd intends to sell the shares whenever it needs the cash. According to ASRB 1016, the lower of cost of market methods is to be used.

7 Sept 2004 Marketable securities $18 000Cash $18 000

31 July 2005 Unrealised loss 2000Allowance for price decline 2000

(c) If Jessica’s Revals Ltd applies a strict historical cost measurement system, it can do nothing about these increases in value, because to do so would violate the historical cost principle. However, according to SAP 1, the current costs of the non-monetary assets are encouraged to be disclosed as supplementary information.

Under the mixed measurement system in use by the vast majority of firms, the entry is not clear, because there is no standard governing the accounting for current assets in general. We recommend the following entry if the firm adopts a mixed measurement system:

July 31 Assets $620 000Asset revaluation reserve $600 000Unrealised gain on current assets (revenue) 20 000

(d) Initial acquisition:July 31 Land $81 000

Cash/other consideration $81 000

The present value of the note must be recorded. Using the present value of an ordinary annuity for 10 periods at 10%, the present value is:

$13 000 × 6.144567 = $79 879

Notes receivable $79 879Loss on Sale of Land 1 121

Land $81 000

Jessica’s Revals Ltd will have interest revenue to record each year.

(e) ASRB 1015 is relevant. There is an exchange of dissimilar non-monetary assets, and therefore the earning process is assumed to be complete. This transaction can be considered a sale. If it is objectively determinable, the value of the asset given should be the basis for determining the value of the asset received. Assuming Jessica’s Revals Ltd works for others at an established sales price, the contract price of $17 000 can be considered objectively determinable.

A case could be made for recording the bricks at $16 500. This is a lower figure, and on the basis of conservatism it can be argued that it should be recorded. However, following the cost principle, the asset received should be at what is sacrificed, which in this case is $17 000 worth of inventory. By paving the bricks, Jessica’s Revals Ltd is forgoing $17 000 in revenue from another contract. Hence, this is the cost.

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Materials (Bricks) $17 000Sales revenue $17 000

Cost of goods sold 12 000Inventory, labour, etc. 12 000

(f) There are two choices here: to record the land at $83 000 or $82 000. Following the cost principle, the land should be stated at $83 000 because that is what was sacrificed: 1000 shares at $83 per share. There is a question as to whether 1000 shares constitute such a large number that the share price would be affected. Assuming that 1000 shares would not materially affect the share price, and given that the market quotation can be relied upon because it is from the Sydney Stock Exchange, the $83 000 represents the cost of the land.

Land $83 000Paid-up capital (1000 × $50) $83 000

15.2 Required: Comment on each of the four estimates with respect to its relevance and reliability to you as a potential seller of the property.

1. Present value. For the decision at hand, this figure is highly relevant. Its reliability depends on how good the estimates are. The use of 15% as the discount rate of return is acceptable. The calculation is based on past experience. Future circumstances may change, perhaps drastically over the next 20 years. However, anyone making a decision to buy or sell an apartment building should make projections about expected cash flows in order to have a rough price to work with. Any offer that is substantially lower than the present value would be rejected. When compared with the fair value, the present value seems to be conservative, which should give the seller confidence that it represents a minimum value.

2. Fair value. This value is the most relevant of the four. It represents the market’s assessment of what the property is worth, and is therefore a more objective value than present value. Present value represents the seller’s expectations of the value in use of the assets over 20 years; fair value represents the market’s expectations if the asset were to be sold now. In this case, you have the opinion of two appraisers as to what they believe the market value is. Their estimates are presumably based on their expert knowledge of the market. The average taken by the accountant of the two figures is a reasonable approach.

3. Carrying amount. The carrying amount is only relevant for computing the accounting gain when the property is sold. It should not be used to determine whether the property should be sold. Exchange value is determined in the marketplace.

One of the assumptions of accounting theory is the ‘going concern’. Based on this, the notion is that allocated cost on the income statement is more pertinent than current value because it shows the cost to the business for using the asset in a given period. Thus, the purpose of the carrying amount is not for making decisions about the sale of the asset in question. It represents unallocated cost — that is, cost that is still waiting to be allocated to the income statement. Because land is assumed to have an indefinite life, the original cost remains the unallocated cost.

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If it were not possible to determine current value, at least the carrying amount can be seen as a very conservative estimate of current value. It is conservative, because of the use of historical cost in accounting and the existence of inflation.

4. Current cost. The current cost calculated on the basis of price indices involves a great deal of estimation. The approach used by the accountant is mentioned in SAP 1. Is this a market price? Although the price indices are market based, they are very general and do not necessarily reflect the current costs in the particular area where the property is located. Construction costs in Sydney could be quite different from those in Hobart, Melbourne, Darwin or Oodnadatta. The deduction of 5 years of depreciation is an accounting procedure, and is not market-based.

The current cost of constructing a building is not necessarily what it will sell for. A contractor would wish to sell to make a gain. Also several buyers may want a particular building and bid the price up.

The relevance of this figure depends on how reliable the computation is. If the computed current cost is reflective of the market prices of the component factors in the area, then it is very relevant. If for some reason, fair value cannot be determined then the computed current cost is an alternative.

In summary, the relevance of the four figures in priority order is: Fair value Current cost (computed) Present value Book value.

Note, however, that present value is highly relevant as a comparison with fair value or current cost to determine the merits of sale or replacement, based on the value in use of the block of units.

Case Study 15.1 — Accounting for crops

1. Outline the attributes of self-generating assets. Why is it so difficult to value them?

This case study highlights the problems associated with valuing SGARAs. The fundamental attribute of SGARAs is their ability to grow and/or reproduce. Hence, it is therefore unlikely that the cost at acquisition date is representative of their value at a later date. The AASB and PSASB determined the appropriate way to measure SGARAs is at net market value (the amount to be received from the disposal of a SGARA in an ‘active and liquid market’). The following arguments supported this conclusion: Net market value best reflects the future economic benefits embedded in SGARAs

because it captures the biological transformation which is inadequately reflected if historical cost accounting is applied.

Historical cost ignores price changes.

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Net market values enable the statement of financial performance to reflect a more relevant measure of periodic performance. This particularly applies to SGARAs involving a long production cycle.

Recognising net market values in the statement of financial position better reflects economic reality and provides information that is more useful for decision-making purposes. This is premised on ‘true’ economic value providing the most useful information to users. Economic value is best measured by future benefits rather than opportunity costs.

The list of industries that would be most affected are those with the following inventories: vineyards plantations (forests, orchards, crops) livestock (cattle, sheep, stud farms).

It is difficult, however, in the absence of active and liquid markets to obtain valuations; and the standard uses the words ‘the best indicator of the net amount’ when there are no liquid markets, and then mentioned four indicators: the most recent net market price of the same asset the most recent net market price of a related asset the NPV of expected cash flows generated by the asset cost.

Clearly these are subjective and debatable on a number of issues including: What does related mean? How would you measure expected cash flows from a SGARA? How did cost sneak in after being dismissed in the original debate?

Note: It was originally intended that AASB 1037 be applicable to financial years ending on or after 30 June 1999. However further lobbying (by organisations such as the Group of 100) was successful in delaying the operative date until 30 June 2000. A delay in the operative date was sought due to the uncertainties, difficulties and diversity in implementation of key aspects of the standard. More time was required for industry participants and industry bodies to consider practical implementation issues and offer implementation guidance.

2. What accounting treatment is required for recording these asset values?

The accounting treatment is outlined in the article and includes a number of very controversial issues, such as: recognition in the statement of financial position at net market value any changes in net market value to be recognised in statement of financial performance at

the end of each financial year the non-adherence to the realisation principle the use of subjective valuations and estimations.

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3. How is the valuation to be determined and what are the advantages and disadvantages of such an approach?

Valuation is at net market value (the amount to be received from the disposal of a SGARA in an ‘active and liquid market’) and if it passes the test that future economic benefits will eventuate and it can be measured reliably. The fallback is the best indicator of net market value (see 1 above).

Advantages are: an increase in the ability to attract equity funding (by increasing the value of firms) putting a higher value on endangered species by recognising their ‘real value’.

Disadvantages are: It would inflate profits by recognising unrealised gains. There is concern over the method used to arrive at net market value (subjective valuation). It give a false impression of the dividend-paying ability of the firm. It could be a political decision related to the lobbying of Earth sanctuaries (this point

could be pursued further by the instructor). Introducing alternative valuation methodologies to be applied to particular asset categories

increases the diversity of valuation techniques and impedes the additive nature of the statement of financial position. The additive nature of the statement of financial position would only be enhanced if a common valuation methodology were applied to all assets.

Case Study 15.2 — The price is right for Kirby and team

1. Why would buyer and seller not agree on the price?

This question relates to the determination of value and the motives of buyers and sellers in obtaining the best price and maximising their own utility. Conceptually, in an information-complete market the valuation of assets, irrespective of whether they are owned by public or private sector organisations, is premised on information that is consistent, comparable and relevant for decision making. Decisions involve the use of financial information that is affected by the valuation methods applied to assets, liabilities, and income determination. However, markets are not complete and naturally buyers and sellers have dissimilar motivations in respect to the valuation decision. Both buyers and sellers may also be operating on different information sets.

Also asset values should reflect economic values. However, the inability to precisely identify and predict these necessitates the use of valuation methodologies to approximate ‘true’ economic value. Ideally present value would be used. However, it is often impossible to determine specific future cash flows associated with assets, so alternative valuation methods are required. Thus the buyers and sellers may be relying on different market valuation methods.

Finally, another concern with valuations based on market values is the volatility introduced into the financial statements. Thus, valuations may have been undertaken at different times.

2. The figure of ‘10 times historic earnings’ is quoted. What is the significance of this ‘rule of thumb’ figure?

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The significance of rules of thumb and the way business is done in the ‘real world’ always has to be questioned. This question also provides an opportunity for students to present reasoned arguments outlining the cases for each of the measurement methods that they could use to evaluate Kiewit and compare them to the rule of thumb of 10 times earnings from an unbiased perspective, and to appreciate the role of academics in the measurement debate. It is also important for students to realise that cost and value are fundamentally very subjective concepts, and that businesses are unlikely to agree on the appropriate valuation method (and the accounting treatment associated with the gains/losses associated with changes in value). The arguments for different price estimation methods are contained in earlier chapters. The instructor should explain that (given no-growth) 10 times earnings represents a 10% return on capital in perpetuity. Given expected growth and capital gains, then the return will be higher.

3. Comment on the market share of Kiewit Materials in determining price. Why would this be important?

A high market share will mean: higher potential monopoly power through future buyouts higher economies of scale greater opportunity to restrict access to markets by other firms potential growth opportunities ability to lower risk and cost of capital.

These are potential intangibles for the firm.

4. What other factors would work to strengthen the intangible value of the purchase?

Other factors include: potential growth outside the west and south-west value added by CSR management (management intangible) the probability of the infrastructure tax Bill being passed federal spending in the future on infrastructure.

Chapter 16

Profit

Theory in Action 16.1 — Chasing certainty

1. In a world of certainty the profit from an activity can be determined precisely. In the world of certainty, should changes in the value of assets used to produce operating profit be included in the calculation of profit or as an adjustment to the equity of owners?

The important point is that it is uncertainty that creates the problems that the accrual system of accounting seeks to address. Uncertainty as to the life of assets and the timing of the returns, the collectability of accounts receivable and so on. If we lived in a certain world then

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we would know exactly how to allocate the life of assets across accounting periods. We would know the contribution of each asset to revenue in any one period and the point at which an asset will become obsolete. Assets used to generate operating income are the productive capital of an entity — they have not been purchased to be traded at a profit or to generate holding gains. The assets are held to produce operating revenue by applying the assets to business activities. As such, they represent the owners’ capital and any gain from holding such assets should be represented in an adjustment to equity. The approach supported depends on the perspective of the respondent. Some may argue that all income, regardless of its source should be reported as such, whereas others may adopt the equity adjustment view advocated here.

2. Why does the calculation of profit become so problematic in our world of uncertainty? In your answer, list the factors that influence the assumptions made to calculate profit for a defined period.

This issue has been answered, to some extent, in question 1 above. Basically, the adoption of a system that breaks the life of a firm into defined accounting periods, which normally bears no relationship to the life of assets employed to operate a business, requires assumptions about the benefits derived from such assets in any one accounting period. Often it is difficult to estimate the contribution made by assets to revenues recognised in any one accounting period. But it isn’t just the contribution of assets. The recognition of unrealised revenue, for example, is also required. The objective is to recognise revenues in the period in which they are achieved, not necessarily realised. In order to calculate profit, assumptions often need to be made about: whether revenue has been achieved because of activity within a particular period the likelihood of future realisation of the revenues the allocation of expenses that extend beyond one accounting period, or were incurred in

developing assets to generate future revenues.

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3. The discussion in the case suggests that in a world of certainty there would be no opportunity to make profits. Explain.

Income represents an inflow of assets, or the right to future inflows, or the gains from holding assets during a particular accounting period. Profits are the net returns from activities after all related expenses are deducted. Profits are the excess asset inflows after all outflows (actual or obliged) are deducted. In a world of complete information a firm’s customers would know the firm’s expenses and therefore the price for goods or services that would be accepted by a firm. There would be profits, but they would be standardised for all firms and products/services. As discussed, there would be no difficulty in directly measuring and reporting income and profits, as there is no need for assumptions in order to apportion income and expenses across or between accounting periods.

Theory in Action 16.2 — Do forecasts and expectations really matter?

1. How do expectations relate to the calculation of profit? Given that the additional profit is a function of a new contract, should the nature and terms of the contract be reported in financial statements, even though there is no compulsion to do so?

Expectations are normally reflected in the share price of an entity, not in the calculation of profits. NATfoods expects earnings to increase, but this will only be supported by the measurement and reporting of revenues over time. Expectations are about budgeted information; actual activity is reported in the statement of financial performance. Reporting the nature and terms of new contracts would make annual reports a very complex and cumbersome document. However, if a contract will have a significant future impact it may well be highlighted in the annual report. Ask students to discuss whether such information belongs in the annual return; and if not, how should it be communicated to shareholders.

2. When a company has a plan to merge brands with the objective of saving costs or increasing profit, should the effect on the expected value of the merged assets be reported?

The value of the merged brand will be measured in the financial performance of the company over time and any speculation as to its value should not be incorporated into the financial statements.

3. NatFoods’ share price increased by 40 cents in the space of a month because of the new milk supply contract. In a simple net assets model, is this profit or capital gain?

Under a simple net assets model it would be profit for those holding shares, but has no relevance to the profit calculation of the company.

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4. Why did Max Ould decline to comment ‘when asked what the company believed was fair value in its share price’? How could the fair value of a company be measured?

The value of a company reflects all available information about the firm. The market value of some assets will be readily ascertained in the marketplace, whereas others will not. In addition, the financial statements do act as a signal of value and performance. The managing director would be on dangerous ground in seeking to assign a fair value, as it may not equate with market expectations; shareholders may use it against him if that value is not realised. In reality, it is almost impossible to measure. Fair value requires the sale of the business as a going concern. Many will argue that this is reflected in the market value of shares at any point in time.

Theory in Action 16.3 — Asset life or management life?

1. Why would the short-term tenure of mining industry management affect investment decisions and reported profits?

Management are normally remunerated against corporate performance. This will normally include a mix of measures that relate to share price and profit performance. As such, if management has a relatively short life at any one company (and in particular where this doesn’t match the future income streams etc. of existing assets) then they will have incentives to increase short-term value or performance at the expense of performance in future periods. This could be achieved by moving forward operating activities or by bringing forward the timing of recognition of revenues and deferring recognition of expenses. Many firms have sought to minimise the effect of the short life cycles of management by linking remuneration to future performance or share price.

2. What is ‘financial engineering’? How is it used to ‘generate short-term profits’?

As identified in the answer to question 1, it is about the timing of recognition of revenue and expenses. Ask the students to discuss whether it is really this simple and whether the market may adjust anyway because it is aware there are incentives for such behaviours.

3. Why can’t firms simply value the total expected benefit from mines as an asset on discovery or acquisition? Would this increase the total value of assets held? How would such an approach be accounted for by a mining company?

This approach is possible in that the total reserves of the mine can be estimated. The problem rests in assigning a value to the total reserves as the price will fluctuate across the life of the mine, as will production, transport and other operating costs. In order to adopt such an approach, future revenues and expenses must be capable of reliable measurement.

4. If the market can effectively value an organisation, why would Hugh Morgan be concerned about the timing of profits?

Because not all information is publicly available.5. Would the economic view of profit remove the incentives to manage or ‘engineer’ the

timing of financial disclosures?

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The economic view would still be open to ‘engineering’ as decisions are required about value.

Theory in Action 16.4 — Has the group really changed value?

1. Given that the effect of the peso decline is likely to be reversed in MIM’s accounts within a year, should any adjustment be made?

Under the matching principle, the impact of the peso variance should be included in the statement of financial position. It provides an indication of the current cost of the value of trading with another currency and the potential exposure that the firm may have. This is consistent with the accounting viewpoint. If, however, a terminal approach were adopted then no adjustment would be made.

2. Are the accounts for MIM comparable over time if changing values in currencies are adjusted in each accounting period? Should MIM take the currency value at the date that the financial year ends or adopt a rolling average approach?

The accounts would be comparable provided a consistent recognition approach is adopted. The point at which the currency differential should be measured is one for debate. The rolling average would appear more appropriate as it would provide some indication of the effect across the year, rather than at a single point in time.

3. MIM is reporting ‘gains’ and ‘expected profits’, which are a function of a book adjustment to recognise the changed value of the peso. Is this profit? Explain your answer in the context of the alternative views of profit.

Adjusting the accounts to reflect shifts in currency rates that have not been realised are consistent with the HC system, but not with the economic or cash-based approach.

4. If analysts and presumably the market do not ‘take account of the “noise” associated with accountancy issues flowing from currency gyrations’, why is MIM required to report them? Do they add any information value at all?

The information value primarily comes from the signal that there is an exposure and that it does or will impact on overall returns. These may be factored in from available information.

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Questions

1. What is profit in the ideal case of perfect certainty? Why can’t such an approach be adopted to measure and report profit?

Profit is the change in value of capital between two points in time. In the ideal case, present value can be used for all items. Capital is the difference between total assets and total liabilities. The problem is assigning a value to capital and being able to directly measure changes in the value of capital.

2. Why, in the ideal case, are assets either cash or receivables and liabilities payables for a firm?

Because the future cash flows are known for all assets and liabilities, all assets, including so called fixed assets, reduce to expectations of cash inflows and thus are receivables; and all liabilities are expectations of cash payments and thus are payables. Since present value is used for all items, there is no ‘matching’ problem; there is strict accrual accounting — all assets and liabilities grow through time by the factor of interest.

3. The going concern concept requires that profit for a defined period is determined by adjusting for revenue and expenses relating to future periods. Would a more appropriate measure of profit be achieved by removing the going concern concept?

Lifetime profit is the difference between total cash receipts and total cash payments (excluding investments by owners and payments to owners during the life of the firm). The qualification (stated parenthetically) is to prevent an offset. Investment by owners are excluded because the amount is used to purchase assets (cash payments); and withdrawals or distributions to owners, which are cash payments, were originally cash received by the firm.

Similarly, lifetime profit is the difference between capital at the end and capital at the beginning. Adjustments must be made for withdrawals by adding these to the ending balance. These would be included in ending capital if not withdrawn from the firm.

There is little problem in computing lifetime profit, because everything comes down to cash, and the time period is definite. Of course, there is the problem of the changing scale of money (inflation), and the time value of money.

4. How does cash flow relate to profit in the ideal case? in the case of lifetime profit?

Capital represents the ‘wealth’ of the entity. In the ideal case, this wealth is not all cash, thus although revenue relates to cash inflows and expense to cash outflows, revenues–expenses are not equivalent to the cash flows. The future cash inflows give rise to the present receivables, and it is the change in value of the assets (receivables) that creates revenue. The future cash outlays give rise to present payable, and it is the change in value of the liabilities (payables) that creates expense. The difference between revenues and expenses is profit.

In the case of lifetime profit, revenue is equivalent to cash inflow and expense is equivalent to cash outflow. The reason is that the ‘wealth’ of the entity is all cash at the end, and therefore ultimately profit must be cash.

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When the firm is terminated, when there is no future for the firm, then lifetime profit is the net cash flow during the life of the firm. Accrual accounting is a device to adjust for the leads and lags of the cash flows to ‘proper’ periods. When there is only one proper period, the lifetime of the firm, then profit is the difference between the cash inflows and outflows.

5. Why in the real world of uncertainty is determining profit so difficult? Why can’t the net cash flow for a given period be considered profit for that period?

Periodic profit determination in the real world of uncertainty is difficult, because the amounts of the cash flows are not known with certainty and the horizon (length of time) of the cash flows is not known with certainty.

As long as the firm continues to exist, profit is not necessarily the net cash flow of the particular period. The ideal case informs us that the receipt of cash is not revenue when the firm has a future; it is the increase in the value of the liabilities. In other words, income has to do with the change in wealth of the firm in a given period, and wealth is not only cash. In the lifetime case, everything (all assets and liabilities) is reduced to cash, so that wealth is the cash involved.

6. What is the essence of the definition of (periodic) profit?

Profit is the change in value of capital (net assets) in a given period (between two points in time). This definition is essentially the same as for the ideal case. To make it easier to calculate, we divide profit into two parts: the positive element (revenues and gains) and the negative element (expenses and losses).

7. How do the concepts of ‘value’, ‘capital’ and ‘scale’ relate to profit?

They are parts of the definition of profit. Based on the definition given in question 6 above, we can be more specific about certain details and present the following definition of profit.

Profit is the change in the capital of an entity between two points in time (excluding changes due to investments by and distributions to owners), where capital is expressed in terms of value and is based on a given scale.

The change in capital, the net assets, is what profit is all about, excluding additional investments and distributions to owners. Profit is to be distinguished from capital; it is the return on capital. Another way of putting it is that costs must be recovered before there is profit.

Since assets and liabilities (the difference is capital) are not all cash, a value must be placed on them. Thus, the question of value arises in the determination of periodic profit.

Since capital is expressed quantitatively, in money terms, its measurement must be on a scale. Every measurement is made on a scale to give meaning to the numbers. The two scales we employ are the nominal dollar scale (the meaning of the dollar is simply its quantity) and the constant dollar scale (the meaning of the dollar is the purchasing power of a given date).

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8. Why can’t present (discounted) value be used to determine profit? How do advocates of this approach determine an appropriate discount rate and period?

We cannot use present value for all assets, because we do not know the separate, individual cash flow related to many assets, especially fixed assets.

9. Explain the difference between financial capital and physical capital. What point of view do you believe is more appropriate? Why?

Financial capital sees capital as a money amount. This is the amount contributed by owners or retained in the firm for them. Financial capital is the dollar amount of the investment of the owners. The return on capital is seen as money earned on a money amount. The ‘cycle’ of business activity is money to goods and services to money. At the end of the period, income is determined as that amount in excess of the dollar amount of the beginning capital (after adjustments for additional investments and distributions). The financial view is the one taken by most people and is the one taken in conventional accounting.

Physical capital looks at the physical capacity of the firm. Capital is seen first in its physical form. Since in accounting everything is translated into dollar figures, the physical capacity is given a dollar amount. At the end of the period, in determining income, the relevant question is: how much would it cost the firm now to maintain its physical capacity — that is, to be in the same physical position as at the beginning of the period? The answer to this question calls for the use of current (or replacement) cost as the pertinent amount. Any dollar amount in excess of the current cost of the beginning capital is income. The ‘cycle’ of business activity takes the form: goods to money to goods. The ‘physical’ position or capacity or capability is interpreted in a variety of ways. The most popular view appears to be volume of production.

The most telling criticism of the financial view is that if the firm is to continue in business and prices are rising, it may not be capable of generating the same level of goods and services if physical capital is maintained. If income is paid out as dividends, the company may be disinvesting.

The most telling criticism of the physical view is that it forces the firm to maintain the same physical level as before through equity financing. It is a managerial prerogative to decide if the same physical level is desired and how to finance it.

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10. Explain the problem for which the constant dollar (purchasing power) scale is proposed as a solution. Discuss which measures of purchasing power are most appropriate for a:(a) manufacturing firm (c) service firm(b) wholesale firm (d) retail sales firm.List any assumptions you make in order to answer this question.

The problem is one of comparability of the figures, especially of figures based on past years. Inflation (or deflation) causes the measuring unit, the dollar, to become distorted so that dollars of different years, although called by the same name, are not really the same. Logically, it is not permissible to add or subtract figures of different units. The constant dollar scale is to put all dollars on the same (constant) basis so that logically they are comparable. Constant dollar adjustments correct a logical (mathematical) problem. For all the industry sectors nominated, a scale would need to be developed which reflects the specific changes in the prices in the goods and services they acquire in order to conduct core business activities.

11.Why do you think accountants are reluctant to recognise unrealised gains or losses resulting in changes in the net market value of assets in the statement of financial performance?

This question is intended as a discussion starter. Reasons include the increased complexity, validity of values adopted and the impact of partial adoption.

12. Develop a simple diagram which outlines the differences between the traditional economic and accounting views of profit.

See the example on p. 581 which considers the difference between physical and financial capital, this is the basis of the difference and should be linked to the concept of terminating value.

13. How can accountants achieve an effective and efficient measure of fair value? If one group of assets is measured at fair value, should all assets be measured and reported in this way? Explain.

The determination of fair value represents a considerable problem. The value at the point of purchase will normally reflect a fair value; however, the change in value from this point forward is difficult to ascertain, particularly: if the asset is not of a class that is readily traded and so equivalent prices could be used where the asset has a value in use different to its fair value where the asset is bundled with a group of assets where some assets are revalue and others are not.

The problems are compounded when the accounting standards and regulations allow for revaluation of some assets and not others and for a range of valuation methods, and provide considerable discretion as to timing. Students should discuss whether it would be useful to move to a uniform model.

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14. Alan Dexter worked on solving a problem on general price level adjustments of the conventional statement of financial position. Using the general price index at the end of the current year, he correctly converted the cost of the land, which was purchased 15 years earlier, from $200 000 to $500 000. However, he is puzzled about the meaning of the $500 000. Give an explanation to Alan so that he will understand what the $500 000 figure represents.

The $500 000 is not current value. Current value is determined in the market. The $500 000 is not what the company would pay if it were to purchase the land now (unless by sheer coincidence current value is $500 000). The $500 000 is the historical cost of the land expressed in the purchasing power of the dollar of December 31 of the current year.

15. Anne Robinson, a prominent accountant, said: ‘If we were to use current cost accounting, the problem produced by inflation on the financial statements would be resolved’. Comment.

Ms Robinson is only partially correct. Current cost accounting would make the figures in the current financial statement more or less comparable, but they would not be comparable with the figures of other years. Even for the current year there will be some distortion, since current costs at the beginning of the year and those at the end of the year will be different, if the general price level has changed during the year. Currently, the change in the general price level in a year is not significant, at least in Australia.

16. Sarah Talbot invested a total of $50 000 in the ordinary shares of a number of companies in January. In December the market price of all her shares amounted to $60 000. She received no dividends during the year. Is she economically ‘better off’ at the end of the year as compared with her status at the beginning of the year?

Ms Talbot is economically better off by $10 000 — that is, her wealth has increased. It is her decision not to sell to realise the cash. Traditional accounting would say that since there is no sale, there is no profit. It is of importance to note that if she wanted to, she could sell her ordinary shares to realise the gain. For a business firm selling a product, it may not be able to sell its product to realise a profit. The difference between Talbot and a business firm is in the marketability of the item. For the ordinary shares, assuming they are listed on a stock exchange, saleability is assured; but for the product of a firm, saleability is not as assured. The accounting recognition principle is applied to both cases without regard to the particular circumstances. The increase in the value of the ordinary shares meets the definition of profit, but fails to meet the traditional revenue–gain recognition principle.

17. Generally, accountants insist on an external transaction before revenue (and thus profit) is recognised. Yet, in some cases, such as accrued interest, revenue is recorded although there is no external transaction. Why are these cases allowed? How does your answer compare with the situation in question 16?

Accruing revenue, such as interest, meets the definition of revenue and profit. These accruals are allowed because the passing of time signifies that the critical factor, a sale, has occurred. The firm has sold a service, the use of its money, and therefore revenue can be recognised. Although there is no external transaction at the time of accrual, a sale has occurred because time has passed.

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In comparison with the situation in question 16, there is a sale in this case, but none in that case.

18. Explain the concept of capital maintenance. Is adjusting for changes in the value of monetary and non-monetary assets consistent with the capital maintenance concept?

The concept of capital maintenance requires that the initial residual equity (owners’ investment) in the firm is retained. Dividends can only be paid from operating profits, not by dipping into owners’ equity. Adjusting for changing asset values is consistent with this approach, as gains or losses from holding assets impacts on the value of the firm and therefore residual equity.

19. Why would managers object to an adjustment to the profit of an entity to recognise the loss or gain in net assets for a specified reporting period? Is there any means by which these concerns could be overcome?

The concerns include: removal of management’s discretion as to the timing or recognition of gains or losses cost involved in incrementally making the adjustments access to reliable current values disclosure of information that may have value to competitors or those seeking to takeover

the entity.

If the incremental adjustment method is universally adopted then there would be less potential for variance between companies and a market for current value information would emerge to support the system.

20. Would systematically adjusting profit each year for changes in the value of net assets avoid the massive write-downs experienced by large firms in recent years?

In most cases the annual adjustment process would reduce the extremes reported when the gains or losses are realised or allowed to build for a period of time.

21. Alice Young purchased a block of land in Year 1 for $40 000, when the general price index was 120. In Year 6, she sold the block for $120 000, when the general price index was 230. What was her ‘real’ gain? What was the ‘fictional amount’?

Money gain ($120 000 – $40 000) $  80 000Sale price in Year 6 $120 000Cost restated: $40 000 230/120 =         76   667 Gain (real) $     43   333 Fictional gain ($80 000 – $43 333) $     36   667

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22. What are some of the objections to the use of the constant dollar scale?

The following objections can be made: People misunderstand the results. They believe them to be current values. The index used may not be relevant to a given firm. There is a cost of implementing the constant dollar scale. The results are not useful. People don’t use the information.

Although not asked for, it would be interesting to ask students to respond to the objections.

23. The following events concerning the inventory of Company X occurred (see page 608). On a quantity of dollars scale (nominal dollars), what is the amount of realized holding gain? of unrealised holding gain?

For Year 1

Current cost of goods sold (60 $460) $27 600Historical cost of goods sold (60 $400)     24   000

Realised holding gain $     3   600

Current cost of ending inventory (40 $480) $19 200Historical cost of ending inventory (40 $400)     16   000

Unrealised holding gain $     3   200

For Year 2

Current cost of goods sold (50 $500) $25 000Historical cost of goods sold (40 $400)

(10 $480)     20   800 Realised holding gain $     4   200

Current cost of ending inventory (90 $520) $46 800Historical cost of ending inventory (90 $480)     43   200

Unrealised holding gain — end of Year 2 $  3 600Less Unrealised holding gain — end of Year 1       3   200 Unrealised holding gain for Year 2 $       400

24.Refer to question 23. Suppose the general price index showed the following (see page 608). Find the ‘real’ amounts of the realised and unrealised holding gains. Use average-for-year purchasing power.

For Year 1Nominal Dollars Constant Dollars

Current cost of goods sold $27 600 112/112 = $27 600Historical cost of goods sold     24   000 112/100 =   26,880 *

Realised holding gain $     3   600 $           720

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* We are able to make the conversion without using the formula to calculate cost of goods sold, because all 60 units sold came out of the current purchase when the index was 100.

Current cost of ending inventory $19 200 112/115 = $18 699Historical cost of ending inventory     16   000 112/100 =     17   920

Unrealised holding gain $     3   200 $           779

For Year 2 Nominal Dollars Constant Dollars

Current cost of goods sold $25 000 123/123 = $25 000Historical cost of goods sold     20   800 (see below)     24   814

Realised holding gain $     4   200 $           186

40 units $400 = $16 000 123/100 = $19 68010 units $480 =         4   800 123/115 =         5   134 Cost of goods sold $20   800 $24   814

On December 31

Current cost of ending inventory $46 800 123/130 = $44 280Historical cost of ending inventory     43   200 123/115 =     46   205

Unrealised holding gain $     3   600 –$ 1   925

On January 1

Current cost of beginning inventory $19 200 123/115 = $20 536Historical cost of beginning inventory     16   000 123/100 =     19   680

Unrealised holding gain on Jan. 1 $     3   200 $           856

Unrealised holding gain (loss) for Yr 2 $           400 –$ 2   781

The real amounts for Year 1 are:Realised holding gain $720Unrealised holding gain 779

The real amounts for Year 2 are:Realised holding gain $   186Unrealised holding gain 2 781

25.Company Y purchases a building on 1 January Year 1 for $400 000. The expected life of the building on the acquisition date is 25 years. At the end of Year 8, an appraiser determines that the market value of the building is $550 000. Under exit price accounting, what is the amount of depreciation expense for Year 8? What is the theoretical justification for your answer?

There is no depreciation, because depreciation is defined as the decrease in the market value of the asset. In this case, there was an increase.

26.The following is a summary of the alternative profit calculations shown in this chapter (see page 609). Assume you are a shareholder of a company. All other

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things being equal, would it make a difference in your decision (say, to invest more in the company) if one of these profit figures were reported as opposed to the others? Explain.

It seems very likely that the decision would be different if, say, alternative 6 profit of $326 was reported as opposed to alternative 7 profit of $40 600. The difference is material. This indicates that the particular interpretation of value, capital, and scale for profit can make a difference to users. If all eight alternatives were reported, would it be more informative to users or cause confusion?

If the shareholders had all of the information concerning these alternative measurement systems and the basis for the calculations, then their decision would not be influenced by these alternatives as they actually equate to each other on this basis. However, if the figures are reported at face value, then the extremely poor nominal performance under some methods may well discourage investors.

27. Review the approaches advocated in AASB 1041 ‘Revaluation of Non-Current Assets’ with respect to the determination of ‘fair value’ for a group of assets (paragraphs 5.1.6 to 5.1.10). How will revaluing defined groups of assets help to determine the profit or change in real value of an entity?

Students should summarise the approaches provided for in AASB 1041. The objective of the question is for students to understand that here is a lack of consistency of valuation methods, both within a single year and across time.

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Problems(for full outline of problems, please see text)

16.1 Calculate the following:1. If a 10% rate of return is desired, what cash should Motorland pay for the

motorboat?2. If the motorboat is purchased for the price determined in question 1, what are

the total values for assets and liabilities on 1 January Year 1?3. What is the total revenue for Year 1?4. What is the total expense for Year 1?5. What is the profit for Year 1?6. What are the totals on 31 December Year 1 of assets, liabilities and

shareholders’ equity?7. Record as journal entries:

(a) the purchase of the motorboat(b) revenue for Year 1(c) expenses for Year 1(d) cash receipts and payments(e) dividends paid.

1. Motorland should pay the present value of net cash flow of the motorboat: $1 516 315.

Present value of ordinary annuity: $1 000 000, 10%, 5 periodsfactor is 3.790787 $3 790 787

Present value of ordinary annuity: $600 000, 10%, 5 periodsfactor is 3.790787 $2   274   472

$1   516   315

2. The value of the assets on January 1 is the present value of the future cash inflows on that date. The value of the liabilities on January 1 is the present value of the future cash outflows on that date. See the calculations above.

Assets (receivables) $3 790 787Liabilities (payable) $2   274   472

$1   516   315

3. Revenue is the increase in the value of the assets during the year. Since all the calculations are based on the theory of the time value of money, as we proceed from January 1 to December 31, the value of the assets grows by 10%. This is strict accrual accounting. Revenue is not the cash received.

$3 790 787 10% = $379 079 Revenue for Year 1

4. Expense is the increase in the value of the liabilities during the year. It is not the cash paid. As we proceed from January 1 to December 31, the value of the liabilities increases by 10%.

$2 274 472 x 10% = $227 447 Expense for Year 1

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5. Profit is the difference between revenue and expense, or the increase in the capital during the year by 10%.

Revenue $379 079Expense     227   447 Profit $151   632

or $1 516 315 10% = $151 632

This illustrates that profit is the increase in capital between two points in time.

6. The value of the assets on December 31 is the present value of the future cash inflows on that date, and the value of the liabilities is the present value of the future cash outflows. These calculations could be made; however, we can derive the same answers by using the figures we already have.

$3 790 787 Value of assets on January 1379 079 Growth in value during the year

–1   000   000 Amount received on December 31

$3   169   866 Value of assets, December 31

$2 274 472 Value of liabilities on January 1227 447 Growth in value of liabilities during year

–   600   000 Amount paid on December 31

$1   901   919 Value of liabilities, December 31

$3 169 866 Value of assets, December 31    1   901   919 Value of liabilities, December 31

$1   267   947 Value of shareholders’ equity, December 31

7. Although not asked for, the cash received by the firm of the initial investment would be recorded as follows:

Cash $1 516 315Capital (Shareholders’ Equity) $1 516 315

(a) The motorboat account is initially recorded but should not remain — it must be divided into receivables and payables. There is no fixed asset to depreciate. All assets and liabilities are receivable and payable because of the certainty of future cash flows.

Motorboat $1 516 315Cash $1 516 315

Receivables 3 790 787Payables 2 274 472Motorboat 1 516 315

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(b) Receivables 379 079Revenue 379 079

(c) Expense 227 447Payables 227 447

(d) Cash 1 000 000Receivables 1 000 000

Payables 600 000600 000

(e) Capital (Shareholders’ Equity) 400 000Cash 400 000

16.2 Calculate the lifetime profit of the business.

Cash at the end:

Cash on hand $ 50 100Collection of receivables 29 000Inventory sold 25 000Plant and equipment sold     275   000

Total $379 100

Less liabilities paid, including $200 interest         70   780

Cash at the end $308 320

Add withdrawals ($170 000 + $24 000)     194   000

Total cash would have had at endif withdrawals not made $502 320

Less amount invested at beginning($110 000 + $75 000)     185   000

Lifetime profit $317   320

Lifetime profit is the total cash inflow less total cash outflow. In this problem, we were not given the details of the inflow and outflow of cash each year, and so lifetime profit was computed as the difference between Capital at the end (plus withdrawals) and Capital at the beginning.

Capital at beginning Capital at end

Invested Taken out of business Cash at end (net)by Burns $110 000 by Burns $170 000 $308 320

200

by Carnes         75   000 by Carnes         24   000

Total $185 000 Total $194 000

When a firm has no future, income reverts to net cash flow, because all assets and liabilities revert to cash. Profit is the increase in the capital between two points in time. The capital, the net assets, represents the wealth of the firm. For a company that is terminated, the wealth (that is, all the assets and liabilities) is cash, and therefore profit is the net cash flow. For a company that has a future, its net assets are not all cash and therefore profit for a given period is not the net cash flow for that period. The change in purchasing power and the time value of money were not considered.

16.3 Required:Present a statement of financial performance for the year under each of the variations of the following assumptions:

Capital = physical or financialEconomic value = represented by historical cost or current cost or exit price

Scale = nominal dollars or purchasing power of dollars (average for current year purchasing power).

This is a long problem. The instructor may wish to assign only parts of it.

Alternative 1

Sales revenue (6000 $10) $60 000Cost of goods sold (3000 $2)

(3000 $3)     15   000

Gross profit $45 000Operating expenses:

Depreciation $5 000Other operating expenses 26   000 31   000

Net income $14   000

This is the income under conventional accounting.

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Alternative 2 Nominal Dollars Constant Dollars

Sales revenue $60 000 228/228 = $60 000Cost of goods sold 6 000 228/220 = $6 218

9 000 228/228 =     9   000     15   218 $44 782

Gross profit

Operating expenses:Depreciation 5 000 228/220 = 5 182Other operating expenses 26 000 228/228 = 26   000 31   182

Income before purchasing power loss $13 600Purchase power loss (see below)     7   996

Net income $     5   604

Calculation of purchasing power loss:

For net monetary itemsBeginning balance $150 000 228/220 = $155 455Sources         60   000 228/228 =     60   000

Sales $210 000 $215 455

Less uses:Equipment $ 50 000 228/220 = $ 51 818Purchases 6 000 228/220 = 6 218

12 000 228/228 = 12 00012 000 228/232 = 11 793

Expenses         26   000 228/228 =         26   000 Total uses $106   000 $107 829

Ending balance $104   000 $107 626

Convert nominal dollars figure to average for year constant dollars104 000 228/238 =     99   630

Purchasing power loss $         7   996

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Alternative 3

Sales revenue $60 000Cost of goods sold (6000 $3)     18   000 Gross profit $42 000

Operating expenses:Depreciation $ 5 600Other operating 26   000 31   600

Income from operations $10 400Realised holding gains (see below):

On inventory sold 3 000On equipment used       600         3   600

Realised income $14 000Unrealised holding gains (see below)

On equipment 10 800On inventory     1   000     11   800

Net income $25   800

The realised income is the same as in Alternative 1, because the same revenue recognition and matching principles are employed. The difference between the results here and Alternative 1 is that the realised income is divided into two parts: that part relating to operations and which the management has a great deal of control over, and that part relating to price increases of assets, which the management has little control over.

Following is the calculation of holding gains includes constant dollar figures, which will be used in the next alternative.

Nominal Dollars Constant Dollars

Current cost of goods sold $18 000 228/228 =           $18 000Historical cost of goods sold 15 000 (6000 228/220 = $6218) 15 218

                            (9000 228/228 = $9000)                             Realised holding gain for

inventory sold $     3   000 $     2   782

Current cost of depreciation $ 5 600 228/228 = $ 5 600Historical cost of depreciation     5   000 228/220 =     5   182 Realised holding gain

for equipment used $       600 $       418

Current cost of equipment (net) $55 800 228/238 = $53 455Historical cost of equipment (net)     45   000 228/220 =     46   636 Unrealised holding gain $10   800 $     6   819

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Current cost of ending inventory(4000 units $4) $16 000 228/238 = $15 328

Historical cost of ending inventory(1000 $3) + (3000 $4) 15 000 (3000 228/228 = $3000) 14 793

                (12 000 228/232 = 11 793)                     

Unrealised holding gain $ 1   000 $ 535

Because this is the first year of operations, for the computation of unrealised holding gains there was no need to deduct any beginning-of-year balances of unrealised holding gains, as there was none.

Alternative 4

Sales revenue $60 000 228/228 = $60 000Cost of goods sold 18 000 228/228 =     18   000

Gross profit $42 000Operating expenses:

Depreciation 5 600 228/228 = $ 5 600Other operating 26 000 228/228 = 26   000 31   600

Income from operations $10 400Realised holding gains (see above):

On inventory sold 2 782On equipment used       418         3   200

Realised income $13 600Unrealised holding gains (see above)

On equipment 6 819On inventory       535 7 354

Income before purchasing power loss $20 954Purchasing power loss (see Alternative 2)         7   996

Net income $12   958

Alternative 5

Sales revenue $60 000Cost of goods sold     18   000

Gross profit $42 000Operating expenses:

Depreciation $ 5 600Other operating 26   000 31   600

Distributable income $10   400

Under the physical capital view, holding gains are not recognised. They are put directly into shareholders’ equity as a capital maintenance adjustment. Compare with alternative 3.

Alternative 6

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Sales revenue $60 000Cost of goods sold     18   000

Gross profit $42 000Operating expenses:

Depreciation $ 5 600Other operating 26   000 31   600

Distributable income $10 400Purchase power loss         7   996

Net profit $     2   404

Compare with Alternative 4. The same items are included except for holding gains, which are considered capital maintenance adjustments.

Alternative 7

There is no established format for the exit price income statement. Two approaches are presented.

Sales revenue $60 000Cost of goods sold (at historical cost)     15   000

Gross profit (on historical cost basis) $45 000Inventory price change:

Adjustment for ending inventory ($44 000 – $15 000)     29   000

Adjusted gross profit (exit price basis) $74 000

Other price changes:Equipment 12   000

$86 000Less operating expenses paid     26   000

Net income $60   000

Sales revenue $60 000Less Purchases $30 000

Operating expenses     26   000 56   000

Funds from operating activities $ 4 000Changes in value (see below):

Inventory $44 000Equipment 12   000     56   000

Net income $60   000 The changes in value are computed as follows:

Ending inventory (exit price) $44 000

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Less beginning inventory (exit price)                 0

Change in value for inventory $44   000

Equipment at end of year (exit price) $62 000At beginning of year (exit price)     50   000

Change in value of equipment $12   000

Alternative 8

Sales revenue $60 000Less purchases $ 6 000 228/220 = $ 6 218

12 000 228/228 = 12 00012   000 228/232 = 11   793

Operating expenses 26 000 228/228 = 26 000 56   011

Funds from operating activities $ 3 989

Changes in value (see below):Inventory 42 152Equipment       7   577

Income before purchasing power loss $53 718Purchasing power loss       7   996

Net income $45   772

Computation of changes in value:

Exit price of ending inventory $44 000 238/238 = $42 152Less exit price of beginning inventory 0               0

Change in value $42   152

Exit price of equipment at end of year $62 000 228/238 = $59 395Exit price of equipment at

beginning of year $50 000 228/220 = $51   818

Change in value $     7   577

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16.4 Required:Determine the profit for the first year for Calvin Ltd under the following:(a) historical cost, financial capital, nominal dollars(b) current cost, financial capital, nominal dollars.

(a) Sales (7000 $13.00) 91 000Cost of goods sold (2000 $3.00) $ 6 000

(4000 $3.50) 14 000(1000 $4.00)     4   000 24   000

Gross profit $67 000Expenses:

Depreciation 5 000Other operating 30   000 35   000

Net income 32   000

(b) Sales (7000 $13.00) $91 000Cost of goods sold (7000 $3.50)     24   500

Gross profit $66 500Expenses:

Depreciation $ 5 300Other operating expenses 30   000 35   300

Income from operating activities $31 200Realised holding gains:

Inventory sold 500Equipment sold 300 800

Realised income $32 000Unrealised holding gains:

Inventory unsold 200Equipment unused 5   400 5   600

Net income 37   600

Notice that realised income is the same as net income under (a). The reason could be discussed. Realised income under current cost accounting follows the same recognition principles.

Realised holding gains:Inventory sold

Current cost of goods sold $24 500Historical cost of goods sold     24   000

Realised holding gain $           500

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Equipment usedCurrent cost depreciation (av.) 5 300Historical cost depreciation 5   000

Realised holding gain $       300

Unrealised holding gains:Current cost of ending inventory 4 200Historical cost of ending inventory 4   000

Unrealised holding gain $       200

Gross current cost of equipment $56 000Accumulated depreciation (1 yr)         5   600

Net $50 400

Gross historical cost of equipment 50 000Accumulated depreciation (1 yr)     5   000

Net 45   000

Unrealised holding gain   $     5   400

For the unrealised holding gain for the equipment, there is no need to consider the amounts for January 1 because this is the first year of operations.

16.5 Required:Prepare a statement of financial performance for Year 2 under the following assumptions:(a) historical cost, nominal dollars(b) historical cost, constant dollars (average for year).

Historical cost Historical costNominal dollars Constant dollars

Sales $9 000 120/120 = $9 000Cost of goods sold:

Beginning inventory $1 500 120/100 = $1 800Purchases     4   000 120/120 =     4   000

Available for sale 5 500 5 800Ending inventory 1   000 120/140 =       857 Cost of goods sold 4   500 4   943

Gross profit $4 500 $4 057Expenses 1 200 120/120 = 1 200Depreciation     1   600 120/100 = 1   920

Total expenses     2   800 3   120

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Income before purchasing power gain $ 937Purchasing power gain     486

Net income 1   700 1   423

Purchasing power gain computation:Net monetary items beginning balance(Cash less Notes Payable) $(3 000) 120/100 = $(3 600)Add sources:

Sales 9   000 120/120 = 9   000

Total $ 6 000 $ 5 400Less uses:

Purchase of inventory $4 000 120/120 = $4 000Expenses     1   200 120/120 =     1   200

Total uses 5   200 5   200

Ending balance $800 $200

800 120/140 =     686

Purchasing power gain $486

This $800 is an end of year dollar amount, and so it must be converted to an average-of-year dollar amount to derive $686.

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Case Study 16.1 — Gold main beneficiary from the latest uncertainty

1. Since uncertainty underlies the value of any commodity or equity traded on an open market, why is the article highlighting uncertainty? List the factors identified in the article as contributing to the uncertainty about the price of gold and commodities.

The value of a firm, particularly a large publicly traded entity, changes constantly. This means there is a significant divergence between what is in the financial records of a company and the value implied by the share price. The value changes as a consequence of the business and related activities of the company and because the factors extraneous to the company are also constantly changing, such as interest rates, consumer confidence and technologies. Factors attributed to the uncertain price of gold and commodities include: terrorist attacks; break down in price negotiations; competition for commodities and prices achieved between competing economies; volume of transactions; changes in the value of related commodities; overall short-, medium- and long-term demand; levels of production.

2. If you were a shareholder in BHP Billiton, would you like a statement explaining the factors influencing the value of commodities in which the company trades? How would it help in determining the current and future value of the company?

Most of the information is publicly available and will be factored into share value; however, a summary statement may be useful, provided management does not use it to seek to support their view of value. Firms could also add a section to the annual report discussing the differences and the factors contributing to any differences between the reported value of net assets and the market value indicated by the share price.

3. Given the level of volatility in the price of some commodities, should companies adopt a rolling average approach or continuous revaluation methods? How would this approach affect the profit reported by an entity?

The question is whether such approaches have information value and whether that value is greater than the cost. The accounting profession does not support a shift to a current value model. In order to progress such a significant shift in approach, the accounting profession would need to support and promulgate appropriate methods and standards. In addition, current value is not a static measure. What is required is current information that relates to the potential value of the firm and the financial press serves this role to some extent.

4. Given all of the factors influencing values, should firms adopt alternative 6 presented in appendix 16.1 in order to determine profit? Explain how this approach could be applied.

The approach could be simply applied, but the question for students is: what value would applying a general price index have with respect to specific commodity values?

Chapter 17

Revenue and recognition

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Theory in Action 17.1 — Disclosure pressures follow collapses

1. Why would companies want to ‘manipulate the appearance of their earnings’? Are shareholders so easily misled?

Companies are under pressure to maintain and achieve growth targets and so in some cases management may seek to use accounting techniques and adjustments that support targets. The incentives are even greater if management’s remuneration is linked to financial performance. Obviously the market will balance all available information, but to a large extent there is an information asymmetry in that management know the full nature of disclosures, so yes they can be misled through the manipulation of financial and related information.

2. If companies are not complying with the profit reporting standard, why would changing it increase compliance?

Changing the disclosure regulations may not increase compliance. If a company is breaking disclosure requirements, changing them will not make a difference. It may in fact just increase the costs of those who do comply. So the question for students is: who is being penalised by changing the regulations? Students should consider whether the rules should be changed to limit choice among alternative accounting techniques or whether the penalties for non-compliance increased dramatically.

3. Explain the difference between ‘cash basis profit’ and ‘statutory profit’.

The cash basis focuses on the inflow and outflow of funds and doesn’t seek to match them to the period to which the outflows relate to the inflows. The statutory profit is derived in accordance with corporate regulations and seeks to provide for matching of expenses against revenues — this creates increased opportunities for the manipulation of accounting information.

4. Does it really matter whether companies report the net or gross gains/losses from the sale of property, plant and equipment? It is not operating revenue and ultimately it is the net effect that will form the bottom line. Discuss.

The issue is whether disclosures can be manipulated if the net amounts are required for disclosure. Perhaps both amounts should be disclosed. Students should discuss whether the net amounts are open to manipulation and how they might prevent such behaviours.

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Theory in Action 17.2 — Timing is everything

1. PwC would have expended a significant amount of funds in tendering for this project and developing appropriate infrastructure and partnerships. How should PwC account for the cost of winning the project?

Normally firms like PwC are involved in tendering for projects on a day-to-day basis and would normally reflect the operating costs of PwC in any one accounting period. However, if PwC incurred significant one-off costs in order to win this contract then the costs should be capitalised and spread across the future revenue stream. Which approach do students feel PwC would opt for?

2. PwC has been awarded a $200 million contract to build a new integrated system for Qantas. When and how should PwC recognise the revenue from this contract?

PwC should recognise the revenue as it flows in, as this will have a direct relationship with the level of completion.

3. Qantas plans to expense the cost of the project over the 10 years of the contract. Is this the basis on which PwC should recognise revenue? Is the cost allocation approach proposed by Qantas consistent with the matching concept?

PwC should recognise the revenue as it is earned and this will not normally have any relationship with the systematic write-off of the cost of the system against its useful life. The approach adopted by Qantas is consistent with the matching principle.

Theory in Action 17.3 — When is research and development revenue?

1. How should Peplin account for the right to a second molecule granted by the cancer institute? Given that the skin cancer drug prompted the cancer institute to award the second molecule, should the value of the skin cancer drug be revised to reflect its power to attract other opportunities?

This is a difficult question to answer as any value and change to the value of the first drug is very much open to viewpoint and to the factors that impact on the possible future value and ultimate success of the drugs. The HC system would require that the purchase cost plus any R&D be capitalised and matched against future revenues, but does not provide for any non-arms-length valuation.

2. How would Peplin value the rights which they now control? Should they recognise the present value of the potential revenue stream of the drugs?

This has been answered in question 1 above. They could recognise the future value as long as this can be reliably determined, and at this stage this is doubtful.

3. Peplin hopes to sell a licence for the drugs to an international drug company. Should the sale of the licence be recognised as revenue or capital? Keep in mind

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that Peplin is seeking ‘very advantageous equity in the products which [they] are licensing’.

It will be difficult to determine the capital gain, given the licences have no real capital value at present. The licence will provide an ongoing revenue flow and this should be recognised as the right to be paid a licence fee occurs.

4. How should Peplin account for its research and development costs? For example, should it offset them against the equity in products they achieve, expense them as incurred, or seek to match them against future licence revenue? Discuss.

The R&D costs should be capitalised where the future income stream can be reliably measured.

Questions

1. What is revenue? Is revenue essentially an event or an object?

The AARF’s definition of revenue contains two important divisions. First is the abstract part that pertains to the accounting equation:

inflows or other enhancements of assets or settlements of its liabilities (or combinations of both).

The second is the real-world part that pertains to what the first does:

from delivery or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Revenue is a monetary event. It has to do with the increase in value of assets or decrease in value of liabilities as a result of sales or production. Increases and decreases are events. Although the AARF’s definition does not specify value, the context obviously implies that value is increasing or decreasing because the abstract portion of the definition relates to the accounting equation.

2. What is the difference between revenue and gain? How does SAC 4 distinguish between revenues, gains and donations?

According to the AARF and FASB, revenue relates to the ‘ongoing major or central operations’, whereas gains relate to ‘peripheral or incidental transactions’ or from events that may be largely beyond the control of the firm. Revenue relates to the production/sale of the company’s products or services for which it is in business, whereas gain is generated from the disposition of items other than products (or services), such as fixed assets, marketable securities or bonds payable. According to SAC 4, gains might be treated as a subset of revenues — they fall within the revenue definition, and SAC 4 does not specify a separate disclosure of them.

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SAC 4 does not distinguish between revenues, gains and donations — all are classed as revenues, although scope remains for their separate disclosure within revenues. The SAC 4 definition of revenues as inflows or savings of outflows, regardless of source, means that inflows do not have to be ‘earned’ to be regarded as revenues.

3. Explain the ‘earning process’. How does the earning process concept relate to the operational view of revenue?

Accounting theory assumes that revenue (and income) cannot arise unless the firm performs — that is, it must do something to make revenue happen. The earning process consists of the activities that cause revenue to occur. For a manufacturing firm, the sequence of events is typically the following: purchase of service inputs (labour, materials, etc.) production storage of product sale of product (on credit) collection of cash (from customers) warranty service.

The operational view is essentially the same as the view expressed above, except that revenues (and income) are defined more explicitly in terms of the particular operations that generate revenues (and income). Professor Bedford, who stresses this viewpoint, lists the following business operations: acquisition of money resources acquisition of services utilisation of services recombination of acquired services disposition of services distribution of money resources.

4. What is the difference between criteria for revenue recognition and revenue recognition principles? Does SAC 4 provide criteria or principles?

Revenue recognition principles are the rules used to determine when and how much to record as revenue. There are four accepted principles. The general and foremost principle is the sales basis — that is, to record the full amount as revenue when a sale has been made. Question 13 goes further into this. There are three exceptions to the sale basis: (1) during production (percentage of completion method), (2) end of production, and (3) cash received after sale (instalment method or cost recovery method). The three exceptions must or are permitted to be used under given conditions. Questions 15 and 16 deal with this point.

Criteria for revenue recognition are the criteria spelling out what kind of objective evidence is needed before revenue is to be recognised. Emphasis is on the need for reliable information. Through the years, three criteria have been identified: (1) receipt (or inflow) of a measurable-collectible asset, (2) existence of a transaction, and (3) substantial completion of the earning process.

SAC 4 provides criteria, not principles.

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5. Why are revenue recognition principles needed? Does it matter which principles are adopted, as long as they are applied consistently across time? Discuss.

These principles are needed because the definition of revenue is too general. More specific rules are needed to identify (recognise) revenue and to ensure that the revenue figure is reliable.

6. What is the significance of the criterion of measurability of the asset received?

The abstract part of the definition of revenue focuses on the inflow or increase in assets. It is logical to demand that the asset received be capable of reasonably reliable valuation. If the asset is a receivable, it is logical to demand that there be reasonable reliable valuation. If the asset is a receivable, it is logical to demand that there be reasonable hope of collection.

7. Explain the concepts of realisation and recognition as they relate to the measurement and disclosure of revenues under the historical cost system and the method proposed in AASB 1037 ‘Self-Generating and Regenerating Assets’.

Under the HC system, revenues are recognised when achieved from trading activities. They are recognised in the period that trading activity takes place and there must be a significant likelihood of collection/realisation of the revenue. Under AASB 1037 changes in the value of assets are recognised on an annual or accounting period basis, regardless of whether they are realised or whether there is any intention whatsoever of doing so. The assets may be held to facilitate operating activities (such as hazelnut trees), but the change in the value of the tree and additional trees that grow from the initial planting are recognised as revenue or expenses in each accounting period on an incremental basis.

8. What do we mean when we suggest that applying the principles adopted in AASB 1037 and 1033, for example, lead to an even greater mix of values presented in the statement of financial position?

Non-SAGRAs and fixed/capital assets are held at cost and systematically depreciated in value over their expected useful life. They may be systematically revalued, subject to independent valuation. Assets generated internally (such as goodwill and brand names) are valued at cost. They may be systematically amortised. Other assets, such as SAGRAs, are revalued each accounting period to reflect current net market value. This reflects a fundamental mix of approaches, values and gains/losses. Why doesn’t the AASB just adopt a single approach?

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9. Suppose you are a manufacturer of plastic products. A new customer, Company X, has purchased a large quantity and gives you a note as payment. The note requires X to make four equal instalments over a period of 2 years. How do you determine the collectability of the note? When should revenue be recognised?

The ability of Company X to pay can be assessed by analysing its financial statements for liquidity and solvency, and by the credit rating of the customer. The latter is based on past experience.

Under SAC 4, revenue should be recognised when the collectability of the note exceeds 50 per cent probability. At this stage, there is a probable inflow that can be measured relatively reliably. Since the earning process and sale have been completed, this stage meets generally accepted criteria for revenue recognition.

10. Should accountants insist that revenue be recognised by a firm only on receipt of a liquid asset in a sale transaction? Why?

NO! For revenue to be recognised it has to be earned, be capable of reliable measurement and it must further meet the requirement that the ‘inflow or other enhancement or saving in outflows of service potential or future economic benefits’ will occur. That is, revenue must be realisable to be recognised, rather than realised.

The term ‘realised’ refers to the inflow of liquid assets, which, if revenue were only recognised when realised, would imply that only sales would be recorded as revenue.

For example, suppose Company X sold a machine to Mr Y on ‘net 30’ terms. Revenue should be recognised when earned (the goods have been provided) and the inflow will probably occur. If revenue has to be realised before it were recognised, then Company X would have to wait until Mr Y paid cash under the strictest interpretation of ‘realised’, or when the sale occurred and the firm acquired an account receivable under a less stringent interpretation of ‘realised’.

Generally, revenue recognition requires that the resulting inflow (or saving in outflow) be probable — the amount owed represents a valid claim or is collectable. However, some circumstances exist where collectability of an inflow is not assured — for example, where a creditor forgives a debt the entity owes. Under SAC 4, this forgiven liability would contribute revenue (being a saving in future outflows of assets), although no amount will even be ‘realised’ in the form of a physical inflow.

The accounting profession has abandoned the position of insistence of receipt of a liquid asset before revenue can be recorded. The basis of insisting on the receipt of a liquid asset is to protect the working capital position of the firm. But accountants now believe that this is a managerial function. Revenue may be recognised even though a non-monetary asset is received. However, the first criterion of measurability is important — that the non-monetary asset be subject to reasonable valuation.

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11. Why is it important to have an external transaction to support the amount of revenue recorded? Name a case in present accounting practice where revenue or gain is not directly based on an external transaction and state the reasons for this exception.

A transaction is needed because personal opinion of the value of the firm’s product or service opens the door to manipulation. If an external party in an arm’s length transaction is willing to pay the price, then that constitutes sufficient objective evidence.

Exceptions that are acceptable today are: use of the ‘end of production’ revenue recognition principle. Although the inventory is to

be sold at year end, it is expressed as NRV and considered revenue on the income statement. This exception is allowed for those cases where the sale transaction is a mere formality, because it is practically guaranteed that everything produced will be sold.

short-term investments — recovery of original cost may be recorded as a gain. The gain is permitted because it is an increase of a previously recorded decrease (loss).

accrued revenue, such as interest revenue. For accruals, the sale is made continuously as time passes, rather than at a specific point in time. For instance, interest revenue denotes the sale of a service, the use of money.

an exchange gain may be recorded based on the difference in exchange rates for relevant assets or liabilities on the original transaction date and the financial statement date. The change in exchange rate connected to the relevant asset or liability is considered an important economic event.

12. If the criterion of ‘existence of a transaction’ is relaxed so that the firms involved need not be direct participants in the transaction, what are the implications?

Relaxation of the criterion would open the door to current value accounting, either current cost or exit price. Revenue or gain would be recorded before the point of sale. The answer to question 10 shows that the criterion is not strictly followed presently. The instructor may wish to ask students for their opinion on whether the criterion should be changed. The need for objective evidence is the basis for the criterion.

13.What is meant by ‘substantial completion of the earning process’? What is the significance of this criterion? How is the criterion incorporated into SAC 4?

The meaning of the phrase is that the activities that generate revenue have been mostly undertaken. Usually, substantial completion of the earning process indicates sale or production has occurred. The significance of the criterion is that there is sufficient performance by the company to say it has ‘earned’ the revenue. In other words, the company has done enough to warrant the recording of revenue.

Another reason is that uncertainty of the costs to match against revenue is minimised, since most of the costs have already been incurred and whatever remains is predictable and estimable.

A further reason is that a relationship exists between costs and revenues so that if costs increase, then revenue (selling price) will also. Until most of the costs have been incurred, the amount of revenue (selling price) is not certain.

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‘Substantial completion of the earning process’ is a criterion that is not incorporated explicitly into SAC 4. To the extent that (1) revenues are not recognised until there is an increase in assets or a decrease in liabilities and (2) these changes are not recognised until there is a greater-than-50 per cent likelihood that service potential is affected and can be reliably measured, the criterion is implicitly incorporated in relation to earnings activities. Note, however, that it is not a criterion in relation to other inflows or savings of outflows, such as donations, that do not arise from earnings activities.

14. Does the percentage-of-completion method meet the criterion of substantial completion of the earning process? Explain.

If the earning process is considered complete only when the project is finished, then the criterion is not met by the percentage-of-completion method. But if the intent of the criterion is considered, which is to ensure that revenue is recorded when there is sufficient performance by the firm, then it is met. Each period is a definable, separate segment of the total performance. Since revenue is based on the performance by the firm, then it is met. Each period is a definable, separate segment of the total performance. Since revenue is based on the performance of a given period, there is completion of the earning process for that period. Revenue is not recorded for any performance not yet undertaken.

15. What are the reasons for selecting the point of sale as the general revenue recognition principle?

The sale basis is selected, because it is the earliest time when the three criteria for revenue recognition are met. The three criteria are: receipt of a measurable asset, existence of a transaction, and substantial completion of the earning process. At the point of sale, there is sufficient, objective evidence to support the amount of revenue.

16. What is the significance of ‘title passing’ in determining whether a sale has taken place?

Legally, title passing is part of the meaning of a sale of a good. In accounting, we use this aspect of a sale to determine in many cases that a sale has taken place. But it is used as a guideline only, not a requirement. For example, in a sale-type capital lease, sales revenue is recorded by the lessor although title has not passed. Economic substance is more important than ‘legal nicety’.

17. What are the reasons proposed for recognising revenue at the end of production?

Objective evidence is the primary concern in revenue recognition. Certain companies can recognise revenue at the end of production (before sale), because there is sufficient evidence of the increase in value without the confirming evidence provided by a sale transaction. This will be the case for firms with forward contracts or a guaranteed buyer, such as gold to the Australian government. In these cases, production, rather than sale, is the ‘critical’ event. Once produced, the output is guaranteed to be sold, at least at the price specified by the contract or government.

18. ‘Revenue should be recognised only where it is supported by the existence of an external transaction.’ Discuss.

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While the existence of an arm’s-length external transaction provides objective evidence that revenue has been earned, revenue can still be earned without the existence of an external transaction. GAAPs in certain circumstances allow revenue to be recognised other than the time of sale. These include: during production AAS 11 and AASB 1009 ‘Accounting for Construction Contracts’ end of production AAS 7 and AASB 1022 ‘Accounting for Extractive Industries’

(provided there is a legally binding contract which establishes sales price) unrealised foreign exchange gains AAS 20 and AASB 1012.

SAC 4 criteria for revenue recognition are that it must be probable and measured reliably, this is generally consistent with the existence of an external transaction. However, the criteria are broad enough to encompass revenue recognition in certain situations without the requirement of an external transaction (provided there is sufficient objective evidence). SAC 4 recognises that it is impossible to specify detailed tests that identify the appropriate point for revenue recognition under all circumstances, but paragraph 130 does provide some tests.

19. Provide an evaluation of Myers’ critical event theory. How does it fit within the notion of a theory?

Myers’ critical event theory proposes that revenue and income accrue throughout the earning process and we should consider the critical event or decision as the moment to record revenue. It is considered different to the traditional position because of Myers’ emphasis on the critical event rather than objective evidence. However, Myers’ argument does actually lend support to the traditional view. Noticing that the accepted principles refer to production or sales, we can now say that sale or production is the critical event where uncertainty about value is sufficiently minimised to warrant the recording of revenue. When the critical event occurs, the earning process is substantially complete. At one of these critical points there is adequate objective evidence to justify the recognition of revenue. Myers’ critical event theory is a normative theory.

20.What are the conditions for use of the ‘cash received’ basis for revenue recognition?

On the one hand, companies are encouraged to employ the sales basis for revenue recognition unless there is great uncertainty about the collectability of the periodic payments in an instalment sale. Then the instalment or cost recovery method is recommended. On the other hand, companies are forbidden to use the sales basis for revenue recognition and are required to use the instalment or cost recovery method if collectability is very uncertain, or if performance is not substantially complete. For example, retail land sales and construction contracts fall in this second category.

The position of the profession at present appears to be this: For instalment sales for typical retail and manufacturing companies, use the sales basis for

revenue recognition, unless there is evidence of great uncertainty about collecting the payments — then use the instalment or cost recovery method.

For certain other industries, such as retail land sales and construction contracts, where it is typical for customers to give a long-term note in a sale, use the instalment or cost recovery method unless there is evidence of substantial performance by the seller and collectability of the note is assured — then the company may use the sale basis for revenue recognition. In some cases, the AASB has spelled out rules to determine collectability.

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21. When should revenue be recognised for the following businesses?(a) a soft-drink manufacturer(b) a legal firm(c) a theatre that sells season tickets to musical productions(d) a magazine publisher producing monthly titles(e) a gold-mining company(f) a farmer who grows wheat(g) a company which sells houses on an instalment plan; term of payment

extending to 20 years; buyers assume all risks of ownership; buyers pay a deposit of 25% of the sales price

(h) a contractor building a bridge for the government

(a) When the soft drinks are delivered to the customers

(b) When services are rendered (after the last act is performed)

(c) After the musical production is performed. In most cases, refunds are not given to those who do not show up (no-shows).

(d) When the magazines are delivered. For advertising revenue, when the advertising appears in the magazine.

(e) Either at end of production (after the gold is mined) or at time of sale. A gold mining company has a choice of using end of production or sale basis for revenue recognition.

(f) Sale as in (e) above. A wheat farmer has a choice between end of production or sale basis for revenue recognition because the wheat board guarantees prices.

(g) It seems the full accrual method (sales basis) can be used. The main point is collectability; and the rule is that if 20% or more is given as down payment, collectability is assured.

(h) Percentage of completion method or completed contract method can be used.

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22.On 20 December Company E sold a portion of its inventory to Company W for $200 000 cash. The cost of the inventory was $80 000. In a related transaction, Company E agreed to repurchase the inventory from Company W 2 months later for $200 000, to be paid in four equal monthly instalments at 10% interest. What should be recorded by Company E?

According to ED51B there is no sale, because essentially the arrangement is a financing transaction. In this case, title has passed, but sales revenue is not to be recorded. The inventory should remain in Company E’s statement of financial position. Company E should debit Cash and credit a liability. Again we see that economic substance prevails over ‘legal nicety’.

23. In mid-2003 Company T sold its 2000 shares of Company Y (representing 10% interest) to Company Z for $1 000 000. The cost was $400 000. However, the sale agreement gives Company T the option to repurchase the shares as follows:

in 2004: 1500 shares for $500 eachor in 2005: 1000 shares for $500 eachor in 2006: 500 shares for $500 each.

What entry should Company T record for the sale of Company Y shares in 2003? Assuming that Company T does not repurchase any of the shares, what entries should be made regarding Company Y shares in 2004, 2005 and 2006?

Is the earning process substantially complete? Since the possibility remains that the gain may be ‘nullified’ by the repurchase of the shares, it seems that Company T should recognise a gain each year to the extent of the expiration of the option.

Mid 2003 Cash $1 000 000Investment in Y Company $400 000Deferred gain 600 000

31 Dec. 2003. By this date, the option for 500 shares has expired.

Deferred gain(500/2000 = 25%; 25% $600 000) 150 000

Realised gain 150 000

31 Dec. 2004 Deferred gain 150 000Realised gain 150 000

31 Dec. 2005 Deferred gain 150 000Realised gain 150 000

31 Dec. 2006 Deferred gain 150 000Realised gain 150 000

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24.Lee Ltd agreed to manufacture Product A according to Smith Ltd’s specifications over a 2-year period. Because special machinery is needed to produce Product A, Smith Ltd is to pay for it. Lee Ltd purchased the machinery for $1 000 000. It debited Machinery and credited Cash. A month later, Lee Ltd received $1 000 000 from Smith Ltd as reimbursement of the cost. What entry should Lee Ltd make for the cash received? When Lee Ltd uses the machinery each year, what entry should be made?

This is what Lee has done:

Cash $1 000 000Machinery $1 000 000

This agreement specifies that Smith is to pay for the machinery. The question is: does Smith intend this to be a donation? The contract is only for two years. The problem does not state what will happen to the machinery at the end of the 2-year period. Will Lee keep it or will Smith expect to receive it?

It does not appear that Smith intends this to be a donation to Lee. Probably, Lee did not want to take the risk of purchasing the special machinery for the sole purpose of making this product for Lee for only two years. Lee should not show the machinery in its statement of financial position as an asset and should not be depreciating it.

Lee should record:

Cash $1 000 000Machinery $1 000 000

Presumably, the agreement specifies a certain (lower) price that Smith will pay for product A, which considered the fact that the special equipment will be purchased by Smith.

When Lee uses the machinery, it will make no entry. Instead, Smith will record the depreciation. When it purchases the product from Lee, it should increase the cost of the pertinent amount of depreciation expense. It would debit the product purchased and credit depreciation expense.

25. If revenue is recognised, does that mean that the revenue has been realised? Explain your answer and provide an example to support your view.

If revenue is recognised that does not mean necessarily that the revenue has been realised. Recognising revenue is the process of including the earning activities conducted by the entity into the financial performance and position of the entity. Recognising that the earning activity has taken place, it therefore must be recorded. Realisation is the conversion of assets into cash or cash equivalence (such as a receivable). It can be said recognition requires an inflow of assets whereas realisation requires an inflow of liquid assets.

There are many examples of revenues being recognised without being realised such as when a firm sells its product and receives raw materials or a fixed asset in return (bartering). Revenue can also be in the form of increase to the market value of fixed assets — whereas the revenue

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has been earned, a cash benefit associated with the revenue may not be realised for many reporting periods in the future.

26. Watson Ltd began operations on 1 January 2003 by purchasing 3000 orange tree saplings at a cost of $4 per sapling. Delivery charges were $500 and it cost $1200 to plant the trees on Watson Ltd’s land, which 2 years earlier cost $60 000. During 2003, the saplings produced fruit that was used to generate 1000 seedlings. The only other expense during the year was herbicidal spraying, which cost $400. At the end of the year the saplings had a market value of $4 per sapling and the seedlings $1 per seedling. Show all journal entries for the calendar year 2003 and the calculation of net profit for the year.

Entries for the Year 2003:

01.01.2003 Dr SGARAs — Orange Trees $13 700Cr Cash $13 700

Purchase of 3000 orange tree saplings (incl. transport & planting costs)

31.12.2003 Dr Spraying Costs $400Cr Cash $400

31.12.2003 Dr SAGRAs — Seedlings $1 000Cr Revenue — Increment Account $1 000

1000 seedlings at a current market value of $1.

We do not have sufficient information to calculate net value as we do not have an estimate of the costs associated with the sale of the seedlings. So record at $1 each and assume this is the net value.

31.12.2003 Dr Increment in market value account $1 700Cr SAGRA — Saplings $1 700

To recognise net market value of orange trees at $4 per tree.

Calculation of profit/loss for 2003:

Seedlings Increment $1 000Saplings Increment ($1   700)

Net Change in Market Value ($ 700)Add: Operating expenses ($ 400)

Net Loss for 2003 ($1   100)

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Problems(For a full outline of problems, please see text.)

17.1 In the following examples (see pages 648–9), indicate whether it was proper for X to record the particular amount of revenue according to accepted recognition principles (accrual system). Your answer should be ‘yes’ or ‘no’.

1. No. The common carrier is the agent of X and it still has possession of the goods. There is no sale, because delivery has not been made, not until the point of destination.

2. Yes. For the sake of convenience to the customer, delivery has not been made. In such a case, delivery is not insisted upon in order to record revenue. If X wished to, X could wait until delivery to record the sale.

3. No. Since Y’s credit rating is good, there is no basis for belief that collectability is very uncertain; therefore, X should not use the instalment method.

4. No. There is also accrued interest for the four months from September 1 to December 31.

5. No. X should have recorded the $600 as revenue last year when the repair service was rendered.

6. No. The consignee is, in effect, an agent of X. Until the consignee sells the goods, there is no sale.

7. No. Until the study is completed, there is no sale of services. The completion of the study is necessary to the meaningfulness of the study. The last act must be performed before there is recognition of revenue.

17.2 State whether revenue (or gain) is to be recorded in the following cases (see page 649).

1. No. There is no sale. An increase in value of the asset does not meet accepted revenue recognition principles.

2. Yes. The tax refund qualifies as ‘other income’. It is not extraordinary and it is not a prior period adjustment. There is a realised increase in assets (increase in wealth) and the transaction is not a capital or financing one.

3. Yes. The cash from the lawsuit qualifies as ‘other income’. It is not extraordinary and it is not a prior period adjustment. There is a realised increase in assets and the transaction is not a capital or financing one.

4. No. Production of paper does not qualify for the end of production revenue recognition principle, unless the firm has a financial contract.

5. Yes. There is a gain of $10 000, and this gain is extraordinary because the basic cause was the fire. A fire is ‘unusual in nature’ and in the foreseeable future it is not expected to happen again.

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6. Yes. An exchange of non-monetary dissimilar assets completes the earning process, and therefore a gain of $10 000 is to be recorded.

7. No. The receipt of an ordinary (ordinary shares for ordinary shares) share dividend is not income. The reason is that the recipient’s economic position is the same, since the percentage interest in the investee company remains the same. Company X now has more shares to represent the same amount of investment in Company Y.

8. Yes. According to ED51A — Definition of equity record as revenue.

17.3 Required:Calculate the amount of revenue for each year under each of the following recognition principles:(a) sales recognition principle (completed contract method)(b) production recognition principle (percentage-of-completion method)(c) instalment recognition principle (cash received method).

1. Completed contract method:

2003 2004 2005 2006 2007Revenue 0 0 0 $600 000 0

The project was completed in 2006, and therefore the ‘sale’ is consummated in that year.

2. Percentage-of-completion method:

2004 2005 2006Revenue $150 000 $375 000 $75 000

For 2004: $100 000/$400 000 = 25%25% $600 000 = $150 000

For 2005: $350 000/$400 000 = 87½% less 25% = 62½%62½ $600 000 = $375 000

For 2006: $400 000/$400 000 = 100% less 87½ = 12½%12½% $600 000 = $75 000

3. Cash received method:

2004 2005 2006 2007Revenue 0 $100 000 $200 000 $300 000

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17.4 Revenue was recognised when the events below (see page 650) occurred (accrual system). State whether it was proper or improper according to accepted recognition principles.

1. No. There is no sale.

2. No. Revenue should have been recorded a year ago when the repair was done.

3. Yes. There is a credit sale.

4. No. Title does not pass until the common carrier has possession of the goods. The common carrier is the agent of the buyer in this case, and the goods have not been delivered to the agent yet.

5. No. Title passes at point of destination, and presumably the goods are still in transit.

6. Yes. The sale has occurred for two reasons. First, delivery is delayed at the convenience and request of the buyer. Second, the item is unique and costly, and therefore, legally, the sale is made when the buyer agrees to purchase the 1912 automobile.

7. No. This is cash received in advance of the sale of the service. This is unearned revenue.

8. It depends on whether the conditions specified in ED51B are met. These are stated in the textbook. If they are, revenue can be recorded now.

9. No. This is a consignment, not a sale.

10. No. There is no performance yet. If the company had already begun to construct the yacht, then it could record the full amount as revenue. If there is performance, then a sale has been made.

11. Yes. The sale was made because the truck was delivered. This is not an instalment sale, since there will be no periodic payments. Despite the fact that title has not passed, this is simply a credit sale.

12. Yes. Although this is an instalment sale, the sales basis should be used, because there is no evidence of great uncertainty in collecting the payments.

17.5 Required:According to generally accepted accounting principles, determine the total amount of sales revenue Steele Ltd should report on its statement of financial performance for 2003.

1. There is no sale.

2. Sale made for $300 000.

3. Sale of $12 000 000 made. It does not matter that $200 000 has not been received in cash, since the accrual method is used.

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4. This is a consignment, not a sale.

5. The sales basis should be used, since there is no great uncertainty of collecting the payments. Sales of $150 000 to be recorded. There is interest income of $3000.

6. There is no sale. Paper products do not qualify for the revenue recognition exception of recording revenue at end of production.

$     300 00012 000 000

              150   000 $12 450 000 Sales revenue for 2003

The interest income is not sales revenue.

17.6 Required:Prepare entries to record the sale of the franchise to T under each of the following assumptions:(a) The deposit is not refundable, no future services are required by the

franchisor and collection of the note is reasonably assured.(b) The franchisor has substantial services to perform and the collection of the

note is very uncertain. D Ltd will charge an annual fee of $4000 for services rendered.

(c) The deposit is not refundable, collection of the note is reasonably certain, the franchisor has yet to perform substantial services and the deposit represents services already performed.

(a) Cash $15 000Notes Receivable (at present value) 12 009

Revenue from Franchise Fees $27 009

It is possible to record the note at $15 000 and credit a discount account for the difference.

Present value of ordinary annuity, 3 periods, 12%2.40183 $5000 = $12 009

(b) Cash 15 000Unearned Franchise Fees 15 000

(c) Cash 15 000Notes Receivable (at present value) 12 009

Revenue from Franchise Fees 15 000Unearned Franchise Fees 12 009

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17.7 Required:Prepare separate statements of financial performance for Divisions A and B for Year 1. For Division B, use the end of production revenue recognition principle.

For Division A, using the percentage-of-completion method:

$190 000 materials used350 000 direct labour100 000 overhead    80   000 administrative expenses (to be used because there is only oneproject)

$720 000 total costs to date    720   000 additional costs to complete, including administrative expenses

$1   440   000 total costs

$720 000/$1 440 00 = 50%, percentage of completion50% $2 000 000 = $1 000 000 revenue

Statement of Financial PerformanceFor the Year Ended December 31, Year 1

Revenue $1 000 000Cost of construction           640   000 Gross profit $ 360 000Administrative expenses 80   000

$ 280   000

For Division B, using the end of production method:

Statement of Financial PerformanceFor the Year Ended December 31, Year 1

Sales revenue:Barley (8000 b. $5.00) $40 000Rye (12 000 b. $3.00)     36   000 Total $76 000

NRV of ending inventory:Barley (2000 b. $5.00) $10 000Rye (8000 b. $2.70)     21   600         31   600

Total revenues $107 600Less operating expenses     50   000 Operating income $57 600Other items:

Gain on sale of beginning inventoryof rye (2000 b. $0.10) 200Loss on sale of beginning inventoryof barley (1000 b. $0.40) -400             –200

Net income $57   400

The NRV for ending inventory was calculated as follows:

Barley: $5.50 expected sale price less $0.50 expected cost of disposition = $5.00

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Rye: $3.20 expected sale price less $0.50 expected cost of disposition = $2.70

The sale of the beginning inventory is made for speculative profit. The beginning inventory was considered revenue in the previous year at NRV. Any difference between the NRV of the previous year and the net realised amount this year is gain or loss.

The NRV for the previous year was:Barley: $5.40 less $0.50 = $4.90Rye: $2.90 less $0.50 = $2.40

The net amount realised this year was:Barley: $5.00 less $0.50 = $4.50Rye: $3.00 less $0.50 = $2.50

The expenses related to the sale of the beginning inventory were deducted in the previous year, since NRV was taken.

17.8 Required:A. Record the journal entries relating to the instalment sales, using a deferred

gross profit account.B. Calculate the realised gross profit, showing it as the difference between

revenue and cost of goods sold.

A. (a) Instalment accounts receivable $700 000Instalment sales $700 000

(b) Cost of instalment sales 420 000Inventory 420 000

(c) Cash 300 000Instalment accounts receivable 300 000

(d) General — administrative expenses 70 000Cash or Accounts payable 70 000

(e) (At end of period)Instalment sales 700 000

Cost of instalment sales 420 000Deferred gross profit 280 000

(f) Deferred gross profit 120 000Realised gross profit 120 000

$280 000/$700 000 = 40%, gross profit rate40% $300 000 (cash received) = $120 000

or $300 000/$700 000 = 42.857%42.875% $280 000 = $120 000

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(g) Realised gross profit 120 000General — administrative expenses 70 000Income summary 50 000

B. Revenue (cash received) $300 000Cost of goods sold     180   000 Realised gross profit $120 000

As can be seen in the entries above, Revenue and Cost of goods sold are not recorded as accounts. Instead, the realised gross profit is an account from the ledger. They are put in this format so that the student can see that the cash received is actually the revenue, when the instalment method is used.

Cost of goods sold is 60% of revenue or it can be calculated as 42.857% of $420 000 = $180 000.

17.9 Required:A. Prepare all journal entries to record the establishment of Brockelsby Station

Ltd.B. Prepare journal entries to reflect the change in net market value of cattle at

30 June 2003 and the sale of calves during the period.C. Assume the only transaction was veterinary fees of $20 000. Show the

calculation of reported profit/loss for Brockelsby Station Ltd at 30 June 2003.

A.Prepare all journal entries to record establishment of Brockelsby Station:

Note: Cannot record purchase of land as we do not know the purchase price.

01.01.2003 Dr SGARAs — livestock $1 115 000Cr Cash $1 115 000

Purchase and transport of livestock

Dr Decrement in Net Market Value of SGARAsRecognised as expenses $120 600

Cr SAGRAs — livestock $120 600Cost of purchase transport costs to buy and sell and 1% auction fee

B.30.06.2003 Dr Cash $8 000

Cr Sales $8 000Sale of livestock

Dr Vet Fees $10 000Cr Cash $10 000

Vet fees for year

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Dr SAGRAs $225 600Cr Net Increment in Market Value (Revenue) $225 600

Net increment in market value of livestock

Net value start of year ($1 115 000 – $120 600) is $994 400.Net change is $1 220 000 – $994 400 = $225 600.

C.Calculation of profit for period:

Sales $ 8 000Market increment $225   600

$233 600Decrement expense $120   600

$113 000less: Expenses $ 20   000 Profit $ 93   000

17.10See Pty Ltd began operations on 1 January 2004 by purchasing 5000 apple tree saplings at a cost of $2.00 per sapling. It cost $3600 to transport and plant the trees on land purchased 3 years earlier for $100 000. During 2000, the only expenses were insecticide spraying and pruning costs totalling $8000. On 15 August an additional 1000 saplings were purchased for $3.00 each (with transport and planting costs of $1800). In November a bush fire destroyed 25% of the planted trees. The year-end market valuation of the trees was $11 000. Show all journal entries for the calendar year 2004 and the calculation of net profit/loss for the year. Assume all transactions are cash based.

01.01.2004 Dr SAGRAs $13 600Cr Cash $13 600

Purchase of saplings including transport and planting costs

Dr Market Value —Expense $3 600Cr SAGRAs $3 600

To recognise net market value off set for transport and planting costs

15.08.04 Dr SAGRAs $4 800Cr Cash $4 800

Purchase of saplings including transport and planting costs

Dr Market Value —Expense $1 800Cr SAGRAS $1 800

Recognise net market value

31.12.2004 Dr Spraying & Pruning Costs $8 000Cr Cash $8 000

Operating expenses

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Dr Natural disaster expense $3 250Cr SAGRAs $3 250

Loss of 25% of trees (25% $10 0000; 25% $3000)

Dr SAGRAs $1 250Cr Market Value Increment Revenue $1 250

Net value at year of saplings was $9750 and market value was $11 000 difference is a gain.

Calculation of profit/loss:

Net Increment $1 250

Less: Loss of SAGRAs $3   250 ($2 000)

Less: Operating Expenses $8   000 Net Loss ($10   000)

Case Study 17.1 — Xerox forced to revise the books for five years

1. What is the point of restating 5 years’ profits? Isn’t it too late to make actual adjustments to financial statements?

The only technical point would be to possibly eliminate any future effect of the actions taken by Xerox. This would be achieved by making the necessary adjustments to past financial records that would have a flow-through effect to current and future statements. Another reason would be to signal the severity of Xerox’s behaviour and to indicate that the legislation has some power over these large corporations.

2. Why would adjustments to previous-year financial statements, which it is argued do not affect overall cash position, cause a significant fall in share price and a downgrade of classification by ratings agencies?

This is a difficult question in one sense, as there may be a range of factors influencing the value of the firm that are not necessarily related to the accounting adjustments. Students should be encouraged to discuss what factors drive share price. It isn’t simply that the value changed in the financial statements, but also the fact that management has engaged in such behaviours. What else is being ‘hidden’ from shareholders? Can management be trusted in the future?

3. What does Christa Carone mean when she states: ‘There’s no revenue that is going away … it is revenue-shifting from one period to another’? Is ‘revenue-shifting’ consistent with SAC 4 and the matching principle?

Christa is correct. All of the revenue exists or existed — it just wasn’t recognised in a manner consistent with accounting and disclosure regulations, which do require some level of matching of revenues against expenses. So basically revenue is earned by held over for

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recognition to a future period. This approach is discretionary recognition and is completely inconsistent with the SAC 4 and the matching principle.

4. Why would management want to shift revenues to other periods? How can such approaches be stopped?

The reason for engaging in revenue shifting practices is to ‘smooth’ revenue across several periods and/or to provide a reserve of revenue to support growth targets. This approach is normally associated with concerns about market reactions to revenues that do not meet market expectations and this becomes more acute where management remuneration is linked to financial performance and share value.

5. A large part of the adjustment appears to be to the classification of revenues, not their timing. Does the classification matter, as long as the revenues are recognised in the appropriate period? Discuss.

Again, it is difficult to isolate the impact of one factor on share price. However, the classifications will have some information impact, as changes in classifications mean that the nature of operating revenues will change.

Case Study 17.2 — Forward orders a plus for Leighton

1. What are ‘one-off items’? How are they normally disclosed in financial statements?

‘One-off’ items are as the term suggests: items that rarely occur and are not normally part of core operating activities. For example, the loss of a factory due to explosion, or the write-off of a poor investment. They are normally disclosed after the disclosure of normal operating revenues or expenses.

2. Why are almost all Leighton’s revenues classified as ‘one-offs’?

Leighton elects to classify revenues as one-offs as most projects are unique or stand alone, such as building a runway or a sewerage system. However, it could be argued that Leighton is in the construction business and so these should all be lumped together as operating revenue. Students should consider the implications of this approach with respect to matching revenues.

3. How could Leighton signal that it has a number of forward orders or ongoing contracts? Why can’t investors determine this from the financial statements?

The contracts are simply not recognised until certain levels of completion are achieved. One way to indicate the level of future contract revenue would be by way of notes to the financial statements or a special disclosure in the annual report. Other reporting mechanisms could be used including web sites, press releases and publications.

4. What accounting method should Leighton use to allocate the costs and revenues associated with building a sewerage system over a 3-year period?

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The most appropriate method would be the percentage or stage of completion method. See page 633 for a discussion of this method.

5. How should Leighton account for the 50% revenue share with Kumagai Gumi? Discuss Leighton’s options, including booking all the revenue and then treating Kumagai’s share as an expense.

In accordance with question 4 above. However, students should be encouraged to discuss the expense option referred to in the question.

Chapter 18

Expense and matching

Theory in Action 18.1 —Moving with the times

1. How should Mitre 10 account for the ‘$11 million e-commerce revamp’? Is it an investment in an asset, or an expense for immediate write-off, or an expense to be assigned across a number of future periods?

The development costs would normally be capitalised and then amortised over an appropriate period of future revenues. That is, the expense matched against the future revenues. The accepted approach would be to capitalise the total expense as an asset and systematically write-off the asset against future revenues. The issue is whether the future revenue streams can be related to the initial system expenses.

2. Given that the technology is being provided to 700 co-op member stores, each store should pay a proportion of the expense and there would, therefore, be no need for any expense/asset in the co-op’s accounts. Discuss.

Each store could provide a proportion of the capital cost, but this would normally be recovered over time and therefore some initial capitalisation may take place that is offset from the reimbursement payments from member stores.

3. How should Mitre 10 account for the web site revamp? Keep in mind that the co-op does not expect the ‘online presence to translate into many sales’. You may also like to refer to UIG Abstract 37 ‘Accounting for Web Site Costs’ (AASB, January 2001).

In accordance with UIG Abstract 37, where there is not a significant relationship between the web site and the sales then the expense would be written-off immediately. See pages 143–4 for a summary of UIG Abstract 37.

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Theory in Action 18.2 — The simple process of matching

1. What do the terms ‘remedial work’ and ‘upgrade’ mean? Do they imply an expense required to keep the assets in operating order, or expenditure which will extend the existing useful life of the assets? Is a $100 million repair an extraordinary item or an operating expense?

The $100 million repair is required so that the asset can continue in use. It is not expected to increase the life of the asset, but to ensure its ongoing use. The terms ‘remedial work’ and ‘upgrade’ make it sound like minor work of an operational nature, but in this case it is a significant rebuilding of an asset to ensure its viability. Given the extraordinary nature of this expenditure it could be classified as such; however, it could equally be argued that it is part of the overall capital value and should be written-off against the remaining life of the asset.

2. If Sydney Airport is required to spend the $100 million to repair the wall, how should it account for it, if the expenditure does not extend the existing useful life of the asset? What is the impact on the annual depreciation charge?

As indicated in question 1 above, the expenditure should be capitalised and written-off over the remaining life of the asset. This will significantly increase the annual depreciation charge. The matching principle is the accrual system. Students should identify this fact. If the concept of matching the expenses associated with revenues within a particular accounting period is abandoned then the concept of depreciation is not necessary. Under the accrual system the value of assets that have a useful life that extends beyond more than one accounting period means that the decline in asset value should be apportioned to each accounting period. The problem is: how long will the asset last? What will it be realised for when its value to the firm is zero? What contribution has the assets decline in value made to current period revenues? Students should also consider whether such assumptions provide considerable leverage for managers to smooth income or accrue changes in asset values to be recognised at a time that suits management.

3. If the 100-year indemnity no longer exists, what changes should Sydney Airport make in its accounts, regardless of who fixes the wall on this occasion?

There would be no need to make any adjustments or changes to the accounts. The loss of the indemnity does not create any transactions to be recorded.

4. The erosion first became apparent in 1997. Should Sydney Airport have started to make provision for future costs at this time?

At the time that the extent of the erosion could be estimated then it would have been appropriate to establish some type of reserve fund to provide for the future expenditure. However, the extent of erosion was initially difficult to determine and who was responsible for covering the costs of repairs was in dispute. Given the level of uncertainty perhaps a contingency fund could have been established or some recognition in the notes to the accounts.

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5. If Hornibrook makes the $100 million repair, how should that company account for the outlay?

It would be an extraordinary expense, as the revenues from building the sea wall have already been recognised.

Theory in Action 18.3 — Branding an identity for life

1. How should PwC account for these branding costs — as an expense for immediate recognition or as an asset for systematic write-off (amortisation)?

Normally the expenses of such branding or rebranding exercises are expensed as incurred. As the brand will requiring ongoing promotion across several years, it could be argued that such costs are ongoing and form part of the operating expenses. However, given the significance of the investment then it could be argued that the costs be capitalised and amortised over an appropriate time period — the problem will be in determining an appropriate time period. Students should be encouraged to discuss what an appropriate time period might be and how this would be determined.

2. On what basis will PwC determine the period over which the costs of the branding should be amortised? Should they be amortised at all, particularly if the value of the firm’s revenues continues to increase?

This has been addressed in question 1. Why would increases in revenues be associated with an argument for immediate write-off? If revenues are rising then the branding exercise is working and is providing future value.

3. Basically, SAC 4 says ‘If in doubt expense it now’. Is this valid when a firm is investing such a significant amount in a brand, which is obviously an important point of differentiation in a highly competitive market? How much doubt is needed?

There needs to be a clear association between future revenues and the initial expenditure. If this cannot be established (and in the case of a general brand development process this would be difficult), then the costs should be expensed. The question for students is: does expensing distort the reporting of net returns in future periods?

4. The alternative is to book the asset and then recognise a gain or loss when the business is sold. This is the economic view. Is it applicable to such intangible assets?

The answer is a matter of viewpoint. What if the firm’s value will never be realised through sale and after many years of trading the brand is again changed? Intangible assets are a very difficult set of assets as often the returns from such assets are difficult to associate. Students should discuss how they might establish the relationship between intangible assets and operating revenues.

Questions

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1. How is the cash outflow of an entity related to expenses?

In the ideal case, liabilities are payables whose value is the present value of the future cash outflow of the firm, and expenses are the increase in value of the liabilities. This shows that expenses relate to cash payments. In other words, eventually all expenses are paid in cash. In the real world of uncertainty, expenses are related to the using up of assets and services in the operations of the business. The assets and services are paid for at some time. Under accrual accounting, the payment may be before the use of the asset or service or at the same time or after. In this sense, we can say that expenses are paid in cash at some point(s) in the life of the firm.

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2. What is the ‘monetary event’ associated with the notion of expense? How is the ‘using up of goods or services’ related to expense?

The monetary event is the increase in the value of liabilities (or shareholders’ equity) or the decrease in the value of the assets. The monetary event relates to the abstract portion of the definition of an expense — that is, that part which relates to the accounting equation. The reason why the monetary event occurs is that the firm does something to make it happen. In particular, the firm uses up goods (assets) and services. The using up of goods and services refers to the real-world part of the definition of expense.

3. What is the difference between expense and loss? How does SAC 4 require losses to be disclosed relative to expenses?

Expenses are incurred so that benefits may arise. Those benefits pertain to the generation of revenue. When a loss occurs, no perceived benefits arise, in the sense of helping to generate revenue. The former relates to the ongoing major or central operations of the firm, whereas losses relate to peripheral or incidental transactions or events, largely beyond the control of the firm.

SAC 4 does not provide disclosure rules, and does not distinguish between losses and expenses. Hence, the statement does not require losses to be disclosed in any manner different from the way in which expenses are disclosed.

4. Explain the connection between accruals and deferrals on the one hand and the process of matching on the other. Give two examples.

Matching is an attempt to deduct the cost of using up assets and services (expenses) with the revenues that were generated (supported) by that ‘using up’ activity. That is to say, matching attempts to associate the real world operations that give rise to expenses and revenues.

AbstractReal-world operations

Revenue: Inflow (increase) in assets or decrease in liabilities

Production or sale of product in current period

Expense: Decrease in assets or increase in liabilities

Using up of assets and services in support of the production or sale activity

Given a certain amount of revenue that is determined by the revenue recognition principle, the matching process focuses on the ‘using up’ operations that helped to generate the amount of revenue recognised in the current period. In the matching process, accruals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded, mainly because they have not been paid. Deferrals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded — mainly because they have not yet been paid. Deferrals refer to ‘using up activities’ that will occur in the future, but which have been recorded (usually as assets) — mainly because they were paid in the current or past period. Accruals and deferrals also refer to revenue, but this question pertains to matching and therefore the focus is on expenses.

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Accrual accounting and the matching process concentrate on certain operations that, by theory, will generate income. If not for theory, these particular operations would not have such significance. Accruals and deferrals are done because of accounting theory — they are imposed on the actual cash flow to ascertain periodic income according to theory.

Examples of accrued expense: Interest, rent, salaries and wages, taxes.

Examples of deferred (prepaid) expense: Interest, insurance, rent, wages, taxes.

5. Name the three basic methods of matching. Give an example of each. How do they align with the expense recognition criteria outlined in SAC 4?

The three basic principles of matching are: Cause and effect: cost of goods sold, sales commissions, salaries and wages, certain

selling costs Systematic and relational allocation: depreciation, amortisation, depletion, insurance Immediate recognition: R&D, advertising, utilities.

Some expense can be said to be due to cause and effect and are immediately recognised — for example, utilities, salaries and wages.

The basic principles of matching do not apply under SAC 4 in the same manner as under GAAP. In fact, under SAC 4, expenses are matched to the period in which the asset expiry or liability increase occurs rather than being matched against the revenues that they have contributed to earning. The recognition criteria relate to the outflow of service potential or future benefits having occurred, and the need for the amount to be reliably measurable. No reference is made to matching expenses with revenues or earnings activity.

6. What are some of the problems connected with the cause and effect method?

On the surface, the cause and effect rule looks reasonable. As certain costs are incurred, these result in revenue. But these associations are difficult to substantiate, although they seem to be very sensible. Critics say that the basis of this rule is costs attach. Since the costs attach theory cannot be verified, then it is not surprising that cause and effect relationships cannot be confirmed. The implication of the rule is that a particular amount of expense can be associated with a particular amount of revenue; but in almost all cases, this cannot be proven.

7. What are some of the problems related to the immediate recognition method?

The immediate recognition rule is applicable when future benefits of a given expenditure cannot be measured, except in an arbitrary manner. Trying to decide if future benefits exist or not and estimating the amount is a difficult task. Because of the difficulty involved, expenses can be manipulated. For example, capitalising or expensing the cost of rearrangement of machinery could go either way. ASRB 1011 on R&D tends to support expensing, but there are cases when such costs could probably be capitalised. Another example is advertising, which is normally expensed as incurred by most companies; but a few do capitalise.

8. What is the ‘allocation problem’ as argued by Thomas? What is your opinion of this problem? How is it dealt with under SAC 4?

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Thomas argues that allocations are theoretically unjustified, because they do not meet the three criteria he poses: additivity, unambiguity and defensibility. A variety of methods of allocation exist, each of which can be defended, but there is no conclusive way to select one over another.

Accountants defend allocations in two ways. First, they say, the allocation patterns reflect the cost of the services received in given periods. Thomas argues that accountants must demonstrate that the service received contributed to a given amount of cash inflows or revenue or cost savings. They can’t, Thomas says, because allocations do not reflect anything real. Also, input patterns cannot be associated with output patterns because of interaction. There is an ‘extra’ amount of output due to interaction that cannot be related to particular inputs.

The second way accountants defend allocations is to argue that allocated data are useful. Thomas says people are conditioned to believe such data are useful.

The fact that accountants continue to allocate shows that they still believe allocations are meaningful. Whether Thomas is correct or not is debatable. Even if his argument is not accepted, Thomas has made accountants more conscious of the need for evidence to support accounting practices.

Under SAC 4, the allocation problem is dealt with indirectly. Expenses are determined by reference to assets and liabilities, not costs. As such, and because SAC 4 is applicable to a variety of accounting measurement systems, the allocation problem is not a major concern of SAC 4. However, SAC 4 Appendix paragraph 50 recognises that assets with finite lives need to have their service potential or economic benefits written off according to some criteria. Thus, it comments that this expensing normally occurs by way of systematic allocation procedures over the expected life of the assets.

9. How has allocation been defended by some researchers?

Eckel believes that allocations could be considered rational if the objective of allocations is redefined. Presently, the objective is to determine income by matching (mainly, cause and effect). Eckel suggests that the objective of allocations can be changed to simply the determination of income by the difference between revenue and allocated costs.

Callen used ‘Shapley’ values in game theory to show that the interactive element can be dealt with so that allocations of individual input costs can be made rationally.

Zimmerman demonstrated that allocations of costs for internal purposes are useful for controlling and motivating managers, and therefore are justified. He showed that cost allocations represent certain hard-to-observe ‘costs’ when managers are given decision-making responsibilities. That is, cost allocations help to lessen some of the problems of control and coordination that arise when managers within the firm are given the right to make certain decisions.

Miller and Buckman showed that there is a logical reason for the allocation of fixed costs by a service department in setting a price to charge a user department.

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10. For the following, determine whether an asset or expense should be charged, and state your reasons:

(a) cost of removing two small machines to make way for a larger new machine

(b) cost of repairing a floor damaged when a new machine was dropped while being unloaded

(c) cost of a new calculator, $48(d) cost of major repairs to equipment. The need for repair was discovered

immediately after acquisition. There is no warranty on the equipment.

(a) It depends. If the estimated salvage value of the two small machines had taken into consideration expected costs of removal so that a net salvage value was used in the calculation of depreciation, then the present cost of removal is an expense. If not, then the cost would be capitalised to the new machinery.

(b) Expense. The cost of repairing the floor is not a ‘necessary’ expenditure to acquire the machine or to put the machine in operating condition. The cost is due to carelessness.

(c) Expense. The amount is not material.

(d) Expense. The company should have inspected the equipment more carefully before purchase. If the need had been discovered, presumably the purchase price would have been reduced to account for the necessary repair.

11. Does SAC 4 support or contradict the convention of conservatism? In what way?

SAC 4 contradicts the doctrine of conservatism. The doctrine of conservatism describes the view that it is better for accountants to err on the conservative side of a reporting entity’s financial position and performance. By applying this doctrine it reduces the risk of overstatement of net assets and profits of an entity.

SAC 4 recognises an expense when it is probable that the consumption or loss of service potential has occurred (para. 116(a)), where a probability criterion of 0.5 is applied. This is both consistent for recognition of revenues and expenses, and will result in a more objective approach in determining the nature of financial statement elements. If SAC 4 is adopted over the doctrine of conservatism, it is likely that expenses will be recognised later in the operating cycle and revenues earlier. In adopting this approach the AARF has decided that the qualities of relevance, reliability and consistency are more important characteristics than conservatism.

12. Several commentators have criticised SAC 4 for placing inadequate emphasis on the matching concept. What evidence is there to suggest that SAC 4 ignores the matching concept? Do you agree with this?

In SAC 4, recognition of an expense (para. 116) while there are a probability and measurement criteria, there is no mention of the principle of matching expenses against revenues. SAC 4’s emphasis is on defining a criterion for recognition of an expense rather than creating rules for when the costs incurred should be matched against revenue. Applying the matching principle without considering the nexus between the expense and the revenue

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may reduce the relevance and reliability of information reported in GPFRs. SAC 4 does make brief mention of the matching principle in the paragraphs following (paras 120–3).

Application of SAC 4 would generally give rise to matching of revenues and expenses where expenses result directly and jointly from the same transactions or other events as do revenues. For example, cost of goods sold, where expenses should be recognised on the basis of a direct association with revenues (para. 138).

However, there will be instances where matching will not be achievable if relevant and reliable information is to be reported. For example, research and development costs, which are incurred in the expectation of future benefits, where at the reporting date it cannot be shown that it is probable the future economic benefits will eventuate. Using the matching principle these costs will be recognised as assets in the current period and expensed when revenues are achieved. Under SAC 4, as they do not meet the criteria of an asset, they will be expensed in the current period (A40–44).

13. SAC 4 has also been criticised for being ‘balance sheet biased’. What evidence is there to suggest this?

Evidence to suggest that SAC 4 is ‘balance sheet biased’ (that is, there is a bias toward the statement of financial position (or balance sheet) rather than the operating statement) include: revenues and expenses were defined in terms of changes in assets and liabilities the requirement that an item needed to satisfy the definition of assets, liability or equity.

To qualify for recognition in the statement of financial position would have precluded some deferrals that previously had been made, so as to report the effect of certain events in the operating statement over a number of reporting periods.

It is argued by the board that defining revenues and expenses in terms of changes in assets and liabilities provides a framework for reporting those elements according to their economic substance, and limits the scope for bias in the reporting of revenues and expenses.

It is also argued by the board that recognition criteria for revenues and expenses cannot be applied independently of the recognition criteria for assets and liabilities if the operating statement and the statement of financial position are to appropriately link with each other. Hence the criteria for recognition of assets and liabilities ‘drive’ the application for the criteria for recognition of revenue and expenses. (SAC A 52–59)

14. Explain the arguments for and against expensing the allocation of share options to management.

The arguments commonly proposed for the recognition of assigning share options to employees as an expense, include: They are basically another component of salary expense and should be recognised as such. There is a legal obligation created at the point that the options are assigned and this

requires recognition. It would provide a clear indication to all stakeholders as to the full remuneration costs of

management and the incentives such options create.

Arguments against include:

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There is no expense until the option is actually exercised and the option may never be exercised.

What value should be placed on the option?.

15.Leonard Ltd is a small firm. For the 6-month period ending 30 June of the current year, it made sales totalling $40 000. These sales were on credit and were all made in the last 4 months. To determine its bad debts expense, it uses an ageing schedule of accounts receivable that has proven to be relatively accurate. For the 6-month period, the following calculation was made of accounts receivable multiplied by the uncollectable percentage (see page 682). There was no remaining balance in Provision for Doubtful Debts at the end of the 6-month period. Leonard Ltd recorded $1560 as a bad debts expense, which was one of the expenses deducted from sales revenue of $40 000 on the statement of financial performance. Is the $1560 the proper amount of expense to match against the $40 000 sales revenue? Explain. Where the Provision for Doubtful Debts is inadequate, leading to a significant expense affecting current year profits but relating to revenue from a previous period, is it consistent with the matching concept to write off the debt in the current period?

The bad debts estimate is based on accounts receivable, a statement of financial position account. This is an acceptable procedure. Since the estimate is based on accounts receivable rather than on sales, the bad debts expense does not match well with the sales revenue for the current period. Receivables in this problem include those that were from sales made in the previous 6-month period. The sales for the current period were all made in the last four months, and therefore proper matching would call for bad debts expense related to sales made in the last four months.

Bad debts expense is considered a cost of generating credit sales. Two ways of ascertaining the amount exist: the statement of financial position approach (% of accounts receivable) and the income statement approach (% of sales). Logically, only the latter method would give a proper matching.

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16. Decide whether the following expenditures should be put into an asset or expense account:(a) The cost of an insurance policy, which had been purchased by Y Ltd to cover

goods in transit to the company from suppliers for the current year.(b) The salary for the general manager in charge of plant operations for Z

Manufacturing Ltd. The cash component of the salary is $100 000; employer-contributed superannuation is $20 000, and the general manager is offered 40 000 share options in the company to be exercised after 2 years at 50% of the market value of the shares at the date the options are exercised. Cover each component of the general manager’s remuneration in your answer.

(c) The legal fees incurred in the unsuccessful prosecution of a patent infringement suit.

(d) The fees paid to a consultant who designed a more efficient layout for plant operations.

(e) The fees paid to an underwriter for handling the share issue when T Ltd was first established.

(a) Capitalise to purchases or inventory. The cost of the insurance is a ‘necessary’ business expenditure to acquire merchandise.

(b) The salary of the general manager is considered a general administrative expense. It does not qualify as direct labour for product costing nor overhead, because the general manager is not involved in the actual manufacturing process.

(c) This is an expense, because the case was unsuccessful.(d) It depends. Theoretically, since the layout is more efficient (greater productivity), the cost

should be placed in an intangible asset account. But the materiality of the amount should be considered — if small, expensing would be justified.

(e) This would be part of establishment costs, which are an intangible asset.

17. The following items are typical expenses. Identify the asset or service that is used up:(a) income tax expense(b) interest expense(c) cost of goods sold(d) warranty expense(e) goodwill amortisation expense(f) research and development expense(g) life insurance expense (on life of chief executive)(h) superannuation expense(i) rates expense.

(a) Government services, such as protection from foreign powers, etc

(b) Cash borrowed

(c) Inventory

(d) Service to make good the deficiency of the product sold (includes labour, parts)

(e) Goodwill (intangible factors that create superior earning power)(f) Services expended doing research and development (includes labour and assets

such as equipment)

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(g) Service of insuring against any loss to company during the past period, because of death of chief executive

(h) Services of employees rendered during the past period, but this portion is payable to them after they retire

(i) State government services, such as fire and police protection.

Problems(For a full outline of problems, please see text.)

18.1 For Ryder Ltd for 2004, record all necessary entries relating to the selected events described below (see pages 683–4). Use generally accepted accounting principles. The records are still open on 31 December 2004.

The purpose of this problem is to indicate the ‘arbitrariness’ of many of the rules concerning expenses.

1. Accepted practice is that the value of the options is the difference between the higher market price and the option price on the date of measurement. In this case, there is no value, and therefore there is nothing to record. But why would executives take options if there is no value? The executives must work for the company over the next three years in order to be able to exercise the options. If they had not received the options then probably the salary expense for those years would have been higher. Therefore, it can be assumed that the options were given as ‘compensation’ — that is, in lieu of an increase in salary. If this is so, then proper matching calls for the recognition of compensation expense related to the options for the three years.

2. Patent $64 000Cash $64 000

Amortisation Expense 4 000Patent 4 000

The journal entries are simple enough to record, but how does one determine the economic life of eight years? How do we know that a good estimate of the cost of the services provided by the patent is $8000 a year? How do companies arrive at their estimates?

3. Research and Development Expense $140 000Cash, etc. $140 000

Patent 13 600Cash 13 600

Amortisation Expense (3/12 $800 a year) 200Patent 200

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As ASRB 1011 supports the expensing of R&D, the patent cost consists only of the legal fees. How does this case compare with the cost and amortisation of the patent in item 2 above? If R&D had been capitalised, the amortisation expense would be $2258 rather than $200.

4. According to ASRB 1013, goodwill is to be amortised for a period not exceeding 20 years. Ryder will therefore be in breach of the ASRB. The entry for 2004 would be:

Dr Amortisation Expense 333Cr Accumulated Amortisation — Goodwill 333

[$80 000/20 1/12]

5. Depreciation Expense of Trucks $18 000Accumulated Depreciation $18 000$35 000 5 trucks = $175 000$175 000 less $25 000 salvage value = $150 000$150 000/1 000 000 miles = $0.15 a mile$0.15 120 000 actual miles = $18 000

Depreciation Expense — Equipment $500 000Accumulated Depreciation $500 000

The amount of depreciation of the trucks was affected by the strike, since the trucks were not used for three months. The amount of depreciation of the equipment was not affected by the strike, because the straight-line method is based on time rather than use. Both methods are acceptable. The depreciation for the trucks could have been on a straight-line basis, and the equipment could have been on the service basis. If so, the depreciation recorded for the trucks and equipment would have been different from that actually recorded. For example, for the trucks, depreciation under straight-line, based on five years, would have been $30 000 instead of $18 000. Both figures are correct, in the sense that both are based on accepted methods of calculation. But the effect on income is quite different.

6. Is this to be capitalised or not? Two factors should be considered. First, when the company estimated the economic life of the building, say, at 20 years, did it expect that the building would be painted in order that it last for 20 years? The answer should be yes; and therefore, the expenditure should be maintenance expense. The second factor has to do with the materiality of the amount. If it is not material, not expensing it confirms the previous conclusion. If material, then capitalising would be acceptable.

Maintenance Expense $20 000Cash or Accounts Payable $20 000

The entry shows the amount to be expensed, but if someone or the company insisted that it be capitalised, it would be difficult to say that capitalisation is incorrect.

7. Extraordinary Loss $50 000Building $50 000

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8. 2004 2003 2002

Depreciation — new method $19 200 $24 000 $30 000Depreciation — old method     15   000     15   000     15   000

Decrease in Income $4 200 $9 000 $15 000

Depreciation Expense 4 200Cumulative Effect Due to Change 24 000

Accumulated Depreciation $28 200

Why should the 2004 income be decreased by $24 000 for the effect of the change pertaining to 2003 and 2002? This is not proper matching.

9. Retained Earnings $125 000Cash $125 000

Retained Earnings are adjusted as the suit relates to a period’s transaction.

10. This is a change in estimate.

$300 000/20 years = $15 000 a year$15 000 10 years = $150 000 accumulated depreciation$150 000 book value on 1 Jan. 2004/20 remaining years = $7500 depreciation a year.

Depreciation Expense $7 500Accumulated Depreciation $7 500

Is the amount of $7500 proper matching of depreciation? If the company had correctly determined its estimated life at the very start, depreciation would have been $10 000 a year (= $300 000/30 years).

11. It is conventional to expense advertising expenditures, because of the difficulty of measuring the future benefits. Despite the fact that the benefits are acknowledged, the uncertainty of the length of time would only make allocation arbitrary.

Advertising Expense $200 000Cash of Accounts Payable $200 000

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12. For the sake of matching, we are willing to estimate and guess at the future amount of the repair cost. There should be past experience to give us a basis for this estimate.

Warranty Expense $68 000Estimated Liability on Product Warranty $68 000

13. On 31 December 2004, the following entry is to be made:

Loss of Purchase Commitment $90 000Liability from Purchase Commitment $90 000

This is a promise in exchange for a promise. The transaction of purchasing the material will occur in 2005, but because of conservatism we anticipate and record the loss now (7500 tonnes $12 = $90 000). Since the transaction has not occurred yet, the matching principle is violated by recording the loss now. This entry shows that conservatism is more important than matching.

14. (a) Construction in Progress $424 000Cash, Materials, etc. $424 000

(b) Accounts Receivable 350 000Partial Billings 350 000

(c) Cash 310 000Accounts Receivable 310 000

(d) Loss on Long-term Contracts 10 000Construction in Progress (or a liability) 10 000

$424 000 actual costs incurred    106   000 expected costs to complete$530 000 total costs    520   000 contract price$  10 000 loss

Again, because of conservatism the loss is recorded now. According to the completed contract method, there is no revenue until the project is completed; yet, a loss is recorded now when the project is not completed.

15. The new asset has a more objectively determinable fair value; therefore, the loss is calculated as follows:

Value received:fair value of new asset $50 000cash         5   000 $55 000

Value given:book value of old asset     70   000

Loss $15   000

Cash $5 000Machine (new) 50 000

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Loss on Exchange 15 000Accumulated Depreciation 20 000

Machine (old) $90 000

A loss is always recorded in an exchange of non-monetary assets.

16. The Allowance account is not debited, because this amount is more than an ordinary bad debt. Bad debt expense is for ‘normal’ write-offs. This is not an extraordinary item, because bankruptcy is not unusual in nature.

Bad Debts Expense/Provision for Doubtful Debts $60 000

Accounts Receivable $60 000

17. The building must be recorded, and accumulated depreciation against it should be recorded over the life of the building. But depreciation should be offset in some way, because really there is no ‘cost’ to the company.

2 Jan. 2004 Land $300 000Building $100 000

General Reserve $400 000

31 Dec. 2004 General Reserve 10 000Accumulated Depreciation 10 000

or Depreciation Expense 10 000Accumulated Depreciation 10 000

General Reserve 10 000Extraordinary Revenue 10 000

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18.2 Mangold Ltd received several donations. Record the entries for the following events:1. Cash of $10 000 is received from a shareholder as a donation.2. The cash donation is used to pay salaries and wages expenses.3. Equipment is received at the beginning of the year from Lin Pty Ltd as a

donation. The fair value is $20 000. The carrying amount for Lin is $15 000. Estimated useful life at the time of receipt of the equipment is 10 years.

4. The equipment received from Lin Pty Ltd is used in operations for the year.5. Land is received from a shareholder as a donation. The fair value is $50 000.6. The land is sold for $55 000.

1. It is conventional that when cash is received as a donation, to consider this to be other income, because it can be used immediately in the business.

Cash $10 000Other income $10 000

2. Salaries and wages expense 10 000Cash 10 000

Notice that although other income is offset by the expense the net income is affected by the donation. If not for other income, the net income for the period would have been less.

3. Although there is no cost, the company does have an asset that should be recorded.

Equipment 20 000Revenue 20 000

4. Journal Entry

Depreciation Expense 2 000Accumulated Depreciation 2 000

5. Land 50 000General Reserve 50 000

6. Most accountants would record the following entry:

Cash 55 000Land 50 000Gain 5 000

18.3 The Finn Group of companies owns the tollway from the centre of Sydney to the airport. Under the agreement with the State government, Finn must upgrade the road every 10 years. Finn has established a provision account to allocate the future cost of upgrading the road over the next 10 years. Outline the accounting entries to provide for such a provision. Is this approach consistent with the matching principle? How does this approach relate to AASB 1021 ‘Depreciation’

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and Urgent Issues Group Abstract 26 ‘Accounting for Major Cyclical Maintenance’?

Accounting entries:

Dr Maintenance Expense Cr Provision for Maintenance

When the maintenance expenditure is incurred then:

Dr Provision for Maintenance Cr Cash

This approach is inconsistent with the depreciation approach adopted under historical cost in that there is a systematic write-down of value; however, the maintenance provision indicates that there will be an extension or at least maintenance of value. Perhaps the provision for maintenance is sufficient; however, the HC system requires the systematic allocation of depreciation. The proposed approach is consistent with UIG 26.

Case Study 18.1 — ANZ boss cashes in options, gains $7m

1. How would ANZ have accounted for the 1 million options it awarded to McFarlane in 1998?

There would have been no transactions recorded in the accounts and no recognition of any offer of options in the financial statements. The use of options shifts a component of remuneration, usually significant, off the financial statements.

2. How much would the ANZ have received when McFarlane exercised the two tranches of options? How would ANZ account for McFarlane exercising the options?

ANZ would receive the exercise price, not the market price at the date the options are exercised. It would simple be an entry recognising the cash paid by McFarlane and the issue of equity. It never gets onto the statement of financial performance.

3. If ANZ sold 1 million shares in the open market at the time McFarlane exercised his options, they would have received $7.2 million more than they received from McFarlane. Is this an expense? If not, what is it?

This is the question that is being debated at present as to the real value of options used to remunerate executives and how they should be accounted for. There is increasing pressure, particularly from the international standard-setting body, to bring options to account as a remuneration expense. Students should be encouraged to debate the appropriate method for accounting for the options, and consideration should be given to the incentives such options create and whether shareholders are currently not being informed of the real costs of management.

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4. Should the ANZ adjust reported profits to show the allocation of options or the impact of management exercising options? (Note that this is not a question about whether ANZ has acted within accepted guidelines, but whether the approach is consistent with expense recognition principles and the matching concept discussed in this chapter.)

As for question 3, this is really a matter of viewpoint until such time as the reporting regulations are changed. One view is that there is no basis to bring the options to account until they are exercised, but it really goes to the fundamental purpose of the options. If the options are remuneration, shouldn’t they be recognised as such? In terms of matching, however, because the options may have a future exercise date, they will influence future performance and decisions, and so they may not be readily assigned to any one or more accounting periods.

Case Study 18.2 — Telstra rings off on old debtors

1. Wouldn’t Telstra provide for doubtful debts using a traditional ageing approach, which leads to a recognition of the bad debts expense during the period that related revenues were earned or due? If so, why has Telstra Mobile taken such a significant hit in the third quarter of the current financial year?

Telstra has allowed the level of bad debts to grow because they were seeking to grow market share. Given the nature of mobile phone contracts perhaps considered they would be recoverable. However, when the level of bad debts continued to grow, management decided to take the hit, rather than systematically recognise the bad debts. ‘Income smoothing’ is the intentional dampening of fluctuations about some level of earnings that is considered to be normal or desirable for the firm. ‘Taking a bath’ refers to the observed behaviour of managers whereby they utilise auspicious circumstances to make large write-offs in one year so that subsequent years appear more profitable than they would have been without taking a ‘bath’. Such policies do not accord with the matching principle, as the timing of recognition is subject to the preferences of management, not necessarily relating the expense to the revenue.

2. What would motivate Telstra Mobile to write off these debts, particularly as a significant proportion appear to have been irrecoverable for some time?

This is the problem with the HC system. Management has considerable discretion as to the timing of disclosures. This is consistent with the income-smoothing concept outlined above. In this case there were industry factors that could be used to support the write-off, and there was, to some extent, a clearing out of the accounts to allow for future growth (and hence profits).

3. Should government regulations be introduced to require an industry average for bad debts be applied on an annual basis, consistent with the matching concept? Or should management be allowed to choose when to write off such debts? Discuss. In your answer consider how One.Tel avoided recognising the bad debt expense.

How would such averages be determined? Which companies would be included in the average? Who would determine and monitor the application of the average? Could firms use the average to actually report lower bad debts, particularly if they are outliers (well above the average)? Perhaps the timing of disclosures should be regulated through the audit process?

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What do students think about strengthening the role of auditors to ensure a stricter level of compliance with the HC system? Encourage a debate on the technology industry and those who sell technology-based services. Ask the class to consider whether the technology industry is yet another special case for specific accounting standards to report the type of behaviour engaged by Freeonline. Given the pace of change, the cash flow model might well prove to be the appropriate alternative. Have the class consider whether accounting periods should follow product life cycles, rather than the traditional financial year model. For example, computer chip and digital phone technology currently has a 3-month cycle. Should the reporting cycle adapt to such cycles?

4. How would Telstra Mobile account for handset subsidies and other deals designed to sign up customers? How should it recognise the loyalty payment to increase customer retention?

In most cases the costs of handsets are recovered. There is just no or very little profit margin, so recovery of costs would offset any sale price. Where they are provided for free or below cost, the cost of the phone should be assigned across the period of the mobile contract. Loyalty payments would be similarly recognised as an expense of providing the telephone services.

Case Study 18.3 — Stockford counts its losses as goodwill write-off hits home

1. Why are results being reported before interest, tax, depreciation and amortisation?

This is the traditional approach, where profits are reported before cost of capital — interest; tax — a function of profit; and depreciation and amortisation — book adjustments to the value of assets.

2. How would Stockford account for the ‘adjustments for surplus leased space’? Should it simply be a lease cost? Is its surplus status irrelevant?

The surplus floor space may reflect a poor decision on the part of management, but the cost needs to be covered on an ongoing basis and relates to normal operations. So, it is simply a lease cost.

3. The goodwill to be written off relates to goodwill purchased in recent years. Why is such a significant write-off now required and what factors would the board take into their ‘deliberations’?

It is obvious that goodwill was purchased at a higher rate than appropriate given how business has declined since the acquisition of the group of companies. The level of reported goodwill is significant and this results in a significant amortisation expense in each year’s statement of financial performance. Management would be thinking that perhaps it is better to take a one-off hit, rather than continue to write-off an asset that really has no or little value to the group.

4. Why is writing off goodwill ‘inviting concern’ as to whether Stockford is a ‘going concern’?

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In service firms like accounting practices, goodwill is an important asset as it indicates the intrinsic value of services provided and the potential growth capacity, and is often an important capital asset, forming part of the partners’ retirement fund. If a firm, such as an accounting group, has no goodwill then what does it have that makes it different to competitors?

5. Why doesn’t Stockford leave the purchased goodwill amount on the books and measure the change in goodwill when and if it sells the business?

They may never sell the business as a group and therefore the realised difference will never be brought to account. Alternatively, it may result in an enormous capital loss. The main objective is to get the amortisation expense out of the financial statements. Should management be allowed to do this?

Chapter 19 Social and environmental reporting

Theory in Action 19.1 — Shareholder action

1. Why should North’s management react to the concerns of minority shareholders?

Shareholders have specific rights under Corporations Law (s. 249D), which allow them to request the board to call a GM so as to table a resolution for shareholders to vote on. Management may also respond through the issue of a statement on their behalf urging shareholders to reject the resolutions at the EGM.

2. Do you believe that such a strategy is an effective means of influencing management?

Will such a strategy change practices? In the immediate future this is unlikely to occur. Resolutions at a GM can be overturned by a majority of shareholders. Considering large institutions are significant shareholders, they are unlikely to support any move that will adversely affect the value of the company. However, the purpose of such moves by shareholders is to publicly highlight the company’s involvement in what they see as an undesirable activity — hence put pressure on the company to be more aware of their performance. This may cause management in the future to be more conscious of such investments; and also it increases the awareness of the general community of the company’s activities.

3. (a) What other strategies might the Wilderness Society adopt to highlight North’s investment in Energy Resources of Australia?

(b) What would be the purpose of these alternative strategies, and how would this differ from questioning directors at an AGM?

(a) Other strategies that have been adopted include protests both at political offices and at the mine site, and at financial institutions that support North and ERA.

(b) Each strategy is aimed at different stakeholders. Public rallies are designed to gain community attention and political pressure. Protests against financial institutions highlight to their customers their involvement in these activities and

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encourage consumers to pressure the institutions. Questions at AGMs place direct pressure on the board to explain and justify their actions, as such seeking to make them directly accountable.

4. With the growth of social responsibility investment funds, would such pressure be more effective with support from institutional investors?

The advent of institutional ethical investments should in theory enable greater pressure on corporations to change strategies. However, a number of factors may need to be considered. First, the investment criteria used for screening by the institutions may preclude investment in many of the ‘unethical’ corporations. Hence any pressure in these circumstances would be indirect. Secondly, institutional investors may take a less proactive stance on forcing corporations to change behaviour. Third, institutional investors may take alternate strategies to force change, such as direct contact with the organisation and its management.

Theory in Action 19.2 — Environmental reporting

1. Why would the AIG advise business to use ‘general information and avoid excessive detail’?

The section does not explicitly state what should be disclosed. This allows considerable discretion, hence the AIG recommend minimal disclosure. The AIG may feel that ‘excessive disclosure’ may create a precedent as to what should be reported. The AIG appear to recommend voluntary reporting.

2. (a) Do you believe the guidance provided by the AIG is consistent with the direction of s. 299(1)(f)?

(b) Why would business be opposed to the imposition of mandatory environmental reporting guidelines?

(a) The vagueness of s. 299(1)(f) does open the question as to what the section actually requires. The AIG appear to be promoting a minimalist approach.

(b) This raises issues of: excessive information in the annual report; the focusing of disclosure on a specific issue that may not be relevant (that is, fines as opposed to overall performance); and arguments that voluntary disclosure separate from the financial statements is more useful to potential users.

3. (a) How does the application of ‘significant’ differ from the term ‘material’?(b) Does such disclosure provide additional significant information to the annual

report user?

(a) From an accounting perspective, $500 may not be material, but it could be argued that the dollar amount is not relevant — it is the fact that a breach occurred that is most relevant.

(b) The disclosure is most important with respect to its opening the company to further scrutiny. In the past, voluntary disclosure has been criticised for being biased with only limited information on the adverse impact. Such disclosures may

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help counter such criticisms. Such disclosure may influence ‘ethical investors’. Other investors are also better informed on environmental performance, which may make them more conscious of company environmental policies and performance.

Theory in Action 19.3 — Environmental concerns in product management

1. What are the pressures causing industry to focus on product management? What are the potential benefits?

Potential legal issues in many situations may initially highlight the need to contend with product management. However, there is also a growing awareness of consumer concerns about products, and that consumers are becoming aware of the costs being transferred to them in regard to product disposal etc. Potential benefits may include a more competitive product, cost savings and a better relationship with the end consumer.

2. How are consumer/community concerns changing the scope of corporate accountability?

Corporate accountability is changing due to a growing awareness by a better-educated and informed community. This has changed their expectations of how companies should act, but more importantly consumers are now empowered to express their views and cause change in how companies interact with them. This can be done, for example, by choice of recyclable products and boycotts of products or companies.

3. What are the potential consequences for industries that do not respond to changing community concerns?

Community concerns are continually changing. Companies must adapt and evolve to meet these changing expectations. This may mean that companies must position themselves to go beyond the minimum requirements. For example, environmental regulations on mining operations in many Third World countries are not as strict as those imposed in Australia. However, companies are fully aware that when judging the company’s performance, shareholders and the community will not be doing so by the legal requirements imposed, but on accepted community standards in Australia. Think, for example, of past allegations of the use of ‘sweat shops’ in Asia by companies in the apparel industry. Whereas the actions are legal, they may not be ‘acceptable’ by the community that can take action against the company.

Theory in Action 19.4 — Valuation of environmental assets

1. Why would these assets not typically be included in the financial statements? (Refer to the conceptual framework definition and recognition criteria.)

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Monetary amounts attached are not associated with past transactions or events. For many of these ‘assets’ there is unlikely to be future economic benefits, as there is no market. The determination of a value is not reliable, and does not appear to be associated with ‘economic benefits’ that may be derived from their usage.

2. Identify the valuation techniques adopted. How have they changed as a consequence of the introduction of AASB 1037?

The valuation of the animals appears to be based on expert opinion, and not on the economic benefits. The interpretation of AASB 1037 has resulted in these ‘assets’ now being recognised in the financial statements, with the company recording gains or losses as a result of valuation changes through the statement of financial performance. This, therefore, has significant implications on the company’s position and performance.

3. (a) What are the limitations in such valuation techniques?(b) Do you believe they derive appropriate values for the assets identified?

Remember, as a result of AASB 1037, valuation will affect asset valuation and revenue recognition.

(a) See above regarding the discussion of reliability and the use of questionable proxies as a basis for valuation.

(b) These ‘assets’ cannot be reliably measured using traditional techniques. It does raise the question as to whether we should be seeking to measure based on economic benefits, when real benefits from such assets are intangible (such as biodiversity), and retaining an asset for future generations. Traditional accounting seems inappropriate as a means of measuring the ‘worth’ of these assets.

4. What alternative means of valuation and reporting do you believe would be appropriate for these assets?

Should we really be seeking to monetorise these assets? It may be worth considering that these assets should be conserved regardless of the cost. How do we value the enjoyment of future generations? Perhaps it would be more appropriate to simply provide an inventory of wildlife. This may then result in more usable information.

Questions

1. What is social and environmental reporting? How does this differ from triple bottom-line reporting?

Social and environmental reporting is the dissemination of information on the interaction between the entity, society and the environment, including information on performance and management. TBL seeks to provide a more formalised model for reporting.

2. What issues constrain the development of reporting regulations for social and environmental issues?

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Issues include: what is relevant to potential users how should performance be measured (financial versus quantitative) and what format

(triple bottom-line) how regularly should reporting occur what is the appropriate reporting medium.

3. What are the major contributing factors for increased corporate accountability for environmental and social performance?

Issues such as increased community attention and government intervention.

4. (a) Why has legislation with respect to the environment extended so as to include penalties for individual directors?

(b) Do you see this as an effective response by legislators?

(a) Legislators have sought to remove the protection afforded by the company structure for those who are responsible for environmental degradation. Such moves make managers personally accountable for corporate performance.

(b) Will this change behaviour? Certainly it may influence decisions where in the past fines have been inadequate and not truly reflective of the economic damage that may be incurred. Now penalties may include more than a financial cost to a large organisation.

5. What are the difficulties in determining social and environmental costs?

There is difficulty in defining impact. In many cases costs are indirect and not incurred by the firm. They are considered as externalities.

6. Why is it important for social and environmental costs to be appropriately identified and allocated?

For those costs that are directly incurred by the organisation it is important to understand cost drivers so as to make appropriate decisions on resource allocation, pricing and remediation of social and environmental impact.

7. What are the possible adverse consequences for valuing environmental assets?

The financial valuation of environmental and social assets (and liabilities) is an attractive idea to many as it would provide them in a context that can be understood and more easily integrated into decision making. However, it would also result in a belief that there can be a rational trade-off between the financial and other ‘assets’. Such data could then be used to justify land degradation and the extinction of species if the financial benefits outweigh the loss of the natural asset.

8. (a) What do you see as the main purpose of social disclosures within the annual report?

(b) What are the benefits to the firm from such disclosures?

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(a) Social disclosures may be used to inform stakeholders of the firm’s role as a ‘good corporate citizen’.

(b) Such disclosure may prove useful in countering adverse community attention to the firm’s performance.

9. (a) What purpose does an environmental report serve?(b) Why would a company seek to highlight its environmental performance to

external stakeholders in such a manner?(c) How does the environmental report differ from the annual report?(d) How would a firm improve the credibility of its environmental report?

(a) An environmental report acts as a separate report card on the firm’s environmental performance.

(b) Such a report is specifically targeted at those stakeholders who are directly interested in the firm’s environmental performance. It may therefore be used as an informative source for these stakeholders, many of whom may use such information to influence their decision process.

(c) The environmental report is voluntary. It focuses on a relatively specific issue with respect to performance. The stakeholders targeted by such a report have more defined information needs with respect to environmental performance.

(d) Credibility can be improved through either following a set of recognised reporting guidelines or seeking external independent attestation as to the reporting process. For companies undertaking attestation, it should be noted that this is not the equivalent to an audit and does not necessarily attest to the reliability of the information — merely to the adequacy of the processes undertaken to collect data.

10. The Institute of Chartered Accountants in Australia (ICAA) has established the Triple Bottom Line Special Interest Group. What role should the accounting profession play in standardisation of the information content of social disclosures?

This raises the question as to what information is desired. Should the information have a financial component? How should information of an economic, environmental and social nature be integrated? If accountants do not become involved, will this disadvantage users who have in the past been significantly reliant upon accounting information for decision-making purposes. How will social and environmental information be appropriately incorporated into the decision-making process?

11. (a) If accountants believe that current reporting practices are inadequate, why is there an opposition to mandatory reporting of environmental information?

(b) What are the alternatives to mandatory reporting?(c) Would such alternatives be effective?

(a) Mandatory reporting restricts the options available to firms. It may also impose additional costs to those firms that do not currently voluntarily disclose information. There is still much debate as to what information is appropriate for all companies to disclose.

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(b) Many parties have argued that a voluntary regime is adequate for the reporting of social and environmental information. The basis of such arguments are that the issues and functions of firms differ significantly; hence regulatory requirements would ‘constrain’ reporting, not allowing companies to provide appropriate information, while currently providing enough information for compliance purposes.

(c) Evidence suggests that voluntary reporting has provided inadequate information on the majority of companies. Whereas leading disclosers of social and environmental information have been provided as examples of how voluntary disclosure is successful (and highlighting that for these few companies disclosure goes beyond what would be required through mandatory requirements), these are a minority of reporting entities. For the majority of companies, reporting is ad hoc and incomplete with what information provided typically biased toward the good news, with few companies prepared to highlight negative aspects of there performance within a social forum. Hence, if information is deemed necessary then mandatory requirements are essential if only to encourage the reporting laggards and to provide consistency for comparative purposes.

12. (a) Do you believe that the targeting of specific operations by environmental lobby groups has a significant impact on the targeted industry?

(b) What would be an appropriate response by industry?

(a) Effective environmental lobbying has the ability to focus community attention, and thereby focus political attention.

(b) This will result in the company being forced to examine and justify their actions and performance, and may result in increased restrictions on future activities.

13. Evaluate the following statement by Jonathan Lash (President, World Resources Institute):

From the board room to the shop floor to the marketplace, business decisions are skewed when environmental costs are hidden. Common accounting practices hide these costs in two ways: by burying them in ‘non-environmental’ accounts and by failing to link costs to the activities that spawn them. As a result, managers are forced to make crucial business decisions — what products to manufacture, what technologies to employ, and what materials to use — without command of all relevant facts.

Inappropriate cost allocation is an issue of concern regardless of what generates the costs. Environmental issues, especially those that relate to by-products and indirect impact, may cause management to further consider the means by which they determine cost drivers. This is most important, for example, when emissions are regulated, where there are restrictions on waste disposal or when restrictions are influencing the availability of supplies or the future acceptance of the product (for example, refrigeration reliant upon CFCs). Firms may consider ABC and life-cycle analysis in identifying and allocating costs.

14. For a mining or manufacturing site (e.g. a coal-burning power station located near a major urban area) identify potential stakeholders concerned with that operation, issues of concern to each stakeholder, when to recognise the impact of the issues, how to measure the impact, and the most appropriate means of disseminating information to each stakeholder. For issues of concern, you may identify either

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financial, environmental, social assets/benefits, or social liabilities/costs. An example is provided for a potential stakeholder, the State EPA (see page 720).

This can be applied to any situation. What is attempted here is to get students to initially identify relevant issues, but more importantly to explore what is the most appropriate means of disseminating information on performance. This requires identifying potential users and their information needs. After a number of issues are explored, discuss how such diverse information can be integrated so as obtain a cohesive overview of performance. How then does this relate to financial information? What are the issues that need to be considered before triple bottom-line reporting becomes a useful tool?

Case Study 19.1 — Melbourne embraces UN business charter

1. What is triple bottom-line reporting?

TBL provides a report on corporations’ economic impact as well as the social and environmental value they add (or destroy). It may therefore be seen as the provision of a framework for the measurement and reporting of corporate performance against economic, social and environmental parameters.

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2. Why would an organisation consider triple bottom-line (a) a threat, or (b) an opportunity?

The context in which the TBL report is prepared needs to be examined. Whereas the TBL may not be seen as a direct threat, it may be seen as another ‘fad’ where considerable effort is being exerted to gather data on performance that is not then utilised for decision making. As such, if there are not direct tangible outcomes from the process that improve overall performance then companies may encounter opposition internally to implementation, and externally may face accusations of tokenism to social and environmental issues. So threats predominantly focus on the company exposing itself to these issues without substance in terms of a commitment to improved performance. Opportunities may exist in focusing attention on a broader range of firm performance criteria. For a company committed to improvement on social and environmental performance, tangible outcomes may be achieved through the development of a greater understanding of the interrelationships of functions and impacts of the firm.

3. What are the advantages for an organisation or company in adopting a scheme such as the United Nations Global Compact, as opposed to developing an in-house triple bottom-line scheme?

In developing a reporting system, there are considerable questions as to the boundaries of what information to include or exclude. Arguably no two firms would provide identical sets of information on social and environmental performance; hence firms that develop in-house reporting mechanisms could provide more appropriate means of measurement and reporting of performance. This, however, has a number of disadvantages. The development of such a scheme is time consuming and expensive, with no guarantee that a better alternative will be derived. In many cases, these are ultimately based on an existing recognised scheme. Ultimately when such a scheme is utilised for external reporting, companies have been criticised for the selective nature of the information provided, with questions raised over any attestation process that may have been undertaken. The adoption of an existing externally developed scheme can be seen as overcoming some of these problems. The company can therefore access the credibility of the scheme itself and also provide a benchmark by which their reporting can be evaluated. Companies, however, may need to be careful in justifying why such a scheme was not adopted in its entirety — for many companies find that issues covered in such schemes are redundant when considering their own operations.

Case Study 19.2 — Analysis of social reporting practices

Examine the company’s site for the following information:1. Identify sections covering possible social responsibility disclosures.2. Does the company have an environmental policy, occupational health and safety

policy and disclosure on community relations?3. What do you perceive as the purpose of such disclosures?4. Is the emphasis of disclosure on issues of current concern?5. Does the level of disclosure sufficiently inform the user of the company’s social

performance?6. Is there detail provided on specific company sites?7. (a) Is there any disclosure on breaches of regulation?

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(b) If such disclosures are made, how much detail is provided?8. Has the company provided detail of financial implications of the social and

environmental management practices?9. Are you able to identify senior personnel whose job description includes

management of social and environmental issues?10. Are there avenues for feedback on social and environmental issues affecting the

company?

This is a research-based case study. This entails students being able to find and identify information provided by a company. It allows students to make subjective judgements on what is provided with the proviso that they are able to defend their findings. For each company they may make differing conclusions.

Case Study 19.3 — Improved sustainability reporting: a business imperative

1. What are the reporting requirements imposed on Australian companies with respect to environmental performance?

Currently Australian companies are required to comply with s. 299(1)(f) of the Corporations Act. This section requires that they report on their environmental performance with respect to state and federal legislation and regulations on environmental issues. In practice, companies are therefore disclosing on environmental compliance.

2. Identify the relevant risks associated with poor social and environmental performance. What are the potential financial consequences for firms with poor performance?

Risks associated with poor performance can range from the direct financial (with associated insurance-related costs) to possible indirect financial consequences as a result of a tainted corporate image. Poor performance by a corporation on a voluntary basis can result in further restrictions on how a business may operate. Consider, for example, the considerable increase in legislation governing environmental performance within Australia. Consider the introduction of consumer protection laws and the greater emphasis on occupational health and safety where corporations are now required to meet minimum standards. Voluntarily undertaking improvements and changing business practices can be done at the corporation’s discretion. However, to meet changing expectations can result in regulators stepping in and enforcing changed behaviour.

3. How effective is social and environmental reporting in reducing corporate risk as a result of poor social and environmental performance? Would such reporting give a company a competitive advantage? Is communication sufficient to gain credibility on social and environmental performance?

Corporate reporting (or communication) to a broad range of stakeholders is seen as a means by which companies seek to counter (and interact) external claims and discussion as to appropriate levels of performance. It may be used as a means of legitimising corporate performance — to highlight positive contributions made by the company and advances with respect to performance. To gain credibility from the reporting process, it must be seen as

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reliable (a number of companies seek external attestation of the reporting process), and free from bias. Disclosure must therefore be seen as contributing to the understanding of performance and not seen as a means of blatant self-promotion (which companies were accused of when first experimenting with social and environmental reporting).

4. What is the importance of balancing ‘external commitment’ and ‘internal management’? What are the potential short-term and long-term consequences if such a balance is not achieved?

Companies that seek to ‘oversell’ their performance and commitment to environmental and social issues through the external reporting process are likely to be discovered. This gets back to the credibility of the reporting process. Hence management systems and governance, and ultimately the performance of the corporation, must align with public expectations. Good reporting requires the disclosure of performance-related data, an understanding of how well the company is going, how it will improve and acknowledgement of shortcomings in corporate performance. Alternatively, if the company has the management systems in place and is confident of its performance, the company could take advantage of improving public understanding of its activities. However, there are consequences. Once the company has committed to a regime of reporting, it is difficult to reverse such actions. Public perceptions may quickly turn as a result of an unforeseen reverse in performance. Additionally, companies in certain industries, regardless of their relative performance, will always be seen as pariahs. In situations such as these, corporate reporting may be ineffective in changing embedded public perceptions.

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