lecture 7 making financial reporting decisions critique of positive accounting theories
TRANSCRIPT
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Lecture Lecture 77
Making Financial Reporting Making Financial Reporting Decisions Decisions
Critique of Positive Accounting Critique of Positive Accounting TheoriesTheories
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Making Financial Making Financial Reporting DecisionsReporting DecisionsModules 3, 4 & 5 deal with
theoretical frameworks related to making financial
reporting decisions
How do I make financial reporting
decisions?
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Lecture OverviewLecture Overview Review of Modules 3 & 4
Positive Accounting Theory (PAT) Legitimacy Theory Stakeholder Theory
Module 5 Criticisms of positive accounting theories (5.1 -
5.3) Usefulness of theories and research results (5.4)
Intro to Modules 6 & 7 Two ways to evaluate the impacts of financial
reporting decisions
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Review - positive Review - positive accounting theory (PAT)accounting theory (PAT)
Major focus is on stewardship role of accounting
Looks at reasons underlying financial reporting decisions
Emphasis on relationship between financial reporting decisions and contracts, particularly management compensation contracts and loan agreements (debt contracts)
Based on ‘agency theory’
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Review - Agency Review - Agency TheoryTheory
Conflicts of interest give rise to agency costs
Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information
Firms prepare audited accounting reports to facilitate monitoring of these contracts (stewardship role of accounting)
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Review - Implications Review - Implications for financial reporting for financial reporting decisionsdecisions
Because contracts are used to bond the agent to the principal, and financial statement information is often used to monitor the agent’s compliance with these contracts
Agents have incentives to present the financial statements in a way that ensures the best outcome under the contracts
Therefore, contracts need to be considered when making financial reporting decisions
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Review – Legitimacy Review – Legitimacy TheoryTheory
Organisations seek to ensure they operate within the bounds and norms of their respective societies
relies upon the notion of a ‘social contract’ Represents the implicit and explicit
expectations that society has about how the organisation should conduct its operations
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Review – Legitimacy Review – Legitimacy TheoryTheory
Legitimacy Theory proposes a relationship between corporate disclosure and community expectations
Consider implications of not meeting social contract when making financial reporting decisions may lead to sanctions such as legal
restrictions on operations, limited resources provided, or reduced demand for products
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Review – Legitimacy Review – Legitimacy TheoryTheory
Disclosures form part of the portfolio of strategies undertaken to bring legitimacy to or maintain legitimacy of the organisation
Increase in environmental disclosures Over time Following social incidents or environmental
disasters Disclosures mostly positive
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Review – Stakeholder Review – Stakeholder TheoryTheory
Definition of stakeholders is very broad Two branches of Stakeholder Theory:
ethical (moral) or normative branch Management ‘should’ be accountable to
all stakeholders positive (managerial) branch
Attempts to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders
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Review – Stakeholder Review – Stakeholder TheoryTheory
positive (managerial) branch stakeholder power is a function of the
stakeholder’s degree of control over resources required by the organisation
Information, including financial accounting and social performance information, is a major element employed to manage stakeholders
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Module 5Module 5
Critique of Positive Critique of Positive Accounting TheoriesAccounting Theories
(PAT, Legitimacy & (PAT, Legitimacy & Stakeholder)Stakeholder)
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What is a critique?What is a critique?
A critical essay or analysis Critical thinking involves questioning
everything that you hear or read The critiquing of claims can alter our
ways of understanding the world Both strengths and weaknesses are
considered
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Importance of critiquing Importance of critiquing in relation to studying in relation to studying this unitthis unit
All theories and related research have limitations Sometimes related to underlying
assumptions These should be understood and kept in
mind when using them to guide financial reporting decisions
More informed (better) decision making will be the result
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Criticisms of PATCriticisms of PAT
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Assumptions Underlying Assumptions Underlying PATPAT
Everything can be explained in terms of utility maximisation (self-interest) Promotes a ‘morally bankrupt view of the
world’ (Gray, Owen and Adams, 1996) Utility maximisation does not necessarily
relate to wealth maximisation (ignores some costs such as social costs)
However, wealth maximisation appears to be a reasonable assumption when explaining corporate decisions
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‘‘Failure’ of PATFailure’ of PAT
Positive accounting theory does not provide prescriptions for how we should account
‘How to account’ is an important issue for practicing accountants and accounting regulators
However, we know that standard setting is a political /social process rather than a matter of deriving a set of ‘ideals’
And…
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While Positive Accounting Theory While Positive Accounting Theory doesn’t tell us how we should doesn’t tell us how we should account, it does tell us what account, it does tell us what economic factors to consider when economic factors to consider when making financial reporting making financial reporting decisions.decisions.
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Other Criticisms of PATOther Criticisms of PAT
Slow / limited development Not ‘value free’ Scientifically flawed – hypotheses
frequently not supported Results apply ‘on average’
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Criticisms of Criticisms of Legitimacy and Legitimacy and Stakeholder Stakeholder TheoriesTheories Limited application to many financial
reporting decisions Eg. Expense vs. capitalise, accounting method
choices, disclosure vs. recognition Usefulness relates mainly to unaudited
disclosures Not ‘value free’ Pursuit of profits is the only ‘moral’
obligation of business (Den Uyl, 1984)
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Criticisms of Criticisms of Legitimacy and Legitimacy and Stakeholder Stakeholder TheoriesTheories Legitimacy theory too broad, why is it
important to be legitimate? Empirical tests often involve counting
the number of pictures and words (lacks statistical rigour compared to PAT)
PAT remains as the dominant paradigm in relation to financial reporting
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The usefulness of positive The usefulness of positive accounting theories and accounting theories and
research resultsresearch results
They are still useful!
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In support of positive In support of positive accounting theoriesaccounting theories
Positive accounting theories provide some useful explanations and predictions for accounting and disclosure practice
Empirical support for the predicted hypotheses gives credibility to the theories
Growing body of evidence to support theories
Theories are simplifications of reality, and all suffer limitations
These theories are the best that we’ve got!
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Using positive Using positive accounting theories in accounting theories in practicepractice
Before applying positive accounting theories in practice, you should be aware of their limitations
Remember, the theories are based on assumptions and these may not hold in reality
Also, before relying on particular research results, the validity of the results must be assessed (critique them)
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Strengths of positive Strengths of positive accounting theoriesaccounting theories
Provide a useful framework for making financial reporting decisions
Helps to predict the effects of changes to accounting regulation Useful in relation to the future
development of accounting regulations Indicates the factors to consider when
making financial reporting decisions
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Factors to consider when Factors to consider when making financial reporting making financial reporting decisionsdecisions
Contracts of the company Assets of the company Information asymmetries Potential political costs Society’s expectations of the company Power of various stakeholders Impact on share price Impact on individual financial statement
users
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The usefulness of The usefulness of normative accounting normative accounting theoriestheories
Examples are the ethical branch of stakeholder theory and the Conceptual Framework
Provide an ‘ideal’ to work towards A starting point for standard setters
However we should not expect final accounting standards to fully reflect these ideals due to the process being political
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Introduction to Modules 6 Introduction to Modules 6 & 7& 7
Impacts of Financial Reporting Decisions
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The Impacts of Financial The Impacts of Financial Reporting DecisionsReporting Decisions
Modules 6 & 7 deal with research into the impacts of financial reporting decisions
How do my financial reporting
decisions impact on thedecisions of financial
statement users?
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Financial Reporting Decisions
You arehere
Unregulated Financial Reporting Decisions
Regulated FinancialReportingDecisions
Making Financial Reporting Decisions
ContractingDeterminants of Financial Reporting
Social Determinants Of FinancialReporting
The Impact ofFinancialReportingDecisions
Critique of PAT
Share prices
Individuals
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Impacts of Financial Impacts of Financial Reporting DecisionsReporting Decisions
There are two ways to assess the impacts of financial reporting decisions: Determine what impact the release of
information had on share price? (capital markets research)
Determine the impact of the information on the decisions of individual information users (behavioural research)
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Comparison of Comparison of Behavioural and Capital Behavioural and Capital Markets ResearchMarkets Research Both examine the impact of financial reporting
decision on users of the info. Capital markets research assesses the aggregate
effect, while behavioural research assesses the effect on individuals
Capital markets research includes only investors, while behavioural research examines other types of financial statement users
Capital markets research assesses WHETHER the information is used, while behavioural research can asses HOW the information is used
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For TutorialsFor Tutorials
Required reading Text chapter 7, pp. 235 – 239 Text chapter 10, pp. 358 - 359
Self assessment questions Questions 1 - 5 from module 5 Question 1 from module 6 Answers in tutorials