Chapter 1

What is theory?
While there are many definitions, many include the word “coherent” - reflecting that different
components of a theory should logically combine together to provide an explanation or
guidance in respect of certain phenomena.
● theories should be based on logical reasoning

Theories can be classified in terms of their perceived level of generalisability to different

settings.

Accounting theories aim to provide a coherent and systematic framework for investigating,
understanding and developing various accounting practices.
● Accounting theory is man-made, unlike natural laws, and will take into account
behaviors and cultural aspects as well as weighing different perceptions and needs for
information.

Theories of accounting
There are different view on what the central objective and role of accounting should be:
● Explain and predict a phenomena - positive (make sense of what is happening).
○ Deductive (logical) reasoning/assumption -> hypothesis development
(predictions) -> test against observations (empirical and inductive) -> provide
explanations and predictions (if successful).
○ Positive Accounting Theory seeks to predict and explain why managers
(and/or accountants) elect to adopt particular accounting methods in
preference to others. The underlying assumption is that everyone is motivated
by self-interest (wealth maximization), and the particular accounting method
will depend on the context.
● Prescribe what to do - normative (what should be done).
○ Based on the norms, values of and beliefs held by the researcher
○ Should NOT be evaluated on the basis of whether the theories reflect actual
accounting practice -> many normative accounting theories are based on a
process of deduction (logical argument) rather than induction.
○ Normative theories can be divided into sub-theories:
■ True income theories: make certain assumptions about the role of
accounting and then seek to provide a single ‘best measure’ of profits.
■ Decision usefulness theories: ascribe a particular type of information
for particular classes of users on the basis of assumed decision-making
needs.
● decision-makers emphasis: ask the users of the information
what they want and prescribe what information should be
supplied to the users of financial statements.
 ● decision-models emphasis: develop models based on the
researchers’ perceptions of what is necessary for efficient
decision making, and concentrates on the types of information
considered useful for decision making.

General classifications of theories

Inductive approach
Inductive approach = development of ideas and theories through observations. The goal is to
construct generalizations and predictions about likely occurrences.
● must meet 3 criteria:
○ The number of observations forming the basis of a generalization must be
large
○ The observations must be repeated under a wide variety of conditions
○ No accepted observation should conflict with the derived universal law
However, these types of empirically based theories are restricted by the data that is currently
available (empirically based studies cannot be undertaken of phenomena that cannot be
observed by the researcher).
Other criticism of the inductive approach:
● focus on “what is” instead of “what should be” -> status quo

On the positive note, generating theories of what is actually done (observations) will typically
reflect the best ways of doing things in practice.
● Accounting Darwinism – a view that accounting practice has evolved, and the
fittest, or perhaps ‘best’, practices have survived.

Deductive approach
Built on logic and some basic accounting premises and proposition

Critical accounting theories

These theories have the standpoint that accounting provides the means of maintaining the
powerful/privileged positions of some sectors of the community (those currently in power
and with wealth) while suppressing the position and interests of those without wealth.
 ● They argue that most rights, opportunities and associated power reside with a small
group and highlight the part accounting plays in forming the inequalities of the
existing social systems.

Grounded theory
According to this perspective, theory emerges from collected data (and without any
commence with prior theories). The aim is to generate theories from the analysis of the data.
● corresponds with the inductive approach because the theory is derived based upon
observing and analyzing particular data.
Grounded theory is likely to emerge when the phenomena is not fully understood and when
important aspects have been overlooked. Grounded theory is in other words appropriate
when we know little about a particular phenomena.
● begin the research broad and narrow down along the way

Situational contexts are important in grounded theories, as this will affect the collected data,
as well as the interpretation and analysis of it.
● contrast to grand theories (applicable to all contexts at all times)

Evaluating theories of accounting

Paradigm = universally recognised scientific achievements that for a time provide model
problems and solutions to a community of practitioners. Paradigms could be seen as an
approach to knowledge advancement that adopts particular theoretical assumptions, research
goals and research methods.
● Scientific and knowledge advancements are revolutionary -> new theories replace old
ones and attack the credibility of a paradigm.

When evaluating theories, it is important to consider that the acceptance of a theory often
depends on subjective and personal value judgements (compatible with our own norms and
beliefs). Other factors that affect the acceptance of theories are:
● the authority and reputation of central figures within the theory
● the extent of acceptance of the theory within our “research community”

Parsimonious
Another issue when evaluating theories is whether they are too simplistic or complex.
● parsimonious theory refers to the preference of a theory that performs the same as
other theories with less complexity (fewer assumptions and less variables).

Proving theories
Karl Popper argues that knowledge develops through trial and error, where there are chances
of rejection. Theories are constantly refined by this process.

Theories must be falsifiable (provides predictions that can be tested and ultimately rejected)
in order to be accepted.
Evaluating theories - considerations of logic and evidence

Logical deduction
Logical deduction refers to a conclusion or judgment that is made based upon logical
argument or reasoning.
● Often developed through a series of steps, where each step is true if the preceding step
is deemed to be true. Represents a process of reasoning using a series of statements
(premises) to generate a logical conclusion.

An argument is logical to the extent that if the premises on which it is based are true then
the conclusion will be true.

There is also a need to consider the underlying assumptions of an argument.

● An assumption is something taken for granted or accepted as true without further
proof.

Accepting the logic and the assumptions on which the arguments are based is necessary in
order to accept the prediction and conclusion.

Generalizing theories
The generalisability of a theory can be seen as one of the key considerations when evaluating
a theory.
● Generalisability is concerned with whether research findings can be generalized
beyond the specific context in which the research was conducted.
○ Is this possible in social sciences where human behavior and activities are
measured? (they may differ between persons).

When talking about generalizing, it is important how the sample data was gathered and
selected.

Can (or should ) more than one theory be used at a time?

In social sciences, such as accounting theory, no theory alone is expected to fully explain and
make sense of all the complex issues that may arise. Therefore, theoretical triangulation
(incorporation of more than one theory) can be useful. This allows for different theoretical
perspectives to examine a research issue (looking at the issue from different theoretical
lenses).
● make sure that the different theories share similar ontological and epistemological
assumptions (how we see the world and how things are determined true or not).
“Theories are abstractions of reality that are developed to help us make sense of the world,
and hence particular theories cannot be expected to provide a full account or description of
particular behavior”.
● It is sometimes useful to consider the perspectives provided by alternative theories

Key factors that influence the research process

For a given research project, issues such as theory selection, development of research
questions and selection of research methods should not be considered independently – they
are all very interdependent.

“how people undertake their research (including the research methods used) will be
influenced by a number of factors, even including the external assessment of research
quality”.

Chapter 3 - The financial reporting

environment
financial accounting = a process involving the collection and processing of financial
information to assist in the making of various decisions by many stakeholders (external and
internal)
 ● “special purpose financial reports” do not need to follow accounting standards as they
target a narrow group based on their information needs
○ larger organizations produce “general purpose financial reports/statements that
reach out to many stakeholders -> compliance with accounting standards and
conceptual framework requirements

The objective, use and regulation of general purpose financial reports

The IASB conceptual framework for financial reporting suggests that the objective of
financial reporting (general purpose financial reporting/statements) is to provide important
information that is useful for existing and potential investors, lenders and other creditors in
making decisions relating to providing resources to the organization.
● other stakeholders are not the primary target

Due to the large audience of general purpose financial reporting, there is more regulation
- stakeholders do not have the power to demand specific information AND many
stakeholders base their resource allocation decisions on this -> make sure that there is
a high quality and that it provide a faithful depiction

Alternative measures of financial performance disclosed within financial reports

Alternative measures of financial performance are additional disclosures of financial
information, besides what is required in terms of regulations.
● meant to provide a better reflection of the underlying performance -> however there is
a risk of manipulating numbers in opportunistic ways

Financial accounting versus management accounting

● Management accounting: providing information for decision making by parties who
work within an organisation
○ internal
○ unregulated (no need to protect the group’s information needs or right, as they
are powerful)

Application of the ‘accountability model’ to the practice of financial reporting

The accountability model explains various forms of accounting, and contains 4 questions:
● why report?
- Regulatory requirements are the key explanation. Reasons include the needs of
stakeholders and that objective financial information creates trust in capital
markets which will typically lead to economic growth. Regulation also allows
for comparisons between different organizations.
- Financial reports allow organizations to attract external funds, and for
managers or owners to monitor progress and operations.

● to whom to report?
- According to the IASB Conceptual Framework, the primary audience is
current and potential investors, lenders and other creditors. However, other
stakeholders are also in need of this information.

● what to report?
- What is disclosed is shaped by the needs and expectations of stakeholders.
Accounting standard-setters base their decisions on what is demanded and
required.
- Managers may voluntarily disclose information based on various motivations,
such as achieving legitimacy.
- Variations in international cultures and accounting laws also influence
accounting practices and disclosures.

● how to report?
- The format and medium for financial disclosures are typically regulated.
These regulations ensure consistency and clarity in the preparation and
presentation of financial reports

The rationale for regulating financial accounting practice

There are 2 schools of thoughts regarding regulation: those for it and those against it.

Arguments for regulation (pro-regulation) include:

● Markets for information are not efficient -> without regulation, a sub-optimal amount
of information will be produced.
● While it may be argued by anti-regulation proponents that capital markets are on
average efficient, it disregards the rights of individual investors rights and
vulnerabilities, and the case where individual investors might suffer great losses due
to it.
● Parties with limited power (limited resources) will generally be unable to secure
information, even if that organisation impacts their existence.
● Investors need protection from fraudulent organisations that may produce misleading
information, which due to information asymmetries, cannot be identified as fraudulent
when used.
 ● Regulation leads to uniform methods being adopted by different entities, thus
enhancing comparability.

Arguments against regulation (anti-regulation) include:

● Accounting information is like any other good, and people will be prepared to pay for
it to the extent that it has use. This will lead to an optimal supply of information by
entities.
● Capital markets require information, and any organisation that fails to provide
information will be punished by the market; an absence of information will be
deemed to imply bad news.
● Because users of financial information typically do not bear its cost of production,
regulation will lead to an over-supply of information (at a cost to the producing firms)
as users will tend to overstate the need for the information.
● Regulation typically restricts the accounting methods that may be used. This means
that some organisations will be prohibited from using accounting methods that they
believe most efficiently reflect their particular performance and position. This is
considered to impact on the efficiency with which the organisation can inform the
markets about its operations.

Who benefits from regulation

Theories that describe who benefits from regulation include:
● public interest theory: regulation is introduced to protect the public (due to efficient
markets)
○ Trade off: cost of regulation vs social benefits
● Capture theory: the regulatory mechanisms are often subsequently controlled
(captured) so as to protect the interests of particular self-interested groups within
society.
○ these groups will impact the regulation (lobbying)
● private interest theory (economic interest group theory): governments are made up
of individuals who are self-interested and will introduce regulations more likely to
lead to their re-election and satisfy their own interests.

Who is best suited to regulate

Public vs private sector regulation:
● Private: superior knowledge about the accounting profession and increased
probability of the regulation being accepted by the community.
● Public: greater enforcement powers that increase the probability of the regulations
being followed. Also less responsive to pressures and instead consider the general
public’s interest.

The costs and benefits of accounting regulation

Economic and social consequences are highlighted as a substantive issue in the setting of
accounting standards.
Regulation and enforcement
Monitoring and enforcement mechanisms need to be in place for regulation to be effective -
> ensure compliance

How powerful is the accountant?

Accountants hold power in society, and this power resides on a number of perspectives:
1. The output of the accounting process (financial reports) is the foundation for many
transfers of funds in society -> the judgement of the accountant may impact people's
wealth
2. Accountants generate information that is used to guide the actions of many people
throughout society.
3. Through different outputs, accountants can give legitimacy to organisations that
otherwise may not be deemed to be legitimate.
4. Accounting standards and practices play a powerful role in shaping economic and
social behaviors. Accounting also influences public perception by emphasizing
metrics as an objective measure of success, despite the subjective judgments and
methods behind them, which is often the case with environmental aspects.

Accountants are able to highlight or downplay particular facets of an organisation’s

performance!

Chapter 4 - THE REGULATION OF

FINANCIAL ACCOUNTING
Larger organizations face regulatory pressures worldwide, regarding social, environmental
and financial performance.

What is regulation?
Regulation is designed to control or govern conduct - how financial statements are to be
prepared (restricting accounting options)

Regulation demands monitoring and enforcement mechanisms to be put in place in order to

be efficient!
Free market view
According to the free market view, information should be treated like other goods, and
demand and supply forces should be allowed to freely operate so as to generate an optimal
supply of information about an entity.

Private contracting
There exists economic-based incentives in the market that would ensure the supply of
credible financial information WITHOUT regulations, as this would decrease the cost of
operations. Reasons for this include agency theory and assumptions of self-interest, as
without this financial information, managers would operate the business for their own
personal gain rather than in the interest of the owners. Managers often have incentive
programs tied to financial reporting figures.
- private incentives to produce accounting information: the costs of potential conflicts
between managers and owners (shareholders) will be mitigated through the process of
private contracting and associated financial reporting.
- By not providing financial information to the market, price-protection will
lead to higher interest rates when acquiring debt.

Given the assumptions of self-interest and opportunistic behaviour, there will be a demand
for external auditors that will ensure credibility of the financial reports. This will reduce the
perceived risk from external stakeholders and will decrease the cost of capital.

Critiques to these arguments involve that it would be time-consuming and costly to

negotiate a contract for information production with every potential investor, given that they
have different information needs.
- contracting approach only seems feasible when there are few parties involved.

Other market-related incentives (arguments)

Market for managers

Assumes an efficient market for managers, in which the previous performance will impact
how much payment they can secure for future periods.

It is argued that managers will be incentivized to provide an optimal amount of financial

reports in order to demonstrate organizational performance and to maximize organizational
value through lower cost of capital.

The market for corporate takeovers

Assumes that an underperforming organization will be subject to takeovers, which involves
changing the management team.
Here, managers would be argued to try to maximize firm value in order to avoid such threats
of takeovers. Financial information will be produced and reported in order to lower the cost
of capital and thus increase the value of the organization.

Information will be produced to minimise the organisation’s cost of capital and thereby
increase the value of the organisation

The market for lemons

Without regulations, managers will have incentives to disclose information, even information
about bad performance, because it will be assumed that the performance is even worse if no
such disclosure is made public.
- No disclosure = market assumes the organization is a lemon (really bad performance)
- This may impact the managers wealth in terms of payments or future career
options (market for managers)

This argument, however, assumes that the market knows that there is information to be
disclosed - may not be the case due to information asymmetry.

The role of courts

When private markets do not provide optimal outcomes, courts are argued to restore
efficiency to the market through application of appropriate case law.
- enforce aspects of the privately negotiated contracts!

Pro-regulation view

Market failures
According to the pro-regulation perspective, financial information is a public good which is
subject to free riding. This means that true demand will be understated, as many will want
to acquire the information for free rather than paying for it (through contracts with the
organization). This will lead to a lack of incentives for organizations to produce financial
reports, as it would be too costly (few actually pay for this), and will result in an
undersupply of information.
● free rider -> lower demand -> undersupply

To remedy this market failure, regulation is argued to be necessary.

- avoid regulatory overloads - over supply and costly for non-users

Level playing field argument

This argument rests on the basis that everyone should have the same access to information.
This will reduce information asymmetries.
● Putting in place greater disclosure regulations will increase the confidence of external
stakeholders that they are playing on a level playing field -> public interest and
ensure the ethical treatment of various stakeholders!
Government intervention should consider cost vs benefits (as it is costly and needs
monitoring/enforcement), and ensure that there is public interest in the forefront of the
agenda that is pushed (not personal self-interest).

The invisible hand

Many theories supporting free market view are based on the invisible hand - (without market
regulation) productive resources will find their productive uses due to the pursuit of self-
interest.
- the views that the market mechanisms will provide the optimal allocation of resources
typically ignores market failures such as information asymmetry and unequal power

The standpoint of Adam Smith is that if business prosper, society as a whole will too
- consistent with the economic interest theory of regulation and the trickle-down
effect

dilemma: is public interest really considered when only the markets mechanisms (invisible
hand) is active - for example various stakeholders and social/environmental aspects

Innovation of reporting: There is a viewpoint that regulation will stifle innovation of

reporting and disclosures and instead create a minimum level of disclosures.
- instead of implementing regulation that is “one-size-fits-all”, market efficiencies and
managers self-interest to maximize value should lead to innovation that benefits all
and is the most efficient.
- Organizations will undertake actions and disclosures that is demanded by society
(social contracts) -> regulation will impede the natural functioning of the market
mechanisms (invisible hand)

Enlightened self-interest
Enlightened self-interest = taking action to address concerns of external stakeholders when
this ALSO benefits oneself.
In relation to CSR, the enlightened self-interest approach may be apparent in cases where
activities that aim to increase CSR also enhance reputation and reduce the risk of losing
customers.
- Have implications on the implementation of regulation, as there may be self-interest
mechanisms driving voluntary disclosures rather than government interventions.

Summary of pro-regulation vs free-market to financial regulation

Public interest theory
Public interest theory suggests that regulation is developed in the public interest. Regulators
are assumed to be motivated by the public interest and will select regulation on the basis that
the social benefits of the regulation exceed the social costs.
- assumption of no self-interest among the regulators!
Regulation is viewed to bring confidence in capital markets!

concerns about public interest theory:

● governments may introduce legislation for their own self-interest (increase wealth and
chances of re-election)

Capture theory
Capture theory describes how lobbying affects the introduction of regulations.
- According to this view, regulations serving the public interest will not be achieved
due to organizations controlling (capturing) the regulatory process.
- organizations affected by the regulations will seek to affect regulations, as
these may have significant implications on the industry!

Factors determining the lobbying effect:

● size of the group
 ● amount of resources in the industry
● degree of implications of the imposed regulations
● regulatory bodies disregard for independence (as their survival often depends on
satisfying the expectations of those parties being regulated)

Private interest theory

Private interest theory (economic interest group theory) suggests that groups form to protect
their self-interest.
● different groups clash and will lobby regulators for legislation at the expense of other
groups
○ for example consumers lobbying for price protection and producers lobbying
for tariffs

Accordingly, this theory suggest that regulation is viewed as a product that is demanded - and
supplied - to those who value it the most -> supply/demand logic

Regulators themself count as a group serving their self-interest:

● governments are made up of individuals who are self-interested and will introduce
regulations more likely to lead to their re-election and satisfy their own interests.

The implications of this theory is that groups that lack sufficient power (perhaps
minorities) won’t be able to lobby and affect regulation that protect their interest
● This is central in the critical accounting theory, which states that the current
legislation supporting our social system protects privileged and powerful groups,
while suppressing the weaker ones (with less financial capital).

Accounting regulation as an output of a political process

Financial reporting affects the distribution of wealth within society -> it will be political

Due process: Regulators often involve affected parties in the standard-setting process to
submit their input and ideas -> evaluation of different views.
- This involves a trade-off and compromise between different parties, as the overall
goal of the regulation is to impose public confidence (political process!!!)
- consider cost vs benefits

Financial reporting standards are results of social and economic considerations -> tied to
values, norms and expectations of society -> questionable whether financial accounting
can ever claim to be neutral, objective or representationally faithful (as the IASB
Conceptual Framework for Financial Reporting suggest)
 Chapter 5 - International Accounting
Dilemma: international standardize financial reporting (one size fits all) VS variation across
countries (suited to unique demands and expectations)

Harmonisation = boundaries to the variation of accounting

Standardisation = narrow set of rules of accounting
standardisation is more rigid and less flexible compared to harmonisation!

Reasons for standardisation

● allows for comparability of information
● improves the understandability and interpretation of the information
○ due to the accountants that produce the information share assumptions and
accounting rules (produced in the same way)
● multinational companies’ financial needs may stretch beyond the domestic market and
need to list on other countries stock exchange
○ need to comply with other countries standards in order to be comparable
○ It makes sense to use a single set of international financial accounting rules
and regulations for all companies listed on any securities exchange ->
accounting procedures would be simplified!
● allows for the transfer of accountants and auditors internationally (between companies
and divisions)
● increased financial information to small investors

Standardisation of accounting standards = standardization of accounting

practice?

Despite the adoption of the IFRS, countries will still have some flexibility regarding the
accounting practice
● national differences still exist and limit the intended benefits of the international
standardisation

Why differences persist in spite of the IFRS introduction

● Differences in taxation systems
 ● Differences in economic and political influences
○ Powerful local economic and political forces influence the implementation of
rules.
● National modifications of the IFRS
○ IASB can’t enforce the application of standards -> modifications locally can
occur
● Issues of translation
○ translations from english to other languages may lead to differences
● Differences in implementation, monitoring and enforcement
○ lead to inconsistencies in how the standards are applied
■ free-rider problems: adoption vs compliance

Explanations of differences in accounting

In the absence of IFRS, differences between countries exist. There are two main models of
accounting:
● anglo-american
○ influenced by professional accounting bodies rather than government
○ emphasis on capital markets
○ emphasis on concepts such as
■ substance over form
■ true and fair view
● continental-european
○ relatively small input from accounting profession but strong reliance on
government
○ less reliance on qualitative concepts such as true and fair
○ funds were generally sourced from government, banks or family members
○ interested parties to obtain information through special purpose financial
reports (not the general public)

Reasons for difference in accounting systems between countries

Cultural factors:
● Culture
○ culture (nation) and sub-culture (organisation)
■ Culture: individualism (self-interest and rational economic theory) vs
collectivism
■ Subculture: professionalism (individual professional judgement) vs
statutory control (compliance with regulatory requirements)
● Religion
○ compliance with beliefs lead to the implications of the international
harmonisation of accounting standards
■ for example no interest payments according to Islam
Institutional factors:
● Legal systems
 ○ common law: law from judges where judgement act as a basis for future cases
○ roman law: statutory law that is detailed to fit every situation (no professional
judgement)
○ Common law countries tend to have fewer detailed accounting laws, allowing
accounting practices to evolve based on professional judgment. Roman law
countries have more codified regulations that dictate specific accounting
treatments for various transactions, reducing the need for professional
judgement.
● Business ownership and financing systems
○ outsider finance system: depending on the capital market for funds ->
providing financial information (fair, unbiased and unbalanced) to external
investors as a basis for their investment decision.
■ require professional judgement for flexibility and adaptations to
business changes
○ insider finance system: depending on family, banks and governments for funds
(no capital market) -> Investors have direct access to management
information, so the need for detailed public financial reporting is reduced.
There is a focus on rules-based accounting practices where consistency is
emphasized.
● Taxations systems
○The type of financing system impacts the relationship between taxation and
financial accounting. Outsider-financed systems maintain a separation
between tax and financial reporting, while insider-financed systems integrate
tax provisions into financial accounting, which can distort the reflection of
economic reality.
● Strength of the accounting profession
○ The strength of the accounting profession is closely linked to the financing
system in a country. Outsider-financed systems require a larger, more
influential accounting profession to exercise professional judgment in
financial reporting, while insider-financed systems have a smaller accounting
profession due to the rules-based nature of their accounting practices.

Summary:
● Anglo-american -> common law -> outside finance system -> little influence of
taxation law on financial reporting -> strong accounting profession (professional
judgment)
● Continental-european -> roman law -> inside finance system -> taxation law
influence financial reporting -> weaker accounting profession (less professional
judgment)

“Accidents of history,” such as major financial crashes or scandals, can significantly

influence the development of accounting systems. These historical events have led to distinct
accounting practices in countries with similar cultural and institutional foundations.
Due to these differences between countries in regard to accounting practices and systems,
should the IASB’s efforts of international standardisation (through IFRS) be pursued?
- Can there really be “one size fits all”?

Chapter 6 - MEASUREMENT ISSUES:

ACCOUNTING FOR THE EFFECTS
OF CHANGING PRICES AND
MARKETS
This chapter focuses on normative theories of accounting with regard to how assets and
liabilities should be measured.

The process of measurement

Measurement affects the monetary value reported in balance sheets and income statements.

Fair value: The price that would be received to sell an asset at current date
Present value: The discounted value of future cash flows, considering the time value of
money.
Historical costs: The price paid to obtain the asset
Current cost: Reflect the current price to either replace or replicate an item
Net realisable value: fair value less the costs of disposal
Deprival value: Considers the loss a company would incur if deprived of an asset and is
typically used for impairment assessments

A “mixed measurement model of accounting” has no single measurement-technique

prescribed for all assets/liabilities -> it is flexible depending on circumstances.
● for instance, whether there is an active or unstable market or can determine if fair
value is appropriate to use

Downsides of the mixed model-approach:

● limit comparability
● “additivity problem” -> the sum of total assets and liabilities may not accurately
represent the company's financial position (different measurement techniques)
● opportunistic behaviour regarding the selection of measurement technique (what bests
suits managers)

IASB Conceptual Framework embraces two objectives for financial reporting:

● Decision usefulness
- providing investors with information that affect resource-allocation
- relevance
- faithful representation
● Resource stewardship
- Accountability and transparency of how well management has utilized the
resources entrusted to them

Determining how assets and liabilities are measured is linked to these financial reporting
objectives. These objectives often conflict when selecting the appropriate measurement
method for financial reporting.
● for example: historical cost to satisfy stewardship vs fair value to satisfy decision
usefulness

Factors to consider when choosing between alternative measurement bases

5 factors affecting the choice of measurement:

1. Value/Flow Weighting and Separation

○ This factor examines the relative importance of understanding the current
value of an asset or liability versus the cash flows it generates. It also
considers how easily and accurately the cash flows can be separated from
changes in value, which affects the relevance of the measurement.
2. Confidence Level
 ○ This considers the level of confidence that can be placed in the chosen
measurement method, ensuring that it accurately represents the asset or
liability being measured. A measurement that cannot be reliably verified
would not provide a faithful representation of the financial position.
3. Measurement of Similar Items
○ Items of a similar nature should be measured in similar ways. This ensures
comparability between financial statements, allowing users to make
meaningful comparisons between companies and across time periods.
4. Measurement of Items That Generate Cash Flows Together
○ Items that generate cash flows as a unit should be measured using the same
method. This enhances understandability and consistency in financial
reporting, as similar items will be measured the same way to reflect their joint
contribution to cash flow generation.
5. Cost-Benefit Analysis
○ This factor assesses the costs of implementing a particular measurement
method against the benefits it provides. If the benefits of a more complex or
precise measurement method do not outweigh the costs of preparing those
measurements, a simpler method may be preferred.

Limitations of historical cost

1. Historical cost accounting has been criticized for its inability to provide useful
information in times of rising prices (the relevance has been questioned).
● The historical cost approach assumes that money holds a constant purchasing
power -> becomes less relevant during periods of inflation or changing market
conditions.
○ consequences: overstating profitability and eroding financial capital (in
times of inflation)

2. Another limitation is the additivity problem -> Historical cost creates inconsistencies
when aggregating assets purchased at different times (different purchasing power of
the currency)

To overcome these problems, approaches such as current cost accounting or general price-
level adjustments may be considered.

Current purchasing power accounting (CPPA)

CPPA is based on historical cost accounting -> adjusted for inflation
● Current purchasing power accounting / general price level: Developed to address the
shortcomings of historical cost accounting during periods of inflation. It aims to
adjust financial statements to reflect changes in the purchasing power of money over
time
○ Reduce the risk of distributing part of capital when aiming to distribute profits

Price indices
A price index is used to adjust for changes in the purchasing power of money. The price
index compares the current prices of goods and services to the prices in a prior period (base
period) and calculates the average change in prices over time.

Price index may relate to changes in prices of particular assets within a particular industry
(specific price index) or they might be based on a broad cross-section of goods and services
that are consumed (general price index)
● The choice of which price index to use is subjective and depends on the context

monetary vs non-monetary assets

When performing price change-adjustments, it is important to separate monetary and non-
monetary assets:
● monetary - assets whose value don’t change with inflation (cash and investments etc)
● non-monetary - assets whose value change with inflation (property, plant, equipment
and inventory etc.)

Liabilities:
● Monetary liabilities are those defined in terms of a specific monetary amount, such as
loans or payables.
● non-monetary liabilities would include obligations to transfer goods or services in the
future, items that could change in terms of their monetary equivalents.

Net monetary assets = monetary assets - monetary liabilities

● determines whether the company experiences a gain or loss (in real terms) due to
inflation
○ Impact of Inflation:
■ More Monetary Assets than Liabilities: If the company has more
monetary assets than liabilities, it faces a purchasing power loss due to
inflation, as its assets are devalued.
■ More Monetary Liabilities than Assets: If the company has more
monetary liabilities than assets, it experiences a purchasing power gain
because it will repay less in real terms.

Limitations of CPPA

1. General Price Index Limitations:

○ CPPA typically uses a general price index like the CPI, which reflects broad
changes in the price level. However, this index may not accurately capture
sector-specific inflation rates. Different industries or asset types might
experience inflation at different rates, so using a general index can lead to
inaccuracies when adjusting financial statements for specific assets.
2. Confusion of Adjusted Amounts:
 ○ The adjusted amounts under CPPA reflect inflation-adjusted values rather than
the true market values of individual assets. This can be confusing for
financial statement users, as they might assume that the adjusted values
represent current market values. However, the adjustments apply uniformly
across all assets based on the CPI, not according to the specific conditions of
each asset.

Current cost accounting (CCA)

An alternative to historical cost or CPPA in times of inflation is current cost accounting. This
approach measures assets at their current cost of replacement.
● differentiates between profits from trading and those gains that result from holding an
asset (unlike historical cost).

Trading Profits vs. Holding Gains in Current Cost Accounting (CCA):

One of the main principles of CCA is the differentiation between trading profits (earned
through day-to-day operations) and holding gains (resulting from price changes in assets).
This distinction ensures that profits are calculated based on the actual operating capacity of
the business and that dividends are only paid from realised profits.
Under the physical capital maintenance perspective, holding gains will be treated as capital
adjustments.
● Both realised and unrealised holding gains are excluded from the calculation of profit
under this model, ensuring that dividends are based on the true operating performance
of the business and not on inflation-driven increases in asset values.

Differentiating profit from holding gains and losses (both realised and unrealised) has been
claimed to enhance the usefulness of the information being provided.

Limitations of Current cost accounting

1. Determining Replacement Costs:

○ A major challenge with CCA is the difficulty in determining accurate
replacement costs for assets, particularly those that are unique or specialized
and lack direct market comparables. This lack of precision in measurement
makes CCA harder to apply consistently and accurately.
2. Replacement Costs vs. Market Value:
○ CCA focuses on the replacement cost of assets to maintain operational
capacity, but it does not always reflect their current market value or sale price.
In certain situations, this could lead to irrelevant or misleading financial
reporting, especially when the company does not intend to replace assets at the
current market price or finds more cost-effective alternatives.
3. Judgment Issues in Depreciation:
○ Like historical cost accounting, CCA also involves subjective judgment in
allocating depreciation. Although replacement costs are considered,
determining how much value an asset has consumed over time remains a
matter of estimation, which can lead to inconsistencies or arbitrary allocations.
 4. Separation of Holding Gains:
○ One of CCA's strengths is its separation of trading profits from holding gains,
providing a clearer picture of the company’s performance. However, this
could oversimplify complex business decisions, as companies might factor in
expected price changes when making operational choices. The exclusion of
holding gains in certain cases may fail to capture the full context of a
company’s decision-making process.
5. Current Relevance:
○ While CCA is no longer widely used, its discussions around measurement
bases, such as replacement cost versus fair value, continue to influence
modern accounting practices. Current debates about using fair value versus
historical cost accounting reflect the ongoing challenges that CCA addressed
in its time.

Advantages

1. Enhanced Profitability Measurement:

○ CCA provides a more accurate measure of an entity's performance by
adjusting for inflation and reflecting the true cost of replacing assets. Unlike
historical cost accounting, which may distort profit figures due to outdated
asset values, CCA ensures that profits from actual trading are clearly separated
from gains resulting from price increases, offering more relevant information
for decision-making.
2. Comparability Across Firms:
○ Since CCA uses replacement costs rather than historical costs, it helps
eliminate discrepancies between companies that acquired assets at different
times. This results in fairer and more comparable financial reports, as
companies are not advantaged or disadvantaged by the timing of asset
purchases, unlike in historical cost accounting where older assets may incur
less depreciation and therefore show higher profits.

Exit price accounting - Continuously Contemporary Accounting

Continuously Contemporary Accounting is about valuing assets based on their exit prices, or
the net selling prices that could be realized from an asset in an orderly transaction at the end
of the reporting period.
● current cash equivalent = the amount of cash that would be expected to be generated
by selling an asset
○ valuable insight into an entity’s financial situation and its ability to respond to
market changes (adaptive capacity)
■ higher the current cash equivalent -> better adaptive capacity

Profits are directly tied to the increase (or decrease) in the current net selling prices of the
entity’s assets.
● no distinction between unrealised and realised gains -> ALL gains is treated as profits
capital maintenance adjustment to account for inflation, ensuring that capital is maintained
in real terms. When general prices rise, this adjustment is applied to the opening residual
equity (owner's equity), and it is reflected in the financial statements.

Advantages of Continuously Contemporary Accounting

1. Additivity of Financial Statements:

○ One of the major strengths of CoCoA is its ability to improve the additivity of
financial statements. Using exit prices (current market values) for all assets,
provides a uniform and consistent valuation, enabling financial statements to
be added together logically without discrepancies. This leads to clearer, more
comparable financial health assessments, unlike historical cost accounting.
2. Enhanced Relevance for Decision Making:
○ CoCoA provides more relevant, up-to-date information for management
decision-making. Since exit prices reflect current market conditions, they offer
a more accurate picture of a company’s ability to react to new opportunities,
risks, and competitive dynamics, especially in fluctuating markets. This
dynamic approach aids in making future-oriented decisions and provides
stakeholders with timely, actionable insights.
3. No Arbitrary Depreciation:
○ Unlike traditional historical cost accounting, which uses fixed depreciation
methods often criticized as arbitrary, CoCoA aligns depreciation with
market fluctuations. Assets are valued according to market conditions,
removing the need for arbitrary depreciation methods that may not accurately
reflect an asset's value loss due to real market changes.

Limitations of Continuously Contemporary Accounting

1. Relevance of Exit Prices:

○ Specialized or Non-Liquid Assets: Exit prices are not always appropriate,
especially for assets that are not meant for sale or have no active market. For
example, a company holding specialized machinery that cannot be sold in the
open market would face a valuation problem. Under CoCoA, such an asset
would be valued at zero if no exit price is available. This disconnect between
exit price and value in use has been a significant critique.
2. Going Concern Assumption:
○ Critics argue that exit prices are not suited to a going concern approach. Exit
prices work better for companies that might sell their assets, but they don’t
show the value of assets used in ongoing business operations (like machinery
or facilities). This makes exit price accounting less relevant for businesses
whose assets are intended to support ongoing operations rather than be sold.
3. Subjectivity and Estimation:
○ Exit prices are inherently subjective, particularly for assets that do not have a
readily available market price. For example, the market value of a specialized
machine may not be easy to determine and may require management
estimates, introducing potential bias or inconsistency in valuations. This
subjectivity can make financial statements less reliable and open to varying
interpretations depending on the estimates provided by different managers.
 4. Exclusion of Goodwill and Non-Transactable Assets:
○ CoCoA excludes goodwill from asset valuations because it cannot be sold
separately. This exclusion is controversial, as goodwill often represents
significant value, particularly in industries such as technology or branding.
Furthermore, intangible assets with no readily available market value are also
excluded, which may lead to an undervaluation of companies reliant on these
assets.
5. Value in Use:
○ CoCoA does not take into account the value in use of certain assets,
particularly intangible assets or those with long-term strategic value. By
focusing only on exit prices, CoCoA fails to capture the full economic value
of a business, especially those that depend on unique operational capabilities
that are not easily transacted in the market.

The demand for price-adjusted and value-adjusted accounting information

Why Do Companies Adopt Price-Adjusted Accounting Methods (Like CCA and
CPPA)?

● Managers Want to Lower Profits (and Taxes): Managers of politically visible

companies, especially those in industries with high capital costs (like
manufacturing), prefer accounting methods that reduce profits. Lower profits mean
lower taxes and less scrutiny from regulators.
● Capital-Intensive Companies: Companies with lots of equipment and assets often
use price-adjusted methods like CCA to increase depreciation (which reduces profits)
and, as a result, lower taxes.
● Corporate Lobbying: Companies often lobby the government for accounting rules
that benefit them. For example, firms in New Zealand and the UK that adopted CCA
were often under high tax pressure and used lobbying to push for methods that would
reduce their tax burden.

Fair value accounting

Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.

● Fair value measurements assume that the transaction is orderly, meaning it reflects
the normal process of market exposure and typical marketing activities. This contrasts
with forced or distressed sales, where the conditions of the sale are not representative
of typical market activity.
● Fair value assumes the transaction is between independent market participants, who
are knowledgeable about the asset, capable of engaging in the transaction, and willing
to do so at market terms.
Recognition of income
Increases in fair value of assets will affect the equity, and since this does not stem from
additional funds provided by the owners, it will be regarded as income.
● Additionally, decrease in the carrying amount of a liability is also considered income
No active market
In cases where there is no active market, fair value may be derived through valuation models
that incorporate observable inputs when possible, such as comparable market data or other
relevant information.
- these valuation models are called mark-to-model approaches,

When there is no active market, many assumptions and professional judgments must be
made. This leads to the risk of subjectivity and creative accounting.
● also a problem when markets are volatile

Fair value hierarchy

Different jurisdictions will have different markets for assets, and different monitoring and
compliance mechanisms -> Fair value will be inconsistent and not standardized

To improve consistency and comparability in fair value measurements and related disclosure,
the fair value hierarchy was developed:

1. Level 1: Quoted Prices in Active Markets

○ Most Reliable Inputs: Level 1 inputs are quoted prices in active markets
for identical assets or liabilities. These are considered the most objective and
reliable as they reflect actual market transactions and do not require
subjective assumptions.
2. Level 2: Observable Inputs for Similar Assets or Liabilities
○ Less Reliable than Level 1: Level 2 inputs are observable prices for similar
assets or liabilities in less active markets. These inputs are less reliable than
Level 1, as they may require adjustments or may not directly reflect the price
of identical assets.
3. Level 3: Unobservable Inputs
○ Least Reliable and Subject to Managerial Discretion: Level 3 inputs are
unobservable and must be estimated using valuation models. These inputs are
based on assumptions made by the entity and are the least reliable due to their
inherent subjectivity.
The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active
markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to
unobservable inputs (Level 3 inputs).
● the higher the level, the higher the risk for manipulation

Fair value and its relationship to volatility and procyclicality in accounting measures
Fair value accounting measures assets and liabilities based on market prices at the end of the
reporting period, meaning that valuations reflect the current market conditions. As a result,
if market conditions are volatile, the fair value of assets and liabilities will also exhibit high
volatility, directly affecting financial statements.
For example: During periods of market instability, such as the 2007-2010 sub-prime
banking crisis, fair value accounting was seen to exacerbate the downturn. When financial
asset prices fell sharply, fair value accounting led to significant declines in the capital and
reserves of banks. This reduction in capital restricted banks' ability to lend, which further
decreased asset prices, creating a downward spiral in the economy. The negative feedback
loop made the crisis worse.
● On the other hand, during periods of economic expansion, fair value accounting can
inflate asset values, contributing to speculative over-lending and the formation of
market bubbles. In such times, asset prices are overvalued, encouraging riskier
investments and lending practices that can eventually lead to financial instability.

During such crises, moving to level 2 or 3 in the fair value hierarchy can dampen and
reduce the speed of any procyclical effects!

Fair value and the decision usefulness versus stewardship role of financial reporting
Fair value accounting, while useful for providing relevant market-based information, has
limitations when it comes to stewardship reporting
● Because fair value measure exit values and the use value of the assets -> they do not
properly measure the managers’ ability to create value for shareholders
○ this is especially the case when it comes to level 2 and 3 of fair value
accounting (more manipulation and subjectivity)

Chapter 7 - NORMATIVE THEORIES

OF ACCOUNTING: THE CASE OF
CONCEPTUAL FRAMEWORK
PROJECTS
Conceptual framework of accounting
The IASB Conceptual framework provides general guidance about issues such as the
objective of financial reports, which entities should produce general purpose financial
reports, the qualitative characteristics financial information should possess, how the elements
of financial accounting (assets, liabilities, equity, income and expenses) should be defined,
and when they should be recognised.
● conceptual framework is much broader than accounting standards (guidance on
specific issues and transactions)

Because conceptual frameworks provide a great deal of prescription they are considered to be
normative in nature.
Conceptual frameworks prohibit inconsistency between accounting standards and practices,
and instead provide a clear, consistent, and logical structure for financial reporting.

Building blocks of a conceptual framework

The conceptual framework for financial reporting is made out of building blocks in a
particular order:

Definition of the reporting entity

The term “reporting entity” refers to those organizations that produce general purpose
financial reports (not special purpose reports)
● users do not have sufficient information regarding resource allocation-decisions and
are dependent on the general purpose report.
○ no reporting entity = no requirement to produce general purpose reports
■ still possibility to produce general purpose reports voluntary

When there is no apparent label of reporting entity, these factors may help assert the
ambiguity:
● stakeholders rely on general purpose reports due to their inability to access specific
financial data directly
● separation between owners and management
● economic/political influence of the entity on other parties
● the increasing financial characteristics of the entity (sales, income, employees etc…)
Users of financial reports
Primary users are (existing/potential) investors, lenders and other creditors.
● reasons for this is:
○ primary users have the most immediate need for the information and many are
not powerful enough to require the information from the entity directly
○ information designed to meet the needs of primary users will most likely meet
the needs of other stakeholders.
There is an expected proficiency in understanding financial accounting information, which
further suggests that the intended users are the “primary” users.
- risk of over-complicating the language to legitimize the accounting profession
- strike a balance between necessity and complexity

Objectives of general purpose financial reporting

According to the IASB conceptual framework, the objective of general purpose financial
reporting is to provide information to existing and potential investors (and lenders, creditors
etc…) about the organization.

Dual objectives:
The information is aimed to provide information about decision usefulness and stewardship.
● Foundation for decision making regarding resource allocation
1. buying, selling or holding equity and debt instruments
2. providing or settling loans and other forms of credit
3. exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources

(1 and 2 are related to resource allocation, while 3 is related to stewardship)

● stewardship = management's accountability for the resources entrusted to them. This
involves monitoring and evaluating past performance and making predictions about
actions and future cash flows.
○ accountability
Qualitative characteristics of financial reports
This building block refers to the qualities or attributes that financial information should
possess in order to meet the objectives of reporting (decision usefulness and stewardship)

Fundamental qualitative characteristics:

● relevance - relevant financial information that is capable of making a difference in
the decisions made by users regarding resource allocation
○ involve both predictive and confirmatory value
● faithful representation - faithfully represent the phenomena that it purports to
represent
○ involve Completeness (necessary details are included), Neutrality (free from
bias or manipulation, and prudence - cautious judgement under uncertainty)
and Freedom from error (information should be as accurate as possible)

For information to be useful, it needs to be relevant AND provide a faithful representation.

There are inherent trade-offs in this need for a balance, for example regarding time vs
accuracy:
● Relevance: Timely information supports quick decision-making but may lack
verification
● Faithful Representation: Delayed reports improve accuracy but may lose relevance
due to outdated information

Enhancing qualitative characteristics (enhances the usefulness of information):

● comparability (measurement and disclosure must be consistent)
○ However, a "one-size-fits-all" approach to accounting can impose costs on
entities whose unique needs may not align with standardized methods
● verifiability
● timeliness (information available in time)
● understandability
Can financial statements provide neutral and unbiased accounts of an
entity’s performance and position?
Can financial statements really produce an unbiased and objective perspective of economic
performance of an organization?
● The practice of accounting is based on professional judgement -> assessments of
probabilities and measurement uncertainties -> there is a degree of subjectivity
associated with assessments of measurements and probabilities.
○ Also: self-interest -> opportunism -> creative accounting
○ Also: standards and conceptual framework are developed through public
consultation -> political process -> trade-offs (groups with different power
affect standards differently)

Definition and recognition of the elements of financial statements

The elements of financial reporting within the Conceptual framework are divided into two
groups (with sub-categories):
● financial position (balance sheet)
○ assets
○ liabilities
○ equity
● performance (income statement)
○ income
○ expenses

The 2018 revisions refined the definitions of financial statement elements, moving from
probabilistic criteria to a broader focus on the existence of rights and obligations.
Approaches to determine profits
To determine profits (income - expenses), there are two main approaches:
● Asset/liabilities approach (adopted by IASB):
○ Profit is determined by changes in assets and liabilities over time.
○ Aligns with economic theories, defining income as the increase in net
resources (assets minus liabilities).
● Revenue/expenses approach:
○ Profit is measured by matching revenues (outputs) with expenses (inputs)
during a period.
○ Focuses on transaction-based performance and the matching principle.
Definition and recognition of assets
Definition:
Asset = a present economic resource controlled by the entity as a result of past events
● consists of 3 core components:
1. an asset is controlled (capacity to capture economic benefits) by the entity
a. example: property held on a lease is an asset if the entity controls the
benefits which are expected to flow from the property
2. an asset exists as a result of past events
3. the resource has the potential to produce economic benefits
a. asset’s use or from its sale

Recognition:
To be recognized, assets are required to meet the two fundamental qualitative characteristics
(relevance and faithful representation)
1. Relevance
○ The information about the asset must be meaningful for users making
decisions.
○ Recognition is inappropriate if:
■ There is significant uncertainty about the asset’s existence
■ The probability of generating economic benefits is so low that it lacks
decision-usefulness
2. Faithful Representation
 ○ The asset must be represented accurately and reliably, including its monetary
measurement.
○ Recognition is avoided when:
■ Measurement uncertainty is too high (e.g., estimating the fair value of
a highly unique asset).
When evaluating existence uncertainty, probability of expected inflows or outflows of
economic benefits and measurement uncertainty (deciding if assets are to be recognized),
professional judgement is involved!
● subjectivity and inconsistency among asset recognition may occur

Definition and recognition of liabilities

Definition:
Liabilities = a present obligation of the entity to transfer an economic resource as a result of
past events
● consists of 3 core components:
1. a liability represents a present obligation of the entity
a. Legal: Based on contracts or laws (e.g., loans, taxes).
b. Equitable: Based on social or moral duties.
c. Constructive: Implied by the entity’s actions or promises
2. it arises from past events
3. it creates an obligation to transfer economic resources away from the entity.

Recognition:
To be recognized, liabilities are required to meet the two fundamental qualitative
characteristics (relevance and faithful representation)
1. Relevance
○ two important factors to consider when assessing relevance include:
■ existence uncertainty
■ assessments about the probabilities of an outflow of economic benefits.
2. Faithful Representation
○ one important factor to consider when assessing faithful representation:
■ Measurement Uncertainty

Just as with assets, professional judgment is present with increasing degrees of uncertainty
regarding liabilities recognition.

Definition and recognition of expenses

Based on assets and liabilities
● consistent with the asset/liabilities approach to profits (income less expenses)

Expenses:
● a decrease in assets, or an increase in liabilities
● a resulting decrease in equity, other than as a result of distributions to owners
Definition and recognition of income
Also based on assets and liabilities

Income:
● an increase in assets, or a decrease in liabilities
● a resulting increase in equity, other than as a result of contributions from owners

To qualify as income or expenses, the changes in assets or liabilities must have the effect
of changing equity!
● Purchasing assets will for example not affect the equity and thus will not be counted
as an increase in assets (and further be counted as income), because this transaction
involves substituting one asset for another.
Definition of equity
Equities = assets - liabilities
● the criteria for the recognition of assets and liabilities, in turn, directly govern the
recognition of equity

Summary of financial elements

Measurement principles
definition -> recognition -> measurement

The IASB conceptual framework provides limited prescription on measurement. Assets and
liabilities are instead often measured in a variety of ways depending upon the class of assets
or liabilities being considered.

There are two broad groups of measurement basis:

● historical cost
● current value
○ Fair Value: Market price in an orderly transaction.
○ Value in Use (Assets): Present value of future cash flows from the asset.
○ Fulfilment Value (Liabilities): Present value of future cash outflows to settle
the liability.
 ○ Current Cost: Amount needed to replace an asset or settle a liability
currently.
The selection should be based on which measurement basis provides the most useful
information.

Pros and cons associated with having a conceptual framework

Advantages of a Conceptual Framework:

1. Enhanced Quality of Financial Information:
○ Leads to more relevant and representationally faithful information for users,
increasing confidence in capital markets.
2. Structured Thinking for Standard-Setters:
○ Forces standard-setters to articulate what they are doing and why, fostering
accountability and rigor.
3. Consistency and Logical Standards:
○ Standards are developed based on agreed principles, avoiding ad hoc rule-
making.
4. Accountability of Standard-Setters:
○ Decisions and deviations from concepts are more explicit, enhancing
transparency and accountability.
5. Improved Communication:
○ Facilitates better understanding between standard-setters, preparers, and
auditors regarding reporting and auditing rationale.
○ Provides a defense against political pressures on standard-setting.
6. Economic Efficiency in Standard Development:
○ Concepts guide decision-making, reducing the need for extensive deliberations
on new standards.
7. Reduced Need for Additional Standards:
○ Where existing concepts address an issue, the need for new standards may be
minimized.

Disadvantages of a Conceptual Framework:

1. Restricted View of Accountability:
○ The IASB Conceptual Framework focuses narrowly on investors, creditors,
and capital providers, potentially ignoring broader stakeholder groups.
2. Stifling Innovation:
○ Detailed frameworks may limit creative approaches to future financial
reporting needs.
3. Distorted View of Performance:
○ Financial performance, as defined by the IASB Conceptual Framework, may
inadequately reflect broader organizational success, such as social or
environmental impacts.
4. Reflection of Existing Practices:
○ Conceptual frameworks may merely codify current accounting practices rather
than providing a forward-looking or innovative foundation.
5. Legitimization of the Profession:
 ○ Frameworks can be seen as tools for legitimizing standard-setters and the
accounting profession, potentially focusing more on appearances than
meaningful progress.

Chapter 8 - Positive accounting theory

A positive theory seeks to explain and predict a phenomena.
● The positive accounting theory (PAT) explains WHY managers within organizations
elect to adopt particular accounting methods in preference to others (and also predict
this choice).

PAT focuses on the relationships of various actors that provide resources to an organization
and how financial accounting stimulates the effectiveness of these relationships.
● for example owners (provide equity), managers (provide managerial labor) and banks
(provide debt)

Principal-Agent problem in PAT

Many relationships involve delegation of tasks from the principle to the agent (agency
relationship) -> incentives may misalign and can lead to loss in efficiency -> agency costs
● Bonding costs = the cost of aligning and making the agent to act in line with the
interest of the principle (costs borne by the agent)
● Monitoring cost = costs of audit and thus removing all opportunistic behavior of the
agent
● Residual cost = not all opportunistic behavior of agents can be controlled by
monitoring and bonding -> residual costs is the cost remaining
○ residual cost occurs because the benefits of putting a mechanism in place is
regarded relative to the costs of these mechanisms -> if benefits < costs, then
mechanisms will not be implemented and residual costs will occur.

Information asymmetry plays a crucial role in the agency problem, where greater information
asymmetry typically leads to greater agency costs.

If appropriate incentives/contractual arrangements are put in place for the agent, and if the
principal incurs costs to monitor the agent, then agency costs can be reduced.

Assumptions of PAT
PAT assumptions: markets are efficient and that all individual action is driven by self-
interest
 ● The underlying assumption of PAT is that all individual actions are driven by self-
interest and will act opportunistically accordingly.

The origins and development of Positive Accounting Theory

The introduction of positive accounting research represented a paradigm shift (from the
previously dominated normative research)
● empirical testing and hypothesis development played a important role in this shift
○ allow for falsification (as stated by Karl Popper)

PAT shares the ontological and epistemological assumptions that there is an objective reality
(all actors are driven by self-interest) and that collected data from various sources can be
generalized across various settings.

Role of the efficient market hypothesis

Efficient market hypothesis (EMH) suggests that capital markets react in an efficient and
unbiased manner to publicly available information.
● share price reflect the public available information (NOT restricted to accounting
disclosures)
Because share prices are expected to reflect information from various sources there was a
view that management cannot manipulate share prices by changing accounting methods in an
opportunistic manner (this will either have no impact or will lead to mistrust by the public).
● Argument AGAINST the regulation of accounting practices

This does not explain and predict the choice of accounting methods - as these are irrelevant
in affecting firm value

Share price reactions to unexpected earnings announcements

Whether unexpected changes in accounting earnings lead to abnormal returns
- abnormal returns = actual returns - expected returns
The standpoint is that new earnings information will lead to changes in the stock price -> this
new information is deemed useful (as it was incorporated in the valuation).

Use of Agency Theory to help explain and predict managerial choice of accounting policies
In the EMH, information and contracting costs were not regarded, and accounting could not
affect firm value.
● However, information and contracting costs exist -> choice of accounting methods
COULD affect firm value (through cash flow changes).
○ explanation to WHY managers choose certain accounting methods
(positive accounting theory).

Understanding managers choice of accounting methods:

 ● information asymmetry -> need incentives and monitoring to reduce agency costs and
make managers work for the interest of the principle. Managers could also agree to
bond themselves to certain activities.
○ A well functioning organization needs contractual mechanisms that reduce
agency costs
● The principle will anticipate that managers will act opportunistically without
contractual mechanisms -> lower salary for the manager (price protection) -> cost
will be borne by the agent for their opportunistic behavior -> manager have incentives
to enter contractual agreements
○ contractual arrangements will be tied to accounting numbers that reflect their
“good” behavior.
■ managers have incentives to provide these disclosures

The perspective of the organization as a “nexus of contracts”

Within Agency Theory, the organization is viewed as a nexus of contracts that align
incentives between different actors and ensures that value for the organization is maximized.
● These mechanisms can be internal (for example a compensation contract that pay
managers a bonus tied to accounting profits) or external (for example market for
managers and market for corporate control -> provide incentives to reduce
opportunistic behavior).

According to AT, organizations exist as they provide an efficient way of organizing

economic activity between various actors, and reducing contracting/transaction costs -> and
thus lower agency costs in this process.

AT and EMH -> no regulation of accounting

Organizations exist because they efficiently coordinate the actions of self-interested agents.
Principals (owners) recognize this self-interest and pay lower rewards unless agents
demonstrate they are working in the principals' best interest. To secure higher payments,
agents are incentivized to provide information that shows they are benefiting the principals.
This idea, from Agency Theory, along with the belief in efficient markets, supports
arguments against strict accounting regulation. Even without regulation, managers
(agents) are motivated to provide accurate information to maintain their reputation and
maximize income opportunities within and outside the organization.

The emergence of Positive Accounting Theory

The assumptions and perspectives from agency theory and efficient market hypothesis are
incorporated in positive accounting theory.

3 key hypotheses that explain and predict whether an organisation would support or oppose
a particular accounting method:
● bonus plan hypothesis (management compensation hypothesis)
○ managers of firms with bonus plans [tied to reported income] are more likely
to use accounting methods that increase current period reported income
 ■ efficiency perspective: increase incentives for agents to work in the
interest of principles
● debt hypothesis
○ the higher the firm’s debt/equity ratio, the more likely managers use
accounting methods that increase income (in order to relax the debt
constraints)
■ higher debt/equity ratio -> tighter constraints in the debt covenants ->
more risk of the costs associated with technical default (non-
compliance with debt covenants)
● political cost hypothesis
○ large firms (rather than small firms) are more likely to use accounting
methods that reduce reported profits
■ firm size is seen as something that draws political attention and thus
intervention. Incentive to reduce earnings to prohibit claims for higher
wages and other requirements.

Opportunistic vs efficient methods

Researchers of the 3 hypothesis often adopted the perspective that managers (or agents) will
act opportunistically when selecting particular accounting methods. However, some argue
that the choice of accounting methods stems from an efficiency perspective.

Opportunistic and efficiency perspectives

researchers in PAT adopt either an opportunistic or efficiency-based perspective when it
comes to managers' choice of accounting methods.

Efficiency perspective
This perspective explains how various contracting mechanisms can be put in place to
minimise the agency costs of the organisation.
● This perspective is “ex-ante” - considers what mechanisms are put in place up front,
with the objective of minimising future agency and contracting costs.

The efficiency perspective also suggests that accounting methods are chosen because they are
thought to provide the best reflection of the underlying performance of the organization.
● Organisations will differ in the nature of their business, and these differences will in
turn lead to differences in the accounting methods (as well as other policies) being
adopted.

Given these assumptions (organisations adopt accounting methods based on the underlying
economic performance and provide the best basis for assessing and monitoring the
performance of management), PAT theorists argue that regulation of financial accounting
can impose unwarranted costs on reporting entities.
● for example a new standard for reporting -> the best and most efficient accounting
method can no longer be used
 ○ the standpoint is that management is best suited to determined these methods,
not the government

Opportunistic perspective
Suggest that opportunistic behavior of managers will occur even if contractual arrangements
of incentive-alignment are in place (derived from the efficiency perspective).
● this perspective states that no contract can be complete
○ Incomplete contracts do not provide guidance on all accounting methods to be
used in all circumstances -> there will always be some scope for managers to
be opportunistic
○ (there is gaps in the contract of incentive-alignment in which the managers
will act opportunistically)

The opportunistic perspective is “ex post” - considers opportunistic actions that could be
undertaken once various contractual arrangements have been put in place.

Even if principles anticipate opportunistic behavior of the manager, and demand a certain
accounting method to reduce this (in line with the efficiency perspective), there will (due to
incomplete contracts) always be some gaps and therefore room for the opportunistic
behavior.

Actions taken to opportunistically manipulate accounting profits are often referred to as

‘earnings management’ strategies.

Earnings management
Earnings management = accounting decisions aimed to generate a (predetermined) desired
measure of profit/earning.
● accounting-related actions that will influence the reported profits
○ Can influence the perception on the organization of stakeholders

Earnings management tends to occur more frequently if there is a greater chance of breaching
a debt covenant.
● Senior managers with a longer expected working life are less likely to engage in
short-term opportunistic behavior, as they prioritize long-term organizational value. In
contrast, CEOs, who often have shorter working horizons, are more inclined to favor
short-term earnings management

Accounting policy choice and creative accounting

Creative accounting = those responsible for the preparation of financial statements select
accounting methods that provide the result desired by the preparers (within the accounting
standard -> hard for auditors to detect faults)
- ties to opportunistic behaviour and the 3 hypothesis of choosing accounting methods
management(bonus, debt and political cost)
The output of creative accounting still has to be credible -> with increasing accounting
standards, these types of endeavors are limited.
- compliance with accounting standards is being monitored and enforced

The important thing to consider regarding creative accounting is that financial statements
may be biased and not objective.

Criticisms of Positive Accounting Theory

● no prescription (normativity) and therefore no guidelines for improving accounting
● not value free (lack of objectivity) and is instead marked by value judgement
(foundational assumptions, methodological choices and the implications of its
findings)
○ all research is value laden and not socially neutral
● lack of development/stagnation within the theory (three hypothesis - managerial
bonus, debt and political cost remains in focus)
● not considering all the accounting choices being made within the organization
(managers may make multiple accounting method choices to accomplish a goal ->
examining only one choice may obscure the overall effect obtained through a
portfolio of choices)
● measurements/proxies being used are too simplistic (for example, debt/equity ratio
may not be a good proxy for determining the default risk)
● PAT is scientifically flawed as the hypothesis (bonus, debt and political) have been
rejected/falsified.
○ however, accounting is related to human behaviour and no theory could be
assumed to provide total explanatory power regarding this.
■ the theory still produce useful results -> don’t disregard
● assumes one “universal truth” and the ability to generate generalizable laws and
principles. This would ignore many organisation-specific relationships and will not
regard the subjectivity when it comes to determining what information is relevant in
the collection process.
● assumption of wealth-maximization and self-interest is regarded as being a too
negative and simplistic perspective of humankind.
○ would deem moral action that is not directly linked to wealth-maximization as
irrational

Summary of PAT
Chapter 9 - Unregulated corporate
reporting decisions
The chapter considers some alternative theoretical perspectives that address the motivations
perceived to be driving voluntary disclosures.
● Legitimacy Theory, Stakeholder Theory and Institutional Theory provide insights

Legitimacy theory, stakeholder theory and institutional theory are sometimes referred to as
systems-oriented theories, which perceive an organization as being part of a broader social
system in which the organization is influenced by, as well as influences, the society in which
it operates.
● relationships between organizations, the state, individuals and groups.

The context of the organization can therefore make sense of the actions and behaviors of the
organization:
When applied to accounting, a systems-oriented view encourages us to consider how
accounting reports are used to shape the opinions and actions of various stakeholder
groups and how accounting reports can be used as a means to provide advantage to some
groups to the potential detriment of others.

Legitimacy theory
Central assumption that the maintenance of a successful organization requires managers to
ensure that their organization operates in conformance with community expectations (bounds
and norms of stakeholders). These expectations from society about how an organization
should operate are called “social contracts”. These consist of explicit (legal) and implicit
(norms and values) aspects.
● Compliance with “social contracts” leads to legitimacy, which ensures sustainable
access to resources and the pursuit of strategy and purpose. Because the expectations
of the community change over time, managers need to be responsive and adapt
according to society and the “social contracts”

Failure to comply with social contracts will result in “legitimacy gaps”, which refers to a
difference between how society believes an organization should act and how it is perceived
that the organization has acted. This may result in social sanctions, boycotts and reduced
demand. It will also limit resources:
● The view of legitimacy theory is that organizations do not have any inherent right and
claim to resources, it has to be earned by achieving legitimacy and thus satisfying
various stakeholders.

What society collectively knows or perceives about the organization’s conduct shapes
legitimacy. Information disclosure - and therefore accounting, is vital to establish legitimacy.
● not what the organization does, but how it is perceived
Perceptions about social contracts
Because social contracts are theoretical constructs (and not solely something written down),
managers will have different perceptions and views about the actual expectations of society.
● possible explanation of why managers act differently

One reason for different perceptions about social contracts is that the explicit (legal) and
implicit (values and norms) aspects are imperfectly correlated - they may be contradictory:
● legal systems are slow to adapt to changes in the norms and values in society
● legal systems often strive for consistency, whereas societal norms and expectations
can be contradictory.
● society may not be accepting of certain behaviors, but may not be willing or
structured enough to have those behavioral restrictions codified within law.

Legitimacy and changing social expectations

Legitimacy gaps may arise due to 2 reasons:
● societal expectations might change, and this will lead to a gap arising even though the
organization is operating in the same manner as it always has.
○ Even if there are efforts towards aligning with community expectations, if the
momentum of their change is slower than the changing expectations of
society, then legitimacy gaps will arise.
● previously unknown information becomes known about the organization (perhaps
through news media).
○ organizational shadows being revealed

- X = legitimacy
- Y = legitimacy gap
- the goal is to increase the area of X, and reduce the legitimacy gaps

Phases of legitimacy
Legitimation strategies are strategies aimed at gaining, maintaining or repairing legitimacy
● Gaining legitimacy - when the organization moves into a new area where it has no
prior reputation
 ○ liability of newness -> engage in activities to win acceptance
■ communication important
● Maintaining legitimacy - continue with activities that are accepted and in line with
expectations (symbolic assurance that all is well). Important to:
○ forecasting future changes
○ protecting past accomplishments
● Repairing legitimacy - crisis management and reactive responses to often unforeseen
crisis. Also reshape societal expectations.
All legitimacy strategies rely on disclosure - relevance of accounting

Loss phase - time when efforts to regain lost legitimacy are deemed useless in the
legitimation effort -> beyond repair!
● an option is either to neglect any legitimacy efforts, or to gain new legitimacy from
the ground up

The phases of legitimation process:

- legitimacy establishment -> maintain legitimacy -> defend legitimacy -> if legitimacy
is lost then two options arise (loss phase): abandon legitimacy efforts or establish new
legitimacy

Accounting reports and legitimacy theory

The public disclosure of organizations are more or less selective (apart from restricted
aspects).
● For example CSR or ESG information may be reported selectively

This is related to symbolic or substantive legitimizing techniques:

● symbolic - not actually reflect any changes in activities
● substantive - reflect real changes in activities
Legitimacy Theory is effectively a positive theory as, given the way it is applied by many
accounting researchers, it is used to explain and/or predict particular accounting/reporting
behavior undertaken by managers.

Legitimacy theory is seen as providing parsimonious explanations of why certain

information (often environmental and social) are voluntarily disclosed.
 ● Social and environmental disclosures are often made by managers for survival and
profitability-related reasons rather than for reasons of objectively demonstrating
proper responsibility, and associated accountability, for the social and environmental
impacts created by an organization.

Issues not currently addressed by the legitimacy theory

● How can legitimacy be measured?
○ suggestion: measure resource flows
● Which disclosures are more effective in the legitimation process?
○ different medium and different stakeholder reactions
● LT is restricted to the assumption of self-interest
○ neglects normative, ethical, cultural and institutional aspects of disclosure
● Disclosures may be made to legitimize particular aspects of the broader social system
○ not only to legitimize the organization within the social system
● Process of legitimation and risk management
○ disclosures could be considered to be linked to an organization's reputation
risk management (rather than a legitimation process)

Stakeholder theory
Stakeholder theory addresses an organization’s various issues associated with relationships
with stakeholders.
● stakeholders = Any identifiable group or individual who can affect the achievement of
an organization’s objectives, or is affected by the achievement of an organization’s
objectives.

The theory suggests that long term relationships are more beneficial compared to short term
(transactional) relationships.
● Stakeholder engagement can help identify issues and what is expected of the
organization, as well as discover opportunities for improvements.

In contrast with legitimacy theory, because different stakeholder groups will have different
opinions about how the organization should be operated, there will be several unique “social
contracts” with different groups - instead of one for society at large.

There are two different branches in stakeholder theory: ethical vs managerial

Ethical branch
The ethical approach states emphasize an ethical treatment of stakeholders according to their
intrinsic rights, which may require that economic metrics of the organization have to be
tempered with.
● normative approach - prescribes that all stakeholders should be treated fairly by the
organization
 ● power of stakeholders does not matter - impact of the organization on the
stakeholders should be what determines the organization’s responsibilities.
○ “equal consideration to the interests of all stakeholders and, when these
interests conflict, manage the business so as to attain the optimal balance
among them”
● all stakeholders (primary and secondary, internal and external) have intrinsic rights
to information about how the organization is affecting them
○ corporate reporting is linked to “right to know” and is a responsibility

Managerial branch
The managerial branch is concerned with stakeholders that can affect the organization, which
is related to their power.
● organization centered and positive approach
● power matters - more effort will be exerted in managing the relationship of powerful
stakeholders.
○ stakeholder hierarchy (power, legitimacy and urgency)
○ successful organizations satisfy powerful stakeholders, as they control
important resources to the organization (needed for survival and
competitiveness).
● information is mainly used to further the interest of key stakeholders and to gain their
support or acceptance.
○ corporate reporting is linked to strategy

As the level of stakeholder power increases, the importance – from a managerial (profit or
value-based) perspective – of meeting stakeholder demands increases.

Classifications of stakeholders
Primary vs secondary:
● primary stakeholders are those who contribute to the organization, and are essential to
the survival of the organization.
● secondary stakeholders are those who influence or are influenced by the organization,
but they are not essential for the survival of the organization.
primary stakeholder are more in line with the managerial branch -> only focus on the
“important ones” -> ethical branch would argue that all are important.

Internal vs external:
● internal stakeholders work within the organization and have formal or contractual
responsibilities.
● external stakeholders are not employed by the organization but are able to affect, or
are affected by the organization’s activities.

Institutional theory
Institutions are composed of regulative, normative and cultural-cognitive elements (formal
and informal). The institutional environment influence how organizations are structured and
operate
● influenced by taken for granted assumptions and formal/informal rules -> guidelines
on “how to do things”
● Following institutions will lead to legitimacy being attributed to organizations
(pragmatic, moral and cognitive legitimacy)

- To gain and maintain legitimacy, all 3 institutional elements have to be considered

Organizations operating within an institutional environment will, in an effort to appear

legitimate, tend to take on similar forms, which is referred to as isomorphism.
● coercive (regulations/rules and stakeholder pressure), normative and mimetic (success
creates followers and imitators) pressures play a crucial role.
○ isomorphism tend to occur later in the organizational/industry life-cycle (when
a organizational field has been established)

Institutionalized ways may not actually be the most efficient ways however.
Organizational effectiveness can be enhanced by being similar to other organizations in their
fields. This similarity can make it easier for organizations to transact with other
organizations, to attract career-minded staff, to be acknowledged as legitimate and reputable,
and to fit into administrative categories that define eligibility for public and private grants
and contracts.
● None of this, however, ensures that conformist organizations do what they do more
efficiently than do their more deviant peers.

There are 2 main viewpoints that together make up institutional theory:

- Institutional aspect: how the institutional environment affects the organizations
processes and practices.
- strategic aspect: how managers can shape the institutional environment through
strategic actions which they are in control of.

Corporate reporting serves as a way of maintaining legitimacy and linking an organization's

formal structure and elements with the expectations of the external environment.
● Voluntary disclosures of information are institutional practices -> organization within
the same institutional context will act in similar ways (isomorphism)
○ coercive isomorphism - stakeholder power and satisfaction (acceptance)
■ tend to be similar demands for organizations
 ○ normative isomorphism - pressures arising from group norms to adopt
particular institutional practices
■ particular groups with particular training will tend to adopt similar
practices (including reporting practices)
○ mimetic isomorphism - imitate other successful organizations (achieve
legitimacy and competitive advantage)
■ increases with uncertainty

Decoupling
While organizations’ formal structures (those that are seen externally) are isomorphic with
their institutional environments (to appear legitimate), a tension develops between these
formal (and visible) structures and the informal (and often unseen) elements within
organizations.
● Gap between how the organization projects itself in its public reports and the internal
(unseen) operational structures and practices within the organization!
Decoupling may be caused by conflicting demands (economic vs environmental for
example).

Ideal type: Formal policy -> daily practices -> intended outcome
● all is aligned

Policy-practice decoupling: no connection between formal policy and daily practices

● Greenwashing -> say something but don’t do it
○ hard to do with greater transparency and information

Means-ends decoupling: no connection between daily practices and intended outcome

● we do not reach what we would like to reach
○ daily practices are not optimal
 Chapter 10 - EXTENDING
CORPORATE ACCOUNTABILITY:
THE PRACTICE OF SOCIAL AND
ENVIRONMENTAL REPORTING
Relating to social and environmental disclosures, the IFRS developed a sustainable reporting
standard board called ISSB. These standard-boards will focus on providing sustainability-
related financial disclosures for capital markets, including disclosures that address the
financial implications associated with climate change.

Steps within the sustainability reporting process

the four-step accountability model:
1. Why is the organisation collecting and reporting particular information?
2. To whom is the organisation reporting the information?
3. What information is it collecting and reporting?
4. How is it reporting the information – where is the information appearing and what
reporting or measurement frameworks are being used?

Why
This step relates to motivations of the managers -> range from ethical to economic incentives
-> ethical or managerial branch of stakeholder theory
● Motives could include
○ a belief that the entity has an accountability to provide particular information
○ to comply with legal requirements
○ to achieve legitimacy

Whom
This step relates to which stakeholders will receive the reports -> ethical or managerial
branch of stakeholder theory

What
What aspects the social/environmental report should contain -> involves dialogue between
the organisation and its identified target stakeholders
● ask target stakeholders for information demand
○ For social and environmental reporting to be effectively used to convince
these stakeholders that the organisation has operated in accordance with
their expectations, the organisation will need to know and understand
these expectations.
How
the production of a report that incorporate the previous steps
● lack of regulation and conceptual frameworks regarding social/environmental
reporting leads to much variation in these types of reports.

Limitations of traditional financial reporting include:

● focus or fixate on the information needs of stakeholders with a financial interest in the
organisation
○ restricting asses to those that are affected non-financially
● applies the entity assumption
○ separate the organisation from stakeholders and the environment -> ignore
environment in accounting
● excludes from expenses the impacts on resources not controlled by the entity
○ public goods are not controlled -> their abuse is not counted as an expense
● applies the recognition criteria of measurability and probability
○ excludes many social and environmental issues that are significant but difficult
to measure or predict with certainty
● focuses on short-term results
○ discouraging long term investments in environmentally friendly technologies
● applies the concept of materiality
○ less financially quantifiable concerns, such as human rights or ecological
degradation, may be deemed immaterial and excluded from reporting
● adopts the practice of discounting liabilities
○ undervalues long-term social and environmental obligations by prioritizing
immediate financial impacts

financial accounting practices are unable to effectively capture and report information
about social and environmental impacts -> tripe bottom line reporting?

Triple bottom line reporting:

● balance between economic, social and environmental sustainability.
○ TBL reporting therefore provides a very broad answer to the question of how
an organisation should report

Another approach is the integrated reporting, which ultimately integrates financial/economic,

social and environmental information -> provides a holistic view of how an organization
creates value over time
 Chapter 11 - REACTIONS OF
CAPITAL MARKETS TO
FINANCIAL REPORTING
Accounting methods affect the information available to stakeholder, which in turn impact the
decision-making process.

In assessing the reactions of financial information, both behavioural and market perspectives
can be taken into account:
● behavioural research: analysis of individual responses to financial reporting
● capital market research: analysis of aggregate responses of investors (main users of
financial information) -> share price is used as the proxy.

Capital markets research

Capital market research investigates how the disclosures of financial information affects the
aggregate trading activities within capital markets.

The underlying purpose (according to the conceptual framework for financial reporting in
IASB) is to provide investors with useful information that lay the ground for decisions
about providing additional resources to the organization.
● central in accounting
The reactions of investors are evident by their capital market transactions.
● Favorable reactions = increase in share price
● Unfavourable reactions = decrease in share price
● No reaction (with new information) = information does not provide anything that is
new

In other words: share price reaction to new financial (or other) information indicates that
there is “information content” in the announcement. Likewise, if there is no reaction in
share price, the announcement is deemed irrelevant (or confirms market expectations)
Ontological and epistemological assumptions of capital markets research
Research within this field typically relies on large data sets that generate generalizable
insights and universal truths. Further, it is assumed that all investors have similar motivations
(self-interest and wealth maximization) and the world is objective.

Efficient market hypothesis

An underlying assumption of capital market research is the efficient market hypothesis.
- equity markets are efficient -> markets react to all public information in an effective
and unbiased manner -> incorporate in the share price
- (semi-strong form efficient)
- compare to weak-form (historical data) and strong-form (private information)

However, EMH does not mean that share prices always reflect the actual value of future cash
flow
● share price reflect the best guesses of all the investors, based on the knowledge
available at that time

The information content of earnings

Confounding events are events (other than the ones regarded in the assessment of the share
price) that may have an impact the valuation. Thus, knowledge of these are essential in
predicting the market reactions of financial assets.

Relationship between accounting earnings and share price

Modern finance theory: a share price is determined by the sum of expected cash flow from
dividends, discounted to their present value using a risk-adjusted discount rate.
- companies with higher expected future earnings will have higher share prices

It is the change in expectations of future earnings that will be reflected in the change of the
share price (new information - due to EMH assumptions). This is called unexpected
earnings (actual earnings deviates from expected earnings).
● there can also be unexpected information regarding macro-factors that will affect the
whole market - for example interest rates or inflation.

Earnings/return relation:
(1)Share price is a function of the expectations of future earnings -> (2)Return is a
function of share price -> (3)return is a function of expected earnings.

Unexpected earnings or information that affect the share price leads to abnormal returns
(actual returns deviates from expected returns).
● in these cases, there has been information content (new valuable information) that
ignite this process
Do current share prices anticipate future accounting earnings
announcements?
As companies grow, less unexpected information is likely to emerge (compared to smaller
companies). The reason is that the share price of a larger company incorporates information
from a wider selection of sources.
● Larger companies, the share price can be argued to anticipate future earnings with a
high degree of accuracy

value relevance studies

Within the perspective of earnings being forecasted in the share price, the share price and
returns reflect the market value and can be used as benchmarks for assessing which
accounting measure best reflects the market’s assessment of company performance
● In other words, it checks if accounting details (like asset values or earnings) are
linked to market value!
○ value relevance occur if there is such a link
The assumption is that markets are efficient and that investors use information from many
sources to arrive at the market prices (helps identify which accounting data is most useful for
investors).

Criticism against market efficiency

● capital market’s response to information takes longer than previously believed
○ post-earnings announcement drift
● opportunities for some capital market participants to make gains in periods when
share prices do not fully reflect the available information (due to the drift)
 Chapter 13 - Critical perspectives on
accounting
The critical perspectives suggest that accounting supports certain economic and social
systems that favor the privileged, while suppressing the poor.
● Uneven distribution of wealth, power and resources across society.
○ in conflict with the view that accounting is “objective”, “fair” or “unbiased”

Examples of criticism
Capital markets: Critical accounting theorists question underlying inequalities inherent in
capital markets, which critical theorists argue are regulated in a manner that benefits investors
to the detriment of many other stakeholders.
Externalities: Critical accounting theorists also address the problem that profits could come at
a great cost of negative profit-making-activities, which are NOT reflected in the share price.
● These profit-making-activities could be linked to environmental degradation or
modern slavery for example.

The critical perspective of accounting defined

Critical Theory aims to promote self-awareness of both ‘what is’ and ‘what might be’, and
how the former might be transformed to install the latter.
● a driver for change to a better society (based on inequalities identified)

The critical perspective allows for self-reflection and alternative knowledge -> move away
from past constraints and challenge dominant views in society.
● emancipatory process: efforts aimed at removing oppression of some groups or
procuring political rights or equality for particular disenfranchised groups

A key concept is “social praxis”: two-way relationship where theory informs (or provides a
foundation for) existing practice and existing practice informs theory.
● when social conditions (practices) change -> theories need to change
● development of new theoretical perspectives can bring about (needed) changes in
social practices and structures (such as the distribution of wealth and power within
society).

A distinct feature of critical thinking is that it promotes epistemological diversity

● counters intellectual dictatorships and the view of an objective world (which is the
case for most positive accounting research)
Critical researchers have convincingly and repeatedly argued that accounting does not
produce an objective representation of reality, but rather provides a highly contested and
partisan representation of the economic and social world.
conceptual compass of critical research
Perspective about the ‘boundaries’ of critical research

Marxist critique of accounting

Marxist theorists view capitalism as a fundamentally flawed system that has enabled the
unfair accumulation of wealth by capital owners through the historical exploitation and
expropriation of labor's value.
One key structural flaw identified by Marxists is the reliance on mechanization to increase
profits.
● reduces labor costs by replacing workers with machinery -> this drive toward
mechanization leads to a decline in total wages paid to workers, reducing overall
consumer purchasing power -> the system risks collapsing due to insufficient demand
for the products being produced.
Link to critical accounting theory: accounting practices prioritize the interests of capital
owners. For example, workers' wages are categorized as expenses, whereas payments to
owners are not, reflecting a bias toward preserving wealth and power for capital owners.
Accounting is portrayed as a tool that sustains and defends the capitalist system, facilitating
the unequal distribution of wealth and power.

Accounting practice is in the hands of organizations, and regulations regarding this comes
from governments and regulatory entities that are influenced by these organizations -> status
quo and support the current system (according to Marx).

Critical accounting research versus social and environmental accounting research

Because corporate social reporting (CSR) will be controlled by the reporting corporations and
a State which has a vested interest in keeping things more or less as they are, CSR has little
radical content.
- Disclosure of corporate social responsibility information, which is under the control
of the organizations themselves, acts to legitimize, and not challenge, those providing
the information.
- CSR efforts are wasted unless they also come with fundamental changes in how
society is structured (away from capitalism)
There will according to this view be limited self-criticism when it comes to CSR-reporting,
and new social accounting systems implemented may be designed to provide support for
current practices.
One way to remedy the problem of social reporting:
● As the demise of the capitalist system is not an option to battle the importance of
social reporting in the short run, another approach is to seek to reform some of the
worst inequities in capitalism. This could be done by engaging with, and winning the
support of, key players in the business world to reduce the most damaging outcomes
of business practices.
○ more likely to be successful in the short- and medium-term.

Impact of critical accounting research on social practice

Factors marginalizing critical theories:
● challenge the status quo and aim for change in social structures
● does not provide “solutions” to what is criticized
Furthermore, accountants are often trained to provide information to solve particular
problems → they might be conditioned against criticism that does not provide solutions.
● Whether critical theory can in practice be applied to accounting research depends on
whether researchers can free themselves from the attitudes and orientations which
result from their social and educational training and the beliefs of the accounting
profession.

Critical theory is critic of positive accounting theory and related capital market research:
● PAT primarily focuses on conflicts among powerful societal groups (owners,
managers, and debtholders) but neglects conflicts involving less powerful parties
who lack the ability to influence the wealth of these dominant groups.
● critical of PAT’s anti-regulation stance, arguing that it disproportionately benefits
powerful groups by allowing them to operate with minimal restrictions. This
undermines the needs of less powerful parties who may require regulatory
protections.
● challenge the PAT approach to evaluating accounting information based on capital
market reactions (share price changes) as this reflects the interests of those with
capital/power while ignoring the perspectives of other stakeholders with less
capital/power.

The role of the state in supporting existing social structures

Critical theorist view the state and government to act in the interest of those groups with
capital and the capitalist system as a whole -> government actions are aimed to increase
legitimacy for the current system
- critical theory skeptical and reject theories about regulation (such as public interest
theory)
- a view that the government does not operate in the public interest but in the
interests of those groups that are already well off and powerful. For example

The role of accounting research in supporting existing social structures

Critical theorists view accounting researchers as providing research results and perspectives
that help to legitimize and maintain particular political ideologies.
- research supported by government that had the same view (consistent with the views
of those in power)
- main argument is unwanted economic consequences of regulation
- share price or changes in employment and salaries
However: accounting failures like the Enron-scandal triggered a reversal towards a more
regulatory approach.
● From a critical perspective, this increase in regulation would be regarded as serving
the needs of large corporations (rather than protecting other stakeholders), as it was
aimed at sustaining investor trust in the capital markets on which large corporations
rely.

Critical scholars suggest such failures are symptoms of capitalism’s inherent instability ->
solution is to replace capitalism with a system where the powerful do not exploit the weak.
● advocate for systemic change to address exploitation and prevent future crises.

Critical theory in accounting critiques both regulation and deregulation because both
primarily serve the interests of powerful corporations within the capitalist system. Instead of
addressing deeper inequalities, regulation restores trust in markets, while deregulation risks
corporate abuses. Critical theorists advocate for systemic change rather than adjustments
within the current system.

The role of accounting practice in supporting existing social structures

The role of accounting in creating a selective reality:
Accountants decide which attributes of organization performance are not important, and
therefore are not worthy of measurement or disclosure (like CSR).
● accountants impose their own views about which performance characteristics are
important -> selective visibility of particular issues

Critical theory argues that accounting information being selectively presented in an

objectified manner to force a single partisan view of the business.

The power of accountants:

● legitimizing the current social and political structure of the organization →
choosing sides in a social conflict
● affect decisions about resource allocation and the distribution of income between and
within social classes
● used as justification for undertaking certain actions which might cause hardship for
some less powerful groups
○ for example: less profits → justify laying of workers

accounting and legitimation:

● Organizations often use documents, such as annual reports and sustainability
reports, to legitimize the ongoing existence of the entity → unless concerns are
aroused (and the managers perceive the existence of such concerns) then
unregulated disclosures could be quite minimal
● Accounting supports capitalism (current social structure) by crafting reports that
respond to challenges inherent in the system, thereby legitimizing and stabilizing it.
These reports shape public perceptions to protect the capitalist framework
○ example: In times of low economic demand, accounting reports may
emphasize consumption as a social norm, encouraging people to buy more
products which boost demand and benefit businesses across the economy.
counter accounts and dialogic accounts
…ask teacher if this is relevant…

A critical reflection on the role of critical accounting researchers in creating change

Goal of critical research is = create positive social change
● require constructive engagement with a broad cross-section of people (not only other
theorists) to not only highlight problems, but to suggest pathways (solutions) for
improvement
○ practice and engagement with the community is needed!

Hypocrisy of critical research: they should provide theories in an understandable manner (as
they are addressed to the poor/minorities that maybe not have philosophical and theoretical
education) and should also engage with the community -> which they do not do!