ACC701 Financial Accounting Theory

Questions and Solutions

Introduction to Financial Accounting Theory

1. What is the difference between a positive theory of accounting and

a normative theory of accounting?

A positive theory seeks to explain and predict particular phenomena.

Positive theories are evaluated by considering how well the explanations or
predictions relate to actual observations.

A normative theory seeks to prescribe what should be done in particular

circumstances based on particular assumptions made by the researcher.
Normative theories are not evaluated with observations of real world.

2. What is a conceptual framework, and would it be considered to be a

positive or a normative theory of accounting?

The conceptual framework has been defined as 'a coherent system of

interrelated objectives and fundamentals that is expected to lead to
consistent standards'.

A conceptual framework, such as the International Accounting Standards

Board (IASB) Framework, provides some fundamental assumptions &
prescription about the role of general purpose financial reporting the
attributes that financial information should possess the qualitative
characteristics that financial information should possess the identification of
the types of entities that should produce general purpose financial reports
the way in which the elements of financial accounting should be defined and
recognised
1. Describe the different functions performed by different accounting theories

Theories:

-prescribe how assets should be valued, based on historical costs or market value

-predict why managers will choose particular accounting methods (ex: managers are given
bonuses on the basis of profits they will adopt those accounting methods that lead to an
increase in reported profits

-explain how an individual 's cultural background affects accounting information provided
-prescribe what accounting information should be provided to particular classes of
stakeholders

-predict that the relative power of a stakeholder group will affect the accounting
information it receives
-explain or predict how accounting disclosures might be used as part of a strategy to
legitimize the operations of an organization

2. Describe and evaluate the different theories in financial accounting.

Inductive / Descriptive Research (1920s to 1960s): theories developed from observing

what accountants did in practice, codified as doctrines or conventions of accounting. It
is assumed that what is done by the majority of accountants is the most appropriate
practice.

Prescriptive Research (Normative Theories) (1960s to 1970s) Based on what the

researcher believes should occur in particular circumstances, not based on observation.
Should not be evaluated on whether they reflect actual accounting practice
Ex: Seek to provide improved approaches to asset valuation in a time of widespread
inflation (assets should be valued at replacement costs / net selling price)

Predictive Research (Positive Accounting Theories) (mid to late 1970s): seeks to explain
and predict particular phenomena in accounting practices. Positive theories are
evaluated by considering how well the explanations or predictions relate to actual
observations.

It begins with some assumptions of particular conditions, through logical deduction,

some predictions will be made about the way accounting practices occur If predictions
are accurate when tested against reality, they are regarded as having provided
explanation of actual accounting practices
Based on assumption that individuals are primarily motivated by self-interest (tied to
wealth maximization), positive theories seek to predict and explain why accountants
elect to adopt particular accounting methods in preference to others [such as the use
of a particular accounting method is tied with accounting-based bonus system, or tied
with debt-to-asset ratio to negotiate a loan covenant.
 Criticisms of:

inductive / Descriptive approach: Inductive approach does not evaluate the logic of
current theories: whether they should and should not be used, also it does not
introduce any improvements for those ones in the future.

-Prescriptive / Normative theory: Normative theories have been criticized for basing
on personal opinion about what should happen, this is like unscientific research

-Predictive / Positive Theory: Not tell us the efficiency of what is being done [will that
method best reflect the performance of the company], not say which method a
firm should use like prescriptive theory

Topic 2: The Financial Reporting Environment

1. Explain the arguments for and against the existence of regulation.

In favor of regulation

-Markets for information are not efficient and without regulation a sub-optimal
amount of information will be produced.
[An 'efficient' market is defined as a market important current information is
freely available to all participants, In an efficient market, competition among the
many intelligent participants leads to a situation where. at any point in time.
actual prices of individual securities already reflect the effects of all information
values.]

-Some parties can obtain their desired information due to their control over scare
resources. Conversely, parties with limited power is generally unable to secure
information without regulation
-Investors need protection from fraudulent organizations that may produce
misleading information
-Regulation leads to uniform methods being adopted by different entities, thus
enhancing comparability.

In against of regulation

-Accounting information is like any other good, and users will prepare to pay for it to
the extent that they need. This will lead to an optimal supply of information by entities
-Regulation will lead to an over-supply of information because users will tend to
overstate the need for the information More cost to the producing firms [accounting
standard overload: when accounting standards provide only limited benefits to financial
statements users, but generate considerable costs for the reporting entities]
-Any organization that fails to provide information in capital markets will be punished
by the market, it will find more costly to attract funds than the other entities
-Regulation typically restricts the accounting methods that may be used This means
some organizations will be prohibited from using accounting methods that best reflect
the performance & position of the entity.
Ex: AASB 138 Intangible, all expenditure on research has to be expensed as incurred
on the basis of efficiency, this regulation is deemed to be inappropriate, as it does not
allow report readers to differentiate between companies with or without valuable
research.

2. Discuss the role of professional judgment in accounting decisions

-While many transactions and events are regulated, many others are unregulated
Ex: the buildings must be depreciated, there is still a range of useful life & residual
value to be selected. The process of accounting treatment depends on many
professional judgments.
-Accountants are expected to be objective and free from bias when performing
their duties. The information being generated should represent faithfully and it should
be neutral.
However, can we accept that accounting can be neutral or objective?
Throughout the world, several national accounting setters have considered the
economic & social implications of proposed accounting standards. If the
economic or social implications of a particular accounting standard have been
deemed to be negative, then it is likely that the introduction of the standard
would have been abandoned, even though the particular standard may reflect
more accurately particular transactions or events It is difficult to accept that
accounting standards are objective or unbiased.
Explain the theoretical perspectives that describe who is likely to gain from the
implementation of regulation

Public interest
Capture Theory
Private Interest Theory

• Public Interest Theory

-The regulation is put in place to benefit the society as a whole. The enactment of
regulation / legislation is a balance between the social benefits and social costs of the
regulation.
-The regulatory body is considered to represent the interests of the society, rather
than the interest of the regulators or any particular stakeholder groups - Criticism:
-Question that economic markets operates inefficiently if unregulated
-Question that government regulation is virtually costless
-Legislators will put in place [set up] legislation only because it might increase their
own wealth (being re-elected) and people will lobby for particular legislation only if it is
in their own self-interest.

• Capture Theory

-Although regulations might be introduced with the aim of protecting the 'public
interest', this aim will not be achieved because the organizations that are subject to the
regulations will ultimately [finally] come to control the regulators because the decisions
made by the regulators will have significant impact on their industry.
It will be difficult for the regulators to remain independent of those parties, as the
survival of the regulatory body over a period of time often depends on satisfying the
expectations of those parties Criticism:
-No reason is suggested why regulated industry is the only group to influence
regulators Customers of the regulated firm have an obvious interest in the outcome of
the regulatory process, they are able to 'capture' the regulators as effectively as the
regulated firm
-No reason is suggested why industries are able to capture only existing agencies
rather than creating of an agency that will promote their interest
-If particular group of companies did not perceive a potential threat or opportunity
from the regulators to their interests, why would they devote resources to capture the
regulators?

• Private Interest Theory (Economic Interest Group Theory)

 -Different groups are viewed as being in conflict with each other & they will lobby
regulators to put in place legislation that economically benefits them (at the expense of
the others).
Ex: Consumers might lobby government for price protection, or producer might lobby
government for tariff (tax) protection
-No notion of public interest in this theory. Private/self-interests are considered to
dominate the legislative process
-The regulator body itself is a group that is motivated to introduce legislations to
ensure its re-election or to maintain its power within the community.
-The minority group does not have sufficient power (reflected by the numbers of
controlled votes, or by funds available to support an election campaign), then that
group will not be able to effectively lobby for regulations that might protect its interests.

Explain the social and economic impact of regulation

There is evidence that accounting regulation have really social & economic
consequences for many organizations and people
Ex: AASB 138 requires expenditure on internally developed brand names & research
expenditure to be written off as an expense when incurred as a result, retained
profits will be reduced, affecting