Normative Theories of Accounting

Question 1

What is the problem of additivity in historical cost accounting?

Answer 1

In times of rising prices, it can overstate profits, leading to an erosion of operating capacity by distorting the current year’s operating results.

Question 2

What are the limitations of historical cost accounting in times of rising prices?

Answer 2

Assumes constant purchasing power.
Affected by specific price level changes, general price level changes (inflation), and exchange rate fluctuations.

Question 3

Why does historical cost accounting still have support?

Answer 3

It remains the predominant method used today, suggesting its usefulness to business entities. If it were not beneficial, it would have been abandoned.

Question 4

Define income according to Hicks (1946)

Answer 4

“The maximum amount that can be consumed during a period while still expecting to be as well off at the end as at the beginning.”

Question 5

What are the three perspectives of capital maintenance?

Answer 5

Financial capital maintenance (historical cost)
Purchasing Power maintenance (adjusted for changes in purchasing power)
Physical capital maintenance (maintaining the operational capacity of the organisation)

Question 6

What is Current Purchasing Power Accounting (CPPA)?

Answer 6

A method based on adjusting historical cost accounts for general price level changes, such as inflation, to maintain the entity’s capital.

Question 7

What are the advantages of Current Purchasing Power Accounting (CPPA)?

Answer 7

Relies on existing historical cost data.
No extra cost for collecting asset data.
CPI data is readily available.

Question 8

What are the disadvantages of Current Purchasing Power Accounting (CPPA)?

Answer 8

General price indices may not reflect industry-specific changes.
Can be confusing for users.
Limited support for decision-making usefulness in share price reactions.

Question 9

What is the key difference between financial capital and physical capital maintenance in terms of holding gains?

Answer 9

Financial capital maintenance treats holding gains as income.
Physical capital maintenance treats holding gains as capital adjustments

Question 10

What is Current Cost Accounting (CCA) under the physical capital maintenance approach?

Answer 10

It focuses on valuing assets at their replacement cost, with operating income calculated after subtracting the replacement cost of consumed assets.

Question 11

What are the criticisms of replacement cost in Current Cost Accounting (CCA)?

Answer 11

Replacement costs vary by firm.
Replacement cost may not reflect market value.
Depreciation based on replacement cost is arbitrary.

Question 12

What is Continuously Contemporary Accounting (CoCoA)?

Answer 12

A method that values assets at their net selling prices (exit prices) and focuses on the firm’s adaptive capacity to changing market conditions.

Question 13

How does CoCoA define profit?

Answer 13

Profit relates to changes in adaptive capital, reflecting the increase in the net selling prices of the entity’s assets.

Question 14

What are the risks of Fair Value Accounting?

Answer 14

Fair value accounting can increase volatility in financial statements and exacerbate issues during economic downturns, such as the procyclicality seen during the subprime crisis.

Question 15

What is the distinction between Fair Value Accounting and Historical Cost Accounting in terms of decision usefulness and stewardship?

Answer 15

Fair value is more relevant for decision-making.
Historical cost accounting is more aligned with the stewardship role, reflecting past transactions.

Question 16

What is the main focus of Capital Market Research (CMR)?

Answer 16

CMR explores the role of accounting and financial information in equity markets, examining how investors react to disclosures and the relationship between financial information and share prices.

Question 17

What does the Efficient Market Hypothesis (EMH) imply in Capital Market Research (CMR)?

Answer 17

It implies that equity markets are efficient, meaning they adjust rapidly to impound all available information into share prices when it is released.

Question 18

What are the three forms of Market Efficiency according to EMH?

Answer 18

Weak form: Prices reflect past prices and trading volumes.
Semi-strong form: Prices fully impound all publicly available information.
Strong form: Prices reflect all information, both public and private.

Question 19

What is the semi-strong form of market efficiency most relevant for in accounting research?

Answer 19

It is most relevant for accounting-based capital market research because it considers the rapid and unbiased incorporation of public information into share prices.

Question 20

How does market efficiency influence accounting research?

Answer 20

If markets are efficient, they use various sources to predict future earnings, and accounting information that does not affect share prices is considered to lack informational value beyond what is already available.

Question 21

What is the “Market Model” Used for in Capital Market Research?

Answer 21

It separates firm-specific share price movements from market-wide movements, allowing researchers to focus on the effects of firm-specific news.

Question 22

What are the two components of actual returns in the Market Model?

Answer 22

Normal returns: Expected returns given market-wide movements.
Abnormal returns: Unexpected returns due to firm-specific price movements.

Question 22

What did the Ball and Brown (1968) study find regarding accounting earnings and share prices?

Answer 22

They found that unexpected changes in accounting earnings led to abnormal returns, and that historical cost accounting information was useful to investors.

Question 22

What did Beaver (1972) suggest regarding accounting standards and share returns?

Answer 22

He suggested that the association of accounting numbers with security returns can be used to determine which accounting methods should be set as standards.

Question 23

How do abnormal earnings announcements in one firm affect other firms in the same industry?

Answer 23

Earnings announcements can result in abnormal returns for other firms if they reflect industry-wide changes or relative changes in market share.

Question 24

What are the benefits of voluntary disclosure in annual reports?

Answer 24

Voluntary disclosure improves analyst forecasts, increases investor following, reduces information asymmetry, and decreases the cost of equity capital.

Question 25

How does firm size affect the impact of earnings announcements on share prices?

Answer 25

Earnings announcements have a greater impact on smaller firms compared to larger firms, where more information is already available to the market.

Question 26

What do studies suggest about accounting earnings and future share prices?

Answer 26

Research shows that share prices often anticipate future earnings, meaning share price movements can predict future earnings announcements, especially in larger firms.

Question 27

What did Healy (1985) find about managerial incentives and earnings manipulation?

Answer 27

He found that managers manipulate accounting methods to maximise bonuses, particularly when bonuses are tied to reaching pre-specified earnings levels.

Question 28

What is the difference between accounting-based and market-based bonus schemes?

Answer 28

Accounting-based schemes rely on accounting profits and can be manipulated, while market-based schemes link bonuses to share price increases, which are influenced by market movements beyond managers’ control.