Topic 1 - Application of Accounting Theory & Ethics

Question 1

Professional judgement in accounting

Answer 1

Accountants needs to exercise professional judgement such as:

• Estimating expected inflows or outflows when measuring assets and liabilities
• Deciding how to account for a transaction that is not covered by a specific accounting standard
• Deciding how to correctly apply an accounting standard
• Deciding which method to adopt when an accounting standard permits choice

Question 2

Four components of an accounting policy decision

Answer 2

1. Definition: whether a transaction or event creates an item that satisfies the definition of an element of financial statements (e.g. asset, liability, revenue or expense)
2. Recognition: whether or when the item should be recognised
3. Measurement: how the item should be measured, which may include a decision about subsequent measurement as well as initial measurement
4. Disclosure: how information about the item should be presented and what information should be disclosed.

Question 3

What is accounting theory?

Answer 3

A theory is a group of propositions or principles forming a general framework or reference for a field or inquiry

Question 4

What values do theories offer?

Answer 4

Accounting theories help us understand:

1. Decisions of financial report preparers
2. Actions of financial report users
3. Influences of organisational environment
4. Potentially better measurement and reporting

Question 5

Normative Theories

Answer 5

Prescribe particular practices e.g. the conceptual framework or ethical theories

Question 6

Positive Accounting Theory (PAT)

Answer 6

A positive theory used to explain and predict accounting practice. It is designed to explain and predict which firms will and which firms will not use a particular method. Positive accounting theory is based on an underlying economic assumption called the ‘rational economic person’ assumption, which assumes that all individuals act in their own self-interest and are rational wealth maximisers. It is derived from the nexus of contracts view of the firm and agency theory.

Question 7

Contracting Theory

Answer 7

Suggests that the organisation is characterised as a legal ‘nexus of contracts’ or as the centre of contractual relationships, with these contracting parties having rights and responsibilities under these contracts. It focuses on two contracts, managerial contracts and debt contracts, both of which are agency contracts used to manage relationships where there is a separation between management and capital providers.

Question 8

Agency Theory

Answer 8

A principal employs the services and decision making to an agent to perform an activity on their behalf. The agent has a legal and fiduciary duty to act in the best interests of the principal.

Principal - person who is in power e.g. shareholders
Agent - person who is not e.g. company executives

Creates a moral hazard - lack of alignment between goals.

Question 9

Agency Theory Costs

Answer 9

3 costs in relation to agency theory

1. Monitoring costs - incurred by the principal to measure, observe, and control the agent’s behaviour. These might include costs to audit the financial reports, putting in place operating rules or costs to set up a management compensation plan.
2. Bonding costs - incurring the time and effort involved in producing and providing quarterly accounting reports to lenders or by agreeing to link part of the remuneration payment to entity performance. If this is done managers have an incentive to enhance entity performance, which is also in the best interests of owners. Activities are known as bonding costs.
3. Residual loss - at times, it might cost more to monitor agents than the expected benefits from monitoring. E.g. it might be too costly to monitor the use of a manager’s travel expenses to ensure they are only for business purposes, or his or her use of business stationery for personal use. This additional deviation is referred to as residual loss.

Question 10

Agency Theory Assumption

Answer 10

That agents are likely to act in their own self interest, rather than the principal’s.

Question 11

Owner-manager / Shareholder-manager Agency Relationships

Answer 11

Managers take risks because they are not at risk if the company goes bankrupt - they could find new employment. Owners and investors are at full risk if the company goes bankrupt.

4 problems results from this relationship:

1. Horizon problem - most shareholders have an interest in long term growth whereas management’s interest is generally short term (e.g. annual bonus)
2. Risk aversion - managers generally prefer less risk than shareholders. Higher risk potentially leads to higher returns. Managers have more to lose with high risk projects (e.g. their job)
3. Dividend retention - managers prefer to retain funds within the organisation to expand the size of the business they control. Shareholders prefer increased dividends.
4. Consumption of excessive perquisites - Perquisite = non cash benefit. E.g. using organisation resource to operate their own business “on the side”.

Question 12

Manager-Lender / Debtholder-Manager Agency Relationships

Answer 12

When a lender agrees to provide funds to an entity there is the risk that the lending party may not repay those funds.

4 problems result from:

1. Claim dilution - arises when an entity takes on a debt or equal or higher priority after entering into an initial debt (e.g. taking a secured loan when an unsecured loan is already in place)
2. Under-investment - if an entity is in financial difficulty it has little incentive to engage in positive NPV projects due to the fact that creditors rank higher than shareholders in the event of liquidation.
3. Excessive dividend payments - payment of excessive dividends may result in the organisation having insufficient funds to service debt.
4. Asset substitution - investments in risker assets after a loan has been arranged. Lenders share the “downside” risk but not the “upside” risk.

To avoid higher interest costs, managers have incentives to show they are acting in a way that is not detrimental to lenders.

Question 13

PAT Political Relationships

Answer 13

Entities have political relationships (including with governments, trade unions, NGOs etc).

Political contracts are typically implicit in nature.
Lobbying and other forms of
political action are costly and therefore more likely to be targeted against larger, more profitable companies.

Political costs:

1. Government imposed taxes
2. Government investigations
3. Adverse media publicity
4. Industrial action
5. Loss of concessions

Question 14

Monitoring Costs

Answer 14

To observe, evaluate and control the manager’s behaviour

Incurred by: the principal initially, and then passed onto management through reduced remuneration or increased interest rates.

Question 15

Monitoring Costs Examples

Answer 15

Having financial statements audited

Corporate governance arrangements

Implementing policies and procedures

Management compensation plans

Property valuations on properties used as security for a loan.

Question 16

Bonding Costs

Answer 16

To provide assurance that the managers are acting in the principal’s best interests.

Incurred by: the manager (to try and avoid the shareholders or debt holders incurring and passing on monitoring costs)

Question 17

Bonding Costs Examples

Answer 17

Voluntary production of quarterly financial reports

Agreeing to link their remuneration to entity performance

Agreeing to limit corporate borrowing to 60% of total assets

Question 18

Implication of Residual Loss in PAT for Accounting Policy Choice

Answer 18

1. Bonus Plan Hypothesis: managers adopt profit increasing accounting methods if their compensation is linked to accounting profit.
2. Debt Hypothesis: managers adopt profit (and equity) increasing accounting methods if debt covenants limit borrowings via accounting numbers, eg. max debt/equity ratio.
3. Political Cost Hypothesis: large firms prefer profit decreasing methods to minimise political costs.