Week 1

Question 1

Explain the agency relationship and the agency problem.

Answer 1

The agency relationship is the delegation of decision making from the principal to the agent. For example, the principal could be the owner and the agent the manager.

Agency problem
delegation of authority can lead to loss of efficiency and increased costs.

Agency costs
costs that arise as a result of the agency relationship:
* monitoring costs
* bonding expenditures
* residual loss
* internal controls
* seperation of duties

Question 2

Key assumptions of positive accounting theory.

Answer 2

PAT seeks to explain and predict accounting practice. It does not seek to prescribe particular actions or provide practitioners with guidance. It focuses on the relationships between resource providing individuals and their organisations.

• individual action is driven by self-interest
• individuals act in an opportunistic manner to increase their wealth
• notions of loyalty and morality are not incorporated within the theory
• organisations are a collection of self-interested individuals who agree to cooperate

Question 3

criticisms of the positive accounting theory.

Answer 3

1. It does not provide prescription
2. It is not value-free,
3. All action is driven by a desire to maximise wealth

Question 4

normative accounting theories

Answer 4

Normative accounting theories are prescriptive in nature. They focus on how accounting should be done, based on ideals or standards of what is considered best practice. These theories are concerned with setting guidelines and rules to achieve what is perceived as accurate or desirable in financial reporting. PROVIDING guidance about how to prepare financial statements, how to measure things as a accountant.

NZ equivalent to the IASB conceptual framework for financial reporting. GPFR.

Current cost accounting, exit price accounting

Question 5

Explain how creative accounting relates to positive accounting theory and why an understanding of this would be important for an accounting practitioner.

Answer 5

• ‘Creative accounting’ refers to when those responsible for the preparation of the financial statements select accounting methods that provide the result desired by the preparers. Selecting policies that best serve their own interest or the desired outcome. ( manipulation of financial statements and accounting practices to present a desired picture of a company’s financial health. This practice can involve techniques such as altering revenue recognition, inflating asset values, or deferring expenses).

PAT provides an explanation of why firms might be ‘creative’ – or opportunistic – with their accounting. This may include situations involving management bonuses, debt or political costs.

There is scope within the accounting standards to select different accounting policies, e.g., straight line or DV depreciation. This is applying professional judgement and selecting the most appropriate accounting policy for the situation. This is not ‘creative accounting’.

Question 6

Define the qualitative characteristics of accounting to justify the choice of either normative or positive accounting theories or accounting measurements (week 2) for a particular situation.

Answer 6

• Normative accounting theories establish standards for accounting practices to ensure financial information is relevant and accurately represented. They focus on achieving faithful representation, where financial statements are complete, neutral, and error-free. For example, historical cost accounting is used to provide reliable asset values, enhancing comparability across periods and entities. These theories are essential in regulatory settings to ensure consistency and adherence to accounting standards.
• Positive accounting theories explain and predict actual accounting practices based on firms’ incentives and pressures. They focus on understanding why companies choose specific accounting methods to meet financial goals or influence stakeholder perceptions. For instance, Positive Accounting Theory (PAT) can reveal why firms might use creative accounting to achieve desired outcomes. This approach helps analyze real-world accounting behaviors and motivations.

Question 7

Owner manager contracting - Market - based bonus plans

Answer 7

Market - based bonus plans reward managers in terms of the market value of the entity’s securities.

• cash bonuses awarded on basis of increase in share prices.
• shares or share options provided

Question 8

Debt contracting

Answer 8

• The closer a firm is to violating accounting-based debt covenants, the more likely the firm manager is to select accounting procedures that shift reported earnings from future periods to the current period.
• By increasing current earnings, the company is less likely to violate debt covenants, and management has minimized its constraints in running the company

Question 9

Political cost

Answer 9

• Political costs are costs that an external group may impose on an entity because of political actions.
• Example for a food producer could include pressure from environment groups on how they dispose of their wastewater or food products, regulations from government to using environmentally friendly packaging, product boycotts from consumers for using not ethically sourced products etc. ( Any appropriate food producer examples accepted.
• High profitability can lead to increased political “heat”, and can lead to new taxes or regulations esp. for large firms which may be held to higher reporting standards

Question 10

Relevance

Answer 10

Information is relevant if it can influence the decisions of users by helping them evaluate past, present, or future events or confirm or correct their past evaluations.

Question 11

Faithful Representation

Answer 11

Financial information should represent what it purports to represent faithfully, meaning it is complete, neutral, and free from error.

Question 12

Explain two (2) differences between normative accounting theories and positive accounting theories (PAT) using specific accounting examples to support your answer.

Answer 12

Normative accounting policies seek to provide guidance in selecting accounting procedures that are most appropriate for given sets of circumstances and prescribe what should be done
e.g., NZ Conceptual Framework contains criteria for recognizing an asset or liability.

Positive accounting theories explain and predict accounting practice, they do not seek to prescribe or provide practitioners with guidance
e.g., delegation of authority to management may explain why creative accounting is used, or
e.g., management may choose depreciation policies that are in their best interests or e.g., organisations will put mechanisms in place to align the interests of owners and managers.

Question 13

Key concepts of Positive Accounting Theory (PAT) are the efficiency perspective and agency costs. Explain the efficiency perspective and agency costs

Answer 13

• The efficiency perspective of PAT seeks to explain how various contracting mechanisms could be put in place to minimise future agency costs. eg. Put in place before anything happens to reduce future agency costs
• Agency costs are costs that arise because of the agency relationship, they include monitoring costs like auditors, board of directors etc.

Question 14

every agent and principal act in their own self-interest to maximise their wealth without any regard for adverse consequences.

For this assumption:

Answer 14

• The central assumption of PAT is all actions are driven/motivated by self-interest.
• Notions of loyalty and morality are not incorporated.
• Individuals act in self-interest so contractual arrangements are put in place for agents tying performance to a key measure.
• This would drive their behaviours to ensure targets are met and their wealth and principals are increased.
• Many examples in the world of the drive for profit and the individual or company appears to have suffered no costs for the adverse consequences including pollution, overfishing, destroying rainforests, water quality, waste etc.
• Maximising wealth is key. Against this there is increased regulation from governments, pressure from environment groups and the public for example water usage, no single use plastic bags, product boycotts etc.

Question 15

every agent and principal act in their own self-interest to maximise their wealth without any regard for adverse consequences.

Against this assumption

Answer 15

• Not all individuals act in self-interest.
• some have charity or social aspect e.g. Eat my lunch, Ronald MacDonald House etc.
• Huge part of every economy is the voluntary sector where people give their time for free.
• Loyalty and morality are not incorporated in PAT but are real factors and considerations that individuals include in their decision making each day e.g. fair trade products, buy NZ made etc.
• It is understandable why this is a key assumption of PAT as there are many examples in the world of the drive for profit and the individual or company appears to have suffered no costs for the adverse consequences including pollution, overfishing, destroying rainforests, water quality, waste etc.
• Maximising wealth is key. Against this there is increased regulation from governments, pressure from environment groups and the public for example water usage, no single use plastic bags, product boycotts etc.

Question 16

Owner manager contracting - Bonus schemes

Answer 16

Bonus schemes are based on the output of the accounting system or on the market value of the entities shares.

Accounting - Based bonus plans tie the managers remuneration directly to the accounting numbers ie % of sales.

Question 17

Opportunistic Perspective - PAT

Answer 17

Seeks to explain opportunistic behaviours that occur once negotiated contracting mechanisms have been put in place.
* Once an mechanism has been put in place, opportunistic behaviors will occur to try get the best outcome for the individual (own self interest)
* Bonus scheme - manager recieves remuneration based on profits, manager adopts manipulative strategies to generate greatest economic benefits for themselves.

Question 18

Exit price/ Cocoa

Answer 18

CoCoA prescribes that assets should be valued based on exit prices and that financial statements should function to inform users about an organisation’s capacity to adapt.

Question 19

“capacity to adapt”

Answer 19

The capacity to adapt will be best reflected by recording assets at their current cash equivalents, that is the amounts expected to be generated by selling the assets.

Question 20

Exit price/ Cocoa Strength

Answer 20

• all assets are valued consistently at current selling prices improves understandability for the readers of financial statements i.e. what is the current cash equivalent of the recorded assets
  *

Question 21

Accounting standard’s and conceptual framework Weaknesses

Answer 21

There is: number of valuation techniques are allowed eg historical cost, fair value, current replacement cost, income approach etc.
* Make it difficult for the readers to compare companies when the financial statements are prepared using different measurement and valuation techniques
*

Question 22

Accounting standard’s and conceptual framework strength

Answer 22

with many valuation techniques: ie historic cost, FV:
* These allow different elements which have different characteristics to be valued using the most appropriate method for that element.
* The conceptual framework recognises that such assets can have a value from their ability to generate revenue.

Question 23

Exit price/ Cocoa Weakness

Answer 23

• Under CoCoA all items are valued at current selling prices even if there no intention to sell the assets.
• CoCoA doesn’t consider ‘value in use’ of assets, highly specialised equipment would not be recognised if can’t be sold for cash.
• Assets that cannot be sold separately have no value in CoCoA e.g. goodwill and some WIP.

Question 24

current accounting rules used were so different in effect that comparison between companies was often quite misleading: AGREEING statement

Answer 24

• The current accounting rules do make it difficult to make comparisons.
• Many different was to value and measure assets, historical cost, NPV, fair value, replacement cost etc.
• For example, internally generated goodwill cannot be capitalised but goodwill from a business combination can be capitalised.
• This is difficult for readers of the financial statements who are not accountants to understand why they are treated differently.
• Under CoCoA cash is a key indicator of an entities ability to survive economically and this is a single easy concept for readers of the financial statements.

Question 25

current accounting rules used were so different in effect that comparison between companies was often quite misleading: DISAGREEING statement

Answer 25

• that current accounting rules seek to provide guidance in selecting accounting procedures that are most appropriate for given sets of circumstances.
• different elements are valued differently.
• This is appropriate as the nature and characteristics of different elements are all different.
• For example, assets such as shares traded on the NZX it is appropriate for them to be valued at current market value but other assets like delivery van then historical cost and depreciation to recognise its useful life.
• This can make comparisons difficult.
• But the accounting standards require disclosure of the different methods so readers of the financial statements understand the different valuations methods use and can factor this into their decision making.

Question 26

theory Current Cost Accounting

Answer 26

Provides a calculation of income that, after adjusting for changing prices, can be withdrawn from the entity and still leave the physical capital (operating capacity) of the entity intact.