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Advanced Financial Accounting Week 2 (Accounting Theory (Overview)…
Advanced Financial Accounting Week 2
Accounting Theory (Overview)
Accounting is a practical discipline
Little use for theory
Rule focused
Theory is Necessary to
Understand the world
Provide a basis for decision-making
All Accounting Is premised on theories
"A description, explanation, or a prediction of accounting practice based on observations/logical reasoning"
Logical reasoning
Provide general framework of reference by which accounting practice can be evaluated
Guide the develop of new practices/procedured
Accounting Theories can help us understand
Actions of report users
Influences of organisational environment
Decisions of financial report preparers
potentially better accounting and financial Practise
Types of theories
Positive Theories
helps understand what happend
based on hypotheses
Describes, explains or predicts
Also called empirical theories
Normative theories
Recommend what should happen
Prescribe action to achieve objectives
Positive Accounting theories
Contracting theory
Contracting parties have rights and responsibilities
These are agency contracts used to manage relationships where there is separation between management and capital providers
Characterizes organisations as a 'nexus of contracts' (focuses on managerial contracts and debt contracts)
Agency Theories
Creates a moral hazard
If interests of both are not aligned -> incentive for agent to act in a way not in the best interest of principle
Shirking
Empire building
Excessive prerequisites (consumption of firm's resources)
Incorrect investment decisions
When a 'principle' employs an agent
Leads to agency costs (monitoring (shareholders), bonding (managers) and residual (shareholders))
Role of accounting info in agency problems
To write terms of managerial contracts
To determine performance against terms of the contract
Owner-Manager Agency Relationships
Risk Aversion
Shareholders: prefer risk for increased returns
Managers: Prefer less risk for job security
Dividend retiention
Shareholders: Prefer to receive cash
Managers: Prefer to retain cash in business
Horizon Problem
Shareholders: Want long-term cash flows
Managers: Want short term Profit
Manager Lender Agency Relationships
Managers have incentices to show they are acting in a way that is not detrimental to lenders (e.g. lower dividends, under investment etc.)
Criticisms
Underlying assumption of 'wealth-maximization' is simplistic
Scientifically flawed
far less value-laden
Does not provide a means of improving Accounting Practise
Normative Accounting Theories
Conceptual Framework
identifies qualitative characteristics for reports
Makes recommendations that mat depart from current practices
Provides guidance with coherent and consistent framework
Identifies objectives of GPFR
System-orientated theories
Stake-holder theory
'any group or individual who can affect organisations objectives'
2 versions
Normative: 'ethical branch'
Organisation should be managed for benefit of all stakeholders
Stakeholders should always be considered in decisions
Should treat all stakeholders fairly
Empirical: positive theory
Explains influence of stakeholders on organisation
Extent organisation should consider stakeholders is related to their power/influence
Considers relationships with various stakeholders
Role of accounting info
Meeting stakeholders needs and expectations
Legitimacy Theory
Relates to expectations society has about how businesses should act to survive
Organisations need to show they are operating in accordance with social contract
Based on idea of social contract
ORGANISATIONAL LEGitimacy
In past: Only in terms of economic peformance
Nor: Must consider environmental and social consequences of their activities
Values or norms in social contract have changed over time
How to maintain oorganisational legitimacy
Change perceptions but not behavior
Manipulate perception by deflecting attention
Educate and inform society about actual changes in peformance
Seek to change expectations of its future peformance
Accounting disclosures and legitimation
Disclosure of effect/relationship with society can be used
Public reporting can be a powerful tool
Institutional Theory
Considers rules, norms and routines
Practices with an organisation can be predicted
Comes from management literature
Contingency Theory
Organisations are affected by a range of factors so must adapt strategy to peform well
Using Accounting Theories to understand Decisions
Expensing and capitalizing costs
Entities with lending agreements with a lending covenant
Agency Theory: Managers with bonuses tied to current measure of entity
Disclosure
Accounting Estimates