Accounting Theory and Policy - Essay Example

Accounting Theory and Policy (2) Principles-based Standards Debate Review and critically evaluate the recent debate in the US on principles-based accounting standards. (Reference: AAA Financial Accounting Standards Committee, 2003) The debate on principles (or concepts)-based accounting standards is concerned with the possible changes that FASB wants to make on U.S. GAAP, transforming the accounting standards from one that is characterised as rules-based into one that would be principles-based, the characteristic shared by other international accounting standards such as U.K. GAAP and IFRS. The main reason for starting the debate was the series of corporate scandals in the U.S. where managers acted opportunistically to circumvent accounting rules to the detriment of investors, a result that accounting standards were supposed to help in preventing. Standards were established to ensure that financial reporting reflected the economic substance, not just the form, of transactions. However, auditors allowed different forms of reporting manipulation provided these were consistent with the interpretation of precise rules-based standards, allowing compliance with the "form" of financial reporting even as it failed to reflect the true economic "substance" of such transactions. Another reason for the debate is the move towards the need for convergence because of the number of accounting standards currently in force, which creates problems related to timeliness, compliance, comparability, and consistency. Accountants find rules-based (also called cookbook or checklist) standards too detailed and time-consuming, causing delays in reporting, and unable to meet the challenges of a complex and fast-changing financial world. Rather than help accountants exercise professional judgment and objectivity, having too many rules provide specific benchmarks that makes it easy for auditors to fulfil compliance in form but not in substance. Therefore, since principles are more general than detailed rules, FASB is of the opinion that developing principles-based standards would make convergence easier and, at the same time, allow auditors to minimise the tendency of managers to engage in manipulations of reported financial results. Rules-based accounting standards-setting in the U.S. resulted from years of consultations regarding increasingly complex financial transactions. Companies and auditors asked for "bright line" rules, so-called because they contained precise numerical cut-off points supposedly to guide transactions reporting. However, as the example of accounting for capital leases showed, companies found a way to use professional expertise, creative arrangements, and over-liberal judgment to circumvent the rules contained in a 450-page FASB document to clarify the topic. Why do companies restructure transactions even in the face of "bright line" rules The main reason is that managing earnings can be beneficial for managers. Managers have incentives to look after their own best interests, leading them to manipulate transactions if the benefits outweigh the costs such as taxes, penalties from SEC enforcement, and balance sheet reclassifications. Minimising costs would maximise profits and, in most cases, benefits to managers. Auditors also have incentives to earn as much revenues from their services, which may be affected by reporting manipulation, so they sometimes allow debt to be classified as equity (some auditing fees depend on company asset size). By maximising profits, earnings manipulation also allows managers to keep their jobs, avoid shareholder lawsuits, and raise the share price so they can exercise stock options and earn higher salaries. Evidence shows that managers are more likely to manipulate financial reporting if there are precise (rules-based) accounting standards than when standards are flexible, and that auditors are more likely to allow this as long as the rules allow it. When there are no "bright line" rules, but only concepts-based standards, managers are less likely to engage in costly transaction structuring but continue to justify earnings management with the consent of the auditors. The literature review by the AAA concluded that the two different approaches (rules- or principles-based) to accounting standards do not change the incentives or the ability of management to report opportunistically. What may change is the nature and characteristics of opportunistic reporting. This shows that it is not the "form" of the standards (whether based on rules or concepts/principles) but rather the "substance" of the managers and auditors that can minimise opportunistic reporting. Managers will continue to manage (or manipulate) earnings and transaction reporting, with the consent of the auditors, because of their incentive to look after their own business interests. The FASB hopes that changing to concept-based standards would give deeper benefits to the accounting profession and, in the long-term, improve the quality of financial reporting. It hopes to achieve this by shifting the burden and responsibility for standards interpretation away from the FASB, which has no enforcement power, to the auditors and managers who would then carry the burden of greater accountability. This way, preparers and auditors would learn how to exercise professional judgment in the public interest because standards would be based on principles instead of precise rules, as IASB Chairman Tweedle argued. FASB also hopes that managers, audit committee members, and auditors would develop their abilities to exercise expert judgment and a desire for unbiased reporting if the standards would result in financial reporting that reflects the underlying economics of transactions. Promoting a concepts-based approach is also in line with FASB's goal of improving the common understanding of the nature and purposes of information contained in financial reports by helping accountants "possess" a conceptual framework for financial information. What this means is that the "truthfulness" of financial reports really depends on the "principles" of the accountant, what we can call their "ethical substance" that would make them react when managers ask them to do what does not "seem" right. Accountants have to be courageous, as they are in many other countries, to make these types of judgments because amongst the key principles of the profession is ensuring that quality accounting helps monitor managers and control their opportunistic tendencies by reporting financial transactions truthfully. Watts and Zimmerman (1978) Using Watts and Zimmerman (1978) and subsequent extensions of their theory, explain why management of a listed company might prefer an accounting policy that decreased reported income, including any examples from accounting controversies. Using economic analysis to study people's behaviour and how people make choices, Watts and Zimmerman concluded that managers of American companies they studied did everything they could - even going to the extent of opposing accounting standardisation measures - to maximise the company's value for their own benefit and, if the managers themselves owned shares or were compensated based on the price of the shares, they also worked for the benefit of shareholders. Their research explored the issue of "positive theory of accounting" to explain how managers make decisions - choosing from amongst the many available accounting guidance principles - which ones to use and why they do so. Their conclusion was that these decisions were related to maximising value and benefits: managers do what they think is best for them and for the company. They cited five factors that affected management preferences of accounting rules: (1) Taxation: managers preferred to reduce the tax bill since this increases profits, bonuses, and the share price; (2) Regulations: managers choose policies that allow adjustments in profits (to bring these down) if the company is in a highly regulated industry such as gas, telephone, and electricity in order to meet (preferably without exceeding) the legislated capital return targets; (3) Political costs: since government has the power to take over companies that attract attention because of their profitability, managers choose accounting policies that bring down profits and share prices so as not to attract attention; (4) Bookkeeping costs: managers will choose accounting standards that would be cheaper for the company to implement in order to minimise expenses, even if this cost (such as training of accountants in the new standards, or filing of disclosures) in practice is usually zero; and, (5) Compensation Plans: if the salaries of managers are linked to profits or the share price, managers would choose accounting policies that would inflate revenues and income. The first three factors (taxes, regulation, and political costs) tend to bring down income, whilst the last two factors (bookkeeping costs and compensation plans) tend to bring up income, either way maximising benefits to managers. By studying managerial behaviour towards their choice of accounting policies, Watts and Zimmerman showed how managerial decisions are affected by government and market forces and by the behaviour of politicians and shareholders. Each has its own set of interests and benefits to fulfil: Government wants more taxes, politicians want less power for business (or funds for the political campaign), and shareholders want to earn more for their investment. In addition, customers want lower prices and suppliers want higher prices, and employees want higher wages. Managers are "caught" in the middle but have the advantage because they know more about the business and their own strategies, and the accounting standards they could follow. Through a rational decision-making process, managers choose those accounting standards that would be best primarily for them and, secondarily, for the company. This issue is important because financial reports are supposed to provide a truthful, accurate, and useful view of company performance, but given the different sets of selfish interests inside and outside the company, managers react by manipulating the reporting system without any intention of breaking the law. One set of decisions concerns decreasing reported income. According to Watts and Zimmerman, big companies may decide to decrease their reported income to avoid political visibility so the company does not attract the attention of politicians. This behaviour is more common with big companies than with small- and medium-sized companies, whose managers prefer to report higher income for an obvious reason: managers of small companies want their share prices to rise to attract attention, be noticed by the public, sell more, and grow faster. This benefits the company and its managers who may or may not be compensated based on share price. Other authors cite a sixth factor that influences the way managers report income: debt covenant provisions that specify a fixed measure such as a required debt/equity ratio. If this ratio is exceeded, creditors (lenders) may decide to call the debt contract, resulting in cash flow problems for the company, so managers choose accounting policies that would keep the D/E within the specified boundaries. Amongst the experiences of listed companies decreasing their reported income, two normal examples can be cited. Take for example the situation where a company is finally making money and generating profits that the company needs badly to invest in the future. It could spend the money buying capital equipment to improve productivity or spend it to raise the wages of workers. However, whilst the former may be sustainable, the latter may not be, so how would management satisfy the labour union And what if shareholders are looking for dividends as a consolation for years of receiving none and not being able to sell their shares because the price is low The company can report lower earnings, and there are some ways that accounting standards can help achieve this without doing something illegal. From 1999-2004, The Royal Mail successfully accelerated depreciation and frontloaded operating costs to report lower earnings to avoid raising wages. Reporting lower earnings also has another benefit: lower earnings in one period can make the next period's figures much more attractive. Management can then arrange for generous salaries and benefits if they reach profit targets in the coming year, and then claim a dramatic "turnaround", finally collecting huge compensation from stock options or performance-based incentives. Declaring lower earnings also allow earnings management where companies meet profit targets to impress analysts and investors, thus benefiting the stock price. Recent stock options scandals and the consistency by which G.E. of the U.S. hit quarterly earnings targets are examples of earnings management. On Conceptual Frameworks Outline the conceptual framework of the IASB and review the critique of the FASB's conceptual framework project offered by Dopuch and Sunder (1980). Why do you think accounting policy-makers, including the IASB, have commissioned conceptual framework projects The IASB's conceptual framework (Framework for the Preparation and Presentation of Financial Statements) can be outlined as follows: (1) The Framework defines the objective of financial statements: "to provide informationthat is useful to a wide range of users in making economic decisions". (2) It enumerates who these users may be: present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agents, and the general public. The information that meets the needs of investors would also meet most of the needs of other users of financial statements. (3) It describes the basic concepts by which financial statements are prepared and serves to guide the IASB in developing accounting standards and in resolving accounting issues not addressed directly in an International Accounting Standard or International Financial Reporting Standard or Interpretation. (4) It emphasises that in the absence of a Standard or an Interpretation that specifically applies to a transaction, (company) management must use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgment, management must consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. (5) It identifies the qualitative characteristics that make information in financial statements useful, and defines the basic elements of financial statements (assets, liabilities, equity, income, expenses, and cash flow) and the concepts for recognising and measuring them. Dopuch and Sander, in their critical review made in 1980 of the FASB's proposed framework (Statement of Objectives and of its Exposure Draft on the elements of financial accounting), predicted that the proposal would be a failure for two reasons. The first reason is that the proposed CF has nothing much that is new or different compared to previous versions of the framework, which have been judged to have failed. The second reason is that the objectives of financial accounting can be interpreted in many ways because users have many potentially conflicting objectives of financial reports arising from their own interests. Dopuch and Sander therefore predict that because of these conflicts, accountants would continue seeking authoritative definitions of objectives and CF's in order to guide them in their work of preparing reports for different users. Dopuch and Sander elaborated on three explanations for defining the objective of financial statements. The first is the "Functional" explanation, which means that it is possible to identify the union of individual objectives of many users, without probing into their motivations, by simply observing the set of consequences of their social activity. The usefulness of financial reports and the function of accounting practice depend on the objectives of a person. People use reports for different reasons, and this can affect the way the framework is developed. The second is the "Common" explanation, which assumes that auditors, managers, and users form a group that share some common objectives, and these common objectives are what accounting standards should try to satisfy. Standards may not be able to satisfy all the objectives of all the groups, but the best that a standards-setting association can do is to come up with standards that auditors are willing to use, managers would be happy to comply with, and users find useful and want to use. The third is the "Dominant Group" explanation, where the dominant or strongest group amongst the three general groups with their own interest in the usefulness of financial reporting - management, auditors, and users - would have the greatest effect on setting standards. The "users" are the most dominant because they are the largest among the three. This makes it difficult for managers and auditors to accept objectives formulated to satisfy the dominant group. As Dopuch and Sander showed, if agreeing on the objectives for financial reporting is already difficult, then setting accounting standards would not be easy. From the Trueblood report definition of the objectives of financial statements - "to provide information useful for making economic decisions" - we can see that differences in the nature of each user's economic decisions would necessarily lead to conflicts. Some users (shareholders, tax collectors, and employees) want higher profits whilst others (managers, politicians, and in some cases competitors) may want lower profits. Besides, like other humans, many auditors (especially in the U.S.) are afraid of being brought to court for mistakes in their interpretation of accounting standards, so they prefer clear-cut rules that would minimise the possibility of committing those mistakes. These arguments give an idea why CF's continue being developed and debated. CF might help groups with different interests have a common understanding of standards. However, since "definitions, no matter how carefully worded, cannot bear the burden of the struggle for economic advantage between various interest groups", the CF can act as a starting point for discussions where agreements can be forged, no matter how difficult it would be to do so. Dopuch and Sander analysed the FASB's (U.S.) CF, but there are ongoing discussions between the FASB and the IASB, including the ASB that is responsible for U.K. GAAP, for convergence in CF and standards. One key argument which may be due to cultural differences between Europe/U.K. and the U.S. is the focus of financial reporting: the IASB, and the ASB, identify this focus as looking after the best interests of the company and its shareholders. The emphasis on stewardship may be too vague and general by present U.S. standards, but by placing the burden and responsibility of looking after the good of the business squarely on their shoulders, management and auditors are reminded of the main reason for the work that they do and who employed them to do it. Managers and auditors must learn to exercise professional judgment in the public interest. This is possible if there is a strong commitment from preparers (company accountants and managers) to provide a faithful representation of transactions, and an equally strong commitment from auditors to resist client pressures. Without these commitments, conceptual frameworks and principles-based standards would continue to be worthless and developing them, a waste of time. Reference List AAA Financial Accounting Standards Committee (2003). Evaluating concepts-based vs. rules-based approaches to standard setting. Accounting Horizons, 17 (1), 73-89. Dopuch, N. and Sunder, S. (1980). FASB's statements on objectives and elements of financial accounting. The Accounting Review, 55 (1), 1-21. Watts, R. L. and Zimmerman, J.L. (1978). Towards a positive theory of the determination of accounting standards. Accounting Review, 53 (1), 112-134. Read More