Positive Accounting Theory and Normative Accounting Theory - Research Paper Example

 Relationship between Positive Accounting Theory and Normative Accounting Theory         Positive accounting theory is one of the many positive theories of accounting. It refers to theory that explains and predicts a certain accounting phenomena or action. Positive accounting theory focuses on relationships of individuals that provide resources to organization. It also focuses on how accounting is used to support these relationships. Theses relationships can be between managers and creditors or owner and mangers. Agency relationship is also one of the relationships focused by positive accounting theory which is delegation of decision making responsibility from one person to another. This can inculcate issue like agency problem and agency cost. Agency problem is decreased efficiency and increased cost. Agency cost refer to any loss that occur when decision making responsibility is delegated form one person to another and that person performs poor enough to cause losses . This theory also excludes notions like honesty and morality due to the fact that Central economics based assumption that “every individual is driven by self interest and acts in an opportunistic manner” governs this theory. This means that mangers should take into account the self interest of employs or creditors such as making them apart of the profit sharing. This cost of aligning interests is known as bonding costs.  Auditing/ monitoring of financial reports come under positive accounting theory as in its absence overstatement of profit and understatement of losses be done for self interest. Positive accounting theory also involves contracts such as performance appraisal or bonus sachems when the target is met. ( positive accounting theory 2007 )   Normative accounting theory derives and prescribes accounting standards it guides to select accounting procedure that is most adequate and feasible. They identify the qualitative aspect of financial reports. Recommendations for departments are part of normative accounting theory. Auditors resort to normative accounting theory while monitoring financial statements of a company. ( positive accounting theory 2007 )       They both contrast in away that positive accounting theory is more of a scientific approach and normative theory is more of an art approach. Positive accounting theory focuses on assumptions whereas normative accounting theory takes in to account logical reasoning. Positive accounting theory focuses on relationships while normative accounting theory focuses on references.  Accounting theory is not reality based as it excludes real life notions like morality and loyalty. However normative accounting theory explains how things in reality interact. (Relationship between positive accounting theory and normative 2010)       The accounting based bonus sachems are way of rewarding the corporate executives. They depend a lot on annual accounting earnings such as profit, sales and return on assets. It may also depend on market price of shares of the firm. Market prices are influenced by expectations about the net present value of expected future cash flows.        The high caliber staff can be retained only if they are offered incentives toss tick toy the organizations. Accounting based schemes is open of the many incentives as recruitment of new mangers and their training is a big cost.  Thus organizations pay a lot of a attention on retention of their employees. These schemes also boost employee’s morale. The accounting based bonus sachems come under positive accounting theory s they are introduced to align with the interests of mangers so that the relationship with them is maintained. The accounting based bonus schemes are categorized under the management by objectives which means that employ performance is measured against certain targets and then appraisals are given. (Relationship between positive accounting theory and normative 2010)         The more he reported earnings are greater than the target earnings the greater is the allocation to bonus pool thus mangers often overstate the accounting nosh so as to get higher bonuses to them. Another reason that compels the managers to manipulate accounting numbers is that they want to improve their apparent performance. By increasing the profits or organizations turnover they might be categorized as good managers and more avenues of excelling top management might be opened for them. Changing accounting methods will bring about changes in accounting earnings of the organization. For example recording purchase of oil for machine as capital expenditure rather than revenue expenditure will certainly affect the profit. Another example is of taking R & D as expense where as previously it was considered an asset and amortized over a period of time will also affect the profit. Methods of recording inventory such as fifo, lifo and avco also makes a difference to accounting numbers of an organization. ( Herring 1998 )       This impacts the future cash flows which directly reflect the value of an organization. The contracts should rely on floating that is generally accepted accounting principles so as to avoid the variations in accounting numbers. When bonuses are dependant on market value of shares then the market price is not controlled by managers only but is also based on certain market factors thus accounting numbers can’t be much manipulated by mangers in this scenario also. Only senior management in this case will be controlling the prices. The manipulation of accounting numbers can be monitored through auditing where the auditor questions the reasonableness of accounting methods that are adopted. ( Craton 1992 )       The results of manipulation can be massive. The managers use this accounting method to fraud. The mangers inflate profits by deflating expenses and provisions of losses. Thus the company doesn’t know of the actual situation company is going through unless the losses are conspicuous in the news regarding the organization. Often it’s too late for companies to take any measures to fix the issue of increased losses and the company goes bankrupt.       The manipulation of accounting numbers is an increased threat during today’s recession. When companies are not doing good managers so as to boost their performance and company’s image often increase the profits in their self interest as me3ntion by positive accounting theory       The results of manipulation may also be boosted and thus result in higher tax payments because the higher the profits the higher is the tax to be paid. The company bears a lot of expenditure through this practice as the amount to be allocated to bonuses plus the amount to be allocated to shareholders in terms of dividends also increase. 1)  Debt to asset ratio is means of Measure Company’s solvency. Its formula is Total liabilities/total assets.       It measures how much the total liabilities are covered up by the total assets. The higher this ratio is the higher risky the organization is. This ratio should be small for smooth operations of organization.   A ratio less than open means all liabilities are financed by assets of the organization and there is no risk involved because it means most of the companies assets are financed by equity not debt . a ratio above 1 means most of the companies assets are financed through debt i.e. liabilities. Companies having debt asset ratio higher than 1 are at risk because creditors may demand the debt anytime and thus it becomes difficult for such companies to pay back on time. Such companies may also go bankrupt. It’s always advised for companies       Asset revaluation is a contemporary practice not only in Australia but also worldwide. Non current assets are revalued. The revaluation is mostly upwards and is defined as reassessment of carrying amount of assets to a fair value. Writing down value of non current assets when its value exceeds its recoverable amount is also done and this is contrary to revaluation of assets. To write down is known as impairment loss. The revaluation is done on the assumption that asset is going concern. For revolution market price of asset is referred at places where the active and fair market of a particular asset exists .Asset revaluations are done by crediting revaluation reserve and debiting assets. Revaluation reserves are a part of shareholders equity .For revaluation of assets it’s necessary that effective disclosures are made. When assets have debt to assets constraints mangers often revalue assets so as to increase the assets and lower this ratio. For example Total assets= $ 500000 Total liabilities= $ 600000 Debt: asset ratio= 600000:500000                              = 1.2 If the buildings are revalued by $ 150000 then debt to asset ratio now is                600000:650000 = 0.92       We saw that just are revaluating buildings the debt to asset ratio decreased by a considerable amount. But the economic consequences of doing this revaluation is that the profits decrease as loss on revaluation is considered as an expense however revaluation surplus is increases on gain on revaluation. The compensation policies such as contracts and accounting based bonus schemes might push the mangers not to revalue assets and continue having higher profits at the cost of company’s solvency. This is very detrimental for companies thus auditors must monitor this practice of managers.        In places where there is political scrutiny, companies often resort to revaluation so as to deflate their profits and have leverage over taxes. This is common practice in many companies. Doing revaluations without referring to market prices gains such as tax leverages requires strict auditing and is time consuming too for organizations. To avoid this practice proper disclosure and strict accounting policies along with strict auditing has to be followed.          2)        Lease is an agreement whereby the lease conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. (AASB 117, par. 4)       The companies have an option of leasing the long-term assets instead of paying the entire amount at one time. It provides tax benefits to the leaser. It provides the firm with flexibility to change their technology and capacity if demanded. Lease payments are somewhat the same obligation as the payment of interest on debts. It they lease an asset it can greatly affect their financial statements making them more attractive.   There are two types of leases: 1. A financial lease also known as capital lease is one in which eth lessee gets the ownership of the asset at the end of the lease period. All the rewards and risks of the leased asset are transferred to the lessee. Even if the ownership is not transferred to the lessee but still the lessee holds the assets for most of its life. In financial lease, the right of using the property is transferred to the lessee and the ownership remains with the leaser. The expense of lease is treated as an operating expense in the income statement and it does not affect the balance sheet.  Leasing an asset in this way can provide benefits or can be risky for the company.  An agreement is signed which is recognizes it both as an asset and liability at the same time. The expenses are recognized sooner than equivalent operating leases    2. An operating lease is one in which the term of the lease is short term compared to the life of the asset and lessee doesn’t get the ownership of the asset eh just pays rental for the asset. The ownership remains with the leaser. Classifying the lease as an operating lease allows the company to treat the lease expenses as operating expenses and the part of the capital of the firm is not shown. If the lease in classified as capital lease, its present value of lease expenses is treated as debt and interest is shown in income statement.       A financial lease is recorded as asset in balanced sheet while rentals for operating lease are recorded as an expense. Recording lease as a financial lease affects the debt asset ratio as the assets increases through this. For example assets previously were $ 600000 and liabilities previously were $ 650000. Thus the debt-asset ratio previously was 650000:600000= 1.083 Now that asset is financially leased. The assets become 700000 and thus the debt – assert ratio now is 650000:700000 =0.928 Thus this shows that debt-asset ratio decreases substantially when financial leases are recorded.       However the operating lease may increase the debt to asset ratio if the rentals for the asset are accrued. For example: the rental payment for the asset is $ 10000 per month and is paid at the beginning of the next year for a 5 year lease term. In this scenario the yearly rental payment becomes 120000 and thus is recorded as accrued payment in the current liabilities section of the balance sheet. The debt asset ratio at the end of the year becomes now: 770000:600000= 1.283        Also operating leases deflates profits as when the rental payments are paid they are considered as an expense. The cash flows are also negative when the lease is recorded as finance lease and these negative cash flows are found to have negative effect on security prices or market prices of shares From an accounting point of view it’s important for firms to record lease as finance lease. Managers also resort to finance lease as it has no defect on their accounting numbers and they don’t have to manipulate them when leases are financed. However at times managers also deliberately record operating lease as finance lease so as to overstate their profit      Conclusion:       We have seen that within the organization positive accounting theory is greatly practiced as everyone works for self interest. Managers often temper the accounting numbers in their favor. We see top management introducing incentives for good relationships. This all is done to get higher performance made better image of a company. However its also extremely important than normative accounting theory is also practices because reality can’t be ignored. Everything has to be done logically within the organizations. For normative accounting theory companies have auditors or they also contact outside auditing agencies. These auditors pay an important role. Leases, accounting schemes and revaluation are some of the many things make the mangers to change accounting policies for their self interest.    Question No 2 Australian Vintage: Business Nature:       Being one of the leading manufacturers of wine, Australian vintage company seeks to provide outstanding and innovative wines for both Australian and international customers. It produces 9% of total Australian wine production. Australian vintage limited has been recognized and rewarded world over for the quality of wines it produces. They have a business in about 50 countries worldwide. Financial Profile:       In the financial year 2008, the Australian vintage company earned revenue of 265 million Australian dollars. After 2 years, 2006 and 2007, in which Australian vintage had loss in their profit and loss account it reached a profit of 1.3 million Australian dollars. It had earnings per share of 1 cent/ share. Australian vintage company had a cash flow in the year 2008 which was .4 million Australian dollars. The share price of the company felt in the year 2008 from AUS$ 2.15 per share to AUS$ 1.15 per share.       The total fixed assets of the company are AUS$ 287,844. Non-current liabilities of a company are AUS$ 159,129. The equity of the company totals at 343,295. Australian vintage has not been able to perform well during the year 2006 and 2007 due to the global recession. And it is still in the phase of recovering its losses. Australian accounting standard board 116:    AASB 116 is an accounting standard which requires that an item of Property plant or equipment, qualifying to be an asset, should be initially measured at cost. There are three elements of cost of an asset. Purchase Price The costs paid to bring the asset to location and get it in operating condition. The costs that were initially estimate to dismantle and to remove the item and to restore it.   It can only be classified as an asset only when it satisfies two conditions. Firstly, the future economic benefits that are associated with asset should flow to the entity. Secondly, the cost of an asset, or at revaluation, fair value of asset can be measure reliably. The accounting policy must be chosen by the entity, after an initial recognition of the asset. There are two models to record cost. Cost Model Revaluation Model Cost Model:       The asset should be recorded on its cost minus accumulated depreciation and impairment losses. The accumulated depreciation is calculated by a systematic method. Revaluation Model:       If the organization chooses this model, it must record the asset on the fair value at the date of revaluation. The accumulated depreciation and the impairment losses must be recorded on Revaluation.  Revaluation model requires the organization to account carrying amount of the asset as follows. The equity is directly credited under the heading of revaluation reserve if there is an increase in carrying amount of asset. The profit and loss account is debited it there is a decrease in carrying amount of an asset. If an item in Property plant and equipment is derecognized than the relevant component of revaluation reserve should be transferred to retained earnings. Depreciation of Property, Plant and Equipment.      AASB 116 States the depreciation of all items should be applied separately to each item of property plant and equipment. For each period the depreciation is recognized in profit or loss account. A systematic basis is used for calculating the depreciation of an asset which considers asset’s residual value and its useful life. The future economic benefits to be consumed by the entity are reflected by the method of depreciation The useful and residual value should be revised annually.  Derecognization       If the use or disposal of an asset gives no expected future benefits, the amount of an item of property plant or equipment is derecognized. The profit and loss account includes the gain or loss arising as a result of recognition where the gain is not recorded as revenue.  Australian Accounting Standards board 138:       There are different treatments of Tangible and an intangible asset therefore the AASB has included a separate section for the intangible assets. AASB deals with intangible assets, which includes its definition, recognition and disclosures. For an asset to be intangible it has to be identifiable. The asset should be controlled by the entity over a resource and future economic benefits should exist. Recognition: The company recognizes the intangible asset on if: The company expects the inflow of future expected economic benefits. There is reliable measurement of the cost of asset. Amortization:       There are two different types of accounting treatment of amortization on the basis of finite life or infinite life of the asset. In the case of finite life, Ammonization is done using a systematic method considering its useful life. The company should review its amortization period at the end of each reporting period. In the case of intangible asset having an indefinite life, the asset is not amortized. PPE OF AUSTRALIAN VINTAGE:    Since Australian vintage is a vine company, there are number of assets in the property plant and equipment of Australian vintage. The assets in PPE include Vineyard improvements Vineyard improvements under lease (from third party) Freehold land Buildings Plant and equipment under lease Plant and equipment    Australian vintage chose cost model to record its assets in PPE. It records all the assets in PPE on cost in compliance with the AASB 116. After recording the asset on cost, it subtracts the accumulated depreciation.    The general users of the financial reports includes the investors of the Australian vintage need the financial statements for making the investment decisions. Australian vintage provide detailed information for the prospective investors which is necessary for decision making. Investment analysts need the information for making the recommendations to their clients. Managers of Australian vintage use the financial statements to assess their own performance.    The rating agencies can get the all information necessary for evaluating their performance and assigning credit rating. The auditors of the company can audit the financial statements of the company easily if they are in accordance with the Australian accounting standard board as it helps them. The government agencies can get detailed and all the relevant information for the purposes of taxation, regulation and investigation of the company.    The performance of the management can be evaluated by the board of directors as it provides all relevant information.                           BIBLIOGRAPHY  Herring, G. 1998. The Beguiled: Misogynist myth or feminist fable? Literature Film Quarterly 26 (3): 214-219. Craton, M. and G. Saunders. 1992. Islanders in the Stream: A history of the Bahamian people. Athens: University of Georgia Press. The Australian Vintage limited, 2008 Australian Vintage Ltd, 13 Joynton Avenue  Zetland NSW 2017 Australia, Viewed 6th may, 2010. Positive Accounting Theory,(n.d) chap7, viewed on 10thMay 2010 (http://docs.google.com/viewer?a=v&q=cache:YeHGWiRR3uQJ:www.download-it.org/free_files/Pages%2520from%2520Chapter%25207%2520Positive%2520Accounting%2520Theory-      d0385ad3b7925717c0b72a06b16de4f4.pdf+positive+accounting+theory&hl=en&gl=pk&pid=bl&srcid=ADGEEShqfryy5mb41oiOQnLLMl2E7lrep6Y2eoOtO3rivuIuvvFhbRLjexMAVAtFyCzQkuAnl6zOj6UNFt8gfXipaPWdRqVZno1-0ZgsKvdfE-RqZSbtsLuOsAf53Vx3NQEIESt2E6Lp&sig=AHIEtbTVPciaX8PYRswpVi6xHsy1kZig6w Satel, Sally. "OxyContin half-truths can cause suffering." USA Today, October 27, 2003, final edition, Lexis-Nexis, via Galileo, http://www.galileo.usg.edu Relationship between positive accounting theory and normative accounting theory (n.d), viewed on 10thApril 2010. http://www.docstoc.com/docs/10324082/Relationship-Between-Positive-Accounting-Theory-and-Normative-Accounting-Theory/ Read More