Financial Accounting Theory - Assignment Example

Financial Accounting Theory What is the purpose of financial accounting theory? Are you a positivist? Explain why you agree or disagree with positive accounting theory. The purpose of financial accounting theory is broad and complex, spanning an array of issues. One of the most overarching perspectives is that financial accounting theory allows for deliberations and insights to be developed regarding more effective and efficient accounting practices. Within this context of understanding there are a number of theoretical elements, oftentimes competing, as to the proper nature of accounting progress. One of the prominent implementations of accounting theory is in terms of developing normative standards. In these regards, accounting theory functions as a means of legitimizing the discipline of accounting in that articulates standards and regulations that establish public faith in the process (Deegan & Unerman 2011). Specific instances such prescriptive theories are implemented can be witnessed in terms of assets, wherein normative theories explore how these elements should be recorded (Deegan & Unerman 2011). Another such instance is prescriptive standards regarding the amount of accounting information that should be supplied to various stakeholders. In addition to normative accounting theories, there is also predictive or positivist accounting theories. Positivist theory seeks to develop predictive insights based on objective occurrences. There is an array of positivist perspectives. For instance, it’s noted that positivist theory seeks to make predications regarding the nature of managerial compensation and accounting practices (Deegan & Unerman 2011). In these ways positivist accounting theories function both to allow investors or stakeholders increased insight into accounting motivations, as well as a means of gaining a broader understanding of financial markets as a means of contributing to more accurate normative structures. There are a number of concerns related to positivist accounting theory. To an extent I would say that I am a positivist. The notion of positivist accounting is linked to philosophical notions of theory. While one of the central tenants of positivist accounting theory is that markets are efficient, clearly this constitutes a weak version of the EMH as contained within it is the notion that corporations and accountants will act in self-interest contingent upon at times a partial understanding that accounting procedures will affect market conditions (Tinker, Merino, and Neimark 1982). I accept the notion this weak notion of EMH, with markets responding to all available information, but also recognize that in many situations human behavior plays a highly important role in security valuations. Not simply in investor behavior, but also in the self-interested behavior of accounting professionals. Considering that markets are oftentimes driven by external and internal behavioral elements the propensity of a positivist approach to accounting theory, while to a great degree fallible, nonetheless holds the propensity towards tangible and functional insight (Chua 1986). In these regards I believe that positivist theoretical explanations of accounting practices and market conditions are essential to a progressive understanding of both human behavior and market impact. Ultimately, a furthered understanding, while understandable imperfect, can still contribute to more equitable and transparent accounting practices. In these regards, I while I would not entirely refer to myself as positivist; I recognize the importance and effectiveness of positivist theory to the accounting profession. 2. Explain why you think regulation of financial accounting is needed or not needed. Recent occurrences in financial markets have brought to light the tremendous need for regulation of financial accounting. From an overarching qualitative perspective, one considers erroneous accounting procedures in organizations such as Enron, or the recent MF Global scandal wherein customer funds were inappropriately implemented in speculation of European debt. These situations not only presented a negative impact on the corporation itself, but tremendously impacted stakeholders and regular main street investors. The impact of these scandals resulted in the Sarbanes-Oxley financial regulatory measures, as well as Dodd-Frank as a means of market reform (‘Sox 404’, 2010). To a large degree the need for financial accounting regulation can be linked to the nature of the market. Indeed, it’s noted that private organizations are not required to disclose financial information. As a corporation enters the public markets its valuation is largely capital driven. Without accurate financial reporting the only individual’s with accurate accounting records will be those with internal connections to the organization, essentially creating a system where securities exchanges are dramatically slanted towards insider information, essentially limiting investment to corporate elite (Grey 1998). In this context of understanding, the very cornerstone of the Western financial system is contingent upon accurate financial data (Anderson-Gough, Grey and Robson 2002). Without regulation, organizations would be free to distort annual reports and balance sheets as a means of gaining an unfair capital valuation in the marketplace. Such procedures could potentially create situations where large-scale financial bubbles occur, as investors pile money into securities without accurate financial data. The subsequent effect of these processes can readily be witnessed in the United States where as overvalued housing assets created a bubble that when popped threw the entire Western world into financial recession. While there is considerable evidence supporting the need for financial accounting regulation, it’s recognized that there are a number of detractors to these measures. One of the most prominent such consideration is in terms of the recently passed Sarbanes-Oxley 404 Assessment of Internal Controls. In requiring corporations to develop mechanisms of determining accounting efficiency, Sarbanes-Oxley 404 placed significant financial burden to achieve corporate compliance (Sarbanes-oxley section 404, 2008).; this resulted in disproportionate financial burden on companies with smaller profit margins (‘Fei survey’ 2007). Indeed, the argument that increased regulation results in increased costs is a prominent position taken against regulation. Added to this are perspectives, including economic and private interest theory, that regulation is not an objective process, but instead necessarily biased. While these arguments are to an extent viable, they ultimately fail to demonstrate that society would benefit from unregulated accounting practices. Still, opposing positions demonstrate that blanket accounting regulation is not only unneeded but also at times counter-productive. In these regards, accounting regulation practices should occur with proper consideration of the financial burden it places on corporate entities, as well as the understanding that regulation is largely subject to partiality and political influence. Ultimately, it’s clear that financial regulation must occur as it accurate accounting is a cornerstone of functioning securities exchanges; yet, like the legal system, proper care and conservative diligence needs to be placed into the establishment of effective and efficient measures. 3. Do you think that conceptual frameworks are useful? Why do you think they exist? One of the most overarching notions in terms of accounting theory is that of the conceptual framework. While there are a number of imperfections, conceptual frameworks are useful in part because they establish models and approaches to accounting standards (Accounting Standards Board 1999). Indeed, one of the prominent definitions of accounting theory notes that conceptual frameworks are a system of interrelated elements than come together to form regular standards (Deegan & Unerman). In further considering conceptual frameworks one comes to recognize that they are essential elements of both normative and positivist accounting theory. Considering their importance to normative theory the conceptual framework establishes the very nature of the context of consideration. While individuals may believe accounting to be objective, in practice it is highly malleable and subject to human manipulation. A conceptual framework that is geared towards corporate profits would include normative regulatory measures that encourage more favorable asset valuations; conversely, a conceptual framework geared towards equitable market knowledge would encourage normative standards more akin to the corporation’s current and future security valuation. In terms of positivist theory, conceptual frameworks function as a means of motivating the very nature of the predictive research. There are a number of reasons that conceptual frameworks exist. The most obvious is that they motivate the very nature of accounting theory. In these regards, it would be possible for to substitute the notion of the conceptual framework with that of ideology. While ideology has garnered a negative connotation, assuming an ideological position is essential for a functioning social order. In the context of accounting practices conceptual ideology operates as a means of establishing the framework wherein future normative standards can be developed. It’s recognized that this is an imperfect process. One considers Popper’s perspectives on falsification, as the normative impulse is subject to continual augmentation or supplementation. Still, the conceptual framework exists as the linkage between the political apparatus – British Parliament, United States legislature – and economic policy. One considers that in large part criticisms of conceptual frameworks have been levied not against the larger notion of a conceptual framework, but rather its ideological nature. For instance, Bryer (1999) rejects the Financial Accounting Standards Board’s (FASB) conceptual framework based on Marxist notions. Even while Bryer criticizes the FASB conceptual framework on the grounds that it is vague and ahistorical encroached in his criticism is the ideological notion that a Marxist framework is more ethical than the capitalist model. Hines (1988) supports this very notion of the conceptual framework as informing reality, as she argues that in communicating reality, we construct reality. The central thorough-put in this notion is simply that conceptual frameworks exist to express the overarching ideological goals of society. Ultimately, whereas normative theory works to implement this framework, the ‘concept’ is the politicized structure that drives it. 4. What are ‘systems-oriented theories’? Do you think these theories are useful in explaining how financial accounting is practised in society? Systems oriented theories are those that examine the interaction between corporations, the State, and stakeholders. They are similar to positivist theories in that they have a degree of predictive consideration in terms of organizational functionality. For instance, consider that systems-oriented theories have been articulated as a, “view of the organization and society…permits us to focus on the role of information and disclosure in the relationship(s) between organisations, the States, individuals and groups” (Deegan & Unerman 2011, p. 320). In this context of understanding, while positivist theories more broadly work to consider predictive patterns of accounting, systems-oriented theories contain a normative element in that they also consider the ethical interaction between stakeholder and corporation. There are a number of prominent systems oriented theories, including legitimacy, stakeholder, and institutional theory. Legitimacy theory argues that corporations seek to develop practices and accounting standards that demonstrate they are in compliance with social norms. Stakeholder governance theory examines the interaction between the corporate entity and the various stakeholders, with prominent consideration given to normative information concerns regarding information disclosure, as well as investigations into the extent that stakeholders influence or shape management decisions. Finally, another major systems oriented approach is institutional theory, which examines the nature of institutional homogeneity or the lack thereof (Zucker 1987). Ultimately, these approaches examine the internal and external impact of environmental forces on the organization. There are various degrees in which systems oriented theories are useful in explaining how financial accounting is practiced in society. To a large extent it appears that systems oriented theories play more descriptive than actual function roles in explaining financial accounting. For instance, legitimacy theory, while emerging in a degree of accounting measures, is perhaps more appropriately linked to advertising, marketing, and product design strategic measures. Still, in certain situations it’s clear that legitimacy theories are highly useful in explaining accounting practices. One of the most prominent examples occurs in companies that have had an oil spill. Patten (2002) notes that social and environmental statements can be a corporation’s means of indicating to the public that they are functioning under legitimate conditions. In this context of understanding, it’s clear that systems oriented theory is clearly useful in explaining such accounting practices. The systems theoretical explorations into the corporation and stakeholder relationship appear to contain a number of useful insights into the nature of accounting practices. For instance, Clement (2005) argues that while individuals are oftentimes initially influenced by their educational background and personal values, the organizational influence becomes so strong that they succumb to institutional influence. One considers the applicability of this information to investment practices as shareholders analyzing financial statements come to recognize the institutional and subjective nature of organizational accounting procedures. While stakeholders may influence these organizational approaches to accounting, it still appears that the more useful applicability of this theoretical approach is in regards to strategic management operations. This makes the usefulness of stakeholder theory to the determination of actual accounting measures of limited use. 5. Do you think environmental and social accounting is useful? Back up your reasons with evidence. There are various degrees to which environmental and social accounting is useful. To an extent I am influenced by Milton Friedman who noted that, “The business of business is business” (Friedman 2002, p. ix). In these regards, Friedman is not indicating that there is no such thing as environment and social concern, but rather that businesses should operate in the spectrum of political regulation as a means of achieving greatest profits. For Friedman this constituted social responsible business practices as it contributed to economic growth and GDP that could then be implemented in environmentally responsible ways (Friedman 2002). To an extent then environmental and social accounting practices carry with them a degree of pandering. Such perspectives on social accounting as pandering or ‘spin’ are supported by research such as Owen, Swift, and Hunt (2001). Still, it’s also clear that to a great extent social and environmental accounting procedures can contribute to stakeholder value. Indeed, this is exactly what corporations such as Ben & Jerry’s have been able to leverage into brand identity. To this extent social and environmental accounting is useful in that it serves the indirect purpose of developing brand identity and large-scale emotional appeal. One must also consider the nature of this practice as oftentimes taking environmental and social change out of the hands of government entities and into the hands of individuals who purchase the product. This is reflected in studies such as Adams, Hill, and Roberts (1998) that indicate that although legitimacy theory can be used to explain differences within sectors and industries, different approaches across countries are a much more challenging issue. In these instances it seems that differences in social and environmental accounting practices across countries are motivated out of varying degrees of public desire to remove such decision making from the government apparatus. Dey, Owen, Evans, and Zadek (1997) consider social accounting more in terms of specific metrics. One considers that such accounting practices could be highly useful if normative regulations were placed on them as a means of determining the true extent that the organization engages in socially responsible practices. Citizens and governmental organizations could then use these metrics alike when attempting to determine the value of the organization to the great society. Such metrics are also considered in research by Gray, Kouhy, and Lavers (1995). Mathews (1997) also refers to the normative period of social and environmental accounting. Still, other theorists, such as Everett and Neu (2000) view the issue from a different paradigm – namely that of environmental modernization movements – and argue that social and environmental accounting procedures may actually be harmful to corporate social responsibility measures. In this context of understanding the argument is that environmental modernism – a movement linking profit gain to environmental responsibility – has normalized corporate responsibility to the extent that nearly all accounting and strategic measures can be cloaked in corporate responsibility patterns; it’s argued this has actually created an environment that stagnates progressive corporate social policies. Gray (2000) argues along similar lines. 6. Do you think capital market research is useful? Your explanations should include the limitations of such research. Similar to the other accounting theories the capital market research approach demonstrates varying degrees of usefulness. Considered from an overarching perspective capital market research implements statistical research in establishing connections between equity value and market information. (Deegan & Unerman 2011). The usefulness of such research is clear, as there are a number of pervasive factors that have been determined to noticeably influence equity value. In this context of understanding some of most prominent uses of capital market research are in understanding the links between earnings statements, mergers and acquisitions, awards, government announcements, and changes in management with that of equity valuation (Kane 2008). From an investment perspective such information is highly useful as it can be factor into the capital asset pricing model as a means of mitigating portfolio risk (Luenberger 1997). Such considerations also play into arbitrage, as value investors seek investment opportunities wherein they purchase undervalued equities for later profit. In these situations capital market research can contribute to a greater understanding of the processes between market efficiency and valuation, creating potential situations for investors to capitalize on inefficient market responses (Subrahmanyam 2001). From a more foundational perspective one considers that the very nature of public accounting disclosures are to ensure that stakeholders have equitable access to an organization’s true value. One comes to recognize that if there is no link between the financial accounting elements and capital market moves then the very nature of accounting would prove to be superfluous. As this is clearly not the case, capital market research is useful as it explores the very bounds of useful market data (Statman 2002). This has profound implications for nearly all fields of corporate accounting, as accounting regulations are designed with notions of market implications in mind. Indeed, specific research has revealed linkages between the very forms in which the data was released, with footnote disclosure containing less of an impact (Statman 2002). Similarly, it’s been demonstrated than revenue growth affects share prices more than cost reduction. Ultimately, this not only makes capital market research useful, but a fundamental exploration into the very confines and conditions for functional market systems. While there are undeniably useful elements gained from capital market research, there are also a number of limitations. One of the most pervasive limitations emerges in terms of understandings regarding efficient markets. Briefly, the efficient market hypothesis argues that investors rationally and efficiently respond to all available market data (Fama 1992). While capital market research has demonstrated the at least partial viability of EMH, the growing discipline of behavioral economics has demonstrated that markets are oftentimes driven by irrational exuberance (De Brouwer 2009). In this context of understanding, the direct and efficient link between financial accounting data and market valuations is potentially obscured by whims of human behavior. Even if the market does respond to financial data, it’s possible that there could be a delay between the data’s release and subsequent shifts in valuation (Mullins 1982). In these regards, developing accurate links between accounting data and market valuations could be impossible. Ultimately, while capital market research has shown clear usefulness there are a number of shortcomings in terms of its overall effectiveness. References Accounting Standards Board, (1999) Statement of Principles for Financial Reporting, Milton Keynes : Accounting Standards Board. Adams, C. Hill, W. Roberts, C. ‘Corporate social reporting practices in western Europe’. British Accounting Review (1998) 30, 1–21 Anderson-Gough, F., C. Grey and K. Robson (2002). "Accounting Professionals and the Accounting Profession: Linking Conduct and Context." Accounting and Business Research 32 (1): 41 - 56. Bryer, R.A. (1999) ‘A Marxist Critique od the FASB’s Critical Framework’. Critical Perspectives on Accounting. 10, 551-589 Clement, R. (2005). ‘Lessons from stakeholder theory for U.S. business leaders’ Business Horizons 48, 255—264 Chua, W F. (1986) Radical developments in Accounting Thought, The Accounting Review, vol. LXI, No. 4, October. Deegan, C. & Unerman (2011) Financial Accounting Theory, 2nd edition. McGraw Hill. De Brouwer, Ph. (2009). "Maslowian Portfolio Theory: An alternative formulation of the Behavioural Portfolio Theory". Journal of Asset Management 9 (6): 359– 365 Dey, C. Owen, D. Evans, R. Zadek, S. (1997) ‘Struggling with the praxis of social accounting’ Accounting, Auditing & Accountability Journal, Vol. 10 No. 3, 1997, pp. 325-364. Everett, J. Neu, D. (2002) ‘Ecological modernization and the limits of environmental accounting?’ Blackwell Publishers Ltd. Fama, Eugene F. (1992). The Cross-Section of Expected Stock Returns. Journal of Finance, June 1992, 427-466. Fei survey: Average 2007 sox compliance cost $1.7 million. (2007). Retrieved from http://fei.mediaroom.com/index.php?s=43&item=204 Friedman, M. (2002) Capitalism and freedom. University of Chicago Press. Gray, R. (2006). ‘Social environmental and sustainability reporting and organizational value creation?’ Accounting, Auditing & Accountability Journal Vol. 19 No. 6 Gray, R. Kouhy, R. Lavers, S. (2002)‘Corporate social and environmental reporting’ Accounting, Auditing & Accountability Journal, Vol. 8 No. 2 Grey, C. (1998). "On Being a Professional in a Big 6 Firm." Accounting, Organizations and Society 23 (5/6): 569 - 587. Hines, R. (1988) ‘Financial accounting in communicating reality’ Accounting. Organizations and Socie!y,Vol. 13, No. 3, pp. 251-261, 1988. Hunt, K. Owen, D. Swift, T. (2002). ‘Questioning the role of stakeholder engagement in social and ethical accounting, auditing, and reporting’. Blackwell Publishers Ltd. Kane, A. (2008). Investments (7th International ed.). Boston: McGraw-Hill. Luenberger, David (1997). Investment Science. Oxford University Press. Mathews. M.R. (1997) ‘Twenty-five years of social and environmental accounting research Is there a silver jubilee to celebrate?’ Accounting, Auditing & Accountability Journal, Vol. 10 No. 4 Mullins, David W. (1982). Does the capital asset pricing model work?, Harvard Business Review, January–February 1982, 105-113. Patten, D. (1992). ‘Intra-industry environmental disclosures in response to the Alaskan oil spill.’ Accounting Organtzatlons and Soctety,Vol. 17,No. 5,pp. 471-475 Sarbanes-oxley section 404:.(2008). Retrieved from www.theiia.org/download.cfm?file=31866 Sox 404 reduces financial misstatements. (2010). Retrieved from http://www.accountingtoday.com/news/SOX-404-Reduces-Financial- Misstatements-56057-1.html Statman, M. (2000). "Behavioral Portfolio Theory". Journal of Financial and Quantitative Analysis 35 (2): 127–151. Subrahmanyam, Avanidhar (2001). "Overconfidence, Arbitrage, and Equilibrium Asset Pricing". Journal of Finance 56 (3): 921–965. Tinker, A.M., Merino, D.V. & Neimark, M.D., “The Normative Origins of Positive Accounting Theory: Ideology and Accounting Thought”, Accounting, Organizations and Society, vol.7, no.2, 1982, pp.167-200. Zucker, L. (1987) ‘Institutional theories of organization’ Ann. Rev. Sociol. 1987. 13:443- 64 Read More