Accounting in Operating the Ontology and Epistemology Research Program Successfully - Literature review Example

Running Head: ARTICLE CRITIQUE Article Critique Name: Institution Course: Lecturer: Date: Introduction Accounting is a system that comprises activities related to measurements as well as recording of various economic and financial data regarding an organization. The processing of data yields information that is applied by a number of stakeholders (users) in making informed decisions. Various sources define accounting as an art that record, classify and summarise transactions and events in a significant manner that aids in interpreting the results thereafter. Summary of the Article The review focuses on positive approach regarding accounting research. According to the review numerous deficiencies pertaining positive accounting research exists. Such deficiencies bar positive accounting research to be relied up in the wider project. The paper examines both ontology and epistemology regarding positive research and hence holding position that the research falls short of the requirements to conduct research program successfully. Several suggestions have been offered by the review which includes a need to invent better theoretical models, better measurements of the existing models, the need to shift focus in testing the hypothesis in estimating the parameters, a need of maintaining data archives as well as use of theoretical frameworks as per the world experience. Research Question Does the current practices of accounting-research falls short of what is required to operate ontology and epistemology research program successfully? Theoretical Framework Modern research related to positive accounting theory started to gain momentum in the 1960s after transformation of empirical finance methods to financial accounting. According to Scott (1997), literature adopted contains assumptions that accounting numbers yield information applicable in security market investment, to investigate relationship between market and stock prices. This perspective (information perspective) has shown how the market relies on accounting numbers. However, the perspective has not fully provided a hypothesis in which accounting choices can be predicted and explained. It has not also explained the reason why companies switch from straight-line-method of depreciation in absence of tax depreciation methods. Kabir (2011) asserts that, in order to successfully predict as well as explain accounting choices, it was ideal to introduce both information and transaction costs. The traditional empirical studies of accounting opted to use positive agency costs (related to debts and compensation-contracts), positive information as well as lobbying costs within the political process aimed at generating value effects; hence developing hypotheses pertaining accounting choice. The finance researchers introduced costs on debts (which increased as per debt equity ratio) to explain the variations of optimal structures across the industries. In this line of thought, Kabir (2011) points that the main costs attached to debt were agency as well as bankruptcy costs. Agency costs were of meticulous interest to accounting because of their nature of reducing debts. Debts contracts aimed at subsidizing dysfunctional behaviour via the use of accounting numbers. As a result, researchers started recognizing the positive effects of accounting choice and started to apply it in debt contracts by generating hypotheses regarding accounting choice. The basis of accounting is also applied in manager’s compensation-contracts. It is hypothesised that application of positive accounting minimizes the agency costs. The use of accounting numbers in resolving bonus plans suggested utmost possibilities that accounting choice could impact on wealth. Therefore, accounting researchers began applying that use to give details about accounting choice. The Significance and Limitations of the Article Contracting costs are rampant in market transactions. For instance, while selling new debts and equity, the process requires legal-fees and underwriting costs. Secondly, the costs are found within the firm’s internal transactions, for example, cost-based transfer price-schemes that are expensive to maintain, which can cause dysfunctional decisions. Thirdly, the costs are attached to political process transactions such as securing government contracts. Contracting costs contain other costs such as brokerage fees, information cost, renegotiation cost as well as agency costs. According to Watts & Zimmerman (1978), the fact the contracting costs exists is quite important to contemporary organizations and accounting choice. Generally, lack of an overall market price is wholly replaced by systems through which decisions are allocated to managers; measuring, rewarding as well as punishing managers in respect of performance. Accounting plays important role within all these systems and is considered part of the organization’s efficient contracting technology. In fact, applying efforts to either explain or predict the organization’s operations in absence of contracting costs is baseless. The overall organising process of the firm, its financial policy to the accounting methods, forms part of the main technology applied to produce the organisation’s products within the production circles. Scott (1997) acknowledges that the extent by which accounting choices impacts the wealth of contracting parties highly depends on magnitudes of contracting costs; for instance, assuming that accounting-based debts agreements possess higher renegotiation price than accounting-based bonus arrangement. Then, the mandatory changes of accounting procedures introduced by FASB (Financial Accounting Standard Board) impose higher relative costs to organisations with debt arrangements than on organisations with bonus plans (ceteris Paribus). Moreover, organisations with debt arrangements will lobby more as well as undertake expensive accounting, to undo the impacts of mandatory change than organisations with just a single bonus plan. This means that developing a positive accounting choice necessitates thorough comprehension of relative magnitudes regarding various forms of contracting costs. According to Mian & Smith (1990), despite the use of accounting numbers on contracts, the interest of managers and contracting parties are not met, if managers have discretion over reported accounting numbers. If managers have the know-how of the accounting methods that best works for subordinates, then the parties to a contract may want the managers to have some discretion over accounting numbers. Hence, it is expected that some restrictions should be exercised on managers over the accounting numbers. However, Mian & Smith (1990) states that some discretion is exercised in some situations. First, the exercise if carried out is aimed at maximising wealth of all the parties. Secondly, by exercising the discretion, such acts make the manager or the organisation better-off than another contracting party or a number of parties. In case the manager exercises the discretion to his advantage (ex post) or to favour himself, and happens that his actions results to adverse effects on the contracting parties, he is deemed to act opportunistically. Kabir (2011) asserts that developing restricted accounting choices is solely determined for efficiency reasons. One of the main reason why managers are mandated more discretion is the likelihood of ex post managerial opportunism; that is, transfer of wealth to managers, through the accounting procedures. However, through ex ante, contracting parties expect redistributive effects. This means that wealth is redistributed through managerial opportunism (ex post), but through ex ante, redistribution had been expected and therefore the parties protected themselves by adopting a price (Kabir, 2011). The accounting procedures through which managers exercise discretion is the ‘accepted set’. This is voluntarily determined by the participating parties. The managerial discretion pertaining accounting method choice gets predicted differently across the industries depending on cost and benefits regarding predictions. These restrictions bring about the best accounting principles even in absence of the accounting standards imposed by the government. The restrictions are further enforced by the external auditors. While reacting to incentive of managers in exercising accounting discretion opportunistically, accepted set include the term ‘conservative’ as well as ‘objective’ accounting procedures. A number of accounting choice studies hold assumption that managers apply accounting methods in the transfer of wealth to themselves and to the firm since they assume the companies observed contracts as received, and then directly determine their incentives. Some other studies hold assumptions that accounting methods exist for efficiency reasons. It is important to point out that no study have ever given a clear explanation regarding ex ante choice of accepted set and ex post choice of the accounting method from accepted set. According to Mian & Smith (1990), the accepted set pertaining accounting method forms part of the organisation implicit as well as explicit contracts which includes organisation’s capital structure, ownership structure as well as compensation plans. All the contracting provisions which include accounting policies are endogenous. The capital structure is directly related to compensation policy as well as accounting policy. However, this relation is not essentially causal. The changes pertaining capital structure do not led to changes in accepted accounting methods. Rather, with some changes in exogenous events, with an example of government deregulation, changes in contracting variables occurs. Moreover, Kabir (2011) points out that most studies on accounting choice tries to explain choice of single accounting method such as choice of depreciation of assets. Focus shun from multiple of accounting methods. Focusing on just a single method of accounting shrinks the overall power of tests. This is because focus is on how the combination of tests impacts earnings instead of impact on one specific accounting method. Some studies tries to explain the accrual concept; that is, the difference of operating cash-flows and earnings. Accounting for accruals sums to one measure which acts as net effect of accounting choices. However, the use of accrual basis of accounting as an aggregate measure regarding choice suffers from absence of control on potential nature of accrual without managerial discretion. According to Scott (1997), most accounting-choice studies applies three variable sets; those variables representing manager’s incentives to choose methods of accounting under bonus plan, political process as well as debt contracts. Variables related to bonus plan as well as debt contract are applied since they are observable. The three hypotheses used in this respect include bonus-plan hypothesis, debt-equity hypothesis and political cost hypothesis. Literature has tended to presume these three hypotheses to have been used by managers while behaving opportunistically. The bonus plan assumes that managers will tend to use accounting method which increases period’s reported income. In case the board members do not adjust to the method chosen, it is presumed that the selection will hike the present-value of bonuses (Scott, 1997). The debt-equity hypothesis do predict that the higher the organisation’s debt-equity ratio, the more the managers will use accounting methods which hikes income. If the debt equity ratio is so high, the tighter the organisation is to debts constraints. Consequently, Scott (1997) points out that if the organisation if too constrained in debts, the higher the probability of violation of the agreement. Managers exercising discretion through selection of income boosting accounting-methods relax the debt constraints and also reduce costs emanating from technical defaults. Mian & Smith (1990) asserts that political-cost-hypothesis presumes that large firms (especially multilateral corporations) are likely to apply accounting choices in the reduction of reported profits. Size is regarded as proxy variable in respect to political attention. The hypothesis contains assumption that is expensive for individuals to be informed of whether accounting profits acts as monopoly profits. There is also an assumption of contracting’ with others within the political process in enacting laws as well as regulations which enhance their welfare. Thus, rational individuals rarely get informed. In that respect, political process is construed as not different from the overall market process. Given the cost arising from both information and monitoring, managers get incentive to exercise discretion over the accounting profits. This make parties within the political process to settle for rational amounts pertaining ex post opportunism. In regard to bonus, debt as well as political process variables, the predictive model asserts that each organisation uses the common accounting-methods combination. The model containing little explanatory appeal is chosen. The alternative model however begs this question - what determines majority accounting choice? Watts & Zimmerman (1978) argues that it would be absurd to claim that a manager chooses the accounting procedures for his firm based on what others are doing. The main issue here is lack of alternative model that has greater explanatory power; not the lesser explanatory power of extant theory. This is because most of the research methods put across contains low explanatory power. Conclusion Positive accounting literature discovers a substantial number of empirical regularities pertaining accounting choice as discussed in the paper. However, critics raise issues surrounding research methods as well as philosophy of science. The methodology that has been used by critics combines economics, finance as well as science. This methodology is however not applicable in accounting. According to Watts & Zimmerman (1978), accounting theory cannot be discarded because of some minor inconsistent observations. Best theory is decided through a competition of meeting students’ demand. However, a perfect theory in accounting or science will never exist since researchers are normally influenced by their own values. To resolve this challenge, careful dichotomy should be carried out between both prescription and theory. Moreover, Mian & Smith (1990) argues that accounting is an activity exercised by individuals. Therefore, one cannot make up a theory which explain and predict the accounting phenomena by solely ignoring incentives of individuals who account. References Kabir, H. (2011). Positive accounting theory and science. Journal of CENTRUM Cathedra, Vol. 3, Issue 2, pp. 136-149, 2010. Auckland University of Technology. Auckland, New Zealand Scott, W. R. (1997). Financial accounting theory (Vol. 2, No. 0, p. 0). Upper Saddle River, NJ: Prentice hall. Watts, R. L., & Zimmerman, J. L. (1978). Towards a positive theory of the determination of accounting standards. Accounting review, 112-134. Mian, S. L., & Smith, C. W. (1990). Incentives for unconsolidated financial reporting. Journal of Accounting and Economics, 12(1-3), 141-171. Approaches to Accounting, Accessed on 13th April 2017, http://www.assignmenthelpsite.com/upload/2014/11/Accounting-Theories.pdf Read More