Financial Reporting, Positive Accounting Theory vs Institutional Theory - Assignment Example

Financial Reporting Name Institution Course Date Question 1A Accounting theory/theories are used for various reasons in the accounting world. They are used in explaining existing accounting practices for purposes of obtaining a better understanding of these practices. It provides a set of coherent logical principles forming general frame of reference for evaluating and developing sound accounting practices (Riahi-Belkaoui 2005, p. 164). The history of accounting theory development informs a good understanding of the current accounting theories and accounting practices. The main objective of accounting theory is provision of basic way of predicting and explaining accounting behavior and events. In the article ‘public losing confidence in capitalism’, positive accounting theory (PAT) is one theory that is relevant to the case. The focus of this theory is on the relationship between individuals providing resources to a firm. Example is between owners of companies and respective managers or organizational managers and providers of credit to a company. It assumes that self-interest drives the actions of an individual. The issue of remuneration structures is one issue that the article have brought up. Often, managers are remunerated based on some bonus scheme tied to the profitability and financial performance of a company. Positive accounting theory assumes that managers acts in a manner that serves their own interest (Yrjo et al., 2009, p. 146). Owners suffer the consequences of their managers’ actions. It has been argued in the article that remuneration of some managers are very complex and too high to the detriment of the company. PAT attempts to explain this phenomena through three hypotheses; bonus plan, political cost and debt/equity hypothesis (Collin & Tagesson 2009, p. 146). Bonus plan hypothesis asserts that those company managers having bonus plans are more likely to utilize methods of accounting which increases the reported income of the current period. Large corporations are assumed to be highly scrutinized- political scrutiny according to political cost hypothesis than small companies. Consequently, these companies tends to use accounting policies that reduces the profits in its financial statements. On the other hand, debt/equity hypothesis predicts that accounting methods that increases the income are more likely to be used by managers having high debt/equity ratio. Stakeholder theory is brought up in the article through capitalism contributions to the society. In this case, organization is seen as affecting the society it operates in and at the same time is affected by it (Jensen 2001, p. 208). Capitalism is seen as failing the society and the public has lost confidence in it. This brings up the issue of legitimacy theory. The legitimacy of an organization in the eyes of the public is cast into doubt when the core essence or policies it operates on is questioned by the public and its subsequent loss of interest in it. Legitimacy theory inform on the action by the public to lose confidence in the public interest because there is breach of ‘social’ contract between society and the organizations. It is expected that organizations takes corrective action when breached of social contract is perceived to have occurred or have taken place. This is in order to restore the confidence the public have in it. Public interest theory greatly features in the article. It asserts that regulation is introduced in order to benefit the entire society (Day 2001, p. 80). Regulatory bodies that oversees the affairs of the companies on behalf of the public are considered to be operating for its interest. This theory assumes that the government acts as a neutral arbitrator. The effects of financial crisis highlighted in the article is therefore expected to be mitigated by the government in order to restore its confidence in the public. In this case, organizations should work hand in hand with the government, regulatory bodies and other stakeholders to come up with solutions that are acceptable by all. In this globalized economy, it even becomes imperative that businesses closely work with all interested parties. This will help corporations in demonstrating its contributions to the public. Accounting theories inform or predicts various occurrences in the business environment. There is none that is accepted all over the world. It seeks to explain and predict accounting-related occurrences such as financial crisis, remuneration structures of companies and contributions of different types of market structures as in the article. All these issues are covered in the case study. It argues that the central role of accounting is provision of optimal accounting approach (es) and the reasons why it is optimal. Stakeholder theory, public interest theory, legitimacy theory and positive accounting theory have all been explore in the article. Issues such as loss of confidence in capitalism and free enterprise, contributions of capitalism to society and remuneration structures are all covered in the case. Furthermore, globalization and financial crisis are covered and which in turn are inform by the above theories. These theories inform on the actions described in the article by prescribing the manner in which solutions to the problems highlighted are going to be undertaken. It lays out the framework where the people concern can take action and mitigate the problems or avoid them. Question 1B. Fahour left hanging over pay Considering Mr. Fahour’s high pay rise, there are various accounting theories that are relevant for the committee to review in designing future regulation and guidelines in increasing salaries of employees. Positive accounting theory is one of the most important theories that can be used to analyze Mr. Fahour’s unethical situation in the company. The theory stipulates that there is concerned with managers predicting the correct choice accounting policies to be employed in reporting financial statement. The theory explains that managers can have a conflict of interest on the use of accounting policies with an aim of gaining material gains through increased bonuses and salaries (Smith & Koken, 2011). The essence of positive accounting theory is that it is introduced as a method to merge economic consequences with efficient market securities. Under, this case, managers act in the best interest of the company rather than for the owner of the company (shareholders). The theory is essential as managers’ uses efficiency perspective bonus plan to enable the earned more through using accounting methods that raise the current period reported income. The positive accounting theory with the bonus plan hypothesis stipulates that if managers are rewarded according to the measure of performance of the company such as end year according to income or profits, their managers will use accounting methods that attempt to increase profits which will considerably increase the general basic pay as in the case of Mr. Fahour. Positive accounting theory provides assumption that is well vested to Fahour case. Mr. Fehour is driven by self-interest and as acted in an opportunistic manner to increase his own personal wealth. Conversely, the theory provides avenues that may have contributed immensely to too high pay rise among managers like Mr. Fahour since the theory does not have the notion of morality and loyalty that would assist in deterring personal self-interest by managers (Aboody, & Kasznik, 2009). On the other hand, managers may be rewarded on fixed basis, on results achieved or on the basis that combines the two methods (Smith & Koken, 2011). Bonus schemes remuneration based on the firm output on accounting policies should be well managed to ensure that managers do not use it as a way of exploiting the shareholders of the income. Therefore, bonuses based on sales, profits of the firm and return on assets employed in paying bonuses to managers should be guided by accounting standards and policies to avoid malicious exploitation by managers on the firm profitability like in the article. In this case, auditors are entitled to undertake monitoring roles and ensure that the information they are reflecting on the financial statement is true and fair and present information faithfulness. Other hypotheses of positive accounting theory that explain accounting practices that managers use to gain their self-interest earning includes equity and political cost hypothesis. Equity hypothesis predicts that managers may manipulate equity ratio of the firm to be higher so as to use accounting methods that successively increase their income and which in the long run will definitely lead to superannuation during retirement as witnessed in Mr. Fahour case. Under political cost hypothesis, it stipulates that firms subjected to a higher level of political scrutiny are more likely to engage accounting choices that reduce accounting profits. As in the case of Mr. Fahour Company, there is a likelihood that the company has a low level of political scrutiny that led to the high endowment of earning to Mr. Fahour. Generally, accounting for employees’ benefits should be considered a critical factor in the firm (AASB 119 (par. 7). Proper accounting method should be followed in calculating and evaluation employee’s salaries and benefits which should reflect transparency and accountability of the firm assets and human resources. Question 2. AASB 13, (par 9) defines fair value as a price consideration that would be received in selling an asset or price paid to shift a liability in a justified and orderly transaction at a measurable date between different market participants. In Handy Limited, the current exit price in different markets includes; market A, $ 150,000; market B, $ 146,000 and market C, $ 156,000. The three market participants meets the required criteria, that is it is independent from each other, have ability to enter into a transaction and a willingly to engage in the transaction. Transport and transaction costs are costs incurred by Handy Limited in the process of availing the assets in the principal market and exchanging ownership by receiving the agreed amount of consideration in monetary terms. The cost incurred to carry an asset from its current location to the principal market where the transaction of selling will occur in this case is referred to as transport cost whereas transaction costs are additional direct costs in the decision to sell the assets. Transaction and transport cost has been used to determine the most advantageous market (Market C, with the pricing of assets at $ 156,000). The valuation technique that is adequate to Handy Limited for measuring its assets fair value is marketing approach. This method is appropriate since it uses information from market transaction and prices for comparison of asset fair value. In applying this method, the first step is to collect necessary information relevant in valuing the asset as represented in the table below. Under this stage, it is necessary to consider a number of factors including the location of the asset, condition of the asset, legal restriction if any, and whether the assets stands-alone or they stand in a group. The assets to be considered in the three markets are stand-alone assets. The second phase is to determine the best basis for assessment in which we take into account the highest fair value and the best use of the asset. The uses of the assets must be legal, physically possible and financially viable. However, determination of the best use of the asset depends on perspective market participant and the asset will be sold individually not as a group of assets although it will be later be used by market participant in collaboration with other assets. In this case, market participant will obtain significant benefits through using the asset on a stand-alone basis. The third step is to evaluate the most advantageous market. Fair value measurement assumes that the business deal took place in the most advantageous market; that is the market that maximizes returns after payment transportation and transaction costs (Mard, Hitchner & Hyden 2011, p. 221). For this case, the most advantageous market is market C with returns on pricing at $ 144,000 as compared to market A and B with $142,000 and $ 136,000 respectively. The fourth step is determining the appropriate valuation technique. As mentioned earlier, market approach is adequate for the valuation of Handy Limited fair value of assets. The main objective of this approach is to estimate the price at which organized transactions would take place between market partakers (AASB 13, par. 61) (Epstein, Nach, & Bragg 2007, p. 169). Marketing approach has been considered because of its appropriateness to the Handy Ltd scenario, adequate data available necessary to be used in this method including prices, transaction and transport costs. The fifth step is prioritizing inputs for valuation in order to achieve comparability and consistency of the assets using hierarchy of inputs (AASB 13, par. 63). There are three levels of inputs. Level 1 input consists of quoted prices in the active market (market A, $15,000; market B, $ 146,000; and market C, $ 156,000). Level 2 inputs that are necessary for valuation of fair value of the firm includes inputs that are directly or indirectly quoted other than quoted prices. In our valuation, it includes transaction and transportation costs which directly impact on asset valuation of fair value. The next level, 3, entails inputs that are unobservable although it is attributed to the assets. Under this scenario, earnings and cash inflows of previous based on firm’s data can be attributed to this level of inputs. The ultimate step concerns with determining the fair value of the assets based on steps earlier outline. The computation is as follows; I). Handy Limited Market Data. Market A Market B Market C Annual market volume of the asset 60,000 24,000 12,000 Price 150,000 146,000 156,000 Transport cost 6,000 6,000 8,000 Transaction cost 2,000 4,000 4,000 a). Assuming that the principal market is market C, of which Handy Ltd trades 60% of the assets, is the principal market; then the fair value would be $ 156,000, since the fair value is the price in the principal market for Handy’s asset. b). Assuming that there is no principal market, and the assets are exchanged equally in all markets. Then the fair value would be the price in the most advantageous market which is calculated in the table that follows. Market A Market B Market C Price 150,000 146,000 156,000 Less Transport cost 6,000 6,000 8,000 Less Transaction cost 2,000 4,000 4,000 Fair value price 142,000 136,000 144,000 From the computation in the table, Handy Ltd would receive a price of $ 142,000 (150,000-6000-2000) in market A, $ 136,000 (146,000-6000- 4,000) in market B and $ 144,000 (156,000-8,000- 4,000) in market C. Therefore, Handy Ltd would maximize the price in Market C for its assets, and thus market C would be considered the most advantageous market to be used. The fair value price 156,000 would be the fair value of the assets. Disclosure of information that will enable users to make an accurate decision as stipulated in AASB 13 (par. 65) is important to highlighting areas such as the technique of valuation and levels of inputs that have been used in the process of measurement of assets. In this case, the financial statement of Handy should reflect the use of marketing approach techniques in the measurement of the fair values of the assets. In addition, the any unobservable inputs (level 3) should also be exposed to show the effect of measurement on a comprehensive income statement. References Aboody, D. and Kasznik, R., 2010. Executive compensation and financial accounting. Foundations and Trends® in Accounting, 4(2), pp.113-198. Collin, Sven-Olof Yrjö, Torbjörn Tagesson, Anette Andersson, Joosefin Cato, and Karin Hansson. "Explaining the choice of accounting standards in municipal corporations: Positive accounting theory and institutional theory as competitive or concurrent theories." Critical perspectives on Accounting 20, no. 2 (2009): 141-174. Day, R., 2001. The ‘public interest’in the context of accounting regulation. In Contemporary issues in accounting regulation (pp. 79-94). Springer US. Epstein, B. J., Nach, R., & Bragg, S. M. (2007). Wiley GAAP 2008: interpretation and application of generally accepted accounting principles. Hoboken, N.J., Wiley. Jensen, M., 2001. Value maximisation, stakeholder theory, and the corporate objective function. European financial management, 7(3), pp.297-317. Mard, M. J., Hitchner, J. R., & Hyden, S. D. (2011). Valuation for financial reporting: fair value, business combinations, intangible assets, goodwill, and impairment analysis. Hoboken, NJ, Wiley. Riahi-Belkaoui, A. (2005). Accounting theory. London: Thomson. Smith, B., & Koken, E. (2011). The Superannuation Handbook 2008-09. Hoboken: John Wiley & Sons. Read More