Positive Accounting Theory Based on the political cost hypothesis, discuss. Why large companies may engage in earning management The political cost hypothesis states that larger and more visible firm are like to adopt accounting policies which reduce their reports earning (or report lower profits) . Firm are motivated to reduce reported earning in order to avoid political costs, which enable may seek to transfer wealth from the company to its company’s wealth. e.g. trade unions- may seek to transfer wealth from the company to its employees, by demanding higher wages Consumer organization and watchdogs may seek to transfer wealth from the company to its customers, by calling for a reduction in prices Government may also transfer wealth from the company to other citizens by imposing special taxes (e.g. a mining tax on all firms in the mining industry) – or withdrawing subsidies. Political Cost Details Wage claims Transfer of wealth to employees, who may call for higher wages based on the banks’ reported profits Reduced interest rates, Transfer of wealth to customers, who may call for bank to fees etc. reduce fees and interest rates since they reported high profits Donations Transfer of wealth to community group, who may request banks to fund various projects since they have reported high profit Special taxes Transfer of wealth to government, who may regard the banks as highly profitable and therefore liable to pay a special tax ( in addition to the normal income tax paid by all other business) which can be used to fund welfare programmers. To avoid these costs, large companies may engage in earning management which enables them to report lower profits and appear less profitable. Reduced profitability lowers the risk of unwanted attention from trade unios, customers, government and the community. Two methods of earning management which they use as part of earning management, firms may use discretionary accruals or they may time their transaction ( e.g. dispose of non-current assets which are expected to generate a loss on sale) - Discretionary accruals include items like depreciation, doubtful debts, cost of goods sold and inventory obsolescence. - Companies can change their depreciation method, percentage of doubtful debts, inventory valuation method or percentage for obsolete inventory. This action can increase expenses and lower reported earning Ruby Ltd has taken a loan from a commercial bank. Using agency theory, discuss two conflicts which may arise between Ruby Lid the bank and suggest how the bank could seek to minimize these conflicts Agency theory - Theory explaining the relationship between principals (shareholder) and agents (manager). Principals appoints agents to manage resource and make decision on their behalf, but it is assured that both groups to be self-interested and can lead to conflict due to divergence (non-alignment) of interest and manager access more information than shareholders (informant asymmetry) (the bank is the principal and Ruby is the agent) > agency problems of Debt Conflict Datils Excessive Dividends Repones Ruby may use cash to pay higher dividends. However, this may reduce her ability to meet loan repayment Claim Dilution After receiving the loan, Ruby may take another loan and give the second loan a higher priority for repayment. This would reduce the claim of the first lender. Asset Substitution After receiving the loan, Ruby may use the funds in a project with a higher risk profile than the one stated on the loan application. Hence the bank is inadequately rewarded for the risk involved i.e. it would have charged a higher interest rate if it had all the information in advance. Underinvestment If the firm is in financial distress, Ruby may reject investment projects with positive NPV since all cash flow will be used to pay off the bank and other creditors Impose a maximum dividend payout ratio to limit excessive dividend. Impose a maximum debt ratio to limit additional loans. Take first chare (priority) for repayment. Take security (collateral) over the asset which it has funded Apply to the court to appoint an official receiver or liquidator, who will protect the creditors interests Agency Problem of Equity Problem Explanation Repones Dividend Retention Shareholders would refer higher dividends if they can re-invest cash for higher returns elsewhere in the market. However, managers may be reluctant to pay dividends because they want to retain The CEO’s contract should specifically link bonuses to the dividend payout ratio (DPR) and specify the minimum acceptable Risk Aversion cash for their own perks and/or to build empires Shareholders would like managers to take on risky projects which are more likely to generate high return. However, managers are reluctant to take on risk because they cannot diversify their employment The CEOs contract should specifically link bonuses to firm profits an specify the minimum acceptable level. Bonus Plan Hypothesis Advantages Disadvantages Cash CEOs may respond positively to the opportunity of earning cash bonuses Shares CEOs are given shares to encourage them to think like shareholders and make decision which are in the best interest of shareholders Share options CEOs benefit from the upside risk but are protected from the downside risk Cash-based bonuses may encourage earning management which does not create any real or long-term growth for shareholders CEOs are not protected from downside risk e.g. if a CEO takes on a risky project which subsequently fails the may lose her job, reputation and value of her share-based bonuses may aggravate risk aversion in CEOs (to CEOs) it may take CEO several year to earn option-based bonuses. To reduce their lending risk, briefly outline: i. two conditions which commercial banks should include in their loan agreements with SMEs. - First claim on collateral/assets of SME - Restrictions on use of funds - Maximum dividend payout ratio - Maximum gearing ratio ii. the specific agency problems that each condition in (i) above is designed to reduce. - Claim dilution - Asset substitution - Excessive dividends Company X has recently appointed a new Chief Executive Officer (CEO). Apart from her base salary, she is also entitled to a bonus based on company profits i. Using Agency Theory, explain why the CEO is paid a base salary. It is assumed managers are risk-averse. As such, the CEO must be offered a reasonable base salary to take up the job. The base salary is not at risk but the bonuses are. ii. The CEO may try to maximize her bonus at the expense of the company’s long-term future. Suggest how shareholders can discourage such behavior. Introduce other performance indicators which are linked to long-term profitability. i.e. share price Together with this, the CEO can be offered share options. She will then be motivated to deliver an increase in share prices, which will benefit all shareholders, including herself. iii. Briefly outline how the CEO’s behavior will be constrained by the market for managers. If she is found to behave opportunistically in one organisation, this information will be passed on to other organisations. She will then face difficulty in finding alternative employment. As such, she will do her best to maintain a credible reputation by minimising self-serving behaviour Company Y provides telecommunication services throughout the country. It has reported profits in excess of $20 million for the last few years. i. Using the political cost hypothesis, predict how Company Y may reduce the threat of special taxes. It may adopt income reducing accounting methods to reduce profits. E.g. higher depreciation, higher estimates of doubtful debts ii. Apart from special taxes, briefly outline two political costs which may be imposed on Company Y. Employees may claim higher wages. Behavioral Accounting and Culture a) Explain how the use of the lens model can assist a user of accounting information in framing investment and lending decisions. The Brunswik Lens Model depicts the processes involved in making decisions. It represents the processes involved when people use information cues in a variety of ways, to come to a decision about future events. The Brunswik Lens Model also suggests that some of the cues might be interrelated. No individual cue is expected to provide a perfect predictor of the future event. Mathematical modelling is typically used when the Brunswik Lens Model is applied and it can be used to model the relationship between the information cues and the actual judgement made by the individuals (because it is a model, it will not perfectly predict the judgements of individuals). The approach can also be used to model the relationship between actual phenomena and particular information cues without explicitly involving individual judgements. The Lens Model can be used to investigate the use of inputs (for example, which information cues are used and whether they are perhaps influenced by how the data is presented), the decision process (for example, how various information cues appear to be weighted by the subjects) and the outputs (for example, how ‘accurate’ the decisions made by the subjects appear to be, or whether the judgements appear to be stable over time). Research has shown that investors and creditors judgement are represented well by a linear model and is more accurate in its predictions than the investor or creditor. b) On the next page (i.e. page 6), there are 2 graphs. i. Identify and explain two ways in which the graphs are misleading. Masking a declining trend – The graph masks the magnitude of the declining trend because the vertical axis begins at -$1000. As a result, the change in the heights of the bars depicts a decline in net income of approximately 25%, whereas net income declined by almost 39%. Reverse Chronological Order – Although financial statements do sometimes present tables in which the most recent year’s data is on the left, we normally expect that graphs to proceed from left to right. The graph here conveys data in reverse chronological order, creating the impression of an increasing trend, only after reading the labels on the horizontal axis does the viewer realise that the initial impression is wrong. Exaggeration of an increasing trend-Changing the beginning point of the vertical scale affects the visual presentation of an increasing trend. The vertical scale begins at $1000, altering the vertical scale origin exaggerates the visual magnitude of the change in the data. Creates a visual impression that net income has increased significantly. ii. Explain two ways in which graphs may communicate information more effectively than text. Graphs: Helpful 1. To provide a broad overview i.e. `big picture’ 2. To show trends 3. For inexperienced users Limitations 1. May be distorted 2. Can’t show the full picture (lack detail) 3. May be misinterpreted Discuss legitimacy theory, focusing on how legitimacy gaps may arise and Legitimacy theory is based on the concept of a social contract. Under legitimacy theory, firms have no inherent or intrinsic right to use resource. Rather this right is conferred by society through a social contract. The contract is implicit or unwritten and reflect the norms or values of society. For instance, society may expect that the firm will not damage the environment. In general, society probably expects the firm to deliver net social benefits, i.e. benefits to society should exceed any social costs imposed by the firm through social and environment impacts. A legitimacy gap – arises where society perceives that the firm has failed to meet the social contract. - This gap presents a threat to the firm, since society could retaliate through customer boycotts, employee strikes and community protests. ultimately, society could revoke the firm’s license to operate. Therefor the firm must address the gap in order to secure its own right to operate. Two strategies which firms can adopt to address legitimacy gaps It may seek to educate the community about actual changes its own behaviour. E.g. a firm which has polluted the environment may disclose that it has installed more efficient technology or is using cleaner, renewable electricity. These actions can be disclosed through various including: the annual report, a sustainability repot, corporate website, paid advertisements The change perceptions by deflecting attention from ‘negative’ news to ‘positive’ news. E.g. firm may produce harmful products such as alcohol (linked to cause kidney failure and domestic violence) or tobacco (linked to lung cancer) while at the same time disclosing donations to charitable organizations. In this case, firms continue producing harmful products but seek to divert attention away from them. lower society’s expectation by arguing that they are unreasonable. E.g. food companies may argue produce items linked to non-communicable diseases such as diabetes. These companies may argue that their products are affordable for consumers with lower income levels and therefore they should be allowed to sell their products in Pacific Island countries with low average incomes. They would argue that it’s inappropriate for expect food companies to produce ‘healthy’ products since they are too expensive for the average consumer. Companies may not change their actual behavior but seek to be associated with an icon or symbol which is positively regarded in society. E.g. in the past alcohol and tobacco manufacturers were able heroes in the mind of society. Therefor society may have perceived those companies as ‘good’ even through their products were harmful to society. The Global reporting Initiative (GRI) is based on 4 reporting principles, which include completeness and inclusivity. Discuss some of the challenges which organizations may encounter in trying to comply with these two principles. The GRL is a voluntary framework which organizations can use to disclose their social and environmental performance Completeness- means that a firm must provide stakeholders with sufficient information to assess its social and environmental performance. Challenging- since it imposes disclosure costs (collecting and reporting information) on the reporting entity. Smaller companies may struggle to absorb these costs and therefore under-report. In addition, it’s impossible to provide complete information when impacts are fully known. E.g. some pharmaceutical companies may have researches or kept hidden/secret. Inclusivity- means that a firm must identify its stakeholders and explain how the report addresses their issues. Organizations may face challenges in identifying their stakeholders. E.g. some stakeholders are physically removed from the organization (e.g. producer in country A, consumers in country B). in extreme cases, manufacturers in one county may be responsible for carbon emissions which contribute to global warming and rising sea levels in levels in low-lying Pacific Island Countries. These stakeholders could also face language barriers if companies report in a language which they don’t understand. Describe 3 limitations of disclosing social and environment performance through financial statement Unjust system Discounting Distance and dispersion Classification Financial accounting is unjust and misleading in the sense that it allows firms to continue reporting profit while also polluting the environment. If firms continue such behavior over a long period, they will eventually have no more profit to report. Long-term liabilities (e.g. restoration costs) are discounted and recorded at present value. This tends to trivialize them and make them appear less significant to user of the financial report. i.e. they are ignored by user. A firm’s social and environmental activities may affect people who not are located far away from the firm (and/ or some of these people may not even realize they are being affected). Therefore it become difficult for firms to report on their social and environment impacts. Items like carbon permits may be reported as asset although they give firms a license to cause pollution. Such a classification may seem quite absurd but it is well within the scope of the conceptual framework. Assume you are studying ANZ sustainability disclosures. Describe the kind of data or evidence you would look for to support the view that the disclosures result from: i) ii) Coercive isomorphism Mimetic isomorphism What is a sustainability disclosure? As defined by the Global Reporting Initiative (GRI), 'sustainability reporting or disclosure is the practice of measuring, reporting, and being accountable to internal and external stakeholders for organizational performance towards the goal of sustainable development' Type Definition Evidence Coercive isomorphism Firms adopt similar practices because Look for evidence that the Reserve they are coerced or forced to do so by an Bank is placing pressure on bank to influential party such as a regulator adopt sustainable practices. This may be found in speeches by the RBF governor or the RBF website etc. Mimetic isomorphism Firms adopt similar practices because Look at when each firms started they tend to copy industry leaders when providing sustainability disclosures faced with uncertainty. e.g. did one bank start providing disclosures first while other started later? a) Briefly outline legitimacy theory and use it to explain three reasons why firms may engage in social and environmental reporting. Brief explanation of legitimacy theory - 3 marks i.e. concept of social of social contract (social expectations) which the firm must fulfil (operate within these bounds) in order to be allowed to continue operating within the community. If not, it may experience a backlash in terms of customer boycotts etc. 3 marks each for any 3 points below. - Actively attempt to change societal expectations, especially to lower the level of expectations. - To highlight the positive activities which the organisation is currently engaged in (i.e. show how it is fulfilling its social contract) e.g. ATH Foundation includes information on donations within its corporate annual report. This also involves educating the public about actual changes in performance and activities. - To deflect attention away from negative activities - The organisation may also create the illusion of caring for society and the environment, while continuing with its harmful activities. E.g. British American Tobacco produces a Social Report but still manufactures cigarettes. b) Discuss whether social and environmental reporting should be voluntary or mandatory in Pacific Island countries Voluntary Advantage - Reduces cost of reporting (can be presented as a disadvantage of mandatory reporting) Disadvantage - Often leads to selective reporting of good news by companies Mandatory Advantage - Force companies to acknowledge negative impacts on society and the environment and seriously consider how to reduce such impacts. - Create greater awareness among readers and society. Disadvantage - No agreement on standards and audit procedures. Large firms are gradually adopting voluntary disclosure of the impacts of social and environmental issues. Required Use both branches of stakeholder theory to explain why firms may engage in voluntary disclosure of social and environmental issues such as climate change [10 marks]. Voluntary disclosure involves providing information that is not mandated by accounting standards, legislation or other regulations that firms are required to comply with. This includes information about a firm’s social and environmental performance. Voluntary disclosures may be provided in printed form including the annual report or stand-alone reports. It can also be disclosed in digital form through company websites and social media platforms. Organizations have many stakeholders including investors, lenders, customers, suppliers, employees, government and the community or general public Stakeholder theory has two branches. - The managerial or positive branch – argues that organizations will only provide voluntary disclosures if they are demanded by powerful stakeholders. This implies not all stakeholders have the same power or influence over decision making. In particular, investors are likely to exert the greatest influence over decision making. Under this branch, organizations will not disclose their impact on social and environmental issues such as climate change unless the controlling shareholders demand it. - The normative or ethical branch- of stakeholder theory is not based no influence but not doing the right thing. This branch argues that organizations should voluntary disclosures because society has a right to be informed of actions that may affect it. Proponents of this branch contend that originations should disclose their impacts on social and environmental issues such as climate change even if powerful stakeholders do not regard this as important. Similarly, they should respond to the requirement of weaker stakeholders. Obviously reporting includes costs so the more an organization discloses, the more costs it would incur. The banking sector occasionally faces allegations of excessive interest rates and unreasonable bank fees. It may also be perceived as failing to support certain groups in the population and certain sectors of the economy. Required Use legitimacy theory to explain some of the strategies that a bank might adopt in light of such allegations Legitimacy theory suggests that organisations may adopt various to regain legitimacy. It may seek to educate the community about actual changes its own behaviour. E.g. a firm which has polluted the environment may disclose that it has installed more efficient technology or is using cleaner, renewable electricity. These actions can be disclosed through various including: the annual report, a sustainability repot, corporate website, paid advertisements The change perceptions by deflecting attention from ‘negative’ news to ‘positive’ news. E.g. firm may produce harmful products such as alcohol (linked to cause kidney failure and domestic violence) or tobacco (linked to lung cancer) while at the same time disclosing donations to charitable organizations. In this case, firms continue producing harmful products but seek to divert attention away from them. lower society’s expectation by arguing that they are unreasonable. E.g. food companies may argue produce items linked to non-communicable diseases such as diabetes. These companies may argue that their products are affordable for consumers with lower income levels and therefore they should be allowed to sell their products in Pacific Island countries with low average incomes. They would argue that it’s inappropriate for expect food companies to produce ‘healthy’ products since they are too expensive for the average consumer. Companies may not change their actual behavior but seek to be associated with an icon or symbol which is positively regarded in society. E.g. in the past alcohol and tobacco manufacturers were able heroes in the mind of society. Therefor society may have perceived those companies as ‘good’ even through their products were harmful to society. Using institutional theory discuss how coercive, mimetic and normative pressure may reduce some of the environment problem associated with prawn farming and forestry in Asia Institutional theory- explains why firms (especially in the same industry) display similar characteristics and adopt similar behavior e.g. isomorphism. Isomorphism Details Coercive This involves a powerful stakeholder such as regulator who can force firms to adopt certain practices e.g. - The Indonesian government may ratify/enforce the convention on international trade in Endangered species. This will force firm to reduce logging since they will be penalized for any breaches - The governments of Bangladesh and the Philippines may enforce and monitor pollution controls with fines for any breaches In this case, firms copy the practices of industry ‘leaders’ e.g. large firm involved in forestry or prawn farming may voluntarily adopt more environmentally friendly practices and begin to market itself as ‘ethical’ or ‘environmentally friendly’. This approach may attract certain investors, customers, employees etc. and force other firm to follow the lead. This relies on the influence of professionals within various organisations e.g. forestry companies may have their own environmental and legal units. These lawyers, environmental scientists etc. may belong to professional bodies or associations their own employers to adopt environmentally friendly or sustainable practices. Mimetic Normative International Financial Reporting standards (IFRS) govern financial disclosures. a) Discuss the core accounting values embedded in IFRS (Hint: Use Gray’s subcultural dimensions) [10 marks]. 1. statutory control versus professionalism – in terms of how IFRS is developed, there is emphasis on professionalism in the sese that standards are developed by the profession 2. uniformity versus flexibility- in terms of standards are applied, IFRS involves flexibility and recognizes differences between organizations. Therefore organizations can use professional judgment to choose alternative policies based on these differences. 3. Conservation versus optimism- in relation to measurement, IFRS is based on neutrality which is neither conservative nor optimistic. However prudence may be closely aligned with conservatism. 4. Secrecy versus transparency- in terms of disclosure, IFRS is based on transparency since it requires firms to provide a wide range of information to the general public. b) Chand and White argue that IFRS for Small and Medium Entities (SMEs) may not be relevant for Pacific Island Countries. Explain the basis of their arguments, citing relevant examples [10 marks]. - SMEs are family-owned and family members can already access financial information about the firm - Banks can demand financial information anyway and may have their own disclosure requiements which could vary from IFRS for SMEs - Not all SMEs aspire to become large firm so they are unlikely to transition to full IFRS anyway - IFRS for SMEs fails to address disclosures that may by relevant for PICs such as disclosure to landowners In the study by Chand and White (2007), accountants in Fiji did not behave in line with these expectations. Outline 3 possible reasons for these findings - Learning effect – through education and work experience, accountants may learn to adopt certain behavior in the work place which is quite different from their cultural values. - Errors in the instrument – the survey instrument may not have been well-designed and/or contained errors. - Incorrect responses- participants may have answered the questions according to what they thought the researchers expected and/or they not have taken the exercise seriously. - Nature of accountants- people may choose to become accountants because their own value are aligned with those of accounting e.g. people who are naturally individualistic. . Discuss three reasons why IFRS may not be useful for SMEs in Pacific Island countries. Comparability Many SMEs do not have stakeholders in other countries so they do not require international standards. One advantage of IASB standards is that they lead to global comparability. However, this issue is not relevant for SMEs in PICs. Understandability IASB standards require certain level of knowledge (i.e. degree level) while many SMEs employ staff with lower qualifications. As such, are likely to have difficulty in understanding and applying the standards. Additionally, the standard of English used in the standards may be another barrier. Users of SME reports are also unlikely to possess the knowledge required to understand IASB standards. Relevance The business environment in PICs is quite different from that of more advanced countries which are influential in the IASB. For example, financial markets are inactive or non-existent, employee benefits are less comprehensive, and ‘related-party’ transactions are quite common and culturally expected/accepted. Pacific Island cultures are generally characterized by larger power distance and low levels of individualism. Given this background, discuss whether accountants as individuals are likely to support or resist IFRS. Resist. As individuals, Pacific Islanders are likely to prefer statutory control, uniformity, conservatism and secrecy. The values are opposed to accounting standards developed under IFRS. Example, IFRS supports transparency through disclosure of more information. It also promotes optimism through the use of fair value measurement. Support. Research has also shown that accountants in Fiji are able to learn and apply values such as professional judgement and flexibility. These are learnt in the working environment and tend to override the cultural values of the individual.
