Revenue, Expense, PSAK 72 and Its Implementation in PWON
REVENUE
IAS 18 : Revenue is the gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
IASB : Revenue is part of the company's income, gain is also a part of income because it has future
economic benefits so that revenue and gain are considered inseparable.
REVENUE RECOGNITION
Revenue has been recognized at several points in the earnings cycle, for example:
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Recognized progressively throughout production
Buat building industry for a long-term contract
Recognized after production finished
Disaat ada kewajiban bagi pembeli untuk ngambil barang
Recognized when goods are delivered
Kebanyakan pakai ini
Recognized when cash received
Proffessional practices (lawyer gtgt) dan installment of credit sales
Kriteria Revenue Recognition :
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Measurability of Asset Value
Viewed as an inflow that increases the value of the total assets of the firm, with a concurrent
increase in equity. Thus measurability of asset value is a reasonable criteria for recognising
revenue.
Existence of A Transaction
When an external party in an arm's-length transaction expresses willingness to pay a given price
for the firm's product, the transaction constitutes objective evidence of an increase in value in
the firm.
Substantial Completion of The Earnings Process
Revenue is not generated until the firm has performed most of the activities for which the firm
earns revenue.
REVENUE MEASUREMENT
Two criteria for revenue recognition :
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It is probable that any future economic benefit associated with the item will flow to or from the
entity
The item has a cost or value that can be measured with reliability.
Provides specific rules for recognition and measurement of different types of revenue :
Sale of Goods
Recognition Criteria for Sale of Goods :
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transferred to the buyer the significant risks and rewards of the ownership of the goods
retains neither continuing managerial involvement to the degree usually associated with
ownership nor effective control over the goods sold
amount of revenue can be measured reliably
probable that the economic benefits associated
costs incurred or to be incurred can be measured reliably.
Exception :
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Percentage of completion method (Construction Contract)
The use of the percentage of completion method for construction contracts is appropriate only
when reasonably reliable estimates can be made of the extent of progress towards completion,
costs, and contract revenue.
At the end of production (Oil Company)
selling barrels of crude might recognize revenue after the oil is packaged and ready for sale,
even if it hasn’t actually been purchased by the end customer
Recognised when cash is received after the sale is made (Cost Recovery Method)
If a company collected 60% of a product’s sale price, it can recognize 60% of total revenue on
that product
Sale of Services
Recognition Criteria for Sale of Services :
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amount of revenue can be measured reliably
probable that the economic benefits
stage of completion of the transaction at the reporting date can be measured reliably
cost incurred for the transaction and the cost to complete can be measured reliably
Other recognition
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Interest shall be recognised using the effective interest method
Royalties shall be recognised on an accrual basis in accordance with the substance of the
relevant agreement
Dividends shall be recognized when the shareholder’s right to receive payment is established
CHALLENGES (ISSUES) FOR STANDARD SETTERS
Development in Revenue Recognition and Measurements :
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Revenue transaction have become more complex
Inconsistency within the IASB framework and some standards related to it
FASB and IASB have proposed some fundamental principles for revenue recognition and
measurement:
o recogning revenues when they arise
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measuring them at fair value at that point
measuring them when they arise from an increase in assets or a decrease in liabilities, at
the fair value of that change
POSITIVE THEORY OF ACCOUNTING POLICY AND DISCLOSURE
There are some observation that couldn’t explained by information hypothesis like :
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Company lobby in relation to proposed accounting standards
Firms made consistent patterns of accounting policy choice that related to characteristic of the
firms
Even before regulation stated the firm to provide their accounting reports, they already done
that.
Consequently, researchers developed a theory built on premises of costly contracting and monitoring.
CONTRACTING THEORY
Characterize the firm as a legal nexus (connection) of contractual relationship among suppliers
and consumers of factors of production. The firm is seen as an efficient way of organizing economic
activity to reduce contracting cost.
Firm are nothing more than a collection of contracts between different parties. Firm also exist
because cost to transact (or contract) will cost less than to do so individually. Example when we want an
ice cream, it will cost less to buy the ice cream directly from ice cream company than buying the
ingredients of the ice cream particularly from different company such as milk, cream, chocolate coating,
etc. In positive accounting, it focuses on two types of contract
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Management Contract
Debt Contract
AGENCY THEORY
An agency contract is one where one party (principal/owner) hires another party (the
agent/management) to act on their behalf. The principal even delegates some decision-making authority
to the agent.
There is no guarantee that the agent will always act in the principal’s best interests. The
difference in interests is an agency problem The agency problem gives rise to agency costs spent to
overcome it:
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Monitoring costs: the cost of monitoring the agent’s behaviour initially borne by the principal
but passed on to the agent through an adjustment to their remuneration (price protection)
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Bonding costs: the cost borne by the agent as an effort to align their interests to the principal or
to guarantee they will compensate principal if they act in a manner contrary to the principal’s
interest
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Residual loss: the loss associated with not being able to fully align the interests of agent to the
principal
Main points of Agency Theory
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Agents perceive that they will not be fully penalised for their divergent behaviour
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They have incentives to act opportunistically
This increases residual loss
In the real world, price protection and settling up are not perfect or complete, resulting in
residual loss being borne partially by the principal as well as (or instead of) the agent
Agency theory attributes a role for accounting
Accounting is part of the monitoring and bonding mechanisms
Accounting numbers are used in contract
Agency Problem
There are two types of agency problem:
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Price protection and shareholder/manager problems
It’s happens because of separation of ownership and management that leads to divergent
behaviour by agents The divergences occur because :
o Risk-Aversion Problem
Risk aversion problem means that agent(s) would prefer lower risk than shareholder.
This caused by:
▪ Different degrees of diversification affecting risk
▪ Limited liability accorded to shareholders
o Dividend-Retention Problem
Dividend retention problem means that agent(s) prefer to pay less dividends than what
shareholder(s) prefer. This caused by:
▪ To pay their remuneration
▪ To build their empire building
o Horizon Problem
Horizon problem means that agent(s) have shorter time to be associated in company
rather than shareholder(s). This caused by:
▪ Shareholders are interested in future cash flows
▪ Managers have a time horizon only as long as they intend to remain with the
firm
These problems could be solved by contracts, as manager remuneration is usually tied to firm
performance in some way to motivate agent(s) to act in the shareholder(s) interest. To maintain
agent(s) performance:
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Using accounting numbers such as sales, profits, return on assets, net asset growth, cash
flow, etc.
By the firm’s share price.
Shareholder - debtholder problems
On this problem, agent is seen as the sole owner of the firm, or has interests that are totally
aligned with the interests of the shareholders. Firm value is the value of debt plus the value of
equity The value of equity can be increased by :
1. By increasing the value of the firm (efficient contracting)
2. Transferring wealth away from debtholders (opportunistic behaviour)
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Excessive Dividend Payments
▪ Reduces the asset base securing the debt
▪ Shareholders have received cash but limited liability protects them from being
personally liable for the debts of the firm in the event of bankruptcy
▪ The debt becomes mispriced
Asset Substitution
▪ Firm invests in higher risk projects to benefit shareholders
▪ This would cause :
• 1. 0 benefit to debtholders
• 2. Share in possible losses
▪ Shareholders are able to diversify and have limited liability
▪ Debt becomes mispriced
Underinvestment
In some circumstances, shareholders have incentives not to undertake positive NPV
projects because to do so would increase the funds available to the debtholders but not
to the shareholders
Claim Dilution
▪ Occurs when the firm issues debt of a higher priority than the debt already on
issue
▪ Increase the fund available to increase value of the firm and the value of
ownership interest
▪ Decreases the relative security and value of the existing debt
Lenders tends to price protect
▪ Through interest rates, the withholding of funds and the length of the loan
The interests of shareholders can be bonded to those of debtholder via restrictions in
lending agreements
▪ Loan covenants
Ex Post Opportunism VS Ex Ante Efficient
Ex post opportunism :
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Occurs when, once a contact is signed, agents take possible actions that transfer wealth from
principals to themselves
Ex ante efficient contracting :
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Occurs when agents take actions that maximise the amount of wealth available to distribute
between principals and agents
Ex ante is done before contracts are finalized
SIGNALING THEORY
Aside of contracting perspectives, there is information perspective. It’s where the managers
voluntarily provide information to investors to help their decision making.
If managers expected a high level of future growth by the firm, they would try to signal that to
investors via the accounts.
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Managers of firm with good result with post their result in the account
Managers of firm with medium result would have incentives to report positive news and only
few bad news
Managers of firm with bad result would have incentives to not to report, but they also have
incentives to report the result to increase their credibility.
The result that the firm will report more than what investor demanded.
POLITICAL PROCESS
Positive accounting theory also models the political process involving the relationship between the firm
and other parties interested in the firm, such as government, trade unions and community groups.
In political market, that there is generally less demand, and therefore less incentive, for the production
of information. High information cost also will arise because in political environment the probability that
one individual’s action will affect that person’s wealth is small.
Often firms try to avoid public attention that is costly to them financially in terms of public perception
and reputation. This resulted some of them reduce their reported profit to prevent any policy that may
charged to them.
Conservatism, Accounting Standard, and Agency Cost
Security Act
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To influence the development of conservative accounting statements.
Traditional (prudent) conservatism in accounting means accelerating expenses and delaying
revenue recognition 'anticipate no profit but anticipate all losses'
Conservatism → asymmetric information requirement that imposes a higher degree of
verification for revenue when compared to expenses and this generally serves to reduce
reported earnings
Valuation system → historical costs; revaluation → not allowed
Internasional Accounting Board (IASB)
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The conservative bias in accounting does not reveal the real financial picture of the firm and
reduces information available to investors.
Recognition of gains as well as losses, are equally important.
Ex ante → discouraging trophy investments
Ex post → discontinuing negative cash flow investments.
Conclude
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Information about FV gains is not as highly demanded because :
o 1. Negative price shocks are the driver for contract renegotiation
o 2. Litigation is always against the non-recognition of loses
o 3. By banks and providers of debt capital
o 4. By restricting gain recognition it place a constraint on the ability of management to
pay out compensation to themselves/shareholders
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Accounting principles that reduce the reported income reduce the manager’s ability to report
opportunistic accounting figures. Therefore, probability of managers and auditors being
sanctioned increases (decreases) the less (more) the reported income accelerates and/or
increases
EMPIRICAL TEST OF THEORY
TESTING THE OPPORTUNISTIC AND POLITICAL COST HYPOTHESIS
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Political cost affect only the largest of firm. Based on how they reduce their profit to avoid any
policy by the government for them
Managers make individual accounting policy choices that increased profit as they come closer to
breaching their debt covenants
TEST USING CONTRACT DETAILS
There are limits for management bonuses in bonus plan such as Lower and Upper limit. Lower
limit are set to make management work harder to achieve better profit. Upper limit are set by
shareholder to make the profit at sustain level.
REFINING THE SPECiFICATION OF POLITICAL COST
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Accounting policy and estimates might be used to manage profit downwards
During election campaign, managers tend to manipulate their accounting reports to increase
their chance of winning the election even it’s not align with cash-flow
TESTING THE EFFICIENT CONTRACTING HYPOTHESIS
Focuses mainly on the efficient selection of accounting procedures that is accounting decisions
that are made up front by management and claim holders on the firm to reduce the agency cost of
contracting
INTEREST CAPITALISATION
Example in real estate firm that finance projects by project-specific loans are more likely to
capitalise interest and expense it to their customers so they bears the risks of the project. This interest
capitalisation will increase managers bonus awards and would save time in negotiation with auditors
and customer’s cost investigators
CHANGES IN CHIEF EXECUTIVE OFFICER
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In their final years of office CEO tend to improve short-term profit performances by cutting back
R&D expenditures (Vice versa)
Management contract can balance share-based and profit-based incentives to ensure attempts
to transfer wealth from shareholder to manager are ineffectual thus accounting and other
contracting terms can reduce agency cost when the incentives for opportunism are strong
EVALUATING THE THEORY
METHODOLOGICAL AND STATISTICAL CRITICISM
A major criticism of positive accounting theory is that the empirical evidence is weak and inconclusive
METHODOLOGICAL AND STATISTICAL CRITICISM
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The explanatory variables in some studies are insignificant and not of the predicted sign
Predictive power (R^2) of hypothesised models is low
Crude measures (such as firm size) to operationalise political costs are not well defined in a
theoretical sense nor in a measurement sense.
One of researcher extend the sample of previous research and they found deterioration in
predictive power of the model.
PHILOSOPHICAL CRITICISM
A researcher stated that positive accounting theory is not accounting theory but human behaviour
theory (sociological approach) ● Positivism is no longer taken seriously ● Does not prescribe and
therefore doesn’t provide a means to improve accounting practices. ● Contrary to its claim. Value-laden
ISSUES FOR AUDITORS
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The demand for auditing can be explained by agency theory as part of the monitoring and
bonding activity and costs
Accounting numbers are used in contracting to determine management compensation and as
the basis of debt covenants. These accounting numbers are required by law to be audited.
Auditing is now a legal requirement, but there is evidence that auditing was voluntarily
undertaken in the past
DeAngelo: “larger auditor are higher quality auditors because they have more to lose” ●
Research shown that higher quality auditors are demanded in situations where clients wish to
signal that their account are of higher quality or where there are severe agency conflicts or weak
control mechanisms
Industry specialist auditors are able to demand higher audit fees, because clients will choose
industry specialist auditors in the cases where the risk on that part is high, example: clients will
demand R&D contract with specialist auditors when firms have highly discretionary
expenditures on R&D growth options. The auditors will provide assurance that the expenditure
on the R&D growth options is reported correctly, and therefore, the risk of underinvestment is
lower
Capital Market Research
Philosophy of Positive Accounting Theory
Has an economic focus and seeks to answer such questions as:
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What are the costs and benefits of using alternative accounting methods?
What are the costs and benefits of regulation and the accounting standard setting process?
What is the effect of reported financial statements on share prices?
Which accounting valuation models are superior in predicting future prices, returns, earnings, or
cash flow?
Managers have discretion to choose accounting policies that directly maximize their utility (selfinterest)
or to alter the firm’s financing, investment and production policies to indirectly maximize their selfinterest
Strength of Positive Theory
Dissatisfaction with prescriptive standards
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Prescriptions not based on upon identified, empirical observations or method
Normative Standards
Theories are not falsifiable
Do not explain and predict accounting practice
Do not assess existing accounting practices
Scope of Positive Accounting Theory
Development divided in two stages
First Stages
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Research into accounting and the behavioral of capital market
Efficient market hypothesis and capital asset pricing model
Second Stages
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Explain and predict accounting practices across the firms
Two central focus in second stages is particular accounting choices for opportunity reasons and
firms select accounting practices for effective reasons
Capital Market Research and Efficient Markets hypothesis
Importance of Capital Market Research in Positive Accounting Theory
1. It attempts to determine the impact of release of accounting information on share return
2. It considers the effects of changes in accounting policy on share prices
Efficient Market Hypothesis reflect microeconomics price theory ( demand and supply of information in
market ) Assumption of Efficient Market
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There are no transaction costs in trading securities
Information is available cost- free to all market participants
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There is agreement on the implications of current information for the current price and
distributions of future prices
Three form of efficient market hypothesis
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Weak
o Security’s price fully reflects past price information
o Cannotprofit from price cycles
Semi strong
o Security’s price fully reflects publicly available information
o Cannotprofit from trading strategies
Strong
o Security’s price fully reflects all information include non public information
o Cannotprofit in all way
Capital Market Research - Empirical research which uses statistical method to test hypotheses
concerning capital market behavior .
Market model - Model that used to research of the share prices and returns in effect of both market
wide and firm specific events
Assumption that used in Market model
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Investors are risk averse
Return are normally distributed and investors select their portfolio on this basis
Investors have homogeneous expectation
Markets are complete
Abnormal return in market model - Abnormal return derived from market model of residual error
variable( firm specific factors) that being concerned by capital market researchers
Impact of Accounting Profits Announcements on Share Prices
Direction
Determine the information content that accounting profit had for the stock market.
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Normative theorists : historical cost profit is meaningless
Study by Ball and Brown tested the usefulness of the historical cost profit figure to investment
decisions
Arguments :
o If the information contained in profit figure were useful and informative, then share
prices would adjust to reflect that information. -- In a ECM, this will occur before, or
very quickly after, the profit figure is released.
o Unexpected increases in profits represent new information for the market.
Implications of Ball & Brown (1968) Results for Financial Accounting Theory
1. There was significant information content in the historical profit figure
2. There was a continuous release of information to the market
3. Market was reasonably consistent in anticipating the information in accounting reports
Magnitude
If an accounting profit release has information content, the magnitude of abnormal returns will be
related to the magnitude of unexpected profits. (Beaver, Clarke, and Wight)
Information Asymmetry and Firm Size
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The smaller the firm, the more informationis contained in accounting reports. (Differential
Information).
The incentive to undertake research for mispricing is greater for large firms.
Liquidity and contractual constraints drives the trading in large firms.
Grant : the reaction of the market to annual profit announcements was greater for smaller OTC
firms
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Freeman :
o Large firms provide a greater variety of information
o Larger firms have a higher degree of exposure
o Security prices of large firms reflect profit information earlier
Magnitude of Profit Releases from Other Firms
‘Information Transfer’ Research Unexpected profits for one firm in a particular industry would transfer
across the industry.
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Foster : The variance of abnormal returns for competing firms increased when another firm in
the same industry made a profit announcement.
Clinch and Sinclair : The last firm in the industry to announce its profits, had the smallest share
price reaction
Freeman and Tse : The association between late announcers’ price reactions and early
announcer’s news was strongest for those with the highest profit correlations
Volatility
If there is information content in profit announcements, larger price changes on the announcement date
should be expected.
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Grant : OTC firms experience a greater variance of abnormal returns than NYSE firms at
announcement date
Accounting becomes more important as the size of the firm decreases and access to other
information reduced.
Association Studies and Earnings Response Coefficients (ERC)
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Accounting profit does capture a portion of information set that is reflected in security returns
Competing sources of information pre-empted annual profits information by about 70-85%.
Annual accounting figures are not timely.
Association Studies : measure the impact of accounting measures on share prices over a longer
event window (1 year or longer)
ERC is found by an ordinary leastsquares regression with returns as the dependent variable and profits
as the independent variable.
The informativeness or valuerelevance of profits is assessed by R2 and the slope coefficient (ERC).
Factors which can affect the ERC:
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Risk and Uncertainty
Risk (beta) negatively affects the ERC. Uncertainty affect either the expected future economic
benefits or the discount rate.
Audit Quality
Audit firm quality are positively related with audit firm size and specialization. Qualified reports
and SEC sanctioned auditors lead to lower ERC.
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Industry
Firms within a particular industry should be homogenous in terms of outcome uncertainty.
Industries with the greatest outcome uncertainty would have the greatest ERCs
Interest Rates
Collins and Kothari : ERS and the risk free rate of interest maintain temporal negative
relationship.
Financial Leverage
Jeter and Chaney : negative association between ERC and leverage (DER) Default, maximum
debt, and optimal leverage theorem.
Firm Growth
Expected growth (Market to Book Value ratio) is positively related with ERC.
Permanent and Temporary Profits
If an amount of unexpected profit was expected to persist, abnormal returns would be
expected. (Positive relationship)
Non-linear Modelling
Freeman & Tse : an Sshaped arctan relationship with increased ERC and higher R2
Disaggregating Profits
Direct estimates of return reactions to component shocks were positively associated with
persistence measures across components. Alternative : decompose profits into cash flows and
accrual components.
Cash Flows
Early research provided inconsistent results, but should be added as an additional explanatory
variable for price. Sloan : significant economic profits can be made from investing in a hedged
portfolio of high and low accrual firms.
Balance Sheet and Its Component
Ohlson : Balance sheet together with profit, provides a higher proportion of the explanatory
power for price (up to about 70- 75%)
Trading strategies
Post announcement drift
Found by Ball and brown and Ou and Penman’s deviation of a trading rule
Post announcement drift occur where abnormal returns continue after a profit announcement ,
so that the information content within the profit announcement is not fully incorporated into share
price at the date of announcement
Ou and Penman examination
Current year’s financial statement accounting information could be used to forecast the sign of the
following year’s profit ( this examination result of return 12,6% market adjusted in 2 year holding period
Reasons behind predictability abnormal return after announcement has become significant issues
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The magnitude of it is daunting
The anomaly is ubiquitous
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Anomaly is scientifically indisputable and has been replicated consistently and with increasing
precision
The anomaly implies that shares market grossly fail the test of competitive economic theory
Anomaly challenges the underlying of most models in modern financial economics
Sloan studies in long horizon
The market behaves naively in that it takes the optimistic forecast at face value.
Profit manipulation related
Market fails to recognise profit manipulation that inferred in the basis of predictable subsequent
negative long horizon price performance
Implication to financial analyst
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Affiliated analyst vs unaffiliated analyst
Profit figures used by financial analyst
Winner / losers and overconfidence
Shares that produce extreme positive or negative returns tend to be reversed in position in the future (
long term horizon )
Mechanistic or behavioral effect
Market reacts mechanistically to changes in accounting numbers, regardless of whether they are
cosmetic or have cash flow implication. This theory implication means that cosmetic accounting can fool
market participant
‘No effects’ Hypothesis
Market ignores accounting changes which have no cash flow consequences . means that cosmetic
change in accounting that had no effect of cash flow does not produce abnormal return
Manipulating accounting numbers
Detecting the quality and probability of accounting management
Sloan and other findings
The manager cosmetic changes of accruals affect the share price. The market as whole does not
have sophisticated of accruals, and hence overreacts to positive income - increasing accruals .
Issues for auditors
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Qualified audit reports and SEC sanctions against auditors create signalling about lower quality
of earnings and lower earnings response coefficient
The firm that audited tend to have lower cost of capital than the same firm that not audited
Changes auditor to big audit firms create a lower cost of capital
The share price of client’s auditor if the audit firm filled with extraordinary cases
Reasons for firms that have lower cost of capital when used big audits
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Investors value either the quality of audit work and/or the insurance protection that the big
audit firms provided
The company is perceived as good investment by investors , and can provided to choose big
auditors
Other factors outside the choice of auditors and lower cost of capitals that affect the investor
perception about the compan
Behavioral Research in Accounting
Definition and Scope
Why Behavioural Accounting Research is Important?
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Provides valuable insights into the ways different types of decision makers
Provides useful information to accounting regulators
BAR leads to efficiencies in the work practices of accountants and other professionals
Development of Behavioural Accounting Research
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1954
o Human judgement theory research started
1967
o The term BAR appeared
Last 30 Years
o Explosion in BAR:
o Auditing
o Importance of judgement
o Brunswik lens model
Three major research approaches
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Brunswik Lens Model
o The dominant approach
Process Tracing
o Build representative decision trees
Probabilistic Judgement
o How do people actually use and process accounting information
Brunswik Lens Model
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Used as an analytical framework and the basis for most judgement studies
o Prediction
o Evaluation
Used to investigate the relationship
o Multiple cues and decisions
o Judgements or predictions
Usually has good predictive powers
o Removes much of the random error due to human things
Valuable insights Provided by Brunswik Lens Model
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Patterns of cue use evident in various tasks
The degree of insight decision makers posses regarding their pattern of use of data
Weights that decision makers implicitly place on a variety of information cues
The consistency of human judgement over time
The relative accuracy of Decision makers of different expertise levels in predicting and
evaluating a variety of tasks
The circumstances under which an expert system and/or ‘model of human behaviour’
outperforms humans
Process Tracing Methods
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Decision maker be given a series of case studies to analyse but asked to verbally describe each
step gone through when making the decision.
These verbal descriptions are recorded by researchers and then analysed to produce a ‘decision
tree’ diagram to represent the decision processes of decision maker.
Hypothetical decision tree for a bank loan officer
Not always a good predictors of the event of interest because decision makers often have
difficulty explaining all the steps they go through for tasks that decision makers do routinely and
often the task become familiar that the decision processes are implicit and unconscious.
Classification and Regression Trees (CART) is combination of the lens and process tracing
methods to overcome the general limitations of both.
CART uses statistical methods to partition (or split) the output of a decision maker’s judgements
into decision “nodes” that maximise the power of the model to correctly predict the
classification of different cases into the right type of decision
Probabilistic Judgment
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Useful for looking at situations in accounting where initial beliefs about prediction or evaluation
once further evidence becomes available.
Correct way to revise initial beliefs is by applying Bayes’s theorem.
Accountants and auditors invoke a series of ‘rules of thumb’, because of the complexity of the
types of judgements they need to make and their own information-processing limitations.
The use of rules of thumb or biases simplify judgement tasks, represent an efficient and
effective method of dealing with complexity and the limitations of human cognitive process
Lens Model Studies -- the evidence
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Examine the accuracy of humans’ predictions of business failure.
Model of human behaviour is developed using a mathematical representation of an individual’s
pattern of use of the cues to analysis of the consistency of judgements and compare prediction
to human.
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The information overload literature has implications for the presentation and disclosure issue in
financial accounting, it provides evidence of lower consensus and lower decision-making
consistency for individuals experiencing overload.
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As the amount of information increases, initially the use of and integration of the information
increases.
Beyond some point, additional information results in a decrease in the amount of information
integrated into the decision-making task.
The judgement confidence literature found that both expert and non-expert subjects are
overconfident of their ability in specific judgement tasks.
Stem from these factors
o Tendency for humans to seek out and overweight positive feedback
o Limited nature of feedback in many instances (e.g. in failure or distress prediction of the
correctness of a decision not to lend is rarely evaluated)
o Interdependency of actions and outcomes (e.g the act of lending/not lending itself
influences success or failure)
Sums of the findings: (Libby)
In many important decision-making situations, the environmental predictability of available
information is low. However, even in situations where environmental predictability is relatively
high, poor judgemental achievement is the norm.
Both human inconsistency and misweighting of cues contribute to the poor achievement.
Combining quantitative information in repetitive tasks does not appear to be a function that
people perform well. Thus, in these situations, replacing people with models (e.g. environmental
regression models, models of man, and equal weighting models) shows promise for increasing
predictive accuracy.
Process Tracing Studies – Evidence
Brunswik lens models and process tracing style are different technologies with the same objective of
modelling decision processes as completely as possible
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Brunswick lens model
treat the decision process as a simple linear combination of the information cues
Process Tracing
generate a decision tree that comes from acknowledging the step-by-step nature of decision
making, in which the information content of one piece of data interacts with another pieces of
data
The majority of these studies conclude that the Brunswik lens assumption is justified, but there is
evidence to suggest that the Tracing Process method is a favorable modeling technique for representing
decision making in some contexts. → because studies in business context found evidence of statistically
significant interactions between information items
This has also been studied by Larcker and Lessig (LL), and Selling and Shank (SS), where:
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LL found that tracing process models outperformed the statistical liner models
Meanwhile SS found that when two approaches were compared in a task involving the
prediction of backruptcy.
This reflects that the types of decision tasks require different decision processing styles. As always, the
complexity of human decision making means more in-depth research is needed, to understand what
types of decision task characteristics determine the most appropriate information processing style
FORMAT AND PRESENTATION OF FINANCIAL STATEMENTS
3 Options for Improved Decision Making
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Changing the presentation and amount of information
Educating decision makers
Replacing decision makers with a model of themselves or with an ideal cue-weighting model
WHY? Surprisingly little research has been undertaken in ascertaining ideal accounting presentation
formats The studies have tended to examine radical changes to financial statements presentation in the
form of multidimensional graphics
The lens model
changing the format of the information report results in an increase in one of the characteristics above,
so that the accuracy of human judgment will increase
Chernoff faces representing changes in financial condition
The faces are constructed by mapping transformed variable onto facial features. Mathematical precision
in term of nose length, brow angle, and mouth curvature, is used to represent changes in financial
position from one period to the next
Conclusions? MIXED RESULT
This finding is of concern in today's era when many companies are turning to the internet and
multimedia-style (graphic oriented and more colour) presentations to communicate with stakeholders.
No well developed and tested theory
PROBABILISTIC JUDGEMENT STUDIES – EVIDENCE
Three rules of thumb (heuristics) :
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Representativeness
items that are viewed by the decision maker a being more representative will be assessed as
having a higher probability of occurrence than those that are less representative
Availability
the assessment of the probability of an event based on the ease with which instances of that
event come to mind.
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Anchoring and Adjustment
general judgement process in which an initially generated or given response serves as an
anchor, and other information is used to adjust that response. the consequence is the possibility
of insufficient adjustment in the light of changing circumstances
Representativeness: The Evidence
When judging the probability that a particular item comes from a particular population of items,
people’s judgement will be determined by the extent to which the item is representative of the
population
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Availability
The assessment of the probability of an event is based on the ease with which instances of that
event come to mind
Anchoring and adjustment
An initially given response serves as an anchor, and other information is used to adjust that
response
Expert Judgement
The research involving experts judgement is concerned with examining the thought processes of
experts and the determinants of expertise
Accounting and Behaviour
Accounting exists as a direct function of the activities of individuals or groups of individuals (defined as
accounting entities).
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Accounting is a direct function of human behaviour and activity → influence behaviour both in
methods adopted to measure and report information, and in response to the information
disclosed.
Accounting no longer seen as mere assembly of calculative routines, it now functions as
cohesive and influential mechanism for economic and social management. (Burchell et al.)
Accounting system is a fundamental component of organisation’s architecture, with senior
managers consistently seeking to adapt the architecture to ensure the best structure of the firm.
(Zimmerman)
Factors affecting accounting system (Zimmerman):
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Accounting information affects the behaviour of individuals both within an entity and external
to it and the influence is two-way
Limitations of BAR
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Frequent contradictions between the findings of similar studies. It means that human
information processing is far more complex than the development of current research theories
and methods.
Maines argued:
o Studies on the same topic have produced conflicting results, preventing conclusive
guidance for policy decisions.
o The experimental subjects and settings used in these studies often differ from those
found in real judgment settings.
o Accounting researchers have questioned whether policy should be influenced by
research on individual decision makers.
Major limitation of BAR is lack of single underlying theory to unify diverse research questions
and findings. BAR researchers have borrowed from a multitude of disciplines and contexts and
have no common framework.
A single theory is unlikely in the foreseeable future.
Issues for Auditors
Industry specialist auditors outperform other auditors when they are in their specialist industry
environment. There are complex interactions between experience and context in auditors’ reporting
decisions Investors react as though they perceive auditor independence is impaired when auditors
receive non-audit service revenue from their audit clients even if actual auditor independence is not
affected
Standard Setting: Economic & Political Issues
Standard Setting: Economic Issues
Regulation
Information as a Commodit
Demand = Information demanded by decision maker
Supply = Information supplied by firms, managers, analysts, media.
Two Incentives for Firms to Produce Information
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Private Incentives
o Market forces motivate firms to produce information
Regulatory Incentives
o Information production required by regulation
In practice, firms face a mixture of private and regulatory incentives to produce information
Two Types of Information
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Proprietary Information
o information that if released, would directly affect future cash flows of the firm.
Non-Proprietary Information
o Information that, if released, does not directly affect firm cash flows
Ways to Characterize Information Production
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Finner Information
o Expanded note disclosure
o Additional line items
Additional Information
o Current value accounting
o MD&A
Credibility
o Audit increases financial statement credibility
First-Best Information Production
Amount that equates the marginal social benefits of information production to the marginal social costs
of information production.
Benefits
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Better-informed investment decisions
Possible lower costs of capital for firms producing the Information
Better-working markets due to greater investor confidence resulting from lower adverse
selection and moral hazard
Reduction of monopoly power
Cost
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Direct costs (preparation, releasing)
Possible release of proprietary information
Possible increased contracting costs
A Closer Look at Market-Based Incentives
The Disclosure Principle
“ A simple argument can be made that suggests that a manager will release all information, good or
bad.”
Signalling
to signal investors their company is better than the others
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Accounting - relevant signals (can be multiple signals)
o Accounting policy : the conservative, the better
o Audit quality : the higher quality auditors hired, the better
o Capital structure : the less shares issued, the better
o Dividend policy : double edged sword
o Forecast : the higher quality good news forecast, the better
o Regulation destroys ability to signal
A signal is an action taken by a high-type manager that would not be rational if that manager was low
type
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High type vs low type
o High types want to separate from low
Crucial aspect of a signal
o Must be less costly for high types to signal
Diversity may not be as bad as it suggested
o Diversity of reporting practices is desirable
Private Information Search
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Investors have incentive to search for information
o Complements information production by firms
o By limiting the time available to insiders to capitalize on inside information, the severity
of the adverse selection problem is reduced
Socially very costly
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Wasteful efforts for the same information
Less wasteful if search affects cost of capital
Hirshleifer (1971) : Society can benefits from private information search if private
information goes public
Market Failure in the Production of Information
EXTERNALITIES
An action taken by a firm or individual that imposes costs or benefits on other firms or individuals for
which the entity creating the externality is not charged or does not receive revenue.
FREE-RIDING
is the receipt by a firm or individual of a benefit from an externality at little or no cost.
How Much Information is Enough? No one Knows, Given these complex cost-benefit considerations, we
simple do not know how much regulation is enough. Numerous market-based reasons why firms want
to produce information. But, numerous sources of market failure also
The Adverse Selection Problem
There are two version of adverse selection problem:
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The problem of insider trading Insiders, including managers, generate excessive profits
by trading on the basis of their insider information.
A second version arises when managers who are privy to bad news about the firm’s
future do not release that information.
The Moral Hazard Problem
Moral hazard occurs when an entity has an incentive to increase its exposure to risk because it
does not bear the full costs of that risk. Moral hazard can occur under a type of information asymmetry
where the risk-taking party to a transaction knows more about its intentions than the party paying the
consequences of the risk.
Unanimity
A characteristic of economies with markets that don't work well is a lack of unanimity, that
derives from the effects of adverse selection and moral hazard. Blazenko and Scott (1986) : While the
firm manager was motivated to choose an audit quality that would maximize firm market value, all
shareholders would prefer a higher-quality audit. The shareholders’ reason is a higher-quality audit will
add credibility to the firm’s financial statement and it will provide a form of insurance.
Standard Setting: Political Issues
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From an economic perspective, the question of the extent of regulation of accounting and
reporting standards is unsettled.
Information asymmetry (and the resulting problems of moral hazard and adverse selection),
which creates the demand for information production by firms, also created a demand for
regulation of that information production.
This is because of the problem of unanimity that may result in investors to push for regulation to
remedy the perceived deficiency.
To understand regulation of information production, we must look at political aspects as well as
economics.
Conflict and Compromise
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Amendment “Prudential Oversight of Accounting Principles and Standards that Pose Systemic
Risk”
The American Bankers Association supported the amendment
Strong objection by other constituencies.
The amendment was withdrawn and replaced.
Distribution of the Benefits of Information, Regulation FD
a complication of standard setting is the distribution of the benefits of information production
among interest groups. Questions of the distribution of economic benefits are difficult, since they also
involve value judgments of fairness among affected parties. Consequently, maximizing the pie is not the
only consideration that standard setters face. Value judgments about who is entitled to property rights
arise because individual utilities cannot in general be aggregated into a social preference ordering
Criteria for Standard Setting
Decision usefulness
the empirical value relevance studies, the more informative about future firm performance an
information system is, the stronger will be investor reaction to information produced by the system.
Economic consequences
standard setters should weigh the possible economic consequences of new standards as an
important source of cost that will affect both the need for the standard and the willingness of
constituencies to accept it.
Reduction of information asymmetry
market forces operate to motivate management and investors to generate information.
Standard setters should be aware of these forces
Consensus
Standard setters, in effect, must engineer a consensus sufficiently strong that even a
constituency that does not like a new standard will nevertheless go along with it
Regulators Information Asymmetry
More recently, the theory of regulation has formally recognized that, like everybody else, the regulator
faces information asymmetry—much of the information needed by the regulator, such as financial
information
International Integration of Capital Markets
Effects of Customs and Institutions on Financial Reporting
Code law countries
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Greater influence of families and banks in corporate governance than in common law countries
Lower moral hazard problem
Shows up as less timely and less conservative reporting, even if country has adopted IASB
standards
Implication that investors should be aware of local practices and customs when interpreting financial
statements, even if country uses IASB standards
Role of Auditor
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Even high quality standards must be enforced
Protection of small investors
Auditors may be under great pressure from controlling interest
Benefits of high quality accounting standards
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Adoption of high-quality accounting standards is potentially worthwhile, since economies with
relatively weak regulatory environments may benefit from higher-quality reporting and
consequent strengthening of their capital and managerial labour markets
Many research about benefits of adopting high quality accounting standards is good for market
Contemporary Issues in Accounting and Auditing
Sustainability and Environmental Accounting
Sustainability accounting is a subset of social accounting Social accounting as a combination of
accounting for different things, in different media to different users, for different people Social
accounting and reporting aims at observing and assimilating issue not necessarily covered by the
traditional accounting function into a form that can be used for decision making by individuals not
necessarily directly or only concerned with the financial success of the entity.
Sustainability can be regarded as meeting the needs of the present without compromising the
ability of future generations to meet their own needs environmental protection and justice between
peoples and generation
Recent development in sustainability reporting
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Global Reporting Initiative = an independent international organization that has pioneered
sustainability reporting.
The GRI Guidelines form the basis of the sustainability disclosure framework and contain
principles and guidelines plus catch standards for all types of organizations
Sustainability reports also increasingly being audited or reviewed by independent auditors.
o More credibility = seek more assurance
o Little authoritative guidance
Trends in sustainability reporting assurance
an important ingredient in the usefullness of company financial report is independent assurance
of the reports independent assurance provides confidence to stakeholders about the credibility,
relevance, and reliability of the reports. Some companies are now seeking assurance for their
sustainability reports
different betweet audit and review
Audit: Provides a reasonable level of assurance
Review: provides only a limited level of assurance
Why seek assurance for sustainability report
Auditing is argued to provide benefits by increasing the credibility of management-prepared
financial statement and improving the quality of an entity's accounting system based on feedback from
the auditing process. Applying that theory to sustainability assurance suggest that companies with the
most to gain from increasing the credibility of their reports are more likely to seek assurance
Sustainability assurance standards
there is limited authoritative guidance for assurance engagment on sustainability reports and
carbon emissions information. ISAE 3000, Assurance Enggagements Other that Audits or Reviews of
Historical Financial Information provides some general guidance but does not addres specific issue in
sustainability and carbon emissions reports. aa1000as provides guidance on sustainability assurance
reports that evaluate an entity adhere to the AA1000 Acountability principle and the quality of publicly
disclosed information on sustainability performance
Corporate reporting on the SDGs: what are the challenges and opportunities?
Improving Data Quality and Addressing Gaps
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Deeper Connections
o Overall, deeper connections between material topics with SDG targets and corporate
priorities are needed.
Opportunities
o There are opportunities to further explore the links between SDG priorities and the
contributions of companies in the countries and jurisdictions where they operate.
Positive Contributions
o Corporate reporting on the SDGs often focuses on positive contributions that companies
make to the SDGs, with a lack of transparency and accountability for negative impacts.
Reporting That Has Impact
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SDG Priorities
o Identifying SDG priorities throughout the value chain is a complex undertaking, as is
demonstrating the cause-and-effect relationship between SDG contributions and
business performance.
Challenge
o Moreover, because of the interconnected and interdependent nature of the SDGs,
companies need to identify and take account of synergies and trade-offs between
positive and negative impacts.
Challenge
o Efforts to quantify impacts on the SDGs and contextualize them (for example,
considering the social thresholds and planetary boundaries) needs strengthened.
Move Beyond
o That is why it is necessary to move beyond assessing activities and outputs, and focus on
how to disclose outcomes and impacts.
Crucial
o This is crucial as it enables businesses to manage their performance and demonstrate
accountability for their impacts.
Making Reporting Relevant to Stakeholders
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Opportunity
o There is increasing interest from a wide range of stakeholders in business contribution
to the SDGs, including how companies are aligning products, services and business
strategy with the SDGs.
Opportunity
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Policy makers, investors, consumers, labor organizations and civil society all increasingly
demand that companies show transparency through providing quality data and
balanced reporting.
Challenge
o Different stakeholders have different expectations and data requests. Business can take
to provide more strategic and relevant information
Developments Related to the Use of XBRL in Digital Financial Reporting
XBRL (EXTENSIBLE BUSINESS REPORT LANGUAGE)
Universal electronic communication languange that is used for the transmission and exchange of
business information.
Allows financial information to be presented in an interactive way that in turn allows individual
items of data to be extracted by software to produce reports custom designed by individual users.
WHY IS XBRL APPLIED?
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Improving the efficiency, comprehensiveness, and reliability of data collection process.
Increasing the competitiveness of the data products offered by stock exchange to investors.
Improving the information's transparency and quality
WORKFLOW OF XBRL
Benefits of XBRL
XBRL Development in Indonesia Stock Exchange
Issues Related to XBRL
Whether the current auditing approach of reconciling a paper version of XBRL-related
documents to the information in the official SEC filing is sufficient.
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Plumlee and Plumplee suggest that the provision of XBRL information is an extension of the
traditional reporting paradigm that will alter the way financial and non-financial data can be
used.
This paradigm shift requires auditors to consider much deeper questions than mere
reconciliation of output. These questions include: What constitutes an error in XBRL What does
materiality mean when individual pieces of financial data will be used outside the context of the
financial statements?
Materiality is traditionally assessed as the impact of users' decision, and quantitative guidelines
suggest that the item is to be considered in an isolation and in aggregate, and in proportion to
the relative base, such as profit. If the data are accessible in isolation or in new combinations,
these materiality guidelines cannot be interpreted in the same way.
Plumlee and Plumlee join Haka in calling for more research to understand the advantages and
disadvantages of XBRL and its impact on the future of financial reporting and auditing
The Development of Earnings Management Research: A Review of Literature From Three
Different Perspectives
Earnings Management
Purposeful intervention in financial reporting, designed to reach earnings targets by varying
accounting practices. However, it is an action which takes place without necessarily violating accounting
regulations, and which takes advantage of the possibilities of choice in accounting policy. The action may
mislead stakeholders, causing them to make decisions on the basis of financial re-ports that they would
not have made otherwise.
The Developments From Three Main Perspectives
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Chronological
o The evolution of earnings management and determining the most key milestones in
understanding the phenomenon of earnings management.
Methodological
o Focuses on the problem of measuring earnings management, and the development of
new ways to detect and measure earnings management.
Cross-country
o The evolution of interests on issue of earnings management from the point of view of
the origin of the sample (the country of origin of the sample).
Chronological Perspective
Study of Jones (1991)
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She uses discretionary accruals as a measure for the scope of earnings management. It is a
different, much more precise methodology, as the previous studies used total ac-accruals as a
proxy.
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She separates the total accruals on the discretionary part (manageable) and non-discretionary
(nonmanageable) part of accruals
Her study tests whether firms that would benefit from import relief (for example, tariff
increases and quota reductions) attempt to decrease earnings through earnings management
during import relief.
It is also a new insight into the development of earnings management literature. Her results of
empirical tests reports support the initial hypothesis suggesting that managers make incomedecreasing accruals during import relief investigations.
Earnings management is an issue which has been influenced by many factors and circumstances.
Different topics on earnings management have been shown which are related to the present
situation of the markets, such as:
o Why managers manage earnings
o Which factors may influence the managers’ decision to opt for earnings management
o How effectively they measure the manipulation
o How the concept is defined.
The major intensification of studies is between 2006 and 2010. Moreover in the previous five
years (2001–2005) the tendency on improvement on research on earnings management was
also observed.
All these investigations lead to underlining the importance of reporting information and the
strong demand for quality information.
Methodological Perspective
McNichols (2000) distinguishes three main research designs commonly used in the literature:
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Aggregate accruals
o Attempt to identify discretionary accruals based on the relation between total accruals
and hypothesized explanatory factors.
Model a Specific accrual
o Focus on industry settings in which a single accrual is sizable and requires substantial
judgment.
Examine the statistical properties of earnings
o Focus on the behaviour of earnings around a specified benchmark, such as zero or a
prior quarter’s earnings, to test whether the incidence of amounts above and below the
benchmark are distributed smoothly, or reflect discontinuities due to the exercise of
discretion.
Possibly the main advance in measuring earnings management is provided by Jones (1991).
Her model is still one of the most popular accrual estimation models in earnings management
research. She relaxes the assumption that non-discretionary accruals are constant.
She estimates nondiscretionary accruals as a regression which includes change in sales and the
level of property, plant and equipment as explanatory variables. Later studies demonstrated and
explained some limitations of the Jones model.
This perspective is related to the use of different models to detect earnings management
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We pointed out the important limitations of the different models to help future researchers opt
for the most appropriate model for their particular research environment, as the perfect model
for measuring earnings management does not exist.
Authors increasingly tried to use other metrics for measuring the discretionary part of accruals
Country Perspective
The country analysis is a new perspective presented. This section comprises a very useful set of
country of origin bibliographical references for earnings management investigators. Leuz et al. (2003),
for example, state that earnings management is more pervasive in countries where the legal protection
of outside investors is weak.